CHRG-110hhrg46591--143 Mr. Price," Thank you, Mr. Chairman. I am not sure how my running shoes are these days, but I will give it a try. I want to thank each of you for your comments. And I want to have you speak specifically about the issue of regulation, deregulation. Each of you mentioned in varying degrees of certitude that the issue wasn't whether or not we had more regulation or less regulation; it was that we had the right regulation. There seemed to be some, however, who still hold to the notion that there was this fanciful groundswell of deregulation that was the cause and genesis of our current situation. I have heard that the situation regarding the lack of regulation, or appropriate regulation, was due to resources, personnel, sense of urgency, lack of flexibility, all those kinds of things. I wonder if each of you would comment very briefly about this notion that it was deregulation that was the cause of where we are right now. Ms. Rivlin? Ms. Rivlin. I don't think it was so much deregulation as failure to recognize that the markets were changing very rapidly and that we needed new kinds of regulation. " 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-111hhrg48867--113 Mr. Garrett," Thank you, Mr. Chairman. And I think that the bankers who sit on this panel are probably astonished and shocked at the opening of today's hearing when you heard from the other side of the aisle--what did they say--we don't regulate anything in this country anymore. You were probably wondering, who are those guys with green eye shades who call themselves examiners, who come into your banks every so often? Who are they if we are not regulating anything? But I digress. Mr. Silvers, on the line of deregulation and what have you, you did make a comment to one of the questions that we have deregulated, and in the last dozen or so years there has been a taking back of so many powers. Just very briefly, aside from Gramm-Leach-Bliley, which we know some people say is deregulation--other people argue it allowed for the diversification which is helping these big banks out there to stay afoot--can you just run down four or five of the major acts of Congress we passed in the last dozen years that you are referring to where we deregulated the financial situation in this country? " CHRG-111hhrg54867--215 Mr. Price," Do you believe we are where we are because of a failure of deregulation? " CHRG-110hhrg46591--156 Mr. Price," But it is a deregulatory philosophy, not the act of deregulating it. Would you agree with that? " CHRG-111hhrg54867--213 Mr. Price," Thank you, Mr. Chairman. Welcome, Mr. Secretary. My background is health care. So I know that as a physician, if you don't make the right diagnosis, you can't treat the patient correctly. And if the patient gets well, it is by luck. To the point of diagnosis, there are some individuals who believe we are in our current situation, in the current boat we are in, because--they will say this--because of a failure of capitalism and a failure of deregulation. My sense in talking with folks is that simply isn't the case. I think that is very concerning because if we conclude as a society that the reason we are here is because of a failure of capitalism and a failure of deregulation, then I suggest that the solutions that we will come up with will not, in fact, correct the problem. Would you comment on those two matters? Do you believe we are where we are because of a failure of capitalism? " 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: CHRG-110hhrg46591--159 Mr. Johnson," Yes, I don't believe the mentality of deregulation was the cause, but if you are going to have a Federal safety net and protect deposits, then you have to regulate and supervise the banking system, and you have to do it very well. " CHRG-110hhrg46591--147 Mr. Stiglitz," I think I agree. It was the deregulation philosophy. And that led them not to use all the regulatory authority that they had. There was a need, probably, for more regulation in certain areas; for instance, the mortgage market that we have been talking about. " CHRG-110hhrg45625--28 Mr. Carson," Thank you, Mr. Chairman. First, let me salute you for your bold, courageous, and visionary leadership with regards to this matter. I come to this hearing on behalf of hardworking American taxpayers, not greedy corporate CEOs. It is taxpayer funding that we are using as collateral for this rescue package, not CEO bonuses, not investment bank revenues, but taxpayer funding. So if hard working American taxpayers are going to front the bill, then we better ensure that they reap the benefits. Tax subsidized corporate welfare must end. It is unbecoming, unjust, and unpatriotic. The American people are skeptical of this rescue package and with good reason. For years, they have seen Wall Street get bailed out while they were sold out. Over the last decade, deregulation rewarded the recklessly rich and penalized the pension dependent poor. Proponents of deregulation would have us believe that it is more important to reach out to America's struggling millionaires and billionaires, because according to them, they are the ones who have been left behind, not our small businesses, not our unemployed, and not our working families. The greed of Wall Street that flourished under these deregulation policies have now brought our economy to her knees. Leading financial institutions have collapsed. Home values have plummeted and thousands of Americans' jobs are at risk. So while it is important that we act, I urge that we proceed cautiously and responsibly. A knee-jerk reaction to a complex problem will only prolong the instability in our markets, not curtail it. Again, thank you for your bold leadership in this matter, Mr. Chairman. I yield back the balance of my time. " CHRG-110hhrg46591--245 Mr. McCotter," Thank you, Mr. Chairman. Thank you for holding this hearing. We heard from the previous panel. From yourselves, I gather that in many ways this was not a failure of deregulation or a philosophy of deregulation. It seems that in many ways the entrepreneurial spirit of the free market had transcended regulation, and that it was a failure then to intelligently, proactively and accountably act as a government to step in, in instances of a failure of self-government on the part of market participants. What I would be very curious to hear, as we enter into this initial discussion of where we are going to head, is when you speak of principles, to me the fundamental principle undergirding a free market economy is the principle of personal responsibility and that appropriate regulation creates a framework in which people can self-govern through the concept of personal responsibility with guidelines that ensure that human nature does not always exceed the better angels of our nature. So, as we move forward, I would like to hear from the panelists as to what specifically we can try to do to encourage personal responsibility within a regulatory environment so that we will wind up with a proper framework as opposed to a governmental dictation to the market, which could have a very deleterious effect on the future prosperity of Americans. " CHRG-111hhrg51698--132 Mr. Greenberger," Mr. Thompson, if I can address that question, a lot has been said here today, if we regulate in the United States, they will go to London, they will go to somewhere else. I have been working with the United Nations and other organizational organizations. I can guarantee you, London will regulate this stuff faster than we will regulate it. Every major central banker around the world is upset that these instruments were deregulated, and, quite frankly, as a loyal patriot, I don't like to hear this, but the blame is being put on the United States for having created this crisis. I know Chairman Peterson went to Europe, maybe he can opine about this, but I have been in front of several international organizations with the central bankers from all over the world, and they are furious with us that we deregulated these markets. All Chairman Peterson is saying is put these instruments back on a transparent market like the Chicago Mercantile Exchange, who has come forth as a central clearing party here, so we know what is going on; require capital adequacy; and if for some reason those general rules are no good, he has provided an exemption from them to be overseen by the CFTC. " CHRG-111hhrg48867--118 Mr. Silvers," They are less because the taxpayers have propped them up. A key issue in Bear Stearns, for example, was the interweaving of Bear Stearns' business with some large amount of hedge fund money. No one really knew for sure how much because it wasn't regulated. My point about deregulation is the responsibility doesn't rest solely with Congress in this matter. The courts have contributed, the failure of agencies to act when they have been given powers have contributed. " CHRG-111hhrg51698--41 Mr. Greenberger," Well, Mr. Damgard should not only debate Mr. Greenberger, but he should debate Mr. Volcker, and Mr. Greenspan, who has said, ``I made a terrible mistake when I allowed these credit default swaps to be deregulated.'' He should debate Mr. Cox, who was Chair of the SEC. He should debate Mr. Geithner, who has now talked about putting these things---- " CHRG-110hhrg46591--353 The Chairman," Well, if I were you, I would take the agreement I can get and go debate your purity elsewhere. But some arguments are easier to win than others. I would just say with regard to covered bonds, and this question of what consequences we should flow in a mark to market, will be very high on this committee's agenda next year. We have a very broad set of things to look at that will not stop us from doing some specific things, including continuing our deregulation in the areas of security and others as well. The gentleman from Alabama. " 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-111hhrg56766--9 Mr. Foster," Finally, I would just like to make one last comment on how did we get here. It is important to understand that the $17.5 trillion of destruction of household wealth that our country just experienced was not the result of a normal business cycle. It was the result of an ideologically driven deregulation of the financial markets. Most importantly, it will happen again if we do not understand and acknowledge what happened and take steps to prevent it from recurring. Thank you. I yield back. " CHRG-111shrg55739--93 Mr. Coffee," I was sort of discussing this in my remarks, because I gave you the example of Rule 2(a)(7), which says money market funds, you can only buy eligible securities and they have to have an investment-grade rating from an NRSRO. I would change that. I would change it in the following way. I would not wholly abolish the rule, because we can't dare deregulate all money market funds that came this close to failure last fall. There have to be some restrictions. Professor White also, I think, agreed with that. I would give institutional investors---- " CHRG-111hhrg74090--211 Mr. Dingell," Let us just go a wee bit further and explain to me why we should give it some of those goodhearted folks who led the fight for the repeat of Glass-Steagall who deregulated banking and financial services and who left us this glorious mess which we now have in the form of probably the biggest depression that this country has had since 1929. Now, why should we do that? Ms. Hillebrand. We need to give the authority to an agency that can make one set of rules that applies to the bank provider and the non-bank provider. If the FTC---- " fcic_final_report_full--452 In this environment, the government’s rescue of Bear Stearns in March of 2008 temporarily calmed investor fears but created a significant moral hazard; investors and other market participants reasonably believed after the rescue of Bear that all large financial institutions would also be rescued if they encountered financial diffi culties. However, when Lehman Brothers—an investment bank even larger than Bear—was allowed to fail, market participants were shocked; suddenly, they were forced to consider the financial health of their counterparties, many of which appeared weakened by losses and the capital writedowns required by mark- to-market accounting. This caused a halt to lending and a hoarding of cash—a virtually unprecedented period of market paralysis and panic that we know as the financial crisis of 2008. Weren’t There Other Causes of the Financial Crisis? Many other causes of the financial crisis have been cited, including some in the report of the Commission’s majority, but for the reasons outlined below none of them alone—or all in combination—provides a plausible explanation of the crisis. Low interest rates and a flow of funds from abroad . Claims that various policies or phenomena—such as low interest rates in the early 2000s or financial flows from abroad—were responsible for the growth of the housing bubble, do not adequately explain either the bubble or the destruction that occurred when the bubble deflated. The U.S. has had housing bubbles in the past—most recently in the late 1970s and late 1980s—but when these bubbles deflated they did not cause a financial crisis. Similarly, other developed countries experienced housing bubbles in the 2000s, some even larger than the U.S. bubble, but when their bubbles deflated the housing losses were small. Only in the U.S. did the deflation of the most recent housing bubble cause a financial meltdown and a serious financial crisis. The reason for this is that only in the U.S. did subprime and other risky loans constitute half of all outstanding mortgages when the bubble deflated. It wasn’t the size of the bubble that was the key; it was its content. The 1997-2007 U.S. housing bubble was in a class by itself. Nevertheless, demand by investors for the high yields offered by subprime loans stimulated the growth of a market for securities backed by these loans. This was an important element in the financial crisis, although the number of mortgages in this market was considerably smaller than the number fostered directly by government policy. Without the huge number of defaults that arose out of U.S. housing policy, defaults among the mortgages in the private market would not have caused a financial crisis. Deregulation or lax regulation . Explanations that rely on lack of regulation or deregulation as a cause of the financial crisis are also deficient. First, no significant deregulation of financial institutions occurred in the last 30 years. The repeal of a portion of the Glass-Steagall Act, frequently cited as an example of deregulation, had no role in the financial crisis. 1 The repeal was accomplished through the Gramm-Leach-Bliley Act of 1999, which allowed banks to affi liate for the first time since the New Deal with firms engaged in underwriting or dealing in securities. There is no evidence, however, that any bank got into trouble because of a securities affi liate. The banks that suffered losses because they held low quality mortgages or MBS were engaged in activities—mortgage lending—always permitted by Glass- Steagall; the investment banks that got into trouble—Bear Stearns, Lehman and Merrill Lynch—were not affi liated with large banks, although they had small bank affi liates that do not appear to have played any role in mortgage lending or securities trading. Moreover, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) substantially increased the regulation of banks and savings and loan institutions (S&Ls) after the S&L debacle in the late 1980s and early 1990s, and it is noteworthy that FDICIA—the most stringent bank regulation since the adoption of deposit insurance—failed to prevent the financial crisis. FOMC20050322meeting--77 75,MS. JOHNSON.," Yes. But it seems to me what is flawed is not so much the Stability and Growth Pact as the Lisbon Agenda. Despite the rhetoric, the major countries in Europe have not taken steps to deregulate themselves, to become more efficient and more dynamic, and to do all the things that they pledged to do in Lisbon. Had they done those things, the old Stability and Growth Pact would have probably been just fine. It’s not obvious to me that the changes they agreed to just recently are going to move us March 22, 2005 23 of 116 uncertainty that has been out there in the market about whether these countries will actually be contracting fiscal policy at a time when unemployment is rising, and that kind of thing." CHRG-110shrg50415--93 Mr. Rokakis," Mr. Chairman, the destruction of the agency relationship, if you look at, I think, the three principal causes of this entire crisis, clearly deregulation at the top of the list, reliance on these complex, mathematical constructs that nobody really understands, yet Wall Street relied upon. But if you look at the destruction of the agency relationship, the fact that that broker sitting across from you is not working for you but is working against you, Mayor Morial talked about some of the other statistics. I think it is absolutely critical that we move in that area of regulation. I also know that when there was talk about eliminating the yield-spread premium, this Congress was bombarded by, I believe, hundreds of thousands of calls and letters arguing against that. But I think it is that yield-spread---- " CHRG-111hhrg54867--294 Mr. Baca," Thank you very much, Mr. Chairman. Mr. Secretary, the regulatory plan proposes moving all standardized derivatives to some sort of clearing process to help bring more transparency and understanding to the market. When Chairman Gensler came before us in July, he said that initially he would envision it being four to five clearinghouses competing with one another. My question concerns this competition. Wouldn't this situation create the same conflict of interest that exists with credit-rating agencies, in that they would be funded by the same institutions whose products they would be reviewing? And my question is, are you concerned about the potential problem? And what kind of oversight do you envision in working to prevent against this? As the chairman indicated before, it wasn't until 2003 that we began to have the oversight and accountability, especially as it pertains to capitalism and deregulation. " CHRG-110hhrg41184--71 Mr. Bernanke," Of course it is possible. As I said in a recent speech, whenever we do regulation, we need to think about the cost and benefit of that regulation, and make sure there is an appropriate balance between them. And as we have done regulations on mortgage lending, I believe, for example, that subprime mortgage lending, if done responsibly, is a very positive thing and can allow some to get homeownership who might otherwise not be able to do so. There is plenty of evidence that people can do subprime lending in a responsible way. So in doing our regulations, we wanted to be sure that we didn't put a heavy hand on the market that would just shut it down and make it uneconomic. We want to help consumers understand the product, but we don't want to censure the market. Mr. Price of Georgia. Sure. Would you agree with the statement that excessive deregulation is the single greatest cause of the challenge that we currently find ourselves in? " CHRG-111shrg55739--100 Mr. Coffee," Well, my great fear is that the status quo will persist, and the way in which it is most likely to persist is if we deregulate some of these rules, what we will get is most institutional investors continue to rely on NRSRO ratings, figuring that is the safest if they ever were to get sued. What I think we should do simultaneously is give them more options. Let them do it themselves or go to consultants. But to the extent that they are relying on the NRSRO alternative, we should upgrade that alternative by insisting on due diligence so it is not an illusory opinion. That way you give them more options, but they are higher-quality options. Senator Shelby. Professor White, Mr. Joynt defends ratings as a common, independent risk benchmark that should be retained in regulations. Do the failures of the rating agencies over the last several years call into question their value as a benchmark? " CHRG-110hhrg46591--454 The Chairman," Well, you have to ask Mr. Greenspan, because he explicitly did. I mean look, this is a deep philosophical approach. Mr. Greenspan explicitly said in Mark Zandi's book, Greenspan's deregulatory failure, it is very clear there were fundamental philosophic issues here. And we are debating--and Mr. McCotter raised it, and Mr. Price raised it in very thoughtful ways. We are now discussing what the role is of regulation. But I agree, I think Mr. Ryan said it best in terms of--and others, and Mr. Yingling and Gramm-Leach-Bliley, this is not a case so much of deregulation as a case of not adopting appropriate new regulations to keep up with innovation. It is not that old rules were dismantled, it is that as the system innovated, appropriate new rules were not adopted. And that is what we need to do. But I do want to say on subprime we were looking at it from the systemic point of view as well as the consumer protection. " 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 .”  fcic_final_report_full--364 COMMISSION CONCLUSIONS ON CHAPTER 19 The Commission concludes AIG failed and was rescued by the government prima- rily because its enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure—a pro- found failure in corporate governance, particularly its risk management practices. AIG’s failure was possible because of the sweeping deregulation of over-the- counter (OTC) derivatives, including credit default swaps, which effectively elim- inated federal and state regulation of these products, including capital and margin requirements that would have lessened the likelihood of AIG’s failure. The OTC derivatives market’s lack of transparency and of effective price discovery exacer- bated the collateral disputes of AIG and Goldman Sachs and similar disputes be- tween other derivatives counterparties. AIG engaged in regulatory arbitrage by setting up a major business in this unregulated product, locating much of the business in London, and selecting a weak federal regulator, the Office of Thrift Supervision (OTS). The OTS failed to effectively exercise its authority over AIG and its affiliates: it lacked the capability to supervise an institution of the size and complexity of AIG, did not recognize the risks inherent in AIG’s sales of credit default swaps, and did not understand its responsibility to oversee the entire company, including AIG Financial Products. Furthermore, because of the deregulation of OTC derivatives, state insurance supervisors were barred from regulating AIG’s sale of credit de- fault swaps even though they were similar in effect to insurance contracts. If they had been regulated as insurance contracts, AIG would have been required to maintain adequate capital reserves, would not have been able to enter into con- tracts requiring the posting of collateral, and would not have been able to provide default protection to speculators; thus AIG would have been prevented from act- ing in such a risky manner. AIG was so interconnected with many large commercial banks, investment banks, and other financial institutions through counterparty credit relationships on credit default swaps and other activities such as securities lending that its po- tential failure created systemic risk. The government concluded AIG was too big to fail and committed more than  billion to its rescue. Without the bailout, AIG’s default and collapse could have brought down its counterparties, causing cascading losses and collapses throughout the financial system. CHRG-111hhrg48867--249 Mr. Silvers," The way Fannie and Freddie were managed, particularly since 2003--and that date is very important--is a substantial contributing factor. However, the narrative that has been put forward by, essentially, people who have a, sort of, principled disagreement with regulation, that Fannie and Freddie are the primary cause of this problem, is completely and utterly wrong. And specifically, it is completely and utterly wrong because Fannie and Freddie functioned, for example, for 10 years, almost, following the strengthening of the Community Reinvestment Act without bringing on systemic crisis. They began to do what my friend Peter was talking about when deregulated mortgage markets began to encroach on their market share and in a context in which credit was available broadly without regard to risk because of policies of the Fed and the Bush Administration. And that began in 2003, and that is when you saw the explosion of subprime. Fannie and Freddie were participants in that conduct starting in 2003. But their existence and the existence of GSEs, the existence of the Community Reinvestment Act are not primarily responsible for this crisis, and to assert so is to fundamentally distort the record. " CHRG-111hhrg51698--173 Mr. Greenberger," I would say the reason they are unable to predict the future that clearly is that a large portion, because of the Enron loophole, the London loophole, the swaps loophole was completely outside of the government's ability to see what was going on. The effect of Mr. Peterson's draft discussion bill is to bring transparency to those markets so everybody else knows what is going on. There were accusations here about the Hunt brothers in 1980 cornering the silver market. Mr. Masters will testify tomorrow, he and Mr. White did a report called The Accidental Hunt Brothers, which showed through the swaps, the deregulated swaps, the passive long investments went from $14 billion in 2004 to $313 billion long in the summer of 2008; and then $70 billion was taken out of that market immediately, which explains the drop. These markets were unregulated. What Mr. Peterson is trying to do is bring them--we have heard a lot of great things about the CFTC here. That is great. Let's give the CFTC the power to see what is going on. " CHRG-110shrg50414--58 STATEMENT OF SENATOR JON TESTER Senator Tester. I do. Thank you, Mr. Chairman, and thank you for allowing me to just ask a few questions. Ten years ago, I got involved in politics because of electrical deregulation in the State of Montana. It was a total disaster. I have got plenty of questions to ask about the plan, and I will as they come forth. But I guess my concern is this: Six months ago, we heard about Bear Stearns, and then we have had Fannie and Freddie, and we have had some other ones come down the pike. A week ago, you came forth with a $700 billion bailout plan--$700 billion, and it was made clear that this was going to be--there was going to be nothing added on to it. Accountability, demand of re-regulation was not going to be accounted. And my question--and this is the concern I have. You guys are a lot smarter in financials than I am. I am a dirt farmer. You guys have been in the business, former Chairman of Goldman Sachs. Why do we have 1 week to determine $700 billion that has to be appropriated or this country's financial systems go down the pipes? Wasn't there some opportunity sometime down the line where we could have been informed of how serious this crisis was so we could take some preventative steps before this got to this point? That is it. Thank you, Mr. Chairman. " CHRG-111hhrg53238--176 Mr. Perlmutter," Thanks, Mr. Chairman. And, Professor, I would just say that ordinarily I don't agree very often with George Mason because my economic philosophy is a little different than yours. But I do agree with you I think with respect to the subprime piece and whether it was really a consumer protection issue or whether it was just a deregulation or refusal to do appropriate underwriting that affected financial institutions and people who invested in financial institutions and people who bought big portfolios. That I agree with. I think you are off base on the credit card piece. That really is a consumer issue. And all the bells and whistles that come along with credit cards are probably one of the top five things discussed if you were to go door-to-door, walk in a precinct or having a town hall. People didn't expect ``X,'' ``Y,'' or ``Z'' with respect to their credit cards. So--which brings me to sort of the general question of who is best, who best can assist consumers with a credit card that has, you know, this fee and that fee and, you know, this surcharge and that penalty charge? Is it a new agency? Is it the FTC? Is it the FDIC? The OCC? The Federal Reserve? And so my question, if we don't go with what has been proposed and create a new agency, how do we--do we set up ombudsmen or new departments in every one of the regulators? If anybody has an answer to that, I would like to hear it. Or do we just beef up the FTC? " fcic_final_report_full--49 Years later, Fed Chairman Greenspan described the argument for deregulation: “Those of us who support market capitalism in its more competitive forms might ar- gue that unfettered markets create a degree of wealth that fosters a more civilized ex- istence. I have always found that insight compelling.”  THE SAVINGS AND LOAN CRISIS: “THEY PUT A LOT OF PRESSURE ON THEIR REGULATORS ” Traditional financial institutions continued to chafe against the regulations still in place. The playing field wasn’t level, which “put a lot of pressure on institutions to get higher-rate performing assets,” former SEC Chairman Richard Breeden told the FCIC. “And they put a lot of pressure on their regulators to allow this to happen.”  The banks and the S&Ls went to Congress for help. In , the Depository Insti- tutions Deregulation and Monetary Control Act repealed the limits on the interest rates that depository institutions could offer on their deposits. Although this law re- moved a significant regulatory constraint on banks and thrifts, it could not restore their competitive advantage. Depositors wanted a higher rate of return, which banks and thrifts were now free to pay. But the interest banks and thrifts could earn off of mortgages and other long-term loans was largely fixed and could not match their new costs. While their deposit base increased, they now faced an interest rate squeeze. In , the difference in interest earned on the banks’ and thrifts’ safest in- vestments (one-year Treasury notes) over interest paid on deposits was almost . percentage points; by , it was only . percentage points. The institutions lost al- most  percentage points of the advantage they had enjoyed when the rates were capped.  The  legislation had not done enough to reduce the competitive pres- sures facing the banks and thrifts. That legislation was followed in  by the Garn-St. Germain Act, which signifi- cantly broadened the types of loans and investments that thrifts could make. The act also gave banks and thrifts broader scope in the mortgage market. Traditionally, they had relied on -year, fixed-rate mortgages. But the interest on fixed-rate mortgages on their books fell short as inflation surged in the mid-s and early s and banks and thrifts found it increasingly difficult to cover the rising costs of their short-term deposits. In the Garn-St. Germain Act, Congress sought to relieve this interest rate mismatch by permitting banks and thrifts to issue interest-only, bal- loon-payment, and adjustable-rate mortgages (ARMs), even in states where state laws forbade these loans. For consumers, interest-only and balloon mortgages made homeownership more affordable, but only in the short term. Borrowers with ARMs enjoyed lower mortgage rates when interest rates decreased, but their rates would rise when interest rates rose. For banks and thrifts, ARMs offered an interest rate that floated in relationship to the rates they were paying to attract money from de- positors. The floating mortgage rate protected banks and S&Ls from the interest rate squeeze caused by inflation, but it effectively transferred the risk of rising interest rates to borrowers. CHRG-109hhrg22160--207 Mr. Greenspan," Congressman, I think that one of the key aspects of the American economy is its increasing integration into a global system. Barriers to cross-border trade are coming down all over the place. The issue of communications has shrunk the distance that is involved. I should say communication plus transportation has shrunk the distance between peoples around the globe. And what we are finding is, in the same context that say 150 years ago, we gradually in this country developed--went from local markets to national markets--is that we are going from national markets now to global markets. And we are exceptionally competitive in that regard in the sense that of all the industrial nations in the world, few have gained from globalization as much as we. The reason for that is we have an exceptionally flexible economic system. We have had bipartisan deregulation since the 1970s of a whole series of different industries. The information technology has created an incredible capability to develop new financial instruments and to develop basically the types of things which enable a system to adjust around the world. And I think the major focus that we have to maintain is, one, to keep that degree of resilience and flexibility, which means eschew issues of protectionism, regulation, and anything which rigidifies the market's adjustments process which has served us so well in the last decade or so. Mr. Davis of Kentucky. Just as a follow-on, how would you adjust current trade policy to continue to strengthen international exports in manufacturing? " CHRG-110hhrg41184--2 The Chairman," The hearing will come to order. First, I would like to note that last summer we saw the passing of the co-author of the Humphrey-Hawkins bill, Congressman Gus Hawkins. He was a Member of the House who had a very distinguished career. He was the predecessor of our colleague from California, Ms. Waters. But the significance of his achievement in structuring that bill, and in particular, giving equal weight to two very important mandates, the need to combat inflation and the need to maintain adequate employment--I think recent events have shown that to be quite wise. I contrast what I think has been the good performance of our Federal Reserve in meeting our needs with a performance that I think has caused more difficultly in Europe in the European Central Bank where they have only the single mandate. So I want to pay again tribute to the wisdom of Gus Hawkins and to the fidelity with which the Federal Reserve under this Chairman has carried out what can be a complicated and sometimes--it's a relationship with some tension. We meet today under the usual circumstances. For many years past, I have focused on the problems of income inequality in our society and the question about how we promoted growth without it adding to inequality. Both the current Chairman and his predecessor acknowledged that those were issues and expressed views about how to deal with them. We have from time to time convened when we were in the midst of a downturn, whether or not it is a recession is a somewhat academic discussion. That we are in a significant downturn with a very chancey near-term future is indisputable. What is interesting is the extent to which this is a very different kind of downturn. We don't have the classic cycle where there were excesses, too much inventory, etc. We are in a downturn, maybe a recession, maybe about to become one, in which the single biggest cause was excessive deregulation. The failure to understand that a vibrant, free enterprise system needs as a partner a public sector that understands how the market works, supports it, helps create the conditions in which the free market can flourish, but also provides a set of rules that diminish abuses. That this current downturn was caused by abuses in the loan market for residences is fairly clear. In the report, the Monetary Report that the Chairman presents, on page 3, part 2, ``The economic landscape after the first half of 2007 was subsequently reshaped by the emergence of substantial strains in financial markets in the United States and abroad, the intensifying downturn in the housing market and higher prices for crude oil. Rising delinquencies on subprime mortgages led to large losses on related structured credit products.'' Skipping over, ``Consequently, in the fourth quarter, economic activity decelerated significantly, and the economy seemed to have entered 2008 with little forward momentum.'' This is relevant for a number of factors. Yesterday in the hearing we had preparatory to this one, the very distinguished economist, Alice Rivlin, a former Vice Chair of the Board of Governors, said this year in your hearing, monetary policy will not be as important. It will be somewhat down on the list. And I think that is accurate. In the classical recession we have had, the role of monetary policy is fairly clear. Here we have this problem that the normal tools we use, including a stimulus package, which in its detail pleased no one, and was therefore able to pass, and I think will on balance be constructive in helping deal with the shortfall, and we have seen a reduction in interest rates. That is, monetary and fiscal policy have been as stimulative as you can expect in this time. And I support both of those directions, but they are not enough. We are faced with the need to deal with a very serious structural problem, the continuing flood of foreclosures. And this committee will be considering measures to deal with that. Let me note that in the absence of the subcommittee chairman, and given the significance here, I'm going to take the 8 minutes that we have. And I apologize to my colleagues, but not so much. We have a structural set of issues to deal with. And in this case, relying on fiscal and monetary policy alone won't be enough. Because unless we can deal with the specific structural problem caused by the deregulation more than anything else, and caused by excesses in the private sector, we will not be able to effectively deal with this situation. And in fact, if we were not to deal with this in a structural manner by trying to deal with foreclosures and with property on which there have been foreclosures, we would put too much of a strain on fiscal and monetary policy. It would not be appropriate to rely only on fiscal and monetary policy. So we will be trying in a variety of ways, and we have been talking to regulators, and I appreciate the cooperation we have gotten from staff at the Federal Reserve and the other Federal regulatory agencies. We may in the end have some differences, but there has been a cooperative effort to try and figure out how to deal with that. What is clear is that the ideology of deregulation is a large part of the cause of the problems we are in today. Indeed, in the mortgage market, it is clear. If you look at mortgages originated by the regulated entities, the deposit-taking institutions, subject to bank regulation, they have performed much better than those that came with very little regulation. And it wasn't simply that. What basically happened was that securitization, which has been a great blessing and a great multiplier of our ability to do things, replaced the lender-borrower discipline. We were told by the private sector that they had ways of replacing that, so that we would have a good deal of responsibility. We had risk management and quantitative models, and a whole range of other things. It turns out, when enough bad loans are put into the system because of the absence of the lender-borrower discipline, i.e., I'm not lending you the money unless I know you're going to pay me back, that some of these techniques did not contain the damage; they spread it. And the consequence has been a very serious, worldwide problem wherein the most significant economic troubles since at least 1998, and in America it is probably going to have more of a negative impact than then, and the single biggest cause was a failure for regulation to keep up with innovation. And of course it has had international consequences as well. We have a new export in America that had a big impact on the rest of the world--bad mortgages, which we exported and which caused economic problems elsewhere. So as we deal with this situation, it is important for us to continue to monitor monetary policy. We have already acted in the fiscal area. I believe that the Chairman and the Federal Reserve has acted appropriately with regard to monetary policy, but they could not be enough, given the cause of this. And what we need first of all is to deal with the problems that we have seen because of the failure to regulate, and we have to do something about the cascade of foreclosures that we still face, or we do not easily pull out of this problem. And we have to, once we have dealt with that, this committee will begin to work on that, think in cooperation with the regulators and the financial community and others what we do going forward so that we do not lose the virtues of securitization but we are able to diminish some of its abuses. The gentleman from Alabama. " fcic_final_report_full--267 COMMISSION CONCLUSIONS ON CHAPTER 13 The Commission concludes that the shadow banking system was permitted to grow to rival the commercial banking system with inadequate supervision and regulation. That system was very fragile due to high leverage, short-term funding, risky assets, inadequate liquidity, and the lack of a federal backstop. When the mortgage market collapsed and financial firms began to abandon the commercial paper and repo lending markets, some institutions depending on them for fund- ing their operations failed or, later in the crisis, had to be rescued. These markets and other interconnections created contagion, as the crisis spread even to mar- kets and firms that had little or no direct exposure to the mortgage market. In addition, regulation and supervision of traditional banking had been weak- ened significantly, allowing commercial banks and thrifts to operate with fewer constraints and to engage in a wider range of financial activities, including activi- ties in the shadow banking system. The financial sector, which grew enormously in the years leading up to the fi- nancial crisis, wielded great political power to weaken institutional supervision and market regulation of both the shadow banking system and the traditional banking system. This deregulation made the financial system especially vulnera- ble to the financial crisis and exacerbated its effects. CHRG-111hhrg48867--231 Mr. Silvers," I really appreciate that this is my friend Peter Wallison's religion, but I think that the facts are that when we had well-regulated financial markets they channelled capital to productive activity, they were a reasonable portion of our economy and they were not overleveraged and we did not suffer from financial bubbles. And that describes the period from the New Deal until roughly 1980. And then we started deregulating, and the result was financial markets that grew to unsustainable size, excessive leverage in our economy, an inability to invest capital in long-term productive purposes, an inability to solve fundamental economic problems, and escalating financial bubbles. That is the history of our country. When we had thoughtful, proportionate financial regulation, it was good for our economy. Now we are in a position, pursuant to your question, where we have global financial markets and where a global financial regulatory floor is an absolute necessity if we are going to have a stable global economy. If we choose to be the drag on that process, it is not only going to impair our ability to have a well-functioning global financial system, it will damage the United States's reputation in the world. This question is immediately before us. And I would submit to you that while systemic risk regulation is important here, underneath that are a series of substantive policy choices which will define whether or not we are serious about real reregulation of the shadow markets or not. And if we choose to be once again the defender of unregulated, irresponsible financial practices and institutions, that the world will not look kindly upon us for doing so, as they did not look kindly upon us for essentially bringing these practices to the fore in the first place. " fcic_final_report_full--538 This dissenting statement argues that the U.S. government’s housing policies were the major contributor to the financial crisis of 2008. These policies fostered the development of a massive housing bubble between 1997 and 2007 and the creation of 27 million subprime and Alt-A loans, many of which were ready to default as soon as the housing bubble began to deflate. The losses associated with these weak and high risk loans caused either the real or apparent weakness of the major financial institutions around the world that held these mortgages—or PMBS backed by these mortgages—as investments or as sources of liquidity. Deregulation, lack of regulation, predatory lending or the other factors that were cited in the report of the FCIC’s majority were not determinative factors. The policy implications of this conclusion are significant. If the crisis could have been prevented simply by eliminating or changing the government policies and programs that were primarily responsible for the financial crisis, then there was no need for the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, adopted by Congress in July 2010 and often cited as one of the important achievements of the Obama administration and the 111 th Congress. The stringent regulation that the Dodd-Frank Act imposes on the U.S. economy will almost certainly have a major adverse effect on economic growth and job creation in the United States during the balance of this decade. If this was the price that had to be paid for preventing another financial crisis then perhaps it’s one that will have to be borne. But if it was not necessary to prevent another crisis—and it would not have been necessary if the crisis was caused by actions of the government itself—then the Dodd-Frank Act seriously overreached. Finally, if the principal cause of the financial crisis was ultimately the government’s involvement in the housing finance system, housing finance policy in the future should be adjusted accordingly. 533 -----------------------------------------------------Page 562-----------------------------------------------------  CHRG-110shrg50416--9 STATEMENT OF SENATOR CHARLES E. SCHUMER Senator Schumer. Thank you, Chairman Dodd, for holding this important hearing to focus on the financial crisis and the administration's response. As we made clear in our negotiations with the administration over the Emergency Economic Stabilization Act, congressional oversight is essential in order to make sure the taxpayers' money is being used well and wisely, and these hearings are a vital and important element of that oversight, and I salute you for having them in a timely way. The unfortunate truth is that the financial crisis we are facing today is not the result of an act of God or a natural disaster, some completely unforeseeable set of entirely unpredictable circumstances. It is the product of two completely avoidable failures: the failure of regulatory agencies to do their job and properly oversee the industries and firms under their purview, and the failure of banks, mortgage brokers, rating agencies, and other financial institutions to appropriately measure risk and to act accordingly. The collapse of the housing bubble, which is at the root of all of this, as Senator Dodd has mentioned, was not the shock that many people want to make it out to be. There was plenty of evidence we were in the midst of a bubble and plenty of warning from a lot of smart people that it was going to pop sooner or later. But what it comes down to is that too many people were making too much money too easily and too quickly. Mortgage and financial firms started to behave like spoiled teenagers whose parents were on vacation. Once the party started, they didn't want it to end. And if they trashed the house in the process, well, maybe the maid would come and clean it up tomorrow. And they were right about one part of it. Their parents weren't home, because with the exception of Chairwoman Bair, who has been the adult voice in all of this, the regulators who should have put a stop to all of this nonsense before it got out of hand were nowhere to be found. This was not an accident. The problem at its root was the lack of regulation. Certainly the Government can overregulate and snuff out all entrepreneurial vigor for which this country is known. But that was not the problem of this administration. The explicit policy of this administration for the last 8 years has been the view ``Deregulate, deregulate, deregulate.'' The administration even appointed an SEC Commissioner and tried to elevate him to Chairman of the FTC who wanted to repeal New Deal regulations. And when that is not possible, the administration tries not to enforce the regulations that are on the books all too often. We need thoughtful, smart, tough, and more unified regulation, which I know under Chairman Dodd and Senator Shelby's leadership we will endeavor to put in place early next year. Now, of course, we know who is stuck with the cleaning bill for this mess: the American taxpayers. If each of us was left to our own devices, each of us would have designed a different rescue plan. Unfortunately, when left with the choice between acting on this package or doing nothing, there wasn't really a choice at all. We had to act. And Secretary Paulson, Chairman Bernanke, and Chairwoman Bair all deserve credit for not letting the ideology of do nothing, complete laissez-faire, get in the way of working to bring us back from the brink of absolute disaster. But that does not mean my colleagues and I are happy about what we have had to do, nor does it mean we do not have serious questions remaining about how we are proceeding. I applaud Secretary Paulson for recognizing, despite his initial opposition, that the best approach to this crisis is the direct injection of capital into banks. I have argued from the very beginning that this is clearly the most effective way to support the banks and the financial system more generally. The history of our own Depression Era agency, the RFC, as well as experiences of both Japan and Sweden in the past decades have shown that, when done properly, capital infusions provide the best bang for the buck. But doing it properly is the key, and I continue to have a number of serious questions about how this program is being implemented. I remain especially concerned that in the Treasury's zeal to make the capital injection program easily digestible for the banks, we are feeding them a little too much dessert and not making them eat enough of their vegetables. Though you and I have spoken about this, Mr. Kashkari--and I very much appreciate your position and your rising to take this job at this crucial time--I am still not convinced that it makes much sense for banks that accept capital from the Government to continue paying dividends on their common stock. There are far better uses of taxpayer dollars than continuing the dividend payments to shareholders. And the program will only be effective if it is put to good use. With that in mind, I, along with my colleagues Senator Jack Reed and Senator Menendez, have been urging the Treasury Department to issue guidelines--not hard rules, not legal regulations, but standards that will help guide institutions' behavior now that taxpayer money has been invested. First and foremost, I believe there should be guidelines on the use of this capital. I would like the Treasury to set out goals, perhaps based upon an institution's previous lending history, for the amount of lending that each institution that receives capital injection should be doing. This will help prevent institutions from hoarding Government capital against future losses and get the money quickly out to Main Street, which has been our stated goal all along. On the flip side of that coin, I think Treasury and the financial regulators should issue guidance to discourage institutions from using this funding to engage in the kinds of risky and exotic financial activities that got us into this mess. We are not investing in these institutions just to see the financial wizards go back to playing their high stakes game, this time with some taxpayer money. Third, and finally, stronger standards of care for loan modifications are needed. Chairman Bair has led the charge on this front, and the rest of the regulators and Treasury should follow her lead. There should be a requirement that any institution receiving assistance under the TARP should have to adopt a systematic and streamlined approach to loan modifications, modeled on the approach that the FDIC has utilized in institutions that it controls. Declining home prices are the root cause of this economic crisis, and avoiding foreclosures through loan modifications is perhaps the single greatest step we can take to alleviate the current situation. Finally, last but not least, I would like to see stronger guidance issued to companies with regard to executive compensation. Even under the rules issued by Treasury, in some cases a great deal of discretion is left in the hands of the compensation committees of each institution. The Treasury Department should provide clarification and oversight for the implementation of its own rules and also begin the process of determining compensation best practices on a broader scale. Thank you, Mr. Chairman. " CHRG-110hhrg46591--29 Mr. Price," Thank you, Mr. Chairman. I want to join with some on both sides of the aisle who have said that the same old politics, frankly, from both sides will not get us to a solution to our current challenges. There has been lots of excellent work done on attempting to identify the cause of our current financial challenge. I will be inserting a number of items into the record. One of them is an article entitled, ``Another Deregulation Myth: A Cautionary Tale about Financial Rules that Failed.'' While the genesis of our current challenge is certainly multifactorial, what began on a microlevel with imprudent borrowers and irresponsible lenders became a full-scale financial crisis, fueled by the GSEs that were rapidly expanding their purchasing and securitization of subprime mortgages. Today, the resulting credit crunch is extended to every area of our economic system. What is taking place, though, is truly unprecedented: The direct Federal intervention in individual mortgages; a broad overreach by the Federal Reserve; an unlimited use of taxpayer dollars; and steps to nationalize banks. These actions are in their totality, I fear, an assault on American principles and on capitalism itself. It is a marked turn toward a nefarious ideal that problems can be solved by centralized decisionmaking here in Washington. To have a full understanding of the financial services' regulatory state, there must be an investigation of all facets of the sector. I look forward to working with the chairman for a more broad appreciation of that in our hearing process. Moving ahead, Congress must be sensible. The goals should be to eliminate previous destructive regulatory actions, not to eliminate all regulation but to have appropriate regulation, close the gaps in the regulatory framework, increase transparency, and enhance market integrity and innovation. The end result must promote economic growth and not stifle opportunity. I look forward to working with all who are of the same mind. Thank you. " CHRG-110hhrg44900--62 Mrs. Maloney," Welcome, and thank you for your service. I want to give a very special welcome to Secretary Paulson who previously was a business and civic leader in the great City of New York, and it is reassuring to me and many Americans that someone who has deep experience in the day-to-day operation of financial markets is at the helm of Treasury and really initiating this conversation and discussion today. I also want to welcome Chairman Bernanke, who has brought the Fed to fully realize its role, not only managing monetary policy and guarding the safety and soundness of our financial institutions, but also focusing on curbing unfair and deceptive practices that have hurt working Americans and our overall economy. Next week we look forward and congratulate you on your new regulations to shore up mortgage lending, and I enthusiastically support your proposed role to eliminate abusive practices in credit cards. I would like to follow up on my colleague's questioning on market discipline and ask Secretary Paulson, who has a great deal of experience in this area. It's clear from recent events that many expected synergies of financial service activities, whatever benefits that they gave during times of economic prosperity, gave rise to conflicts and excessive risk taking. It appears that many firms are in so many lines of businesses that conflicts and excessive risk arise. Huge trading operations have also put more mundane activities of financial institutions at risk. For example, some have said Bear Stearns' trading operation may have caused risk to its clearing operations. And in view of these recent events and challenges, some have said that the repeal and deregulation of Glass-Steagal may have gone too far. And I would like to ask, would a financial service industry where banks, hedge funds, investment banks, and other entities were more limited to the array of business they are in help the situation by providing competitive and arm's-length checks and balances on financial activities through the marketplace? And would a more diversified financial service industry that had more specialization and less concentration offer any benefits in reducing risk and the need for regulation? " fcic_final_report_full--453 The shadow banking business . The large investment banks—Bear, Lehman, Merrill, Goldman Sachs and Morgan Stanley—all encountered diffi culty in the financial crisis, and the Commission majority’s report lays much of the blame for this at the door of the Securities and Exchange Commission (SEC) for failing adequately to supervise them. It is true that the SEC’s supervisory process was weak, but many banks and S&Ls—stringently regulated under FDICIA—also failed. This casts doubt on the claim that if investment banks had been regulated like commercial banks— or had been able to offer insured deposits like commercial banks—they would not have encountered financial diffi culties. The reality is that the business model of the investment banks was quite different from banking; it was to finance a short-term trading business with short-term liabilities such as repurchase agreements (often called repos). This made them especially vulnerable in the panic that occurred in 2008, but it is not evidence that the existence of investment banks, or the quality of their regulation, was a cause of the financial crisis. Failures of risk management . Claims that there was a general failure of risk management in financial institutions or excessive leverage or risk-taking are part of what might be called a “hindsight narrative.” With hindsight, it is easy to condemn managers for failing to see the dangers of the housing bubble or the underpricing of risk that now looks so clear. However, the FCIC interviewed hundreds of financial experts, including senior offi cials of major banks, bank regulators and investors. It is not clear that any of them—including the redoubtable Warren Buffett—were suffi ciently confident about an impending crisis that they put real money behind their judgment. Human beings have a tendency to believe that things will continue to go in the direction they are going, and are good at explaining why this must be so. Blaming the crisis on the failure to foresee it is facile and of little value for policymakers, who cannot legislate prescience. The fact that virtually all participants in the financial system failed to foresee this crisis—as they failed to foresee every other crisis—does not tell us anything about why this crisis occurred or what we should do to prevent the next one. 1 See, e.g., Peter J. Wallison, “Deregulation and the Financial Crisis: Another Urban Myth,” Financial Services Outlook , American Enterprise Institute, October 2009. 447 CHRG-111hhrg74090--14 Mr. Dingell," Mr. Chairman, I thank you, and I commend you for this hearing. It is a very important one. It follows on a series of events which began with a raid on this committee by other committees and by the banking industry and by repeal of Glass-Steagall, which removed all the penalties and prohibitions against many of the illegal activities which brought us to the current lowest state in which we find ourselves financially and economically. At the Treasury Department, there was an office still in being called the Controller of the Currency, who pushed to totally deregulate banks and to unlearn the lessons which we learned during the Depression and to permit the abuses which the Pecora Commission found to be a problem, things which brought about the 1929 crash, and lo and behold, the failure to learn those lessons or to preserve the protections which the Congress and the President in the 1930s put into place led to the economic collapse which occurred in the United States in the last calendar year and this calendar year. So the questions that we will be concerned with are going to be, are consumers protected, is the Federal Trade Commission able to continue doing the work that it does to protect consumers, and this committee is going to concern ourselves this morning with these issues and means by which to ensure improved consumer protections continue to exist with regard to financial products and services and to see to it that the Federal Trade Commission is able to carry out the responsibilities which in a rather contemptible fashion were disregarded by the SEC and also by the Controller of the Currency. Now, we need to know if our concerns here and the pause which it gives us occurs in part because of a transfer of existing authority from the Federal Trade Commission to a newly minted Consumer Financial Protection Agency, an agency whose behavior we don't know but an agency which is going to probably be composed of many of the goodhearted people who have brought us to this curious and unfortunate state of events. I will be truthful: I have significant concerns about these plans and I will be intending to engage today's witnesses in a frankly discussion about their merits. The Administration, which has no fault in the events of the deregulation and the collapse of the American economy last year, envisions consolidating all consumer protection functions related to financial products including rulemaking, supervision, examination and enforcement under the aegis of the new CFPA, which would receive sole rulemaking enforcement authority over consumer financial protection statutes such as the Truth in Lending Act. At first glance, this strikes me as a dejure and possible unwarranted reassignment of FTC's consumer protection authorities in the financial services area. I will be looking to see whether this is so and whether in fact is a good thing or can be justified by the Administration. While a comparatively small agency, it is to be observed that FTC has some superb work in protecting consumers, and in this the country would benefit not from a diminished mandate to that agency but rather to additional statutory authority, personnel and funding. Consequently, I have more than a modest degree of skepticism regarding the Administration's proposal. In brief, I wish for our witnesses to elucidate upon several matters associated with the CFPA proposal. First, if CFPA were mandated under law, what authorities would be left to FTC and why would that occur. Second, what latitude would FTC have in enforcing consumer protection statutes as they relate to financial services, and what consumer protection statutes would be denigrated or dissipated under this proposal. Third, how would one characterize the level of interagency cooperation in the drafting of the Administration's proposal. Financially, if CFPA receives its proposed mandate, what will become of this committee's jurisdiction over consumer protection as designated under rule 10 of the House of Representatives? I will welcome the witnesses' responses to these and other questions in order to properly establish an adequate record for additional action by the Congress if such is deemed necessary. I would ask at this time that I have unanimous consent to keep the record open to submit a list of questions to the witnesses today and to have those responses and the questions inserted into the record. I want to commend you, Mr. Chairman, for your courtesy and foresight in this hearing. I would conclude by a personal note in welcoming Dr. Stephen Calkins, associate vice president for academic personnel and professor of law at Wayne State University in my home State of Michigan. His testimony has been invaluable to my understanding of this matter and I look forward to his participation in the continuing debate on consumer financial protection, and I note, Mr. Chairman, that my wife is a member of the Board of Governors of that great institution, which gives me a particularly warm feeling about it, and again, Mr. Chairman, I urge you and my colleagues to be most diligent, most cautious, most careful and most dutifully suspicious of the events that we inquire into today. Thank you. " CHRG-110shrg50414--82 Secretary Paulson," Senator, thank you for the comment. The first thing I wanted to say is this plan is broad based and it is dealing with the root cause. And when we have needed to come in and do something to save a failing institution, there have been very harsh consequences. And when we deal with one-off situations, I think there always should be very significant consequences. That is No. 1. No. 2, in terms of what needs to be done to fix the system, we could have a long conversation about that, and you are going to be busy for a long time, and you are going to be busy after I am gone doing that. I have given you my suggestions, and they are suggestions that have to do with a totally outmoded and insufficient regulatory structure. When I got down here and after about several months on the job, I was shocked, absolutely shocked, to find it was not deregulation or too much regulation or too little regulation. It was just a flawed regulatory structure. It was built for a different model, for a different financial system. The financial system changed. The regulatory system did not change. And so that clearly has to be corrected. When you look at these mortgages, the vast majority of the mortgages that were originated with very, very shoddy procedures were regulated at the State level. OK? You cannot come down here, come down to Washington at Treasury Secretary and fix all that. We made a proposal that I think is the right proposal for this mortgage origination commission, which would be a Federal commission not to invalidate State regulation but to make sure there are common standards enforcement. So there are a lot of things that need to be done, and in terms of the compensation issue, there are a lot of things that need to be done there. But I would respectfully submit that we cannot do those as quickly as it takes to get this system up and running, because that is what you care about. You care about the constituents in your State, the average people, and Americans in terms of what the impact is going to be on them. And, unfortunately--and it may make you angry; it makes me angry--when you ask about the taxpayers being on the hook, guess what? They are already on the hook. They got put on the hook by the system we have, the system we all let happen, the system that Congress, the administration, future administrations let exist. And so if this system is not stabilized, they are going to bear the costs. The Chairman explained that. I have explained it. So the best thing we can do for all of them is to stabilize the financial markets so that people can continue to get loans, small businesses can get loans, small farmers in your States can get loans, big farmers in your States can get loans. And then go to work to make sure that this does not happen again, and that is going to take a longer period of time. Senator Johnson. Given what occurred with AIG, should the Federal Government regulate some or all insurance companies? Would an optional Federal charter model be appropriate? " CHRG-111shrg50564--191 STATEMENT OF SENATOR CHARLES SCHUMER First, I'd like to thank Chairman Dodd for holding the first of what I'm sure will be many hearings on financial regulatory reform. For decades, America generally, and New York in particular, have been the financial capitals of the world. Our markets have been the deepest, most liquid and safest. Our dominant position was built not only on our talent, ingenuity and expertise, but also on a foundation of strong but efficient regulation, and a reputation for fairness, that demonstrated to investors that they would be protected from fraud and financial recklessness here. The events of past 24 months have destroyed our reputation as the system has been gripped by a financial crisis that resulted from years of regulatory neglect at all levels. Eight years of the Bush Administration's one-sided, laissez-faire, deregulatory ideology have helped cripple our financial system, and an outdated and overmatched regulatory system in this country compounded their failure. Even former Federal Reserve Chairman Alan Greenspan, once an ardent defender of deregulation and the free market, recently acknowledged that there was a ``flaw'' in his belief that markets could and would regulate themselves. I hope that we've learned that as appealing as deregulation may seem in good times, the price we ultimately pay will be far higher than had we exercised the good judgment and restraint imposed by responsible regulation. Designing a regulatory system is a complicated and difficult task. Regulation must strike a delicate balance--providing a sense of safety and security for investors, without snuffing out the flame of entrepreneurial vigor and financial innovation that drives economic growth. It's easy, and even tempting, to go to the ideological extremes on either end of the spectrum. But threading this needle correctly is an essential component of restoring confidence and long-term stability to the financial system. For many years, the United States had struck that balance very well. However, new factors, including technology, globalization, and industry consolidation and evolution have left our regulatory infrastructure too far behind the reality of today's global financial system. Where does this leave us? Well, it leaves us needing significant reform. As we go forward, I believe there are a number of clear principles that we must adhere to. I've discussed these principles before, but I think they're worth repeating now as we begin the discussion of regulatory reform under a new Administration. 1.) We must focus on controlling systemic risk and ensuring stability. In increasingly complex markets, even the most sophisticated financial institutions don't always understand the risks their decisions involve. Smaller institutions like some hedge funds and private equity firms, can also create systemic risk in today's world and cannot escape regulation, particularly when it comes to transparency. We need regulation that looks at risk systemically and above all, we need to ensure that whatever may happen to any individual financial actor, we can be confident that the financial system itself will remain strong and stable. 2.) We need to look closely at unifying and simplifying our regulatory structure. In this era of global markets and global actors, we cannot maintain the older model of separate businesses with separate regulators. Right now there are too many regulators at the Federal level with overlapping authority. This creates a regulatory ``race to the bottom'' as less responsible firms are able to play the regulators off one another in their efforts to operate with as little oversight and as few restrictions as possible. 3.) It is clear that we must figure out how to regulate currently unregulated parts of the financial markets and opaque and complex financial instruments. There are too many vital players and products in the financial markets that operate beyond the scope of Federal regulators, yet have the ability to put the system at risk. We must create an effective regulatory framework for those actors and for more exotic financial instruments like complex derivatives and even the relatively plain vanilla credit-default swaps, which have grown into a multi-trillion dollar part of the financial system. 4.) We must recognize that a global financial world requires global solutions. In this era of global finance, while we have international markets, we still have national regulations. The danger is that there is often a rush to the place where regulation is lightest and least effective. This may be our toughest challenge. 5.) Increased transparency must be a central goal. We must continue to emphasize transparency among all market participants. The ability of investors, lenders and especially regulators to evaluate the quality of holdings and borrowings is essential for restoring confidence. A complete overhaul of this nation's financial regulatory system will be difficult, complex and time consuming. I look forward to working with President Obama, and under the leadership of Chairman Dodd to advance this process so that as we begin to recover from the current financial crisis in the coming months, we have a system in place to prevent its repetition. ______ fcic_final_report_full--376 Meanwhile, in the absence of a liquid derivatives market and efficient price dis- covery, every firm’s risk management became more expensive and difficult. The usual hedging mechanisms were impaired. An investor that wanted to trade at a loss to get out of a losing position might not find a buyer, and those that needed hedges would find them more expensive or unavailable. Several measures revealed the lack of liquidity in derivatives markets. First, the number of outstanding contracts in a broad range of OTC derivatives sharply de- clined. Since its deregulation by federal statute in December , this market had increased more than sevenfold. From June ,  to the end of the year, however, outstanding notional amounts of OTC derivatives fell by more than . This de- cline defied historical precedent. It was the first significant contraction in the market over a six-month period since the Bank for International Settlements began keeping statistics in .  Moreover, it occurred during a period of great volatility in the fi- nancial markets. At such a time, firms usually turn to the derivatives market to hedge their increased risks—but now they fled the market. The lack of liquidity in derivatives markets was also signaled by the higher prices charged by OTC derivatives dealers to enter into contracts. Dealers bear additional risks when markets are illiquid, and they pass the cost of those risks on to market participants. The cost is evident in the increased “bid-ask spread”—the difference be- tween the price at which dealers were willing to buy contracts (the bid price) and the price at which they were willing to sell them (the ask price). As markets became less liquid during the crisis, dealers worried that they might be saddled with unwanted exposure. As a result, they began charging more to sell contracts (raising their ask price), and the spread rose. In addition, they offered less to buy contracts (lowered their bid price), because they feared involvement with uncreditworthy counterpar- ties. The increase in the spread in these contracts meant that the cost to a firm of hedging its exposure to the potential default of a loan or of another firm also in- creased. The cost of risk management rose just when the risks themselves had risen. Meanwhile, outstanding credit derivatives contracted by  between December , when they reached their height of . trillion in notional amount, and the latest figures as of June , when they had fallen to . trillion.  CHRG-110hhrg44900--4 The Chairman," Okay, so there is an overflow room for people who can't find seats. We have gotten the agreement of the Chairman and the Secretary, preliminary to any opening statements, to stay until 1 p.m. We will probably have some votes, so we will maximize our time. Let me remind the members that Chairman Bernanke will be before this committee next week for the Humphrey-Hawkins hearing on the economy. Members are obviously free to raise anything they want today, but it is my hope that we would focus on these very important questions of financial regulation. I know there are members who want to review what happened with Bear Stearns and then what we do going forward, but I personally believe the best use of the committee's time today would be to focus on those structural questions and regulatory questions. We will have the Chairman before us for 3 more hours next week to talk about the economy and Humphrey-Hawkins; and, again, I would urge members to do that. All members are free, as we know, to bring up whatever they want, but that would be our hope, because I did note that some of the members of the committee had asked previously for a hearing to look into what happened with Bear Stearns. And I said at the time that I thought that was very important. I believed it was best to do that in this broader context. Members want to get a new context because the experience regarding Bear Stearns is clearly the context in which much of this hearing is and much of what we will be talking about is what happens if that should occur. So those are the parameters. Given the importance of this, and given the interest of members in speaking, we are going to hold pretty firmly to the 5-minute rule. And, obviously, we are not going to completely finish in 5 minutes, but no question can be asked after the 5 minutes have expired. We will allow the answers to conclude. But I am going to have to restrain myself and others from asking any questions after the 5 minutes. Under the rules that apply when we have cabinet and cabinet-level officials, there are two opening statements on each side, the chairs and ranking members of the appropriate subcommittees. In this case, it seems clear to me that it is the Financial Institutions Subcommittee that is the developing subcommittee so that is how we will proceed. The official part of the hearing will now begin and I will recognize myself for a fairly strict 5 minutes. When I was about to become chairman of this committee in 2006, I was told by a wide range of people that our agenda should be that of further deregulating. I was told that the excess regulation in America from Sarbanes-Oxley and other acts was putting American investment companies and financial institutions at a competitive disadvantage and that people much prefer the softer touch of the financial services authority to the harshness of the American regulatory structure. Things have changed. Where there was a strong argument as recently as November of 2006 that we had been over-regulating the financial system, I believe the evidence is now clear that we are in one of the most serious economic troubles that we have seen recently, in part because of an inadequacy of regulation. Clearly, that has been the case with regard to subprime mortgages, but what has been striking is not simply that we had the problems with subprime mortgages, but that those problems infected so much of the financial system, including, I must say, many in Europe. One of the things though that I do take away from that set of conversations, and then it's a fairly clear one is that what we do, and I believe there is a consensus now among people in the Administration, among many of us in Congress, and among people in the financial industry, that an increase in regulation is required. It must be done sensibly. It must be market sensitive. But I believe we have seen a significant shift from the notion that the most important issue was to deregulate further to one recognizing the need for more sensible regulation, but more regulation. It is clear that this needs to be done in the context of international cooperation, and I am encouraged to believe, and the first trip this committee took when I became chairman was to Belgium and London to meet with people from the European Union and Great Britain in terms of their financial regulation. This needs to be done with international cooperation and I think the prospects of that are very good. I think there was a broad international recognition that some form of increased regulation was necessary. And the form we are talking about is regulation of risk-taking outside the very narrowly defined commercial banking. Innovation is very important, and an innovation that has brought a great deal of benefit during the last few decades is securitization. Securitization replaces the lender-borrower relationship and the discipline that you have in the lender-borrower relationship. A very large part of our problem is that we have not yet found sufficient replacement for the discipline of a lender not lending to a borrower unless the lender is sure that the borrower will be able to repay. Something that simple causes problems in subprime, and it has caused problems elsewhere. We have had too many loans made without sufficient attention to whether or not the loans could be repaid. And, what we now have is a contagion, because people who bought loans in various forms that they shouldn't have bought are now resistant to buying things that they should buy. That is why I believe regulation properly done, regulation of risk that is too unconstrained today, because the various risk management techniques that were supposed to replace the lender-borrower relationship have not been successful. Diversification and quantitative models and the rating agencies, we have not yet replaced them. Some form of regulatory authority is necessary. If properly done, a market sensitive regulatory authority not only prevents some of the problems, but is pro-market, because we have investors now who are unwilling to invest even in things they should. Many of our nonprofit institutions and our State and local governments have been the victims of this. So our job, I believe--and I congratulate the officials of this Administration for having done a good job in the current legal context of dealing with these problems--is to look at what happened, to look at what is now going on, and to decide what should be done to provide a better statutory framework for the increase in regulation that I believe people agree should happen. The gentleman from Alabama. " CHRG-109shrg21981--61 Chairman Greenspan," Senator, it is an extraordinary part of a phenomenon which has been going on for the last decade worldwide. Prior to 1995, there was a very major grossing up of exports and imports around the world, leaving as a consequence on average imports as a percent of GDP growing every year virtually. We nonetheless did not find that there was any evident consistent increase in the dispersion of trade or current account surpluses and deficits. In other words, there was what economists call a very considerable amount of home bias, meaning that countries tended to use their domestic savings to very largely finance their domestic investment. But since 1995, there has been a very pronounced change in which cross-border use of savings to invest in foreign countries all over the world has increased dramatically, which has meant that the dispersion of current account balances, both as surpluses on the one hand and deficits on the other, with the United States as the largest deficit, has increased. That phenomenon has given us the capacity to create a very large deficit, and indeed it has been a major source of financing to our domestic investment. But as I also said, and I think you pointed out, over the longer-run it is just not credible that it could go on without change because you will get an undue concentration of dollar claims on U.S. residents, which even though they are considered a highly valuable, and have high rates of return and the like, they lack the diversification of a good portfolio, and foreign investors would therefore start to ease off. And if you cannot finance a current account deficit, it will not exist. So that is surely the case. But I have also said that the degree of flexibility, owing to deregulation, owing to technology, owing to lots of innovation, has created a degree of flexibility and therefore resilience in this economy that has in the past and is very likely in the future to defuse this large current account balance without undue negative economic effects on the American economy. So what I said in the last several weeks is, one, this is a problem; we are approaching it and I think coming to grips with it in the marketplace, and the evidence is that for the first time we are beginning to see the impact of stable margins of foreign exporters at very low levels now beginning to produce increases in import prices in the United States, which is the first stage in the adjustment process. Senator Bunning. As you know, the SEC has proposed a new Regulation B to Section 2 of the Gramm-Leach-Bliley Act. The Fed, along with the FDIC and the OCC, wrote a very strong letter to the SEC opposing their proposed regulation. Would you comment on how this proposed regulation could affect the bankers? " CHRG-111shrg53822--56 Mr. Stern," Yes. As I said, I think that would be constructive. Senator Warner. Could there be even the advancement of that type of legislation? Could that have any short-term, positive---- Ms. Bair. I think it could be an important catalyst, perhaps, for more fundamental restructurings or assets sales. It could serve as a wake-up call, to perhaps move things along a little faster. Senator Warner. It might force some of our banks to move quicker into which assets they might be willing to dispose of. Ms. Bair. Right. Well, in these smaller institutions, we find that it is a viable mechanism to use. Just having that there is a good catalyst to take more aggressive action, whether it is major changes or restructurings, or asset sales or just selling the whole institution, which is more practical with the small institution. I think, absolutely, just having the lever there can contribute to some very constructive activity. Senator Warner. Well, I hope Chairman Dodd and Ranking Member Shelby get a chance to weigh in on that. I would love to see their sense of whether expedited on that would make some sense. Again, we will go very quickly, if any other member wants to ask this panel. Senator Merkley? Okay. Then I would then thank the panel for their very productive testimony and, always, your good work. Thank you. And we will move now to the second panel. Recognizing we have some votes, I will go ahead, and as the panel is setting up, I will go through a few introductory comments. For our second panel, we will hear from Peter J. Wallison, the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute for Public Policy Research, where his research focuses on banking, insurance and Wall Street regulation. Previously, Mr. Wallison served as general counsel to the U.S. Treasury, the depository institution's Deregulation Committee, and as White House counsel to President Ronald Reagan. After Mr. Wallison, we will hear from the Honorable Martin Baily, Senior Fellow in Economics Studies at the Brookings Institution. Mr. Baily served as chairman of the Council of Economic Advisors during the Clinton Administration. Finally, we will hear from Mr. Raghuram R.J. Rajan, the Eric J. Gleacher Distinguished Service Professor of Finance, University of Chicago, Booth School of Business. He served as chief economist at the International Monetary Fund. His major research focuses in the role of finance, planning and economic growth. We were asked for Mr. Wallison to testify first, but we seem to be missing Mr. Wallison. " fcic_final_report_full--398 Over the next several months Bank of America worked with its regulators to iden- tify the assets that would be included in the asset pool. Then, on May , Bank of America asked to exit the ring fence deal, explaining that the company had deter- mined that losses would not exceed the  billion that Bank of America was required to cover in its first-loss position. Although the company was eventually allowed to ter- minate the deal, it was compelled to compensate the government for the benefits it had received from the market’s perception that the government would insure its as- sets. On September , Bank of America agreed to pay a  million termination fee:  million to Treasury,  million to the Fed, and  million to the FDIC. COMMISSION CONCLUSIONS ON CHAPTER 20 The Commission concludes that, as massive losses spread throughout the finan- cial system in the fall of , many institutions failed, or would have failed but for government bailouts. As panic gripped the market, credit markets seized up, trading ground to a halt, and the stock market plunged. Lack of transparency contributed greatly to the crisis: the exposures of financial institutions to risky mortgage assets and other potential losses were unknown to market participants, and indeed many firms did not know their own exposures. The scale and nature of the over-the-counter (OTC) derivatives market cre- ated significant systemic risk throughout the financial system and helped fuel the panic in the fall of : millions of contracts in this opaque and deregulated market created interconnections among a vast web of financial institutions through counterparty credit risk, thus exposing the system to a contagion of spreading losses and defaults. Enormous positions concentrated in the hands of systemically significant institutions that were major OTC derivatives dealers added to uncertainty in the market. The “bank runs” on these institutions in- cluded runs on their derivatives operations through novations, collateral de- mands, and refusals to act as counterparties. A series of actions, inactions, and misjudgments left the country with stark and painful alternatives—either risk the total collapse of our financial system or spend trillions of taxpayer dollars to stabilize the system and prevent catastrophic damage to the economy. In the process, the government rescued a number of fi- nancial institutions deemed “too big to fail”—so large and interconnected with other financial institutions or so important in one or more financial markets that their failure would have caused losses and failures to spread to other institutions. The government also provided substantial financial assistance to nonfinancial corporations. As a result of the rescues and consolidation of financial institutions through failures and mergers during the crisis, the U.S. financial sector is now more concentrated than ever in the hands of a few very large, systemically signifi- cant institutions. This concentration places greater responsibility on regulators for effective oversight of these institutions. CHRG-110hhrg45625--47 Mr. Kanjorski," Good afternoon, Mr. Chairman. In this hearing room, in the halls of Congress, and all across Washington, the $700 billion Treasury proposal is a subject of much debate, but the American taxpayers remain in the dark. The Administration has only told them in general terms that our economy has reached a tipping point and that the Executive Branch needs unprecedented powers and a blank check to fix the situation. In my view, the current dire circumstances require that the American people receive more information rather than less. The President must also deliver a national address to explain why the largest government intervention since the Great Depression is needed. If our markets and capitalism itself are truly on the line, then the President must speak openly, frankly, and publicly about these problems. Once the Administration establishes the predicate for emergency action, only then should the Congress consider passing this package of truly massive proportions. And if we do decide that the Treasury plan is the proper course, we must revise it to protect taxpayers. Their interests must trump those of corporate fat cats and cowboy capitalists. As we proceed on these matters, we must also put partisanship aside. Bipartisan is a two-way street. The American people want cooperation and leadership by government in tough times. As my fellow Pennsylvanian, Ben Franklin, said at the founding of our Nation, ``We must all hang together or we shall surely all hang separately.'' Unfortunately, the initial Treasury plan would have the taxpayer picking up the tab for a Wall Street party to which they were not even invited. It would also have taxpayers playing the role of venture capitalists without a share of profits in the long run. Americans are tired of enabling corporate excess. Therefore, once the Administration makes its case and the Congress decides to act, the legislation we write must meet many conditions. We must protect taxpayers and limit the Treasury's power. We must prevent those who contributed the most to this crisis from further profiting. We must establish strong oversight with a permanent in-house watchdog and a robust external congressional monitor. We must also control the program's costs and seek ways to pay for its intervention, including surcharges on millionaire's incomes and fees on securities transactions. Finally, we must help families with troubled loans to remain in their homes. Moreover, every one of these debates must commit to significant regulatory reform of the financial system in the next Congress. The era of deregulation is over. As many of us on this side of the aisle have long believed, only regulation can save capitalism from its own excess. In sum, the economy is a man-made construct. Man made it and man can fix it. I am committed to doing just that. " 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--68 In , the Economic Growth and Regulatory Paperwork Reduction Act re- quired federal regulators to review their rules every decade and solicit comments on “outdated, unnecessary, or unduly burdensome” rules.  Some agencies responded with gusto. In , the Federal Deposit Insurance Corporation’s annual report in- cluded a photograph of the vice chairman, John Reich; the director of the Office of Thrift Supervision (OTS), James Gilleran; and three banking industry representa- tives using a chainsaw and pruning shears to cut the “red tape” binding a large stack of documents representing regulations. Less enthusiastic agencies felt heat. Former Securities and Exchange Commission chairman Arthur Levitt told the FCIC that once word of a proposed regulation got out, industry lobbyists would rush to complain to members of the congressional committee with jurisdiction over the financial activity at issue. According to Levitt, these members would then “harass” the SEC with frequent letters demanding an- swers to complex questions and appearances of officials before Congress. These re- quests consumed much of the agency’s time and discouraged it from making regulations. Levitt described it as “kind of a blood sport to make the particular agency look stupid or inept or venal.”  However, others said interference—at least from the executive branch—was mod- est. John Hawke, a former comptroller of the currency, told the FCIC he found the Treasury Department “exceedingly sensitive” to his agency’s independence. His suc- cessor, John Dugan, said “statutory firewalls” prevented interference from the execu- tive branch.  Deregulation went beyond dismantling regulations; its supporters were also disin- clined to adopt new regulations or challenge industry on the risks of innovations. Federal Reserve officials argued that financial institutions, with strong incentives to protect shareholders, would regulate themselves by carefully managing their own risks. In a  speech, Fed Vice Chairman Roger Ferguson praised “the truly im- pressive improvement in methods of risk measurement and management and the growing adoption of these technologies by mostly large banks and other financial in- termediaries.”  Likewise, Fed and other officials believed that markets would self-reg- ulate through the activities of analysts and investors. “It is critically important to recognize that no market is ever truly unregulated,” said Fed Chairman Alan Greenspan in . “The self-interest of market participants generates private market regulation. Thus, the real question is not whether a market should be regulated. 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 .  fcic_final_report_full--450 INTRODUCTION Why a Dissent? The question I have been most frequently asked about the Financial Crisis Inquiry Commission (the “FCIC” or the “Commission”) is why Congress bothered to authorize it at all. Without waiting for the Commission’s insights into the causes of the financial crisis, Congress passed and the President signed the Dodd-Frank Act (DFA), far reaching and highly consequential regulatory legislation. Congress and the President acted without seeking to understand the true causes of the wrenching events of 2008, perhaps following the precept of the President’s chief of staff—“Never let a good crisis go to waste.” Although the FCIC’s work was not the full investigation to which the American people were entitled, it has served a useful purpose by focusing attention again on the financial crisis and whether—with some distance from it—we can draw a more accurate assessment than the media did with what is often called the “first draft of history.” To avoid the next financial crisis, we must understand what caused the one from which we are now slowly emerging, and take action to avoid the same mistakes in the future. If there is doubt that these lessons are important, consider the ongoing efforts to amend the Community Reinvestment Act of 1977 (CRA). Late in the last session of the 111 th Congress, a group of Democratic congressmembers introduced HR 6334. This bill, which was lauded by House Financial Services Committee Chairman Barney Frank as his “top priority” in the lame duck session of that Congress, would have extended the CRA to all “U.S. nonbank financial companies,” and thus would apply, to even more of the national economy, the same government social policy mandates responsible for the mortgage meltdown and the financial crisis. Fortunately, the bill was not acted upon. Because of the recent election, it is unlikely that supporters of H.R. 6334 will have the power to adopt similar legislation in the next Congress, but in the future other lawmakers with views similar to Barney Frank’s may seek to mandate similar requirements. At that time, the only real bulwark against the government’s use of private entities for social policy purposes will be a full understanding of how these policies were connected to the financial crisis of 2008. Like Congress and the Administration, the Commission’s majority erred in assuming that it knew the causes of the financial crisis. Instead of pursuing a thorough study, the Commission’s majority used its extensive statutory investigative authority to seek only the facts that supported its initial assumptions—that the crisis was caused by “deregulation” or lax regulation, greed and recklessness on Wall Street, predatory lending in the mortgage market, unregulated derivatives and a financial system addicted to excessive risk-taking. The Commission did not seriously investigate any other cause, and did not effectively connect the factors 443 it investigated to the financial crisis. The majority’s report covers in detail many elements of the economy before the financial crisis that the authors did not like, but generally failed to show how practices that had gone on for many years suddenly caused a world-wide financial crisis. In the end, the majority’s report turned out to be a just so story about the financial crisis, rather than a report on what caused the financial crisis. CHRG-111shrg53176--50 Mr. Levitt," Thank you, Chairman Dodd and Ranking Member Shelby, for the opportunity to appear before the Committee this morning. Thank you for your kind words. It is good to be back with former friends and colleagues. When I last appeared before this Committee, I focused my remarks on the main causes of the crisis we are in and the significant role played by deregulation. Today, I would like to focus on the prime victim of deregulation, investors. Their confidence in fair, open, and efficient markets has been badly damaged, and not surprisingly, our markets have suffered. Above all the issues you now face, whether it is public fury over bonus payments or the excesses of companies receiving taxpayer assistance, there is none more important than investor confidence. The public may demand that you act over some momentary scandal, but you mustn't give in to bouts of populist activism. Your goal is to serve the public not by reacting to public anger, but by focusing on a system of regulation which treats all market actors the same under the law, without regard to their position or their status. Many are suggesting we should reimpose Glass-Steagall rules. For six decades, those rules kept the Nation's commercial banks away from the kinds of risky activities of investment banks. While it would be impossible to turn back the clock and reimpose Glass-Steagall, I think we can borrow from some of the principles and apply them to today's environment. The principles ensured are regulation's need to match the market action. Entities engaged in trading securities should be regulated as securities firms, while entities taking deposits and holding loans to maturity should be regulated as depository banks. Regulation, I think, is not one-size-fits-all. Accounting standards must be consistent. The mere mention of accounting can make the mind wander, but accounting is the foundation of our financial system. Under no circumstances should accounting standards be changed to suit the momentary needs of market participants. This is why mark-to-the-market accounting should not be suspended under any condition. The proper role of a securities regulator is to be the guardian of capital markets. Of course, there is an inherent tension at times between securities regulators and banking supervisors. But under no circumstances should securities regulators, especially those at the SEC, be subordinated. You must fund them appropriately, give them the legal tools they need, and hold them accountable to enforce the laws you write. And finally, all such reforms are best done in a complementary, systemic way. You can't do regulation piecemeal. Allow me to illustrate how these principles can be put to work in specific regulatory and policy reforms. First, some have suggested that you create a super-regulator. I suggest you take a diverse approach using the existing strengths of our existing regulatory agencies. For example, the Federal Reserve is a banking supervisor. It has a deep and ingrained culture that is oriented toward the safety and soundness of our banking system. Ultimately, the only solution to the tension is to live with it. when I was at the SEC, there was tension between banking regulators and securities regulators all the time. While this was frustrating for the regulators and the financial institutions themselves, I think it served the overall purposes of reducing systemic risk. Regulatory overlap is not only inevitable, I think it may be desirable. Second, mark-to-the-market or fair value standards should not be suspended. Any effort that seeks to shield investors from understanding risk profiles of individual banks would, I believe, be a mistake and contribute greatly to systemic risk. The Chairman of the Federal Reserve, the heads of the major accounting firms maintain that maintenance of mark-to-the-market standards is essential. Third, this Committee and other policymakers seek to mitigate systemic risk. I suggest promoting transparency and information discovery across multiple markets, specifically credit rating agencies, municipal bond issuers, and hedge funds. For years, credit rating agencies have been able to use legal defenses to keep the SEC from inspecting their operations even though they dispense investment advice and sit at a critical nexus of financial information and risk. In addition, these rating agencies operate with significant protections from private rights of actions. These protections need to be reconsidered. In the same manner, the SEC should have a far greater role in regulating the municipal bond market, which consists of State and local government securities. Since the New York City crisis of 1975, this market has grown to a size and complexity few anticipated. It is a ticking time bomb. The amount of corruption, the amount of abuse, the amount of pain caused to municipal workers and will be caused to municipal workers in an environment that is almost totally unregulated is a national scandal. Because of the Tower amendment, many participants, insurers, rating agencies, financial advisors, underwriters, hedge funds, money managers, and even some issuers have abused the protection granted by Congress from SEC regulation. Through multiple scandals and investment debacles hurting taxpayers, we know self-regulation by bankers and brokers through the Municipal Services Rulemaking Board simple does not work. We must level the playing field between the corporate and municipal markets, address all the risks to the financial system. In addition, I would also recommend amending the Investment Advisers Act to give the SEC the right to oversee specific areas of the hedge fund industry and other pockets of shadow markets. These steps would require over-the-counter derivatives market reform, the outcome of which would be the regulation by the SEC of all credit and securities derivatives. To make this regulation possible and efficient, it would make sense, as my predecessor, Chairman Breeden, has said so often, to combine the resources and responsibilities of the SEC and CFTC. Under no condition should the SEC lose any of its current regulatory authority. The Commission is the best friend investors have. The resulting regulatory structure would be flexible, effective in identifying potential systemic risk and supportive of financial innovations and investor choices. Most importantly, these measures would help restore investor confidence by making sure rules are enforced equally and investors are protected from fraud and outright abuse. As we have seen in the debate over mark-to-market accounting rules, there will be strong critics of a strong and consistent regulatory structure, but someone must think of the greater good. That is why this Committee must draw on its heritage of setting aside partisanship and the concerns of those with single interests and affirm the rights of investors whose confidence will determine the health of our markets, our economy, and ultimately our Nation. Thank you. " fcic_final_report_full--475 Indeed, the Commission’s entire investigation seemed to be directed at minimizing the role of NTMs and the role of government housing policy. In this telling, the NTMs were a “trigger” for the financial crisis, but once the collapse of the bubble had occurred the “weaknesses and vulnerabilities” of the financial system— which had been there all along—caused the crisis. These alleged deficiencies included a lack of adequate regulation of the so-called “shadow banking system” and over-the-counter derivatives, the overly generous compensation arrangements on Wall Street, and securitization (characterized as “the originate to distribute model”). Coincidentally, all these purported weaknesses and vulnerabilities then required more government regulation, although their baleful presence hadn’t been noted until the unprecedented number of subprime and Alt-A loans, created largely to comply with government housing policies, defaulted. 6. Conclusion What is surprising about the many views of the causes of the financial crisis that have been published since the Lehman bankruptcy, including the Commission’s own inquiry, is the juxtaposition of two facts: (i) a general agreement that the bubble and the mortgage meltdown that followed its deflation were the precipitating causes—sometimes characterized as the “trigger”—of the financial crisis, and (ii) a seemingly studious effort to avoid examining how it came to be that mortgage underwriting standards declined to the point that the bubble contained so many NTMs that were ready to fail as soon as the bubble began to deflate. Instead of thinking through what would almost certainly happen when these assets virtually disappeared from balance sheets, many observers—including the Commission majority in their report—pivoted immediately to blame the “weaknesses and vulnerabilities” of the free market or the financial or regulatory system, without considering whether any system could have survived such a blow. One of the most striking examples of this approach was presented by Larry Summers, the head of the White House economic council and one of the President’s key advisers. In a private interview with a few of the members of the Commission (I was not informed of the interview), Summers was asked whether the mortgage meltdown was the cause of the financial crisis. His response was that the financial crisis was like a forest fire and the mortgage meltdown like a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest? 44 The Commission majority adopted the idea that it was the tinder-dry forest. Their central argument is that the mortgage meltdown as the bubble deflated triggered the financial crisis because of the “vulnerabilities” inherent in the U.S. financial system at the time—the absence 44 FCIC, Summers interview, p.77. of regulation, lax regulation, predatory lending, greed on Wall Street and among participants in the securitization system, ineffective risk management, and excessive leverage, among other factors. One of the majority’s singular notions is that “30 years of deregulation” had “stripped away key safeguards” against a crisis; this ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the FDIC Improvement Act, which was by far the toughest bank regulatory law since the advent of deposit insurance and was celebrated at the time of its enactment as finally giving the regulators the power to put an end to bank crises. fcic_final_report_full--51 Almost , commercial banks and thrifts failed in what became known as the S&L crisis of the s and early s. By comparison, only  banks had failed between  and . By , one-sixth of federally insured depository institu- tions had either closed or required financial assistance, affecting  of the banking system’s assets.  More than , bank and S&L executives were convicted of felonies.  By the time the government cleanup was complete, the ultimate cost of the crisis was  billion.  Despite new laws passed by Congress in  and  in response to the S&L crisis that toughened supervision of thrifts, the impulse toward deregulation contin- ued. The deregulatory movement focused in part on continuing to dismantle regula- tions that limited depository institutions’ activities in the capital markets. In , the Treasury Department issued an extensive study calling for the elimination of the old regulatory framework for banks, including removal of all geographic restrictions on banking and repeal of the Glass-Steagall Act. The study urged Congress to abolish these restrictions in the belief that large nationwide banks closely tied to the capital markets would be more profitable and more competitive with the largest banks from the United Kingdom, Europe, and Japan. The report contended that its proposals would let banks embrace innovation and produce a “stronger, more diversified finan- cial system that will provide important benefits to the consumer and important pro- tections to the taxpayer.”  The biggest banks pushed Congress to adopt Treasury’s recommendations. Op- posed were insurance agents, real estate brokers, and smaller banks, who felt threat- ened by the possibility that the largest banks and their huge pools of deposits would be unleashed to compete without restraint. The House of Representatives rejected Treasury’s proposal in , but similar proposals were adopted by Congress later in the s. In dealing with the banking and thrift crisis of the s and early s, Con- gress was greatly concerned by a spate of high-profile bank bailouts. In , federal regulators rescued Continental Illinois, the nation’s th-largest bank; in , First Republic, number ; in , MCorp, number ; in , Bank of New England, number . These banks had relied heavily on uninsured short-term financing to ag- gressively expand into high-risk lending, leaving them vulnerable to abrupt with- drawals once confidence in their solvency evaporated. Deposits covered by the FDIC were protected from loss, but regulators felt obliged to protect the uninsured deposi- tors—those whose balances exceeded the statutorily protected limits—to prevent po- tential runs on even larger banks that reportedly may have lacked sufficient assets to satisfy their obligations, such as First Chicago, Bank of America, and Manufacturers Hanover.  CHRG-110hhrg46591--3 Mr. Kanjorski," Mr. Chairman, we have reached a crossroads. Because our current regulatory regime has failed, we now must design a robust, effective supervisory system for the future. In devising this plan, we each must accept that regulation is needed to prevent systemic collapse. Deregulation, along with the twin notions that markets solve everything while government solves nothing, should be viewed as ideological relics of a bygone era. We also need regulation to rein in the private sector's excesses. In this regard, I must rebuke the greed of some AIG executives and agents who spent freely at California spas and on English hunting trips after the company secured a $123 billion taxpayer loan. Their behavior is shocking. The Federal Reserve must police AIG spending and impose executive pay limits. If it does not, I will do so legislatively. After all, the Federal Reserve's lending money to AIG is no different from the Treasury's investing capital in a bank. Returning to our hearing's main topic, I currently believe that the oversight system of the future must adhere to seven principles: First, regulators must have the resources and flexibility needed to respond to a rapidly evolving global economy full of complexity and innovation. Second, we must recognize the interconnectedness of our global economy when revamping our regulatory system. We must assure that the failure of one company, of one regulator or of one supervisory system does not produce disastrous, ricocheting effects elsewhere. Third, we need genuine transparency in the new regulatory regime. As products, participants, and markets become more complex, we need greater clarity. In this regard, hedge funds and private equity firms must disclose more about their activities. The markets for credit default swaps and for other derivatives must also operate more openly and under regulation. Fourth, we must maintain present firewalls, eliminate current loopholes, and prevent regulatory arbitrage in the new regulatory system. Banking and commerce must continue to remain separate. Financial institutions can neither choose their holding companies' regulators nor evade better regulation with a weaker charter. All financial institutions must also properly manage their risks, rather than shift items off balance sheet to circumvent capital rules. Fifth, we need to consolidate regulation in fewer agencies but maximize the number of cops on the beat to make sure that market participants follow the rules. We must additionally ensure that these agencies cooperate with one another, rather than to engage in turf battles. Sixth, we need to prioritize consumer and investor protection. We must safeguard the savings, homes, rights, and the financial security of average Americans. When done right, strong consumer protection can result in better regulation and more effective markets. Seventh, in focusing financial firms to behave responsibly, we must still foster an entrepreneurial spirit. This innovation goal requires a delicate but achievable balancing act. In sum, we have a challenging task ahead of us. Today's esteemed witnesses will help us to refine our seven regulatory principles and ultimately construct an effective regulatory foundation for the future. I look forward to their thoughts and to this important debate. Thank you, Mr. Chairman. " fcic_final_report_full--458 Given the likelihood that large numbers of subprime and Alt-A mortgages would default once the housing bubble began to deflate in mid- 2007—with devastating effects for the U.S. economy and financial system—the key question for the FCIC was to determine why, beginning in the early 1990s, mortgage underwriting standards began to deteriorate so significantly that it was possible to create 27 million subprime and Alt-A mortgages. The Commission never made a serious study of this question, although understanding why and how this happened must be viewed as one of the central questions of the financial crisis. From the beginning, the Commission’s investigation was limited to validating the standard narrative about the financial crisis—that it was caused by deregulation or lack of regulation, weak risk management, predatory lending, unregulated derivatives and greed on Wall Street. Other hypotheses were either never considered or were treated only superficially. In criticizing the Commission, this statement is not intended to criticize the staff, which worked diligently and effectively under diffi cult circumstances, and did extraordinarily fine work in the limited areas they were directed to cover. The Commission’s failures were failures of management. 1. Government Policies Resulted in an Unprecedented Number of Risky Mortgages Three specific government programs were primarily responsible for the growth of subprime and Alt-A mortgages in the U.S. economy between 1992 and 2008, and for the decline in mortgage underwriting standards that ensued. The GSEs’ Affordable Housing Mission. The fact that high risk mortgages formed almost half of all U.S. mortgages by the middle of 2007 was not a chance event, nor did it just happen that banks and other mortgage originators decided on their own to offer easy credit terms to potential homebuyers beginning in the 1990s. In 1992, Congress enacted Title XIII of the Housing and Community Development Act of 1992 6 ( the GSE Act), legislation intended to give low and 6 Public Law 102-550, 106 Stat. 3672, H.R. 5334, enacted October 28, 1992. 453 moderate income 7 borrowers better access to mortgage credit through Fannie Mae and Freddie Mac. This effort, probably stimulated by a desire to increase home ownership, ultimately became a set of regulations that required Fannie and Freddie to reduce the mortgage underwriting standards they used when acquiring loans from originators. As the Senate Committee report said at the time, “The purpose of [the affordable housing] goals is to facilitate the development in both Fannie Mae and Freddie Mac of an ongoing business effort that will be fully integrated in their products, cultures and day-to-day operations to service the mortgage finance needs of low-and-moderate-income persons, racial minorities and inner-city residents.” 8 The GSE Act, and its subsequent enforcement by HUD, set in motion a series of changes in the structure of the mortgage market in the U.S. and more particularly the gradual degrading of traditional mortgage underwriting standards. Accordingly, in this dissenting statement, I will refer to the subprime and Alt-A mortgages that were acquired because of the affordable housing AH goals, as well as other subprime and Alt-A mortgages, as non-traditional mortgages, or NTMs CHRG-111hhrg53248--13 Mr. Hensarling," Thank you, Mr. Chairman. When you have the wrong diagnosis, you will in turn offer the wrong remedy, and that is exactly the case with the Administration's proposal before us. Our economic turmoil has not arisen from deregulation, but more so from dumb regulation. That, and regulators who did not lack adequate regulatory authority but may have lacked adequate judgment. Although I have a number of concerns about the plan, I am simply taken aback by the lack of reform of Fannie Mae and Freddie Mac, the epicenter of the financial crisis, not to mention the suggested creation of an agency to abridge consumer rights. Rather than taking on the current status quo for these GSEs, the Administration's plan institutionalizes the problem. When President Obama referenced sweeping reform, I didn't know he meant sweeping Fannie and Freddie under the rug. Worse yet, his plan actually gives the Federal Reserve power to create more systemic risk by establishing tier one financial holding companies which can simply create more Fannies and Freddies, and signals to the market that the biggest institutions among us will always have a taxpayer safety net. In other words, the proposal enshrines us as a perpetual bailout nation. One of the more troubling components of the proposed plan is the creation of a new consumer financial product approval agency ruled by five unelected bureaucrats. Based upon their subjective determination of ``fairness,'' they will be empowered to decide which credit cards we can receive, which home mortgages we are permitted to possess, and even whether we can access an ATM machine. The proposal represents one of the greatest assaults on consumer rights I have ever witnessed. The legislation will stifle innovation, perhaps the next online banking service or the next frequent flyer mile offering, and worse yet will contract credit to our small businesses at a time of historic unemployment. There is a better way. The Republican plan under Ranking Member Bachus' leadership creates a new chapter of the Bankruptcy Code to enhance the resolution of large nonbank financial institutions. It puts an end to taxpayer-funded bailouts and too-big-to-fail. A market stability and capital adequacy board will be established and tasked with monitoring the interactions of all sectors of the financial system and identifying risk that can endanger the stability and soundness of the system. The Republican plan focuses the Federal Reserve on its core mission of conducting monetary policy. And although we preserve its 13(3) exigent powers, we do not leave them unlimited. Once the housing market is stabilized, we would phase out taxpayer subsidies of Fannie Mae and Freddie Mac and end the current model of privatized profits and socialized losses. Furthermore, our proposal creates an Office of Consumer Protection to empower consumers with effective disclosure and enhance the penalties for fraud. There are choices between more bailouts and no bailouts; market discipline or government control; consumer empowerment or the laws of consumer rights. Let's hope this committee and this Congress chooses wisely. I yield back the balance of my time. " fcic_final_report_full--566 Fed could have granted up to three one-year extensions of that exemption. 15. FCIC staff computations based on data from the Center for Responsive Politics. “Financial sector” here includes insurance companies, commercial banks, securities and investment firms, finance and credit companies, accountants, savings and loan institutions, credit unions, and mortgage bankers and brokers. 16. U.S. Department of the Treasury, Modernizing the Financial System (February 1991); Fed Chair- man Alan Greenspan, “H.R. 10, the Financial Services Competitiveness Act of 1997,” testimony before the House Committee on Banking and Financial Services, 105th Cong., 1st sess., May 22, 1997. 17. Katrina Brooker, “Citi’s Creator, Alone with His Regrets,” New York Times, January 2, 2010. 18. John Reed, interview by FCIC, March 24, 2010. 19. FDIC Institution Directory; SNL Financial. 20. Fed Governor Laurence H. Meyer, “The Implications of Financial Modernization Legislation for Bank Supervision,” remarks at the Symposium on Financial Modernization Legislation, sponsored by Women in Housing and Finance, Washington, D.C., December 15, 1999. 21. Ben S. Bernanke, written 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 1, session 1: The Federal Reserve, September 2, 2010, p. 14. 22. Patricia A. McCoy et al., “Systemic Risk through Securitization: The Result of Deregulation and Regulatory Failure,” Connecticut Law Review 41 (2009): 1345–47, 1353–55. 23. Fed Chairman Alan Greenspan, “Lessons from the Global Crises,” remarks before the World Bank Group and the International Monetary Fund, Program of Seminars, Washington, DC, September 27, 1999. 24. David A. Marshall, “The Crisis of 1998 and the Role of the Central Bank,” Federal Reserve Bank of Chicago, Economic Perspectives (1Q 2001): 2. 25. Commercial and industrial loans at all commercial banks, monthly, seasonally adjusted, from the Federal Reserve Board of Governors H.8 release; FCIC staff calculation of average change in loans out- standing over any two consecutive months in 1997 and 1998. 26. Franklin R. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” Jour- nal of Economic Perspectives 13 (1999): 198. 563 27. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” Report of the Pres- ident’s Working Group on Financial Markets, April 1999, p. 14. 28. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” pp. 200, 197; and CHRG-111hhrg51698--133 Mr. Gooch," I just want to clarify a couple of things. Mr. Greenberger mentioned that the assets in the bad banks, so to speak, are credit default swaps, and they are not. Credit default swaps are not the assets that would be taken off the balance sheets of banks. I think they are CDOs, collateralized debt obligations, and CMOs and CLOs and that type of thing that have gone bad. It is not CDS. So, part of why I am here today talking about not killing the credit default swap market is because of this misinformation. It isn't the other credit default swaps. The other gentleman asked me what did I mean by, the markets functioned fine. When Lehman finally did go out of business, their credit default swap book settled perfectly with all counterparties. There wasn't this systemic risk that people seemed to fear that was as the result of credit default swaps. So credit default swaps end up getting a bad name. I am totally in favor of having essential clearing mechanisms, one or more, as long as you have the situation from the major dealers that are actually involved with marketing these instruments. I am totally in favor of that and regulation and oversight. I think it is very important for the marketplace. But we need to be very careful here today not to get caught up in that hyperbole of blaming credit default swaps when they are not to blame, and risking cutting off a source of credit in the marketplace at a very fragile time in the recovery, hopeful recovery, of the United States and the global economy. To answer your question, Mr. Thompson, in terms of trading overseas, I will just mention, when I started in this business in 1978, the United States Government didn't allow U.S. banks to spot trade foreign exchange internationally, nor to make your dollar deposits with foreign banks. As a result, there was a massive foreign exchange market and euro/dollar deposit market that traded outside of the United States. At that point in time, when I worked for a brokerage company in the U.K., we had 300 or 400 employees involved in these marketplaces, and their New York office had less than 20 employees. It was 1979 when they deregulated that and put the American banks on a level playing field that the business exploded in the U.S., which is how come I got to be brought out to the United States, because at 20 years old, I was considered an experienced foreign exchange trader. But that will give you an example of how the United States was behind in those global markets. Absolutely, certainly, if you squeeze a balloon here, it is going to pop out somewhere else. Right now, the Russian ruble trades massively in London on what is known as a nondeliverable forward. Russia, the Government of Russia, has no control over that marketplace. They trade the Russian ruble in London on a nondeliverable forward. That is the case with a number of currencies around the world. If the United States wants to put themselves in that position by potentially introducing regulation that stifles their competition in the marketplace, the markets will move overseas. Just one last quick comment. I don't know much about the agricultural markets, but I do understand that there is some CFTC regulation that requires the elevator owners that buy the grain to hedge that in the futures market. It is because of the margin requirement on those hedges that they couldn't buy grain from the producers, which is why those producers weren't able to actually lock in the high prices when the high prices were there. So all I would say is it was probably a very good piece of regulation when it was introduced, but it didn't work in a very volatile market. So you just have to be careful with regulation that you have flexibility, but I do certainly support transparency in these markets. " CHRG-111shrg52619--78 Mr. Smith," On behalf of the States, I will say that with regard to the mortgage issue, for example, the State response to the mortgage issue may have been imperfect, and it may not have been complete. In North Carolina, we started addressing predatory lending in 1999. I would say that I think that the actions of State AGs and State regulators should have been and ought to be in the future, market information in assessing systemic risk ought to be taken into account. And I think this has not been done in the past. Again, I do not claim that we are perfect. I do claim that we are closer to the market as a rule than our colleagues in the Federal Government. And I think we have something to add if we are allowed to add it. So I hope as we go forward, sir, the State role in consumer protection will be acknowledged and it will be given a chance to do more. Senator Merkley. OK. Well, let me just close with this comment since my time is up. The comment that this issue has had robust attention--I believe, Mr. Polakoff, you made that--WAMU was a thrift. Countrywide was a thrift. On the ground, it does not look like anything close to robust regulation of consumer issues. I will say I really want to applaud the Fed for the actions they took over subprime lending, their action regarding escrow for taxes and insurance, their addressing of abusive prepayment penalties, the ending of liar loans in subprime. But I also want to say that from the perspective of many folks on the ground, one of the key elements was booted down the road, and that was the yield spread premiums. Just to capture this, when Americans go to a real estate agent, they have all kinds of protection about conflict of interest. But when they go to a broker, it is a lamb to the slaughter. That broker is being paid, unbeknownst to the customer is being paid proportionally to how bad a loan that consumer gets. And that conflict of interest, that failure to address it, the fact that essentially kickbacks are involved, results in a large number of our citizens, on the most important financial transaction of their life, ending up with a subprime loan rather than a prime loan. That is an outrage. And I really want to encourage you, sir, in your new capacity to carry this conversation. The Fed has powers that it has not fully utilized. I do applaud the steps it has taken. And I just want to leave with this comment: that the foundation of so many families financially is their homes, and that we need to provide superb protections designed to strengthen our families, not deregulation or loose regulations designed for short-term profits. Thank you. Senator Reed. Senator Johanns. Senator Johanns. Thank you very much. I am not even exactly certain who I direct this to, so I am hoping that you all have just enough courage to jump in and offer some thoughts about what I want to talk about today. As I was sitting here and listening to the great questioning from my colleague, the response to one of the questions was that we do make a risk assessment when there is a merger. We make an assessment as to the risk that is being taken on by this merger. And I sit here, I have to tell you, and I think to myself, well, if it is working that well, how did we end up where we are at today? So that leads me to these questions. The first one is, who has the authority, or does the authority exist for somebody to say that the sheer size of what we end up with poses a risk to our overall national, if not international economy, because you have got so many eggs in one basket that if your judgment is wrong about the risk assessment, you are not only wrong a little bit, you are wrong in a very magnificent sort of way. So who has that authority? Does that authority exist, and if it doesn't, should it exist? " CHRG-109hhrg23738--17 Mr. Frank," Thank you, Mr. Chairman. I do have to note one further example, among many, of your discretion, when the chairman asked you about the Laffer Curve. You said--it was fairly early in his 5 minutes--that you did not have the time to answer it. There is an old, crude joke: ``Do you have the time?'' ``Well, if you have the inclination.'' My inference, frankly, is that you had the time but not the inclination. I honor that, and I understand it. I think it is very discreet. I want to go back to the point I raised before, and that is--and I agree with you, we have this resistance to many of the measures that have been helpful, that I think would be helpful. I may disagree on some. And we have had a bipartisan cooperation in many of these areas, going back to President Carter and others, who did deregulation. But people need to understand, people in the business community need to understand, that bipartisan cooperation is breaking down in the economic area--and I am not talking about bickering or squabbling; I am talking about profound philosophical differences. Many of us are convinced that we are in a situation now, because of information technology, globalization, and a lot of other factors which are, in many ways, benign, but they combine so that we are getting increased growth with increased inequality. You yourself have commented on this trend. You told the Joint Economic Committee over a year ago that a substantial part of the increased wealth and productivity was going to corporate profits. In fact, what you said was that--this is a little over a year ago: ``The consequence was a marked fall in the ratio of employee compensation to gross non-financial corporate income to a very low level by the standards of the past 3 decades.'' Now, we had unemployment, but people are celebrating a decline in unemployment. But reading Paul Krugman's article in July, my attention was called to a policy paper done of the Boston Federal Reserve, by Katharine Bradbury. And you are justly proud, I know, of the high-quality work that is done by your analysts. I do not know if you have had a chance to look at this one. It is a fairly recent policy brief. But her point is very straightforward: ``Decrease in unemployment is substantially because of a decrease in the labor participation rate. Improvements in the unemployment rate overstate the strength of the recovery, since the nation's labor force participation rate has not rebounded to date.'' Even after job counts began to rise and joblessness subside, however, the fraction of the population that is employed did not increase, and it has not improved measurably to date. And that also, of course, is one of the reasons why we have not seen any increase in wages. And you noted in 2004 that wages were depressed. You have said yes, the wage sector is going up. But again, as your Monetary Report--and I am consistently grateful for the intellectual honesty and clarity of these reports--that is largely because of stock options and bonuses, so that people working for hourly wages---- And I am going to ask to put in the record here a chart that Mr. Morris on my staff has prepared from Department of Labor, Department of Commerce data. Real wages, average hourly earnings for production and non-supervisory workers, adjusted for inflation, 2001, $14.52. As of June of this year, $14.05: a 47-cent-per-hour decrease. Now, it is one thing for people to experience a decrease when they read about bad economic times; it is another when they read celebrations of how well the economy is doing but they are not doing well. That, to me, is the explanation for the phenomenon you deplored in your statement, about the ``growing resistance.'' Why do you think we are running into this growing resistance? Would you agree, or do you have some other explanation? I mean, do workers suddenly turn mean and surly or what? " fcic_final_report_full--73 But it was a completely different proposition to argue that a hedge fund could be considered too big to fail because its collapse might destabilize capital markets. Did LTCM’s rescue indicate that the Fed was prepared to protect creditors of any type of firm if its collapse might threaten the capital markets? Harvey Miller, the bankruptcy counsel for Lehman Brothers when it failed in , told the FCIC that “they [hedge funds] expected the Fed to save Lehman, based on the Fed’s involvement in LTCM’s rescue. That’s what history had proved to them.”  For Stanley O’Neal, Merrill’s CFO during the LTCM rescue, the experience was “indelible.” He told the FCIC, “The lesson I took away from it though was that had the market seizure and panic and lack of liquidity lasted longer, there would have been a lot of firms across the Street that were irreparably harmed, and Merrill would have been one of those.”  Greenspan argued that the events of  had confirmed the spare tire theory. He said in a  speech that the successful resolution of the  crisis showed that “di- versity within the financial sector provides insurance against a financial problem turning into economy-wide distress.”  The President’s Working Group on Financial Markets came to a less definite conclusion. In a  report, the group noted that LTCM and its counterparties had “underestimated the likelihood that liquidity, credit, and volatility spreads would move in a similar fashion in markets across the world at the same time.”  Many financial firms would make essentially the same mis- take a decade later. For the Working Group, this miscalculation raised an important issue: “As new technology has fostered a major expansion in the volume and, in some cases, the leverage of transactions, some existing risk models have underestimated the probability of severe losses. This shows the need for insuring that decisions about the appropriate level of capital for risky positions become an issue that is explicitly considered.”  The need for risk management grew in the following decade. The Working Group was already concerned that neither the markets nor their regulators were prepared for tail risk—an unanticipated event causing catastrophic damage to financial institu- tions and the economy. Nevertheless, it cautioned that overreacting to threats such as LTCM would diminish the dynamism of the financial sector and the real economy: “Policy initiatives that are aimed at simply reducing default likelihoods to extremely low levels might be counterproductive if they unnecessarily disrupt trading activity and the intermediation of risks that support the financing of real economic activity.”  Following the Working Group’s findings, the SEC five years later would issue a rule expanding the number of hedge fund advisors—to include most advisors—that needed to register with the SEC. The rule would be struck down in  by the United States Court of Appeals for the District of Columbia after the SEC was sued by an investment advisor and hedge fund.  Markets were relatively calm after , Glass-Steagall would be deemed unnec- essary, OTC derivatives would be deregulated, and the stock market and the econ- omy would continue to prosper for some time. Like all the others (with the exception of the Great Depression), this crisis soon faded into memory. But not before, in Feb- ruary , Time magazine featured Robert Rubin, Larry Summers, and Alan Greenspan on its cover as “The Committee to Save the World.” Federal Reserve Chairman Greenspan became a cult hero—the “Maestro”—who had handled every emergency since the  stock market crash.  fcic_final_report_full--43 This new system threatened the once-dominant traditional commercial banks, and they took their grievances to their regulators and to Congress, which slowly but steadily removed long-standing restrictions and helped banks break out of their tra- ditional mold and join the feverish growth. As a result, two parallel financial sys- tems of enormous scale emerged. This new competition not only benefited Wall Street but also seemed to help all Americans, lowering the  costs  of their mortgages and boosting the returns on their (k)s. Shadow banks and commer- cial banks were codependent competitors. Their new activities were very prof- itable—and, it turned out, very risky. Second, we look at the evolution of financial regulation. To the Federal Reserve and other regulators, the new dual system that granted greater license to market par- ticipants appeared to provide a safer and more dynamic alternative to the era of tradi- tional banking. More and more, regulators looked to financial institutions to police themselves—“deregulation” was the label. Former Fed chairman Alan Greenspan put it this way: “The market-stabilizing private regulatory forces should gradually dis- place many cumbersome, increasingly ineffective government structures.”  In the Fed’s view, if problems emerged in the shadow banking system, the large commercial banks—which were believed to be well-run, well-capitalized, and well-regulated de- spite the loosening of their restraints—could provide vital support. And if problems outstripped the market’s ability to right itself, the Federal Reserve would take on the responsibility to restore financial stability. It did so again and again in the decades leading up to the recent crisis. And, understandably, much of the country came to as- sume that the Fed could always and would always save the day. Third, we follow the profound changes in the mortgage industry, from the sleepy days when local lenders took full responsibility for making and servicing -year loans to a new era in which the idea was to sell the loans off as soon as possible, so that they could be packaged and sold to investors around the world. New mortgage products proliferated, and so did new borrowers. Inevitably, this became a market in which the participants—mortgage brokers, lenders, and Wall Street firms—had a greater stake in the quantity of mortgages signed up and sold than in their quality. We also trace the history of Fannie Mae and Freddie Mac, publicly traded corpora- tions established by Congress that became dominant forces in providing financing to support the mortgage market while also seeking to maximize returns for investors. Fourth, we introduce some of the most arcane subjects in our report: securitiza- tion, structured finance, and derivatives—words that entered the national vocabu- lary as the financial markets unraveled through  and . Put simply and most pertinently, structured finance was the mechanism by which subprime and other mortgages were turned into complex investments often accorded triple-A ratings by credit rating agencies whose own motives were conflicted. This entire market de- pended on finely honed computer models—which turned out to be divorced from reality—and on ever-rising housing prices. When that bubble burst, the complexity bubble also burst: the securities almost no one understood, backed by mortgages no lender would have signed  years earlier, were the first dominoes to fall in the finan- cial sector. fcic_final_report_full--7 We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts, in no small part due to the widely accepted faith in the self- correcting nature of the markets and the ability of financial institutions to effectively police themselves. More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor. Yet we do not accept the view that regulators lacked the power to protect the fi- nancial system. They had ample power in many arenas and they chose not to use it. To give just three examples: the Securities and Exchange Commission could have re- quired more capital and halted risky practices at the big investment banks. It did not. The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup’s excesses in the run-up to the crisis. They did not. Policy makers and regulators could have stopped the runaway mortgage securitization train. They did not. In case after case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting troubles, often downgrading them just before their collapse. And where regulators lacked authority, they could have sought it. Too often, they lacked the political will—in a political and ideological environment that constrained it—as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee. Changes in the regulatory system occurred in many instances as financial mar- kets evolved. But as the report will show, the financial industry itself played a key role in weakening regulatory constraints on institutions, markets, and products. It did not surprise the Commission that an industry of such wealth and power would exert pressure on policy makers and regulators. From  to , the financial sector expended . billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than  billion in campaign contributions. What troubled us was the extent to which the nation was deprived of the necessary strength and independence of the oversight necessary to safeguard financial stability. • We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this cri- sis. There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady regulatory hand, which, the firms argued, would stifle innovation. Too many of these institu- tions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding. In many respects, this reflected a funda- mental change in these institutions, particularly the large investment banks and bank holding companies, which focused their activities increasingly on risky trading activ- ities that produced hefty profits. They took on enormous exposures in acquiring and supporting subprime lenders and creating, packaging, repackaging, and selling tril- lions of dollars in mortgage-related securities, including synthetic financial products. Like Icarus, they never feared flying ever closer to the sun. fcic_final_report_full--69 Rather, the real question is whether government intervention strengthens or weakens private regulation.”  Richard Spillenkothen, the Fed’s director of Banking Supervision and Regulation from  to , discussed banking supervision in a memorandum submitted to the FCIC: “Supervisors understood that forceful and proactive supervision, espe- cially early intervention before management weaknesses were reflected in poor finan- cial performance, might be viewed as i) overly-intrusive, burdensome, and heavy-handed, ii) an undesirable constraint on credit availability, or iii) inconsistent with the Fed’s public posture.”  To create checks and balances and keep any agency from becoming arbitrary or inflexible, senior policy makers pushed to keep multiple regulators.  In , Greenspan testified against proposals to consolidate bank regulation: “The current structure provides banks with a method . . . of shifting their regulator, an effective test that provides a limit on the arbitrary position or excessively rigid posture of any one regulator. The pressure of a potential loss of institutions has inhibited excessive regulation and acted as a countervailing force to the bias of a regulatory agency to overregulate.”  Further, some regulators, including the OTS and Office of the Comp- troller of the Currency (OCC), were funded largely by assessments from the institu- tions they regulated. As a result, the larger the number of institutions that chose these regulators, the greater their budget. Emboldened by success and the tenor of the times, the largest banks and their reg- ulators continued to oppose limits on banks’ activities or growth. The barriers sepa- rating commercial banks and investment banks had been crumbling, little by little, and now seemed the time to remove the last remnants of the restrictions that sepa- rated banks, securities firms, and insurance companies. In the spring of , after years of opposing repeal of Glass-Steagall, the Securi- ties Industry Association—the trade organization of Wall Street firms such as Gold- man Sachs and Merrill Lynch—changed course. Because restrictions on banks had been slowly removed during the previous decade, banks already had beachheads in securities and insurance. Despite numerous lawsuits against the Fed and the OCC, securities firms and insurance companies could not stop this piecemeal process of deregulation through agency rulings.  Edward Yingling, the CEO of the American Bankers Association (a lobbying organization), said, “Because we had knocked so many holes in the walls separating commercial and investment banking and insur- ance, we were able to aggressively enter their businesses—in some cases more aggres- sively than they could enter ours. So first the securities industry, then the insurance companies, and finally the agents came over and said let’s negotiate a deal and work together.”  In , Citicorp forced the issue by seeking a merger with the insurance giant Travelers to form Citigroup. The Fed approved it, citing a technical exemption to the Bank Holding Company Act,  but Citigroup would have to divest itself of many Travelers assets within five years unless the laws were changed. Congress had to make a decision: Was it prepared to break up the nation’s largest financial firm? Was it time to repeal the Glass-Steagall Act, once and for all? CHRG-110hhrg46591--450 The Chairman," That said that the Federal Reserve should regulate mortgages. And it was assumed at the time that the bank regulators were regulating the mortgages on the regulated institutions, but that the Fed should do across-the-board mortgage regulation, knocking out a lot of things that should happen. Well, this is an important point, and it is not what you said. Mr. Greenspan, under his philosophy of deregulation, refused to use it. Now it is true, as some of my colleagues over there said, the law was on the books. But Mr. Greenspan said, no, the market is smarter than I am, and explicitly refused to use it. Federal Reserve Governor Gramlich urged him to use it, and he refused on philosophical grounds. Finally, frustrated that that wasn't happening, in 2005, four members of this committee--Mr. Bachus, who was then the chairman of the Financial Institutions Subcommittee as a Republican, Mr. Watt of North Carolina, Mr. Miller of North Carolina, and myself--began conversations to adopt legislation. So it is simply not true that no one was looking at this. In 2005, we began negotiations among us to adopt a bill to do what Mr. Greenspan wouldn't do, to restrict subprime mortgages that shouldn't have been granted. Those negotiations went on for a while, and I was then told by the then-chairman of the committee--I think Mr. Bachus got the same message--the Republican House leadership did not want that to go forward. And the efforts ended. In 2007, when I became the chairman, we took that issue up, and we did pass a bill in 2007. And Mr. Bachus, who voted for the bill, indicated he thought some of the people testifying had been against it, but we did pass a bill that would restrict most of these things. But here is some good news, and we don't like to talk about the good news for some reason. Even though that bill didn't pass in the Senate, which is a phrase you hear quite a lot these days, or forever, Mr. Bernanke, after the House acted, and in conversation with the House, then used exactly the authority that Alan Greenspan refused to use, and has promulgated a set of restrictions on subprime mortgage origination which will stop this problem from happening again. So the problem was twofold. And this is what the acceleration question is, Mr. Ryan. The weapons that destroyed the financial system of the world were the subprime loans. They shouldn't have been granted. A lot of people, certainly myself included, but top-ranked officials, all thought that while this would be damaging, the damage would be confined to the mortgage market. What very few people understood was the extent to which subprime damages would rocket throughout the system. And yes, it was the super sophisticated, not very well-understood, and not very well-regulated financial instruments that took these subprime loans and spread them around. Now, we have solved part of that problem going forward because, thanks to Ben Bernanke, acting after the House moved, there will be no more of those subprime loans. Ben Bernanke's rules are pretty good ones, and everything I would like to do. And we want to go further on yield spread premiums and elsewhere. The problem is that while subprime loans won't be the weapon that is loaded into these super sophisticated instruments and shot around, there may be something else. So that is why the second part of the job, having seen that subprime loans don't go forth, the second part of the job is what we have been talking about today--and you have all been very helpful and we appreciate it--how do we put some constraints on excessive risk-taking in the financial system so the next time--and nobody can be sure it won't happen-- loans are made that shouldn't have been made, we don't have them multiplied in their effect. But I did want to say it is really not fair to say that no one was looking at subprime loans. Many of us were doing it in 2005, and even earlier, trying to get Mr. Greenspan to do it. Yes, Mr. Yingling. " CHRG-111shrg55479--140 PREPARED STATEMENT OF RICHARD C. FERLAUTO Director of Corporate Governance and Pension Investment, American Federation of State, County, and Municipal Employees July 29, 2009 Good Afternoon, Chairman Reed and Members of the Subcommittee. My name is Richard Ferlauto, Director of Corporate Governance and Investment Policy at the American Federation of State, County, and Municipal Employees. AFSCME is the largest union in the AFL-CIO with 1.6 million members who work in the public service. Our members have their retirement assets invested through public retirement systems with more than one trillion dollars in assets. They depend on the earnings of these systems to support their benefits in retirement. Large public pension system investments in the public markets are diversified, largely owning the market, and heavily indexed, which operate with time horizons of 20 years or more to match the benefit obligations they have to their plan participants. Indeed, public pension systems are the foundation of patient capital investment in this economy, which seeks long-term shareholder value creation. AFSCME places strong emphasis on improving corporate governance through direct company engagement, regulation, and legislation as a way to achieve long-term shareholder value. As an active shareowner, we have been a leading advocate for a shareholder advisory vote on CEO compensation and shareholder proxy access to nominate directors on company proxy materials. I am also chairman of ShareOwners.org, a new nonprofit, nonpartisan social network designed to give a voice to retailers or individuals who rarely have opportunities to communicate with regulators, policy makers, and the companies in which they are invested. We urge the Committee to create better protections for the average American investor in the financial marketplace. The severe losses suffered by tens of millions of Americans in their portfolios, 401(k)s, mutual funds, and traditional pension plans all point to the need for a new emphasis on shareowner rights and meaningful regulation in order to ensure the financial security of American families. America has tried going down the road of financial deregulation and reduced corporate accountability. That path has proven to be a dead end that is now imperiling the financial well-being of millions of long-term shareowners. Unfortunately, shareholders in America's corporations--who actually should more correctly be thought of as ``shareowners''--have limited options today when it comes to protecting themselves from weak and ineffectual boards dominated by management, misinformation peddled as fact, accounting manipulation, and other abuses. Under the disastrous sway of deregulation and lack of accountability, corporate boards and executives either caused or allowed corporations to undertake unreasonable risks in the pursuit of short-term financial goals that were devoid of real economic substance or any long-term benefits. In most cases, it is long-term shareowners--not the deregulators and the speculators--that are paying the price for the breakdown in the system. According to a recent scientific survey that the Opinion Research Corporation conducted for ShareOwners.org of 1,256 U.S. investors, ``American investors clearly want to see tough action taken soon by Congress to reform how our financial markets work and also to clean up abuses on Wall Street. Support for such action is strong across all groups by age, income, educational achievement and political affiliation. It is particularly noteworthy that such a high percentage of investors (34 percent) would use a term as strong as `angry' to describe their views about the need for such action. And, even though they are not angry, the additional nearly half of other investors (45 percent) who want to see strong clean-up action taken sends an unmistakable message to policy makers. This is particularly true when you look at that data alongside the finding that nearly 6 out of 10 investors (57 percent) said that strong Federal action would help to restore their lost confidence in the fairness of the markets.'' The full survey from ShareOwners.org is attached as an addendum to this testimony [Ed. note: not included, please see http://www.shareowners.org/profiles/blogs/read-all-about-it], but I would like to point out the following findings: More than four out of five American investors (83 percent) agree that ``shareholders should be permitted to be actively involved in CEO pay and other important issues that may bear on the long-term value of a company to their retirement portfolio or other fund.'' More than four out of five investors (82 percent) agree that ``shareholders should have the ability to nominate and elect directors of their own choosing to the boards of the companies they own.'' Only 16 percent of Americans say that ``shareholders should NOT be able to propose directors to sit on the boards of the companies they own.'' Nearly nine out of 10 investors (87 percent) say that ``investors who lose their retirement savings due to fraud and abuse should have the right to go to court if necessary to recover those funds.'' Only one in 10 American investors think that ``investor lawsuits clog up the courts and make it more expensive for companies to run their businesses.'' The number one reason for loss of investor confidence in the markets: ``overpaid CEOs and/or unresponsive management and boards'' at (81 percent). It is time for America to get back on the road of prudent financial regulatory oversight and increased corporate accountability. We urge you to recognize the devastating impact that a lack of appropriate regulation and accountability has had on our economy. In order to restore the confidence of investors in our capital markets, it is now necessary to take the following steps:I. Strengthen the regulation of the markets. Key reforms needed to protect the interests of shareowners include the following: Beef up the Securities and Exchange Commission (SEC). Congress should assess the funding needs of the SEC and take steps to bring the agency as quickly as possible to the point that it can fully carry out its mission of oversight of the markets and financial professionals in order to protect and advocate for investors. Among other priorities, the SEC should impose requirements for the disclosure of long and short positions, enhance disclosures for private equity firms bidding for public companies, and require both the registration of hedge fund advisors with the Commission as investment advisors and additional disclosures of the underlying hedge fund. Following the request of the Administration, the SEC should be given additional authority to create a full-fledged fiduciary standard for broker dealers, so that the interests of clients who purchase investment products comes before the self interest of the broker. The SEC Division of Enforcement should be unshackled to prosecute criminal violations of the Federal securities laws where the Department of Justice declines to bring an action. Clear the way for forfeiture of compensation and bonuses earned by management in a deceptive fashion. Legislation should be adopted to allow for the ``clawing back'' of incentive compensation and bonuses paid to corporate executives based on fraudulent corporate results, and should provide for enforcement through a private right of action. There is no reason why directors and executives should not give back ill- gotten gains when innocent shareowners are victimized by crippling losses. The outrageous bonuses at AIG, Morgan Stanley, and other banks responsible for our financial meltdown were not deserved and should not be allowed to stand. If they know their compensation is on the line, corporate managers and directors will be less likely to engage in or turn a blind eye toward fraud and other wrongdoing. Strengthen State-level shareowner rights. Corporation structures and charters are regulated under State law. The corporate law in most States has not clarified the rights, responsibilities and powers of shareholders and directors or ways that they should communicate outside of annual general meetings. If regulation to strengthen shareholder rights does not occur at the Federal level, it will be up to the States to move forward. State corporate law should require proxy access, majority voting and the reimbursement of solicitation expenses in a board challenge. We would encourage robust competition among States for corporate charters based on a race to the top for improved shareowner rights. If necessary, Federal law should be changed to allow for shareholders to call a special meeting to reincorporate in another State by majority vote, in order to avoid being shackled by the corporate State laws that put the interests of management ahead of shareowners. Protect whistleblowers and confidential sources who expose financial fraud and other corporate misconduct. Confidential informants--sometimes called ``whistleblowers''--are of immeasurable value in discovering and redressing corporate wrongdoing. The information provided by these individuals may be crucial to victims' ability to prove their claims. Often, these individuals only come forward because they believe their anonymity will be preserved. If their identities were known, they would be open to retaliation from their employers and/or others with an interest in covering up the wrongdoing. Whistleblowers might lose their job or suffer other harm. Legislation is needed to clearly state that the corporate whistleblowers and other confidential informants will be protected when they step forward.II. Increase the accountability of boards and corporate executives. Key reforms needed to protect the interests of shareowners include the following: Allow shareowners to vote on the pay of CEOs and other top executives. Corporate compensation policies that encourage short-term risk-taking at the expense of long-term corporate health and reward executives regardless of corporate performance have contributed to our current economic crisis. Shareowners should have the opportunity to vote for or against senior executive compensation packages in order to ensure managers have an interest in long-term growth and in helping build real economic prosperity. The recently enacted stimulus bill requires all companies receiving TARP bail-out funds, nearly 400 companies, to include a ``say-on-pay'' vote at their 2009 annual meetings and at future annual meetings as long as they hold TARP funds. It is now time for Congress to implement Treasury Secretary Geithner's plan for compensation reform by passing ``say-on-pay'' legislation for all companies and to make it permanent as the center piece of needed reforms to encourage executive accountability. A key item to making the advisory vote meaningful will be not to permit brokers to cast votes on management sponsored executive compensation proposals as was recently done by the SEC in support of changes to NYSE Rule 452 in board elections. Stockbrokers who hold shares in their own name for their client investors have no real economic interest in the underlying corporation but can cast votes on routine items on the proxy. These pay votes are not routine items and should not be treated as such by investors, issuers or the regulators and we do not believe would be the intent of Congress if they give authorization to the SEC to require advisory votes on pay. Brokers almost universally vote for management's nominees and proposals and, in effect, interfere with shareowner supervision of the corporations they own. Empower shareowners to more easily nominate directors for election on corporate boards through proxy access. The process for nominating directors at American corporations is dominated today by incumbent boards and corporate management. This is because corporate boards control the content of the materials that companies send to shareholders to solicit votes (or ``proxies'') for director elections, including the identification of the candidates who are to be considered for election. The result is that corporate directors often are selected based on their allegiance to the policies of the incumbent board, instead of their responsiveness to shareowner concerns. Unless they can afford to launch an expensive independent proxy solicitation, shareowners have little or no say in selecting the directors who are supposed to represent their interests. The solution is to enable shareowners, under certain circumstances, to require corporate boards to include information about candidates nominated by shareowners in the company's proxy materials. We are very encouraged that the SEC is in the process of rule making on the issue but this is such an important right that we believe that it should not become a political football for future commissions. There needs to be long-term consistency in securities law and the Exchange Act is the appropriate place to clearly codify the authority that the Commission has to require the disclosure of nominees running for board seats. And to further enunciate that access to the proxy is fundamental to free and fair elections for directors. Require majority election of all members of corporate boards at American companies. Corporate directors are the elected representatives of shareowners who are responsible for overseeing management. Under the default rule applicable to virtually every corporation in the United States, however, corporate directors can be elected with just a single affirmative vote, even if that director's candidacy is opposed by the overwhelming majority of shareowners. While a few corporations have adopted policies that would require a director to receive support of the majority of shareowners in order to be elected, most corporations--particularly those not in the S&P 500--have not. True majority voting should be mandatory in every uncontested director election at all publicly traded corporations. Split the roles of chairman of the board and CEO in any company. (1) receiving Federal taxpayer funds, or (2) operating under Federal financial regulations. It already is the practice in most of the world to divide these two key positions so that an independent chairman can serve as a check on potential CEO abuses. Separation of the CEO and board chair roles helps to ensure good board governance and fosters independent oversight to protect the long-term interests of private shareowners, pension funds and institutional investors. A strong independent chair can help to address legitimate concerns raised by shareowners in a company. Splitting these roles and then requiring a prior shareowner vote to reintegrate them would be in the best interests of investors. Allow shareowners to call special meetings. Shareowners should be allowed to call a special meeting. Shareowners 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 shareowners. They also should be given the right to call for a vote on reincorporation when management and corporate boards unduly use State laws detrimental to shareowner interests to entrench themselves further.III. Improve financial transparency. Key reforms needed to protect the interests of shareowners include the following: Crackdown on corporate disclosure abuses that are used to manipulate stock prices. Shareowners in securities fraud cases have always had the burden of proving that defendants' fraud caused the shareowners' losses. When corporate wrongdoers lie to shareowners and inflate the value of publicly traded stock through fraudulent and misleading accounting statements and other chicanery, those culpable parties should be held responsible for the damage wrought on the investing public that is caused by their fraud. Defendants should not be allowed to escape accountability to their shareowners for fraudulent conduct simply by cleverly timing the release of information affecting a company's stock price. Improve corporate disclosures so that shareowners can better understand long-term risks. To rebuild shareowner confidence regulators should emphasize transparency by creating more mechanisms for comprehensive corporate disclosure. The SEC should devote particular attention to the adequacy of disclosures concerning such key factors as credit risk, financial opacity, energy and climate risk and those reflecting the financial challenges to the economy as identified by the transition team and the new Administration. The SEC should develop internal expertise on issues such as environmental, social, and governance factors that pose material financial risks to corporations and shareowners, and also to require disclosure of these types of risks. Protect U.S. shareowners by promoting new international accounting standards. Our current financial crisis extends far beyond the borders of the U.S. and has affected financial markets and investors across the globe. Part of the problem has been a race to the bottom in favor of a more flexible international accounting standard that would decrease disclosure protection for the average investor. The current crisis makes a compelling case for why we need to slow down the movement toward the use of international accounting standards that could provide another back door route to financial deregulation and further erode confidence in corporate book keeping. A slower time frame is necessary to protect shareowners and allow the Administration to reach out to other governments that share a commitment to high accounting and transparency standards.IV. Protect the legal rights of defrauded shareowners. Key reforms needed to protect the rights of shareowners include the following: Preserve the right of investors to go to court to seek justice. Corporate and financial wrongdoers in recent years have effectively denied compensation to victims of fraud by requiring customers to sign away their rights to access Federal courts as individuals and participate with other victims in class actions when their individual claims are small. Absent the ability to proceed collectively, individuals have no means of redress because--as the wrongdoers know--it is frequently economically impossible for victims to pursue claims on an individual basis. The ability of shareowners to take civil actions against market wrongdoers provides an effective adjunct to securities law enforcement and serves as a strong deterrent to fraud and abuse. Shareowners should have the right to access Federal courts individually or as a member of a class action. Ensure that those who play a role in committing frauds bear their share of the cost for cleaning up the mess. What is known as private ``aiding and abetting'' liability is well established in criminal law, and private liability for engaging in an unlawful and fraudulent scheme is widely recognized in civil law. In cases of civil securities fraud, however, judicial decisions effectively have eliminated private liability of so-called ``secondary actors''--even when they knowingly participated in fraud schemes. Eliminating the private liability of such ``secondary actors'' as corporate accountants, lawyers and financial advisors has proven disastrous for shareowners and the economy. Most recently, in the subprime mortgage-backed securities debacle, bond rating agencies--who were paid by the very investment bankers who created the securities they were asked to rate--knowingly gave triple-A ratings to junk subprime debt instruments in order to generate more business from the junk marketers. The immunity from private liability that these culpable third parties currently enjoy should be eliminated. Allow State courts to help protect investor rights. The previous decade saw the greatest shift in governmental authority away from the States and to the Federal Government in our history. The effect of this shift was to deny individuals their legal rights under State laws and to protect corporate defendants. Corporate interests and an Administration devoted to the ideology of deregulation used the ``doctrine of preemption'' (that Federal law supersedes State law) to bar action at the State level that could have stopped many of the abuses in subprime mortgage lending that are now at the heart of our economic crisis. Indeed, State attorneys general were blocked from prosecuting subprime lenders who violated State laws. The integrity of State law should be restored and both State officials and shareowners should be allowed to pursue remedies available under State law. Federal policy should make clear that State law exists coextensively with Federal regulations, except where State law directly contradicts Federal law. In conclusion, I would like to thank the Chairman for the opportunity to testify today. Rebuilding investor confidence in the market depends upon thoughtful policy making that expands investor rights and authorizes the SEC to strengthen its advocacy role on behalf of all Americans' financial security. I would be pleased to answer any questions. CHRG-109hhrg22160--3 The Chairman," Gentleman's time has expired. Now, recognize the chairwoman of the Domestic and International Monetary committee, the gentlelady from Ohio, Mrs. Pryce. Ms. Pryce. Thanks, Chairman Oxley. Welcome, Chairman Greenspan, and thank you for taking the time to discuss with us your insights on monetary policy and many other things I am sure we will hear from you. I am especially happy to be returning to the committee for these very special opportunities. This will be an exciting and very busy year for us. As you know, the President has outlined an aggressive second-term agenda, which includes Social Security, tax and legal reform. Social Security is an issue that, if addressed today, could safeguard the future of millions of young people, and, if ignored, could become the biggest shortcoming of a generation. As you noted yesterday, the existing structure isn't working, and I am sure that this committee will have plenty of questions on this issue, and I look forward to hearing your answers later in the morning. Last month, the Bureau of Labor Statistics released revised data showing gains of 2.7 million jobs for 20 straight months, with those gains beginning of June of 2003, which was 3 months earlier than previously estimated. My home state of Ohio, which has been hit hard by manufacturing job loss over the last 2 years, has recently seen an increase in workers returning to the job market, and Ohio is not alone in that recovery. The national unemployment rate ticked down 0.2 percentage points in January, the lowest rate since September of 2001. Mr. Chairman, reflection on the measured rise in inflation taken by FOMC and the role you had in it, I am particularly interested in hearing you address the role raising rates will have on manufacturing states like Ohio, where the manufacturing sector is a large part of the economy. Also, I would like to hear how you feel it will affect the housing market, which has been such a stable influence in the economy over the last several years. I appreciate, Mr. Chairman, your support and encouragement of deregulation and technological innovation. You have said before that continued movement on these fronts, along with maintenance of a rigorous and evolving education system, will drive our economy into the future. I am particularly interested to hear you speak in more length on the demands put on our education system. You have voiced concern in the past that while our fourth graders outperform their peers around the world in math and science, our eighth graders are about average, and our 12th graders rank near the bottom. How can this happen? I hope to discuss with you now and in the future possible reasons for this failure and how best we resolve our education system to graduate more skilled workers and how that will affect our economy. I am also concerned about the state of financial literacy among all Americans. I am concerned over the state of our nation's savings rate, something I was glad to hear you address in yesterday's hearing and I hope you discuss further today. We must grow our economy and not our government, and we must change the current system of Social Security to ensure its solvency for our children. Through fiscal discipline and by implementing policies that increase the rate of personal savings and retirement security, we can provide financial freedom to all Americans and allow them to take ownership over their families' future and prosperity. I thank you, Mr. Chairman, for your appearance today. I look forward to your testimony. And with that, I yield back, Mr. Chairman. " 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-109hhrg28024--3 Mr. Frank," Thank you, Mr. Chairman and Mr. Chairman, thank you and thank you for the courtesies you've extended to us. You have made yourself very available for the kind of conversations that will be helpful in our having to work together and including be able to articulate those legitimate policy disagreements that are part of a democracy. I just want to apologize in advance because the Fund Joint bill has been scheduled to come up, and I'm going to go over after I do my questioning, I'm sorry to say to you. But I will be on the floor and come back again. So I apologize for that. But I want to just talk to the Chairman because I think we are facing a kind of crisis in our economy. I am glad to see that economic growth is steady and solid. I agree with the projections that it will good going forward. But we face a problem we haven't faced a long time in America. I'm not enough of an economic historian to know when, if ever, that was. There is a decoupling between growth in the gross domestic product and the economic situation of the average American. The report documents that--the monetary report to Congress. On page nine of the report, page eight, ``With profits posting further solid gains in 2005,'' et cetera, and on page nine, ``Corporate profits continue to grow strongly in 2005. The ratio of before-tax profits of domestic non-financial corporations to that sector's gross value added grows to more than 12 percent of its 1997 peak.'' ``Operating earnings for S&P 500 firms appear to have been nearly 14 percent above their level four quarters earlier. That's explained in part by the growth in productivity. It was not as high last year as it's been, but it will still considerably above trend. If you look productivity over the last 5 years, as has been noted, it has been very high.'' Then we get to page 17. ``Increases in hourly labor compensation were moderate in 2005.'' In fact, real wages, wages paid to people who work for other people, taking into account inflation, have not gone up for years. They have been flat. What we have is an economy in which thanks to increased productivity, gross domestic product goes up and a very, very large share, an excessive share of the increased wealth has gone to a very small number of people who own the capital. Now obviously for the system to work, there needs to be compensation for those who own capital. No one is, I hope, arguing that that shouldn't happen at all. But in recent years, that has become disproportionate. Your predecessor had acknowledged that on several occasions. You have wages flat; you have insecurity caused by pensions being underfunded, being abandoned, defined benefits going over to 401(k)s; you have medical care costs increasing, the extent to which workers have to pay them. The consequence is this, and it's something that people compare. I will tell you when I was in Davos listening to a leader of one our financial institutions lament the fact that the American people seem so unimpressed with globalization, so resistant to the effort to adapt that very productivity which many believe is so important for the economy, and I share that. He said, ``Recent studies show that globalization adds a trillion dollars a year to the American economy. That's $9,000 per family. Why are Americans so resistant to something that adds $9,000 per family?'' My answer was, ``Because they don't have the $9,000. Not only do they not get the $9,000,'' I said to this individual, ``but they think you have their $9,000. In fact, you have the $9,000 for about 2,000 of them or more.'' This disparity, this problem is why you now encounter increasing resistance to trade to deregulation, to the very flexibility that many think are important for the economy. So these numbers are right here. Productivity goes up. The economy is going to go well. But average Americans collectively assert that they are getting little if any of the benefit. And then those people tell you, ``Well, you know, some of these things, globalization means that tee shirts are a lot cheaper now than they used to be at Wal-Mart and elsewhere.'' But I'm talking about real wages. That factors in the cost of living. So when you talk about real wages being flat, you can't double-count the low prices. Real wages is obviously nominal wages discounted by inflation. So if we do not do a better job in this country of not getting rid of inequality, which is essential for our society's markets to function, but diminish it, you will continue to have the resistance to many of the policies that people advocate, and that I think is the major test before us. We have to end this decoupling of growth of the GDP and the economic well-being of the average American. " fcic_final_report_full--50 Then, beginning in , the Federal Reserve accommodated a series of requests from the banks to undertake activities forbidden under Glass-Steagall and its modifi- cations. The new rules permitted nonbank subsidiaries of bank holding companies to engage in “bank-ineligible” activities, including selling or holding certain kinds of se- curities that were not permissible for national banks to invest in or underwrite. At first, the Fed strictly limited these bank-ineligible securities activities to no more than  of the assets or revenue of any subsidiary. Over time, however, the Fed re- laxed these restrictions. By , bank-ineligible securities could represent up to  of assets or revenues of a securities subsidiary, and the Fed also weakened or elimi- nated other firewalls between traditional banking subsidiaries and the new securities subsidiaries of bank holding companies.  Meanwhile, the OCC, the regulator of banks with national charters, was expand- ing the permissible activities of national banks to include those that were “function- ally equivalent to, or a logical outgrowth of, a recognized bank power.”  Among these new activities were underwriting as well as trading bets and hedges, known as derivatives, on the prices of certain assets. Between  and , the OCC broad- ened the derivatives in which banks might deal to include those related to debt secu- rities (), interest and currency exchange rates (), stock indices (), precious metals such as gold and silver (), and equity stocks (). Fed Chairman Greenspan and many other regulators and legislators supported and encouraged this shift toward deregulated financial markets. They argued that fi- nancial institutions had strong incentives to protect their shareholders and would therefore regulate themselves through improved risk management. Likewise, finan- cial markets would exert strong and effective discipline through analysts, credit rat- ing agencies, and investors. Greenspan argued that the urgent question about government regulation was whether it strengthened or weakened private regulation. Testifying before Congress in , he framed the issue this way: financial “modern- ization” was needed to “remove outdated restrictions that serve no useful purpose, that decrease economic efficiency, and that . . . limit choices and options for the con- sumer of financial services.” Removing the barriers “would permit banking organiza- tions to compete more effectively in their natural markets. The result would be a more efficient financial system providing better services to the public.”  During the s and early s, banks and thrifts expanded into higher-risk loans with higher interest payments. They made loans to oil and gas producers, fi- nanced leveraged buyouts of corporations, and funded developers of residential and commercial real estate. The largest commercial banks advanced money to companies and governments in “emerging markets,” such as countries in Asia and Latin Amer- ica. Those markets offered potentially higher profits, but were much riskier than the banks’ traditional lending. The consequences appeared almost immediately—espe- cially in the real estate markets, with a bubble and massive overbuilding in residential and commercial sectors in certain regions. For example, house prices rose  per year in Texas from  to .  In California, prices rose  annually from  to .  The bubble burst first in Texas in  and , but the trouble rapidly spread across the Southeast to the mid-Atlantic states and New England, then swept back across the country to California and Arizona. Before the crisis ended, house prices had declined nationally by . from July  to February   —the first such fall since the Depression—driven by steep drops in regional markets.  In the s, with the mortgages in their portfolios paying considerably less than current interest rates, spiraling defaults on the thrifts’ residential and commercial real estate loans, and losses on energy-related, leveraged-buyout, and overseas loans, the indus- try was shattered.  CHRG-111shrg53176--57 Mr. Atkins," With respect to the subject of regulatory reform, your hearings have so far been a very good start and I would suggest that you ask some very hard questions in subsequent hearings. For example, why was the SEC in the course of the last dozen years or so has the SEC experienced such catastrophic failures in basically every one of its four competencies--rulemaking, filing review, enforcement, and examinations? What led to the failures of the SEC and other regulatory agencies, both in the United States and globally, to discern the increasing risk to financial institutions under their jurisdiction? What led the failures at financial institutions to recognize the inadequacy of their own risk management systems and strategy in time to avert a collapse? How did so many investors get lulled into complacency and not adequately do their own due diligence? What is the proper role of credit rating agencies, and has regulation, in fact, fostered an oligopoly by recognizing the opinions of a few as being more privileged than those of the rest? These are hard questions, and if there are to be changes to the Federal securities laws, I think they need to be made carefully through a robust analysis of the costs and benefits of various potential actions and how those actions might affect human behavior in the market. The current situation is certainly no time to wing it or to act on gut instincts because investors ultimately pay for regulation. And if Congress doesn't get it right, severe consequences could be in store for the U.S. Once on the books, laws, especially in this area, seem to be very hard to change and unintended consequences live on. Prior to the recent crisis, the subject of regulatory balance was being discussed. Senator Schumer, Mayor Bloomberg, the U.S. Chamber of Commerce, and others cited many reasons why the U.S. as a marketplace was not so competitive. In fact, in 2006, the value of Rule 144A unregistered offerings in the U.S. for the first time exceeded that of public offerings. 2006 seems like a long time ago, but it still is very much a valid concern, especially once the global financial system recovers. The worrisome thing to me is that if care is not taken to have solid analysis, the wrong lessons may be gleaned from this latest crisis and that will ultimately hurt investors. It takes a long time, as I said, to change legislation in this area. So what we need is an analysis to determine how we can effectively and efficiently promote honesty and transparency in our markets and ensure that criminality is not tolerated. For example, I disagree with the assertion that deregulation in the past four, eight, ten, or what have you years has led to the current problems in the financial markets. One can hardly say that the past eight to 10 years have been deregulatory with the adoption of new laws and rules, such as Sarbanes-Oxley. More regulation for regulation's sake is not the answer What we need is smarter regulation. The global crisis has primarily affected regulated versus nonregulated entities all around the world, not just in the supposedly deregulatory United States. The question is, how did so many regulators around the world operating under vastly different regimes with differing powers and differing requirements all get it wrong? Indeed, how did so many firms with some of the best minds in the business get it wrong? During the past dozen years, the SEC has experienced catastrophic operational failures in its four core functions of filing review, rulemaking, enforcement, and examinations. ENRON's corporate filings were not reviewed for years in the 1990s. Tips were not pursued regarding Bernie Madoff and regarding the late trading of mutual funds in 2003. It took literally an Act of Congress led by this Committee to get transparency and a reformed SEC process with respect to credit rating agencies. These mistakes, I think, were a long time in the making and were caused by failures of the system of senior staff management. First, management applied faulty motivational and review criteria, and second, since resources are always limited, there is an opportunity cost in choosing to spend time and resources on one thing because then, of course, there is less time and less resources to spend on other things. With respect to opportunity costs, I believe that the SEC, especially in the years 2003 to 2005, was distracted by controversial, divisive rulemaking that lacked any grounding in cost-benefit analysis during this very crucial period right when many instruments, like CDOs and CDSs, took off and established their trajectory. Because these rules and the arguments for them were ultimately invalidated by the courts after both long litigation and much distraction for the agency and the industry, a lot of essential time was wasted. Because life is full of choices, if you devote resources to one thing, you have less to devote to another, and the one risk that you haven't focused on just may blow up in your face. That is, in fact, exactly what happened to the SEC, and it was really through back office processes and documentation that weren't attended to that led to the current crisis. There are other things that I would be happy to talk about that I put into my written testimony. With respect to that, I have mentioned in my written testimony an article on enforcement and the processes at SEC. I ask that I be able to submit that for the record. " 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-111shrg54533--14 Chairman Dodd," Senator Schumer. Senator Schumer. Thank you, Mr. Chairman, and I want to thank you and congratulate you on the blueprint that you put together, Secretary Geithner, because I do believe it will close many of the most important regulatory gaps in our system. There are a few issues where I think the administration should have pushed a bit farther, but this is an excellent framework and charts a clear course to fix the problems that led us to the crisis. Two places I would like to just give you a pat on the back, I agree with Senator Dodd, a Financial Consumer Product Safety Commission is essential. The Fed failed significantly in this responsibility. So while you have got to be leery of starting over, in this case, you have to start over and a new agency is what is called for. Second, of less noticed but of great importance is the idea that the mortgage issuer and securitizer must hold a piece of the mortgage. That would have stopped Countrywide and others like it in its tracks. It certainly would have greatly lessened the crisis. It might have even avoided it. So that is a great addition, because now they can't issue these junky mortgages and then just not hold them and sell them. On the systemic risk regulator, we need one, there is no question, and the old way is certainly bad. We can criticize any proposal, but keeping the present system is worse. Every agency had a piece of the system to oversee and protect, but nobody had responsibility to mind the whole store rather than just looking after individual aisles. I agree with Senator Shelby, it is really hard to do. But, tackle it we must, or we risk having the same kind of widespread financial crisis that we have just been going through. You cannot let the perfect be the enemy of the good here or we end up with less, and believe me, it is hard to do. Who predicted--you could probably count on your hands and toes the number of people in financial services, the commentators, the press, in government, who predicted 5 years ago that mortgages and this mortgage crisis would bring the whole system down. It is very hard to see around the corner. And my view, I tend to agree--I am not certain, but I tend to agree that the Fed is the best answer. There are no great ones. A council? That is a formula for disaster in something like this. A council, everyone will pass the buck and it will stop nowhere. You must have the buck stop somewhere with systemic risk. So then maybe you should have a new regulator, just someone new. The problem is, you need deep, deep knowledge of how the financial system works and a new council is going to be much slower to start. The Fed has that knowledge. You could argue the reason the Fed failed in the past, and it did, was because of the attitude of some of the people at the top who were for abject deregulation rather than the structure, but to me at least, until shown a better example, I think the Fed, at least tentatively, is the best one. The question I wanted to ask you is about bank responsibility. For years, everybody has said one of the problems of banking regulation is that it is too divided up. The system allowed banks, most recently and notably again Countrywide--that has been a nemesis to me--to game the system for the slightest regulation possible, yet your plan, while consolidating OTS and OCC, leaves significant prudential supervisory authority with the Fed and FDIC. If you count the new consumer watchdog agency, which I am all for, there would be four bodies involved in bank supervision, the same as we started with, no consolidation. A multiplicity of regulators tends to produce less oversight overall. The whole is greater than the sum of its parts when it comes to a symphony orchestra or the New York Giants, but with our patchwork system of banking regulators, the whole is less. So please tell us why you didn't do more consolidation, and particularly with the Fed gaining these powers, why do they have to be the supervisor of State banks, setting up this duplication of systems where you have a Fed regulator, the OCC, for the same exact bank who then shops around to be State chartered? If you want to remove another power from the Fed, which is getting a lot, take it away. Don't have them regulate State banks. Why didn't you consolidate the banking regulators more? " 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. " CHRG-111hhrg51591--27 Mr. Grace," Thank you, Mr. Chairman. Thank you, Mr. Garrett, and the members of this committee for inviting me to testify before you today. As you heard, my name is Martin Grace. I have been a professor at Georgia State for 21 years, and in this background of financial services regulation and deregulation, this is where I have been focusing my work for almost my entire career. Most recently, in the last 4 or 5 years, I have been thinking about this particular problem. In fact, last year we even had a very large conference talking about not Federal and State regulation per se, but the optimal regulation of the insurance industry. So today what I am going to talk to you about is a lot about what I have done my work on in the last couple of years and what I think, from an economist's perspective, might be fruitful ways of thinking about the future of insurance regulation. I have three main points. The first point is the proper level of regulation, whether it is State or Federal. The second one is the placement of a systemic risk regulator in this functional area of regulation. And I would like to make some comments on what I believe is the future for the role of States in insurance regulation. My first point basically looks at whether we should have a Federal or a State system of regulation. The way to think about this is that the costs and benefits of regulation need to be at the same level. So if you think about the local restaurant regulator, the local county health inspector, all the benefits and costs of regulation are really to that county. But the airline safety regulation really has a national audience, and the costs of that regulation should be borne at that level. Now, not everything about insurance is cut and dried. Fifty years ago, insurance was really a local kind of contract, a local industry. But today, only about, on the average State, about 12 to 15 percent of the insurance is sold by domestic companies. It is really an interstate business. And as such, if the costs of regulation go beyond the States, it may be a reason for the level of regulation to be moved up to the Federal Government's level. My second point is how to think about the risk regulator, the placement of this risk regulator. We can think of this as, very simply, in part because if you think about just AIG, its failure caused problems not just across State insurance markets but across other types of markets, banking markets and international markets. This is not something the State can really deal with. So a Federal risk regulator that looked at systemic risk may be something that is important at the Federal level. The problem, however, with application to insurance is that not all companies are AIG. Most insurance companies are really very conservatively run. And to paint with a broad brush might be imposing an extra costly layer of regulation on some insurers. So the devil, again, is in the details about how you choose which company is regulated at the Federal level under the systemic risk regulator. At the same time, just the signal of choosing a company might be a bad thing. So if a company is chosen to be systematically important and people assert that choice is based because they might be too-big-to-fail, that will have dramatic effects on the private insurance market. My third point is the role of States in insurance regulation. Insurance regulation, as I mentioned before, has historically been at the State level. And if we think about it, it is because it is a transaction that occurs in or near your house. And that is still true, but it is by a company that could be many States away. So now we have to think about the effect of sort of duplicative compliance costs and the different types of other types of costs that are put on insurers that are paid by consumers and shareholders across the country. So all these States have duplicative regulation, and the question is, are we getting additional benefits from that regulation consistent with those costs? And I think most people think the answer is no. States also tend to be very reactive rather than proactive. One of the things about regulation is that we really have a good idea about the past problem. We never really think about the problems we haven't discovered yet. For example, I was going to mention the asteroid example, too, but thinking about things proactively in the future. Regulators are really good at figuring out things that happened in the past, but we should have a way of thinking about the future. I don't think the States are really up to that. States react to outside pressure. Congressman Dingell's report some 20-odd years ago pressured the States to change. The OFC pressure by the industry is pressuring the NAIC and the States to change. They won't do this on their own, in part because consumers in many respects don't care enough and don't make it a salient point. So in sum, I think the States are in a very difficult position going forward because they are not proactive enough. Thank you for your time. [The prepared statement of Professor Grace can be found on page 46 of the appendix.] " fcic_final_report_full--311 N ot i ona l Amount and G ross M ar k et V a l ue o f O T C D er iv at iv es Outstand i ng IN TRILLIONS OF DOLLARS, SEMIANNUAL Not i ona l Am o u nt $800 7 00 600 500 4 00 300 200 100 0 1999 G r oss M a rk et V a lu e $ 4 0 35 30 25 20 15 10 5 0 2001 2005 200 7 2009 SOURC E: Ban k fo r I nte r nat i ona l Sett l e m ents June 2010 Figure . the global derivatives market. At the end of June , the notional amount of the over-the-counter derivatives market was  trillion and the gross market value was  trillion (see figure .). Adequate information about the risks in this market was not available to market participants or government regulators like the Federal Re- serve. Because the market had been deregulated by statute in , market partici- pants were not subject to reporting or disclosure requirements and no government agency had oversight responsibility. While the Office of the Comptroller of the Cur- rency did report information on derivatives positions from commercial banks and bank holding companies, it did not collect such information from the large invest- ment banks and insurance companies like AIG, which were also major OTC deriva- tives dealers. During the crisis the lack of such basic information created heightened uncertainty. At this point in the crisis, regulators also worried about the interlocking relation- ships that derivatives created among the small number of large financial firms that act as dealers in the OTC derivatives business. A derivatives contract creates a credit relationship between parties, such that one party may have to make large and unex- pected payments to the other based on sudden price or rate changes or loan defaults. If a party is unable to make those payments when they become due, that failure may cause significant financial harm to its counterparty, which may have offsetting obli- gations to third parties and depend on prompt payment. Indeed, most OTC deriva- tives dealers hedge their contracts with offsetting contracts; thus, if they are owed payments on one contract, they most likely owe similar amounts on an offsetting contract, creating the potential for a series of losses or defaults. Since these contracts numbered in the millions and allowed a party to have virtually unlimited leverage, the possibility of sudden large and devastating losses in this market could pose a sig- nificant danger to market participants and the financial system as a whole. The Counterparty Risk Management Policy Group, led by former New York Fed President E. Gerald Corrigan and consisting of the major securities firms, had warned that a backlog in paperwork confirming derivatives trades and master agree- ments exposed firms to risk should corporate defaults occur.  With urging from New York Fed President Timothy Geithner, by September ,  major market participants had significantly reduced the backlog and had ended the practice of as- signing trades to third parties without the prior consent of their counterparties.  Large derivatives positions, and the resulting counterparty credit and operational risks, were concentrated in a very few firms. Among U.S. bank holding companies, the following institutions held enormous OTC derivatives positions as of June , : . trillion in notional amount for JP Morgan, . trillion for Bank of America, . trillion for Citigroup, . trillion for Wachovia, and . trillion for HSBC. Goldman Sachs and Morgan Stanley, which began to report their holdings only after they became bank holding companies in , held . and . tril- lion, respectively, in notional amount of OTC derivatives in the first quarter of .  In , the current and potential exposure to derivatives at the top five U.S. bank holding companies was on average three times greater than the capital they had on hand to meet regulatory requirements. The risk was even higher at the investment banks. Goldman Sachs, just after it changed its charter, had derivatives exposure more than  times capital. These concentrations of positions in the hands of the largest bank holding companies and investment banks posed risks for the financial system because of their interconnections with other financial institutions. Broad classes of OTC derivatives markets showed stress in . By the summer of , outstanding amounts of some types of derivatives had begun to decline sharply. As we will see, over the course of the second half of , the OTC deriva- tives market would undergo an unprecedented contraction, creating serious prob- lems for hedging and price discovery. CHRG-111hhrg53240--105 Chairman Watt," Press that button and pull it close to you. Ms. McCoy. Chairman Watt, Ranking Member Paul, and members of the subcommittee, thank you for inviting me here today to discuss restructuring financial regulation. Today I will testify in support of the Consumer Financial Protection Agency Act of 2009. This bill would transfer consumer protection and financial services from Federal banking regulators to one agency dedicated to consumer protection. We need this to fix two problems: first, during the housing bubble, fragmented regulation encouraged lenders to shop for the easiest regulators and laws; and second, banking regulators often dismiss consumer protection in favor of the short-term profitability of banks. Under our fragmented system of credit regulation, lenders could and did shop for the easiest laws and regulators. One set of laws applies to federally chartered banks and thrifts and their operating subsidiaries. Another set of laws applies to independent nonbank lenders and mortgage brokers. Because lenders could threaten to change charters, they were able to play regulators off one another. This put pressure on regulators, both State and Federal, to relax their standards and enforcement. Countrywide, for example, turned in its charters in early 2007 in order to drop the OCC and Federal Reserve regulators and to switch to the OTS. The result was a regulatory race to the bottom that only the Fed had the power to stop. During the housing bubble, three of the four Federal banking regulators--the Federal Reserve, the OCC, and the OTS--succumbed to pressure to loosen loan underwriting standards and safeguards for consumers. Today I will focus on the Fed. Under Chairman Alan Greenspan, the Federal Reserve Board failed to stop the mortgage crisis in thee crucial ways: First, the Federal Reserve was the only agency that could have stopped the race to the bottom. That was because it had the ability to prohibit unfair and deceptive lending for all lenders nationwide under the Home Ownership Equity Protection Act. But Chairman Greenspan refused to exercise that authority. The Fed did not change its mind until last summer when it finally issued such a rule. At that point, the horse was out of the barn. Second, the Fed as a matter of policy did not do regular examinations of the nonbank subprime lenders under its jurisdiction. These included the biggest subprime lender in 2006, HSBC Finance, and Countrywide ranked number three. Finally, the last time the Fed did a major overhaul of its Truth in Lending Act mortgage disclosures was 28 years ago, in 1981. With the rise in subprime loans and nontraditional ARMs, those disclosures became solely obsolete. Nevertheless, the Fed did not even open a full review of its mortgage disclosure rules until 2007, and it still has not completed that review. So why did the Federal Reserve drop the ball? One reason was its overriding belief in deregulation. Another, however, was an attitude that a good way to improve bank safety and soundness was to bolster fee income at banks. We still see that today with respect to rate hikes with credit cards still going on. This focus on short-term profits not only hurt consumers, it undermined our Nation's financial system. The Act would fix these problems in three ways: first, it would stop shopping by providing one set of consumer protection rules for all providers nationwide; second, the Act puts the authority for administering those standards in one Federal agency whose sole mission is consumer protection. We are asking the Fed to do too much when we ask it to excel at four things: monetary policy; systemic risk regulation; bank safety and soundness; and consumer protection. Housing consumer protection in a separate agency in fact will provide a healthy check on the tendency of Federal banking regulators to underestimate risk at the top of the business cycle. Finally, to avoid any risk of future inaction by the new agency, the Act gives backup enforcement authority to the Fed and other Federal banking regulators in the States. My time is up. Thank you and I will welcome any questions. [The prepared statement of Professor McCoy can be found on page 161 of the appendix.] " 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.] " CHRG-111shrg61513--51 Mr. Bernanke," Well, first, I agree that the economy is still very weak and very disappointing in that respect. I think low interest rates do tend to help, and I will give you a couple of examples. One, you mentioned the durable goods. Notwithstanding--I have not had a chance to get into those numbers in detail this morning, but investment, actually equipment investment, equipment and software investment has been something of a bright spot and has been growing. And part of the reason for that is that larger firms at least have pretty good access to credit at reasonable rates in the corporate bond market, for example, and that has supported the investment rebound, which is a big part of what we are seeing in the recovery. Another example is that the Fed's actions, interest rate actions and our purchases of mortgage-backed securities, have helped bring down mortgage rates. That has helped to some extent to stabilize demand for housing and helped--as you may know, house prices seem to have flattened out and begun to rise a bit, which is very important for consumers in terms of their wealth, in terms of the risk of foreclosure, and in terms of, you know, restarting activity in the residential construction sector. So those are two examples where we see growth. We did have 4-percent growth in the second half of 2009. I think the issue we face is will the growth be fast enough to materially reduce the unemployment rate at a pace that we would like to see, and that is a big uncertainty right now. But we are getting some output growth at this point. Senator Johanns. Mr. Chairman, thank you. Senator Johnson. Senator Brown. Senator Brown. Thank you, Mr. Chairman. Mr. Chairman, nice to see you. We all know for most of our Nation's history--I am going to go in a bit different direction. For most of our Nation's history, manufacturing and agriculture and transportation drove our economy, whether it is steel in Youngstown or agriculture around places like Lexington, Ohio, or the Port of Cleveland shipping raw materials and finished goods all over the Midwest. As an expert on--as an economic historian, as you are, and an expert on the Great Depression, you are aware, obviously, of the role of manufacturing, especially a historic role, in pulling our Nation out of recession. As many Ohioans can tell you, can painfully tell you, manufacturing steadily declined over the last three decades. At the same time, we know that the financial industry has rapidly expanded. As recently as the 1980s, manufacturing made up 25 percent of GDP; financial services made up less than half of that, in the vicinity of 11 or 12 percent. Those numbers crossed in the 1990s. Now it is almost a direct flip. Manufacturing, 12 percent; financial services, 20 or 21 percent. Wall Street's output, put another way, was equal to all the Farm Belt States and the Industrial Belt States combined. In 2004, 44 percent of all corporate profits in the United States came from the financial sector compared with 10 percent from manufacturing. And I say that as a preface to my question for this reason: Kevin Phillips, the writer, has noted sort of the history of great nations in the last 400 years. Habsburg Spain, the United Provinces of Netherlands, and Imperial England, all three saw their economies go from manufacturing, shipping, agriculture--depending on which of each of the three--and energy into more and more emphasis on financial services. And the financialization in that sense is what probably cost those empires their empire. They were countries that never really recovered in the wealth creation. It really is the fact that banking is not an independent source of wealth. It does not cause our prosperity. The success of banking is created by our success and our ability to create wealth. Then I hear people, when I talk about manufacturing policy, I hear your predecessors say this, I hear advisers in the White House, regardless of party, say we cannot have a manufacturing policy, we cannot pick winners and losers. Well, it is pretty clear in the 1980s that this country, this Government, your predecessors, and the Treasury Department picked winners and losers. They decided that financialization, the financial services sector should be the winner as we got rid of usury laws, as we changed rules and deregulated and all those things. So we put ourselves in a position where, as Kevin Phillips said, finance is the chosen sector of the U.S. economy. So my question is this: As your role, your statutory role, a mandated target of 4-percent unemployment, it is at least twice, maybe three times that right now. When I look at a building on the Oberlin College campus 20 miles from my house, fully powered by solar energy, the largest solar-powered building on any college campus in America, about 8 years it was built. All the panels were built in Germany, a country that had an industrial policy that stimulated demand and supply and have built clean energy jobs way better than we have. You read the articles in the paper about what China is about to way outcompete us on alternative energy, solar and wind turbines. We know all that. We still sit with no manufacturing policy. So my question is this: As the economic historian that you are, are you troubled by the fact that the financial sector is now twice the size of the manufacturing sector? And I put parentheses around the next part of that, that no country that I can see in economic history has done well when that happened. Are you troubled by that? And if you are troubled by that fact that the financial industry is twice the size of manufacturing, flipping what it was, what should we do about it and what are you doing about it? " CHRG-111hhrg48867--2 The Chairman," The hearing will come to order. The purpose of this hearing is to continue to focus even more on a very broad question, the importance of an effect that has been undermined by recent events and by the considerably larger crowd we will have here tomorrow when we deal with the apparently three most fearsome letters in the English language: ``AIG.'' We will deal with that tomorrow. But what we need to do is to figure out how we avoid ever again being in this situation. ``Ever again'' overstates it. How do we make it much less likely that we are not again in this situation? So this begins a set of hearings that we are going to be having on what, if anything, should be done at the legislative level and then carrying through obviously to the executive level to prevent some of the problems that we are now dealing with from recurring. There will be a series of hearings. As you know, the Secretary of the Treasury will be testifying at our hearing on March 26th. But we want to hear from a wide range of people on the consumer side, on the labor side, and on the financial industry side, former regulators, other commentators, and people in the industry. We will have a series of hearings on this. We have several hearings planned between now and the break. We will resume and continue the hearings, and it is my hope that we will be able to begin the drafting of legislation sometime in early May. That is when we come back and have a couple more weeks of hearings. I urge people to be thinking seriously about what we are doing. This will be a lengthy process. It will go through all of the regular order. The Senate also is engaged in this. The White House and the Treasury are engaged in it. It is a very important task, and we will be addressing it with great seriousness and with full input. I am not at this point going to get into anything substantive because I really hope that we will have a full and unfettered conversation with a variety of people about this, and I would hope people would feel totally free to make whatever recommendations they may have. Everyone who is here will, I am sure, be asked again to comment on this, but you don't have to wait to be asked. We have as important a task as we have had in this general area, I believe, since the 1930's. But I will just say briefly what seems to me to be the situation. We are a society that understands the value of free enterprise in a capitalist system in creating wealth. Some political rhetoric to the contrary, that is not in question now, and won't be in question in the future. No one is seriously talking about diminishing the role of the private sector as the wealth creator, and for this committee's jurisdiction of the financial services industry as the intermediary, as the entity that helps accumulate wealth from a wide variety of sources and makes it available for those who will be taking the lead in the productive activity, that is the intermediation function, and it is a very important one. From time to time in economic life, the private sector, which is constantly innovating, but achieves the level of innovation that is almost a qualitative change when a very new set of activities comes forward. Now, by definition, if those activities do not provide value to the society, they die of their own weight. Only those that are in fact genuinely adding significant value thrive. But also by definition because they are innovative, as they thrive they do a lot of good, but there is some damage because they are operating without rules, they are new, and that is why I think the problem here is not deregulation, but nonregulation. It is not that rules that had been in place were dismantled, it is that as new activities come forward there need to be new rules that are put in place that to the maximum extent possible provide a structure in which the value of these innovations can continue but some of the abuses are restricted. I will give two examples where it seems to me we went through that process. In the late 19th Century, the formation of the large industrial enterprises, then called trusts. This country could not have industrialized. The wealth could not have spread to the extent that it has here or elsewhere without large enterprises. But because they were new, there were not rules. So while they were formed and thrived in the late 19th Century and on into the next century, the presidencies of Theodore Roosevelt and Woodrow Wilson were aimed at preserving the value while containing the damage that could be done. The antitrust acts, the Federal Trade Act, even the Federal Reserve Act itself came out of that situation. Because you had the large enterprises you then had the stock market become so important, because you had now gone beyond what individuals could finance. And the stock market obviously provided an important means of support for this process, but with some abuses. So in the New Deal period and then after we had rules adopted that gave us the benefits of this finance capitalism but tried to restrain some of the abuses, the SEC and other factors. I believe that securitization, the ability to use pools of money not contributed by depositors, and are therefore relatively unrestricted, to finance activities and to sell the right to be repaid, obviously has a lot of advantages. If mortgage loans can be made, securitized, and remade, that money can support a lot more activities. Securitization greatly increases the ability to use the money. But like these other innovations it comes in an area without regulation. And our job now I believe is in some ways comparable to what happened under Franklin D. Roosevelt or Theodore Roosevelt and Woodrow Wilson, to come up with a set of rules that create a context in which a powerful, valuable tool can go forward in its contributions but with some restriction on the negative side. And that is never easy to do and you never do it 100 percent. I regard it, by the way, as very much a pro-market enterprise, because one of the problems we have now is an unwillingness on the part of many who have the money to make it available. We have investors who are reluctant to get involved. That is a great problem. It is nice from the standpoint of calculating our interest costs to have Treasuries be so popular. But it is not healthy for the economy for Treasuries to be disproportionately the investment people want to make. One of the advantages of this being done properly is to get a set of rules that will tell investors that it is safe to get back into the business of investing. So we regard this again as very pro-market, of taking a market-driven innovation, in this case securitization, and trying to preserve its value while limiting some of the harm that comes when it acts in a totally unregulated atmosphere and in a manner that will give a great deal of confidence to investors so that we can resume this function of intermediation of gathering up resources and making them available for productive uses. The gentleman from Alabama. " CHRG-110hhrg45625--44 Mr. Crowley," Thank you, Mr. Chairman. Let me first thank you for asking me to testify today. I want to testify that, although from New York, not necessarily from the perspective of Wall Street, but from the perspective of 65th in Woodside, Queens as well. I served on this committee for 6 years, and I learned a tremendous amount about our Nation's financial services sector, but I do not begin to claim I know exactly how to fix the problems in our financial market. What I do know, however, is that the problem on Wall Street stands to affect every American. As a New Yorker, that is where the problems will and are hitting first. The cause and effect of what happens on Wall Street and what happens to the services provided by the City and the State are directly related. That is because almost one-third of New York City's and 20 percent of New York State's tax base comes from Wall Street. So just as jobs are being cut on the street, State and City-supported senior centers, health services, and public programs are being cut as well. Just today, Mayor Bloomberg announced cuts of $1.5 billion in this year's City budget alone. But, my colleagues, the reverberations of the downturn in our financial markets are not limited to New York. So what is at stake for hardworking Americans? First, their pension plans. Whether we like it or not, our Nation is moving away from the traditional defined benefit pension plan, where an employer guarantees an employee a fixed income for life, towards a new hybrid of a defined contribution system, highlighted by the 401K plan, which is routed in the activity of the stock markets and investments. That means the retirement savings of millions of workers are held in the balance every day by Wall Street. So when the market goes up, retirement plans make money. But, if it goes down, we all lose a part of our nest eggs. Second, credit is becoming harder and harder to obtain. We are already seeing a credit crunch where even creditworthy Americans are not being able to obtain a mortgage to purchase a home or the ability to refinance out of an adjustable rate mortgage or subprime loan. This is just the beginning. What is potentially next? Student loans. We are seeing a massive tightening in the student loan industry. At the moment, student loan lenders have a direct call on the Treasury to keep these important loan available for parents and students, but as tough times get tougher, it can mean that going to college pursuing a higher education will be even more difficult for families on a budget because student loans will not be available. Auto loans. It is feared the next market to tighten up will be the auto loan market, and if Americans cannot afford to buy a car, what will happen to Chrysler, Ford, GM, and thousands of UAW employees. Finally, salaries and jobs are at risk. Employers, if they cannot obtain credit to grow and expand their businesses, or even to meet their payroll, we are looking at massive layoffs. So, yes, Wall Street and Main Street are linked. Do I know if the Bush-Treasury package is the right answer? I don't, and neither does anyone else. But I don't have a fear of doing something; I do, however, have a fear of doing nothing. Our markets are based on confidence, and I believe steps must be taken to provide confidence to our markets. I think that must include an injection or liquidity or, simply put, cash to grease our economy. So where do we go from here? I do not believe we should accept the Treasury's package as it was drafted by the White House, but I do believe support is needed for our financial services sector so it can, in turn, go back to allowing Americans to safely invest their savings. What Congress and the President must remember throughout this process is that the $700 billion we are talking about today is the taxpayers' money. The White House and Republican Leader Boehner have argued for straight passage of the President's Treasury plan, but that is not going to happen. Democrats are building in a number of protections for the taxpayer. We are demanding both civil and criminal accountability for Wall Street executives, we will require oversight of the Treasury Department, and will ensure that there is a financial return to the taxpayer so this does not add to the $5 trillion-plus debt, which we have right now, which was added by the Bush Administration and the former Republican majority of the Congress, many of whom are, ironically, still arguing for further deregulation. Chairman Frank, his staff, and members of the committee have spent this past week inserting into the package much-needed limits on executive compensation because we cannot provide support to our Nation's financial institutions without appropriate and tough measures to ensure that corporate executives are not enriching themselves at taxpayer expense. This bill will require those who seek help from the Treasury to limit their pay and their benefits. Executives, like all employees, should be rewarded for success and not for failure. Chairman Frank has also demanded would swift action by the Federal regulators and the FBI to investigate if fraud was perpetrated against taxpayers during this crisis. The government should be giving out metal bracelets and not golden parachutes. These actions are a solid start to ending the era of Cowboy Capitalism. Chairman Frank and his committee have included in its package important oversight protections to ensure the Treasury Department adequately and appropriately executes the program, as well as new oversight over our markets. This new oversight is necessary, and I won't go into details on what happened during the 1930's, but we know if we don't do something, we are heading in that same direction. My colleagues, no one is happy to be in this predicament, but we are here and we need to address before it comes a cancer to our entire economy. So I understand pollsters are asking our constituents if they think it is the right thing to do for the government to potentially invest billions to keep financial institutions and markets secure. The answer is: Do we have a choice? Or is the consequence of inaction a far, far worse choice. I thank the committee for allowing me to testify, and I would be happy to answer any questions. " CHRG-111shrg55739--84 Mr. Coffee," I am honored, Chairman Reed and fellow Members of the Committee, to be back before this Committee, but I am in the very embarrassing position of having to begin by commending and congratulating the Chairman, because what we are looking at in the Treasury bill is 95 percent what was in the Reed bill. The Reed bill, introduced in April, was substantial, constructive, well crafted, and I think it does just about everything that you can do through administrative regulation to deal with this problem. The problem is, there are dimensions to this whole area that are beyond simply administrative regulation and that is what the Treasury bill in particular leaves out. Thus, because--there is a shortfall, because not all of the provisions in the Reed bill are in the Treasury bill and because there needs to be a consideration of some issues beyond administrative regulation. I would have to say there is a shortfall in the Treasury regulation, and I would have to predict that we will see a persistence of the status quo, dysfunctional and perverse as it is, if all we do is what is in the Treasury bill. In this regard, I think there are two distinctive critical features about credit rating agencies which distinguish them from all of the other gatekeepers in the financial markets that have to be focused on. One, credit rating agencies do not perform due diligence. Accountants are bean counters. They go out and count the beans. Credit rating agencies give ratings based on hypothetical assumed facts, and thus you are getting hypothetical ratings. I think that has to be corrected. Second, the credit rating agencies today do not face any meaningful risk of liability. Because, as I look at the future, even though I wish to encourage the user-pay system, I think the issuer-pays model will persist and predominate. There is going to remain a built-in conflict of interest, and when you have a built-in conflict of interest, the other professions have found that the only thing that keeps the professional honest is the threat of litigation. The accountants have learned, painfully, how to steer a course between acquiescence to the client and maintaining high integrity and litigation is one of the forces that maintains that equilibrium. Therefore, based on that diagnosis, what do I think we should do? I think the first thing we have to focus on is how to encourage third-party due diligence. The Treasury bill does this, largely adopting many of your provisions. The problem is that it does this by requiring disclosure when you decide to use a third-party due diligence firm, and it requires certification by that firm to the SEC. That raises the cost of using a third-party due diligence firm and I think there would be many underwriters, at least if we get back into a bull market at some point in the future, that will simply opt not to use the third-party due diligence firm. They did this in the past. These due diligence firms were widely employed in the 1990s, and as the market grew bubbly, they dropped their use because they kept learning disquieting facts that they didn't want to hear about. So you can put in boilerplate disclosure that says, we are not using a third-party due diligence firm, and hope that in that more favorable market, you can get away with this, and I think you probably would be able to get away with this. How, then, should we deal with encouraging third-party due diligence? I would suggest that we look here at a different level of regulation. No one has been talking much about regulating the users of this information, and the users now are closely regulated by rules that I think are over-broad and ill conceived. Let me give you one example. Rule 2(a)(7) of the SEC under the Investment Company Act tells money market funds that they cannot buy securities unless they are eligible securities, and to be an eligible security, you have to have a requisite rating from an NRSRO rating agency. We could deregulate much of that, but many of the users of this information do want to rely on an NRSRO rating. They have made that very clear to the SEC. What I think we should say is that to the extent you choose to rely on an NRSRO rating, it has to be a rating that is based upon third-party due diligence that verified the essential facts. That way, we have at least something that is not illusory, that is not a hypothetical rating, and that way--because this rule already exists. I am not proposing new rules. I am proposing making the existing rule meaningful by making it based on third-party due diligence. There are other of these rules, but they are in my statement and I won't take it further. The point in doing this is by focusing on the user, we are not regulating the rating agency and that allows us to sidestep some arguable constitutional problems about whether we are overly regulating commercial speech. I don't think we are, but we aren't doing it at all if we regulate the user and say, you only get the right to do this if you use one of these techniques and you have good due diligence. Now, let me move on to this issue of liability because I see the business-pays model as persisting. I think we need some risk. In 10 seconds, let me just say that my proposal is not to open the flood gates. It is really your proposal. I think you struck a very sensible compromise, because it doesn't really increase the likelihood of litigated outcomes. It simply says, your proposal, your bill in April contains a provision that says if credit rating agencies--they can be found to have acted recklessly if they give an opinion, a rating, without conducting some due diligence or receiving due diligence from a third-party expert. This does not subject them to liability. It just tells them there is one easy, safe strategy for avoiding liability and that is to make sure that the underwriter pays for and gives you a third-party due diligence report that covers the critical facts in your model. This will not produce a rash of litigation. It will produce behavior that avoids litigation and thus this is another technique to get the critical core of due diligence back into the ratings process. Thank you. I apologize for overstepping my time. Senator Reed. Thank you, Professor Coffee. Professor White.STATEMENT OF LAWRENCE J. WHITE, LEONARD E. IMPERATORE PROFESSOR fcic_final_report_full--562 Chapter 2 1. Ben Bernanke, written 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 1, session 1, September 2, 2010, p. 2. 2. Alan Greenspan, “The Evolution of Banking in a Market Economy,” remarks at the Annual Confer- ence of the Association of Private Enterprise Education, Arlington, Virginia, April 12, 1997. 3. Charles Calomiris and Gary Gorton, “The Origins of Banking Panics: Models, Facts, and Bank Regulation,” in Calomiris, U.S. Bank Deregulation in Historical Perspective (Cambridge: Cambridge Uni- versity Press, 2000), pp. 98–100. Prior to the end of the Civil War, banks issued notes instead of holding deposits. Runs on that system occurred in 1814, 1819, 1837, 1839, 1857, and 1861 (ibid., pp. 98–99). 4. R. Alton Gilbert, “Requiem for Regulation Q: What It Did and Why It Passed Away,” Federal Re- serve Bank of St. Louis Review 68, no. 2 (February 1986): 23. 5. FCIC, “Preliminary Staff Report: Shadow Banking and the Financial Crisis,” May 4, 2010, pp. 18– 25. 6. Arthur E. Wilmarth Jr., “The Transformation of the U.S. Financial Services Industry, 1975–2000: Competition, Consolidation, and Increased Risks,” University of Illinois Law Review (2002): 239–40. 7. Frederic S. Mishkin, “Asymmetric Information and Financial Crises: A Historical Perspective,” in Financial Markets and Financial Crises, ed. R. Glenn Hubbard (Chicago: University of Chicago Press, 1991), p. 99; Wilmarth, “The Transformation of the U.S. Financial Services Industry, 1975–2000,” p. 236. 8. Federal Reserve Board Flow of Funds Release, table L.208. Accessed December 29, 2010. 9. Kenneth Garbade, “The Evolution of Repo Contracting Conventions in the 1980s,” Federal Reserve Bank of New York Economic Policy Review 12, no. 1 (May 2006): 32–33, 38–39 (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=918498). To implement monetary policy, the Fed- eral Reserve Bank of New York uses the repo market: it sets interest rates by borrowing Treasuries from and lending them to securities firms, many of which are units of commercial banks. 10. Alan Blinder, interview by FCIC, September 17, 2010. 11. Paul Volcker, interview by FCIC, October 11, 2010. 12. Fed Chairman Alan Greenspan, “International Financial Risk Management,” remarks before the Council on Foreign Relations, November 19, 2002. 13. Richard C. Breeden, interview by FCIC, October 14, 2010. 14. Wilmarth, “The Transformation of the U.S. Financial Services Industry, 1975–2000,” p. 241 and n. 102. 15. Thereafter, banks were only required to lend on collateral and set terms based upon what the mar- ket was offering. They also could not lend more than 10% of their capital to one subsidiary or more than 20% to all subsidiaries. Order Approving Applications to Engage in Limited Underwriting and Dealing in Certain Securities,” Federal Reserve Bulletin 73, no. 6 (Jul. 1987): 473–508; “Revenue Limit on Bank-Inel- igible Activities of Subsidiaries of Bank Holding Companies Engaged in Underwriting and Dealing in Se- curities,” Federal Register 61, no. 251 (Dec. 30, 1996), 68750–56. 16. Julie L. Williams and Mark P. Jacobsen, “The Business of Banking: Looking to the Future,” Busi- ness Lawyer 50 (May 1995): 798. 17. Fed Chairman Alan Greenspan, prepared testimony before the House Committee on Banking and Financial Services, H.R. 10, the Financial Services Competitiveness Act of 1997, 105th Cong., 1st sess., May 22, 1997. 18. FCIC staff calculations. 19. FCIC staff calculations. 20. FCIC staff calculations using First American/CoreLogic, National HPI Single-Family Combined (SFC). 21. This data series is relatively new. Those series available before 2009 showed no year-over-year na- tional house price decline. First American/CoreLogic, National HPI Single-Family Combined (SFC). 22. For a general overview of the banking and thrift crisis of the 1980s, see FDIC, History of the Eight- ies: Lessons for the Future, vol. 1, An Examination of the Banking Crises of the 1980s and Early 1990s (Washington, DC: Federal Deposit Insurance Corporation, 1997). 559 23. Specifically, between 1980 and 1994, 1,617 federally insured banks with $302.6 billion in assets and 1,295 savings and loans with $621 billion in assets either closed or received FDIC or FSLIC assis- tance. See Federal Deposit Insurance Corp., Managing the Crisis: The FDIC and RTC Experience, 1980– 1994 (Aug. 1998), pp. 4, 5. 24. William K. Black, Associate Professor of Economics and Law, University of Missouri–Kansas City, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 4. And see Kitty Calavita, Henry N. Pontell, and Robert H. Till- man, Big Money Crime: Fraud and Politics in the Savings and Loan Crisis (Berkeley: University of Califor- nia Press, 1997), p. 28. 25. FDIC, History of the Eighties: Lessons for the Future, 1:39. 26. U.S. Treasury Department, “Modernizing the Financial System: Recommendations for Safer, More CHRG-111shrg50814--3 Chairman Dodd," I am sure the Federal Reserve operates in a similar pattern as we do here on the Banking Committee. Do you get as much luck as the Chairman as I just did on that? Well, let me tell you how we will proceed here this morning, and we welcome you, Mr. Chairman, to the Committee. We have got a good turnout of our Members here for all the obvious reasons. When the Chairman of the Federal Reserve comes before our Committee, it is obviously of deep interest to the country, and we welcome you here this morning. I will take a few minutes for some opening comments, turn to Senator Shelby for any opening comments he may have, and then we will go right to you, Mr. Chairman, for your statement this morning, and we will try and follow the 5-minute rule so that everybody gets a chance to raise questions with you. And if we need a second round, we will do so. The record will stay open for a few days to submit questions, and any and all statements, documents, and other materials that my colleagues and others feel would be important to include in the record will be considered included at this moment, without objection. Well, Chairman Bernanke, we welcome you to the Committee to present the Fed's semiannual monetary policy report to the U.S. Congress. We meet obviously at a very important moment for our country, with our Nation in the midst of the worst economic crisis in generations. Since the end of World War II, America's business cycles have oscillated between periods of growth and rising inflation, with the Fed raising interest rates to slow the economy, creating a recession, which then caused inflation to slow. The Fed then typically lowered interest rates, restarting the Nation's economy again. And while the Fed manages our recessions, our economic recoveries have typically been led by the housing and automobile sectors, which are highly sensitive to interest rates. In the past, the typical American worker saved during the good times for rainy days, and when recession hit, they may have been laid off. But once the recession receded, they not only had some savings hopefully stored up, but also a reasonably good chance of getting their jobs back or finding new employment. This time, however, Mr. Chairman, our housing and auto sectors are leading us not out of recession but into it in many ways. This time our recession is being caused not by rising interest rates but, rather, a massive credit crunch, resulting from years of reckless spending and, as the Banking Committee has uncovered during the 80 hearings and meetings in the last Congress, regulatory neglect as well. Such neglect allowed for and even encouraged a problem that began in the subprime mortgage market to spread throughout our Nation and the entire global financial system like a cancer. This time, nearly half the jobs we have lost are not likely to come back, we are told, and that is why the American Recovery and Reinvestment Act is so essential. This time, the American people entered this recession with a negative personal savings rate and a false sense of confidence that we can count on the value of our homes and stocks to go up forever. In fact, Mr. Chairman, I read with great interest that your own boyhood home recently went into foreclosure. I am saddened by that, as I am sure you are. Most recently, that home was owned by a soldier in the South Carolina Army National Guard, who reportedly volunteered to go on active duty during wartime in order to try and save his home and your former home. Mr. Chairman, I do not suggest that you are to blame for any of this. Quite the contrary. I happen to commend your conduct of monetary policy during your tenure. Last year, you began to cut interest rates in the face of opposition from some regional bank presidencies at the Fed. You followed through on your commitment that you made, a meeting which I will never, ever forget in August of 2007, when you were in my office with Hank Paulson. And I will never forget the words you spoke to me that day when asked what we could about the problems, and you said at that time you would use all the tools at your disposal to attack the problems in the global financial market. And I commended you for those comments then, and your efforts, through aggressive and often innovative monetary policy. You have worked creatively to adapt the Fed to handle the greatest financial market crisis in any of our lifetimes. If, as it is said, those who do not study history are doomed to repeat its mistakes, I am relieved we have one of the foremost scholars of the Great Depression at the helm of the Fed at this moment. But for all the successes the Fed has had in carrying out its core mission--monetary policy--its regulation and consumer protection missions have been abject failures, in my view. And while many of these failures predate your arrival, they cannot be ignored. When I am approached by a constituent in New London, Connecticut, for instance, who was outraged that some of these banks were allowed to grow into behemoths and given a clean bill of health, only to turn around months later on the verge of bankruptcy, asking for billions of dollars in taxpayer funding, I am reminded of the shortcomings in the Fed's regulation of bank holding companies. When a family in Bridgeport, Connecticut, with their 5,000 foreclosures in that one city in my home State pending, who have lost everything ask me where the cops were on the beat, where were they to stop the abusive predatory mortgages from being written, I am reminded of the Fed's failure to implement the law Congress passed in 1994 to protect consumers and regulate mortgage lending practices. When I learn a direct marketing business in greater Hartford has to close its doors, not because they missed a payment to their bank but because the bank is having capital problems, I cannot help but remember your predecessor's fondness for ``regulatory competition,'' as he called it, for actually encouraging bank regulators to compete with one another to see who could provide the most effective regulation of our banks, but apparently at the least. As a result, today countless banks are left with dangerously low cash reserves and a massive buildup of leverage, which have created a veritable boomerang of debt that has now snapped back, ensnaring countless honest small businesses in the process. Finally, when I am asked how our Government could have allowed these toxic financial products to proliferate, products that served to dilute the appearance of risk rather than the risk itself, I remember the Federal Reserve's mantra of financial innovation and its leaders' repeated warnings against any additional Government regulation of any kind. I remember very, very clearly the mood in January of 2007 when I became Chairman of this Committee and the mantra--the mantra in those months was, ``Deregulate, fast, before everyone runs to London.'' Mr. Chairman, you have an extraordinarily difficult task ahead of you, not only to fulfill the Fed's primary mandate to conduct monetary policy to create maximum economic growth, full employment, and price stability, you do so in the face of an economy in deep recession, closing credit markets and unemployment rising at its fastest pace in a generation, having already cut interest rates to almost zero. You do so managing a balance sheet that has spiked to $2 trillion and now includes the remnants of an investment bank and the control of the world's largest insurance company. You do so having to conduct monetary policy in ways never tried before to unlock frozen credit markets, and you do so with an agency whose structure is virtually unchanged since its creation in 1913, when nearly a third of the Americans worked on farms, even as your mission has expanded exponentially from regulating the smallest banks in the country to the largest bank holding companies, from protecting consumers to being the lender of last resort for any company in the Nation. Mr. Chairman, I would say your plate is full, to put it mildly. As this Committee works to modernize our Nation's financial regulatory structure, the question is whether we should be giving you a bigger plate or whether we should be putting the Fed on a diet. I do not question your track record on monetary policy, as I have said--the Fed's primary goal. But when you keep asking an agency to take on more and more and more, it becomes less and less and less likely that the agency will succeed at any of it. And at the same moment, in my view, nothing will be more important for the Federal Reserve than getting monetary policy right. It is absolutely paramount, and I know you know that as well. So we welcome you to this Committee, and let me turn to Senator Shelby for any opening comments he may have. CHRG-111shrg53176--148 PREPARED STATEMENT OF ARTHUR LEVITT Former Chairman, Securities and Exchange Commission March 26, 2009 Thank you, Chairman Dodd and Ranking Member Shelby, for the opportunity to appear before the Committee at this critical moment facing our markets, our economy, and our Nation. When I last appeared before this Committee, I focused my remarks on the main causes of the crisis we are in, and the significant role played by deregulation. Today, I would like to build upon that testimony and focus your attention on the prime victim of deregulation--investors. Because of failures at every level of our financial system, investors no longer feel that they receive correct information or enjoy meaningful protections. Their confidence in fair, open, and efficient markets has been badly damaged. And not surprisingly, our markets have suffered from this lack of investor confidence. Above all the issues you now face, whether it is public anger over bonus payments or the excesses of companies receiving taxpayer assistance, there is none more important than investor confidence. The public may demand that you act over some momentary scandal, but you must not give in to bouts of populist activism. Your goal is to serve the public not by reacting to public anger, but by focusing on a system of regulation which treats all market actors the same under the law, without regard to their position or status. In coming months, you will adopt specific regulatory and policy solutions to the problems we face, yet none of that work will matter much unless we find a way to restore investor confidence. If at the end of the process you don't place investor confidence at the heart of your efforts, no system of regulation and no amount of spending on regulatory agencies can be expected to succeed.Core Principles You are focusing now on the issue of systemic risk, and therefore whatever response you take must be systemic as well. Specifically, some have suggested that we should re-impose Glass-Steagall rules regarding the activities and regulation of banks. Those rules kept the Nation's commercial banks away from the kinds of risky activities of investment banks. But by 1999, the law no longer had the same teeth--multiple workarounds had developed, and it no longer was practical to keep it in place. Perhaps we were too hasty in doing away with it, and should have held onto several key principles that made Glass-Steagall an effective bulwark against systemic risk in America's banking sector. That does not mean we should pursue ``turn-back-the-clock'' regulation reforms and re-impose Glass-Steagall. The world of finance has changed greatly since 1999 and we have to change with it. But we can borrow some important principles from Glass-Steagall, apply them to today's environment, as we address the serious weaknesses of our current system of financial regulation. Those principles, in short, are: Regulation needs to match the market action. If an entity is engaged in trading securities, it should be regulated as a securities firm. If an entity takes deposits and holds loans to maturity, it should be regulated as a depository bank. Moreover, regulation and regulatory agencies must be suited to the markets they seek to oversee. Regulation is not one size fits all. Accounting standards serve a critical purpose by making information accessible and comprehensible in a consistent way. I understand that the mere mention of accounting can make the mind wander, but accounting is the foundation of our financial system. Under no circumstances should accounting standards be changed to suit the momentary needs of market participants. That principle supports mark-to-market accounting, which should not be suspended under any condition. The proper role of a securities regulator is to be the guardian of capital markets. There is an inherent tension at times between securities regulators and banking supervisors. That tension is to be expected and even desired. But under no circumstance should the securities regulator be subsumed--if your goal is to restore investor confidence, you must embolden those who protect capital markets from abuse. You must fund them appropriately, give them the legal tools they need to protect investors, and, most of all, hold them accountable, so that they enforce the laws you write. And finally, all regulatory reforms and improvements must be done in a coordinated and systemic way. The work of regulation is rarely done well in a piecemeal fashion. Rather, your focus should be to create a system of rules that comprise a complete approach, where each part complements the other, and to do it all at once.Specific Reforms Allow me to illustrate how these principles can be put to work, in specific regulatory and policy reforms: First: Some have suggested that you create a single super-regulator. I would suggest that a more diverse approach should be adopted, taking advantage of the relative strengths of our existing regulatory agencies. For example, the Federal Reserve, as a banking supervisor, has a deep and ingrained culture that is oriented towards the safety and soundness of our banking system. But when banks--or any financial institution--engage in securities transactions, either by making a market in securities, or by securitizing and selling loans, or by creating derivatives backed by equities or debt, they fundamentally require oversight from trained securities regulators. What serves the health of banks may run exactly counter to the interests of investors--and we have seen situations where bank regulators have kept information about poorly performing assets from the public in order to give a bank time enough to dispose of them. In that case, banking regulators will work at cross-purposes with securities regulators. Ultimately, the only solution to that tension is to live with it. When I was at the SEC, there was tension between banking regulators and securities regulators all the time. This creative tension served the ultimate goal of reducing overall risk to our economy, even if it occasionally was frustrating for the regulators and the financial institutions themselves. And so we should not be surprised if regulatory reforms yield a bit of regulatory overlap. That is both natural, considering the complexity of financial institutions, and even desirable. Second: Mark to market or fair value standards should not be suspended under any circumstance. Some have come forward and suggested that these are unusual times, and we need to make concessions in our accounting standards to help us through it. But if we obscure investor understanding of the value of assets currently held by banking institutions, we would exacerbate the crisis, and hurt investors in the bargain. Unfortunately, recent steps taken by the FASB, at the behest of some politicians, weaken fair value accounting. Those who argue for a suspension of mark-to-market accounting argue this would punish risk-taking. I strongly disagree. Our goal should be to make sure risk can be priced accurately. Failure to account for risk, and failure to present it in a consistent way, makes it impossible to price it, and therefore to manage it. And so any effort that seeks to shield investors from understanding risk profiles of individual banks would, I believe, be a mistake, and contribute to greater systemic risk. I would add that mark-to-market accounting has important value for internal management of risk within a firm. Mark-to-market informs investment bank senior managers of trading performance, asset prices, and risk factor volatilities. It supports profit and loss processes and hedge performance analyses, facilitates the generation and validation of risk metrics, and enables a controlled environment for risk-taking. If treated seriously by management, mark-to-market is a force for internal discipline and risk management, not much different than a focus on internal controls. Yes, valuing illiquid or complex structured products is difficult. But that doesn't mean the work should not be done. I would argue that it has to be done, both inside the firm and by those outside it, to reduce risk throughout our system. And so I agree with the Chairman of the Federal Reserve, and the heads of the major accounting firms, that the maintenance of mark-to-market standards is essential. Third: As this Committee and other policymakers seek to mitigate systemic risk, I would suggest taking a broad approach to the challenge. It would be a mistake, I believe, to designate only one agency to focus on systemic risk, because systemic risk emanates in multiple ways. You may find the task best accomplished by enacting a series of complementary regulatory enhancements aimed at promoting transparency and information discovery across multiple markets. Those remaining pockets of financial activity covered by self-regulation and protected from litigation should be brought in under a more vigorous regulatory structure with fully independent regulators and legal remedies. For years, credit ratings agencies have been able to use legal defenses to keep from the SEC from inspecting the way they do their ratings the way the PCAOB is empowered to examine the way audits are done, even though these agencies dispense investment advice and sit at a critical nexus of financial information and potential risk. In addition, these ratings agencies cannot be fined by the SEC and they operate with significant protections from private rights of action. These protections from regulatory review and legal remedies need to be reconsidered. The credit ratings agencies have an abysmal record of performance in recent years and their failure has had an outsized impact on the health of our entire financial system. They are not merely expressing views that would ordinarily receive legal protections. They are playing a much larger role, and their activities should be treated in the same way as other market actors who are subject to SEC review and regulation. In the same manner, the SEC should have a far greater role in regulating the municipal bond market, which consists of state and local government securities. This is the market where Wall Street and Main Street collide. Since the New York City crisis of 1975, this market has grown to a size and complexity that few anticipated. It now includes not-for-profit institutions and even for-profit business corporations who sell securities through government conduit entities. The debt and derivative products sold are substantially the same as those sold in the corporate market. Small investors make up a substantial part of this market and because of the Tower Amendment many participants--insurers, rating agencies, financial advisors to issuers, underwriters, hedge funds, money managers and even some issuers--have abused the protection granted by Congress from SEC regulation. This market has shown that self-regulation by bankers and brokers through the Municipal Services Rulemaking Board all too often has come at the expense of the public interest. The New York City debacle in 1975, the San Diego pension fund fraud in 2006, the Orange County California derivatives crisis in 1994, the Washington Public Power System defaults in 1980, the auction securities settlements of 2008, and the current investigations into derivatives, bid rigging, pay to play and other scandals--this is an industry prone to scandal. In recent months, we have even seen several well-documented scandals where small municipalities and public agencies were encouraged to float bonds even though the money was not to be spent on public purposes, but rather used as an investment pool. We may not want to treat municipals like we do other securities--but we do need to level the playing field between the corporate and municipal markets and address all risks to the financial system. Municipal issuers are ill-equipped and some are reluctant to do this on their own. We may have to develop ways protect small municipal issuers from over regulation just as we do for small corporations, so long as we do not develop a double standard for principles of disclosure, transparency, finance and compliance with market rules. Former Chairman Cox has suggested granting the SEC authority to regulate the municipal bond industry to promote integrity, competition and efficiency, and I agree. In addition, I would also recommend amending the Investment Advisers Act to give the SEC the right to oversee specific areas of the hedge fund industry and other pockets of what some have called the ``shadow markets''--those areas of finance beyond the oversight of regulators. In particular, I would urge that you require banks and hedge funds create an audit trail and clearinghouse for all trades, to create a better awareness of investment products that could pose risks to overall markets. I would also recommend placing hedge funds under SEC regulation in the context of their role as money managers and investment advisors. There will be some who argue that SEC oversight of some aspects of hedge funds will come at the expense of financial market innovation. In fact, such regulation could help improve the environment for financial innovation. For example, we know that new investment vehicles can be a source for risk even as they supply investors with a desired financial product. How do we balance those competing qualities? Perhaps the SEC could increase the margin requirement for the purchase of new products, until those products are road-tested and have developed a strong history of performance in different economic conditions. Nor are all forms of regulation going to simply involve more disclosure requirements. I could see a greater focus on better disclosure, so that investors and regulators receive information that has more value. For example, a system that allows financial institutions to make their own risk assessments, or relies on credit rating agencies for purposes of determining how much capital they should have, lacks adequate independence and credibility. At the same time, adopting a one size fits all approach is likely to be shortsighted and ineffective. As SEC Chairman, I favored risk-based principles for regulation, and think greater application of those principles is needed. Such a system should be forward-looking, independent and free of bias in its assessment of risks and liquidity needs within an entity, overseen by a regulator with a mission, culture and necessary resources to do the job, and finally, be fully transparent not only to regulators but also to investors, taxpayers and Congress. Such a system would be far more useful than our current system. And it would contribute greatly to our awareness of potential sources of systemic risk. These steps would require OTC derivative market reform, the outcome of which would be the regulation by the SEC of all credit and securities derivatives. To make this regulation possible and efficient, it would make sense to combine the resources and responsibilities of the SEC and CFTC. In today's financial markets, the kinds of financial instruments regulated by these two agencies share much in common as economic substitutes, and this change would allow regulators to share their skillsets, coordinate their activities, and share more information, thus providing a deeper level of understanding about risk. Supporting all these activities will require an appropriately funded, staffed and empowered SEC. Under the previous administration, SEC funding and staffing either stayed flat or dropped in significant areas--enforcement staff dropped 11 percent from 2005 to 2008, for example. We have seen that regulators are often overmatched, both in staffing and in their capacity to use and deploy technology, and they can't even meet even a modest calendar of regular inspections of securities firms. Clearly, if we are to empower the SEC to oversee the activities of municipal bond firms and hedge funds, we will need to create not only a stronger agency, but one which has an adequate and dedicated revenue stream, just as the Federal Reserve does. My final recommendation relates to something you must not do. Under no condition should the SEC lose any of its current regulatory responsibilities. As the primary guardian of capital markets, the SEC is considered the leading investor representative and advocate. Any regulatory change you make that reduces the responsibility or authority of the SEC will be viewed as a reduction in investor protections. That view will be correct, because no agency has the culture, institutional knowledge, staff, and mission as the SEC to protect investors.Conclusion These actions would affirm the core principles which served the Nation's financial markets so well, from 1933 to 1999--regulation meeting the realities of the market, accounting standards upheld and strengthened, regulators charged with serving as the guardians of capital markets, and a systemic approach to regulation. The resulting regulatory structure would be flexible enough to meet the needs of today's market, and would create a far more effective screen for potential systemic risks throughout the marketplace. Financial innovations would continue to be developed, but under a more watchful eye from regulators, who would be able to track their growth and follow potential exposure. Whole swaths of the shadow markets would be exposed to the sunlight of oversight, without compromising the freedom investors have in choosing their financial managers and the risks they are willing to bear. Most importantly, these measures would help restore investor confidence by putting in place a strong regulatory structure, enforcing rules equally and consistently, and making sure those rules serve to protect investors from fraud, misinformation, and outright abuse. These outcomes won't come without a price to those who think only of their own self-interest. As we have seen in the debate over mark-to-market accounting rules, there will be strong critics of strong, consistent regulatory structure. The self-interested have reasons of their own to void mark-to-market accounting, but that does not make them good reasons for all of us. Someone must be the guardian of the capital market structure, and someone must think of the greater good. That is why this Committee must draw on its heritage of setting aside partisanship and the concerns of those with single interests, and maintain a common front to favor the rights of the investor, whose confidence will determine the health of our markets, our economy, and ultimately, our Nation. ______ 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-111shrg51395--14 Mr. Coffee," Well, good morning, and thank you, Chairman Dodd, Ranking Member Shelby, and fellow Senators. I have prepared an overly long, bulky, 70-page memorandum for which I apologize for inflicting on you. It attempts to synthesize a good deal of recent empirical research by business school scholars, finance scholars, and even law professors, about just what went wrong and what can be done about it. I cannot summarize all that, but I would add the following two sentences to what Senators Dodd and Shelby very accurately said at the outset. The current financial crisis is unlike others. This was not a bubble caused by investor mania, which is the typical cause of bubbles. It was not a demand-driven bubble; rather, it was more a supply driven bubble. It was the product of a particular business model, a model known as the ``originate-and-distribute model,'' under which financial institutions, including loan originators, mortgage lenders, and investment banks, all behaved similarly and went to the brink of insolvency and beyond, pursuing a model. What is the key element of this originate-and-distribute model? You make lax loans. You make non-creditworthy loans because--because you do not expect to hold those loans for long enough to matter. You believe that you can transfer these loans to the next link in the transmission chain before you will bear the economic risk. When everyone believes that--and they correctly believed that for a few years--then all standards begin to become relaxed, and we believe that as long as we can get that investment grade rating from the credit rating agencies, we will have no problem, and weak loans can always be marketed. There is no time for statistics here, but let me add just one. Between 2001 and 2006, a relatively short period, some of the data that I cite shows you that low-document loans in these portfolios went from being something like 28 percent in mortgage-backed securities in 2001 to 51 percent in 2006--doubling in 4 or 5 years. Investment banks and credit rating agencies are not responding to that change. That is the essential problem. This gives rise to what I will call and economists call a ``moral hazard problem,'' and this moral hazard problem was compounded by deregulatory policies that the SEC and other institutions followed that permitted investment banks to increase their leverage dramatically between 2004 and 2006, which is only just a few years ago. This is yesterday we are talking about. They did this pursuant to the Consolidated Supervised Entity Program that you have already been discussing, and it led to the downfall of our five largest, most important investment banks. All right. Essentially, the SEC deferred to self-regulation, by which these five largest banks constructed their own credit risk models, and the SEC deferred to them. The 2008 experience shows, if there ever was any doubt, that in an environment of intense competition and under the pressure of equity-based executive compensation systems that tend to be very short-term oriented, self-regulation alone simply does not work. The simplest way for a financial institution to increase profitability was to increase its leverage, and it did so to the point where they were leveraged to the eyeballs and could not survive the predictable downturn in the economic weather. So what should be done from a policy perspective? Well, here is my first and most essential point: All financial institutions that are too big to fail, which really means too entangled to fail, need to be subjected to prudential financial oversight, what I would call ``financial adult supervision,'' from a common regulator applying a basically common although risk-adjusted standard to all these institutions, whether they are insurance companies, banks, thrifts, hedge funds, money market funds, or even pension plans, or the financial subsidiaries of very large corporations, like GE Capital. In my judgment, this can only be done by the Federal Reserve Board. That is the only person in a position to serve as what is called the ``systemic risk regulator.'' I think we need in this country a systemic risk regulator, and specifically to define what this means, let me say there are five areas where their authority should be established. The Federal Reserve Board should be authorized and mandated to do the following five things: One, establish ceilings on debt-to-equity ratios and otherwise restrict leverage for all major financial institutions. Two, supervise and restrict the design and trading of new financial products, including, in particular, over-the-counter derivatives and including the posting of margin and collateral for such products. Three, mandate the use of clearinghouses. The Federal Reserve has already been doing this, formulating this, trying to facilitate this, but mandating it is more important. And they need the authority to supervise these clearing houses, and also if they judge it to be wise and prudent, to require their consolidation into a single clearinghouse. Four, the Federal Reserve needs the authority to require the writedown of risky assets by financial institutions, regardless of whether accounting rules mandate it. The accountants will always be the last to demand a writedown because their clients do not want it. The regulator is going to have to be more proactive than are the accounting firms. Last, the Federal Reserve should be authorized to prevent liquidity crises that come from the mismatch of assets and liabilities. The simple truth is that financial institutions hold long-term illiquid assets which they finance through short-term paper that they have to roll over regularly, and that mismatch regularly causes problems. Now, under this ``Twin Peaks'' model that I am describing, the systematic risk regulator--presumably, the Federal Reserve--would have broad authority. But the power should not be given to the Federal Reserve to override the consumer protection and transparency policies of the SEC. And this is a co-equal point with my first point, that we need a systemic risk regulator. Too often, bank regulators and banks have engaged in what I would term a ``conspiracy of silence'' to hide problems, lest investors find out, become alarmed, and create a run on the bank. The culture of banking regulators and the culture of securities regulators is entirely different. Bank regulators do not want to alarm investors. Securities regulators understand that sunlight is the best disinfectant. And for the long run, just as Senator Shelby said, we need accounting policies that reveal the ugly truth. We could not be worse off now in terms of lack of public confidence. This is precisely the moment to make everyone recognize what the truth is and not to give any regulator the authority to suppress the truth under the guise of systematic risk regulation. For that reason, I think SEC responsibilities for disclosure, transparency, and accounting should be specially spelled out and exempted from any power that the systematic risk regulator has to overrule other policies. Now, two last points. As a financial technology, asset-based securitization, at least in the real estate field, has decisively failed. I think two steps should be done by legislation to mandate the one policies that I think will restore credibility to this field. First, to restore credibility, sponsors must abandon the originate-and-distribute business model and instead commit to retain at least a portion of the most subordinated tranche, the riskiest assets. Some of them have to be held by the promoter because that is the one signal of commitment that tells the marketplace that someone has investigated these assets because they are holding the weakest, most likely to fail. That would be step one. Step two, we need to reintroduce due diligence into the process, into the securitization process, both for public offerings and for Rule 144A offerings, which are private offerings. Right now Regulation AB deregulated; it does not really require adequately that the sponsor verify the loans, have the loan documentation in its possession, or to have examined the creditworthiness of the individual securities. I think the SEC can be instructed by Congress that there needs to be a reintroduction of stronger due diligence into both the public and the private placement process. Last point. Credit rating agencies are obviously the gatekeeper who failed most in this current crisis. The one thing they do not do that other gatekeepers do do is verify the information they are relying on. Their have their rating methodology, but they just assume what they are told; they do not verify it. I think they should be instructed that there has to be verification either by them or by responsible, independent professionals who certify their results to them. The only way to make that system work and to give it teeth is to reframe a special standard of liability for the credit rating agencies. I believe the Congress can do this, and I believe that Senator Reed and his staff are already examining closely the need for additional legislation for credit rating agencies, and I think they are very much on the right track, and I would encourage them. What I am saying, in closing, is that a very painful period of deleveraging is necessary. No one is going to like it. I think some responsibility should be given to the Federal Reserve as the overall systematic risk regulator, but they should not have authority to in any way overrule the SEC's policies on transparency. Thank you. " 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 CHRG-111shrg53176--150 PREPARED STATEMENT OF PAUL S. ATKINS Former Commissioner, Securities and Exchange Commission March 26, 2009 Thank you very much, Mr. Chairman, Ranking Member Shelby, and Members of the Committee, for inviting me to appear today at your hearing. It is an honor and privilege for me to provide information for your deliberations on possible legislation regarding the U.S. financial markets. This Committee has a long history of careful study and analysis of matters relating to the financial markets and the financial services industry. There are multiple, complex, and interrelated causes to the current situation in the global financial markets. These causes have been decades in the making. Those who would tell you otherwise are simply misguided, have ulterior motives, or are unaware of the intricacies of global finance. These causes are more than the competence or incompetence of individuals in particular roles, but have more to do with fundamental principles of organizational behavior and incentives. Your topic for today is rather broad, so I would like to touch on a few specific items that go to the heart of an agency that I know very well--the Securities and Exchange Commission. I have been working in and around the SEC for all of my professional career. I have spent almost 10 years as a staff member and as a Commissioner. In 15 years of private practice I have applied the Commission's regulations in transactions and in real business situations. In the course of my work, I have interacted with every one of the SEC's divisions and offices in one way or another. With respect to the subject of regulatory reform, I would suggest that you ask very hard questions in subsequent hearings: For example, why has the SEC in the course of the past dozen years or so experienced catastrophic failures in every one of its four core competencies--rulemaking, filing review, enforcement, and examinations? What led to failures at the SEC and other regulatory agencies--both in the United States and globally--to discern the increasing risk to financial institutions under their jurisdiction? What led to failures at financial institutions to recognise the inadequacy of their own risk management systems and strategy in time to avert a collapse? How did many investors get lulled into complacency and not adequately do their own due diligence? What is the proper role of credit rating agencies, and has regulation fostered an oligopoly by recognizing the opinions of a few as being more privileged than the rest? Your challenge in formulating laws and regulations is that every action leads to a reaction, just as in physics. Just as investors should know that there is no riskless or easy way to make money, policymakers should know that there is no riskless or easy way to oversee the financial markets. I respectfully submit that changes to the securities laws should be made carefully and with the knowledge that modern financial services is a quickly evolving industry. Sooner or later the markets will stabilize, depending on what actions governments take. The goal should be a balance, using the facts as they best can be discerned, through a robust analysis of the costs and benefits of various potential actions and how those actions might affect human behavior. The current situation is certainly no time to ``wing it'' or act on ``gut'' instinct. The weighing of costs and benefits is vital, because investors ultimately pay for regulation. If regulations impose costs without commensurate benefits, investors suffer the costs of lack of effectiveness and efficiency, not only through higher prices but also through constrained investment opportunities. That ultimately hurts them in their investment performance, because it means less opportunity for diversification. Why should we care about the capital markets? Despite all of the recent gloomy and tragic news of the past couple of years, we must not forget that one of the most important underlying purposes of our capital markets is to allow entrepreneurs with great new ideas to make their dreams possible by raising capital, thereby helping the economy grow by creating jobs, improving the lives of consumers through producing innovative products, and providing a return to investors who have risked their savings to help finance that entrepreneur's dream. This is the role--and genius--of the United States capital markets that has helped our economy to be the engine of the world's growth and made our standard of living the best in the world. Notwithstanding the current economic conditions, I feel confident that the role of the United States capital markets will return to what it was, barring ill-advised legislation or regulatory actions. An example of legislation that had a detrimental effect on the attractiveness of U.S. markets was the so-called Interest Equalization Tax, a short-lived tax imposed in 1963 on borrowing by U.S. and foreign companies in the U.S. The goal was to encourage capital to stay in this country and to equalize the costs between selling debt and equity securities. It essentially backfired when U.S. companies found that they could issue dollar-denominated debt in London, avoiding the tax and increasing yields. The London markets, which had yet to fully recover after World War II, experienced a boom in size and credibility that eventually led them to eclipse the U.S. in some benchmarks by 2007. We should not forget that just prior to the recent problems in the credit markets, which began more or less in June 2007 when a small fund was closed to redemptions, setting off a world-wide reassessment of the creditworthiness of U.S. housing-related debt securities, public offerings of securities in the United States were on the decline, compared to offerings in the private markets. In fact, in 2006, the value of Rule 144A unregistered offerings in the U.S. for the first time exceeded the value of public offerings. All of this is to suggest that Congress be especially deliberative and pragmatic in legislating in this area. The worrisome thing to me is that if care is not taken to have solid analysis, the wrong lessons may be gleaned from this latest crisis that hurt investors. It takes a long time to change legislation in this area. We still have not dug ourselves out of some of the mistakes and false premises that drove the decision making during the 1930s and 1940s. For example, it took 40 years for Congress and the SEC to end fixed commissions for brokerage services that were essentially imposed by law in the 1930s, and we still have many aspects of the so-called ``managed competition'' philosophy that led to that policy. We still have the alphabet soup of regulators and self-regulatory organizations in the financial services industry, with all of the distortions and inefficiencies that have contributed to the current crisis and become so painfully evident to the world. Many have complained about this situation for years, but others have opposed any restructuring as ``dangerously deregulatory,'' and ignored the inherent systemic risks, overlapping jurisdiction, turf wars, and wasted resources of the current structure. In the wake of the stock market crash of 1929, over the next decade this Committee and others held many hearings and explored the abuses in the marketplace including conflicts of interest, shady transactions with affiliates, less-than-adequate disclosure, and squirrelly valuations. Congress responded by passing the Securities Act of 1933, the Securities Exchange Act of 1934, the Public Utility Holding Company Act of 1935 (``PUHCA''), the Trust Indenture Act of 1939, the Investment Advisers Act of 1940, and the Investment Company Act of 1940, among other laws. Many provisions of these laws were helpful to the market and to investors and stood the test of time. But, as time passed, it became clear that some laws were counter-productive. For example, by the end of the 20th century, PUHCA was cited as a reason for a relative paucity of investment in the electric and gas utility industry. In fact, for the first 25 years of its existence, the SEC's main task was to break up interstate investor-owned electric and gas utilities by using PUHCA. This was the investment management division's primary job, and more people were devoted to this mission than any other at the SEC for more than 20 years. By the end of the 1950s, this mission was mostly accomplished. Finally, Congress repealed PUHCA in 2006. What lesson can we draw from PUHCA? Congress passed the Act because of the self-dealing and manipulation concerning interstate utility holding companies in the1920s. Instead of focusing on the problematic practices and addressing them directly, Congress reshaped the entire industry. What were the unintended consequences? After repeal, for example, alternative energy technologies are easier to finance. In addition, What would our power industry be like today if a different legislative strategy had been pursued originally? What would our capital markets be like today if the SEC had spent more of its energy for those three decades focusing on more general problems of the capital markets?Forthright Analysis Needed Certainly, many mistakes were made by business people, investors, and regulators during the past decade, but too many these days are looking in hindsight to pass judgement or blame. What we need is an analysis to determine how we can efficiently and effectively promote honesty and transparency in our markets and ensure that criminality is not tolerated. For example, some have claimed that ``deregulation'' over the past 4, 8, or 10 years has led to the current problems in the financial markets. One can hardly say that the past 8 to 10 years have been deregulatory. The enactment of the Sarbanes-Oxley Act in 2002 led to the promulgation by the SEC of more rules in a shorter amount of time than ever before. In addition, the last 7 years have seen many new SEC and self-regulatory organization rules regarding compliance and trading, which have certainly been very regulatory. The Financial Accounting Standards Board, the Public Company Accounting Oversight Board (``PCAOB''), and the Municipal Securities Rulemaking Board have promulgated a host of new rules, standards, and interpretations. This attitude that blames our current problems on ``deregulation'' is not only completely wrong, but dangerous because it is off the mark. If that is what policy makers think is the reason for the current situation, then they will have learned the wrong lesson and their solutions will cause more problems than they will solve. More regulation, for regulation's sake, is not the answer. We need smarter regulation. Some say that we need to trust less in the marketplace and more in the capabilities of regulators, including a putative ability to foresee bubbles and intervene to stop them. That is much easier said than done. This assertion ignores the reality that what may seem to be a bubble to one person may be another person's honest livelihood. What if the regulator is wrong? How will you ever know the opportunity cost to individuals or to society as a whole for curtailing some particular activity? It is always easier in hindsight to say what should have been done. How can you build public policy for years in the future on hoped-for brilliance or luck of individual, fallible human beings, especially if they are independent, nonelected, and essentially unaccountable? This global crisis has primarily affected regulated (versus nonregulated) entities all around the world, not just in the supposedly deregulatory United States. How did so many regulators operating under vastly different regimes with differing powers and requirements all get it wrong? Indeed, how did so many firms with some of the best minds in the business get it wrong? The housing bubble occurred in the US as well as the United Kingdom, Ireland, and Spain. Heavily regulated financial institutions had problems with their housing-related investments not only in the US but also in Germany, Switzerland, France, Belgium, Netherlands, Ireland, the United Kingdom, and many others. We must recognize that businesses ultimately are better than governments at business, because both can and do make mistakes. In addition, by removing risk management from firms and placing it in the hands of government, there is a danger that firms will become careless and take on additional risk, believing regulators are protecting them. If they believe that the government is backstopping their losses, then they may take greater risks, reap the rewards of taking those risks, and avoid the consequences if things go awry. This is the moral hazard that we all try to avoid. Regulators have a legitimate interest in setting capital standards to control this risk taking, but the ultimate risk management function must remain in the hands of the firms that face the risk.What Caused the SEC's Operational Failures? During the past dozen years, the SEC has experienced catastrophic operational failures in its four core functions of filing review, rulemaking, enforcement, and examinations. Enron's corporate filings were not reviewed for years in the late 1990s; Congress addressed this issue in Sarbanes-Oxley by mandating that the SEC review each issuer's filings on a periodic basis. In enforcement and examinations, tips were not pursued regarding Bernard Madoff and late trading of mutual funds. In rulemaking, the Commission proposed in December 1997 and again in April 2005 regulations regarding credit rating agencies, but never adopted any. This Committee led the effort to reform the SEC's approach to nationally recognized statistical rating organizations (``NRSROs'') that culminated in the Credit Agency Reform Act of 2006, but unfortunately this statute came too late to affect the crisis in the financial markets and the 30-year history of NRSRO regulation. The SEC to its credit and benefit has attracted many hard-working, bright, energetic staff members over its history. But, these mistakes were caused by failures of senior management, rather than by staff members. First, management applied faulty motivational and review criteria. Second, since resources are always limited, there is an opportunity cost in choosing to spend time and resources on one thing, because there is less time and fewer resources to spend on other things. Unfortunately, the SEC suffered from poor prioritization decisions during the critical years of 2003-2005 when the market for collateralized debt obligations and credit default swaps started to explode and its trajectory could have been diverted. Some argue that low pay or poor morale contributed to these failures. Thanks to this Committee through the Sarbanes-Oxley Act, pay caps were removed from SEC staff pay in 2002. When I left the SEC, more than half of the 3,500 employees earned more than I did as a commissioner and many earn more than the chairman. Today, a staff attorney or accountant (SK-14) earns nearly $168,000 in Washington, DC ($177,000 in New York), and senior managers earn well in excess of $200,000. As with anyone else, I am sure that SEC employees would like more pay, but how much should they be paid? As much as PCAOB board members, who earn more than the President? As with most government employees, the vast majority of SEC employees go to work because they like their job and they are committed to the agency's mission. In addition, they have job security and other benefits that cannot be duplicated in the private sector. Management Failures. Management philosophies like Total Quality Management and Six Sigma teach that in any organization, measurement drives human behavior because the incentive is to try to meet the measurement criteria (``You get what you measure''). Essentially, Enron was not reviewed for years because review personnel were judged by how many filings they reviewed, not necessarily by the quality of their review. The incentive was to postpone review of the complicated Enron filing because one could review many others in the time it would take to review Enron. By the late 1990s, this focus on numbers more than quality had decreased staff morale so much that employees began to organize to form a union. Despite management's campaign to thwart it, in July 2000 SEC employees voted overwhelmingly to unionize the workforce. The emphasis on numbers over quality also affects behavior in the enforcement division and examination office. Every enforcement attorney knows that statistics (or ``stats'') help to determine perception and promotion potential. The statistics sought are cases either brought and settled or litigated to a successful conclusion, and amount of fines collected. These statistics do not necessarily measure quality (such as an investigation performed well and efficiently, but the evidence ultimately adduced did not indicate a securities violation). Thus, the stats system does not encourage sensitivity to due process. In addition, the stats system tends to discourage the pursuit of penny stock manipulations and Ponzi schemes, which ravage mostly retail investors. These frauds generally take a long time and much effort to prove--the perpetrators tend to be true criminals who use every effort to fight, rather than the typical white-collar corporate violator of a relatively minor corporate reporting requirement who has an incentive to negotiate a settlement to put the matter behind him and preserve his reputation and career. Thus, over the years several staff attorneys have told me that their superiors actively discourage them from pursuing Ponzi schemes and stock manipulations, because of the difficulty in bringing the case to a successful conclusion and the lack of publicity in the press when these cases are brought (with the exception of Madoff, these sorts of cases tend to be small). Some senior enforcement officers openly refer to these sorts of cases as ``slip-and-fall'' cases, which disparages the real effect that these cases have on individuals, who can lose their life savings in them. Because of the interstate and international aspect of many of these cases, if the SEC does not go after them, no one can or will. During my tenure as commissioner, I emphasized the need to focus from an enforcement perspective on microcap fraud, including Ponzi schemes, pump-and-dump schemes, and other stock manipulations. I was a strong advocate for the formation of the Microcap Fraud Group in the Enforcement Division, which as finally formed in 2008. I also strongly support the good efforts of the Office of Internet Enforcement, established under Chairman Levitt in the late 1990s, which works closely with other law enforcement agencies to tackle internet and other electronic fraud. There are many intelligent, competent, dedicated, hard-working people at the SEC. It is the management system and how it determined priorities over the past decade that has let them down. Last year in an article published in the Fordham Journal of Corporate and Financial Law, \1\ I called for the SEC to follow the example from 1972 of Chairman William Casey, who formed a committee to review the enforcement division--its strategy, priorities, organization, management, and due-process protections. Thirty-seven years later, and especially after the Madoff incident, this sort of review is long overdue.--------------------------------------------------------------------------- \1\ See Paul S. Atkins and Bradley J. Bondi, ``Evaluating the Mission: A Critical Review of the History and Evolution of the SEC Enforcement Program,'' 8 Fordham Journal of Corp. & Fin. Law 367 (2008).--------------------------------------------------------------------------- The Opportunity Cost of Misplaced Priorities. I believe that the SEC was distracted by controversial, divisive rulemaking that lacked any grounding in cost-benefit analysis during a critical period. In 2003-2005, the agency pushed through three controversial rules regarding mutual fund governance, hedge fund registration, and the so-called National Market System rules. In these cases, the SEC did not conduct an adequate analysis of the costs versus the benefits of these proposed rules. The hedge fund and mutual fund rules were invalidated by the courts after long litigation and much distraction for the agency and the industry. In each of these cases, former Commissioner Cynthia A. Glassman and I offered alternatives and compromises, but we were presented with a take-it-or-leave-it choice that left no alternative but dissent. These controversies now sound rather trivial in light of the current situation in the financial markets. However, important legal principles were involved, including lack of authority to promulgate the hedge fund rule and lack of observing a legislative mandate for analyzing costs and benefits in connection with the mutual fund governance rule. Hedge funds ultimately were not the problem in the current financial crisis; risk management at regulated entities was the problem. Moreover, Regulation NMS cost the securities industry more than $1.5 billion to try to implement a rule to address a theoretical problem that did not exist. Ultimately, after much effort and distraction, many exemptions and exceptions have been issued by the SEC staff that effectively have gutted the rule. Because life is full of choices, if you devote resources to one thing, you have less to devote to another. And, the one risk that you have not focused on just may blow up in your face. That, in fact, is just what happened to the SEC. During this critical 2003-2005 time period when so much effort was wasted on these quixotic detours, the market for collateralized debt obligations (CDOs) and credit default swaps (CDSs) was taking off. What might the SEC have done, had it not been so distracted by other false priorities? Sometimes the issues are a lot more basic than we think. With respect to CDOs and CDSs, the SEC did not have jurisdiction to regulate them as instruments. But, one of the critical factors that developed as market interest in them grew was the inadequate documentation for these OTC derivatives. While the SEC was trying to devise complex solutions to nonexistent problems, it neglected a real risk management issue in the fundamental infrastructure that enables the markets to work smoothly. For example, in the failure of the hedge fund Amaranth in 2006, I was told that it took a couple of hundred people several weeks to sort through the OTC derivatives documentation issues and figure out valuation. One of the primary difficulties has been the lack of standardized documentation, which has often resulted in lengthy confirmations. At the time, I and others had called for this to be addressed. I am happy that the industry and regulators are making progress in this area. The incomplete and inaccurate documentation in this area was a legitimate risk management issue, especially since no centralized, automated trade processing existed for these instruments. As we have witnessed over the past year, valuation is a challenge, because these instruments are complicated and not standardized. Novations create a huge challenge to follow the chain of ownership.Proposals for Financial Services Reform Several general proposals have been made recently for structural reforms to the financial services regulatory framework. Since these have not yet become concrete proposals, I have a few general comments in this regard. Systemic Risk Regulator. This concept was raised last year in the Treasury Department's Blueprint for a Modernized Regulatory Structure. As a theory, it has some general appeal, but as a practical matter it raises many questions. Just who would be the systemic risk regulator? The Treasury, the Federal Reserve, some newly created entity, or a council of regulators (such as the President's Working Group)? What would its powers be? Would it be a merit regulator of new products? If it is the Treasury, what would its role be with respect to other independent agencies? Issues of systemic risk can be raised in many different contexts. For example, in the 1990s, the Federal Reserve and the SEC disagreed over the levels of loan loss reserves taken by certain banks. The Fed argued on the basis of safety and soundness concerns, and the SEC was worried about earnings management and disclosure. Merit regulation of new products is always problematic, because a government agency is making determinations for investors as to appropriateness. What standards would the systemic regulator use to vet the new products? The time for review adds to the cost of the new products and adds to uncertainty Although the federal rules with respect to public offerings of securities are based on disclosure, some states have a merit-regulatory regime. An illustrative example of how government officials can make incorrect determinations, with the best intentions of investor protection, is the initial public offering of Apple Computer. The SEC approved Apple's registration statement under the federal Securities Act, but Massachusetts prohibited the offering of Apple shares because they were ``too risky.'' Texas approved the sale after an extensive review, but its securities regulator called his decision ``a close call,'' and Apple did not even bother to offer its shares in Illinois due to strict state laws on new issues. The subsequent performance of Apple stock is a matter of history. With respect to CDOs and CDSs, would a systemic regulator have identified the potential problems of documentation and trading? Merger of the SEC and CFTC. If this merger is to be effected, it should be done with care. The statutes and rules governing the securitie s and futures markets are different, and the approaches that the two agencies take are different. The futures markets are mostly dealer markets, while the securities markets have a large retail investor component. A merger cannot simply be the combining of two agencies under one roof; it would be a complicated task. Short of merger, Congress could help by laying out guidelines for the two agencies to resolve conflicts regarding products that have indicia of both securities and futures. This issue has existed since the 1980s, and the two agencies have periodically tried to address the conflicts. In fact, this issue would still exist even if the agencies were combined, just as issues exist between SEC divisions. Credit Rating Agencies. Thanks to the hard work of this Committee, Congress passed the Credit Rating Agency Reform Act of 2006, which set out a regulatory regime for the SEC's staff-designated NRSROs through a frustratingly slow process that had the effect of limiting competition in issuing credit ratings. The 2006 legislation made the application process speedier and more transparent. The subprime problems made it clear that many investors relied on credit ratings without performing their own due diligence. Government agencies relied on credit ratings to their detriment as well. Even if conflicts of interest are addressed and fully disclosed, we still have the problem that opinions of certain institutions are given great regulatory weight. Thus, few realized the great systemic risk inherent in the holdings of CDOs by financial institutions, because they were deemed to be the highest-rated instruments. Over the past 30 years or so, references to NRSRO ratings have become embedded in many federal and state statutes and SEC and other agency rules. Has this created a perception that the government endorses the process by which NRSROs produce their ratings? That would be an incorrect perception; the SEC or any government agency can never be equipped to assess the quality of NRSRO ratings or the procedures by which they are devised. I would argue that it would be a mistake to ask any government agency to attempt to do so. Is it time to remove these ratings from our statutes and rulebooks? Can we create alternatives to this flawed system that accords undue weight to informed, albeit potentially flawed, opinions? The rating agency industry over the years had become an oligopoly--three large firms control 90 percent of the market, and two of them control 80 percent. This concentration was a direct result of a nontransparent, arcane SEC oversight system. The consequence was a lack of competition and lack of new entrants. For example, a non-U.S. rating agency waited 16 years before its application was finally approved. The 2006 enactment of the Credit Rating Agency Reform Act directed the SEC to open up the process, encourage competition, and increase transparency and oversight of the credit rating firms to protect against conflicts of interest. Would more voices in the rating industry have averted the problems with ratings of structured products? SEC Strategic and Risk Assessment. Congress should encourage Chairman Schapiro to engage in a thorough strategic and risk assessment, especially if the agency is to receive more resources and authority. In the past 10 years, the agency's budget has more than doubled and its staffing has increased commensurately. However, the internal organization and management structure is essentially the same. Would today's crisis have occurred if the SEC had had a real risk evaluation capability? Former Chairman Harvey Pitt undertook an extensive review of the SEC's organization and functionality in 2001 with a view to modernize it. He conceived of a risk assessment office that would work closely with the operating divisions. The plan was to give it its own personnel, but also to have personnel seconded to it in order to generate buy-in from the operating divisions. Unfortunately, when his successor established the office, it did not have adequate resources and it did not have any secondments. Thus, the group was not integrated into the flow of the agency's operations and became an orphaned group filling a niche role with very limited effectiveness. In addition, should the examination function continue in its current form? In the aftermath of the Madoff affair, the structure and function of the Office of Compliance Inspections and Examinations should be reviewed. If Congress chooses to require that hedge funds and private equity firms register as advisors under SEC oversight, the burden added to the agency's examiners would be enormous. The current paradigm of periodic inspections of funds by government examiners cannot endure, unless the agency increases tremendously in size, inevitably leading to more managerial problems. One solution could be to re-integrate the examination function into the operating divisions and to establish the opportunity for registered advisors to submit to independent reviews, which would be overseen by the SEC. In conclusion, regulation of financial markets needs to be modernized and rationalized. But, it must be done in an informed way, taking into account costs and benefits and being mindful of potential unintended consequences. Financial markets are global, integrated, and quickly changing, and the legislative process is not as responsive. I stand ready to assist the Committee going forward as you deliberate these issues and if you develop any legislation. Thank you again for extending me the privilege of appearing before you today. You have a momentous task before you. I wish you all the best in your work. ______ 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. 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. " CHRG-111shrg51395--119 Under high competition, lower ratings declined and investment grade rations soared. The authors conclude that increased competition may impair ``the reputational mechanism that underlies the provision of good quality ratings.'' \28\--------------------------------------------------------------------------- \28\ Id. at 21.--------------------------------------------------------------------------- The anecdotal evidence supports a similar conclusion: the major rating agencies responded to the competitive threat from Fitch by making their firms ``more client-friendly and focused on market share.'' \29\ Put simply, the evidence implies that the rapid change toward a more competitive environment made the competitors not more faithful to investors, but more dependent on their immediate clients, the issuers. From the standpoint of investors, agency costs increased.--------------------------------------------------------------------------- \29\ See ``Ratings Game--As Housing Boomed, Moody's Opened Up,'' The Wall Street Journal, April 11, 2008, at p. A-1.---------------------------------------------------------------------------The Responsibility of the SEC Each of the major investment banks that failed, merged, or converted into bank holding companies in 2008 had survived prior recessions, market panics, and repeated turmoil and had long histories extending back as far as the pre-Civil War era. Yet, each either failed or was gravely imperiled within the same basically 6 month period following the collapse of Bear Stearns in March 2008. \30\--------------------------------------------------------------------------- \30\ For a concise overview of these developments, see Jon Hilsenrath, Damian Palette, and Aaron Lucchetti, ``Goldman, Morgan Scrap Wall Street Model, Become Banks in Bid To Ride Out Crisis,'' The Wall Street Journal, September 22, 2008, at p. A-1 (concluding that independent investment banks could not survive under current market conditions and needed closer regulatory supervision to establish credibility).--------------------------------------------------------------------------- If their uniform collapse is not alone enough to suggest the likelihood of regulatory failure, one additional common fact unites them: each of these five firms voluntarily entered into the SEC's Consolidated Supervised Entity (``CSE'') Program, which was established by the SEC in 2004 for only the largest investment banks. \31\ Indeed, these five investment banks were the only investment banks permitted by the SEC to enter the CSE program. A key attraction of the CSE Program was that it permitted its members to escape the SEC's traditional net capital rule, which placed a maximum ceiling on their debt to equity ratios, and instead elect into a more relaxed ``alternative net capital rule'' that contained no similar limitation. \32\ The result was predictable: all five of these major investment banks increased their debt-to-equity leverage ratios significantly over the brief two year period following their entry into the CSE Program, as shown by Figure 1 below: \33\--------------------------------------------------------------------------- \31\ See Securities Exchange Act Release No. 34-49830 (June 21, 2004), 69 FR 34428 (``Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities''). \32\ The SEC's ``net capital rule,'' which dates back to 1975, governs the capital adequacy and aggregate indebtedness permitted for most broker-dealers. See Rule 15c3-1 (``Net Capital Requirements for Brokers and Dealers''). 17 C.F.R. 240.15c3-1. Under subparagraph (a)(1)(i) of this rule, aggregate indebtedness is limited to fifteen times the broker-dealer's net capital; a broker-dealer may elect to be governed instead by subparagraph (a)(1)(ii) of this rule, which requires it maintain its net capital at not less than the greater of $250,000 or two percent of ``aggregate debit items'' as computed under a special formula that gives ``haircuts'' (i.e., reduces the valuation) to illiquid securities. Both variants place fixed limits on leverage. \33\ This chart comes from U.S. Securities and Exchange Commission, Office of the Inspector General, ``SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program'' (`Report No. 446-A, September 25, 2008) (hereinafter ``SEC Inspector General Report'') at Appendix IX at p. 120. For example, at the time of its insolvency, Bear Stearns' gross leverage ratio had hit 33 to 1. \34\--------------------------------------------------------------------------- \34\ See SEC Inspector General Report at 19.--------------------------------------------------------------------------- The above chart likely understates the true increase in leverage because gross leverage (i.e., assets divided by equity) does not show the increase in off-balance sheet liabilities, as the result of conduits and liquidity puts. Thus, another measure may better show the sudden increase in risk. One commonly used metric for banks is the bank's value at risk (VaR) estimate, which banks report to the SEC in their annual report on Form 10-K. This measure is intended to show the risk inherent in their financial portfolios. The chart below shows ``Value at Risk'' for the major underwriters over the interval 2004 to 2007: \35\--------------------------------------------------------------------------- \35\ See Ferrell, Bethel, and Hu, supra note 15, at Table 8. Value at risk estimates have proven to be inaccurate predictors of the actual writedowns experienced by banks. They are cited here not because they are accurate estimates of risk, but because the percentage increases at the investment banks was generally extreme. Even Goldman Sachs, which survived the crisis in better shape than its rivals, saw its VaR estimate more than double over this period. Value at Risk, 2004-2007------------------------------------------------------------------------ 2004 2005 2006 2007 Firms ($mil) ($mil) ($mil) ($mil)------------------------------------------------------------------------Bank of America................. $44.1 $41.8 $41.3 -Bear Stearns.................... 14.8 21.4 28.8 $69.3Citigroup....................... 116.0 93.0 106.0 -Credit Suisse................... 55.1 66.2 73.0 -Deutsche Bank................... 89.8 82.7 101.5 -Goldman Sachs................... 67.0 83.0 119.0 134.0JPMorgan........................ 78.0 108.0 104.0 -Lehman Brothers................. 29.6 38.4 54.0 124.0Merrill Lynch................... 34.0 38.0 52.0 -Morgan Stanley.................. 94.0 61.0 89.0 83.0UBS............................. 103.4 124.7 132.8 -Wachovia........................ 21.0 18.0 30.0 -------------------------------------------------------------------------VaR statistics are reported in the 10K or 20F (in the case of foreign firms) of the respective firms. Note that the firms use different assumptions in computing their Value of Risk. Some annual reports are not yet avaialble for 2007. Between 2004 and 2007, both Bear Stearns and Lehman more than quadrupled their value at risk estimates, while Merrill Lynch's figure also increased significantly. Not altogether surprisingly, they were the banks that failed. These facts provide some corroboration for an obvious hypothesis: excessive deregulation by the SEC caused the liquidity crisis that swept the global markets in 2008. \36\ Still, the problem with this simple hypothesis is that it may be too simple. Deregulation did contribute to the 2008 financial crisis, but the SEC's adoption of the CSE Program in 2004 was not intended to be deregulatory. Rather, the program was intended to compensate for earlier deregulatory efforts by Congress that had left the SEC unable to monitor the overall financial position and risk management practices of the nation's largest investment banks. Still, even if the 2004 net capital rule changes were not intended to be deregulatory, they worked out that way in practice. The ironic bottom line is that the SEC unintentionally deregulated by introducing an alternative net capital rule that it could not effectively monitor.--------------------------------------------------------------------------- \36\ For the bluntest statement of this thesis, see Stephen Labaton, ``S.E.C. Concedes Oversight Plans Fueled Collapse,'' New York Times, September 27, 2008, at p. 1. Nonetheless, this analysis is oversimple. Although SEC Chairman Cox did indeed acknowledge that there were flaws in the ``Consolidated Supervised Entity'' Program, he did not concede that it ``fueled'' the collapse or that it represented deregulation. As discussed below, the SEC probably legitimately believed that it was gaining regulatory authority from the CSE Program (but it was wrong).--------------------------------------------------------------------------- The events leading up to the SEC's decision to relax its net capital rule for the largest investment banks began in 2002, when the European Union adopted its Financial Conglomerates Directive. \37\ The main thrust of the E.U.'s new directive was to require regulatory supervision at the parent company level of financial conglomerates that included a regulated financial institution (e.g., a broker-dealer, bank or insurance company). The E.U.'s entirely reasonable fear was that the parent company might take actions that could jeopardize the solvency of the regulated subsidiary. The E.U.'s directive potentially applied to the major U.S. investment and commercial banks because all did substantial business in London (and elsewhere in Europe). But the E.U.'s directive contained an exemption for foreign financial conglomerates that were regulated by their home countries in a way that was deemed ``equivalent'' to that envisioned by the directive. For the major U.S. commercial banks (several of which operated a major broker-dealer as a subsidiary), this afforded them an easy means of avoiding group-wide supervision by regulators in Europe, because they were subject to group-level supervision by U.S. banking regulators.--------------------------------------------------------------------------- \37\ See Council Directive 2002/87, Financial Conglomerates Directive, 2002 O.J. (L 35) of the European Parliament and of the Council of 16 December 2002 on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate and amending Council Directives. For an overview of this directive and its rationale, see Jorge E. Vinuales, The International Regulation of Financial Conglomerates: A Case Study of Equivalence as an Approach to Financial Integration, 37 Cal. W. Int'l L.J. 1, at 2 (2006).--------------------------------------------------------------------------- U.S. investment banks had no similar escape hatch, as the SEC had no similar oversight over their parent companies. Thus, fearful of hostile regulation by some European regulators, \38\ U.S. investment banks lobbied the SEC for a system of ``equivalent'' regulation that would be sufficient to satisfy the terms of the directive and give them immunity from European oversight. \39\ For the SEC, this offered a serendipitous opportunity to oversee the operations of investment bank holding companies, which authority the SEC had sought for some time. Following the repeal of the Glass-Steagall Act, the SEC had asked Congress to empower it to monitor investment bank holding companies, but it had been rebuffed. Thus, the voluntary entry of the holding companies into the Consolidated Supervised Entity program must have struck the SEC as a welcome development, and Commission unanimously approved the program without any partisan disagreement. \40\--------------------------------------------------------------------------- \38\ Different European regulators appear to have been feared by different entities. Some commercial banks saw French regulation as potentially hostile, while U.S. broker-dealers, all largely based in London, did not want their holding companies to be overseen by the U.K.'s Financial Services Agency (FSA). \39\ See Stephen Labaton, ``Agency's '04 Rule Let Banks Pile Up Debt and Risk,'' New York Times, October 3, 2008, at A-1 (describing major investment banks as having made an ``urgent plea'' to the SEC in April, 2004). \40\ See Securities Exchange Act Release No. 34-49830, supra note 31.--------------------------------------------------------------------------- But the CSE Program came with an added (and probably unnecessary) corollary: Firms that entered the CSE Program were permitted to adopt an alternative and more relaxed net capital rule governing their debt to net capital ratio. Under the traditional net capital rule, a broker-dealer was subject to fixed ceilings on its permissible leverage. Specifically, it either had to (a) maintain aggregate indebtedness at a level that could not exceed fifteen times net capital, \41\ or (b) maintain minimum net capital equal to not less than two percent of ``aggregate debit items.'' \42\ For most broker-dealers, this 15 to 1 debt to net capital ratio was the operative limit within which they needed to remain by a comfortable margin.--------------------------------------------------------------------------- \41\ See Rule 15c3-1(a)(1)(i)(``Alternative Indebtedness Standard''), 17 C.F.R. 240.15c3-1(a)(1). \42\ See Rule 15c3-1(a)(1)(ii)(``Alternative Standard''), 17 C.F.R. 240.15c3-1(a)(1)(ii). This alternative standard is framed in terms of the greater of $250,000 or 2 percent, but for any investment bank of any size, 2 percent will be the greater. Although this alternative standard may sound less restrictive, it was implemented by a system of ``haircuts'' that wrote down the value of investment assets to reflect their illiquidity.--------------------------------------------------------------------------- Why did the SEC allow the major investment banks to elect into an alternative regime that placed no outer limit on leverage? Most likely, the Commission was principally motivated by the belief that it was only emulating the more modern ``Basel II'' standards that the Federal Reserve Bank and European regulators were then negotiating. To be sure, the investment banks undoubtedly knew that adoption of Basel II standards would permit them to increase leverage (and they lobbied hard for such a change). But, from the SEC's perspective, the goal was to design the CSE Program to be broadly consistent with the Federal Reserve's oversight of bank holding companies, and the program even incorporated the same capital ratio that the Federal Reserve mandated for bank holding companies. \43\ Still, the Federal Reserve introduced its Basel II criteria more slowly and gradually, beginning more than a year later, while the SEC raced in 2004 to introduce a system under which each investment bank developed its own individualized credit risk model. Today, some believe that Basel II represents a flawed model even for commercial banks, while others believe that, whatever its overall merits, it was particularly ill-suited for investment banks. \44\--------------------------------------------------------------------------- \43\ See SEC Inspector General Report at 10-11. Under these standards, a ``well-capitalized'' bank was expected to maintain a 10 percent capital ratio. Id. at 11. Nonetheless, others have argued that Basel II ``was not designed to be used by investment banks'' and that the SEC ``ought to have been more careful in moving banks on to the new rules.'' See ``Mewling and Puking: Bank Regulation,'' The Economist, October 25, 2008 (U.S. Edition). \44\ For the view that Basel II excessively deferred to commercial banks to design their own credit risk models and their increase leverage, see Daniel K. Tarullo, BANKING ON BASEL: The Future of International Financial Regulation (2008). Mr. Tarullo has recently been nominated by President Obama to the Board of Governors of the Federal Reserve Board. For the alternative view, that Basel II was uniquely unsuited for investment banks, see ``Mewling and Puking,'' supra note 43.--------------------------------------------------------------------------- Yet, what the evidence demonstrates most clearly is that the SEC simply could not implement this model in a fashion that placed any real restraint on its subject CSE firms. The SEC's Inspector General examined the failure of Bear Stearns and the SEC's responsibility therefor and reported that Bear Stearns had remained in compliance with the CSE Program's rules at all relevant times. \45\ Thus, if Bear Stearns had not cheated, this implied (as the Inspector General found) that the CSE Program, itself, had failed. The key question is then what caused the CSE Program to fail. Here, three largely complementary hypotheses are plausible. First, the Basel II Accords may be flawed, either because they rely too heavily on the banks' own self-interested models of risk or on the highly conflicted ratings of the major credit rating agencies. \46\ Second, even if Basel II made sense for commercial banks, it may have been ill-suited for investment banks. \47\ Third, whatever the merits of Basel II in theory, the SEC may have simply been incapable of implementing it.--------------------------------------------------------------------------- \45\ SEC Inspector General Report, 10. \46\ The most prominent proponent of this view is Professor Daniel Tarullo. See supra note 44. \47\ See ``Mewling and Puking,'' supra note 43.--------------------------------------------------------------------------- Clearly, however, the SEC moved faster and farther to defer to self-regulation by means of Basel II than did the Federal Reserve. \48\ Clearly also, the SEC's staff was unable to monitor the participating investment banks closely or to demand specific actions by them. Basel II's approach to the regulation of capital adequacy at financial institutions contemplated close monitoring and supervision. Thus, the Federal Reserve assigns members of its staff to maintain an office within a regulated bank holding company in order to provide constant oversight. In the case of the SEC, a team of only three SEC staffers were assigned to each CSE firm \49\ (and a total of only thirteen individuals comprised the SEC's Office of Prudential Supervision and Risk Analysis that oversaw and conducted this monitoring effort). \50\ From the start, it was a mismatch: three SEC staffers to oversee an investment bank the size of Merrill Lynch, which could easily afford to hire scores of highly quantitative economists and financial analysts, implied that the SEC was simply outgunned. \51\--------------------------------------------------------------------------- \48\ The SEC adopted its CSE program in 2004. The Federal Reserve only agreed in principle to Basel II in late 2005. See Stavros Gadinis, The Politics of Competition in International Financial Regulation, 49 Harv. Int'l L. J. 447, 507 n. 192 (2008). \49\ SEC Inspector General Report at 2. \50\ Id. Similarly, the Office of CSE Inspectors had only seven staff. Id. \51\ Moreover, the process effectively ceased to function well before the 2008 crisis hit. After SEC Chairman Cox re-organized the CSE review process in the Spring of 2007, the staff did not thereafter complete ``a single inspection.'' See Labaton, supra note 39.--------------------------------------------------------------------------- This mismatch was compounded by the inherently individualized criteria upon which Basel II relies. Instead of applying a uniform standard (such as a specific debt to equity ratio) to all financial institutions, Basel II contemplated that each regulated financial institution would develop a computer model that would generate risk estimates for the specific assets held by that institution and that these estimates would determine the level of capital necessary to protect that institution from insolvency. Thus, using the Basel II methodology, the investment bank generates a mathematical model that crunches historical data to evaluate how risky its portfolio assets were and how much capital it needed to maintain to protect them. Necessarily, each model was ad hoc, specifically fitted to that specific financial institution. But no team of three SEC staffers was in a position to contest these individualized models or the historical data used by them. Effectively, the impact of the Basel II methodology was to shift the balance of power in favor of the management of the investment bank and to diminish the negotiating position of the SEC's staff. Whether or not Basel II's criteria were inherently flawed, it was a sophisticated tool that was beyond the capacity of the SEC's largely legal staff to administer effectively. The SEC's Inspector General's Report bears out this critique by describing a variety of instances surrounding the collapse of Bear Stearns in which the SEC's staff did not respond to red flags that the Inspector General, exercising 20/20 hindsight, considered to be obvious. The Report finds that although the SEC's staff was aware that Bear Stearns had a heavy and increasing concentration in mortgage securities, it ``did not make any efforts to limit Bear Stearns mortgage securities concentration.'' \52\ In its recommendations, the Report proposed both that the staff become ``more skeptical of CSE firms' risk models'' and that it ``develop additional stress scenarios that have not already been contemplated as part of the prudential regulation process.'' \53\--------------------------------------------------------------------------- \52\ SEC Inspector General Report at ix. \53\ SEC Inspector General Report at ix.--------------------------------------------------------------------------- Unfortunately, the SEC Inspector General Report does not seem realistic on this score. The SEC's staff cannot really hope to regulate through gentle persuasion. Unlike a prophylactic rule (such as the SEC's traditional net capital rule that placed a uniform ceiling on leverage for all broker-dealers), the identification of ``additional stress scenarios'' by the SEC's staff does not necessarily lead to specific actions by the CSE firms; rather, such attempts at persuasion are more likely to produce an extended dialogue, with the SEC's staff being confronted with counter-models and interpretations by the financial institution's managers. The unfortunate truth is that in an area where financial institutions have intense interests (such as over the question of their maximum permissible leverage), a government agency in the U.S. is unlikely to be able to obtain voluntary compliance. This conclusion is confirmed by a similar assessment from the individual with perhaps the most recent experience in this area. Testifying in September, 2008 testimony before the Senate Banking Committee, SEC Chairman Christopher Cox emphasized the infeasibility of voluntary compliance , expressing his frustration with attempts to negotiate issues such as leverage and risk management practices with the CSE firms. In a remarkable statement for a long-time proponent of deregulation, he testified: Beyond highlighting the inadequacy of the . . . CSE program's capital and liquidity requirements, the last six months--during which the SEC and the Federal Reserve worked collaboratively with each of the CSE firms . . . --have made abundantly clear that voluntary regulation doesn't work. \54\--------------------------------------------------------------------------- \54\ See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing, and Urban Affairs, United States Senate, September 23, 2008 (``Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions''), at p. 4 (available at www.sec.gov) (emphasis added). Chairman Cox has repeated this theme in a subsequent Op/Ed column in the Washington Post, in which he argued that ``Reform legislation should steer clear of voluntary regulation and grant explicit authority where it is needed.'' See Christopher Cox, ``Reinventing A Market Watchdog,'' the Washington Post, November 4, 2008, at A-17. His point was that the SEC had no inherent authority to order a CSE firm to reduce its debt to equity ratio or to keep it in the CSE Program. \55\ If it objected, a potentially endless regulatory negotiation might only begin.--------------------------------------------------------------------------- \55\ Chairman Cox added in the next sentence of his Senate testimony: ``There is simply no provision in the law authorizes the CSE Program, or requires investment bank holding companies to compute capital measures or to maintain liquidity on a consolidated basis, or to submit to SEC requirements regarding leverage.'' Id. This is true, but if a CSE firm left the CSE program, it would presumably become subject to European regulation; thus, the system was not entirely voluntary and the SEC might have used the threat to expel a non-compliant CSE firm. The SEC's statements about the degree of control they had over participants in the CSE Program appear to have been inconsistent over time and possibly defensively self-serving. But clearly, the SEC did not achieve voluntary compliance.--------------------------------------------------------------------------- Ultimately, even if one absolves the SEC of ``selling out'' to the industry in adopting the CSE Program in 2004, it is still clear at a minimum that the SEC lacked both the power and the expertise to restrict leverage by the major investment banks, at least once the regulatory process began with each bank generating its own risk model. Motivated by stock market pressure and the incentives of a short-term oriented executive compensation system, senior management at these institutions affectively converted the process into self-regulation. One last factor also drove the rush to increased leverage and may best explain the apparent willingness of investment banks to relax their due diligence standards: competitive pressure and the need to establish a strong market share in a new and expanding market drove the investment banks to expand recklessly. For the major players in the asset-backed securitization market, the long-term risk was that they might be cut off from their source of supply, if loan originators were acquired by or entered into long-term relationships with their competitors, particularly the commercial banks. Needing an assured source of supply, some investment banks (most notably Lehman and Merrill, Lynch) invested heavily in acquiring loan originators and related real estate companies, thus in effect vertically integrating. \56\ In so doing, they assumed even greater risk by increasing their concentration in real estate and thus their undiversified exposure to a downturn in that market. This need to stay at least even with one's competitors best explains the now famous line uttered by Charles Prince, the then CEO of Citigroup in July, 2007, just as the debt market was beginning to collapse. Asked by the Financial Times if he saw a liquidity crisis looming, he answered:--------------------------------------------------------------------------- \56\ See Terry Pristin, ``Risky Real Estate Deals Helped Doom Lehman,'' N.Y. Times, September 17, 2008, at C-6 (discussing Lehman's expensive, multi-billion dollar acquisition of Archstone-Smith); Gretchen Morgenson, ``How the Thundering Herd Faltered and Fell,'' N.Y. Times, November 9, 2008, at B4-1 (analyzing Merrill Lynch's failure and emphasizing its acquisitions of loan originators). When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing. \57\--------------------------------------------------------------------------- \57\ See Michiyo Nakamoto & David Wighton, ``Citigroup Chief Stays Bullish on Buy-Outs,'' Financial Times, July 9, 2007, available at http://www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html In short, competition among the major investment banks can periodically produce a mad momentum that sometimes leads to a lemmings-like race over the cliff. \58\ This in essence had happened in the period just prior to the 2000 dot.com bubble, and again during the accounting scandals of 2001-2002, and this process repeated itself during the subprime mortgage debacle. Once the market becomes hot, the threat of civil liability--either to the SEC or to private plaintiffs in securities class actions--seems only weakly to constrain this momentum. Rationalizations are always available: ``real estate prices never fall;'' ``the credit rating agencies gave this deal a `Triple A' rating,'' etc. Explosive growth and a decline in professional standards often go hand in hand. Here, after 2000, due diligence standards appear to have been relaxed, even as the threat of civil liability in private securities litigation was growing. \59\--------------------------------------------------------------------------- \58\ Although a commercial bank, Citigroup was no exception this race, impelled by the high fee income it involved. From 2003 to 2005, ``Citigroup more than tripled its issuing of C.D.O.s to more than $30 billion from $6.28 billion.'' See Eric Dash and Julie Creswell, ``Citigroup Pays for a Rush to Risk'' New York Times, November 22, 2008, at 1, 34. In 2005 alone, the New York Times estimates that Citigroup received over $500 million in fee income from these C.D.O. transactions. From being the sixth largest issuer of C.D.O.s in 2003, it rose to being the largest C.D.O. issuer worldwide by 2007, issuing in that year some $49.3 billion out of a worldwide total of $442.3 billion (or slightly over 11 percent of the world volume). Id. at 35. What motivated this extreme risk-taking? Certain of the managers running Citigroup's securitization business received compensation as high as $34 million per year (even though they were not among the most senior officers of the bank). Id. at 34. This is consistent with the earlier diagnosis that equity compensation inclines management to accept higher and arguably excessive risk. At the highest level of Citigroup's management, the New York Times reports that the primary concern was ``that Citigroup was falling behind rivals like Morgan Stanley and Goldman.'' Id. at 34 (discussing Robert Rubin and Charles Prince's concerns). Competitive pressure is, of course, enforced by the stock market and Wall Street's short-term system of bonus compensation. The irony then is that a rational strategy of deleveraging cannot be pursued by making boards and managements more sensitive to shareholder desires. \59\ From 1996 to 1999, the settlements in securities class actions totaled only $1.7 billion; thereafter, aggregate settlements rose exponentially, hitting a peak of $17.1 billion in 2006 alone. See Laura Simmons & Ellen Ryan, ``Securities Class Action Settlements: 2006, Review and Analysis'' (Cornerstone Research 2006) at 1. This decline of due diligence practices as liability correspondingly increased seems paradoxical, but may suggest that at least private civil liability does not effectively deter issuers or underwriters.--------------------------------------------------------------------------- As an explanation for an erosion in professional standards, competitive pressure applies with particular force to those investment banks that saw asset-back securitizations as the core of their future business model. In 2002, a critical milestone was reached, as in that year the total amount of debt securities issued in asset-backed securitizations equaled (and then exceeded in subsequent years) the total amount of debt securities issued by public corporations. \60\ Debt securitizations were not only becoming the leading business of Wall Street, as a global market of debt purchasers was ready to rely on investment grade ratings from the major credit rating agencies, but they were particularly important for the independent investment banks in the CSE Program.--------------------------------------------------------------------------- \60\ For a chart showing the growth of asset-backed securities in relation to conventional corporate debt issuances over recent years, see J. Coffee, J. Seligman, and H. Sale, SECURITIES REGULATION: Case and Materials (10th ed. 2006) at p. 10.--------------------------------------------------------------------------- Although all underwriters anticipated high rates of return from securitizations, the independent underwriters had gradually been squeezed out of their traditional line of business--underwriting corporate securities--in the wake of the step-by-step repeal of the Glass-Steagall Act. Beginning well before the formal repeal of that Act in 1999, the major commercial banks had been permitted to underwrite corporate debt securities and had increasingly exploited their larger scale and synergistic ability to offer both bank loans and underwriting services to gain an increasing share of this underwriting market. Especially for the smaller investment banks (e.g., Bear Stearns and Lehman), the future lay in new lines of business, where, as nimble and adaptive competitors, they could steal a march on the larger and slower commercial banks. To a degree, both did, and Merrill eagerly sought to follow in their wake. \61\ To stake out a dominant position, the CEOs of these firms adopted a ``Damn-the-torpedoes-full-speed-ahead'' approach that led them to make extremely risky acquisitions. Their common goal was to assure themselves a continuing source of supply of subprime mortgages to securitize, but in pursuit of this goal, both Merrill Lynch and Lehman made risky acquisitions, in effect vertically integrating into the mortgage loan origination field. These decisions, plus their willingness to acquire mortgage portfolios well in advance of the expected securitization transaction, left them undiversified and exposed to large writedowns when the real estate market soured.--------------------------------------------------------------------------- \61\ For a detailed description of Merrill, Lynch's late entry into the asset-backed securitization field and its sometimes frenzied attempt to catch up with Lehman by acquiring originators of mortgage loans, see Gretchen Morgenson, ``How the Thundering Herd Faltered and Fell,'' New York Times, November 9, 2008, at BU-1. Merrill eventually acquired an inventory of $71 billion in risky mortgages, in part through acquisitions of loan originators. By mid-2008, an initial writedown of $7.9 billion forced the resignation of its CEO. As discussed in this New York Times article, loan originators dealing with Merrill believed it did not accurately understand the risks of their field. For Lehman's similar approach to acquisitions of loan originators, see text and note, supra, at note 56.---------------------------------------------------------------------------Regulatory Modernization: What Should Be Done?An Overview of Recent Developments Financial regulation in the major capital markets today follows one of three basic organizational models: The Functional/Institutional Model: In 2008, before the financial crisis truly broke, the Treasury Department released a major study of financial regulation in the United States. \62\ This document (known as the ``Blueprint'') correctly characterized the United States as having a ``current system of functional regulation, which maintains separate regulatory agencies across segregated functional lines of financial services, such as banking, insurance, securities, and futures.'' \63\ Unfortunately, even this critical assessment may understate the dimensions of this problem of fragmented authority. In fact, the U.S. falls considerably short of even a ``functional'' regulatory model. By design, ``functional'' regulation seeks to subject similar activities to regulation by the same regulator. Its premise is that no one regulator can have, or easily develop, expertise in regulating all aspects of financial services. Thus, the securities regulator understands securities, while the insurance regulator has expertise with respect to the very different world of insurance. In the Gramm-Leach-Bliley Act of 1999 (``GLBA''), which essentially repealed the Glass-Steagall Act, Congress endorsed such a system of functional regulation. \64\--------------------------------------------------------------------------- \62\ The Department of the Treasury, Blueprint for Modernized Financial Regulatory Structure (2008) (hereinafter, ``Blueprint''). \63\ Id. at 4 and 27. \64\ The Conference Report to the Gramm-Leach-Bliley Act clearly states this: Both the House and Senate bills generally adhere to the principle of functional regulation, which holds that similar activities should be regulated by the same regulator. Different regulators have expertise at supervising different activities. It is inefficient and impractical to expect a regulator to have or develop expertise in regulating all aspects of financial services. H.R. Rep. No. 106-434, at 157 (1999), reprinted in 1999 U.S.C.C.A.N. 1252.--------------------------------------------------------------------------- Nonetheless, the reality is that the United States actually has a hybrid system of functional and institutional regulation. \65\ The latter approach looks not to functional activity, but to institutional type. Institutional regulation is seldom the product of deliberate design, but rather of historical contingency, piecemeal reform, and gradual evolution.--------------------------------------------------------------------------- \65\ For this same assessment, see Heidi Mandanis Schooner & Michael Taylor, United Kingdom and United States Responses to the Regulatory Challenges of Modern Financial Markets, 38 Tex. Int'l L. J. 317, 328 (2003).--------------------------------------------------------------------------- To illustrate this difference between functional and institutional regulation, let us hypothesize that, under a truly functional system, the securities regulator would have jurisdiction over all sales of securities, regardless of the type of institution selling the security. Conversely, let us assume that under an institutional system, jurisdiction over sales would be allocated according to the type of institution doing the selling. Against that backdrop, what do we observe today about the allocation of jurisdiction? Revealingly, under a key compromise in GLBA, the SEC did not receive general authority to oversee or enforce the securities laws with respect to the sale of government securities by a bank. \66\ Instead, banking regulators retained that authority. Similarly, the drafters of the GLBA carefully crafted the definitions of ``broker'' and ``dealer'' in the Securities Exchange Act of 1934 to leave significant bank securities activities under the oversight of bank regulators and not the SEC. \67\ Predictably, even in the relatively brief time since the passage of GLBA in 1999, the SEC and bank regulators have engaged in a continuing turf war over the scope of the exemptions accorded to banks from the definition of ``broker'' and ``dealer.'' \68\--------------------------------------------------------------------------- \66\ See 15 U.S.C. 78o-5(a)(1)(B), 15 U.S.C. 78(c)(a)(34)(G), and 15 U.S.C. 78o-5(g)(2). \67\ See 15 U.S.C. 78(c)(a)(4),(5). \68\ See Kathleen Day, Regulators Battle Over Banks: 3 Agencies Say SEC Rules Overstep Securities-Trading Law, Wash. Post, July 3, 2001, at E3. Eventually, the SEC backed down in this particular skirmish and modified its original position. See Securities Exch. Act Release No. 34-44570 (July 18, 2001) and Securities Exchange Age Release No. 34-44291, 66 Fed. Reg. 27760 (2001).--------------------------------------------------------------------------- None of this should be surprising. The status quo is hard to change, and regulatory bodies do not surrender jurisdiction easily. As a result, the regulatory body historically established to regulate banks will predictably succeed in retaining much of its authority over banks, even when banks are engaged in securities activities that from a functional perspective should belong to the securities regulator. ``True'' functional regulation would also assign similar activities to one regulator, rather than divide them between regulators based on only nominal differences in the description of the product or the legal status of the institution. Yet, in the case of banking regulation, three different federal regulators oversee banks: the Office of the Controller of the Currency (``OCC'') supervises national banks; the Federal Reserve Board (``FRB'') oversees state-chartered banks that are members of the Federal Reserve System and the Federal Deposit Insurance Corporation (``FDIC'') supervises state-chartered banks that are not members of the Federal Reserve System but are federally insured. \69\ Balkanization does not stop there. The line between ``banks,'' with their three different regulators at the federal level, and ``thrifts,'' which the Office of Thrift Supervision (``OTS'') regulates, is again more formalistic than functional and reflects a political compromise more than a difference in activities.--------------------------------------------------------------------------- \69\ This is all well described in the Blueprint. See Blueprint, supra note 62, at 31-41.--------------------------------------------------------------------------- Turning to securities regulation, one encounters an even stranger anomaly: the United States has one agency (the SEC) to regulate securities and another (the Commodities Future Trading Commission (CFTC)) to regulate futures. The world of derivatives is thereby divided between the two, with the SEC having jurisdiction over options, while the CFTC has jurisdiction over most other derivatives. No other nation assigns futures and securities regulation to different regulators. For a time, the SEC and CFTC both asserted jurisdiction over a third category of derivatives--swaps--but in 2000 Congress resolved this dispute by placing their regulation largely beyond the reach of both agencies. Finally, some major financial sectors (for example, insurance and hedge funds) simply have no federal regulator. By any standard, the United States thus falls well short of a true system of functional regulation, because deregulation has placed much financial activity beyond the reach of any federal regulator. Sensibly, the Blueprint proposes to rationalize this patchwork-quilt structure of fragmented authority through the merger and consolidation of agencies. Specifically, it proposes both a merger of the SEC and CFTC and a merger of the OCC and the OTS. Alas, such mergers are rarely politically feasible, and to date, no commentator (to our knowledge) has predicted that these proposed mergers will actually occur. Thus, although the Blueprint proposes that we move beyond functional regulation, the reality is that we have not yet approached even a system of functional regulation, as our existing financial regulatory structure is organized at least as much by institutional category as by functional activity. Disdaining a merely ``functional'' reorganization under which banking, insurance, and securities would each be governed by their own federal regulator, the Blueprint instead envisions a far more comprehensive consolidation of all these specialized regulators. Why? In its view, the problems with functional regulation are considerable: A functional approach to regulation exhibits several inadequacies, the most significant being the fact that no single regulator possesses all the information and authority necessary to monitor systemic risk, or the potential that events associated with financial institutions may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected. \70\--------------------------------------------------------------------------- \70\ Blueprint, supra note 62, at 4.--------------------------------------------------------------------------- But beyond these concerns about systemic risk, the architects of the Blueprint were motivated by a deeper anxiety: regulatory reform is necessary to maintain the capital market competitiveness of the United States. \71\ In short, the Blueprint is designed around two objectives: (1) the need to better address systemic risk and the possibility of a cascading series of defaults, and (2) the need to enhance capital market competitiveness. As discussed later, the first concern is legitimate, but the second involves a more dubious logic.--------------------------------------------------------------------------- \71\ In particular, the Blueprint hypothesizes that the U.K. has enhanced its own competitiveness by regulatory reforms, adopted in 2000, that are principles-based and rely on self regulation for their implementation. Id. at 3.--------------------------------------------------------------------------- The Consolidated Financial Services Regulator: A clear trend is today evident towards the unification of supervisory responsibilities for the regulation of banks, securities markets and insurance. \72\ Beginning in Scandinavia in the late 1980s, \73\ this trend has recently led the United Kingdom, Japan, Korea, Germany and much of Eastern Europe to move to a single regulator model. \74\ Although there are now a number of precedents, the U.K. experience stands out as the most influential. It was the first major international market center to move to a unified regulator model, \75\ and the Financial Services and Markets Act, adopted in 2000, went significantly beyond earlier precedents towards a ``nearly universal regulator.'' \76\ The Blueprint focuses on the U.K.'s experience because it believes that the U.K.'s adoption of a consolidated regulatory structure ``enhanced the competitiveness of the U.K. economy.'' \77\--------------------------------------------------------------------------- \72\ For recent overviews, see Ellis Ferran, Symposium: Do Financial Supermarkets Need Super-Regulators? Examining the United Kingdom's Experience in Adopting the Single Financial Regulator Model, 28 Brook. J. Int'l L. 257, 257-59 (2003); Jerry W. Markham, A Comparative Analysis of Consolidated and Functional Regulation: Super Regulator: A Comparative Analysis of Securities and Derivative Regulation in the United States, the United Kingdom, and Japan, 28 Brook. J. Int'l L. 319, 319-20 (2003); Giorgio Di Giorgio & Carmine D. Noia, Financial Market Regulation and Supervision: How Many Peaks for the Euro Area?, 28 Brook. J. Int'l L. 463, 469-78 (2003). \73\ Norway moved to an integrated regulatory agency in 1986, followed by Denmark in 1988, and Sweden in 1991. See D. Giorgio & D. Noia, supra note 72, at 469-478. \74\ See Bryan D. Stirewalt & Gary A. Gegenheimer, Consolidated Supervision of Banking Groups in the Former Soviet Republics: A Comparative Examination of the Emerging Trend in Emerging Markets, 23 Ann. Rev. Banking & Fin. L. 533, 548-49 (2004). As discussed later, in some countries (most notably Japan), the change seems more one of form than of substance, with little in fact changing. See Markham, supra note 72, at 383-393, 396. \75\ See Ferran, supra note 72, at 258. \76\ See Schooner & Taylor, supra note 65, at 329. Schooner and Taylor also observe that the precursors to the U.K.'s centralized regulator, which were mainly in Scandinavia, had a ``predominantly prudential focus.'' Id. at 331. That is, the unified new regulator was more a guardian of ``safety and soundness'' and less oriented toward consumer protection. \77\ Blueprint, supra note 62 at 3.--------------------------------------------------------------------------- Yet it is unclear whether the U.K.'s recent reforms provide a legitimate prototype for the Blueprint's proposals. Here, the Blueprint may have doctored its history. By most accounts, the U.K.'s adoption of a single regulator model was ``driven by country-specific factors,'' \78\ including the dismal failure of a prior regulatory system that relied heavily on self-regulatory bodies but became a political liability because of its inability to cope with a succession of serious scandals. Ironically, the financial history of the U.K. in the 1990s parallels that of the United States over the last decade. On the banking side, the U.K. experienced two major banking failures--the Bank of Credit and Commerce International (``BCCI'') in 1991 and Barings in 1995. Each prompted an official inquiry that found lax supervision was at least a partial cause. \79\--------------------------------------------------------------------------- \78\ Ferran, supra note 72, at 259. \79\ Id. at 261-262.--------------------------------------------------------------------------- Securities regulation in the U.K. came under even sharper criticism during the 1990s because of a series of financial scandals that were generally attributed to an ``excessively fragmented regulatory infrastructure.'' \80\ Under the then applicable law (the Financial Services Act of 1986), most regulatory powers were delegated to the Securities and Investments Board (SIB), which was a private body financed through a levy on market participants. However, the SIB did not itself directly regulate. Rather, it ``set the overall framework of regulation,'' but delegated actual authority to second tier regulators, which consisted primarily of self-regulatory organizations (SROs). \81\ Persistent criticism focused on the inability or unwillingness of these SROs to protect consumers from fraud and misconduct. \82\ Ultimately, the then chairman of the SIB, the most important of the SROs, acknowledged that self-regulation had failed in the U.K. and seemed unable to restore investor confidence. \83\ This acknowledgement set the stage for reform, and when a new Labour Government came into power at the end of the decade, one of its first major legislative acts (as it had promised in its election campaign) was to dismantle the former structure of SROs and replace it with a new and more powerful body, the Financial Services Authority (FSA).--------------------------------------------------------------------------- \80\ Id. at 265. \81\ Id. at 266. The most important of these were the Securities and Futures Authority (SFA), the Investment Managers' Regulatory Organization (IMRO), and the Personal Investment Authority (PIA). \82\ Two scandals in particular stood out: the Robert Maxwell affair in which a prominent financier effectively embezzled the pension funds of his companies and a ``pension mis-selling'' controversy in which highly risky financial products were inappropriately sold to pension funds without adequate supervision or disclosure. Id. at 267-268. \83\ Id. at 268.--------------------------------------------------------------------------- Despite the Blueprint's enthusiasm for the U.K.'s model, the structure that the Blueprint proposes for the U.S. more closely resembles the former U.K. system than the current one. Under the Blueprint's proposals, the securities regulator would be restricted to adopting general ``principles-based'' policies, which would be implemented and enforced by SROs. \84\ Ironically, the Blueprint relies on the U.K. experience to endorse essentially the model that the U.K. concluded had failed.--------------------------------------------------------------------------- \84\ See infra notes--and accompanying text.--------------------------------------------------------------------------- The ``Twin Peaks'' Model: As the Blueprint recognizes, not all recent reforms have followed the U.K. model of a universal regulator. Some nations--most notably Australia and the Netherlands--instead have followed a ``twin peaks'' model that places responsibility for the ``prudential regulation of relevant financial institutions'' in one agency and supervision of ``business conduct and consumer protection'' in another. \85\ The term ``twin peaks'' derives from the work of Michael Taylor, a British academic and former Bank of England official. In 1995, just before regulatory reform became a hot political issue in the U.K., he argued that financial regulation had two separate basic aims (or ``twin peaks''): (1) ``to ensure the soundness of the financial system,'' and (2) ``to protect consumers from unscrupulous operators.'' \86\ Taylor's work was original less in its proposal to separate ``prudential'' regulation from ``business conduct'' regulation than in its insistence upon the need to consolidate ``responsibility for the financial soundness of all major financial institutions in a single agency.'' \87\ Taylor apparently feared that if the Bank of England remained responsible for the prudential supervision of banks, its independence in setting interest rates might be compromised by its fear that raising interest rates would cause bank failures for which it would be blamed. In part for this reason, the eventual legislation shifted responsibility for bank supervision from the Bank of England to the FSA.--------------------------------------------------------------------------- \85\ Blueprint, supra note 62, at 3. For a recent discussion of the Australian reorganization, which began in 1996 (and thus preceded the U.K.), see Schooner & Taylor, supra note65, at 340-341. The Australian Securities and Investments Commission (ASIC) is the ``consumer protection'' agency under this ``twin peaks'' approach, and the Australian Prudential Regulatory Authority (APRA) supervises bank ``safety and soundness.'' Still, the ``twin peaks'' model was not fully accepted in Australia as ASIC, the securities regulator, does retain supervisory jurisdiction over the ``financial soundness'' of investment banks. Thus, some element of functional regulation remains. \86\ Michael Taylor, Twin Peaks: A Regulatory Structure for the New Century i (Centre for the Study of Financial Institutions 1995). For a brief review of Taylor's work, see Cynthia Crawford Lichtenstein, The Fed's New Model of Supervision for ``Large Complex Banking Organizations'': Coordinated Risk-Based Supervision of Financial Multinationals for International Financial Stability, 18 Transnat'l Law. 283, 295-296 (2005). \87\ Lichtenstein, supra note 86, at 295; Taylor, supra note 86, at 4.--------------------------------------------------------------------------- The Blueprint, itself, preferred a ``twin peaks'' model, and that model is far more compatible with the U.S.'s current institutional structure for financial regulation. But beyond these obvious points, the best argument for a ``twin peaks'' model involves conflict of interests and the differing culture of banks and securities regulators. It approaches the self-evident to note that a conflict exists between the consumer protection role of a universal regulator and its role as a ``prudential'' regulator intent on protecting the safety and soundness of the financial institution. The goal of consumer protection is most obviously advanced through deterrence and financial sanctions, but these can deplete assets and ultimately threaten bank solvency. When only modest financial penalties are used, this conflict may sound more theoretical than real. But, the U.S. is distinctive in the severity of the penalties it imposes on financial institutions. In recent years, the SEC has imposed restitution and penalties exceeding $3 billion annually, and private plaintiffs received a record $17 billion in securities class action settlements in 2006. \88\ Over a recent ten year period, some 2,400 securities class actions were filed and resulted in settlements of over $27 billion, with much of this cost (as in the Enron and WorldCom cases) being borne by investment banks. \89\ If one agency were seeking both to protect consumers and guard the solvency of major financial institutions, it would face a difficult balancing act to achieve deterrence without threatening bank solvency, and it would risk a skeptical public concluding that it had been ``captured'' by its regulated firms.--------------------------------------------------------------------------- \88\ See Coffee, Law and the Market: The Impact of Enforcement, 156 U. of Pa. L. Rev. 299 (2007) (discussing average annual SEC penalties and class action settlements). \89\ See Richard Booth, The End of the Securities Fraud Class Action as We Know It, 4 Berkeley Bus. L. J. 1, at 3 (2007).--------------------------------------------------------------------------- Even in jurisdictions adopting the universal regulator model, the need to contemporaneously strengthen enforcement has been part of the reform package. Although the 2000 legislation in the U.K. did not adopt the ``twin peaks'' format, it did significantly strengthen the consumer protection role of its centralized regulator. The U.K.'s Financial Services and Markets Act, enacted in 2000, sets out four statutory objectives, with the final objective being the ``reduction of financial crime.'' \90\ According to Heidi Schooner and Michael Taylor, this represented ``a major extension of the FSA's powers compared to the agencies it replaced,'' \91\ and it reflected a political response to the experience of weak enforcement by self-regulatory bodies, which had led to the creation of the FSA. \92\ With probably unintended irony, Schooner and Taylor described this new statutory objective of reducing ``financial crime'' as the ``one aspect of U.K. regulatory reform in which its proponents seem to have drawn direct inspiration from U.S. law and practice.'' \93\ Conspicuously, the Blueprint ignores that ``modernizing'' financial regulation in other countries has generally meant strengthening enforcement.--------------------------------------------------------------------------- \90\ See Financial Services and Markets Act, 2000, c. 8, pt. 1, 6, http://www.opsi.gov.uk/ACTS/acts2000/pdf/ukpga_20000008_en.pdf \91\ See Schooner & Taylor, supra note 65, at 335. \92\ Id. \93\ Id. at 335-36.--------------------------------------------------------------------------- A Preliminary Evaluation: Three preliminary conclusions merit emphasis: First, whether the existing financial regulatory structure in the United States is considered ``institutional'' or ``functional'' in design, its leading deficiency seems evident: it invites regulatory arbitrage. Financial institutions position themselves to fall within the jurisdiction of the most accommodating regulator, and investment banks design new financial products so as to encounter the least regulatory oversight. Such arbitrage can be defended as desirable if one believes that regulators inherently overregulate, but not if one believes increased systemic risk is a valid concern (as the Blueprint appears to believe). Second, the Blueprint's history of recent regulatory reform involves an element of historical fiction. The 2000 legislation in the U.K., which created the FSA as a nearly universal regulator, was not an attempt to introduce self-regulation by SROs, as the Blueprint seems to assume, but a sharp reaction by a Labour Government to the failures of self-regulation. Similarly, Japan's slow, back-and-forth movement in the direction of a single regulator seems to have been motivated by an unending series of scandals and a desire to give its regulator at least the appearance of being less industry dominated. \94\--------------------------------------------------------------------------- \94\ Japan has a history and a regulatory culture of economic management of its financial institutions through regulatory bodies that is entirely distinct from that of Europe or the United States. Although it has recently created a Financial Services Agency, observers contend that it remains committed to its traditional system of bureaucratic regulation that supports its large banks and discourages foreign competition. See Markham, supra note 72, at 383-92, 396. Nonetheless, scandals have been the primary force driving institutional change there too, and Japan's FSA was created at least in part because Japan's Ministry of Finance (MOF) had become embarrassed by recurrent scandals.--------------------------------------------------------------------------- Third, the debate between the ``universal'' regulator and the ``twin peaks'' alternative should not obscure the fact that both are ``superregulators'' that have moved beyond ``functional'' regulation on the premise that, as the lines between banks, securities dealers, and insurers blur, so regulators should similarly converge. That idea will and should remain at the heart of the U.S. debate, even after many of the Blueprint's proposals are forgotten.Defining the Roles of the ``Twin Peaks'' (Systemic Risk Regulator and Consumer Protector)--Who Should Do What? The foregoing discussion has suggested why the SEC would not be an effective risk regulator. It has neither the specialized competence nor the organizational culture for the role. Its comparative advantage is enforcement, and thus its focus should be on transparency and consumer protection. Some also argue that ``single purpose'' agencies, such as the SEC, are more subject to regulatory capture than are broader or ``general purpose'' agencies. \95\ To the extent that the Federal Reserve would have responsibility for all large financial institutions and would be expected to treat monitoring their capital adequacy and risk management practices as among its primary responsibilities, it does seem less subject to capture, because any failure would have high visibility and it would bear the blame. Still, this issue is largely academic because the SEC no longer has responsibility over any investment banks of substantial size.--------------------------------------------------------------------------- \95\ See Jonathan Macey, Organizational Design and Political Control of Administrative Agencies, 8 J. Law, Economics, and Organization 93 (1992). It can, of course, be argued which agency is more ``single purpose'' (the SEC or the Federal Reserve), but the latter does deal with a broader class of institutions in terms of their capital adequacy.--------------------------------------------------------------------------- The real issue then is defining the relationships between the two peaks so that neither overwhelms the other. The Systemic Risk Regulator (SRR): Systemic risk is most easily defined as the risk of an inter-connected financial breakdown in the financial system--much like the proverbial chain of falling dominoes. The closely linked insolvencies of Lehman, AIG, Fannie Mae and Freddie Mac in the Fall of 2008 present a paradigm case. Were they not bailed out, other financial institutions were likely to have also failed. The key idea here is not that one financial institution is too big to fail, but rather that some institutions are too interconnected to permit any of them to fail, because they will drag the others down. What should a system risk regulator be authorized to do? Among the obvious powers that it should have are the following: a. Authority To Limit the Leverage of Financial Institutions and Prescribe Mandatory Capital Adequacy Standards. This authority would empower the SRR to prescribe minimum levels of capital and ceilings on leverage for all categories of financial institutions, including banks, insurance companies, hedge funds, money market funds, pension plans, and quasi-financial institutions (such as, for example, G.E. Capital). The standards would not need to be identical for all institutions and should be risk adjusted. The SRS should be authorized to require reductions in debt to equity ratios below existing levels, to consider off-balance sheet liabilities (including those of partially owned subsidiaries and also contractual agreements to repurchase or guarantee) in computing these tests and ratios (even if generally accepted accounting principles would not require their inclusion). The SRR would focus its monitoring on the largest institutions in each financial class, leaving small institutions to be regulated and monitored by their primary regulator. For example, the SEC might require all hedge funds to register with it under the Investment Advisers Act of 1940, but hedge funds with a defined level of assets (say, $25 billion in assets) would be subject to the additional and overriding authority of the SSR. b. Authority To Approve, Restrict and Regulate Trading in New Financial Products. By now, it has escaped no one's attention that one particular class of over-the-counter derivative (the credit default swap) grew exponentially over the last decade and was outside the jurisdiction of any regulatory agency. This was not accidental, as the Commodities Futures Modernization Act of 2000 deliberately placed over-the-counter derivatives beyond the general jurisdiction of both the SEC and the CFTC. The SRR would be responsible for monitoring the growth of new financial products and would be authorized to regulate such practices as the collateral or margin that counter-parties were required to post. Arguably, the SRR should be authorized to limit those eligible to trade such instruments and could bar or restrict the purchase of ``naked'' credit default swaps (although the possession of this authority would not mean that the SRR would have to exercise it, unless it saw an emergency developing). c. Authority To Mandate Clearing Houses. Securities and options exchanges uniformly employ clearing houses to eliminate or mitigate credit risk. In contrast, when an investor trades in an over-the-counter derivative, it must accept both market risk (the risk that the investment will sour or price levels will change adversely) and credit risk (the risk that the counterparty will be unable to perform). Credit risk is the factor that necessitated the bailout of AIG, as its failure could have potentially led to a cascade of failures by other financial institutions if it defaulted on its swaps. Use of the clearing house should eliminate the need to bail out a future AIG because its responsibilities would fall on the clearing house to assume and the clearing house would monitor and limit the risk that its members assumed. At present, several clearinghouses are in the process of development in the United States and Europe. The SRR would be the obvious body to oversee such clearing houses (and indeed the Federal Reserve was already instrumental in their formation). Otherwise, some clearing houses are likely to be formed under the SEC's supervision and some under the CFTC's, thus again permitting regulatory arbitrage to develop. A final and complex question is whether competing clearing houses are desirable or whether they should be combined into a single centralized clearing house. This issue could also be given to the SRR. d. Authority To Mandate Writedowns for Risky Assets. A real estate bubble was the starting point for the 2008 crisis. When any class of assets appreciates meteorically, the danger arises that on the eventual collapse in that overvalued market, the equity of the financial institution will be wiped out (or at the least so eroded as to create a crisis in investor confidence that denies that institution necessary financing). This tendency was palpably evident in the failure of Bear Stearns, Lehman, Fannie Mae and Freddie Mac. If the SRR regulator relies only on debt/equity ratios to protect capital adequacy, they will do little good and possibly provide only illusory protections. Any financial institution that is forced to writedown its investment in overpriced mortgage and real estate assets by 50 percent will necessarily breach mandated debt to equity ratios. The best answer to this problem is to authorize the SRR to take a proactive and countercyclical stance by requiring writedowns in risky asset classes (at least for regulatory purposes) prior to the typically much later point at which accountants will require such a writedown. Candidly, it is an open question whether the SRS, the Federal Reserve, or any banking regulator would have the courage and political will to order such a writedown (or impose similar restraints on further acquisitions of such assets) while the bubble was still expanding. But Congress should at least arm its regulators with sufficient power and direct them to use it with vigor. e. Authority To Intervene To Prevent and Avert Liquidity Crises. Financial institutions often face a mismatch between their assets and liabilities. They may invest in illiquid assets or make long-term loans, but their liabilities consist of short-term debt (such as commercial paper). Thus, regulating leverage ratios is not alone adequate to avoid a financial crisis, because the institution may suddenly experience a ``run'' (as its depositors flee) or be unable to roll over its commercial paper or other short-term debt. This problem is not unique to banks and can be encountered by hedge funds and private equity funds (as the Long Term Capital Management crisis showed). The SRR thus needs the authority to monitor liquidity problems at large financial institutions and direct institutions in specific cases to address such imbalances (either by selling assets, raising capital, or not relying on short-term debt). From the foregoing description, it should be obvious that the only existing agency in a position to take on this assignment and act as an SRR is the Federal Reserve Board. But it is less politically accountable than most other federal agencies, and this could give rise to some problems discussed below. The Consumer Protection and Transparency Agency: The creation of an SSR would change little at the major Federal agencies having responsibilities for investor protection. Although it might be desirable to merge the SEC and the CFTC, this is not essential. Because no momentum has yet developed for such a merger, I will not discuss it further at this time. Currently, there are over 5,000 broker-dealers registered with the SEC. They would remain so registered, and the SRR would concern itself only with those few whose potential insolvency could destabilize the markets. The focus of the SEC's surveillance of broker-dealers is on consumer protection and market efficiency, and this would not be within the expertise of the Federal Reserve or any other potential SRR. The SEC is also an experienced enforcement agency, while the Federal Reserve has little, if any, experience in this area. Further, the SEC understands disclosure issues and is a champion of transparency, whereas banking regulators start from the unstated premise that disclosures of risks or problems at a financial institution is undesirable because it might provoke a ``run'' on the bank. The SEC and the Controller of the Currency have long disagreed about what banks should disclose in the Management Discussion and Analysis that banks file with the SEC. Necessarily, this tension will continue. Resolving the Conflicts: The SEC and the PCAOB have continued to favor ``mark to market'' accounting, while major banks have sought relief from the write-downs that it necessitates. Suppose then that in the future a SRR decided that ``mark to market'' accounting increased systemic risk. Could it determine that financial institutions should be spared from such an accounting regime on the ground that it was pro-cyclical? This is an issue that Congress should address in any legislation authorizing a SRR or enhancing the powers of the Federal Reserve. I would recommend that Congress maintain authority in the SEC to determine appropriate accounting policies, because, put simply, transparency has been the core value underlying our system of securities regulation. But there are other areas where a SRR might well be entitled to overrule the SEC. Take, for example, the problem of short selling the stocks of financial institutions during a period of market stress. Although the SEC did ban short selling in financial stocks briefly in 2008, one can still imagine an occasion on which the SRR and the SEC might disagree. Here, transparency would not be an issue. Short selling is pro-cyclical, and a SRR could determine that it had the potential to destabilize and increase systemic risk. If it did so, its judgment should control. These examples are given only by way of illustration, and the inevitability of conflicts between the two agencies is not assumed. The President's Working Group on Financial Markets has generally been able to work out disagreements through consultation and negotiation. Still, in any legislation, it would be desirable to identify those core policies (such as transparency and full disclosure) that the SRR could not override. The Failure of Quantitative Models: If one lesson should have been learned from the 2008 crisis, it is that quantitative models, based on historical data, eventually and inevitably fail. Rates of defaults on mortgages can change (and swiftly), and housing markets do not invariably rise. In the popular vernacular, ``black swans'' both can occur and even become predominant. This does not mean that quantitative models should not be used, but that they need to be subjected to qualitative and judgmental overrides. The weakness in quantitative models is particularly shown by the extraordinary disparity between the value at risk estimates (VaRs) reported by underwriters to the SEC and their eventual writedowns for mortgage-backed securities. Ferrell, Bethel and Hu report that for a selected group of major financial institutions the average ratio of asset writedowns as of August 20, 2008, to VaRs reported for 2006 was 291 to 1. \96\ If financial institutions cannot accurately estimate their exposure for derivatives and risky assets, this undermines many of the critical assumptions underlying the Basel II Accords, and suggests that regulators cannot defer to the institutions' own risk models. Instead, they must reach their own judgments, and Congress should so instruct them.--------------------------------------------------------------------------- \96\ See Farrell, Bethel, and Hu, supra note 15, at 47.---------------------------------------------------------------------------The Lessons of Madoff: Implications for the SEC, FINRA, and SIPC No time need be wasted pointing out that the SEC missed red flags and overlooked credible evidence in the Madoff scandal. Unfortunately, most Ponzi schemes do not get detected until it is too late. This implies that an ounce of prevention may be worth several pounds of penalties. More must be done to discourage and deter such schemes ex ante, and the focus cannot be only on catching them ex post. From this perspective focused on prevention, rather than detection, the most obvious lesson is that the SEC's recent strong tilt towards deregulation contributed to, and enabled, the Madoff fraud in two important respects. First, Bernard L. Madoff Investment Securities LLC (BMIS) was audited by a fly-by-night auditing firm with only one active accountant who had neither registered with the Public Company Accounting Oversight Board (``PCAOB'') nor even participated in New York State's peer review program for auditors. Yet, the Sarbanes-Oxley Act required broker-dealers to use a PCAOB-registered auditor. \97\ Nonetheless, until the Madoff scandal exploded, the SEC repeatedly exempted privately held broker-dealers from the obligation to use such a PCAOB-registered auditor and permitted any accountant to suffice. \98\ Others also exploited this exemption. For example, in the Bayou Hedge Fund fraud, which was the last major Ponzi scheme before Madoff, the promoters simply invented a fictitious auditing firm and forged certifications in its name. Had auditors been required to have been registered with PCAOB, this would not have been feasible because careful investors would have been able to detect that the fictitious firm was not registered.--------------------------------------------------------------------------- \97\ See Section 17(e)(1) of the Securities Exchange Act of 1934, 15 U.S.C. 78(q)(e)(1). \98\ See, e.g., Securities Exch. Act Rel. No. 34-54920 (Dec. 12, 2006).--------------------------------------------------------------------------- Presumably, the SEC's rationale for this overbroad exemption was that privately held broker-dealers did not have public shareholders who needed protection. True, but they did have customers who have now been repeatedly victimized. At the end of 2008, the SEC quietly closed the barn door by failing to renew this exemption--but only after $50 billion worth of horses had been stolen. A second and even more culpable SEC mistake continues to date. Under the Investment Advisers Act, investment advisers are required to maintain client funds or securities with a ``qualified custodian.'' \99\ In principle, this requirement should protect investors from Ponzi schemes, because an independent custodian would not permit the investment adviser to have access to the investors' funds. Indeed, for exactly this reason, mutual funds appear not to have experienced Ponzi-style frauds, which have occurred only in the case of hedge funds and investment advisers. Under Section 17(f) of the Investment Company Act, mutual funds must use a separate custodian. But in the case of investment advisors, the SEC permits the investment adviser to use an affiliated broker-dealer or bank as its qualified custodian. Thus, Madoff could and did use BMIS, his broker dealer firm, to serve as custodian for his investment adviser activities. The net result is that only a very tame watchdog monitors the investment adviser. Had an independent and honest custodian held the investors' funds, Madoff could not have recycled new investors' contributions to earlier investors, and the custodian would have noticed that Madoff was not actually trading. Other recent Ponzi schemes seem to have similarly sidestepped the need for an independent custodian. At Senate Banking Committee hearings on the Madoff debacle this January, the director of the SEC's Office of Compliance, Inspection and Examinations estimated that, out of the 11,300 investment advisers currently registered with the SEC, some 1,000 to 1,500 might similarly use an affiliated broker-dealer as their custodian. For investors, the SEC's tolerance for self-custodians makes the ``qualified custodian'' rule an illusory protection.--------------------------------------------------------------------------- \99\ See Rule 206(4)-2 (``Custody of Funds or Securities of Clients By Investment Advisers''), 17 CFR 275.206(4)-2.--------------------------------------------------------------------------- At present, the Madoff scandal has so shaken investor confidence in investment advisors that even the industry trade group for investment advisers (the Investment Advisers Association) has urged the SEC to adopt a rule requiring investment advisers to use an independent custodian. Unfortunately, one cannot therefore assume that the SEC will quickly produce such a rule. The SEC's staff knows that smaller investment advisers will oppose any rule that requires them to incur additional costs. Even if a reform rule is proposed, the staff may still overwhelm such a rule with exceptions (such as by permitting an independent custodian to use sub-custodians who are affiliated with the investment adviser). Congress should therefore direct it to require an independent custodian, across the board for mutual funds, hedge funds, and investment advisers. The Madoff scandal exposes shortcomings not only at the SEC but elsewhere in related agencies. Over the last 5 years, the number of investment advisers has grown from roughly 7,500 to 11,300--more than one third. Given this growth, it is becoming increasingly anomalous that there is no self-regulatory body (SRO) for investment advisers. Although FINRA may have overstated in its claim that it had no authority to investigate Madoff's investment adviser operations (because it could and should have examined BMIS's performance as the ``qualified custodian'' for Madoff's investment advisory activities), it still lacks authority to examine investment advisers. Some SRO (either FINRA or a new body) should have direct authority to oversee the investment adviser activities of an integrated broker-dealer firm. Similarly, the Securities Investor Protection Corporation (SIPC) continues to charge all broker-dealer firms the same nominal fee for insurance without any risk-adjustment. Were it to behave like a private insurer and charge more to riskier firms for insurance, these firms would have a greater incentive to adopt better internal controls against fraud. A broker-dealer that acted as a self-custodian for a related investment adviser would, for example, pay a higher insurance commission. Also, if higher fees were charged, more insurance (which is currently capped at $500,000 per account) could be provided to investors. When all broker-dealers are charged the same insurance premium, this subsidizes the riskier firms--i.e., the future Madoffs of the industry. Finally, one of the most perplexing problems in the Madoff story is why, when the SEC finally forced Madoff to register as an investment adviser in 2006, it did not conduct an early examination of BMIS's books and records. Red flags were flying, as Madoff (1) used an unknown accountant, (2) served as his own self-custodian, (3) had apparently billions of dollars in customer accounts, (4) had long resisted registration, and (5) was the subject of plausible allegations of fraud from credible whistle-blowers. Cost constrained as the SEC may have been, the only conclusion that can be reached here is that the SEC has poor criteria for evaluating the relative risk of investment advisers. At a minimum, Congress should require a report by the SEC as to the criteria used to determine the priority of examinations and how the SEC proposes to change those criteria in light of the Madoff scandal. Some have proposed eliminating the SEC's Office of Compliance, Inspection and Examinations and combining its activities with the Division of Investment Management. I do not see this as a panacea. Rather, it simply reshuffles the cards. The real problem is the criteria used to determine who should be examined. Credible allegations of fraud need to be directed to the compliance inspectors.Asset-Backed Securitizations: What Failed? Asset-backed securitizations represent a financial technology that failed. As outlined earlier, this failure seems principally attributable to a ``moral hazard'' problem that arose under which both loan originators and underwriters relaxed their lending standards and packaged non-creditworthy loans into portfolios, because both found that they could sell these portfolios at a high profit and on a global basis--at least so long as the debt securities carried an investment grade credit rating from an NRSRO credit rating agency. Broad deregulatory rules contributed to this problem, and the two most important such SEC rules are Rules 3a-7 under the Investment Company Act \100\ and Regulation AB. \101\ Asset-backed securities (including CDOs) are typically issued by a special purpose vehicle (SPV) controlled by the promoter (which often may be an investment or commercial bank). This SPV would under ordinary circumstances be deemed an ``investment company'' and thus subjected to the demanding requirements of the Investment Company Act--but for Rule 3a-7. That rule exempts fixed-income securities issued by an SPV if, at the time of sale, the securities are rated in one of the four highest categories of investment quality by a ``nationally recognized statistical rating organization'' (NRSRO). In essence, the SEC has delegated to the NRSROs (essentially, at the time at least, Moody's, S&P and Fitch) the ability exempt SPVs from the Investment Company Act. Similarly, Regulation AB governs the disclosure requirements for ``asset-backed securities'' (as such term is defined in Section 1101(c) of Regulation AB) in public offerings. Some have criticized Regulation AB for being more permissive than the federal housing agencies with respect to the need to document and verify the loans in a portfolio. \102\ Because Regulation AB requires that the issuer not be an investment company (see Item 101(c)(2)(i) of Regulation AB), its availability (and thus expedited registration) also depends on an NRSRO investment grade rating.--------------------------------------------------------------------------- \100\ 17 CFR 270.3a-7 (``Issuers of Asset-Backed Securities''). This exemption dates back to 1992. \101\ 17 CFR 229.1100 et seq. (``Asset-Backed Securities''). Regulation AB was adopted in 2005, but reflects an earlier pattern of exemptions in no-action letters. \102\ See Mendales, supra note 18.--------------------------------------------------------------------------- No suggestion is here intended that SPVs should be classified as ``investment companies,'' but the need for the exemption given by Rule 3a-7 shows that the SEC has considerable leverage and could condition this exemption on alternative or additional factors beyond an NRSRO investment grade rating. The key point is that exemptions like Rule 3a-7 give the SEC a tool that they could use even without Congressional legislation--if the SEC was willing to take action. What actions should be taken to respond to the deficiencies in asset-backed securitizations? I would suggest two basic steps: (1) curtail the ``originate-and-distribute'' model of lending that gave rise to the moral hazard problem, and (2) re-introduce due diligence into the securities offering process (both for public and Rule 144A offerings). Restricting the ``Originate-and-Distribute'' Model of Lending. In a bubble, everyone expects that they can pass the assets on to the next buyer in the chain--``before the music stops.'' Thus, all tend to economize on due diligence and ignore signs that the assets are not creditworthy. This is because none expect to bear the costs of holding the financial assets to maturity. Things were not always this way. When asset-backed securitizations began, the promoter usually issued various tranches of debt to finance its purchase of the mortgage assets, and these tranches differed in terms of seniority and maturity. The promoter would sell the senior most tranche in public offerings to risk averse public investors and retain some or all of the subordinated tranche, itself, as a signal of its confidence in the creditworthiness of the underlying assets. Over time, this practice of retaining the subordinated tranche withered away. In part, this was because hedge funds would take the risk of buying this riskier debt; in part, it was because the subordinated tranche could be included in more complex CDOs (where overcollateralization was the investor's principal protection), and finally it was because in a bubbly market, investors no longer looked for commitments or signals from the promoter. Given this definition of the problem, the answer seems obvious: require the promoter to retain some portion of the subordinated tranche. This would incentivize it to buy only creditworthy financial assets and end the ``moral hazard'' problem. To make this proposal truly effective, however, more must be done. The promoter would have to be denied the ability to hedge the risk on the subordinated tranche that it retained. Otherwise it might hedge that risk by buying a credit default swap on its own offering through an intermediary. But this is feasible. Even in the absence of legislation, the SEC could revise Rule 3a-7 to require, as a price of its exemption, that the promoter (either through the SPV or an affiliate) retain a specified percentage of the bottom, subordinated tranche (or, if there were no subordinated tranche, of the offering as a whole). Still, the cleaner, simpler way would be a direct legislative requirement of a minimum retention. 2. Mandating Due Diligence. One of the less noticed but more important developments associated with asset-backed securitization is the rapid decline in due diligence after 2000. Once investment banks did considerable due diligence on asset-backed securitizations, but they outsourced the work to specialized ``due diligence'' firms. These firms (of which Clayton Holdings, Inc. was the best known) would send squads of ten to fifteen loan reviewers to sample the loans in a securitized portfolio, checking credit scores and documentation. But the intensity of this due diligence review declined over recent years. The Los Angeles Times quotes the CEO of Clayton Holdings to the effect that: Early in the decade, a securities firm might have asked Clayton to review 25 percent to 40 percent of the sub-prime loans in a pool, compared with typically 10 percent in 2006 \103\ \103\ See E. Scott Reckard, ``Sub-Prime mortgage watchdogs kept on leash; loan checkers say their warnings of risk were met with indifference,'' Los Angeles Times, March 17, 2008, at C-1.--------------------------------------------------------------------------- The President of a leading rival due diligence firm, the Bohan Group, made an even more revealing comparison: By contrast, loan buyers who kept the mortgages as an investment instead of packaging them into securities would have 50 percent to 100 percent of the loans examined, Bohan President Mark Hughes said. \104\--------------------------------------------------------------------------- \104\ Id. In short, lenders who retained the loans checked the borrowers carefully, but the investment banks decreased their investment in due diligence, making only a cursory effort by 2006. Again, this seems the natural consequence of an originate-and-distribute model. The actual loan reviewers employed by these firms also told the above-quoted Los Angeles Times reporter that supervisors in these firms would often change documentation in order to avoid ``red-flagging mortgages.'' These employees also report regularly encountering inflated documentation and ``liar's loans,'' but, even when they rejected loans, ``loan buyers often bought the rejected mortgages anyway.'' \105\--------------------------------------------------------------------------- \105\ Id.--------------------------------------------------------------------------- In short, even when the watchdog barked, no one at the investment banks truly listened. Over the last several years, due diligence practices long followed in the industry seemed to have been relaxed, ignored, or treated as a largely optional formality. That was also the conclusion of the President's Working Group on Financial Markets, which in early 2008 identified ``a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors.'' \106\--------------------------------------------------------------------------- \106\ See President's Working Group on Financial Markets, Policy Statement on Financial Market Developments at 1 (March, 2008). (emphasis added). This report expressly notes that underwriters had the incentive to perform due diligence, but did not do so adequately.--------------------------------------------------------------------------- Still, in the case of the investments bank, this erosion in due diligence may seem surprising. At least over the long-term, it seems contrary to their own self-interest. Four factors may explain their indifference: (1) an industry-wide decline in due diligence as the result of deregulatory reforms that have induced many underwriters to treat legal liability as simply a cost of doing business; (2) heightened conflicts of interest attributable to the underwriters' position as more a principal than an agent in structured finance offerings; (3) executive compensation formulas that reward short-term performance (coupled with increased lateral mobility in investment banking so that actors have less reason to consider the long-term); and (4) competitive pressure. Each is briefly examined below, and then I suggest some proposed reforms to address these problems. i. The Decline of Due Diligence: A Short History: The Securities Act of 1933 adopted a ``gatekeeper'' theory of protection, in the belief that by imposing high potential liability on underwriters (and others), this would activate them to search for fraud and thereby protect investors. As the SEC wrote in 1998: Congress recognized that underwriters occupied a unique position that enabled them to discover and compel disclosure of essential facts about the offering. Congress believed that subjecting underwriters to the liability provisions would provide the necessary incentive to ensure their careful investigations of the offering.'' \107\--------------------------------------------------------------------------- \107\ See SEC Release No. 7606A (``The Regulation of Securities Offerings''), 63 Fed. Reg. 67174, 67230 (Dec. 4 1998). Specifically, Section 11 of the Securities Act of 1933 holds the underwriters (and certain other persons) liable for any material misrepresentation or omission in the registration statement, without requiring proof of scienter on the part of the underwriter or reliance by the plaintiff. This is a cause of action uniquely tilted in favor of the plaintiff, but then Section 11(b) creates a powerful incentive by establishing an affirmative defense under which any defendant (other ---------------------------------------------------------------------------than the issuer) will not be held liable if: he had, after a reasonable investigation, reasonable ground to believe and did believe, at the time such registration statement became effective, that the statements made therein were true and that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading. 15 U.S.C. 77k (b)(3)(A). (emphasis added) Interpreting this provision, the case law has long held that an underwriter must ``exercise a high degree of care in investigation and independent verification of the company's representations.'' Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 554, 582 (E.D.N.Y. 1971). Overall, the Second Circuit has observed that ``no greater reliance in our self-regulatory system is placed on any single participant in the issuance of securities than upon the underwriter.'' Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F. 2d 341, 370 (2d Cir. 1973). Each underwriter need not personally perform this investigation. It can be delegated to the managing underwriters and to counsel, and, more recently, the task has been outsourced to specialized experts, such as the ``due diligence firms.'' The use of these firms was in fact strong evidence of the powerful economic incentive that Section 11(b) of the Securities Act created to exercise ``due diligence.'' But what then changed? Two different answers make sense and are complementary: First, many and probably most CDO debt offerings are sold pursuant to Rule 144A, and Section 11 does not apply to these exempt and unregistered offerings. Second, the SEC expedited the processing of registration statements to the point that due diligence has become infeasible. The latter development goes back nearly thirty years to the advent of ``shelf registration'' in the early 1980s. In order to expedite the ability of issuers to access the market and capitalize on advantageous market conditions, the SEC permitted issuers to register securities ``for the shelf''--i.e., to permit the securities to be sold from time to time in the future, originally over a two year period (but today extended to a three year period). \108\ Under this system, ``takedowns''--i.e., actual sales under a shelf registration statement--can occur at any time without any need to return to the SEC for any further regulatory permission. Effectively, this telescoped a period that was often three or four months in the case of the traditional equity underwriting (i.e., the period between the filing of the registration statement and its ``effectiveness,'' while the SEC reviewed the registration statement) to a period that might be a day or two, but could be only a matter of hours.--------------------------------------------------------------------------- \108\ See Rule 415 (17 C.F.R. 230.415)(2007).--------------------------------------------------------------------------- Today, because there is no longer any delay for SEC review in the case of an issuer eligible for shelf registration, an eligible issuer could determine to make an offering of debt or equity securities and in fact do so within a day's time. The original premise of this new approach was that eligible issuers would be ``reporting entities'' that filed continuous periodic disclosures (known as Form 10-Ks and Form 10-Qs) under the Securities Exchange Act of 1934. Underwriters, the SEC hoped, could do ``continuing due diligence'' on these issuers at the time they filed their periodic quarterly reports in preparation for a later, eventual public offering. This hope was probably never fully realized, but, more importantly, this premise never truly applied to debt offerings by issuers of asset-backed securities. For bankruptcy and related reasons, the issuers of asset-backed issuers (such as CDOs backed by a pool of residential mortgages) are almost always ``special purpose vehicles'' (SPVs), created for the single offering; they thus have no prior operating history and are not ``reporting companies'' under the Securities Exchange Act of 1934. To enable issuers of asset-backed securities to use shelf-registration and thus obtain immediate access to the capital markets, the SEC had to develop an alternative rationale. And it did! To use Form S-3 (which is a precondition for eligibility for shelf-regulation), an issuer of asset-backed securities must receive an ``investment grade'' rating from an ``NRSRO'' credit-rating agency. \109\ Unfortunately, this requirement intensified the pressure that underwriters brought to bear on credit-ratings agencies, because unless the offering received an investment grade rating from at least one rating agency, the offering could not qualify for Form S-3 (and so might be delayed for an indefinite period of several months while its registration statement received full-scale SEC review). An obvious alternative to the use of an NRSRO investment grade rating as a condition for Form S-3 eligibility would be certification by ``gatekeepers'' to the SEC (i.e., attorneys and due diligence firms) of the work they performed. Form S-3 could still require an ``investment grade'' rating, but that it come from an NRSRO rating agency should not be mandatory.--------------------------------------------------------------------------- \109\ See Form S-3, General Instructions, IB5 (``Transaction Requirements--Offerings of Investment Grade Asset-Backed Securities'').--------------------------------------------------------------------------- After 2000, developments in litigation largely convinced underwriters that it was infeasible to expect to establish their due diligence defense. The key event was the WorldCom decision in 2004. \110\ In WorldCom, the court effectively required the same degree of investigation for shelf-registered offerings as for traditional offerings, despite the compressed time frame and lack of underwriter involvement in the drafting of the registration statement. The Court asserted that its reading of the rule should not be onerous for underwriters because they could still perform due diligence prior to the offering by means of ``continuous due diligence'' (i.e., through participation by the underwriter in the drafting of the various Form 10-Ks and Form 10-Qs that are incorporated by reference into the shelf-registration).--------------------------------------------------------------------------- \110\ In re WorldCom Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y. 2004). The WorldCom decision denied the underwriters' motion for summary judgment based on their asserted due diligence defense, but never decided whether the defense could be successfully asserted at trial. The case settled before trial for approximately $6.2 billion.--------------------------------------------------------------------------- For underwriters, the WorldCom decision was largely seen as a disaster. Their hopes--probably illusory in retrospect--were dashed that courts would soften Securities Act 11's requirements in light of the near impossibility of complying with due diligence responsibilities during the shortened time frames imposed by shelf registration. Some commentators had long (and properly) observed that the industry had essentially played ``ostrich,'' hoping unrealistically that Rule 176 would protect them. \111\ In WorldCom's wake, the SEC did propose some amendments to strengthen Rule 176 that would make it something closer to a safe harbor. But the SEC ultimately withdrew and did not adopt this proposal.--------------------------------------------------------------------------- \111\ See Donald Langevoort, Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment, 63 Law and Contemporary Problems, U.S. 62-63 (2000).--------------------------------------------------------------------------- As the industry now found (as of late 2004) that token or formalistic efforts to satisfy Section 11 would not work, it faced a bleak choice. It could accept the risk of liability on shelf offerings or it could seek to slow them down to engage in full scale due diligence. Of course, different law firms and different investment banks could respond differently, but I am aware of no firms attempting truly substantial due diligence on asset-backed securitizations. Particularly in the case of structured finance, the business risk of Section 11 liability seemed acceptable. After all, investment grade bonds did not typically default or result in class action litigation, and Section 11 has a short statute of limitations (one year from the date that the plaintiffs are placed on ``inquiry notice''). Hence, investment banks could rationally decide to proceed with structured finance offerings knowing that they would be legally exposed if the debt defaulted, in part because the period of their exposure would be brief. In the wake of the WorldCom decision, the dichotomy widened between the still extensive due diligence conducted in IPOs, and the minimal due diligence in shelf offerings. As discussed below, important business risks may have also motivated investment banks to decide not to slow down structured finance offerings for extended due diligence. The bottom line here then is that, at least in the case of asset-backed shelf offerings, investment banks ceased to perform the due diligence intended by Congress, but instead accepted the risk of liability as a cost of doing business in this context. But that is only the beginning of the story. Conflicts of Interest: Traditionally, the investment bank in a public offering played a gatekeeping role, vetting the company and serving as an agent both for the prospective investors (who are also its clients) and the corporate issuer. Because it had clients on both sides of the offering, the underwriter's relationship with the issuer was somewhat adversarial, as its counsel scrutinized and tested the issuer's draft registration statement. But structured finance is different. In these offerings, there is no corporate issuer, but only a ``special purpose vehicle'' (SPV) typically established by the investment bank. The product--residential home mortgages--is purchased by the investment bank from loan originators and may be held in inventory by the investment bank for some period until the offering can be effected. In part for this reason, the investment bank will logically want to expedite the offering in order to minimize the period that it must hold the purchased mortgages in its own inventory and at its own risk. Whereas in an IPO the underwriter (at least in theory) is acting as a watchdog testing the quality of the issuer's disclosures, the situation is obviously different in an assets-backed securities offering that the underwriter is structuring itself. It can hardly be its own watchdog. Thus, the quality of disclosure may suffer. Reports have circulated that some due diligence firms advised their underwriters that the majority of mortgages loans in some securitized portfolio were ``exception'' loans--i.e., loans outside the bank's normal guidelines. \112\ But the registration statement disclosed only that the portfolio included a ``significant'' or ``substantial'' number of such loans, not that it was predominantly composed of such loans. This is inferior and materially deficient disclosure, and it seems attributable to the built-in conflicts in this process.--------------------------------------------------------------------------- \112\ See, e.g., Vikas Bajaj and Jenny Anderson, ``Inquiry Focuses on Withholding of Data on Loans,'' New York Times, January 12, 2008, at A-1.--------------------------------------------------------------------------- Executive Compensation: Investment bankers are typically paid year-end bonuses that are a multiple of their salaries. These bonuses are based on successful completion of fee-generating deals during the year. But a deal that generates significant income in Year One could eventually generate significant liability in Year Two or Three. In this light, the year-end bonus system may result in a short-term focus that ignores or overly discounts longer-term risks. Moreover, high lateral mobility characterizes investment banking firms, meaning that the individual investment banker may not identify with the firm's longer-term interests. In short, investment banks may face serious agency costs problems, which may partly explain their willingness to acquire risky mortgage portfolios without adequate investigation of the collateral. Competitive Pressure: Citigroup CEO Charles Prince's now famous observation that ``when the music is playing, you've got to get up and dance'' is principally a recognition of the impact of competitive pressure. If investors are clamoring for ``investment grade'' CDOs (as they were in 2004-2006), an investment bank understands that if it does not offer a steady supply of transactions, its investors will go elsewhere--and possibly not return. Thus, to hold onto a profitable franchise, investment banks sought to maintain a steady pipeline of transactions; this in turn lead them to seek to lock in sources of supply. Accordingly, they made clear to loan originators their willingness to buy all the ``product'' that the latter could supply. Some investment banks even sought billion dollar promises from loan originators of a minimum amount of product. Loan originators quickly realized that due diligence was now a charade (even if it had not been in the past) because the ``securitizing'' investment banks were competing fiercely for supply. In a market where the demand seemed inexhaustible, the real issue was obtaining supply, and investment banks spent little time worrying about due diligence or rejecting a supply that was already too scarce for their anticipated needs. Providing Time for Due Diligence: The business model for structured finance is today broken. Underwriters and credit rating agencies have lost much of their credibility. Until structured finance can regain credibility, housing finance in the United States will remain in scarce supply. The first lesson to be learned is that underwriters cannot be trusted to perform serious due diligence when they are in effect selling their own inventory and are under severe time pressure. The second lesson is that because expedited shelf registration is inconsistent with meaningful due diligence, the process of underwriting structured finance offerings needs to be slowed down to permit more serious due diligence. Shelf registration and abbreviated time schedules may be appropriate for seasoned corporate issuers whose periodic filings are incorporated by reference into the registration statement, but it makes less sense in the case of a ``special purpose vehicle'' that has been created by the underwriter solely as a vehicle by which to sell asset-backed securities. Offerings by seasoned issuers and by special purpose entities are very different and need not march to the same drummer (or the same timetable). An offering process for structured finance that was credible would look very different than the process we have recently observed. First, a key role would be played by the due diligence firms, but their reports would not go only to the underwriter (who appears to have at time ignored them). Instead, without editing or filtering, their reports would also go directly to the credit-rating agency. Indeed, the rating agency would specify what it would want to see covered by the due diligence firm's report. Some dialogue between the rating agency and the due diligence firm would be built into the process, and ideally their exchange would be outside the presence of the underwriter (who would still pay for the due diligence firm's services). At a minimum, the NRSRO rating agencies should require full access to such due diligence reports as a condition of providing a rating (this is a principle with which these firms agree, but may find it difficult to enforce in the absence of a binding rule). To enable serious due diligence to take place, one approach would be to provide that structured finance offerings should not qualify for Form S-3 (or for any similar form of expedited SEC review). If the process can occur in a day, the pressures on all the participants to meet an impossible schedule will ensure that little serious investigation of the collateral's quality will occur. An alternative (or complementary approach) would be to direct the SEC to revise Regulation AB to incorporate greater verification by the underwriter (and thus its agents) of the quality of the underlying financial assets. Does this sound unrealistic? Interestingly, the key element in this proposal--that that due diligence firm's report go to the credit rating agency--is an important element in the settlement negotiated in 2008 by New York State Attorney General Cuomo and the credit rating agencies. \113\--------------------------------------------------------------------------- \113\ See Aaron Lucchetti, ``Big Credit-Rating Firms Agree to Reforms,'' The Wall Street Journal, June 6, 2008 at p. C-3.--------------------------------------------------------------------------- The second element of this proposal--i.e., that the process be slowed to permit some dialogue and questioning of the due diligence firm's findings--will be more controversial. It will be argued that delay will place American underwriters at a competitive disadvantage to European rivals and that offerings will migrate to Europe. But today, structured finance is moribund on both sides of the Atlantic. To revive it, credibility must be restored to the due diligence process. Instantaneous due diligence is in the last analysis simply a contradiction in terms. Time and effort are necessary if the quality of the collateral is to be verified--and if investors are to perceive that a serious effort to protect their interests is occurring.Rehabilitating the Gatekeepers Credit rating agencies remain the critical gatekeeper whose performance must be improved if structured finance through private offerings (i.e., without government guarantees) is to become viable again. As already noted, credit rating agencies face a concentrated market in which they are vulnerable to pressure from underwriters and active competition for the rating business. At present, credit rating agencies face little liability and perform little verification. Rather, they state explicitly that they are assuming the accuracy of the issuer's representations. The only force that can feasibly induce them to conduct or obtain verification is the threat of securities law liability. Although that threat has been historically non-existent, it can be legislatively augmented. The credit rating agency does make a statement (i.e., its rating) on which the purchasers of debt securities do typically rely. Thus, potential liability does exist under Rule 10b-5 to the extent that it makes a statement in connection with a purchase or sale of a security. The difficult problem is that a defendant is only liable under Rule 10b-5 if it makes a material misrepresentation or omission with scienter. In my judgment, there are few cases, if any, in which the rating agencies actually know of the fraud. But, under Rule 10b-5, a rating agency can be held liable if it acted ``recklessly.'' Accordingly, I would proposed that Congress expressly define the standard of ``recklessness'' that creates liability under Rule 10b-5 for a credit rating agency to be the issuance of a rating when the rating agency knowingly or recklessly is aware of facts indicating that reasonable efforts have not been conducted to verify the essential facts relied upon by its ratings methodology. A safe harbor could be created for circumstances in which the ratings agency receives written certification from a ``due diligence'' firm, independent of the promoter, indicating that it has conducted sampling procedures that lead it to believe in the accuracy of the facts or estimates asserted by the promoter. The goal of this strategy is not to impose massive liabilities on rating agencies, but to make it unavoidable that someone (either the rating agency or the due diligence firm) conduct reasonable verification. To be sure, this proposal would involve increased costs to conduct such due diligence (which either the issuer or the underwriter would be compelled to assume). But these costs are several orders of magnitude below the costs that the collapse of the structured finance market has imposed on the American taxpayer.Conclusions 1. The current financial crisis--including the collapse of the U.S. real estate market, the insolvency of the major U.S. investment banks, and the record decline in the stock market--was not the product of investor mania or the classic demand-driven bubble, but rather was the product of the excesses of an ``originate-and-distribute'' business model that both loan originators and investment banks followed to the brink of disaster--and beyond. Under this business model, financial institutions abandoned discipline and knowingly made non-creditworthy loans because they did not expect to hold the resulting financial assets for long enough to matter. 2. The ``moral hazard'' problem that resulted was compounded by deregulatory policies at the SEC (and elsewhere) that permitted investment banks to increase their leverage rapidly between 2004 and 2006, while also reducing their level of diversification. Under the Consolidated Supervised Entity (CSE) Program, the SEC essentially deferred to self-regulation by the five largest investment banks, who woefully underestimated their exposure to risk. 3. This episode shows (if there ever was doubt) that in an environment of intense competition and under the pressure of equity-based executive compensation systems that are extraordinarily short-term oriented, self-regulation does not work. 4. As a result, all financial institutions that are ``too big to fail'' need to be subjected to prudential financial supervision and a common (although risk-adjusted) standard. This can only be done by the Federal Reserve Board, which should be given authority to regulate the capital adequacy, safety and soundness, and risk management practices of all large financial institutions. 5. Incident to making the Federal Reserve the systemic risk regulator for the U.S. economy, it should receive legislative authority to: (1) establish ceilings on debt/equity ratios and otherwise restrict leverage at all major financial institutions (including banks, hedge funds, money market funds, insurance companies, and pension plans, as well as financial subsidiaries of industrial corporations); (2) supervise and restrict the design, and trading of new financial products (particularly including over-the-counter derivatives); (3) mandate the use of clearinghouses, to supervise them, and in its discretion to require their consolidation; (4) require the writedown of risky assets by financial institutions, regardless of whether required by accounting rule; and (5) to prevent liquidate crises by restricting the issuance of short-term debt. 6. Under the ``twin peaks'' model, the systemic risk regulatory agency would have broad powers, but not the power to override the consumer protection and transparency policies of the SEC. Too often bank regulators and banks have engaged in a conspiracy of silence to hide problems, lest they alarm investors. For that reason, some SEC responsibilities should not be subordinated to the authority of the Federal Reserve. 7. As a financial technology, asset-backed securitizations have decisively failed. To restore credibility to this marketplace, sponsors must abandon their ``originate-and-distribute'' business model and instead commit to retain a significant portion of the most subordinated tranche. Only if the promoter, itself, holds a share of the weakest class of debt that it is issuing (and on an unhedged basis) will there be a sufficient signal of commitment to restore credibility. 8. Credit rating agencies must be compelled either to conduct reasonable verification of the key facts that they are assuming in their ratings methodology or to obtain such verification from professionals independent of the issuer. For this obligation to be meaningful, it must be backstopped by a standard of liability specifically designed to apply to credit-rating agencies. ______ CHRG-111hhrg53248--202 Mr. Meeks," I will ask Chairman Bair, and anyone can answer this question, I am always concerned about what took place with Lehman Brothers, especially currently with the bankruptcy that still has a lot of U.S. investors' money tied up in London. I was wondering how would we prevent something--you know, if we had with the new regulatory reform program coming in, how would we handle the same situation that we had with Lehman Brothers? How would it be different? How could we make sure we don't fall into the same situation that we are currently in in regards to an international holding company like Lehman? Ms. Bair. With a resolution authority that is patterned off of what the FDIC has now, you could have, in a situation like that, put the systemic functions into a bridge facility and required that derivative counterparties continue to perform on those contracts. In a bankruptcy situation, counterparties have an immediate right to close out netting, and that is in point of fact what happened. They exercised those rights, pulled collateral out of the institution, netted out their positions, and went out to re-hedge. That caused a lot of disruption in the system. With the resolution authority along the lines of what we have now, you could have wiped out shareholders and unsecured creditors under our claims priority. But, you could have required secured creditors, such as counterparties, to continue performing on their contracts and had an orderly wind-down of the institution. But with the rights of immediate closeout netting that are triggered with bankruptcy, you had a very disruptive situation. Any resolution is going to be a difficult thing, but I do think that with the kinds of tools that we have, you can also do advanced planning with our resolution process, particularly for a bank. We work with the primary regulator. When we see trouble coming, we start planning in advance. So, you can control the timing as well. In bankruptcy, there is no control over the timing. There are a lot of advantages that we have that I think provide in appropriate circumstances a more orderly process, while at the same time imposing significant losses on shareholders and creditors. " CHRG-110shrg50414--73 Mr. Bernanke," Yes. Senator Shelby. Could you just in a few minutes describe several of the proposals that you considered, telling us in detail in specific terms why those proposals were deemed inadequate by both the Treasury and the Fed? " Secretary Paulson," OK. I will go first. We have, as you know, Senator, been talking with Congress and talking among ourselves for some time about what is going on in the housing area. And we have worked very hard together to approach the foreclosure issue. And so there is a lot of work that was done in dealing with foreclosures, No. 1. No. 2, as you yourself have said, you saw some case-by-case approaches, and, you know, I would argue that every one of those was absolutely essential and was necessary. And as we looked at this situation, we said the root cause of this is housing. The root cause is housing and the housing correction, and until we get at that, we are not going to solve it. And as we looked at how we get at that, there are some that said we should just go and stick capital in the banks--put preferred stocks, stick capital in the banks. And that is what you do when you have failures. That is what happened in Japan. That is what happened in other spots. We have dealt with some failures, and we have dealt with them where there is capital. But we said the right way to do this is not going around and using guarantees or injecting capital--and there have been various proposals to do that--but to use market mechanisms. And, again, I think that some of the questions here and some of the frustration here I share, you know, on compensation and so on. And when you deal with ad hoc situations, when you deal with an institution that is failing or about to fail, and you have to buy mortgages or securities well above value, or you need to put capital in, then you take tough compensation measures. But as we looked at it and thought about this--and we consulted together about this, you know, for a long time--and said ultimately--and we hope we do not get there. We hope that this decline can be arrested. But we both had said that until the biggest part of the correction in housing prices is over, there is no way to really have a stable financial system. So we decided that this market mechanism and going out very broadly--this is broadly to financial institutions all over, and working on the asset prices and helping develop value that the market can build around. Senator Shelby. Do you agree with that, Chairman Bernanke? " CHRG-111hhrg53021--166 Mr. Garrett," And we do that because we want to get to the underlying causes that brought us to this morass in the first place. Right? Let's take a look at one of those pictures which is always on the front page, the AIG situation. The AIG situation, with the derivatives that they were involved with there, the underlying problem there was, what, mortgage-backed securities. Right? " CHRG-111hhrg53021Oth--166 Mr. Garrett," And we do that because we want to get to the underlying causes that brought us to this morass in the first place. Right? Let's take a look at one of those pictures which is always on the front page, the AIG situation. The AIG situation, with the derivatives that they were involved with there, the underlying problem there was, what, mortgage-backed securities. Right? " FinancialCrisisInquiry--156 In your opinion, if the management systems of these companies had stronger accountability, would that not be an appropriate step before structural change in the industry? SOLOMON: Yes. I mean, great management will take bad situations and make them better, but they’ll be bad situations. I think we are dealing with a structural problem, and we’d better hope that management’s fabulous, and it isn’t always fabulous. It’s a—it’s a reality. Even the best business schools can’t turn out fabulous people for enough places. THOMPSON: Thank you very much. CHAIRMAN ANGELIDES: All right, Mr. Hennessey, if I’m—no? Mr. Georgiou already did it. Aren’t his comments seared into your brain? (CROSSTALK) HENNESSEY: My apologies. Can you compare the—can you compare Fannie and Freddie, what happened with them to the failures at other large financial institutions? I’m interested in both the competence of management, the risks that they took, and the impacts on the financial system of their failure. As—as we look at what are the causes of the financial crisis and we have to figure out how to allocate our time and other resources, looking into the failure at WaMu or the failure at, you know, Lehman or Bear Stearns and Fannie and Freddie, can you give us a sense how important were those firms relative to other failures, and can you also give us a sense of how should we—we’ve heard a lot; we’ve been talking a lot about ability to manage risks and about the risks that they were taking. Can you give us some sense of comparison? FinancialCrisisInquiry--227 THOMPSON: Thank you. CHAIRMAN ANGELIDES: Actually on my time just a quick question. Mr. Zandi just a quick couple of comments on what Mr. Rosen said. Any divergence? Any nuance? ZANDI: Well, my interpretation of this discussion is what is the root cause of this mess? And my answer is there are many—it’s a mélange of problems. But three things—first is the surfeit of global saving, which provided the fodder for all this lending. Second was the failure of the process of securitization. The intent of securitization was to take all this global saving and funnel it into good loans, and it failed to do that. And there are a lot of bad actors in that process. And then third was the regulatory failure. There was no regulatory oversight, and this is where I would agree with—with Ken. That the key regulator is the Federal Reserve. It failed in that process. CHAIRMAN ANGELIDES: All right. Thank you very, very much... ZANDI: I wouldn’t ascribe it to monetary policy per se—you know there’s a lot of reasonable debate about that. But it’s clearly the regulatory failure I would agree with. CHAIRMAN ANGELIDES: So you—because one of these always—I wondered to the extent that there’s still the global and savings imbalance if you accept that that’s the reason and the only reason which I’m not prejudging it. It dooms you to the same result unless you believe there are other things that occurred that could have been controlled. CHRG-110hhrg41184--175 Mr. Shays," What I used to look at, though, is I would say, you know, OPEC, the price is so high that they are causing tremendous dislocation throughout the world. But from their standpoint, they're saying, you know, we're not getting that much more. And I'm wondering, have you had dialogue with OPEC about this issue, or with folks indirectly about this issue from overseas? " 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. ______ FOMC20070131meeting--46 44,MR. LACKER., Ex post subprime mortgage-backed securities seem to have been overvalued in the sense that they underestimated default risk for some market segments. So the presumption would be that such information gets taken on board and reflected in the prices of new mortgage-backed securities and that it would translate into higher credit spreads at the retail level. In your remarks you seemed to suggest that there is a chance that this process of adjustment might cause markets not to work. I’m wondering what you meant by that. 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-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. " CHRG-111hhrg53246--142 Mr. Baca," And the other question I have, I was wondering if you could speak to the concerns that a quick transaction to either a mandatory clearing process or a mandatory exchange process for all derivatives may cause a disruption in the market? Do you share this concern? And what can be done to counter this potential problem? " CHRG-111hhrg53244--292 Mr. Posey," Thank you very much, Mr. Chairman. Mr. Chairman, of all the testimony we hear in this committee, I enjoy yours the most. You are always very interesting. We have an awful lot of academics who come in here and try to convince us that a circle is a square and vice versa, and I appreciate your forthrightness. I was a little bit perplexed today by your answers to the first gentleman from Texas' questions. First, about inflation. I heard you talk about how you use pricing as a reference, and that purely printing more money doesn't cause inflation, which was really new news to me. And I wonder if you would tell me what you think causes inflation? " CHRG-110hhrg44901--69 Mr. Bernanke," Well, let me address the oil price situation. I discussed this a bit in my testimony. There are multiple causes, no doubt, for energy price increases. But the most important cause is the global supply and demand balance. The fact that oil, for whatever reason and there are a number of reasons, has not kept up with--oil production has not kept up with the growth in demand for oil particularly in emerging countries which are growing quickly and industrializing. So that suggests that probably the best thing we as a country can do about this is to--perhaps working with other countries, is to promote conservation, alternatives, new energy exploration, all the measures that will help bring us to a more sustainable situation as far as energy is concerned. On speculation, I also discussed this in my testimony. The Federal Reserve is working as part of a task force with the CFTC to look at these issues empirically. But my sense, based on the information I have at this point, is that speculation or, more properly defined, manipulation is not a major cause of oil price increases at this juncture. " 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. FOMC20071211meeting--57 55,MR. STERN.," Dave, I’m having difficulty reconciling the employment and hours data for the current quarter with your forecast of no growth whatsoever. It seems to me that, even if domestic final demand doesn’t grow or grows little, we still have inventories and exports that could take up whatever output turns out to be, and we don’t know very much about those two components for the current quarter, if I understand the situation right. Alternatively, obviously you can get a very bad productivity number, and that would square the circle. But I’m wondering what we know in particular about inventories and exports that would lead us to something as weak as this forecast." CHRG-110shrg50414--74 Mr. Bernanke," I do, Senator, but let me just add a couple comments. As you know, I am a student of financial crises and financial history, and we have looked at past experiences in the United States and other countries, like the Homeowners Loan Corporation, the RTC, the RFC, Japan, other situations. Those were all situations, again, as the Secretary said, where you were dealing with failed institutions and having to dispose of relatively simple assets that were taken over by the Government. That works in that context, and there are ways to do that. The situation we have now is unique and new. It involves not failing institutions--although we have had a few failures. Where we had failures, we dealt with them in a very tough way. You know, we have insisted on, you know, bringing the shareholder value down close to zero, imposing tough terms and so on. But the firms we are dealing with now are not necessarily failing, but they are contracting, they are de-leveraging, they are pulling back. And they will be unwilling to make credit available as long as these market conditions are in the condition they are. So, in order to address the illiquidity of the market and how to deal with these complex securities in the hands of going concerns, the methods used to resolve failed institutions in other contexts are not really appropriate because that would involve, I think, a great deal of concern on the part of other potential investors that if they invest in a bank that the Government is going to come in and take away their value. So I think that we are better off trying to address the root cause of the problem. Senator Shelby. What banks would be eligible to participate in this plan, assuming Congress adopted it as you proposed it, in selling their nonperforming assets to the Treasury or to an entity? And what size banks would be eligible to participate in that plan? " CHRG-111hhrg56778--45 Mr. Foster," Thank you, and thank you all for appearing today. First, I was wondering if anyone is aware of any documented benefits of diversification, that is, studies where people have looked to see if the customer actually gets a better price from horizontally or vertically diversified corporations in terms of just getting a better price for insurance. And if you're aware of this, it's one of the things we're struggling with as to what are the benefits for AIG-like structures compared to self-contained smaller units. And if you're aware of any of this or could respond afterwards, if you become aware of it, I would appreciate it. Ms. Frohman. I am aware of situations where in the homeowners market, in the auto market, that by pursuing coverages under one umbrella of a group, there are discounts that are available to two individuals, and so they can price competitively and take advantage of that. " CHRG-110hhrg44901--84 Mr. Sherman," Okay. Now a question for the record relating to Bear Stearns. The rules of capitalism which are applied with a vengeance on Main Street would have said that in a situation like that, the shareholders and the subordinated debt holders should take the losses long before anybody else. But in the deal that was worked out, not only did the shareholders get $10 a share, which I realize is far less than they had hoped for, but the subordinated debt holders are going to get every penny with interest. And I wonder whether giving you the right to demand the conservatorship immediately would put us in a position where we could impose the risks and costs not on the taxpayer but on those who are supposed to bear them. " CHRG-111shrg54589--93 Mr. Hu," What was interesting was the swaps did work for Goldman, but this situation helps suggest some of the social dimensions of credit default swaps. Do we really want---- Senator Bunning. Well, we are still--as you know, Professor, we are still wondering where the bottom is on AIG. " CHRG-110hhrg46593--181 Mr. Bernanke," Certainly, this situation has sometimes been represented as a failure of capitalism. I don't think that is right. The problem is that our financial system, there have been problems of regulation and problems of execution that have created a crisis in the financial system. We have seen, in many cases, historically and in other countries, that a collapse in the financial system can bring down an otherwise very strong economy. So our efforts have been very focused on stabilizing the financial system. And as that situation is rectified, going forward, we need to really think hard about our supervision and regulation and make sure we get it right. But I don't think that this is an indictment of the broad market system. " CHRG-111hhrg54867--157 Secretary Geithner," I hear your concern. But if we were proposing that, I would not support it. If you proposed that, I wouldn't support it. But you are right about the concern. The question is about how to get the balance right. Look what happened to the country when we allowed a system to build up where we had no choices in the event of failure between stepping in or letting it cause enormous damage. " CHRG-111hhrg56847--206 Mr. Moore," Thank you, Mr. Chairman. Since this economic situation started back in 2008, we have seen in our country a significant rise in defaults on home mortgages. At the same time, the absence of the home buyers' tax credit will, I am afraid and I believe, lead to a decrease in demand. It would seem these happenings will cause housing prices to drop even more significantly in the future. What is the appropriate response of the Fed in such a scenario? What can the Fed do to address this situation, if anything? " FinancialCrisisInquiry--458 SOLOMON: That’s why you’re there. All right? To figure out what the clarity is, but—because all these things happened and they all happened simultaneously. The point that the chairman made, I believe it was—or the vice chairman—is they weren’t caused from outside. They were caused inside the institutions, and that’s the point you’ve got to continue to probe on. And I think we all agree on that. So I think—I think Brian is right on that point. It’s just management. It’s how you set the standards, how you set the risk and how you manage the risk, and your own hubris at managing the risk. You see, a lot of this is just pure management failure even in the best of institutions. You heard Mr. Dimon, Mr. Blankfein—all of them—Mr. Mack— say that we failed. They’re right. HOLTZ-EAKIN: Thank you. CHRG-110hhrg46591--108 Mr. Seligman," I agree with Mr. Johnson that there have to be multiple objectives, and clearly law enforcement would be one of them. I think that when you look at the recent failures, the reality is the failure of inspection, examination, and supervision is a pivotal part. The Office of Inspector General of the Securities and Exchange Commission recently did a report on Bear Stearns. And it noted that among other apparent causes of the failure, there were rules that didn't adequately address liquidity, the Commission did not have sufficient staff to engage in sufficient examinations, and it did not respond to red flags in a meaningful way. Apparently someone on the staff changed the requirement that was in the so-called consolidated supervised entity structure of the SEC that you use outside auditors to internal and that didn't rise to the Commission's level for review. There wasn't a sense as you saw the Bear Stearns devastation in the spring that you almost needed to say what is going on here, how systemic is this, this is a crisis, we have to look much harder and change rules much faster than we would otherwise. There were a lot of different causes. Sometimes regulatory agencies have the right rules, sometimes even the right people, but don't have the right sense of urgency. Too often, though, what you find is they are understaffed, they are underbudgeted and they get stuck in a kind of rut of doing the same things over and over again and don't respond effectively to changes in fundamental dynamics. " FOMC20050809meeting--72 70,MR. FISHER.," David, we’ve been discussing anecdotal evidence in the last few meetings on the lack of pricing power in the corporate sector. And we’ve anticipated that margins would be squeezed unless there was substantial top-line or revenue expansion. I’m wondering if you’re seeing any evidence that that situation has changed. Is there any evidence in the data that companies are not just meeting these increased price pressures through cost-cutting but are beginning to pass their higher costs on? And then, Karen, my question for you is: Could you give a number for the trend-line rate of dollar depreciation, including the yuan, you anticipate?" CHRG-111hhrg53021Oth--96 Secretary Geithner," I think there has been dramatic changes in the basic scale, design, and development of those markets. And even though, as I said in my testimony, the failures in those markets were not the principal cause of this crisis, they did cause substantial damage. And I think that justifies substantial reform. " CHRG-111hhrg53021--96 Secretary Geithner," I think there has been dramatic changes in the basic scale, design, and development of those markets. And even though, as I said in my testimony, the failures in those markets were not the principal cause of this crisis, they did cause substantial damage. And I think that justifies substantial reform. " CHRG-110shrg50418--59 Chairman Dodd," Yes. Well, let me open up a question here and then we will move right along pretty quickly. But one of the things that struck me, and Mr. Wagoner, you began to address this in your comments and I appreciate them, but in most of the testimony I went through and read, we talk about the economic implications, and I want to read for you, because Hank Paulson the other day, in fact, he is quoted in, I think it is today's Wall Street Journal speaking why he is reluctant. Let me first of all say, as someone who was directly involved in the writing of the Emergency Economic Stabilization Act, there is no question in my mind whatsoever that within that Act, within that authority we extended, the authority exists to respond to this issue. Now, it doesn't require it. It doesn't mandate it. But I think even the Treasury has acknowledged that if they wish to respond to this situation, they could do so, and so I want to at least as one of the coauthors of that bill state clearly that that authority exists. Now, he has taken the position, however, though, that the purpose of this bill, and I quote him here, ``I don't see the purpose,'' talking about the automobile situation, ``of the bailout program, which is intended to stabilize jittery financial markets and get lending flowing more freely, which eventually should help revive the ailing economy.'' The point I want to make here is that I don't think we have addressed as effectively as we could and as you could the financial implications, because that is the argument he is making. They are not financial implications to the conditions facing the automotive industry. I wonder if each of you would begin, and Mr. Wagoner, why don't we begin with you, to talk about the financial implications. We know about job losses. We know about all of these other elements. But what are the financial implications if your company fails, your company goes into bankruptcy, putting aside the questions that Professor Morici has raised. And then, Mr. Nardelli, if you would go down the line, and then Mr. Mulally, if you would also comment on this, and Ron, if you would, too, what are the financial implications of a failure. " FOMC20080724confcall--60 58,MS. PIANALTO.," Thank you. During the presentation, it was mentioned that many banks were asking for this longer-term TAF. I am not getting that request here in my District, but I wonder whether any thought was given to keeping the 28-day TAF and then adding the longer 84-day TAF. Is that even an option? The reason I raise this question is that I am concerned about the credit risk. We have had situations in which it has been difficult to assess whether an institution was going to stay in sound financial condition over a 28-day period. Obviously, it would be even more challenging over an 84-day period. So I just wondered if it 1s even an option to keep the 28-day TAF and add the 84-day TAF. " CHRG-110shrg50415--42 Chairman Dodd," Let me, if I can, I wanted to get Gene Ludwig, if I could, to pick up on this. And, again, we heard the comments on CRA, and, of course, you had dealt directly with this issue when you served as Comptroller of the Currency, and you have some insight into the experience with CRA. At the time you were Comptroller, OCC worked with other banking agencies to overhaul CRA regulations, and you have had experience supervising CRA lending and investment by banks. I wonder if you could tell us about whether CRA helped to fuel the current economic crisis in your view. And on the topic of CRA, I would like to--well, I read that comment earlier. I wonder if you could just pick up on those thoughts as well about the pernicious argument being posed by those who suggest the CRA was a part of this or a major cause of this problem. " FinancialCrisisInquiry--72 Again, if your—you should be, in terms of your knowledge, you should be in a good place in both cases. In terms of incentive, I can’t think of a bigger incentive than having $50 billion of the stuff accumulating on your balance sheet. GEORIGOU: Right. BLANKFEIN: And they had that incentive and it didn’t work. GEORGIOU: OK. BLANKFEIN: I think it was a failure of competence more than... GEORGIOU: Let me ask one—let me just ask one question. Some of you talked about claw-back provisions. Have any of you actually utilized your claw-back provisions? And I wondered whether each of you, since I don’t have time to hear your answers, I wonder whether each of you would undertake to advise us in writing of whether you’ve actually applied the claw-backs to people within your firms, without naming the particular person, but how much money you clawed back from them; what percentage of their compensation it was. And if you could provide that in writing, we’d appreciate it very much. CHAIRMAN ANGELIDES: Terrific. We’re going to now take a—literally a five- minute break, if that would be desirable. But let’s make it five minutes and get on back and get on with our business. (RECESS) FOMC20080130meeting--336 334,MR. PARKINSON.," Well, partly what I would say, in general, about the pricing of risk is that many, many people, including people in the Federal Reserve, were concerned about how narrow spreads were, were concerned about some of the slippage of practices, and were predicting that trouble lay ahead. But--and I'm certainly speaking for myself--I never expected this magnitude of trouble. What I've been focusing on are some of the factors that essentially made a bad situation much worse than we expected it to be. But there is no question that we entered the period with risk being priced very cheaply and a fundamental reassessment of risk. Again, I think that shouldn't have surprised anyone, but almost everyone except the most extreme pessimists has been surprised by just how much trouble that repricing of risk has caused. Some things that we have focused on certainly were not anticipated, and we think they made the situation markedly worse than we expected it to be. " CHRG-111hhrg52400--235 Mr. Garrett," But I guess what I heard--and Mr. Skinner can comment on it--is was there a failure also not only on the Federal Reserve part, not only on the Federal regulators looking at the AIG situation, but was also a failure from the European regulators, as well, looking at this situation and not catching this going into it? " CHRG-110shrg50409--84 Mr. Bernanke," Well, as I said, based on the evidence that is available, I would not estimate that speculation or particularly manipulation is a significant part of the rise in oil prices. That said, the CFTC and others are looking at the data and trying to evaluate that. These are very difficult matters. We do not want to do anything that will stop the futures markets from legitimate functions like providing liquidity and hedging. So, my advice would be to go slow and carefully and to take the insights that you get from the CFTC and others who are associated directly overseeing these activities. Despite the concerns--and I fully understand the concerns about high gas prices--I don't think it is likely that you can have a big effect on gas prices with short-term moves in the futures markets. And I would urge careful and deliberate action in this area. Senator Carper. All right. Thank you, Mr. Chairman. Senator Martinez is next, and then followed by Senator Akaka. Senator Martinez. Thank you, Mr. Chairman. Mr. Chairman, thank you very much for being with us today. I wanted to focus on a couple of areas. One was your remarks during your testimony regarding the fundamental issue in the energy situation which you identify one of supply and demand, which makes sense to me. I wonder if you might dwell just for a moment on the speculation side as to why you do not see that as a fundamental part of the problem, but then also what we could do to be more helpful in the area of transparency and oversight. " CHRG-111shrg54533--57 Secretary Geithner," I think you expected that answer, Senator. Senator Corker. I actually expected that--I don't know. I think it would be good for us to know as we move through that none of the folks involved in helping create these new powers under the Fed are potential Fed Chairmen. I think that would be good to know. But I will leave that to you all. Let me just move on. The resolution authority, you and I have talked about this since the very first time you came up here. It seems to me that what you are doing is, in essence, making TARP exist in perpetuity. I know that you have the authority to actually cause organizations to not exist, but you also hold upon yourself the ability to do exactly what is happening in TARP today. I think most of us don't like that much. I think most of us would like to see that end. I know you were asked earlier whether you were going to extend it. And I just wonder, you know, the ad hoc nature of what has occurred, I think is what has created much of the instability, and yet you resume under yourself under this resolution, the power--the ability to do exactly what is taking place under TARP and I am just wondering why that makes much sense and not going ahead and having something that is very clear cut. Some people have talked about a special bankruptcy court. Some people have talked about the FDIC resolving. But you, in essence, are reserving to yourself the ability to cause TARP to go on into the future. " CHRG-111hhrg54872--177 Mr. John," Well, I have mentioned this briefly in the past. One of the strong situations that I think is not necessarily going to pop up immediately, but it is definitely going to be the situation if you do create a CFPA, is that there will be a siloization; that the Chairman's Advisory Board is a good step, but the Chairman's Advisory Board is not sufficient to prevent that siloization. So essentially the consumer regulations of the future, whether that is 5 years, 10 years or 2 years down the line, are going to be made without a direct input or a direct one-on-one understanding of how particular regulated financial institutions work. One of the things that deeply concerns me about this whole situation is that if a CFPA focuses explicitly on the largest types of financial institution, i.e. the banks, the special characteristics of smaller types of financial institutions, such as credit unions, are likely to be ignored or placed in a secondary basis. And that is going to cause problems for consumers. It is going to cause problems for financial institutions of different types, etc. You are going to see a homogenization, which is very dangerous. " 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 FOMC20080430meeting--282 280,MR. PLOSSER.," Yes, just an implementation question. One thing you talked about was in periods of stress, the way we've conducted policy intraday, you have had firmness in the funds rate in the morning and then weakness in the afternoon causing some intraday volatility. The difficulty of hitting the target was partly the fact that we were entering the market only once a day, in the morning, and you had to see through that. With all these other strategies, as they are implemented in other countries, are the central banks doing the same thing? Are they entering the market only once a day, or do they come in several times a day? I just wondered if there are differences in their approaches as to how often they interact in the marketplace. " CHRG-111shrg52619--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Chairman Dodd. We are in the midst of an unprecedented financial crisis. I believe the challenge before us involves three tasks: First, we must work to stabilize the system. Second, we must understand the origins of the current crisis. And, third, we must work to restructure our regulatory regime to meet the demands of a 21st century financial system. Today, the Committee will focus primarily on the third task, rebuilding the regulatory structure. I believe the success of our effort will depend a great deal on our ability to determine what led us to this point. Without that knowledge, we will not know whether we are regulating the right things in the right way. We need to determine whether the regulators had sufficient authority and whether they used the authority they had to the fullest extent. We need to consider here whether market developments outpace current regulatory capabilities. We also need to better understand the impact regulation has on the private sector's due diligence and risk management practices. After understanding the nature of the regulatory structure, I believe we need to come to an understanding as to the specific cause or causes of the regulatory failure. We then need to address those failures in such a manner where we create a durable, flexible, and robust regime that can grow with markets while still protecting consumers and market stability. This is a very tall order. It will take an intensive and extended effort on our behalf, but in the end, getting this thing done right is more important than getting it done quickly. Thank you, Mr. Chairman. " FOMC20080805meeting--93 91,MR. WILCOX.," I don't know what the story is with regard to permits that you're mentioning. I do know that the cancellation rate of new home sales has declined a bit. Previously we were emphasizing that the high level of cancellations that the builders were experiencing was actually causing the supply situation to be even worse than one would infer from the Census Bureau data. Now the cancellation rates have come down, and so that situation is not as severe as it was six or nine months ago, I believe. " CHRG-111hhrg53245--17 Mr. Wallison," Thank you very much, Mr. Chairman. Leaving aside Fannie Mae and Freddie Mac, which I think are a very special case, if there is such a thing as a firm that is too big to fail, it is only a large commercial bank. And we now have several of them that are enormous. When we say that a firm is too big to fail, we mean that its failure could have a major, adverse effect on the entire economy. This is not simply a mere disruption of the economy. It would have to be a systemic breakdown. We can't define that very well, but it would have to be something greater than simply the kind of disruption that would occur from the failure of a firm. In my view, only a large commercial bank can create this kind of systemic breakdown. When a large bank fails, its depositors are immediately deprived of the funds they expected to have to meet payrolls and to pay their bills. Smaller banks are depositors in the larger banks, so the failure of a large bank can send a cascade of losses through the economy. If there is such a thing as a systemic breakdown, this would be it. For the same reasons, it is difficult to see how a large non-bank financial institution, that is, a bank holding company, a securities firm, a finance company, or a hedge fund can cause systemic risk. And thus it is difficult to see why a non-bank can ever be, in terms we are talking about today, too big to fail. Non-banks do not take deposits. They borrow for the short-, medium-, and long-term, but if they fail, their creditors don't suffer any immediate cash losses that would make it difficult for them to pay their bills. No one deposits his payroll or the money he expects to use for doing business with a securities firm or a finance company. In addition, their creditors are likely to be diversified lenders, so all their eggs are not in the same basket. However, the freeze-up in lending that followed the collapse of Lehman Brothers has led some people to believe, and I think incorrectly, that Lehman caused that event. This is not accurate. They conclude that a non-bank financial firm can cause a systemic breakdown that it can thus be too big to fail. But Lehman's failure caused what is called a common shock, where a market freezes up because new information has come to light. The new information that came to light with Lehman's failure was that the government was not going to rescue every firm larger than Bear Stearns, which had been rescued 6 months before. In this new light, every market participant had to reevaluate the risks of lending to everyone else. No wonder lending ground to a halt. Common shocks don't always cause a financial crisis. This one did, because virtually all large banks were thought at that time to be weak and unstable. They held large amounts of mortgage backed securities, later called toxic assets, that were of dubious value. If the banks had not been weakened by these assets, they would have continued to lend to each other. There would not have been a freeze-up in lending and the investor panic that followed. So if we want to avoid another crisis like that, we should focus solely on ensuring that the banks--we're talking about commercial banks--are healthy. Other financial firms, no matter how large, are risk takers and should be allowed to fail. Accordingly, if we want to deal with the problem of too big to fail and systemic risk bank regulation should be significantly reformed. Capital requirements for large banks should be increased as those banks get larger, especially if their assets grow faster than asset values generally. Higher capital requirements for larger banks would cause them to reconsider whether growth for its own sense really makes sense. Bank regulators should develop metrics or indicators of risk taking that banks should be required to publish regularly. This will enhance market discipline, which is fundamentally the way we control risk taking in the financial field. Most important of all, Congress should create a systemic risk council on the foundation of the Presidents Working Group, which would include all the bank supervisors and other financial regulators. The council should have its own staff and should be charged with spotting the development of conditions in the banking industry, like the acquisition by virtually all banks of large amounts of toxic assets, that might make all major banks weak or unstable and leave them vulnerable to a common shock. If we keep our banks stable, we'll keep our financial system stable. Finally, as a member of the Financial Crisis Inquiry Commission, I urge this committee to await our report before adopting any legislation. Thank you. [The prepared statement of Mr. Wallison can be found on page 79 of the appendix.]STATEMENT OF SIMON JOHNSON, PROFESSOR, MASSACHUSETTS INSTITUTE CHRG-110hhrg41184--127 Mr. Royce," Thank you, Mr. Chairman. I wanted to ask Chairman Bernanke a question. To date, the U.S. banking system, I think, has handled the stress originated in the housing sector. But I think this is a result of these institutions being adequately capitalized prior to the turmoil that we found ourselves into. And given the ability of these institutions now to adequately handle that stress with existing leverage ratio requirements, I wondered if it caused you to rethink your attitude toward implementation of Basel II? " CHRG-111hhrg56766--274 Mr. Foster," As you know, I am an enthusiast for actually looking into this as a way of stabilizing our economy against future, especially real estate, bubbles. We had some testimony from our snow-canceled hearing by a gentleman called Richard Koo from Nomura Securities Institute, and he talked about what he called a ``balance sheet recession.'' He said there was a qualitative difference between normal business circumstances where businesses respond to a lower interest rate by actually expanding operations, and a situation where after the bursting of a bubble that was fueled by deficits and so on, that you behave differently. If you are terrified you are insolvent, then a lower interest rate does not interest you, except in helping you pay off your debt faster. I was wondering if you think that is a valid point of view and really if there is an element to that. He made the comparison also of Japan 15 years ago and the United States today. I was wondering if you would comment on that. " CHRG-111hhrg56766--294 Mrs. Bachmann," Another question that I wondered if you could address would be on the GSEs, with Freddie and Fannie, and it appears we may have an attending risk up to $5 trillion. Those are some figures we are hearing, that we are looking at potentially $400 billion directly, but we may have exposure up to $5 trillion. What are we doing really to limit that risk? It does not seem there has been any appreciable reform of the GSEs, Freddie and Fannie, and it seems like if anything, we are making that situation worse by raising the levels of loans that people can have access to. What are we doing to protect taxpayer risks? " FinancialServicesCommittee--64 First, how was CME able, during that frenetic day, to absolve Citigroup of any involvement? And, second, how do you reconcile CME’s Citigroup statement with its policy of not commenting on in- dividual market participation? Mr. D UFFY . Congressman, that is a great question. It was a very difficult situation for us at the time because you have to realize we are working on real time, with the situation happening, with the rumors that somebody from Citigroup entered in a $16 million no- tional transaction in the E-mini and instead entered $16 billion of notional into the E-mini. We knew, because of the systems we have in place, that was categorically false. We could ring-fence Citibank’s inventory that they did on CME Group on a real-time basis within moments. We traditionally would not ever make statements like that because of the situation the banks have been in. We thought it was the prudent thing to do on Citibank’s behalf and, actually, on behalf of the taxpayers, since they own such a big portion of Citi. We thought it was the right thing to do to make the statement to make sure the rumor went away. Mr. C ARSON . Mr. Leibowitz, although the cause of the May 6th volatility spike has yet to be determined, do preliminary investiga- tions indicate flaws in the current regulatory framework? And, also, can regulatory improvements, whether at the SEC or the CFTC or exchange levels, prevent what essentially could be an ex- traordinary technological glitch? Mr. L EIBOWITZ . I think what we have recognized is the lack of marketwide circuit breakers that everyone obeys on a stock-by- stock basis is clearly a failure among our markets to work together properly and create the right market environment. I think the SEC concept review, which they are doing right now, will help identify other areas where we may feel that either regula- tion is lacking; maybe there is not enough surveillance. I think many of us believe, at this point, that centralized surveillance is critical in this market. To be honest, I feel sorry for the SEC staff who has to assemble from 40 different venues the amount of data they have done. And they have done amazing work in doing it. But we need to not be in this situation going forward, and I think we are committed and I know Mr. Noll’s group is committed to working with the SEC to make that happen. Mr. C ARSON . Okay. And lastly, Mr. Noll, can you please give us a rundown of the decision-making process that resulted in the can- cellation of almost 300 trades of stocks and exchange-traded funds? Mr. N OLL . Sure, I would be happy to do that. First of all, I think it is important to note that this was a multi- exchange decision. All the marketplaces participated in the decision to break the trades that occurred in that period of time between 2:40 and 3:00, so it was not one market making the decision on be- half of all others; it was all markets in consultation with one an- other. And I think we were governed by two things that influenced our decision-making process there. The first one was: When, in fact, did the markets become disorderly as opposed to orderly? So, if you look at some of the time in sales and some of the trades that oc- curred in that period of time, their fall, even though it was drastic and fast, was what we would call orderly. In other words, they were walking down the order books step-by-step in the way they were supposed to happen. It was only at the very bottom where we started to see very anomalous prints. So we were very concerned about drawing the line at a level where we addressed the anoma- lous prints and not the, sort of, order-by-order orderly trading that was going on. CHRG-111hhrg55814--64 Secretary Geithner," Then the only authority we would have is to manage their failure without causing the economy to go through what this economy went in this crisis. That's the basic-- " CHRG-109shrg30354--38 Chairman Bernanke," Senator, that is absolutely right. Again, our goal is to achieve a sustainable expansion. There are risks in both directions, if I may say so. Clearly, we do not want to tighten too much to cause the economy to grow more slowly than its potential, and we are very aware of that concern, and we think about it and we look at it and try to evaluate it. The risk in the other direction is that, if we were to stop tightening too soon and inflation were to get higher and more persistent, then we would be faced with the situation of having to address that later on with perhaps even more interest rate increases. So our goal is to achieve a sustainable expansion. We have to balance those risks and those two directions. And we do that by looking forward to our forecasting process and thinking about how actions we have already taken are likely to affect the economy in the long-run. " CHRG-111shrg51290--7 STATEMENT OF SENATOR MERKLEY Senator Merkley. Thank you very much, Mr. Chair, and welcome to the experts testifying before us. I will say just simply that too often, the failure of regulation has turned the American dream of home ownership into an American nightmare of home ownership, and that the failure of regulation on Wall Street has created the situation where these same mortgages have contributed enormously to the meltdown of our economy, and just not our economy, but now to the world economy. So this is incredibly important to the success of our families that we get this right, and to the success of our economy and the world economy. I look forward to your testimony. Thank you very much, Mr. Chair. " fcic_final_report_full--442 Conclusion: The risk of contagion was an essential cause of the crisis. In some cases the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance-sheet losses in its counterparties. These institu- tions were too big and interconnected to other firms, through counterparty credit risk, for policymakers to be willing to allow them to fail suddenly. Systemic failure type two: a common shock If contagion is like the flu, then a common shock is like food poisoning. A common factor affects a number of firms in the same way, and they all get sick at the same time. In a common shock, the failure of one firm may inform us about the breadth or depth of the problem, but the failure of one firm does not cause the failure of another. The common factor in this case was concentrated losses on housing-related assets in large and midsize financial firms in the United States and some in Europe. CHRG-110hhrg45625--61 Secretary Paulson," As we have dealt with some of the other situations and we have dealt with them and we have gone over them on a case-by-case basis and we dealt with failure either to prevent failure or to deal with failure. And what we want to do here is deal with it systemically and get ahead. And so this program that we are proposing is not one that is aimed just at big financial institutions. We could--you could design programs that would come in and deal with big financial institutions and take a lot of assets off their balance sheets at prices that were very helpful and, of course, when you do that, then you have other measures that go with it. But what we are looking at doing here and which we think is very important is to get price discovery and transparency and price discovery with very complex mortgage and mortgage related assets. And we think the way to do that is design a process where you get hundreds, even thousands of institutions for some of these asset classes and mortgage represented securities to participate. And there are different programs that will be used. There are reverse auctions. There are different-- " CHRG-111hhrg53238--145 Mr. Meeks," Thank you, Mr. Chairman. I think that part of what--some of what we are looking at is credibility issues, etc. I would have liked to have heard--and what I think a lot of the members have heard, at least on this side, is that if people are diametrically opposed to a CFPA, I would have liked to have heard and would like to hear in the future how we can make it work, what we can do to make sure that it works. Because, obviously, consumers do need protection. Someone--I don't know whether it was the professor or not, but somebody talked about how there are no foreclosures in Europe. And I don't think you really want to go where they are. Because if you look at Europe in particular, there are generally huge consumer protection programs, and banks primarily offer only vanilla products. And, you know, I am not so sure that I want to go all the way there, because I think that there is some good utilization of some diversity in products. But there has to be a buy in, some kind of way that we need to talk. And I, for one, want to again sit down, as I have with many of you, to talk and to try to figure out so that we can get this thing right. Because I am hoping that we will put a piece of legislation in place that is going to survive the test of time and try to minimize any unintended consequences but make sure that individuals who are in my district, for example, number one in New York City, which is small compared to some of my colleagues in other States, in home foreclosures, and how we can figure out how to make them. Because that is what--people are coming to me. They are saying, how do we fix this thing? I am going to change the area that I am going to, because the question that I really wanted to ask to get your opinion has to deal with the subcommittee of which I am the Chair, and that is dealing with international monetary policy. And I know that many industry organizations and individual financial firms, and from what I am hearing here, agree that we must have some kind of a change and a resolution authority so that there would be a systemic risk manager. The FDIC has typically put forward a successful example of how we can bring this kind of stability to the industry. But several of the key bank failures that brought the global financial system to the brink of collapse were international bank holding companies, with operations in multiple sovereign jurisdictions; and I was wondering if you had any thoughts on whether and how an FDIC-type model could work to manage these type of global banks so that, you know, people get out here, go to another jurisdiction and cause a systemic risk in Europe or other places where we don't have the direct jurisdiction. I was wondering if there were any thoughts on how we could manage that. " CHRG-110hhrg46591--49 Mr. Kanjorski," Thank you very much, Mr. Chairman. Gentlemen, there have been suggestions out there from various members of the panel that we create some sort of commission or select committee. And I assume that is so that we could get to the basis of what the cause of the present economic situation is and where there is a failure or a weakness in the existing system. I guess my question to you is, one, is this ever attainable or is it not only an economic problem but also a political problem? I notice of late and even occurring here today that there is a constant argument about who is at fault. I have heard a lot of my colleagues question that it is truly a problem of the Clinton Administration. And then someone said no, it is really a problem of the Buchanan Administration. And going all the way back, I am not sure whose fault it is. Maybe it is the fault of George Washington; if we didn't have the country, we wouldn't have the problem. But before we can get to a clean-up situation, would you recommend that almost immediately we take steps to create either a commission empowered for 90 or 180 days to report back to the Congress to get some equilibrium as to cause so that we can then decide legislatively how to approach this? And particularly, before I turn it over to you all for answers, I was impressed in listening to you that if you remember just 3 years ago, the country was in the throes of almost a 50/50 argument that Social Security should be privatized. And at that time, the argument was being made that, look, if we did that, how much greater that would be to the assistance of people having a better retirement. And I didn't hear a lot of people raise objections to the risk. It was like, great idea, let us do it. And I just keep thinking as I meet with my constituents today how, thank God, 3, 3\1/2\ years ago, this country didn't fall into that terrible trap or we would really have a disaster on our hands in terms of all of the Social Security funds that probably would have been lost by this time. So what I am sort of asking you for is, if you can, give us an outline of how we would start this--a commission, a select committee, whether or not then we should go to the regular order of the Congress, how to act, and can we do it without establishing some basic foundation, if I may? Dr. Seligman. " CHRG-111shrg61651--59 Mr. Corrigan," So whether Goldman Sachs continued to be a bank holding company or not, it would still be subject to consolidated prudential supervision. I think that is the way it should be. Senator Corker. I was struck by your testimony regarding all institutions, that no institutions should be too big to fail, and then your solution was that if a company failed, they would go into temporary conservatorship. That is not much of a failure. So I am shocked by that and I wonder---- " FOMC20080130meeting--113 111,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Nellie, I have two questions for you. One is on exhibit 9, where you forecast in the middle right panel the rate of increase in defaults on subprime ARMs. If you compare that with your reset rate estimate and your house-price assumption or the house-price assumption in the market, I wonder whether that looks a little optimistic. Can you just say a little more about why, under the baseline scenario, given what has happened to house prices already and what is ahead, you wouldn't think that would be substantially greater? " CHRG-111hhrg52261--93 Chairwoman Velazquez," Time has expired. Ms. Fallin. Ms. Fallin. Thank you, Madam Chair. I am sorry I couldn't be here for all the hearing, but what I have heard is very interesting; and I will talk about what I am hearing in my home State of Oklahoma. I am hearing from businesses that lines of credit are hard to come by, that they are seeing sometimes double-increased rates on their interest rates. I am hearing that their lines of credit have been, many times, cut in half to where they do not have the lines of credit. And I am hearing from some of our business owners that when they do want to take equity out of their businesses, they can't take it out of their businesses to expand their product. My question would be, what has changed over the last 2 to 3 years that has caused this market to tighten up? And what are the problems associated that have caused those things? And in this new Consumer Financial Protection Act, do you think that will help the situation where more money will be available and the credit will start flowing? Or are we reaching too far, and it is going to cause the market to contract? " CHRG-111hhrg54872--116 Mr. John," For one thing, I think there are some different causes of the financial crisis and that just focusing on consumer activities and consumers lending is somewhat misleading. If the laws that exist on the books, and this includes both State laws and Federal laws, had been properly enforced and had been carefully considered, meaning the coverage of things like unregulated mortgage brokers and things like that had been covered by some of the States, I think that would have gone a long way toward preventing some of the consumer products breakdowns that caused the situation. As I say, I think there was a lot more than just that. Mr. Moore of Kansas. What laws were not enforced that should have been enforced and who was to have enforced those laws, sir? " CHRG-111shrg51395--117 PREPARED STATEMENT OF JOHN C. COFFEE, JR. Adolf A. Berle Professor of Law, Columbia University Law School March 10, 2009 Enhancing Investor Protection and the Regulation of Securities Markets ``When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing.'' ----Charles Prince, CEO of Citigroup Financial Times, July 2007 Chairman Dodd, Ranking Member Shelby, and Fellow Senators, I am pleased and honored to be invited to testify here today. We are rapidly approaching the first anniversary of the March 17, 2008, insolvency of Bear Stearns, the first of a series of epic financial collapses that have ushered in, at the least, a major recession. Let me take you back just one year ago when, on this date in 2008, the U.S. had five major investment banks that were independent of commercial banks and were thus primarily subject to the regulation of the Securities and Exchange Commission: Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns. Today, one (Lehman) is insolvent; two (Merrill Lynch and Bear Stearns) were acquired on the brink of insolvency by commercial banks, with the Federal Reserve pushing the acquiring banks into hastily arranged ``shotgun'' marriages; and the remaining two (Goldman and Morgan Stanley) have converted into bank holding companies that are primarily regulated by the Federal Reserve. The only surviving investment banks not owned by larger commercial banks are relatively small boutiques (e.g., Lazard Freres). Given the total collapse of an entire class of institutions that were once envied globally for their entrepreneurial skill and creativity, the questions virtually ask themselves: Who failed? What went wrong? Although there are a host of candidates--the investment banks, themselves, mortgage loan originators, credit-rating agencies, the technology of asset-backed securitizations, unregulated trading in exotic new instruments (such as credit default swaps), etc.--this question is most pertinently asked of the SEC. Where did it err? In overview, 2008 witnessed two closely connected debacles: (1) the failure of a new financial technology (asset-backed securitizations), which grew exponentially until, after 2002, annual asset-backed securitizations exceeded the annual total volume of corporate bonds issued in the United States, \1\ and (2) the collapse of the major investment banks. In overview, it is clear that the collapse of the investment banks was precipitated by laxity in the asset-backed securitization market (for which the SEC arguably may bear some responsibility), but that this laxity began with the reckless behavior of many investment banks. Collectively, they raced like lemmings over the cliff by abandoning the usual principles of sound risk management both by (i) increasing their leverage dramatically after 2004, and (ii) abandoning diversification in pursuit of obsessive focus on high-profit securitizations. Although these firms were driven by intense competition and short-term oriented systems of executive compensation, their ability to race over the cliff depended on their ability to obtain regulatory exemptions from the SEC. Thus, as will be discussed, the SEC raced to deregulate. In 2005, it adopted Regulation AB (an acronym for ``Asset-Backed''), which simplified the registration of asset-backed securitizations without requiring significant due diligence or responsible verification of the essential facts. Even more importantly, in 2004, it introduced its Consolidated Supervised Entity Program (``CSE''), which allowed the major investment banks to determine their own capital adequacy and permissible leverage by designing their own credit risk models (to which the SEC deferred). Effectively, the SEC abandoned its long-standing ``net capital rule'' \2\ and deferred to a system of self-regulation for these firms, which largely permitted them to develop their own standards for capital adequacy.--------------------------------------------------------------------------- \1\ See John C. Coffee, Jr., Joel Seligman & Hillary Sale, SECURITIES REGULATION: Cases and Materials (10th ed. 2007) at 10. \2\ See Rule 15c3-1 (``Net Capital Requirements for Brokers and Dealers''), 17 CFR 240.15c3-1.--------------------------------------------------------------------------- For the future, it is less important to allocate culpability and blame than to determine what responsibilities the SEC can perform adequately. The recent evidence suggests that the SEC cannot easily or effectively handle the role of systemic risk regulator or even the more modest role of a prudential financial supervisor, and it may be more subject to capture on these issues than other agencies. This leads me to conclude (along with others) that the U.S. needs one systemic risk regulator who, among other tasks, would have responsibility for the capital adequacy and safety and soundness of all institutions that are too ``big to fail.'' \3\ The key advantage of a unified systemic risk regulator with jurisdiction over all large financial institutions is that it solves the critical problem of regulatory arbitrage. AIG, which has already cost U.S. taxpayers over $150 billion, presents the paradigm of this problem because it managed to issue billions in credit default swaps without becoming subject to regulation by any regulator at either the federal or state level.--------------------------------------------------------------------------- \3\ I have made this argument in greater detail in an article with Professor Hillary Sale, which will appear in the 75th Anniversary of the SEC volume of the Virginia Law Review. See Coffee and Sale, ``Redesigning the SEC: Does the Treasury Have a Better Idea?'' (available on the Social Science Research Network at http://ssrn.com/abstract=1309776).--------------------------------------------------------------------------- But one cannot stop with this simple prescription. The next question becomes what should be the relationship between such a systemic risk regulator and the SEC? Should the SEC simply be merged into it or subordinated to it? I will argue that it should not. Rather, the U.S. should instead follow a ``twin peaks'' structure (as the Treasury Department actually proposed in early 2008 before the current crisis crested) that assigns prudential supervision to one agency and consumer protection and transparency regulation to another. Around the globe, countries are today electing between a unified financial regulator (as typified by the Financial Services Authority (``FSA'') in the U.K.) and a ``twin peaks'' model (which both Australia and The Netherlands have followed). I will argue that the latter model is preferable because it deals better with serious conflict of interest problems and the differing cultures of securities and banking regulators. By culture, training, and professional orientation, banking regulators are focused on protecting bank solvency, and they historically have often regarded increased transparency as inimical to their interests, because full disclosure of a bank's problems might induce investors to withdraw deposits and credit. The result can sometimes be a conspiracy of silence between the regulator and the regulated to hide problems. In contrast, this is one area where the SEC's record is unblemished; it has always defended the principle that ``sunlight is the best disinfectant.'' Over the long-run, that is the sounder rule. If I am correct that a ``twin peaks'' model is superior, then Congress has to make clear the responsibilities of both agencies in any reform legislation in order to avoid predictable jurisdictional conflicts and to identify a procedure by which to mediate those disputes that are unavoidable.What Went Wrong? This section will begin with the problems in the mortgage loan market, then turn to the failure of credit-rating agencies, and finally examine the SEC's responsibility for the collapse of the major investment banks.The Great American Real Estate Bubble The earliest origins of the 2008 financial meltdown probably lie in deregulatory measures, taken by the U.S. Congress at the end of the 1990s, that placed some categories of derivatives and the parent companies of investment banks beyond effective regulation. \4\ Still, most accounts of the crisis start by describing the rapid inflation of a bubble in the U.S. housing market. Here, one must be careful. The term ``bubble'' can be a substitute for closer analysis and may carry a misleading connotation of inevitability. In truth, bubbles fall into two basic categories: those that are demand-driven and those that are supply-driven. The majority of bubbles fall into the former category, \5\ but the 2008 financial market meltdown was clearly a supply-driven bubble, \6\ fueled by the fact that mortgage loan originators came to realize that underwriters were willing to buy portfolios of mortgage loans for asset-backed securitizations without any serious investigation of the underlying collateral. With that recognition, loan originators' incentive to screen borrowers for creditworthiness dissipated, and a full blown ``moral hazard'' crisis was underway. \7\--------------------------------------------------------------------------- \4\ Interestingly, this same diagnosis was recently given by SEC Chairman Christopher Cox to this Committee. See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing and Urban Affairs, United States Senate, September 23, 2008. Perhaps defensively, Chairman Cox located the origins of the crisis in the failure of Congress to give the SEC jurisdiction over investment bank holding companies or over-the-counter derivatives (including credit default swaps), thereby creating a regulatory void. \5\ For example, the high-tech Internet bubble that burst in early 2000 was a demand-driven bubble. Investors simply overestimated the value of the Internet, and for a time initial public offerings of ``dot.com'' companies would trade at ridiculous and unsustainable multiples. But full disclosure was provided to investors and the SEC cannot be faulted in this bubble--unless one assigns it the very paternalistic responsibility of protecting investors from themselves. \6\ This is best evidenced by the work of two University of Chicago Business School professors discussed below. See Atif Mian and Amir Sufi, ``The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis'', (http://ssrn.com/abstract=1072304) (May 2008). \7\ Interestingly, ``moral hazard'' problems also appear to have underlain the ``savings and loan'' crisis in the United States in the 1980s, which was the last great crisis involving financial institutions in the United States. For a survey of recent banking crises making this point, see Note, Anticipatory Regulation for the Management of Banking Crises, 38 Colum. J. L. & Soc. Probs. 251 (2005).--------------------------------------------------------------------------- The evidence is clear that, between 2001 and 2006, an extraordinary increase occurred in the supply of mortgage funds, with much of this increased supply being channeled into poorer communities in which previously there had been a high denial rate on mortgage loan applications. \8\ With an increased supply of mortgage credit, housing prices rose rapidly, as new buyers entered the market. But at the same time, a corresponding increase in mortgage debt relative to income levels in these same communities made these loans precarious. A study by University of Chicago Business School professors has found that two years after this period of increased mortgage availability began, a corresponding increase started in mortgage defaults--in exactly the same zip code areas where there had been a high previous rate of mortgage loan denials. \9\ This study determined that a one standard deviation in the supply of mortgages from 2001 to 2004 produced a one standard deviation increase thereafter in mortgage default rates. \10\--------------------------------------------------------------------------- \8\ See Mian and Sufi, supra note 6, at 11 to 13. \9\ Id. at 18-19. \10\ Id. at 19.--------------------------------------------------------------------------- Even more striking, however, was its finding that the rate of mortgage defaults was highest in those neighborhoods that had the highest rates of securitization. \11\ Not only did securitization correlate with a higher rate of default, but that rate of default was highest when the mortgages were sold by the loan originator to financial firms unaffiliated with the loan originator. \12\ Other researchers have reached a similar conclusion: conditional on its being actually securitized, a loan portfolio that was more likely to be securitized was found to default at a 20 percent higher rate than a similar risk profile loan portfolio that was less likely to be securitized. \13\ Why? The most plausible interpretation is that securitization adversely affected the incentives of lenders to screen their borrowers.--------------------------------------------------------------------------- \11\ Id. at 20-21. \12\ Id. \13\ See Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant Vig, ``Did Securitization Lead to Lax Screening? Evidence from Subprime Loans,'' (http://ssrn.com/abstract=1093137) (April, 2008). These authors conclude that securitization did result in ``lax screening.''--------------------------------------------------------------------------- Such a conclusion should not surprise. It simply reflects the classic ``moral hazard'' problem that arises once loan originators did not bear the cost of default by their borrowers. As early as March, 2008, The President's Working Group on Financial Markets issued a ``Policy Statement on Financial Market Developments'' that explained the financial crisis as the product of five ``principal underlying causes of the turmoil in financial markets'': a breakdown in underwriting standards for subprime mortgages; a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors, related in part to failures to provide or obtain adequate risk disclosures; flaws in credit rating agencies' assessment of subprime residential mortgages . . . and other complex structured credit products, . . . risk management weaknesses at some large U.S. and European financial institutions; and regulatory policies, including capital and disclosure requirements, that failed to mitigate risk management weaknesses. \14\--------------------------------------------------------------------------- \14\ The President's Working Group on Financial Markets, ``Policy Statement on Financial Market Developments,'' at 1 (March 2008). Correct as the President's Working Group was in noting the connection between the decline of discipline in the mortgage loan origination market and a similar laxity among underwriters in the capital markets, it did not focus on the direction of the causality. Did mortgage loan originators fool or defraud investment bankers? Or did investment bankers signal to loan originators that they would buy whatever the loan originators had to sell? The available evidence tends to support the latter hypothesis: namely, that irresponsible lending in the mortgage market was a direct response to the capital markets' increasingly insatiable demand for financial assets to securitize. If underwriters were willing to rush deeply flawed asset-backed securitizations to the market, mortgage loan originators had no rational reason to resist them. The rapid deterioration in underwriting standards for subprime mortgage loans is revealed at a glance in the following table: \15\--------------------------------------------------------------------------- \15\ See Allen Ferrell, Jennifer Bethel and Gang Hu, Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis (Harvard Law & Economics Discussion Paper No. 612, Harvard Law School Program in Risk Regulation Research Paper No. 08-5) at Table 4. Underwriting Standards in Subprime Home-Purchase Loans, 2001-2006---------------------------------------------------------------------------------------------------------------- Debt Year Low/No-Doc Payments/ Loan/Value ARM Share Interest- Share Income Only Share----------------------------------------------------------------------------------------------------------------2001...................................... 28.5% 39.7% 84.0% 73.8% 0.0%2002...................................... 38.6% 40.1% 84.4% 80.0% 2.3%2003...................................... 42.8% 40.5% 86.1% 80.1% 8.6%2004...................................... 45.2% 41.2% 84.9% 89.4% 27.3%2005...................................... 50.7% 41.8% 83.2% 93.3% 37.8%2006...................................... 50.8% 42.4% 83.4% 91.3% 22.8%----------------------------------------------------------------------------------------------------------------Source: Freddie Mac, obtained from the International Monetary Fund. The investment banks could not have missed that low document loans (also called ``liar loans'') rose from 28.5 percent to 50.8 percent over the 5 year interval between 2001 and 2006 or that ``interest only'' loans (on which there was no amortization of principal) similarly grew from 6 percent to 22.8 percent over this same interval. Thus, the real mystery is not why loan originators made unsound loans, but why underwriters bought them. Here, it seems clear that both investment and commercial banks saw high profits in securitizations and believed they could quickly sell on a global basis any securitized portfolio of loans that carried an investment grade rating. In addition, investment banks may have had a special reason to focus on securitizations: structured finance offered a level playing field where they could compete with commercial banks, whereas, as discussed later, commercial banks had inherent advantages at underwriting corporate debt and were gradually squeezing the independent investment banks out of this field. \16\ Consistent with this interpretation, anecdotal evidence suggests that due diligence efforts within the underwriting community slackened in asset-backed securitizations after 2000. \17\ Others have suggested that the SEC contributed to this decline by softening its disclosure and due diligence standards for asset-backed securitizations, \18\ in particular by adopting in 2005 Regulation AB, which covers the issuance of asset backed securities. \19\ From this perspective, relaxed discipline in both the private and public sectors overlapped to produce a disaster.--------------------------------------------------------------------------- \16\ See text and notes infra at notes 56 to 61. \17\ Investment banks formerly had relied on ``due diligence'' firms that they employed to determine whether the loans within a loan portfolio were within standard parameters. These firms would investigate and inform the underwriter as to the percentage of the loans that were ``exception'' loans (i.e., loans outside the investment bank's normal guidelines). Subsequent to 2000, the percentage of ``exception loans'' in portfolios securitized by these banks often rose from the former level of 25 percent to as high as 80 percent. Also, the underwriters scaled back the intensity of the investigations that they would authorize the ``due diligence'' firm to conduct, reducing from 30 percent to as few as 5 percent the number of loans in a portfolio that it was to check. See Vikas Bajaj & Jenny Anderson, ``Inquiry Focuses on Withholding of Data on Loans,'' N.Y. Times, January 12, 2008, at p. A-1. \18\ See Richard Mendales, ``Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent the CDO Meltdown And How To Fix It'' (Working Paper 2008) at 36 (forthcoming in 2009, U. Ill. L. Rev.). \19\ See Securities Act Release No. 8518 (``Asset-Backed Securities'') (January 7, 2005, 79 FR 1506). Regulation AB codified a series of ``no action'' letters and established disclosures standards for all asset-backed securitizations. See 17 C.F.R. 229.1100-1123 (2005). Although it did not represent a sharp deregulatory break with the past, Regulation AB did reduce the due diligence obligation of underwriters by eliminating any need to assure that assets included in a securitized pool were adequately documented. See Mendales, supra note 18.---------------------------------------------------------------------------Credit Rating Agencies as Gatekeepers It has escaped almost no one's attention that the credit rating agencies bear much responsibility for the 2008 financial crisis, with the consensus view being that they inflated their ratings in the case of structured finance offerings. Many reasons have been given for their poor performance: (1) rating agencies faced no competition (because there are really only three major rating agencies); (2) they were not disciplined by the threat of liability (because credit rating agencies in the U.S. appear never to have been held liable and almost never to have settled a case with any financial payment); (3) they were granted a ``regulatory license'' by the SEC, which has made an investment grade rating from a rating agency that was recognized by the SEC a virtual precondition to the purchase of debt securities by many institutional investors; (4) they are not required to verify information (as auditors and securities analysts are), but rather simply express views as to the creditworthiness of the debt securities based on the assumed facts provided to them by the issuer. \20\ These factors all imply that credit rating agencies had less incentive than other gatekeepers to protect their reputational capital from injury. After all, if they face little risk that new entrants could enter their market to compete with them or that they could be successfully sued, they had less need to invest in developing their reputational capital or taking other precautions. All that was necessary was that they avoid the type of major scandal, such as that which destroyed Arthur Andersen & Co., the accounting firm, that had made it impossible for a reputable company to associate with them.--------------------------------------------------------------------------- \20\ For these and other explanations, see Coffee, GATEKEEPERS: The Professions and Corporate Governance (Oxford University Press, 2006), and Frank Partnoy, ``How and Why Credit Rating Agencies Are Not Like Other Gatekeepers'' (http://ssrn.com/abstract=900257) (May 2006).--------------------------------------------------------------------------- Much commentary has suggested that the credit rating agencies were compromised by their own business model, which was an ``issuer pays'' model under which nearly 90 percent of their revenues came from the companies they rated. \21\ Obviously, an ``issuer pays'' model creates a conflict of interest and considerable pressure to satisfy the issuer who paid them. Still, neither such a conflicted business model nor the other factors listed above can explain the dramatic deterioration in the performance of the rating agencies over the last decade. Both Moody's and Standard & Poor were in business before World War I and performed at least acceptably until the later 1990s. To account for their more recent decline in performance, one must point to more recent developments and not factors that long were present. Two such factors, each recent and complementary with the other, do provide a persuasive explanation for this deterioration: (1) the rise of structured finance and the change in relationships that it produced between the rating agencies and their clients; and (2) the appearance of serious competition within the ratings industry that challenged the long stable duopoly of Moody's and Standard & Poor's and that appears to have resulted in ratings inflation.--------------------------------------------------------------------------- \21\ See Partnoy, supra note 20.--------------------------------------------------------------------------- First, the last decade witnessed a meteoric growth in the volume and scale of structured finance offerings. One impact of this growth was that it turned the rating agencies from marginal, basically break-even enterprises into immensely profitable enterprises that rode the crest of the breaking wave of a new financial technology. Securitizations simply could not be sold without ``investment grade'' credit ratings from one or more of the Big Three rating agencies. Structured finance became the rating agencies' leading source of revenue. Indeed by 2006, structured finance accounted for 54.2 percent of Moody's revenues from its ratings business and 43.5 percent of its overall revenues. \22\ In addition, rating structured finance products generated much higher fees than rating similar amounts of corporate bonds. \23\ For example, rating a $350 million mortgage pool could justify a fee of $200,000 to $250,000, while rating a municipal bond of similar size justified only a fee of $50,000. \24\--------------------------------------------------------------------------- \22\ See In re Moody's Corporation Securities Litigation, 2009 U.S. Dist. LEXIS 13894 (S.D.N.Y. February 23, 2009) at *6 (also noting that Moody's grossed $1.635 billion from its ratings business in 2006). \23\ See Gretchen Morgenson, ``Debt Watchdogs: Tamed or Caught Napping?'' New York Times, December 7, 2008, at p. 1, 40. \24\ Id.--------------------------------------------------------------------------- Beyond simply the higher profitability of rating securitized transactions, there was one additional difference about structured finance that particularly compromised the rating agencies as gatekeepers. In the case of corporate bonds, the rating agencies rated thousands of companies, no one of which controlled any significant volume of business. No corporate issuer, however large, accounted for any significant share of Moody's or S&P's revenues. But with the rise of structured finance, the market became more concentrated. As a result, the major investment banks acquired considerable power over the rating agencies, because each of them had ``clout,'' bringing highly lucrative deals to the agencies on a virtually monthly basis. As the following chart shows, the top six underwriters controlled over 50 percent of the mortgage-backed securities underwriting market in 2007, and the top eleven underwriters each had more than 5 percent of the market and in total controlled roughly 80 percent of this very lucrative market on whom the rating agencies relied for a majority of their ratings revenue: \25\--------------------------------------------------------------------------- \25\ See Ferrell, Bethel, and Hu, supra note 15, at Table 2. For anecdotal evidence that ratings were changed at the demand of the investment banks, see Morgenson, supra note 23. MBS Underwriters in 2007-------------------------------------------------------------------------------------------------------------------------------------------------------- Proceed Amount + Rank Book Runner Number of Market Overallotment Sold in U.S. Offerings Share ($mill)--------------------------------------------------------------------------------------------------------------------------------------------------------1....................................................... Lehman Brothers 120 10.80% $100,1092....................................................... Bear Stearns & Co., Inc. 128 9.90% 91,6963....................................................... Morgan Stanley 92 8.20% 75,6274....................................................... JPMorgan 95 7.90% 73,2145....................................................... Credit Suis109 7.50% 69,5036....................................................... Bank of America Securities LLC 101 6.80% 62,7767....................................................... Deutsche Bank AG 85 6.20% 57,3378....................................................... Royal Bank of Scotland Group 74 5.80% 53,3529....................................................... Merrill Lynch 81 5.20% 48,40710...................................................... Goldman Sachs & Co. 60 5.10% 47,69611...................................................... Citigroup 95 5.00% 46,75412...................................................... UBS 74 4.30% 39,832-------------------------------------------------------------------------------------------------------------------------------------------------------- If the rise of structured finance was the first factor that compromised the credit rating agencies, the second factor was at least as important and had an even clearer empirical impact. Until the late 1990s, Moody's and Standard & Poor's shared a duopoly over the rating of U.S. corporate debt. But, over the last decade, a third agency, Fitch Ratings, grew as the result of a series of mergers and increased its U.S. market share from 10 percent to approximately a third of the market. \26\ The rise of Fitch challenged the established duopoly. What was the result? A Harvard Business School study has found three significant impacts: (1) the ratings issued by the two dominant rating agencies shifted significantly in the direction of higher ratings; (2) the correlation between bond yields and ratings fell, suggesting that under competitive pressure ratings less reflected the market's own judgment; and (3) the negative stock market reaction to bond rating downgrades increased, suggesting that a downgrade now conveyed worse news because the rated offering was falling to an even lower quality threshold than before. \27\ Their conclusions are vividly illustrated by one graph they provide that shows the correlation between grade inflation and higher competition:--------------------------------------------------------------------------- \26\ Bo Becker and Todd Milburn, ``Reputation and Competition: Evidence from the Credit Rating Industry,'' Harvard Business School, Working Paper No. 09-051 (2008) (http://ssrn.com/abstract =1278150) at p. 4. \27\ Id. at 17. FOMC20071211meeting--54 52,MR. POOLE.," I’m talking particularly about the delinquencies, foreclosures, and business failures because I think that they usually occur on the way down during the contraction phase of the business cycle and ordinarily those measures look their best close to a business cycle peak. That’s what I remember, but I haven’t gone back and reviewed it, but from just my memory of looking at a lot of business cycle data over the years. That would say that, if my observation is correct, this is quite an unusual situation—unless of course we are past the peak or right at the peak." CHRG-111hhrg53238--147 Mr. Meeks," Thank you. One other question I want to ask really quickly. I was wondering, you know, because I am concerned about like the failure of Lehman Brothers. Many individuals in the United States have some--they thought they were investing in Lehman United States. They now found out they were investing in Lehman U.K. Their money is caught up in a bankruptcy proceeding in the U.K. They can't get it out, foundations, universities, etc. I was wondering if any of your banks or institutions fell into that problem, where you are stuck with the U.K. And how you think we need to deal with bankruptcy proceedings in a foreign land or how do you think we can resolve those issues to protect those United States investors, citizen investors who invested here thinking they were investing safely in the United States, but actually the money was in the U.K. proceedings. " CHRG-109hhrg31539--226 Mr. Pearce," Okay. Just making sure my facts were right. And I am also--as far as labor I would tell you that, in my home county, we do gas work. Those are basically labor jobs with no high school education required. And a kind of a minimum salary right now in the oil field is about $30,000. If you have some experience, it is up around $50,000. And if you are actually one of the lead forepersons, it is up around $100,000. So I don't really find anybody even at the Burger King, the entry-level price is $8.50. And I don't always see that the minimum wage is what is pulling us into financial difficulty as a country. You had made an observation earlier about the price of natural gas not accelerating, and I would point out that nationwide we have got about 1,400 or 1,500 drilling rigs and over 1,000 of those are drilling for natural gas, only about 300 or 400 drilling for oil, which tells us why the price of oil continues to go up. And so, again, we find that the supply and demand actually can be affected right now in today's current situation. So I continue to be a little bit surprised by our land management agencies that restrict access to the service of them. They restrict access. So if you ever have a chance to comment on that, I won't ask you to do it at this point, but we are choosing policies which absolutely give us a higher price of gasoline and then cause inflationary pressures. I think my question is, what price do you--you have adequately stated that labor is a little bit harder driver in inflationary pressures. But what price of crude oil would you be very concerned that we have inflationary pressures, significant inflationary pressures from energy? " CHRG-111hhrg54872--73 Mrs. Capito," Thank you, Mr. Chairman. I would like to thank the panel. Mr. Shelton, I would like to ask you a question. I am concerned, I live in a more rural area, where we really are community bankers and our local lenders are the ones who are face-to-face with constituents every day. And they have voiced concerns about this because of--concerns of losing the flexibility that they believe, and I believe they do as well, offer at the local level to be able to forge financial products that meet an individual situation more on a case-by-case kind of situation. So I want to get to the issue of choice and choice of financial products, and I am wondering if you have any concerns since really the not so implicit premise of this is that consumers, some of them are simply not sophisticated enough or knowledgeable enough to invest in certain products or have certain products offered to them. Do you have any concerns that this might lead to some more insidious kind of redlining where there is a double standard or even one standard that only could be applicable maybe to a more sophisticated or wealthier borrower? " CHRG-111hhrg48867--32 Mr. Wallison," Thank you, Mr. Chairman, and Ranking Member Bachus, for this opportunity to testify about a systemic risk regulator. There are two questions here, it seems to me. First, will a systemic regulator perform any useful function? And second, should a government agency be authorized to regulate so-called systemically significant financial institutions? I am going to start with the second question because I believe it is by far the most important. Giving a government agency the power to designate companies as systemically significant and to regulate their capital and activities is a very troubling idea. It has the potential to destroy competition in every market where a systemically significant company is designated. I say this as a person who has spent 10 years warning that Fannie Mae and Freddie Mac would have disastrous effects on the U.S. economy and that ultimately the taxpayers of this country would have to bail them out. Because they were seen as backed by the government, Fannie and Freddie were relieved of market discipline and able to take risks that other companies could not take. For the same reason, they also had access to lower cost financing than any of their competitors. These benefits enabled them to drive out competition and grow to enormous size. Ultimately, however, the risks they took caused their collapse and will cause enormous losses for U.S. taxpayers. When Fannie and Freddie were taken over by the government, they held or guaranteed $1.6 trillion in subprime and Alt-A mortgages. These loans are defaulting at unprecedented rates, and I believe will ultimately cost U.S. taxpayers $400 billion. There is very little difference between a company that has been designated as systemically significant and a GSE like Fannie or Freddie. By definition a systemically significant firm will not be allowed to fail because its failure could have systemic effects. As a result it will be seen as less risky for creditors and counterparties and will be able to raise money at lower rates than its competitors. This advantage, as we saw with Fannie and Freddie, will allow it to dominate its market, which is a nightmare for every smaller company in every industry where a systemically significant company is allowed to operate. Some will contend that in light of the failures among huge financial firms in recent months, we need regulation to prevent such things in the future, but this is obviously wrong. Regulation does not prevent risk-taking or loss. Witness the banking industry, the most heavily regulated sector in our economy. Many banks have become insolvent and many others have been or will be rescued by the taxpayers. It is also argued that since we already have rescued a lot of financial institutions, moral hazard has been created, so now we should regulate all financial institutions as if they will be rescued in the next crisis. But there is a lot of difference between de jure and de facto, especially when we are dealing with an unprecedented situation. Anyone looking at the Fed's cooperation with the Treasury today would say that the Fed de facto is no longer independent. But after the crisis is over, we would expect that the Fed's independence will be reestablished. That is the difference between de jure and de facto. Extending regulation beyond banking by picking certain firms and calling them systemically significant would, in my view, be a monumental mistake. We will simply be creating an unlimited number of Fannies and Freddies that will haunt our economy in the future. Let me now turn to the question of systemic regulation in general. Why choose certain companies as systemically significant? The theory seems to be that the failure of big companies caused this financial crisis or without regulation might cause another in the future. But is the U.S. banking system in trouble today because of the failure of one or more large companies? Of course not. It is in trouble because of pervasive losses on trillions of dollars of bad mortgages. So will regulation of systemically significant companies prevent a recurrence of a financial crisis in the future? Not on the evidence before us. An external shock that causes asset prices to crash or investors to lose confidence in the future will have the same effect whether we regulate systemically significant companies or not. And regulation, as with banks, will not even prevent the failure of systemically significant companies; it will only set them up for bailouts when inevitably they suffer losses in their risk taking. Finally, the Federal Reserve would be by far the worst choice for systemic regulator. As a lender of last resort, it has the power to bail out the companies it is supervising, without the approval of Congress or anyone else. Its regulatory responsibilities will conflict with its central banking role, and its involvement with the politics of regulation will raise doubts about its independence from the political branches. We will achieve nothing by setting up a systemic regulator. If we do it at the cost of destroying faith in the dollar and competition in the financial services market, we will have done serious and unnecessary harm to the American economy. Thank you, Mr. Chairman. [The prepared statement of Mr. Wallison can be found on page 159 of the appendix.] " CHRG-111hhrg61852--19 Mr. Koo," My idea of the situation is that once the bubble burst, the economy began to weaken because of all these balance sheet problems that I mentioned. But we had one accident in between, which was, in my view, totally unnecessary, and that was the Lehman shock. The fact that Lehman Brothers was allowed to fail when so many other financial institutions had the same problem at the same time, that caused a massive panic, which was, in my view, totally unnecessary. " FinancialCrisisInquiry--702 GEORGIOU: Right. I just wonder whether—what you think might be certain—other methodologies we might use to—to ensure that there’s—responsibility remains on the part of originators for the consequences of the securities that they originate? CHRG-111shrg52966--45 Mr. Sirri," Sure. The question of a ``run on the bank,'' which is the term I used, is always a difficult one because it implicitly depends on confidence in the institution. Of course, we did not have a bank, and the run was different. It was not deposits. But, nonetheless, it was funding with certain kinds of securities through the repo market. You know, it is hard to know why something like that starts. The instruments became the instruments in these firms, in some of the firms that are no longer with us. Lehman Brothers, for instance, suffered a lot of uncertainty about valuation, so you have a financial firm, they are typically opaque. You do not know exactly what is going on with them. That is the nature of a financial firm. Valuations become questions because you are holding, for example, commercial whole loans in the case of Lehman, where people doubted valuations. In a situation like that, people will be wary about funding because even if you can potentially get your money back, you are not in the business of getting tied up in an uncertainty. And that causes a situation that can cause a run. Senator Reed. Thank you very much. Let me ask a general question, which I do not think requires a specific answer unless you--my assumption is that the umbrella regulator--and each one of these large institutions had an umbrella regulator--had the responsibility for the risk assessment throughout the organization, that it was not a case where the overall enterprise risk assessment or enterprise activities were not at all under the authority of a regulator. Is that your understanding, Dr. Sirri, in terms of the law? " 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. CHRG-111hhrg48674--157 Mr. Bernanke," Thank you. First, I would like to make the point that the $2 trillion Fed balance sheet is not government debt. In fact, the $2 trillion Fed balance sheet is a source of income for the government because we lend at higher interest rates than we pay, and that difference, so-called seigniorage, is paid in the tens of billions of dollars to the Federal budget every year. So that is a profit center, not a loss center. With respect to the other issues, though, in terms of the deficits, you are absolutely right that the deficits planned for this year and next year are extraordinarily large. They reflect the severity of the overall economic situation. Partly they are caused by the recession itself, which is hitting tax revenues and so on. And as the President and others have emphasized, it is very important that discipline be regained as soon as possible consistent with getting this economy going again and getting the financial system going again. Because if we leave the system in kind of a stagflation kind of situation, without growth, then the debt will be that much harder to service in the long term. But your point is absolutely right, that the deficits are an issue and a concern. It will raise the debt to GDP ratio of the United States probably by about 15 percent points. That is tolerable for a growing economy, but we do need to make sure, first, that we are growing and, secondly, that we have mechanisms to unwind these fiscal expenditures and loans as the economy improves. " fcic_final_report_full--394 Once again, the FDIC Board met late on a Sunday to determine the fate of a strug- gling institution. Brief dissent on the  P . M . conference call came from OTS Director John Reich, who questioned why similar relief had not been extended to OTS-super- vised thrifts that failed earlier. “There isn’t any doubt in my mind that this is a sys- temic situation,” he said. But he added, In hindsight, I think there have been some systemic situations prior to this one that were not classified as such. The failure of IndyMac pointed the focus to the next weakest institution, which was WaMu, and its fail- ure pointed to Wachovia, and now we’re looking at Citi and I wonder who’s next. I hope that all of the regulators, all of us, including Treasury and the Fed, are looking at these situations in a balanced manner, and I fear there has been some selective creativity exercised in the determina- tion of what is systemic and what’s not and what’s possible for the gov- ernment to do and what’s not.  The FDIC Board approved the proposal unanimously. The announcement beat the opening bell, and the markets responded positively: Citigroup’s stock price soared almost , closing at .. The ring fence would stay in place until December , at which time Citigroup terminated the government guarantee in tandem with repaying  billion in TARP funds. In December , Treasury announced the sale of its final shares of Citigroup’s common stock.  BANK OF AMERICA:  “A SHOTGUN WEDDING ” With Citigroup stabilized, the markets would quickly shift focus to the next domino: Bank of America, which had swallowed Countrywide earlier in the year and, on Sep- tember , had announced it was going to take on Merrill Lynch as well. The merger would create the world’s largest brokerage and reinforce Bank of America’s position as the country’s largest depository institution. Given the share prices of the two com- panies at the time, the transaction was valued at  billion. But the deal was not set to close until the first quarter of the following year. In the interim, the companies continued to operate as independent entities, pending share- holder and regulatory approval. For that reason, Merrill CEO John Thain and Bank of America CEO Ken Lewis had represented their companies separately at the Columbus Day meeting at Treasury. Treasury would invest the full  billion in Bank of America only after the Merrill acquisition was complete. In October, Merrill Lynch reported a net loss for the third quarter of . billion. In its October  earnings press release, Merrill Lynch described write-downs related to its CDO positions and other real estate–related securities and assets affected by the “severe market dislocations.” Thain told investors on the conference call that Merrill’s strategy was to clean house. It now held less than  billion in asset-backed-security FinancialCrisisInquiry--147 SOLOMON: Yes, I think that’s—yes, I think that’s not a bad point. It is clear that the more diversified firms did survive, and that’s why I don’t pin the blame on Gramm-Leach-Bliley. That’s why I said it was just one—that was my response. So I don’t—I think it is—I’m not sure anything is clear, incidentally, and that’s why you have the commission. HOLTZ-EAKIN: That’s not encouraging. We need to figure this out. (LAUGHTER) SOLOMON: That’s why you’re there. All right? To figure out what the clarity is, but—because all these things happened and they all happened simultaneously. The point that the chairman made, I believe it was—or the vice chairman—is they weren’t caused from outside. They were caused inside the institutions, and that’s the point you’ve got to continue to probe on. And I think we all agree on that. So I think—I think Brian is right on that point. It’s just management. It’s how you set the standards, how you set the risk and how you manage the risk, and your own hubris at managing the risk. You see, a lot of this is just pure management failure even in the best of institutions. You heard Mr. Dimon, Mr. Blankfein—all of them—Mr. Mack— say that we failed. They’re right. HOLTZ-EAKIN: Thank you. CHAIRMAN ANGELIDES: Thank you, Mr. Holtz-Eakin. Mr. Georgiou? GEORGIOU: Thank you, gentlemen. You know, Mr. Mayo, you said that innovation always outpaces regulation. fcic_final_report_full--424 HOW OUR APPROACH DIFFERS FROM OTHERS’ During the course of the Commission’s hearings and investigations, we heard fre- quent arguments that there was a single cause of the crisis. For some it was interna- tional capital flows or monetary policy; for others, housing policy; and for still others, it was insufficient regulation of an ambiguously defined shadow banking sec- tor, or unregulated over-the-counter derivatives, or the greed of those in the financial sector and the political influence they had in Washington. In each case, these arguments, when used as single-cause explanations, are too simplistic because they are incomplete. While some of these factors were essential contributors to the crisis, each is insufficient as a standalone explanation. The majority’s approach to explaining the crisis suffers from the opposite prob- lem–it is too broad. Not everything that went wrong during the financial crisis caused the crisis, and while some causes were essential, others had only a minor im- pact. Not every regulatory change related to housing or the financial system prior to the crisis was a cause. The majority’s almost -page report is more an account of bad events than a focused explanation of what happened and why. When everything is important, nothing is. As an example, non-credit derivatives did not in any meaningful way cause or contribute to the financial crisis. Neither the Community Reinvestment Act nor re- moval of the Glass-Steagall firewall was a significant cause. The crisis can be ex- plained without resorting to these factors. We also reject as too simplistic the hypothesis that too little regulation caused the crisis, as well as its opposite, that too much regulation caused the crisis. We question this metric for determining the effectiveness of regulation. The amount of financial regulation should reflect the need to address particular failures in the financial sys- tem. For example, high-risk, nontraditional mortgage lending by nonbank lenders flourished in the s and did tremendous damage in an ineffectively regulated en- vironment, contributing to the financial crisis. Poorly designed government housing policies distorted market outcomes and contributed to the creation of unsound mortgages as well. Countrywide’s irresponsible lending and AIG’s failure were in part attributable to ineffective regulation and supervision, while Fannie Mae and Freddie Mac’s failures were the result of policymakers using the power of government to blend public purpose with private gains and then socializing the losses. Both the “too little government” and “too much government” approaches are too broad-brush to explain the crisis. The majority says the crisis was avoidable if only the United States had adopted across-the-board more restrictive regulations, in conjunction with more aggressive regulators and supervisors. This conclusion by the majority largely ignores the global nature of the crisis. For example: • A credit bubble appeared in both the United States and Europe. This tells us that our primary explanation for the credit bubble should focus on factors common to both regions. CHRG-110hhrg44900--134 Mr. Bernanke," All those things were relevant but another thing that was quite relevant was that the Federal Reserve did not follow through on its responsibility to try to stem the bank failures, and the continuation of bank failures over a number of years contributed to the decline in the money supply and to the contraction of credit and was a major source of the Depression. So it was exactly the failure of the Fed to act in the early 1930's that made the situation as bad as it was. " CHRG-110hhrg46596--525 Mr. Foster," Thank you for hanging around for this. And I would like to say these are spectacular questions. You know, if the quality of the questions coming from this committee were a fifth the quality of these, I would be proud to be a Congressman. And let's see, one question, is the staffing situation and the support you are getting adequate for your job? Ms. Warren. Wonderful. We have received terrific support from the people here in Congress. It is literally just a problem of we were trying to write the report at the same time we were trying to buy the fax machine. You know, I feel like I am flying an airplane and trying to screw the wings on at the same moment. " CHRG-110shrg50414--97 Mr. Bernanke," The reason is that when we dealt with Bear Stearns or AIG or Fannie and Freddie, those were situations where the company was about to fail, had no option. We came in to prevent failure for systemic reasons. In those situations, it is appropriate to knock the share values down low to reduce the moral hazard for subsequent events. But if we are dealing with going concerns, companies that, you know, are still operating, have reasonable business prospects, we do not want to threaten the companies with reducing their share values to zero because that will obviously---- Senator Reed. Well, no one is suggesting that you reduce their share values to zero. But I think in that context of going companies, this program will be strictly voluntary. There will have to be a business judgment made by the managers of that company whether it is worth it to them to enter into this transaction to rid their balance sheets of toxic assets. Right now the price of admission is zero. I think it is not inconceivable or inappropriate to demand in that calculation they recognize if they will benefit from this transaction in the future--and that is the notion of participation in the future--that they will share that benefit with the taxpayers who made the benefits possible. " CHRG-111shrg50814--196 Chairman Dodd," The last point I would make I think is very important. I think obviously the markets are skittish, and obviously there is a lot going on. And clarity is very important, the transparency you are talking about. I think the more people--Bob mentioned this earlier, and I wish I had said it myself at the outset. So much of what is missing is getting that sense of the framework, where are we. I think people understand how we got here. We can talk about that. But where are we? What needs to be done to get us moving in the right direction? And I think to the extent people understand that--they may not like it, but they understand it--then you do not get these kind of high volatility and jerking around that we see so often where one statement from one individual can have a significant impact on a market fluctuation. I think that is in a sense what happens when there is this lack of certainty or clarity, to the extent you can have certainty, obviously, in an environment like this. I think these closing comments, while they have not involved a lot of people here, I think they have been tremendously valuable and important, and your responses to Senator Shelby I think have been very helpful as well on all of that. And I do think sometimes we--the markets are very important, obviously. We watch them every day. But I think too many times we look at only that every day as an indication of where things are going. And it is an important indication, but it is not the only indication of what is happening. And I think that is the point you were trying to make, and I welcome that. We thank you very, very much---- Senator Corker. Mr. Chairman, could I--this is not getting into an ideology discussion. The statement was made earlier that the Federal Reserve does not have the authority to close down a large institution. I think the Chairman may have been referring to AIG. I am not sure. But I am wondering if it would be good for him to clarify, and then since this Committee, I guess, would have something to do with that, if there is something that he is asking for, because what I would hate to happen is 2 years from now we end up in a situation, if it is AIG--he might have been talking about Citigroup. I do not know who he is talking about. I would love the clarification. But I would hate for us to wake up 2 years from now and the Fed be saying, well, we would have done it, but we did not have the authority to do it. And I am just wondering if he might clarify since that is an important---- " FOMC20081029meeting--182 180,MR. LACKER.," Right. So the thought that sparks is that, if the mechanism involves creating inflation, then I'd wonder what checks we have on the scale of open market operations now to ensure that we're not, by expanding our balance sheet as much as we have, risking an increase in inflation. " CHRG-111hhrg48868--711 Mr. Liddy," It was never an obligation; again, it was a decision made before I was there. But as I understand it, the representatives of the Federal Reserve and the Treasury believed that AIG's failure would cause a shock to the system, on a worldwide basis, that would be unpalatable. " CHRG-111hhrg51698--431 Mr. Massa," We have great agility in our ability to shift. The point being, sir, you said just because we think it is illegal, we should tolerate it, because it might move overseas. If you could give me an example, singularly or in numerous quantities, of things that this country, based on our value systems, think that are illegal that we have made illegal, that you think we should bring back here because it is being processed or conducted elsewhere in the world, I would love to consider those options. I happen to believe that is a specious argument, and that it is the requirement of this argument to ferret out potentially illegal activity and protect the citizens of this nation. So if you would be willing to engage in a conversation in writing with me on that, I would very much welcome that. Last, not many people understand out of New York how badly New York has been hit by our current financial situation. I am honored to know that Chairman Morelle has been at the forefront of the forensic investigation as to many of the things that have happened. We heard here today a lot of what did not contribute to the failure of AIG. Mr. Morelle, in 1 minute or less, and then perhaps followed up under a special hearing, could you tell me what you think the factors are that did in fact cause the AIG crisis? " CHRG-111shrg53176--53 Mr. Atkins," Thank you very much, Chairman Dodd, Ranking Member Shelby, and Members of the Committee, for inviting me here today to the hearing. It is a great honor for me to be here today, and especially appearing today with two great public servants whom I know very well and admire. This Committee has had a long history of careful study and analysis of matters relating to the financial markets and the financial services industry, and as you have already heard in your hearings, there are multiple, complex, and interrelated causes to the current situation in global financial markets. I believe that these causes are more than the competence or incompetence of individuals in particular roles, but have more to do with fundamental principles of organizational behavior and incentives. Your topic for today is rather broad, so I would like to touch on a few specific items that go to the heart of an agency that I know very well, the Securities and Exchange Commission. With respect to the subject of regulatory reform---- " CHRG-111hhrg54867--130 Secretary Geithner," I agree. I think the legislation has to make sure that it is clear what authority they have and do not have. And one thing we proposed is to make sure they have a board as a check and balance against that risk that has on it representatives of the supervisors and others who have a stake in this. And I think you are right to point out the risks that we overdo it at this time. That was not the failure of the past. The past was probably we under-did it, and that did cause a lot of damage and does put at risk potentially a lot of what was desirable, healthy productive economic activity by financial institutions. So I agree with your concern and I think there are lots of different ways to make sure that you don't create too much unbridled authority that would be damaging to what is an important part of our financial system. " CHRG-110hhrg45625--216 Mr. Meeks," Now, wouldn't it also be wise since we seem to have gotten caught into this situation because only a few people, the large firms are the only ones that had all the money, so therefore the risks were greater because of a few firms? If we would then set it up so that we could diversify the management of those to not only to the big firms, but to some of the smaller and medium sized firms also, that would diversify our risk management so that we don't have the danger of a few people holding all the money, causing all the problems. " FOMC20080724confcall--84 82,MR. EVANS.," Thank you, Mr. Chairman. I am concerned about the credit risk associated with the term lending here, and I suppose if everybody feels comfortable with it, then that would be all right. It does seem, though, that the value of these new programs, much as President Stern just mentioned, seems small. These are temporary facilities exercised under unusual and exigent circumstances. They are currently anticipated to go away. I would think that we should be having big value added from additions to these programs. I wonder a bit about how confident we are about what the market reaction to the introduction of these pretty complicated programs is going to be. Are they going to wonder about what we're looking at versus what they're looking at? These are supposed to be temporary; but the way we add more to it, it seems as if it's going to be more difficult to take this away, at least in terms of the expectations of our borrowers and the markets. We have been doing this as we make comparisons to the ECB and the Bank of England, and they have been doing this for some time. It sort of suggests that this is something that we're going to do for a longer period of time. I am not saying that that might not be the right decision ultimately under the right risk management, but it does seem to be prejudging that a little. Thank you. " CHRG-111hhrg52400--9 Mr. Scott," Thank you very much, Mr. Chairman. I think this, of course, is a very important and timely hearing. The issue is, of course, I think, what is systemic risk as it relates to our insurance industry? And where and how is it best regulated, at the State or Federal level? But I think that the major model that we are using, AIG, is flawed, at its best. Because, as we look back at it, what caused the problem at AIG was their Financial Products Division, based in London, which again was regulated at the Federal level. So the question becomes, if we use a Federal charter, or regulate insurance at the Federal level, would that have prevented the situation at AIG? I think, going forward, we have to be very careful to make sure that the points we take into consideration are these: that we have the sound consumer protections in place; that we also do not deter competition; that we do not bring on excessive operating costs; and, in fact, in our efforts to do some good, that we do something that could very well be dangerous down the road. So, the question becomes, do we do it at the Federal level or the State level? And, of course, as I say, we have to look with a very jaundiced eye, to make sure that we are looking right when it comes to the cause of this at AIG. Because if we did have Federal intervention there, as we had, and it didn't prevent it, what's to say that the Federal charter and Federal regulation is the way to go? I think there is a lot to be said with making sure that we have regulations at the State level that work. Thank you, Mr. Chairman. " CHRG-111hhrg56778--142 Mr. Royce," Thank you, Mr. Chairman. I have a question for Mr. Dilweg. Something you said really got my attention. When you said, well, on these triple-A rated securities, the credit rating agency has given us this assessment. And I just wondered, do you always just outsource to the credit rating agencies these questions? That clearly was a mistake in my view, and another aspect of that, the bond rating agencies or the bond insurance industry. Let me ask you this. Would you like to comment on the failure of the bond insurance industry, especially given that so much of that was in Wisconsin? And what has changed on each of these fronts? You have State regulation on both fronts, bond insurance as well, and we had a failure here to uncover this. Give me your observation on what has changed. " FOMC20080625meeting--136 134,MR. KOHN.," It's very difficult. We don't know what inflation expectations are. We're all using proxies, as came forth very strongly at the Cape Cod conference where we both were, President Plosser. We don't even understand very well how expectations are formed, and I think what we're looking for is how people perceive the cost of capital to finance purchases. So we're wondering whether this low interest rate is causing them to bring purchases forward from the future to the present to induce them to buy things, capital goods, right? That's the interest rate we're really looking at--the perceived cost of credit to folks--and I'm not sure that subtracting any rate of inflation is the way to get that. Obviously, the cost of credit for housing is perceived as hugely high right now. The cost of credit for automobiles is perceived as hugely high for reasons that perhaps aren't related to monetary policy. I don't think we see a surge in purchases of capital equipment that would suggest that businesses perceive the cost of credit to be very negative. So I think, because we don't understand inflation expectations and can't measure them, you have to look for a lot of different things around the edges to confirm what people perceive the real rate to be. I just don't see a lot of information that suggests that people perceive the real rate to be very negative and that it is influencing how they manage their purchases of goods and services over time. " CHRG-109shrg30354--100 Chairman Shelby," Senator Allard. Senator Allard. Thank you, Mr. Chairman. Obviously, we are going through a period of time where there has been a huge relative change in the price of energy. And the most recent period of time when we experienced this great a change would be in the late 1970's. At that particular point in time in our Nation's history, we had double-digit inflation, we had double-digit unemployment, we had double-digit interest rates. In fact, all of this was put together and frequently referred to as the misery index. We have a similar situation today. But when you look at these same figures that we looked at today, our unemployment is 4.6 percent. Our inflation rate is 4.3 percent. Our interest rate is 5 to 6 percent. What is the difference between the late 1970's, when we had this huge increase in energy costs, yet the economy did not respond, and today when we have a huge increase--the economy is still staying very strong. I wondered if you could shed some light on your view on that? " FOMC20071211meeting--52 50,MR. POOLE.," Dave, I want to lump together all the various forms of financial distress here—the mortgage market, auto loans, credit card loans, and maybe even business failures. If my memory serves correctly (and it may well not), if we look at the history of business cycle fluctuations, all those different forms of financial distress rise after a business cycle peak when we have increases in unemployment and actual declines in GDP. Assuming that we are not after a business cycle peak right now, it appears that we have a great deal of financial distress ahead of— I’m hoping it remains ahead of—a business cycle peak. So this is a very atypical situation in the context of U.S. business cycle history." FOMC20080805meeting--27 25,CHAIRMAN BERNANKE.," Thank you. I guess I would comment that there is an asymmetry here, which is the possibility of systemic risk. There are situations in which failures--major collapses of certain markets--can have discontinuous and large effects on the economy. We have seen that in many contexts across a large number of countries. These stresses do reflect the working out of equilibriums given fundamental losses, which we can't do very much or anything about. But they do create machinery that is less flexible and less able to respond to new shocks, and that raises systemic risk. That is the risk that we want to try to minimize, even as we allow the markets to work their way through and to price the changes we have seen. " CHRG-111shrg56262--45 Mr. Miller," I would agree. I don't think it is desirable to legislate or regulate underwriting standards per se. I do think it is important, though, for those involved in credit underwriting functions, and I am thinking specifically in the residential mortgage market, for those involved in those activities--mortgage lenders, brokers, and others--to be subject to the same type of regulation so that you have a level playing field and consistent standards that apply to all who are engaged in those functions. Ms. McCoy. I am forced to disagree. We saw a situation in which the residential mortgage lending industry was unable to organize self-regulation, and, in fact, engaged in a race to the bottom in lending standards, which was aided and abetted by our fragmented regulatory system which, as Senator Bunning noted, refused to impose strong standards. That is how we got in this mess, and I think the only way that we prevent that from happening is to have some basic common sense standards that apply to all lenders in all States from the Federal Government. To my mind, the most important one is require borrowers to produce documentation that they have the ability to repay the loan at inception. That is common sense. We don't have to obsess about down payment requirements. But that, to me, is essential. Senator Gregg. I don't want to--doesn't that go to recourse? I mean, should there be recourse? Ms. McCoy. Against the borrower? Senator Gregg. Right. Should that be a standard that we subscribe to in this country, which we don't now? Ms. McCoy. Well, some States do subscribe to it. It depends on the State. Senator Gregg. Well, is it a good idea or bad idea? Ms. McCoy. I think right now, it is causing people who have already lost their houses to be pushed further into crisis and it is not helping the situation right now. Senator Gregg. And didn't this push to the bottom--wasn't the shove given by the Congress with the CRA and the way it set up Fannie Mae and Freddie Mac as basically guaranteed entities? Ms. McCoy. Actually, CRA loans have turned out to perform pretty well, and one of the reasons is that banks held them in portfolios so that those higher underwriting standards actually applied to CRA loans. They have been a success story among different classes of loans. Fannie Mae and Freddie Mac, I agree, they cut their underwriting standards, but they joined the bandwagon late. The private label nonconforming loans created a strong competitive threat that they felt necessary to meet, and so they were not the cause of the problem, although they did join the bandwagon. Senator Gregg. Thank you. " CHRG-111shrg53176--33 Chairman Dodd," Thank you very much, Senator. Senator Martinez. Senator Martinez. Thank you, Mr. Chairman. Madam Chairwoman, I wanted to follow up on a question that Senator Johanns had asked regarding the Madoff situation, and that is not really where I was going, but I heard your response, and it sparked the old lawyer in me. I just wanted to ask, when you said that if not resources, it was not resources that prevented the SEC from more aggressively pursuing the Madoff matter, then you went into a series of more technical issues involved in that. But if it was not resources, that goes to some other motivation. What do you attribute that to? Ms. Schapiro. What I intended to say is that I do not lay the problems with Madoff solely at the foot of a lack of resources. The information came into the agency over a period of years. It is not clear to me yet--and we have, obviously, an Inspector General review ongoing right now--whether it was people who received the information did not understand the import of it and, therefore, did not pursue it, or they did not send it to the right people who could understand it and analyze the data that was contained therein. We have very disparate processes throughout the agency around the country in all of our offices for how we handle the massive amounts of data that come into the agency. Whether it fell through the cracks or somebody just did not understand what they were doing, I cannot--I do not know. I would tell---- Senator Martinez. So you do not know at this point. You are still undergoing an investigation. You have not reached a conclusion. Ms. Schapiro. No. Senator Martinez. You just do not think it was a lack of resources as such. It was more about either an understanding of it or an unwillingness to understand it or it just did not get to the right person. Ms. Schapiro. It is one of those things, and my view is that we will fix all of those things, on the assumption that it is one of those things that has caused the agency not to pursue that information when it came in the door. Senator Martinez. The issue I really wanted to get to is the issue of systemic risk. I know there has been some commentary from the Secretary of the Treasury about this as part of this new regulatory situation, and I wondered if you could define for us how you view systemic risk. In the old days of, you know, Fannie and Freddie concerns, obviously their size was a concern, and view them by size alone as perhaps posing a systemic risk. I think that has been proven all too much to be true. And also their capital requirements were fairly thin, which I think also made them, again, a systemic risk. How do you define what is the systemic risk that we need to be looking for? Ms. Schapiro. That is probably the $64,000 question, because I think how you define it matters very much in how we ultimately structure any kind of a systemic risk regulator. Certainly, size would be a component. Relationship to other important financial institutions within our economy or---- Senator Martinez. Interlink between those? Ms. Schapiro. Interdependency or interlinkage; the amount of leverage. I think it matters very much how we define it, because there are a lot of criteria that can go to this issue, and how we define it will define how we regulate it. And whether we have a monolithic approach, a college of regulators approach, or a functional approach with some kind of overlay of systemic risk oversight that monitors exposures, perhaps requires the reduction of leverage, requires other prudential capital or other standards to be put in place, those definitions matter greatly. Senator Martinez. How do you think we will come to a definition? Is this something that the Secretary of the Treasury is going to define for us? Or is that part of what we---- Ms. Schapiro. Well, I hope the Congress will be very much engaged in coming to that definition and that the other regulatory agencies that have profound responsibilities for components of the financial regulatory system will be engaged in that process as well. " CHRG-111hhrg54872--24 Mr. Ellison," Thank you, Mr. Chairman. One of the most important causes of the financial crisis was the complete and utter failure of our system of consumer financial protection. The most abusive and predatory lenders were not federally regulated, while regulation was overly lax for banks and other institutions that were covered. To address this problem, we need a new agency dedicated to consumer financial protection, a Consumer Financial Protection Agency. Of course there are some who would like to keep the same regulators on the job and thereby duct-tape together the shards of a broken system. Anyone who wants to take this bankrupt approach should read the Washington Post article from this last Sunday, which I will submit for the record, that discussed the Fed's failures to act on consumer protection. Those failures were so great that even former Fed Chairman Alan Greenspan has backtracked and said the Administration's proposal is probably the ``right decision'' regarding a Consumer Financial Protection Agency. Of course, that initial proposal was not perfect, but we will continue to work on it over the weeks ahead. I yield back. Thank you. " CHRG-111shrg55739--39 Mr. Barr," That is very old fashioned of you, Senator. Senator Corker. Yes. Thank you for that, actually. [Laughter.] Senator Corker. I do wonder whether we should consider a different payment mechanism, where in essence the credit rating agencies have skin in the game over time. And then instead of being paid up front, they are paid based on how it performs. We have talked about that a little bit with mortgage brokers and others who have had no skin in the game. And I wonder if you might comment on that. And I think some folks, some colleagues in the other body, on the other side of the aisle, have actually been promoting something called covered bonds, where in essence, instead of getting all of this risk off banks' balance sheets, they in essence are in the game all the way through. I wonder if you might comment on those two, and thank you for your testimony. In spite of some of the differences we have, and there is not time to enumerate all those right now, I do look forward to working with you and others to come up with something that is in the middle of the road. " CHRG-109shrg24852--77 Chairman Shelby," Mr. Chairman, your testimony also discussed at length what others have referred to as the savings glut. One factor you note is corporate behavior and the softness in capital investment. This is particularly puzzling in light of strong profits in the corporate sector and lower interest rates. Could you touch further on the potential causes of this behavior and whether our Nation's economy has ever experienced similar circumstances? Should the situation persist, how would this affect the Federal Reserve's growth projections? " CHRG-110shrg50420--382 Mr. Zandi," Sure. Point one is that the Federal Government should provide aid. Without it, they would go into liquidation, there would be mass layoffs, and at this point in our economy's economic situation, that would be extremely damaging. So I don't think you have a choice. Point two is that the cost of ensuring that the auto makers don't go into bankruptcy at some point in the next couple of years is going to end up being measurably higher than $34 billion. I give you a range of $75 to $125 billion, but I think the odds are high that it is going to be measurably more than---- Senator Carper. I saw that number and I wondered, does the higher number, your higher number, $75 or $125 billion, does that include the so-called Section 136 money which we have already offered---- " CHRG-111hhrg56847--207 Mr. Bernanke," Well, the main thing we are doing, of course, is that we have purchased a large amount of mortgage-backed securities guaranteed by the government-sponsored enterprises. And right now, the 30-year mortgage rate is about 4.8 percent, so that is clearly going to make it accessible. Affordability right now in terms of house prices and interest rates is about the best it has been for a very long time. You are right that the large amount of vacant and foreclosed properties is a major drag, particularly in some areas of the country. And I agree with Ms. Kaptur on this issue that we need to work with the Treasury and with the banks to do what we can to get these resolved as quickly as possible, whether it is through renegotiation of the mortgage, whether it is through a short sale or however it is done to get people situated and allow those houses to be turned over in the marketplace. So we are working to try to manage that situation. But that is clearly a big overhang for the housing market. " CHRG-111shrg54789--43 Mr. Barr," That is correct. Senator Merkley. Second, I wanted to ask you about a phrase, there is a set of tests in the law for what can be done, and to quote, ``The agency must have a reasonable basis to conclude that the act or practices cause or are likely to cause substantial injury to consumers which is not reasonably avoidable by consumers, and such substantial injury is not outweighed by countervailing benefits.'' So we have a ``substantial'' test, a ``not reasonably avoidable'' test, and a ``not outweighed by countervailing benefits.'' Can you expand a little bit on those, and particularly this ``not reasonably avoidable''? And let me give you an example. I have a constituent, an elderly constituent, who cashed in a check that came in the mail that was from an established financial institution that he did business with. He thought it was related to simply a refund of an excess escrow fees or something of that nature. And, in fact, what it was in the fine print on the back was a high-interest loan--a very high-interest loan. And then the bank turned around and asked him to consolidate that loan with his other debt, and he ended up converting basically a very sound financial situation in short order into a situation that destroyed his equity in short order. But one could argue that he could reasonably have avoided that by simply not depositing the check, that he could have read all of the fine print on the back of the check and made sure he understood it. How does this test work in kind of the real world? " CHRG-110hhrg46594--481 Mr. Foster," Thank you. First, I was wondering if you could give us some estimate of what you consider the aggregate overcapacity of the automobile industry and just in normal economic times right now in terms of the--the aggregate overcapacity. I think there is a general consensus that even if things are maintained, you know, relatively normal economic conditions, there was an overcapacity both in terms of the number of vehicles built per year, the number of dealerships, the number of brands supported by the manufacturers and so on. And so you could talk about those in optimistic scenarios in which things return to normal or pessimistic ones in which they continue. And I was wondering if you have any numbers on that. " CHRG-111hhrg48873--40 Mr. Bernanke," Quite differently. It could have been taken into receivership or conservatorship. This bonus issue would not have arisen because all the contracts could have been adjusted by the conservator. As necessary, we could have taken haircuts against some of the counterparties without creating a default or disorderly situation. So it is very similar, as you pointed out, to the way the FDIC would now handle an IndyMac, for example, and with some disruption obviously but not nearly the consequences of a failure, of a disorderly failure of a large insurance company. " 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? " CHRG-110hhrg44901--2 The Chairman," The hearing will come to order. This is a hearing pursuant to law on monetary policy and the state of the economy. It is one of two hearings we have every year according to statute on the state of the economy under the Humphrey-Hawkins Act. Let me say preliminarily before we get into the opening statements that there was a good deal of interest in the recent proposal from the Bush Administration involving some standby financial authority for dealing with the situation in Fannie Mae and Freddie Mac. Obviously, Members are free to ask whatever they wish. I intend to focus here on the macroeconomy. We did, of course, have the Chairman before us last week on the Board of Regulatory Authorities. Members are free to ask, obviously, whatever they wish. I would note that the official subject is the macroeconomy, and that is what I intend to discuss. Members will use their time as they wish. We will have four opening statements; two 5-minute statements by myself and the ranking member, and two 3-minute statements from the chairman and the ranking member of the subcommittee. I will begin my statement now, so we can start the clock. I am sorry; kill the clock for a minute. Let me also explain that on the Democratic side--I take from the ranking member the order in which questions are asked on their side--we have been following the procedure of going first in this hearing to members who did not get reached when we did the questioning in the first hearing this year. So we will begin with those members who did not get a chance to ask questions during the first round. With that, we will start the clock, and I will begin my statement. I want to focus on the very difficult situation facing a great majority of Americans, people who work for other people for a living. Unemployment this year has become a serious problem. If you look at the numbers for the unemployment figures, if the second half of this year is not better economically than the first half, and I don't see any reasons to believe that it will be, although we obviously hope it will be, but if the numbers on unemployment in the second half are no better than the first half, we are on track to lose nearly 1 million jobs this year, which means 1 million fewer people on the official employment rolls than at the beginning of the year. It is not only a case of jobs being lost. There is also a continued erosion in the real earnings per hour of working people. We had a debate in this country, in this committee, for several years about whether that was true or not. It is now conceded that even in those periods when we were generating wealth, and this continues to be a wealthy country with a great capacity to generate wealth through our free markets, the distribution was badly skewed. No one expects equality. Equality is not a good thing, and you can't have an economy that works if everything is equal. But too much inequality also has negative consequences. Former Commerce Secretary Don Evans, a close friend of the President, commissioned a study which showed how the overwhelming majority of the wealth generated in the good times went to a handful of people. Here is the report of the Federal Reserve, the Monetary Policy Report to the Congress, dated yesterday, when Chairman Bernanke testified first before the Senate. On page 20, the section begins: ``Productivity and Labor Compensation. Gains in labor productivity have moved up significantly.'' Let me go to page 21. People who wonder about the state of people's feelings are those who think that the American people are just whiners and that the troubles are all in their mind. For those who wonder why we have resistance to further globalization without changes in the basic policies of this country, this sentence should help them understand it. This is a direct quote from the Monetary Report on page 21: ``Broad measures of hourly labor compensation have not kept pace with the rapid increases in both overall consumer prices and labor productivity, despite a labor market that, until recently, had been generally tight.'' I want to emphasize, hourly labor compensation has not kept pace either with consumer prices or with productivity. People who worry about inflation should understand from this that no part of the blame for inflation, if it comes, can be put on workers, because, as the Chairman has acknowledged previously, and as economists understand, wages which rise along with productivity at the same level are not inflationary. We have increased productivity and compensation lagging productivity. Working Americans are producing more wealth for this country than they are being allowed to share, and that has been exacerbated by the fact that prices are going up. So the situation, according to the report of the Federal Reserve, is one in which workers have increased their productivity, in cooperation with the employers, and have failed to be compensated either to keep up with the productivity or to keep up with prices. The point to the business community is very clear. How can you understand this, how can you look at our being on track to lose nearly a million jobs this year, how can you note that workers are getting less compensation than they are earning for the economy and less than is needed to come up with prices, and wonder why you can't get trade bills through, wonder why there is resistance to outsourcing? I believe that full participation in the global economy is a good thing, but if it continues to go forward on terms which give a disproportionate share of the benefits to a relatively small number, and the great majority are not simply even--even here, they are falling behind, despite increased productivity, then we have to stop and get our own house in order before we go further. I now recognize the gentleman from Alabama. " FinancialCrisisInquiry--154 THOMPSON: So a bubble mentality. BASS: Well, do we prick the bubble or not? All right? THOMPSON: Mr. Mayo? MAYO: Yes, three things. Number one, I went back. I did a thousand-page report in 1999, and, right upfront, I talked about what—the real estate situation and how that could fall out and cause a lot of difficulties. So I had to think about why did I put that in there. And I remembered, because every—not every—many management presentations I went to—we as analysts sit in an audience, hear what the company wants to do over the next three, five years. Many management presentations I went to, they said, “We want to expand home equity.” “We want to expand home equity.” “We want to expand home equity.” And so, they all had the same goal. So the goal by itself may have made sense. They just weren’t paying enough attention to what their competition was doing. By the way, the same thing happened with branches. Right? They said, “Oh, I think there’s a good spot for a branch,” they just weren’t anticipating the other two or three banks also opening up a branch on that corner. Right? So that’s what happened in home equity, and that was certainly a tipoff to me. And that is a tipoff that might not have been gotten by the regulators that early, but analysts who were going to all these meetings would get that. The second thing would be deposit insurance. I’ve written about this nonstop since 1994. And in the early part of this decade, I thought it would be increased. It wasn’t. I was wrong. And some of my clients, you know, reminded me of that. CHRG-110hhrg34673--24 Mr. Kanjorski," Do you have any opinion as to the United Kingdom's approach of actually enacting advisory opinions expressed by shareholders and whether or not that has had any positive effect on the reduction of some of these packages and/or other shareholders rights, litigation, and other things that may have been modified? When you look at the numbers, the U.K. is significantly lower than the American market. We are wondering whether that is something that has been reviewed by the Federal Reserve? " FOMC20050503meeting--53 51,MR. MOSKOW.," You now have higher energy prices built into the forecast—significantly higher energy prices—and the futures market does, too. I’m just wondering if you could talk about how that factors into your thinking about potential output going forward." CHRG-110shrg50409--10 Mr. Bernanke," Mr. Chairman, I think that the central issue in the economic situation right now is the housing market. It is the continued uncertainty about house prices and housing activity which is creating financial stress, is affecting consumer wealth and consumer expectations and causing the stress we are seeing in the economy. So my suggestion would be in the near term to focus on issues related to housing. I understand that you have already passed a bill that would address, for example, GSE reform. We need the GSEs to continue to be active in supporting the mortgage markets, as well as FHA modernization and other steps that Congress determines would strengthen and support mortgage finance in the housing sector. I think that is the most critical central issue we face. On a second stimulus package, my own sense is that we are still trying to assess the effects of the first round. It appears that it does seem to be helping. But it might be a bit more time before we fully understand the extent to which additional stimulus may or may not be needed. If additional stimulus is, in fact, invoked, it would be important to find programs that would be, as in the first round, timely, temporary, and targeted, in particular, that would take place quickly and would put money into the economy relatively quickly. In the case of infrastructure, it is often well justified on its merits, but one would have to ask whether the flow of funding would go into the economy in a relatively prompt way, or would there be long delays associated with the planning process? " FOMC20070807meeting--35 33,MR. DUDLEY.," Two areas of the asset-backed commercial paper market are being closely scrutinized, which means that a whole bunch of the asset-backed commercial paper market is fine, such as the asset-backed commercial paper with backstops—you know, credit card receivables. That area is fine; it is not a problem. One difficult area is the extendable commercial paper programs that are funding some of the stuff that is very illiquid right now. The risk is that investors, typically money market mutual funds, will look at the situation and say, “Gee, if they can’t roll over commercial paper, my commercial paper investment will automatically be extended to a longer maturity.” They are worried about the headline risk of that. They are also worried—and it is hard to know how worried—that there is no guarantee that the extended commercial paper would necessarily trade at par. If it traded below par, then they would have to worry about breaking the buck, which is the last thing they want to do. So the risk is that the investors, who are quite risk averse in the commercial paper market in this area, will pull back and that very pulling back will cause extension. That is what was happening yesterday. Apparently a couple of commercial paper programs were extended. Now, does extension mean anything really necessarily bad? It is not clear. It hasn’t happened before, and so we really haven’t experienced how this extension process is going to work. These programs are backstops in various forms. At the end of the day, the commercial paper holders should come out whole; but until that is demonstrated, you can imagine that the extensions could cause other people to pull back. So there is a risk of a cascading of extensions that has crossed all of these extendable commercial paper products. That is a risk. You know, it is an interesting tension right now because the large investors know that, if they don’t roll, they’ll probably be extended. So at the current time, most of them are continuing to roll so that they don’t get stuck with extended commercial paper. But this situation is very fragile day to day. The second area is more complex—structured investment finance vehicles that basically fund pipelines of highly rated CDO and CLO kind of stuff. I can’t say I fully appreciate exactly how this structure works, but basically there is some risk that the collateral values of these structures could fall below certain thresholds. In that case, the securities would have to be liquidated. Again, commercial paper investors are saying, “Do I really want to see what this means?” So they are pulling back from that market as well. Of the two, the extendable commercial paper issue seems to be the more immediate one in the market’s attention, but the SIV asset-backed commercial paper is also an ongoing issue." CHRG-111hhrg51698--369 Mr. Short," If I could add one point, the whole issue arises because there is a limit in the amount that a price can move in the cotton contract, and the situation that was faced by the exchange was we hit the limit and the OTC market and options markets were indicating that the real price was going well above that limit. From the standpoint of properly margining positions in the clearinghouse, we have to protect all market participants. We used the synthetic price indicated by the options price rather than where the futures price cut off. From our perspective we were trying to do what was right from the standpoint of risk management. " FOMC20050630meeting--166 164,MR. KOHN.," Thank you, Mr. Chairman. I have three questions. The first one is on the price-to-rent ratio. We’ve been treating it as if most of the adjustment has come on prices. And I wanted to ask Josh particularly whether, as you’ve been looking at the micro data and thinking about this, the dynamics of some of these innovations that have led to a shift from renting to home ownership might have artificially depressed rents relative to prices. And I wondered, after that shift is over, if rents will start rising faster and close the gap that way—use up some of that 20 percent. My question is what you thought of that. And my observation is that that would present a much more difficult situation for us sitting around this table. It would be kind of like a supply shock because prices would be rising, inflation would be higher—and that homeowners’ equivalent rent June 29-30, 2005 54 of 234 if house prices fall. That’s a pure demand shock. But if rents start rising, that’s another matter. So I wondered if you’d comment on that. And then, while I have the floor, let me ask my questions of Glenn and John. Glenn, on the 1994 bubble analogy, I was surprised to see that classified as a bubble. I think there was some inflation scare then, but there was also a real rate adjustment at the same time. If you looked at any of the surveys, I think you wouldn’t have seen much of an increase in inflation expectations. I agree that we had to raise real rates in order to prevent that from happening. But that seems to me a very different animal than equity price changes or house-price changes because we are responsible for inflation. So if we see inflation moving, we’ve got to do something about that, whereas we’re not responsible for the relative prices of houses or equity and other things. So I wouldn’t have put 1994 on a list of situations we might think about as we’re looking at this issue of house-price gains. It seems to me very different. I’d like to hear your comment on that. And finally, my other question for John has to do with this point about the misallocation of resources. Doesn’t it matter what the state of the business cycle is? If we hadn’t had so many houses built and so much consumption over the last few years, we would have had more unemployment. So it’s not obvious that resources have been misallocated. The resources that went into building houses, furniture, and cars, and so forth might have been unemployed, especially if we had raised rates more in order to lean against the house-price increases. If we had, surely unemployment would be higher. So it seems to me that it’s one thing to talk about misallocating resources between two states of full employment, but it’s another thing to talk about a misallocation of resources where there would otherwise be slack in the economy. And the latter case I don’t think really is a misallocation of resources. There’s no opportunity cost. June 29-30, 2005 55 of 234 I’ve looked at the rent side of the picture. As to this idea that perhaps prices are getting too high relative to rents, I’d argue that they’re going to come back in line. Now, maybe rents are going to be doing some of the correcting, as it were. The work that I’ve done gives just a little hint of evidence that maybe rents do a bit of the correcting. So, what we might see going forward is rent growth slightly higher than it otherwise would have been. But statistically speaking, it’s basically no different from zero. Statistically, it doesn’t look like rents do any of the correcting. What really seems to be happening is that rents go up at some rate determined by economic conditions and then prices move around them." CHRG-111shrg57709--186 Mr. Volcker," That is correct. And they have--because there are so few, the competitor situation is quite different because it is a stable oligopoly. Senator Schumer. Right. Any other lessons you might draw from the Canadian situation? " CHRG-110hhrg46591--105 Mr. Barrett," Thank you, Mr. Chairman. Panel, thank you for being here today. I love the idea about the select committee and I think that is a great way to start. But Mr. Johnson, let's start with you. I am sitting on the select committee and you are giving me advice today. The goal of the Federal regulation should be what, stability and growth, or to ensure that fraud and malfeasance are punished? And of the current situation, how much has been caused by lack of enforcement or lack of effective regulations? " CHRG-111hhrg56776--208 Mr. Scott," Thank you very much, Mr. Chairman. And welcome to both Chairman Bernanke and Chairman Volcker. Let me ask you, Chairman Bernanke, as we grapple with this whole issue of stripping the Fed of its supervisory authority and concentrating on the larger banks only--and I must admit, you make a good argument, but I'm torn for this one reason. Let me give you an example where there has been a massive failure on the part of the Fed, in my opinion, to be able to handle both the big banks and the smaller banks. I represent the State of Georgia. And in the State of Georgia, over the last 36 months, there have been 27 bank failures of these smaller banks. And that accounted for 26 percent of all of the bank failures in this country, 1 State. The issue becomes, where was the Fed in this? Is this not a sign of a realization as to why maybe we're asking too much of the Fed, as we move into this new economic climate? And I'm wondering, where was the Fed? How did this happen under your watch, where 1 State accounted for 26 percent of all the bank failures, and over a short period of just 36 months, 27 banks failed in 1 State? " FinancialCrisisInquiry--741 ZANDI: Well, my interpretation of this discussion is what is the root cause of this mess? And my answer is there are many—it’s a mélange of problems. But three things—first is the surfeit of global saving, which provided the fodder for all this lending. Second was the failure of the process of securitization. The intent of securitization was to take all this global saving and funnel it into good loans, and it failed to do that. And there are a lot of bad actors in that process. And then third was the regulatory failure. There was no regulatory oversight, and this is where I would agree with—with Ken. That the key regulator is the Federal Reserve. It failed in that process. CHRG-111hhrg48867--303 Mr. Green," All right. And if you realize that AIG is a cause of or may be a cause of systemic risk, would you not want to prevent AIG from being a systemic risk, creating a systemic risk? " FOMC20060328meeting--75 73,MS. JOHNSON.," Well, again, over a longer period, I think we face a real energy issue as a global economy. And I find it very hard to believe that energy prices are, in fact, going to be five or six or seven or eight years from now where that far-dated futures price is putting them right now. But I’m sure they’ll go both up and down in between. And for the period over which monetary policy is made, I can’t do better than what the markets are seeing. I am expecting that, over time, the standard of living of many, many, many people on the planet is going to rise. And I’m assuming that the rise will imply some overall higher consumption of energy per capita and that the higher prices are indeed precisely what we need to stimulate new technologies, to stimulate substitutions in all the right places. It will be because the economy is growing that prices of energy will go up, not because the economy is somehow going to get in trouble. Other things can also arise. The political situation in China is by no means guaranteed. I may be a bit more concerned than others about this subject, but I see no reason not to think that we’ll have another bad hurricane season. I just don’t know why people don’t see serial correlation in what’s going on with the hurricanes. Not only in the Caribbean but around the world, we’re seeing more and more weather-driven phenomena owing to the higher temperature in the oceans and various other things. But I don’t see endogenous weaknesses. I think the global economy in a very fundamental sense actually has balanced risks—many of the worst shortcomings in many of the economies with whom we trade, both financially and in real goods and services, have been fixed. I think the conduct of policy is better, broadly speaking. I think we could have a very good five years. I can’t put my finger on anything that in the next five years is inevitably bound to cause us a problem. But I think that over some long period, as more and more people have higher standards of living, we are going to have a big change in relative prices. And some economies are going to do a better job of absorbing those relative prices than others. But the U.S. economy might do one of the best jobs in absorbing those relative price changes." CHRG-111shrg50814--163 Mr. Bernanke," Call it public-private partnership. It is not nationalization because the banks will not be wholly owned or probably not even majority owned by the government. The government will be a shareholder, along with private shareholders---- Senator Corker. But you are putting in a mechanism to where our common equity holdings will be large by virtue of creating this convertible preferred situation and you know that the losses are coming because you are going to do this stress test. I mean, that is why you are putting this vehicle in place. And I do wonder how we ever get to the end game where in essence there are, in fact, people willing to buy common shares. I mean, I can't imagine in these 19 or 20 institutions anybody, after hearing this statement today, which maybe you have said it before and I hadn't heard it, but why would anybody go buy common shares in banks today in those 19 or 20? Why would anybody do it? " FinancialCrisisInquiry--490 HENNESSEY: My apologies. Can you compare the—can you compare Fannie and Freddie, what happened with them to the failures at other large financial institutions? I’m interested in both the competence of management, the risks that they took, and the impacts on the financial system of their failure. As—as we look at what are the causes of the financial crisis and we have to figure out how to allocate our time and other resources, looking into the failure at WaMu or the failure at, you know, Lehman or Bear Stearns and Fannie and Freddie, can you give us a sense how important were those firms relative to other failures, and can you also give us January 13, 2010 a sense of how should we—we’ve heard a lot; we’ve been talking a lot about ability to manage risks and about the risks that they were taking. Can you give us some sense of comparison? Maybe—Mr. Bass, I know you’ve talked about it a lot. fcic_final_report_full--423 CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS CONTENTS Introduction ......................................................................................................  How Our Approach Differs from Others’ .........................................................  Stages of the Crisis .............................................................................................  The Ten Essential Causes of the Financial and Economic Crisis .......................  The Credit Bubble: Global Capital Flows, Underpriced Risk, and Federal Reserve Policy ................................................................................  The Housing Bubble .........................................................................................  Turning Bad Mortgages into Toxic Financial Assets .........................................  Big Bank Bets and Why Banks Failed ...............................................................  Two Types of Systemic Failure ...........................................................................  The Shock and the Panic ...................................................................................  The System Freezing .........................................................................................  INTRODUCTION We have identified ten causes that are essential to explaining the crisis. In this dis- senting view: • We explain how our approach differs from others’; • We briefly describe the stages of the crisis; • We list the ten essential causes of the crisis; and • We walk through each cause in a bit more detail. We find areas of agreement with the majority’s conclusions, but unfortunately the areas of disagreement are significant enough that we dissent and present our views in this report. We wish to compliment the Commission staff for their investigative work. In many ways it helped shape our thinking and conclusions. Due to a length limitation recently imposed upon us by six members of the Com- mission,  this report focuses only on the causes essential to explaining the crisis. We regret that the limitation means that several important topics that deserve a much fuller discussion get only a brief mention here.  CHRG-111hhrg54872--180 Mr. Scott," Thank you, Mr. Chairman. I would just like to kind of focus my remarks on unintended consequences, one-size-fits-all dangers of this, as well as the confusion between State and Federal laws as we move forward. It is an important legislation. Let's take my first problem of unintended consequences and whether or not this would work, particularly with some unique situations. I am sure you all are familiar with the Farm Credit Administration. The Farm Credit Administration is very, very unique. They already have what they call a borrowers' bills of rights, which basically covers much of what we are attempting to do in this bill, resulting in if they were into this duplicatory obligations, burdensome regulatory concerns as well. Consumer lending is a very, very small part of what they do. Mortgage lending, for example, is only allowed in communities with less than 2,500 individuals. Their products were not anywhere near the toxic level that caused the problem in the first place. So my question is, would not we be doing a better service here if we allowed the farm credit to continue to operate under its own current regulatory process away from this legislation? I take it all of you agree that it would be the best thing to do in this situation, to allow farm credit. The reason I mention that is, also, farm credit does not come under the jurisdiction of financial services. It is an agricultural area. And I am simply saying that it makes sense--this is a complex, complicated area, covers a lot of the waterfront when we are dealing with the financial services industry. And it might be wise as we move forward with this to look inward-outward instead of outward-inward. And I think that what I am getting from the committee here is that you agree that the Farm Credit Administration should be left away from this or doing what they are doing with the bill of rights; weren't a part of the problem in the first place; and this would be a duplication. " CHRG-111hhrg48868--406 Mr. Liddy," Sir, that is what I have attempted to set in motion this morning; I have asked the folks at AIG FP to, in fact, return that money, give it back, at least 50 percent of it, and for the leadership group, 100 percent of it. The issue I have, I never got a chance a moment ago to fully explain the legal side of it. And I'm not one who hides behind the legal aspect of this. What we can't do is have a group of individuals or have an event which causes AIG FP to get into a situation of cross-default. If it does that, it will be bankruptcy and it won't be a very good picture. " CHRG-111hhrg51698--588 Mr. Rosen," Right. In that event, you are left to requiring that the CFTC have transparent insights into the positions that affect those markets. And clearly the linkages that exist between the various markets are critical to that, including the over-the-counter positions, but also physical positions. I think if you had a position in that approach which didn't take into account physical provisions, which many people would observe have a more direct influence or ability to influence prices and market liquidity and available supply, is going to be an inadequate tool. Having said that, I don't think you would have any choice if you were trying to give the CFTC the tools that it needed to deal with situations where the conclusion was reached that markets are disorderly as a result of this excessive speculation. You would have to give the CFTC the ability, and it may already have this under the statute, to go in and say these we are putting position limits on, or reducing them, or reducing the amount that you can take advantage of during this period while the markets are exhibiting this pricing behavior, I think it is a situation---- " fcic_final_report_full--426 These facts tell us that our explanation for the credit bubble should focus on fac- tors common to both the United States and Europe, that the credit bubble is likely an essential cause of the U.S. housing bubble, and that U.S. housing policy is by itself an insufficient explanation of the crisis. Furthermore, any explanation that relies too heavily on a unique element of the U.S. regulatory or supervisory system is likely to be insufficient to explain why the same thing happened in parts of Europe. This moves inadequate international capital and liquidity standards up our list of causes, and it moves the differences between the regulation of U.S. commercial and invest- ment banks down that list. Applying these international comparisons directly to the majority’s conclusions provokes these questions: • If the political influence of the financial sector in Washington was an essential cause of the crisis, how does that explain similar financial institution failures in the United Kingdom, Germany, Iceland, Belgium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark? • How can the “runaway mortgage securitization train” detailed in the majority’s report explain housing bubbles in Spain, Australia, and the United Kingdom, countries with mortgage finance systems vastly different than that in the United States? • How can the corporate and regulatory structures of investment banks explain the decisions of many U.S. commercial banks, several large American univer- sity endowments, and some state public employee pension funds, not to men- tion a number of large and midsize German banks, to take on too much U.S. housing risk? • How did former Fed Chairman Alan Greenspan’s “deregulatory ideology” also precipitate bank regulatory failures across Europe? Not all of these factors identified by the majority were irrelevant; they were just not essential. The Commission’s statutory mission is “to examine the causes, domestic and global, of the current financial and economic crisis in the United States.” By fo- cusing too narrowly on U.S. regulatory policy and supervision, ignoring interna- tional parallels, emphasizing only arguments for greater regulation, failing to prioritize the causes, and failing to distinguish sufficiently between causes and ef- fects, the majority’s report is unbalanced and leads to incorrect conclusions about what caused the crisis. We begin our explanation by briefly describing the stages of the crisis. CHRG-111shrg55117--78 Mr. Bernanke," No, and I don't really think that is--that is not my interpretation of the Treasury's proposal. I think that the idea would be to have something analogous to the current FDIC laws which allows the FDIC to intervene before the actual failure, seize the company, sell off assets and so on in order to avoid a costly bankruptcy. Senator Corker. Back to the independence issue. I know there has been discussion about the Fed being the systemic regulator, and I guess one of my major concerns is you have received criticism here today about activities that have taken place. I find it difficult to believe that anybody, even as intelligent as you are, can actually look out and see what all systemic risks are, and I see that as not possible. I mean, there are going to be other failures down the road, I think we know that, regardless of what we do. That is the way the market works. I guess I have a fear that if you become, or if the Fed becomes a systemic regulator and you miss it and you are, it is going to happen again, we all know that, that that will create an opportunity for even further attacks, if you will, on your independence, and I wonder how you might respond to that. " CHRG-110hhrg45625--120 Secretary Paulson," I would just say that he should be angry and he should be scared. I think right now he is more angry than he is scared. It puts us in a difficult position because no one likes to be painting an overly dire picture and scaring people. But the fact is that if the financial markets are not stabilized, the situation can be very severe as it relates to not just his current situation, but keeping his job, his retirement account, investment in equities and securities, his ability to borrow. So this is a serious situation, and it is one he should be concerned about, and we need to figure out how to communicate better. " CHRG-111hhrg48867--179 Mr. Price," So somebody in the wonderful buildings around here will determine whether or not a financial institution ought to have explicit support of the Federal Government. Is that what you are saying? " FOMC20070321meeting--12 10,MR. DUDLEY.," You’re absolutely right. The market was much smaller at that time. I would characterize the deterioration that you saw in 2001 as probably mostly driven by the macroeconomy, and the deterioration that you saw in 2006 as driven mostly by two things: more laxity in the underwriting process and a change in the trajectory of home prices. So I think the causes of the deterioration in the two cases were quite different. The subprime mortgage market in 2006 is several times the size of the originations in 2001; so obviously it will have a bigger consequence." FOMC20060808meeting--29 27,MS. MINEHAN.," I have a follow-on question to Sandy’s. I know how the benchmark GDP revisions work into your forecast. But if you look just at the headline numbers, we seem to have the worst of all circumstances for a central bank: a good deal slower growth for a number of reasons—the benchmark being one of them—even though all the output gaps and everything else remain relatively the same, slower headline growth in both GDP and consumption, and higher inflation. This is not an easy set of circumstances by any means. One thing I am concerned about, like Sandy, is the speed with which you have consumers reacting in their consumption to potential GDP changes. You haven’t changed the saving rate that much from your earlier forecast, but you do get the 0.3 percentage point out of GDP growth. I was just wondering about your thoughts on that—the reaction seemed fast. Second, outside of a recession, have we ever seen this kind of decline in real estate investment in a period of growth? We were trying to find it, but it’s hard to sort through cause and effect here. The decline seemed very large in terms of the negative real estate investment. Finally, Karen mentioned that we haven’t seen wage inflation or wage growth outstrip productivity here or in major countries anywhere else in the world. I’m wondering, given all the focus on the fact that median family incomes are not growing on a real basis, whether there is at least some chance that we’re going to start seeing an increasing return, particularly for skilled people, which everybody tells you they can’t find." CHRG-111shrg53822--24 Mr. Stern," Well, I think there are several aspects to that. One is, certainly, I am not trying to curtail appropriate innovation in the financial markets. I think, to the extent that we get the incentive--improve the incentives, we will get better pricing of risk. And that will deal directly with some of the concerns you have and the development of some of these instruments that, obviously, with the benefit of hindsight anyway, contained a good deal more risk than was appreciated at the outset. So I think that is one way to go. I think something we can also probably do in the supervisory area is where we see a very complex structure of an organization, ask about the economic rationale for that structure. And it is very good economic rationale for having X-hundred subsidiaries, for example. And if not, we could ask for streamlining of that kind of structure. So I think that is something else that could be done to help clarify the situation. I should also add--and this will be my final comment right now on this--is I think it is not just a question of incentives. I think ``too big to fail'' is a big, challenging problem. We need to improve incentives where we can. We also need to improve capital where we can. We should charge institutions some kind of insurance premiums, as I commented, where they are of systemic importance and pose systemic risks. I think we really need to address this on a number of fronts. Senator Bennet. Chairwoman Bair, I do not know if you would like to add anything to that. As I have puzzled through the news accounts of this, one of the things you are really struck by is how evolutionary all of this is. You start out with credit default swaps that are based on one set of assets, and then you move over time to another set of assets, mortgages. And people lose track; the risk gets higher. I just wonder how we are going to write those rules in such a way that we are going to stay ahead of the curve rather than following behind. Ms. Bair. Well, it is a challenge. And that is why we think there is a need to have greater market discipline. Too big to fail has diluted market discipline. There is only so much regulators can do, and you really need the market. You need people who want to invest or extend credit to these institutions, looking at their balance sheet, looking at their management, looking at the sophistication of their management and the risk management systems. What are their off-balance sheet exposures--are they done with proprietary trading, structured finance? All the things that we have seen have posed heightened risks for these larger institutions. You want the private sector in there looking at that as well. If they think the institution is ``too big to fail,'' you are going to dilute market discipline. And that is why we think it is particularly important to have a resolution authority. We also think that an assessment system can complement and enhance regulation. We have risk-based insurance assessments now for depository institutions. So there are certain categories of higher risk activity where we charge them a higher insurance assessment, for instance, for excessive reliance on broker deposits. This can also influence behavior, and I think this would be another tool that should be used for the systemic institutions. Senator Bennet. I am going to ask the Chairman's indulgence because while I have got you here, I want to ask a slightly unrelated question about New Frontier Bank in Greeley, Colorado, which I know you are aware of. I wonder if you might say a word about where we are with that; and, also, more broadly, in the context of a region like that, a rural part of my state, where the local economy is heavily reliant on one institution, namely that one. That carries with it its own systemic risk for that little corner of the world. I wonder if you might talk a little about that situation; also, more broadly, the FDIC's approach in an area like that versus one where there are many other options. Ms. Bair. Well, we did. We had a nice chat with Congresswoman Markey yesterday, too, about this. For the depositors, we have arranged for another bank to take over their accounts and help them transition into a new deposit account relationship. And for the loans, we are trying very hard to find other lenders to refinance those loans or to purchase them. I think one of the things where we engaged Congresswoman Markey, and I will take the opportunity to engage you as well, is to encourage other local lenders in the area to work with us and help these borrowers find new lending relationships. We are working very hard on that, and have been providing some additional financing out of the receivership to borrowers as we seek to transition them to lenders that are stronger. But we would love to work with your office. We talked with her about maybe having a town hall meeting. So we would be happy to work with you on that. Senator Bennet. Thank you. I would appreciate that. Mr. Chairman, thank you very much. " fcic_final_report_full--52 During a hearing on the rescue of Continental Illinois, Comptroller of the Cur- rency C. Todd Conover stated that federal regulators would not allow the  largest “money center banks” to fail.  This was a new regulatory principle, and within mo- ments it had a catchy name. Representative Stewart McKinney of Connecticut re- sponded, “We have a new kind of bank. It is called ‘too big to fail’—TBTF—and it is a wonderful bank.”  In , during this era of federal rescues of large commercial banks, Drexel Burnham Lambert—once the country’s fifth-largest investment bank—failed. Crip- pled by legal troubles and losses in its junk bond portfolio, the firm was forced into the largest bankruptcy in the securities industry to date when lenders shunned it in the commercial paper and repo markets. While creditors, including other investment banks, were rattled and absorbed heavy losses, the government did not step in, and Drexel’s failure did not cause a crisis. So far, it seemed that among financial firms, only commercial banks were deemed too big to fail. In , Congress tried to limit this “too big to fail” principle, passing the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which sought to curb the use of taxpayer funds to rescue failing depository institutions. FDICIA mandated that federal regulators must intervene early when a bank or thrift got into trouble. In addition, if an institution did fail, the FDIC had to resolve the failed institution in a manner that produced the least cost to the FDIC’s deposit insurance fund. However, the legislation contained two important loopholes. One exempted the FDIC from the least-cost constraints if it, the Treasury, and the Federal Reserve determined that the failure of an institution posed a “systemic risk” to markets. The other loophole ad- dressed a concern raised by some Wall Street investment banks, Goldman Sachs in particular: the reluctance of commercial banks to help securities firms during previ- ous market disruptions, such as Drexel’s failure. Wall Street firms successfully lobbied for an amendment to FDICIA to authorize the Fed to act as lender of last resort to in- vestment banks by extending loans collateralized by the investment banks’ securities.  In the end, the  legislation sent financial institutions a mixed message: you are not too big to fail—until and unless you are too big to fail. So the possibility of bailouts for the biggest, most centrally placed institutions—in the commercial and shadow banking industries—remained an open question until the next crisis,  years later. CHRG-111hhrg55809--142 Mr. Price," Any time I can count a dollar twice on my books, if I were allowed to do that by law, that would be a wonderful, wonderful thing, but it certainly wouldn't be more healthy for the economy. There was discussion about the banning of products. There are products out there that--in fact, a statement was made there are some products that are just too risky. You talked a lot about process in that, the transparency that Americans ought to be able to receive when they are evaluating a product, but you never talked about a product that was too risky. Are you willing to say that there are--well, are you willing to identify a product that is too risky? " CHRG-111hhrg54867--63 Secretary Geithner," Well, again, it was very significant. The biggest part of the failure of our system was to allow very large institutions to take on leverage without constraint. And that is what really causes crises, what makes them so powerful. And that is why a centerpiece of any reform effort has to be the establishment of more conservative constraints on leverage applied to institutions whose future could be critical to the economy as a whole. " CHRG-111hhrg52397--270 Chairman Kanjorski," Yes? Mr. Larry Thompson. I do not think anybody has actually done a real study on the causes of the AIG failure. It could have been due to a number of reasons. One, it could be that the counterparties did not know what their full exposure was, they are relying totally on the fact that it was a triple A rated company and therefore did not think that they needed to take the same margin requirements. Some of them we know did hedge some of their positions though with AIG. We also know now that the particular regulator, who did regulate that particular section of AIG, perhaps did not go in and do the right kind of examinations. So I think what you had called for earlier in the first panel, which is really an examination of AIG to see what occurred, should occur before we begin to speculate as to what went wrong there. Obviously, we believe that having all of those contracts in one central location where regulators could have gone in, could have looked at what the positions were, would have been something that would have been something that would have been very good from a regulatory standpoint. Thank you. " CHRG-109hhrg31539--36 Mr. Frank," Good. And they are below inflation--below productivity, below inflation. So workers in this great economy that we have had, and in many ways it has been a very good one, most of them--I am not talking about 20 percent, I am talking about 80 percent, the people who get paid by wages, their compensation, their wages have dropped. You are talking about compensation there, but that includes, you know--let's be careful when we talk about overall compensation in this report. One of the things we are talking about is when the employer pays more for health care, the worker can't bring that money home. So real wages have lagged. And here is the fact; it is not purely a force of nature. When you refuse to raise the minimum wage so inflation erodes it, when you have an active policy of breaking labor unions, and when you have a tax policy that favors people at the high end, you are reinforcing those tendencies. And so what we have is a national policy which takes advantage of factors that are keeping real wages depressed and keeping productivity way ahead of wages so that all the increase--as Alan Greenspan said 2 years ago and apparently is still the case, virtually all of the increased wealth in this society that comes from increased productivity goes to the owners of capital, and obviously they should be getting some of it, but not all of it. It is not healthy. And so you get that situation, you get a public policy that reinforces it, and then Mr. Hubbard shouldn't wonder why the American people don't give him credit for this wonderful economy. They don't give him credit because they are not getting any cash. Thank you, Mr. Chairman. " CHRG-110shrg50416--67 Mr. Kashkari," It worries us, too. We want these institutions to lend, absolutely, but also recognize the situation we are all in right now is the situation of unprecedented lack of confidence in the system. Senator Schumer. Understood " CHRG-111hhrg51592--164 Mr. Neugebauer," I wonder what the difference of the analysis that the people who were taking on those risks for, you know, a relatively small amount of money. You have to be right on those, because they're taking a relatively small premium for a fairly large risk. I mean, so what did they know that you didn't know? " Mr. Joynt," I'm not sure how to react to that. There's--whomever was selling or buying protection, there would have been two people thinking two different things about that risk at that price. So one might have been thinking, ``That was a great trade, I'm glad I got this premium,'' and another was thinking, ``I'm glad I shed that risk.'' So--also, the CDS market is a synthetic and a derivative market. It's not physical securities. So the people who trade or act in that market aren't necessarily--they can act with leverage and volumes that might indicate they have much greater rewards than holding physical securities or risks. " CHRG-109shrg24852--51 Chairman Greenspan," I do not know that. That is factually capable of being ascertained, and I assume some of my colleagues do know the answer to that question. It is not, in my judgment, at least what I have heard, an issue that is critical or something that requires immediate response. But it is enough of an issue that I think we have to look at it, and that is what we are doing, we are looking very closely. Senator Allard. I appreciate your response on that. Now, on various occasions you have downplayed the idea of a national housing bubble, and have instead pointed to a situation which some regions of the country are exhibiting signs of, I quote, ``froth'' I guess. And I am pleased to hear comments that while housing prices may well decline, such a decline would not necessarily derail the economy. Would you not agree though that while this may be true for the Nation as a whole, a correction could have a significant impact within a specific community or region? Could you please elaborate what the future could hold for such a city or region, and what can or should be done to mitigate the damage such a correction could cause? " FOMC20060328meeting--29 27,MR. KOS.," Right now, there are no signs of that. Again, the hard data that we have are limited. So some of this information is anecdotal, and some of it we are reading from price relationships and correlations that we see. Right now, I can’t tell you that there is any evidence to suggest that the Latin currencies might be next. The situation seems to have been fairly isolated so far. My point in raising this issue is that, basically, the world looks pretty good right now. Markets look pretty good. Again, you’re going to have to go to Iceland to find some signs of strain. So, overall, the picture is positive. But it’s useful to remind ourselves that some leveraged money out there has gone off into some fairly obscure places." CHRG-111hhrg56766--266 Mr. Foster," Thank you. In this week's Economists magazine, there was an interesting article on Canada and the situation they are in, where they are seeing an incipient housing bubble re-emerge. They have kept interest rates very low for the same reasons we are doing, to try to restart industrial and business spending, and because if this persists for a long time, some of that money is going to leak out and could make a housing bubble. China is also facing similar problems where they have responded, as has Canada, by actually increasing the amount of money you have to put down on a real estate investment, an investment, as opposed to one you live in. I was wondering do you have contingency planning? Are there tools available that you are thinking of in case you keep interest rates low for an extended period of time, and all of a sudden, in regions of the United States, this starts to show up as a local or national real estate bubble? " CHRG-111shrg55739--52 Mr. Barr," Senator, I think, unfortunately, the whole country is paying the price. Every consumer is paying the price today of a significant failure of our financial regulatory system. So we are all paying for it now in spades. I think we need to have a system in the future in which the level playing field and high standards are established in a way that makes it much less likely we are going to blow up our financial system and cause this amount of harm to the average American homeowner, consumer, small business person. So in our judgment, the tradeoff isn't even close. The kind of approach that we are suggesting here is not a heavy regulatory burden, but it is an essential one. Senator Johanns. Mr. Chairman, thank you very much. " CHRG-109hhrg28024--97 Mr. Sherman," Thank you. Chairman Bernanke, I'm the only member of this committee to actively work to thwart your appointment. Nothing personal. I simply authored legislation to extend your predecessor's term limits. You owe your office to that bill's sole and very powerful opponent, Andrea Mitchell. Speaking of how you get appointed, you are as insulated from politics as anyone in Government. The natural tendency of Congress year in and year out, the pressures on us are to spend more, tax less. It's caused many to wonder whether the U.S. is ready for self-government. Now can we count on you, being so insulated, to make the tough decisions? I'm going to ask a whole bunch of questions and allow you to respond at the end. And I realize I may be asking too many for you to respond to all of them, and I hope that you'll respond for the record. I also ask unanimous consent that we all be given 5 days to submit additional questions for the record. " CHRG-111hhrg56766--164 Mr. Meeks," We have seen that, for example, also--and I think especially in California, to a degree in New York also, and other places--I have talked quite frankly to some friends of mine. But in California where they have no recourse laws, we find that where banks are unwilling to write down the principal--and I know you talked about the HOPE program and writing down, but it seems now banks are not willing to write down principal. A lot of it was simply walking away. And then that is causing a difficulty on the banks and especially the small and community banks, and thus we heard about banks that may be closing as a result, especially the smaller community banks. So I was wondering if there are any steps that the government, the Federal Government, can take or the Fed can take to help banks--or to encourage banks, I should say, to write down principal on homes that are now underwater, which is to me one of the biggest drags on the economy overall also. " FOMC20061025meeting--99 97,MR. POOLE.," Mr. Chairman, I was going to make a suggestion. I don’t know whether there is general assent to this. It seems to me it would be helpful, before our December meeting, to have a better read on the vulnerability of the housing firms to bankruptcy. I can imagine a lot of defaults there, causing us some concern or a lot of public concern. Presumably, with all our banking and housing contacts, we ought to be able to get a better read. All I know is the very informal kind of feedback that I received over recent weeks, and a lot of people brought up that all these builders have only six months or so and some of them are going to go under. So a suggestion is that, as part of the Beige Book process, we try to get a better read on that situation." CHRG-111shrg57319--302 Mr. Schneider," As we got into 2007, three or four things happened. The subprime market was increasingly challenged. We saw signs that home prices were starting to deteriorate. Long Beach, as I showed you on the numbers earlier, as a percentage of our business was relatively small, actually very small as a percentage of our business, and it simply was not worth the management attention required at that point. Senator Kaufman. But you have been getting reports--and I know you just came in 2005, right? You are getting reports, I mean just terrible things are going on down at Long Beach. I mean, based on the previous panel and just what you have said, it was such a small portion of the business, and there was so much problem with that area, I just wonder why you waited until 2007 to close it down? " CHRG-110hhrg44900--170 Mr. Bernanke," Well, the two that we used was our 13(3) authority, which allows us to lend to individuals, partnerships, and corporations, so long as there are not other credit accommodations available. That was set up by Congress with the intention of creating a very flexible instrument that could be used in a variety of situations, and it allowed us to address a situation in which we did not anticipate and which had not been seen before. And so in that respect, having that flexibility, I think, was very valuable. That being said, both in the short term, I think it would be entirely appropriate for us to have discussions. And as I have discussed personally with congressional leadership about what the will of the Congress is and how we should be approaching these types of situations; and, in the longer term, as Secretary Paulson has proposed, it would be better if we had a more formal mechanism that created some hurdles from decisionmaking that set a high bar in terms of when these kinds of power would be invoked and provided more than this lending tool, which was really not well-suited in some cases to address systemically important failures. So I think the IPC authority is an important authority and it has important flexibility, but I certainly agree that ultimately it is the decision of Congress about, you know, in terms of advice and in terms of legislation about how they want the authorities addressing these kinds of situations. " CHRG-111shrg53085--201 PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY Thank you, Mr. Chairman. I think the events of the last few days have made it clear that our efforts must remain directed at dealing with the problems in the financial system. As we have seen from the huge swings in the markets with each announcement coming from Washington, the situation remains extremely volatile. Until we effectively deal with our financial system our efforts may, at best, be misguided and, at worst, damaging. After we deal with the financial crisis, we will then have to focus on correcting the weaknesses in the existing regulatory framework. I look forward to continuing the examination we began last week at our hearing with the banking regulators. Among the other issues that emerged from our hearing, I think it is clear that we need to have a better understanding about the nature and causes of systemic risk. With greater knowledge regarding this very difficult problem, we will have a better chance at fashioning the necessary measures to deal with it in the future. As I stated last week, it should be our goal to create a durable, flexible and robust regime that can grow with markets while still protecting consumers and market stability. This can only be done through a serious and considered effort on the part of the Committee. Once more, getting this done right is more important than getting it done quickly. Thank you Mr. Chairman. ______ CHRG-111hhrg74855--210 Mr. Gensler," I think it does. I think right now these markets are internalized and there are five or six large concentrated pools of capital. They are sophisticated. Many Americans wonder as they go home for the holidays why so much money is being made on Wall Street. This is at the core of it. It is not the only reason but they internalize dark markets and I understand that but I think it is now time I believe working with Congress to bring transparency as this Congress did with President Roosevelt in the '30s to the securities and futures markets. " CHRG-111shrg61513--114 Mr. Bernanke," We are hearing the same things on venture capital that you are hearing. Senator Bennett. Thank you, Mr. Chairman. Senator Reed. Thank you, Senator Bennett. Mr. Chairman, again, thank you for your testimony and for your leadership. You, in response to several questions, pointed out how central the housing sector is to our economy, and one of the areas of great concern to all of us is the mortgage foreclosure situation. Frankly, we have not effectively responded to that yet. It is a growing phenomenon. In my State, one out of ten homes are either in foreclosure or 90-days delinquent, and that saps not only the energy from the economy, but with the uncertainty in the employment market, with the fear of losing your home, particularly for people at mid-life, their sense of the American dream is evaporating. Part of what we have to do is not only get the economy right, we have to get the confidence of the American people restored, and their trust. So specifically, I am wondering what you can do as the Federal Reserve to compel institutions to do more to modify mortgages. I get complaints constantly, I am sure my colleagues do, that there is a help line number. You call it and, oh, yes, sure, and then we don't get back to it. I know there are a lot of press releases about everything that is being done, but until I think you make it clear that this is an important objective, we will get a lot of motion and not a lot of results. And I would assume, for example, I would hope that as within your powers of supervising the management could insist that at least there is a calculation done for each mortgage, whether a refinancing would be better than a foreclosure, or something like that which would be an open process, a quick process, and encourage institutions that you regulate--if you can't order them, then encourage them, and you have many tools to encourage them--to do more. " CHRG-111hhrg51585--81 Mr. Bachus," Thank you. Let me say this: These did appear to be safe investments. I understand there was some indication that Lehman was in trouble, but Bear had been bailed out at that time. There is a section that Ms. Eshoo added to the TARP bill and I think, Chairman Frank, you engaged here in a colloquy which added, as one of the purposes of TARP, the need to ensure stability for U.S. public instrument penalties, such as counties and cities that may have suffered significantly increased cost or losses in the current market turmoil. I can certainly see how that fits your description. I am wondering, though, as Mr. Street said, there are a lot of other entities, with WaMu dead and others. Has anyone made an estimate of what those total? If you add WaMu and some of these other failures, what we are talking about? Mr. Thornberg, do you know? " CHRG-110shrg50369--40 Mr. Bernanke," Well, we are certainly aiming to achieve our mandate, which is maximum employment and price stability. We project that that will be happening. We are watching very carefully because there are risks to those projections. One of the risks, obviously, is the performance of the financial markets, and that again, as I mentioned before, complicates the situation. As events unfold--and certainly there are many things that we cannot control or cannot anticipate at this point--we are simply going to have to keep weighing the different risks and trying to find an appropriate balance for policy going forward. Senator Shelby. As a bank regulator, too--this will be my last question, Mr. Chairman--do you fear some bank failures in this country? I know there are big risks where they are heavily involved in real estate lending. Does that bother you as a bank regulator? " FOMC20071211meeting--55 53,MR. STOCKTON.," This is obviously a situation in which, in some sense, the financial stress is the shock to the system rather than the endogenous response to some other shock, either an aggressive tightening of policy or some other type of aggregate demand shock. So in that sense this particular configuration, I think, sort of fits with the situation we’re currently facing. Obviously we’re not forecasting a business cycle peak. So in our forecast, we’re not yet saying that we’re on the downside of a business cycle. We have a growth recession in this forecast and nothing more than that. If we were to get a true cyclical downturn, I think you could obviously expect that to have some very considerable effects on foreclosures, business failures, and so forth; that channel or mechanism would amplify the downturn in this particular episode." CHRG-110hhrg44900--71 The Chairman," That's not very likely. [Laughter] Dr. Paul. But anyway, I would like to pursue the theme of the day, and that has to do with systemic risk. And there's a lot of talk about systemic risk and also taken in the context of market discipline. But, you know--and we are talking so much about more regulations. And quite frankly, I think we should have a lot more regulations, but I think we should have market regulations. I would like to see a lot more regulations on the government and on the Federal Reserve, because I think it's the ability of the government, through regulatory agencies as well as the Federal Reserve, to disrupt markets and destroy market discipline. That is where I think our problem lies. When Enron failed, we immediately said, well, it must have happened because we didn't have enough regulation, so Congress immediately responded by passing Sarbanes-Oxley. It hasn't exactly helped our markets. You know, our markets today, almost every index of the market today is where it was 8 to 9 years ago, and that's not taking into consideration inflation, the devaluation of the dollar. So the markets are in severe trouble. They are very dysfunctional. But the real question is, why are they in such disarray? And of course I maintain that they're in disarray because our monetary policy disrupts the markets because we create interest rates below market rates. Right now the money is free to the banks. They can borrow money at 2 percent. Real inflation is 10 or 12 percent. And we wonder why there are disruptions when you have artificially low interest rates, you cause the malinvestment, you cause excessive debt to accumulate, and you cause the bubbles to burst. And then when they burst, the only thing we can come back for is more regulations and more inflation, we need lower interest rates, we need to print more money. But it is back to this basic fundamental problem that we think that we can compensate for lack of savings by creating money out of thin air, and it doesn't work. It has never worked throughout history, it's not going to work this time, and we can't bail ourselves out by more regulations and more monetary inflation. And that is where we are today. I think the IMF is correct in this circumstance. They say we are in worse shape than since the Depression. And yet our government tells us there's not even a recession. This is utterly amazing. Ask the American people. Our government tells us inflation is 4 percent. Nobody believes that. I mean, just look at the cost of energy. So we have to someday get back to the fundamentals of what is a dollar, where do they come from, and who's in charge of the dollar. So my question is directed to Secretary Paulson dealing with the dollar, because evidently he is the spokesman and he is the champion of the dollar, and all public statements are that the dollar is to be strong. Well, the dollar lost 20 percent in the last 2 years. In the last 3 years, we have created $4 trillion of new dollars. But when we go to China, we tell the Chinese we want a weak dollar. I would like to see if I can get the Secretary of the Treasury to explain this to me. Do we want a weak dollar or a strong dollar, and why don't we worry about the value of our dollar? " CHRG-111shrg54789--123 Mr. Plunkett," Mr. Chairman, Ranking Member Shelby, Members of the Committee, it is good to be back with you. I am testifying today on behalf of the Consumer Federation of America and 23 consumer, community, civil rights, and labor organizations. We strongly support the Administration's proposal to create a Federal Consumer Protection Agency focused on credit, banking, and payment products because it targets the most significant underlying causes of the massive regulatory failures that have led to harm for millions of Americans. First, agencies did not make protecting consumers from lending abuses a priority. In fact, they appeared to compete against each other to keep standards low and reduce oversight of financial institutions, ignoring many festering problems that grew worse over time. If they did act, and they often didn't, the process was cumbersome and time consuming. As a result, they did not stop abusive lending practices in many cases until it was too late. Finally, regulators were not truly independent of the influence of the financial institutions they regulated. The extent and impact of these regulatory failures is breathtaking. I offer 10 pages of detail on 12 separate regulatory collapses in my testimony over the last decade that have harmed consumers and increased their financial vulnerability in the middle of a deep recession. This involves not just the well-known blunders that we have heard about on mortgage lending and credit card lending. I also offer lesser-known but quite damaging cases of regulatory inaction, such as the failure of regulators to stop banks from offering extremely high-cost overdraft loans without consumer consent, the permission that Internet payday lenders have gotten from regulators to exploit gaps in Federal law, and the fact that regulators have not stopped banks that impose unlawful freezes on accounts containing Social Security and other protected funds. Meanwhile, the situation for consumers keeps getting worse as a result of these regulatory failures and the economic problems in our country. One in two consumers who get payday loans default within the first year. Mortgage defaults and credit card charge-offs are at record levels. Personal bankruptcies have increased sharply, up by one-third in the last year. Combining safety and soundness supervision with its focus on bank profitability in the same institutions, regulatory institutions, as consumer protection magnified an ideological predisposition or antiregulatory bias by Federal officials that led to unwillingness to rein in abusive lending before it triggered the housing and economic crisis. But we now know that effective consumer protection leads to effective safety and soundness. Structural flaws in the Federal regulatory system compromised the independence of banking regulators and encouraged them to overlook, ignore, and minimize their mission to protect consumers. The Administration's proposal would correct these structural flaws. Key facets of this proposal include streamlining the Federal bureaucracy by consolidating consumer protection rulemaking for seven different agencies in almost 20 statutes; providing the agency with authority to address unfair, abusive, and deceptive practices; ensuring that agency rules would be a floor and not a ceiling and that States could exceed and enforce these standards. In response to this far-sighted proposal, the financial services industry has launched an elaborate defense of the status quo by minimizing the harm that the current disclosure-only regime has caused Americans, making the usual threats that improving consumer protection will increase costs and impede access to credit, and offering recommendations for reform that barely tinker with the existing failed regulatory regime. These critics are hoping that this Committee will overlook the fact that the deregulatory regime that they championed and largely controlled has allowed deceptive, unsustainable, and abusive loan products to flourish, which has helped cause an economic crisis and a credit crunch. In other words, the regulatory system that creditors helped create has not only led to direct financial harm for millions of vulnerable Americans, but it has reduced their access to and increased their costs on the credit they are offered. Only a substantial restructuring of the regulatory apparatus through the creation of this kind of agency offers the possibility of meaningful improvement for consumers in the credit markets. The agency will be charged with spurring fair practices, transparency, and positive innovation in the credit markets, which should lead to a vibrant, competitive credit marketplace for many years to come. We strongly urge the Committee to support this proposal. Thank you. Senator Reed. Thank you, Mr. Plunkett. Mr. Wallison, please. STATEMENT OF PETER WALLISON, ARTHUR F. BURNS FELLOW, AMERICAN CHRG-110hhrg46591--369 The Chairman," Sometimes I wonder if price discovery is kind of like heartbeat discovery. We are trying to find out if there is one. The gentleman from Florida is next. The intervening members have agreed to let him go next. " CHRG-111shrg61651--118 Mr. Reed," Well, I think what happened is that they didn't attract much capital and so it appeared that you were able to significantly augment your earnings. I mean, what happened is the banks were basically using capital both for their customer business and for their trading businesses and they were doubling up on it. Obviously, this causes your return on capital to go way up. I mean, the Deutsche Bank is a wonderful example. They announced publicly that they were going to get their return on capital up to 20 percent. Anybody who has done business in Germany knows that sort of a natural rate in the German market is maybe 7 or 8 percent. The only way they were able to do that was to build a significant trading and proprietary investing business on top of their banking business, and they did, in fact, achieve that result. They also ducked the great bulk of the problems that we are today confronting. They never did get any form of government assistance in Europe or elsewhere. So it can be done. But the point is, the attractiveness of this kind of activity is that it hasn't brought capital with it and therefore you are basically doubling up and you are able to earn better returns for your stockholders. Senator Reed. Mr. Johnson. " FinancialCrisisReport--230 Hindsight establishes that the CAMELS ratings assigned to Washington Mutual Bank were inflated. Whether the ratings inflation was attributable to the OTS culture of deference to management, examiners who were too intimidated to downgrade the agency’s largest institution, an overly narrow regulatory focus that was blinded by WaMu’s short term profits and ignored systemic risk, or an absence of forward-looking risk analysis, the WaMu collapse suggests that the CAMELS rating system did not work as it should. (e) Fee Issues During the investigation, when asked why OTS senior officials were not tougher on Washington Mutual Bank, several persons brought up the issue of fees – that WaMu supplied $30 million or nearly 15% of the fees per year that paid for OTS’ operating expenses. WaMu’s former Chief Risk Officer James Vanasek offered this speculation: “I think you have to look at the fact that Washington Mutual made up a substantial portion of the assets of the OTS and one wonders if the continuation of the agency would have existed had Washington Mutual failed.” 876 The issue was also raised by Treasury IG Thorson who warned that OTS should have been “very clear from top to bottom” that WaMu’s payment of $30 million in fees per year to OTS was “not a factor. It just [was] not.” 877 The OCC and OTS are the only federal banking regulators reliant on fees paid by their regulated entities to fund their operations. At OTS, Washington Mutual was far larger than any other thrift overseen by the agency and was a far larger and more important contributor to the agency’s budget. It is possible that the agency’s oversight was tempered by recognition of the thrift’s unique importance to the agency’s finances and a concern that tough regulation might cause WaMu to convert its charter and switch to a different regulator. Its dependence on WaMu fees may have given OTS the incentive to avoid subjecting WaMu to regulatory enforcement actions and ultimately compromised its judgments. Conclusion. WaMu is the largest bank failure in the history of the United States. When OTS seized it, WaMu had $307 billion in assets. By comparison, the next largest U.S. bank failure was Continental Illinois, which had $40 billion in assets when it collapsed in 1984. OTS’ failure to act allowed Washington Mutual to engage in unsafe and unsound practices that cost borrowers their homes, led to a loss of confidence in the bank, and sent hundreds of billions of dollars of toxic mortgages into the financial system with its resulting impact on financial markets at large. Even more sobering is the fact that WaMu’s failure was large enough that, if the bank had not been purchased by JPMorgan Chase, it could have exhausted the entire Deposit Insurance Fund which then contained about $45 billion. Exhausting the Deposit Insurance Fund 876 April 13, 2010 Subcommittee Hearing at 40 (Testimony of James Vanasek). 877 See April 16, 2010 Subcommittee Hearing at 25. could have triggered additional panic and loss of confidence in the U.S. banking system and financial markets. (2) Other Regulatory Failures CHRG-111hhrg51698--265 Mr. Marshall," Okay. Mr. Slocum, just an observation, something I am sure that you are already aware of, but the CEA permits people to trade on insider information. And so to the extent that you are wondering whether or not we should permit parties to have physical assets that are associated with the futures that they are trading and the derivatives that they are trading in. You are wondering whether or not we should revisit altogether, at least if you are worried about insider trading, revisit altogether the CEA's permission to use insider trading, the whole idea there being that we want to get the best possible angle on what the right price is and that that helps the entire market. It helps all the farmers. It helps the elevators. It helps everybody. I think you are absolutely right, that to the extent that there is an entity that has control of a substantial or a critical part of the physical infrastructure associated with a particular market, and at the same time is in the derivatives or futures market, there can be a temptation to use physical control, somehow, for manipulation--not just information but to actually manipulate the market. As Mr. Roth has pointed out, we have laws that address that. You are worried that a lot of the fraud that could potentially occur as a result of this kind of control is not really discoverable. So you might want to suggest ways in which we could enhance our ability to discover problems along those lines. I will just make one further observation. We heard lots of testimony last year that one of the reasons why there wasn't convergence, and one of the reasons why the futures markets weren't working effectively is because we didn't have enough storage for delivery. Some of us said how we deliver products should not be driven by the way these contracts are drafted, and it is kind of stupid for all of us, for the world to reorganize itself just to meet this contractual need that could be changed. Others said, no there is a real reason why these contracts are so narrowly drawn, that delivery has to be in a particular place. So it is not farfetched for me to think that Morgan Stanley and others legitimately are concerned about delivery and the ability to deliver, and the ability to store those sorts of things and want to do that to enhance their ability to participate in these markets, given what happened over the last few years. I suspect that is the argument they would make. So if you could just help us out, not necessarily right now--but with some specific suggestions for how we enhance our ability to determine who is manipulating, that would be enormously helpful to us. " CHRG-111shrg56376--231 PREPARED STATEMENT OF MARTIN N. BAILY Senior Fellow, Economic Studies, The Brookings Institution September 29, 2009 Thank you Chairman Dodd, Ranking Member Shelby, and Members of the Committee for asking me to discuss with you the reform of Federal regulation of financial institutions. \1\--------------------------------------------------------------------------- \1\ Martin Neil Baily is the Bernard L. Schwartz Senior Fellow in the Economic Studies Program at the Brookings Institutions, the cochair of the Pew Working Group on Financial Sector Reform and a member of the Squam Lake group of academics studying financial reform. He was Chairman of the Council of Economic Advisers under President Clinton. The opinions expressed are his own but he would like to thank Charles Taylor, Alice Rivlin, Doug Elliott, and many other colleagues for helpful comments.--------------------------------------------------------------------------- I would like to share with the Committee my thoughts on consolidation of the Federal financial regulatory agencies and what it would take to make them successful in the future. However, this is part of a larger puzzle--the reorganization of Federal financial regulation generally and, in some respects, it is difficult to discuss the narrower topic without examining the broader context. I will therefore also say something about possible complementary changes in the roles of the Federal Reserve, the SEC and the proposed CFPA. A summary of my testimony today is as follows: The best framework to guide current reform efforts is an objectives approach that divides regulation up into microprudential, macroprudential, and conduct of business regulation. The quality of regulation must be improved regardless of where it is done. Regulatory and supervisory agencies must have better qualified, better trained and better paid staff with clear objectives to improve safety and soundness and encourage innovation. Regulatory personnel must be accountable for their actions. A single Federal microprudential regulator should be created combining the regulatory and supervisory functions currently carried out at the Fed, the OCC, the OTS, the SEC, and the FDIC. This regulator should partner closely with State regulators to ensure the safety and soundness of State chartered financial institutions, sharing supervisory authority. The U.S. needs effective conduct of business regulation. The SEC is currently charged with protecting shareholders and the integrity of markets and must improve its performance in this area. In my judgment, the SEC should also create a new division within the agency to protect consumers, that is to say, it would add a CFPA division and become the consolidated conduct of business regulator. Although my first choice is for a single conduct of business regulator, a well-designed standalone CFPA could also be effective. The Fed should be the systemic risk monitor with some additional regulatory power to adjust lending standards. In this it should work with a Financial Services Oversight Council, as has been proposed by the Treasury.The Objectives Approach to Regulation I support an objectives-based approach to regulation. The Blueprint for financial reform prepared by the Paulson Treasury proposed a system of objectives-based regulation, an approach that is the basis for successful regulation in Australia and other countries overseas. The White Paper prepared by the Geithner Treasury did not use the same terminology, but it is clear from the structure of the paper that their framework is an objectives-based one, as they lay out the different elements of regulatory reform that should be covered. However, they do not follow through the logic of this approach to suggest a major reorganization of regulatory responsibilities. There are three major objectives of regulation: First is the microprudential objective of making sure that individual institutions are safe and sound. That requires the traditional kind of regulation and supervision--albeit of improved quality. Second is the macroprudential objective of making sure that whole financial sector retains its balance and does not become unstable. That means someone has to warn about the build up of risk across several institutions and take regulatory actions to restrain lending used to purchase assets whose prices are creating a speculative bubble. Third is the conduct of business objective. That means watching out for the interests of consumers and investors, whether they are small shareholders in public companies or households deciding whether to take out a mortgage or use a credit card. An objectives-based approach to regulation assigns responsibilities for these three objectives to different agencies. The result is clear accountability, concentration of expertise, and no gaps in coverage of the financial services industry--even as its structure changes and new products, processes and institutional types emerge. No other way of organizing regulation meets these important criteria while avoiding an undue concentration of power that a single overarching financial services regulator would involve. \2\ The main focus of this testimony will be to make the case for a single microprudential regulator, something I believe would enhance the stability of the financial sector. Having a single microprudential regulator is not a new idea. In 1993, the Clinton Administration and the Paulson Blueprint in 2008 proposed the same thing.--------------------------------------------------------------------------- \2\ See, ``Pew Financial Reform Project Note #2: Choosing Agency Mandates'', by Charles Taylor.--------------------------------------------------------------------------- It is important to remember that how we organize regulation is not an end in itself. Our plan must meet the three objectives efficiently and effectively, while avoiding over-regulation. In addition for objectives-based regulation to work, it is essential to use the power of the market to enhance stability. Many of the problems behind the recent crisis--executive and trader compensation, excessive risk taking, obscure transaction terms, poor methodologies, and conflicts of interest--could have been caught by the market with clearer, more timely and more complete disclosures. It will never be possible to have enough smart regulators in place that can outwit private sector participants who really want to get around regulations. An essential part of improving regulation is to improve transparency, so the market can exert its discipline effectively.The Independence of the Federal Reserve In applying this approach, it is vital for both the economy and the financial sector is that the Federal Reserve has independence as it makes monetary policy. Experience in the U.S. and around the world supports the view that an independent central bank results in better macroeconomic performance and restrains inflationary expectations. An independent Fed setting monetary policy is essential.The Main Regulators and Lessons From the Crisis The main Federal microprudential regulators had mixed performance at best during the recent crisis. OTS did worst, losing its most important institutions--WaMu, IndyMac, and AIG--to sale and outright failure. Without any economies of scale in regulation, OTS suffered from a small staff in relation to their supervisory responsibilities. Its revenue was dominated by fees on a very small number of institutions, leading to regulatory capture. And, as many have observed, OTS lax standards attracted institutions to a thrift charter and it because the weakest link in the Federal financial depository regulatory chain. The lessons were: regulatory competition can create a de facto race to the bottom; and large institutions cannot be supervised and regulated effectively by small regulators--not only because of the complexity of the task but also because of capture. The Office of the Comptroller of the Currency (OCC) fared only somewhat better. Their responsibilities were far wider and their resources were far greater. Nevertheless, several of their larger institutions failed and had to be rescued or absorbed. While an element of the problem was that there were parts of these institutions where their writ did not reach--OCC-regulated banks bought billions of dollars of CDOs, putting many of them into off-balance-sheet entities--it was not the only problem. Somehow, even this relative powerhouse failed to see the crisis coming. The lessons were: even the best of the Federal regulators may not have been up to the demanding task of overseeing highly complex financial institutions; and balkanized and incomplete coverage by microprudential regulators can be fatal. The FDIC is rightly given credit for having championed the leverage ratio as an important tool of policy. While the Fed and the OCC became increasingly enamored of Basel II over the past 10 years, the FDIC suffered repeated criticism for their stick-in-the-mud insistence on the leverage ratio. On that issue, they have been vindicated not only here in the U.S., but internationally. But they did not do so well in prompt corrective actions during this crisis. Their insurance fund dropped from $45bn to $10bn in 12 months. Several of the firms that failed were well capitalized just days beforehand. The lesson is that liquidity and maturity transformation can matter as much as leverage in a crisis. Prompt corrective action focused on capital ratios alone is not enough. While some State regulators have a fine record, nonbank financial institutions, largely overseen at the State level, were a major source of trouble in the recent financial crisis. Often working with brokers, these institutions originated many of the subprime, prime, and jumbo mortgages that have subsequently defaulted. They provided the initial funding for mortgages, but then quickly sold them to other entities to be packaged and securitized into the CDOs that were sliced and diced and resold with high credit ratings of dubious quality. They made money by pushing mortgages through the system and did not carry risk when these mortgages defaulted. Many State regulators failed to control bad lending practices. The main lessons: skin in the game is needed to keep the ``handlers'' of securitizations honest; and any reform of financial regulation has to somehow strengthen State regulation as well as Federal. Perhaps the most difficult regulator to assess in the current crisis is the Federal Reserve. More than any other institution, it has prevented the financial system from falling off a cliff through often brilliant and unprecedented interventions during the worst days of the crisis. I have expressed publicly my admiration for the job that Ben Bernanke has done in managing this crisis with Secretary Geithner and others. Taxpayers are understandably angry because of the funds that have been spent or put at risk in order to preserve the financial sector, but the alternative of a more serious collapse would have been much worse. The historical experience of financial crises here in the United States and around the world is that a banking collapse causes terrible hardship to the economy, even worse than the current recession. Bernanke and Geithner have helped avoid that disaster scenario. However, the Fed did nothing at all for 14 years to prevent the deterioration in mortgage lending practices, even though Congress had given it the authority to do so in 1994 under HOEPA. Several of the bank holding companies under Fed supervision faced severe problems in the crisis--its microprudential regulation was ineffective. And, while the Fed has repeatedly claimed that systemic risk management was their responsibility, they failed to anticipate, or even prepare for, the crisis in any meaningful way. In short, in its role as a regulator of bank holding companies, the record of the Fed is not good. Bank regulation has been something of a poor relation at the Fed compared to the making of monetary policy. The Fed as an institution has more stature and standing than any other Federal financial institution, but this stature comes from its control over monetary policy, not on its role in bank supervision and regulation. In addition, the Fed's powers were limited. It could not gain access to key information from many large financial institutions and had no power to regulate them. Lehman and Bear Stearns are two examples. While, the Fed has increased its knowledge and understanding of the large banks as a result of managing the crisis and conducting the stress tests, the lessons are: having an institution with a secondary mandate for consumer protection (under HOEPA) does not work well; and the Fed's focus on monetary policy also makes it difficult to direct enough institutional focus on supervision. Finally, there is the Securities and Exchange Commission which did an abysmal job in this crisis. It told the public that Bear Stearns was in fine shape shortly before the company failed; in fact it failed to supervise effectively any of the bulge bracket firms, Merrill Lynch, Bear Stearns, Goldman Sachs, Morgan Stanley, and Lehman). It did nothing to restrain the credit agencies from hyping the ratings of CDOs. And it did not stop Madoff and others from defrauding investors. However, the leadership has changed at the SEC and I believe it has learned important lessons from the crisis: its strong suit is not microprudential regulation of institutions; it must focus on investor protection and the integrity of the markets--not only the traditional ones like the stock and bond markets, but also the securitization market--including the development and implementation of policies to revamp securitization credit ratings. One vital issue to recognize in regulating the large financial institutions is that they are run as single businesses. They decide what their business strategies will be and how to execute them most effectively. The specific legal forms they choose for their different divisions is determined by what they think will work best to achieve their strategic goals, given the tax, regulatory and legal environment that policymakers have set up. Under the current regulatory system, the Fed supervises and regulates the bank holding company while, for example, the OCC supervises the U.S. banks that are the subsidiaries of the holding company. Most of the large financial institutions are in several lines of business and, at present, are regulated by more than one agency. Inevitably, this encourages them to shift activities to the subsidiary and hence the regulator that is most tolerant of the activity they want to pursue. Balkanized regulation is unlikely to stop the next crisis. This short review is not inclusive. There are credit unions that have a separate regulator and there are important issues around the GSE's and their regulation and around derivatives and their regulation that I will not tackle in this testimony. This review has been critical of the regulatory agencies but I want to note that there are many people to blame for the financial crisis, including bankers who took excessive risks and failed to do due diligence on the assets they purchased. Economists generally did not predict that such a severe crisis was possible. Very few people saw the possibility of a 20 percent or more decline in the price of housing and almost nobody saw the depth of problems that have resulted from the sharp declines in house prices.What Structure Best Meets the Objectives of Financial Regulation?Regulatory Performance Must Be Improved Regardless of Where It Is Done There must be improved performance in the supervision and regulation of financial institutions regardless of who is doing it. There were rooms full of regulators sitting in all of the large regulated financial institutions prior to the crisis and they failed to stop the crisis. This means there should be more accountability for regulators, so that they are censured or removed if they do not perform the role they were hired to do. It means they should be better paid. It seems paradoxical to reward a group that did not do so well historically, but if we want better regulators then they must receive salaries that make their jobs attractive to high quality people, those who can understand complex institutions and products and who may have the option of earning high incomes in the private sector. Adequate training must be available. Better quality regulation is a ``must-have'' of financial reform and must be part of the legislation now being considered. A lot of improvement can be made even under existing legislation if regulators have the incentives and abilities to do their jobs. Some people argue that regulation has been the cause of the problem and that if the Government were removed from the equation then the financial sector would regulate itself, with weak companies failing and the strong companies surviving. Overall, I am a strong supporter of letting markets work and letting companies fail if they cannot be efficient or innovative. This includes financial institutions that should be allowed to fail if they do make bad decisions and fail to meet the market test. The financial sector has unique features that make it different from most other industries, however. Failure in one institution can spill over to others and problems in the financial sector can rock the whole economy, as we have seen in this crisis. Regardless of one's perspective on this issue, however, it is clearly a mistake to create worst of both worlds. If the Government provides a safety net for consumer deposits and props up financial institutions in a crisis, then there must be effective high quality regulation that will protect the interests of taxpayers.The Case for a Consolidated Microprudential Regulator for the Financial Sector A single prudential regulator would become a powerful institution with stature in the policy community that could hire talented staff and attract strong and able leadership. It would be formed by drawing together the best people from the existing supervisors and regulators in the OCC, the OTS, the SEC, the FDIC, and the Federal Reserve, it would hire financial experts in areas where more expertise was needed, and it would be the primary supervisor of the institutions that make up the financial sector of the United States. The head of the organization would be chosen by the President with the consent of the Senate and would serve for a term of several years. It would be worth considering a structure like that of the Federal Reserve, with a board that served staggered 16 year terms. Thus constituted, the financial regulator would have the standing and capability to stand up to the heads of leading financial institutions and to be an independent arbiter. It would be a partner with and advisor to the Administration, Congress and the Federal Reserve. The financial sector does not stand still. It evolves and innovates and new institutions and products are born. A single prudential regulator with the necessary staff and skills would be best positioned to evolve along with the industry and adapt regulation to a changing world. Having a single prudential regulator would make it much easier to avoid gaps in regulation and discourage the kind of regulatory evasion that contributed to the crisis. It would also reduce the regulatory burden on financial institutions because it would avoid much of the duplication that now exists. A single prudential regulator would supervise and regulate large institutions and small and be able to maintain a level playing field for competition. It would be able to examine all of the activities of the large global banks and make sure they were not accumulating excessive risks through a combination of activities in different parts of their business. There is a great deal to be said for competition in our economy. Ultimately, competition in the private sector drives innovation and growth and provides choices to consumers. It is the lifeblood of our economy. It is not clear, however, that competition among regulators a good thing. The serious danger in regulatory competition is that it allows a race to the bottom as financial institutions seek out the most lenient regulator that will let them do the risky things they want to try, betting with other people's money. One possible advantage of regulatory competition is that it could make it easier for companies to innovate whereas a single regulator might become excessively conservative and discourage new products even if these would bring substantial benefits. However, given the experience of the recent crisis, the dangers created by multiple regulators, including a race to the bottom, are greater and outweigh the possible advantages of competition among regulators. An effective single prudential regulator acting as a cop on the beat could actually increase the level of effective competition among private companies in the financial sector, thus making the private market work better. In addition, it would be very important that the mandate of the single prudential regulator include the promotion of innovation and economic growth. The U.S. financial sector has been one of the strongest in the world and has been one of our major exporters. Prior to the crisis there was great concern that the New York financial markets were losing their global competitive position--See, for example the Bloomberg-Schumer report. The goal of sustaining a dynamic and competitive sector remains vital. Another advantage of creating a single Federal prudential regulator is that it would enhance the independence of the Federal Reserve in making monetary policy. It gets the Fed out of the regulatory business and lets it concentrate on its main tasks.The Role of the FDIC With a single microprudential regulator, the FDIC would lose the supervisory and regulatory authority it has now. Staff from the FDIC that have performed well in this crisis would move to the new prudential regulator, so there would not be a loss of knowledge or expertise. The role of the FDIC as manager and supervisor of the deposit insurance fund would continue. In this position, it would also be able to sound warnings about depository institutions in difficulties, acting as a backup for the new unified prudential regulator. Another possibility is that the FDIC would become the principle agency dealing with the resolution of failing institutions. \3\--------------------------------------------------------------------------- \3\ I have testified to this Committee before on the dangers of ``too big to fail'' or ``too interconnected to fail.'' An important aspect of regulatory reform is to make sure badly run financial companies are allowed to fail in a way that does not imperil the whole system, either through a resolution mechanism or through a special bankruptcy court. The FDIC would play an important role with either system.---------------------------------------------------------------------------The SEC as the Conduct of Business Regulator Under the single prudential regulator described above, the SEC would lose its authority to supervise nonbank financial institutions, which would reside instead with the prudential regulator. The SEC would continue to have a very important role as a protector of the interests of shareholders, a bulwark against insider trading, market manipulation, misselling and other practices that can undermine our capital markets. There is a case for giving the SEC additional authority to provide consumers protection against financial products that are deceptive or fraudulent. The Treasury White Paper proposed establishing a new standalone agency, the CFPA, to provide consumer protection and it is understandable that such a proposal is made given what has happened. There were a lot of bad lending practices that contributed to the financial crisis. As noted earlier, many brokers and banks originated mortgages that had little chance of being repaid and that pushed families onto the street, having lost their savings. There was also misbehavior by borrowers, some of whom did not accurately report their income or debts or manipulated their credit scores. I agree with the Administration and many in Congress--notably Chairman Dodd--on the importance of protecting families against a repetition of the bad behavior that proliferated in recent years. My first choice would be to place the responsibility for consumer protection in a new division within the SEC rather than creating a separate agency. The proliferation of regulators was a contributory factor in the crisis, so that adding a new agency is something that should be done reluctantly. While the SEC did badly in the crisis, there has been an important change in leadership and the new head of the agency is clearly someone of strength and talent who has pledged reform in the operations of the agency. Congress should ask the SEC to form a new CFPA division within its ranks charged specifically with consumer protection. \4\--------------------------------------------------------------------------- \4\ The Federal Reserve did not do a good job in protecting consumers in the period leading up to this crisis, nor did it stop the erosion of mortgage lending standards that contributed to build up of toxic assets in the financial system. Since the crisis, however, the consumer protection division within the FED has been strengthened and is now an effective force with strong leadership. The personnel from the consumer protection division of the FED, together with the best personnel in this function in other agencies, could be moved into the new CFPA division.--------------------------------------------------------------------------- Placing the tasks of the CFPA into the SEC would create a single strong conduct of business regulator with divisions specifically tasked to protect both consumers and small and minority shareholders. It would also make it easier to gain acceptance for greater consumer protection from the financial industry. The CFPA has become a lightning rod for opposition to regulatory reform. Given that the financial sector is largely responsible for the crisis, it is surprising that this sector is now lobbying so hard against greater consumer protection. Greater protection for consumers is needed and that would also provide greater protection for taxpayers. However, having the CFPA functions as a division within the SEC would accomplish that goal while calming industry fears. Having the CFPA functions within the SEC is my first choice, but if Congress decides against this approach, I could support a standalone agency. The Treasury White Paper does a good deal to allay the fears that the new agency would stifle innovation, including: the overall focus on unfair, deceptive, and dangerous practices, rather than risk, per se; the instruction to weigh economic costs and benefits; the instruction to place a significant value on access to financial products by traditionally underserved consumers; the prohibition against establishing usury limits and; the option to consider previous practice in regard to financial products. The Treasury recognizes the dangers of having an agency that would overreach and its proposed structure would avoid that possibility. \5\--------------------------------------------------------------------------- \5\ See, additional discussion of these issues by Douglas Elliott of Brookings and also by the current author posted on the Brookings Web site. The financial reform project of the Pew Charitable trusts has also posted material on the topic.--------------------------------------------------------------------------- One final issue with the CFPA is preemption. The Treasury proposal indicates that State regulators would have the power to enact consumer protection legislation that was stronger than that in the Federal statute. I understand the case for States' rights in this arena, but the prospect of a myriad of different State rules is daunting and has the potential to reduce the efficiency of the massive U.S. marketplace. There has been enormous progress towards a single market in financial products, leveling the playing field for businesses and consumers, so that the terms of loans or other financial activities are the same in all States. Whether or not Federal consumer protection rules preempt State rules is not a major issue for safety and soundness, but having single set of consumer rule uniform in all States would improve economic efficiency. As a result, I support the view that Federal rules should preempt State rules in this area.Regulating State Chartered Financial Institutions Starting with a clean sheet of paper, I would prefer to see all banks and relevant nonbank financial institutions have Federal charters and be supervised by the unified prudential regulator. However, that is not the situation we are in and I recognize the importance of States' rights and the desire to have local institutions that can help local businesses by using the power of personal knowledge and relationships. It is a fact of life that there will continue to be State chartered banks subject to State supervision. In the short run, it is unlikely that we will see again State chartered nondepository institutions that are originating and selling bad mortgages. The markets have been burned and will remember for a while that such institutions may not be selling quality products. Over the years, however, memories will fade and regulatory reform enacted today should avoid problems in the future as far as possible. I urge Congress to require State regulators to partner with the Federal prudential regulator in order to harmonize safety and soundness standards and to exchange information for State chartered banks and nonbanks. The Federal prudential regulator should set out minimum standards that it would like to see in State run financial institutions. And State regulators should be required to exchange data with the Federal regulator and work in cooperation with them. This is already how things work for most banks and it is important that we do not see in the future a situation where State charters are exploited by nonbank financial institutions to undercut the safety of the financial system.The Federal Reserve as Systemic Risk Monitor or Regulator The Treasury White Paper has proposed that there be a council, an extension of the President's Working Group on financial stability to coordinate information and assess systemic risk. The Working Group has played a valuable role in the past and I support its extension to include the leaders of all institutions with power to regulate the financial sector. As others have said, however, committee meetings do not solve crises. The proposal outlined earlier in this testimony is for a single microprudential regulator, which would deprive the Fed of all its microprudential functions. However, I propose that monitoring and managing systemic stability and responding to increased exposure to systemic risks formally be added to the Fed's responsibilities. The strong performance of the Fed in managing this crisis strongly suggests that this institution should be the primary systemic risk monitor/regulator. Moreover, this role is a natural extension of monetary policy, which can be thought of as the monitoring of, and response to, macroeconomic developments. It fits with the dominant culture of economists and the Fed's strong tradition of independence, which are both needed for systemic risk management to be effective. It would slightly cut into the role you have proposed for the Financial Services Oversight Council, but not much. For monitoring the economy and for making monetary policy the Fed needs, among other things, quick access to a broad base of financial information. Currently, the regulatory reporting is primitive. More complete, relevant and real time data should be available to all Federal financial regulators. A coordinated information strategy for the Federal financial regulatory agencies ought to be one of the first tasks of the FSOC. The Fed as systemic regulator would need to work closely with the prudential regulator so that it knows what is going on inside the big institutions, and the small ones. It would also need to work closely with the Treasury and the FSOC, exchanging information with all members that could help it see dangerous trends as they emerge. To respond to specific systemic risks, the Fed needs another instrument in addition to its control over short term interest rates and I suggest that Congress should grant the Fed the power to adjust minimum capital, leverage, collateral and margin requirements generally in response to changing systemic risks, in addition to the specific power it has had to adjust margin requirements in stock trading since the Great Depression. The microprudential regulator would set basic minimum standards. The Fed would adjust a ``multiplier'' up or down as systemic circumstances required. This additional power should be used rarely and in small increments; recall how the Volcker-Carter credit restrictions stopped the U.S. economy on a dime in 1980. No one can guarantee that a systemic regulator will be able to foresee the next bubble or crisis, but it is definitely worth the effort to spot trouble forming. In particular, the Fed may be able to spot a concentration of purchases of risky assets made with borrowed funds. A systemic regulator could have seen that many banks had lent large sums to LTCM to speculate in Russian bonds or other risky assets. It should have been able to spot the build up of risky CDOs in SIVs that were affiliated with the banks. It could potentially see if large hedge funds or private equity companies were using borrowed funds and concentrating on a particularly risk class of assets. Analysts who were studying the real estate market prior saw signs of trouble well before the crisis started.Conclusions A single strong agency would meet the objective of microprudential regulation of all financial institutions that were subject to regulation and supervision. It would work with State regulators, especially to make sure the abuses that contributed to the crisis could not be repeated. It would work closely with the conduct of business regulator(s) (the SEC and the CFPA) and the Federal Reserve to ensure that consumer protection is adequate, that monetary policymakers are well informed and that all these institutions and the Treasury would work together effectively to deal with a new crisis should it occur in the future. The Federal Reserve has shown its mettle in managing the crisis and should be given the role of principle systemic regulator or monitor. It would work closely with the members of the risk council in performing this task. It should have the power to adjust borrowing rules prudently if it sees a bubble developing driven by excessive leverage. The SEC is the natural institution to become the conduct of business regulator with a mandate to protect small and minority shareholders and, with a CFPA division, also to protect consumers in financial markets. A single prudential regulator plus a single conduct of business regulator would constitute the so-called ``twin peaks'' approach to regulation that many experts around the world see as the best regulatory structure. However, a well-designed standalone CFPA could also be an effective protector of consumers and taxpayers.Appendix: Lessons From the U.K. and Australia Opponents of regulatory consolidation in the United States frequently cite the experience of the United Kingdom, which has a consolidated regulator, the Financial Services Authority (FSA) but did not escape the crisis, indeed it has suffered perhaps even worse than the United States. Given London's status as a global financial center it was to be expected that the U.K. would face problems in the global crisis, but it is surprising that the extensive regulatory reforms undertaken in the late 1990s did not better insulate the country from the effects of the financial crisis. In 1997 the U.K. overhauled its financial regulatory system, combining a myriad of independent regulatory authorities (including the regulatory functions of the Bank of England, the Securities Investment Board, and the Securities Futures Board, among nine total) into a single entity. Then Chancellor of the Exchequer Gordon Brown argued that the distinctions between banks, securities firms and insurance companies had broken down, and that in this new era of more fluid and interchangeable institutional definitions, the old regulatory divisions no longer made sense. The FSA's statutory objectives are to maintain market confidence, to promote public awareness on financial matters, to protect consumers, and to reduce financial crime. To achieve those ends, the FSA employs broad investigatory, enforcement, and prosecutorial powers. Although the external structure of regulation in the U.K. may appear simple enough, there is a great deal of internal complexity. There are two main branches within the FSA; one branch which deals with retail markets and another branch, which focuses on wholesale and institutional markets. Within each branch, there are further divisions based on specific financial activities and institutional design, including insurance, banking and mortgages, asset management, and credit unions. There also exist some internal groups which look at specific financial activities in each of the retail and wholesale sectors. Therefore, in practice the FSA did not create an effective single prudential regulator. Instead it preserved some of its older agency divisions, albeit under a single umbrella. Critics of the FSA have pointed to the haste with which the FSA was formed and the failure of the new integrated regulator to fully overcome the old institutional divisions of its former approach to regulation. The FSA has admitted on its own to significant failings over Northern Rock. An internal FSA report cited inadequate resources devoted to overseeing the institution, including high personnel turnover and limited direct contact with the institution (no one had visited the bank for 3 years), and a failure to push management at the bank to modify an eventually disastrous business model. \6\ The U.K. Government was determined to develop London as the key financial center in Europe and that London could compete effectively with New York. As part of this strategy, they instituted ``light touch'' regulation, in which financial institutions were given the goals or principles that they should follow but were given considerable leeway to determine how the goals should be met. While there is some merit in this approach, it created significant danger and it meant in practice that U.K. financial institutions took on excessive risks. Some U.K. banks developed a reputation around the world for lending money to companies that local banks would not touch and the regulators were not stopping them from taking these bad risks.--------------------------------------------------------------------------- \6\ Hughes, 2008.--------------------------------------------------------------------------- Another problem is that there was totally inadequate communication between the FSA and the Bank of England. The Bank of England was intent on maintaining its independence and focused on its mission of fighting inflation. When the crisis struck, the Bank was unwilling to step in quickly to support troubled institutions and markets because it had not been kept up to date about the condition of the banks and had not been tasked with the job of maintaining system stability. In summary, the U.K. experience does not provide an appropriate counter example for the regulatory model proposed in this testimony. They did not create an effective, strong single prudential regulator. They did not make the Bank of England responsible for systemic stability, nor did they ensure that the Bank of England was informed about the condition of the U.K. banks. Australia does not have a major financial center serving the global market and so it cannot provide an ideal example for the United States to copy. Nevertheless, the Australian regulatory reforms seem to have been well designed and well-executed and there are some lessons to be learned. Australia determined that the ``twin peaks'' model was the right one and they created the Australian Prudential Regulatory Authority (APRA), which is responsible for prudential regulation while the Australian Securities and Investment Commission (ASIC) oversees conduct-of-business regulation. A cross-agency commission seeks to resolve conflicts of overlap and facilitate communication between the two agencies. The Australian economy weathered the financial crisis better than many other developed countries, and its experience owes much of its better-than-average performance during the financial crisis to sound policy choices and the effectiveness of its financial regulation. There was not a housing bubble and there was not the same erosion in lending standards as had occurred in the U.S. This was in part due to stricter regulation of mortgage lending. Australia's prudential regulator had raised capital requirements for banks investing in riskier mortgage products. \7\ Consumer protection laws and foreclosure laws also discouraged borrowers from taking out mortgages that they could not afford.--------------------------------------------------------------------------- \7\ Ellis, 2009.--------------------------------------------------------------------------- Until 1998 Australian financial regulation resided with the country's Central Bank and took an institutional approach. Following a review of the country's overall financial system, the twin peaks approach was put into place. As in the U.K., APRA's regulation is a largely a principles-based approach, relying heavily on dialogue between the regulators and the regulated institutions, but with a considerably heavier touch by the regulators to guard against excessive risk taking. The ASIC oversees securities market and financial services providers. ASIC has the power to impose criminal or civil sanctions against financial firms or individuals. As a corporate regulator, ASIC oversees company directors and officers, capital raising, takeovers, financial reporting, etc. It also provides licensing and monitoring for financial services firms. In addition, ASIC has been tasked to protect consumers against misleading or deceptive conduct related to financial products and services. The Australian approach is cited as a model for other countries, for example in the Paulson Treasury's blueprint, in part because it allows flexibility and innovation, while maintaining protections. The regulatory structure is not the only reason for the fact that their economy avoided the worst of the financial crisis, but it seems to have helped. One aspect of the Australian regulatory approach that could serve as a model is the process by which it arrived at reform. Where the road to reform in the U.K. was hasty and lacked adequate consideration, the Australian reform process began with the Wallis Inquiry in 1996 to review how financial system reform could be structured in Australia. The inquiry looked specifically at how prior attempts at deregulation had affected the Australian financial system, what forces were at work changing the system further, and what would provide the most efficient, effective and competitive regulatory structure for the country going forward. In summary, Australia provides a good positive example where a single prudential regulator has worked well. ______ CHRG-110hhrg34673--186 Mr. Bernanke," That is a very wide-ranging question. I think I would like to separate that into two issues. One is the trade aspect, and the other is the budget/current account deficit issue. On trade, as I have discussed several times today, trade can create painful dislocations, painful changes. Competition from abroad, movements of firms out of the country, can cause people to lose jobs, and that is a serious problem. On the other hand, trade also creates a lot of benefits to the country. It creates a lot of jobs both in terms of exports, and in terms of transplants. Like you mentioned Saturn. Well, there are also transplanted auto firms that hire Americans here in the United States, and as someone mentioned here, it does allow Americans to purchase goods and services at a lower price than they otherwise would. So there are disruptions caused by trade. There are also a lot of benefits from trade, and one of the messages I have been trying to convey is that the right solution is not to stop trade or to block trade but, rather, to try to find ways to help people adjust or to retrain as necessary to deal with these very real--and I take them very seriously--dislocations and problems that arise because of this changing, dynamic economy we have. A somewhat different question is about the trade deficit and the current account deficit, and to some extent, it is related to the budget deficit in the sense that, as I have indicated, the current account deficit reflects the fact that our savings rate is low relative to our investment, and therefore we have to borrow the difference abroad. In order to mitigate that situation over time, we need to raise our national saving, and that could be done either in terms of private saving or it could be done in terms of reducing budget deficits or increasing surpluses at both the Federal and the State and local government levels. That is going to take some time. I think, you know, we do not have to solve this problem overnight, but we should be, I think, working to reduce the current account deficit over time and at the same time that we continue to allow trade and technology to help our economy grow more quickly. Mr. Davis of Tennessee. We have actually tripled our budget-- " CHRG-111hhrg53238--205 Mr. Zywicki," Sure. That has been around for 10, 20, 30--that has been around forever, those sorts of problems. But the problems that were caused here were caused, as you read my testimony, as you see, I think caused by incentives. It was interest rates, Federal Reserve monetary policy, and incentives when house prices fell. That is what caused the problem. There were other things that exacerbated it that were around the margins. " CHRG-111hhrg48674--119 Mr. Bernanke," So, as I have tried to emphasize throughout the hearing, there are two types of intervention. There are the interventions that have involved trying to stabilize systemically critical firms whose failure would create substantial problems for the financial system and the economy. As I have indicated, I am very unhappy about having to be involved in those things, and the sooner I can shed that responsibility, the happier I will be. On the other side, the other type of activities has to do with our expansion, trying to create and stimulate credit markets where credit markets have broken down. And there, we want to keep looking for situations where we believe we have tools that can get the markets working again; that will create lower rates or better credit availability; and will stimulate the economy. I think those things are in the interests of the people and that it can be explained to them that it is in their interests. I don't know how much more, but I think, given the severity of the situation, that we do expect to expand somewhat more to address the severe dislocations we are seeing in a number of key credit markets, including consumer credit markets " CHRG-111shrg57321--228 Mr. McDaniel," I don't believe it would be. Senator Levin. OK. This is Exhibit 62.\1\ This is a Standard and Poor's exhibit. It is at the bottom of page one. ``How do we handle existing deals especially if there are material changes that can cause existing ratings to change?'' And if you look at the top of page two, again, this is Standard and Poor's, it says, ``I do not know of a situation where there were wholesale changes to existing ratings when the primary group changed assumptions or even instituted new criteria. The two major reasons why we have taken this approach is, (i) lack of sufficient personnel resources.'' Are you familiar with that document, Ms. Corbet?--------------------------------------------------------------------------- \1\ See Exhibit No. 62, which appears in the Appendix on page 471.--------------------------------------------------------------------------- Ms. Corbet. No, I am not. This is the first--I just reviewed it this week. Senator Levin. All right. But this is not accurate This is not true? You said that---- Ms. Corbet. This is not my understanding of how securities were surveiled. Senator Levin. OK. And then if you take a look at Exhibit 92a,\2\ Mr. McDaniel.--------------------------------------------------------------------------- \2\ See Exhibit No. 92a, which appears in the Appendix on page 543.--------------------------------------------------------------------------- " CHRG-109shrg26643--62 Chairman Bernanke," Yes, Senator, it is. Senator Sarbanes. Okay. All right. Now, if Feldstein is right, that it is foreign governments that are putting in the capital, would that cause you added concern? " CHRG-111shrg54789--14 Mr. Barr," Thank you, Mr. Chairman. Let me first say I agree with you that the Consumer Financial Protection Agency is good for banks as well as for consumers. If banks are competing on the basis of price and quality, that is good for them. If banks and credit unions and their communities can compete on a level playing field so we do not have a situation where a community bank wants to do the right thing but an independent mortgage company is stealing all market share with a policy that consumers cannot understand, we don't want that in the future. We want a level playing field based on fair competition, based on transparency to consumers. With respect to the Community Reinvestment Act, I think the empirical evidence here, Mr. Chairman, is quite strong. I looked at this when I was researching at the University of Michigan. The Federal Reserve economists have looked at this question. The Federal Reserve found that about 6 percent of subprime mortgage loans were made by CRA-regulated institutions with respect to low-income communities or low-income borrowers. Six percent is unlikely to have driven, highly unlikely to have driven the subprime mortgage crisis. If you look at the timing of our subprime mortgage crisis in the mid-2000's, it is hard to imagine that that was caused by changes in CRA regulations a decade earlier in 1995. If you look at the performance of CRA lending with respect to equivalent subprime loans, comparable performance levels. So I think the empirical evidence just does not support that claim. " CHRG-111hhrg48674--148 Mr. Bernanke," They haven't normalized, first, because they were traumatized by the huge losses and the failures and all the factors that have created much risk aversion and caused people to pull back from markets. But now, going forward, the main concern of many bankers and others is the uncertainty about where the economy is going. If the economy is weakening, that means that credit quality is going to deteriorate, and that makes it harder to make loans and makes you more worried about your capital. So we need both to stabilize the economy and to stabilize the financial system. You have to have both in order to get a return to growth. " CHRG-111hhrg49968--95 Mr. Latta," I guess real quickly, when you say more of a normal situation, the situation that we are in right now, would you consider that normal for the time? Or are we looking at a longer period of time that these jobs are going to have to be created over, especially getting back to work in the private sector? " CHRG-110shrg46629--66 Chairman Bernanke," First, on the subprime rules, as I said, I asked for a top to bottom review. We looked at every possible power that we have. We have examined each one. We have had a lot of input, a lot of hearings, and we are moving forward. We will move as expeditiously as the process allows, making sure, of course, that we do a good job. But we will move forward as expeditiously as possible to try to address these issues. With respect to inflation, I agree in the sense that certainly over 2007 food and energy prices have risen significantly so that the overall inflation rate is higher than we would like it to be. Our concern is that high food and energy prices might somehow infect the underlying trend of inflation, for example causing people's expectations--this is Senator Bunning's question--to rise and become less persuaded that inflation will be stable in the long-run. Therefore, that is part of the reason why we continue to treat inflation as our predominant policy concern. With respect to the household financial situation, it is a complicated story. Part of the reason that official saving rates for households are negative as that those saving rates do not include any capital gains in assets that households may own. So in some cases, people have had their homes appreciated, as happened over the last 5 years until recently and they took money out, the money they took out would count as spending but the appreciation in their home would not count the saving. So that has been part of the reason that saving has been so low, that people have seen increases until recently in their home equity. As that situation flattens out---- Senator Menendez. But if they took their savings on their appreciation, the only way to do that would be to sell and/or accrue debt? " CHRG-110hhrg46591--162 Mr. Price," Right. Thank you. I think we all are interested in appropriate regulation, not an absolute unregulated system. I want to touch, in my remaining few moments, on a concern that I have that much of the criticism of what has gone on I believe to be an attack on the capitalist system of markets and the ability to take risk and realize reward. I wonder if you might comment briefly on whether or not financial regulators should try to reduce systemic risk by setting limits on private risk-taking. Ms. Rivlin? Ms. Rivlin. I think we need limits of various kinds on leveraging. I think we were overleveraged in many respects. And in respect to the derivatives, I think--or even the credit default swaps--was the basic problem that we had credit default swaps or was it the people who were trading them were way overleveraged? And I would worry about the overleveraging. " CHRG-111shrg61513--50 Mr. Bernanke," The Government's commitment at this point is a couple hundred billion to those institutions. Senator Johanns. Let me also draw your attention to something, and I am running out of time here, but I was just catching up on some things, and I noticed today that first-time unemployment filings have increased. That was not expected. Durable goods orders have fallen the most since August. That is not a good sign. And that excludes, I think, transportation. The market has responded by dropping at least at this point by 160, and I appreciate the market can have up days and down days. I am starting to read more and more articles about the national debt interfering with economic recovery. And yet I do not see an effort to slow that down here. In fact, if we were just to stand down and say, OK, we will adopt the President's plan, there are trillion dollar deficits over the next decade. I cannot imagine how that turns out for--you know, I will be 70 years old the next decade. I am not going to live long enough to pay that off. That means my children and grandchildren are going to have to deal with that. I am beginning to wonder, Mr. Chairman--and I do not want this to sound overly pessimistic, but I am beginning to wonder whether low interest rates really have any possibility of spurring this economy. And I will tell you what I am thinking about, and you may not even have enough time to respond. Unless there is demand, unless we can get consumers back into it, it just seems very unlikely to me that you are going to see much growth. I talked to people who handle the freight--the railroads, the trucking companies. They are not seeing much improvement. All these signs point to a situation where, quite honestly, this economy is still enormously flat. And I am not sure that offering somebody an interest rate at 2 percent versus 4 percent is going to get us on the other side of this, and I would just like your thought on that. " CHRG-110shrg50420--459 Mr. Nardelli," I have been married for 38 years. I am doing just fine. Senator Corker. I am talking about the company. So what is it that--what is the right thing to do as it relates to your company when the best thing for our country and the best thing for the automobile industry and the best thing for the wonderful employees that work at your company is for you all to go away as a stand-alone entity? So what, as we negotiate this deal, is the best thing for us to do? " FOMC20070628meeting--23 21,MR. FISHER.," Mr. Chairman, I would argue that there are similarities in that, with Long-Term Capital, most of the stress-testing had been just computer-model driven. Then when actual market prices began to be quoted, you saw the deterioration. That is clearly the case here. The ABX is a technical index. For a lot of the CDO-squared market, nobody knows what the values, as opposed to the prices, really are. There is a difference between price and value. Price is what you pay; value is what you get. I suppose one charitable interpretation of this, Bill, would be that the good thing about this situation is that we actually may be creating a real market to determine value on these things or at least price relative to value. But I think the phenomena are similar, and I would argue—having been in the business, although the business wasn’t as sophisticated when I used to be in it—that this has broader dimensions than those we had before. If you look at the growth rate of these instruments—again, without any underlying sense of what you ultimately can cash in if you’re pressed—it has been a straight upcurve. The numbers are quite huge. Again, I was once a hedge fund manager—I know all the tricks that are played there, including, by the way, the valuation of underlying securities—in a day when the business was less sophisticated than it is now. I don’t feel I understand this issue. I don’t know about my other colleagues around the table, but you did kindly send someone down to brief our staff on this. They came out with more questions than they did answers, but it was very helpful. I am worried that we will be asked publicly at different intervals and perhaps starting now what our opinions and perspectives are. I’m also worried about giving the wrong answer. I wonder if there is not a way—not during this meeting but at some point— that all the principals at this table can be briefed so that we can understand and have a common approach to this issue. I don’t think the issue is contained. I do think there is enormous risk. I hope that something good comes out of this, but speaking personally, I would like to understand this better, and I hope that we all understand it very well in case a negative scenario obtains. That’s just a request." 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-111hhrg53245--166 The Chairman," You are right because I do not know of an antitrust regime in which 10 percent gets you into the anti-competitive situation. " CHRG-110shrg50420--410 Mr. Zandi," Right. Senator Bennett. But that is the situation we are in with respect to this. Thank you, Mr. Chairman. " CHRG-111hhrg53244--121 Mr. Bernanke," The haircuts are set based upon evaluations of the riskiness of the various assets. I think there is a lot of uncertainty right now about floor plans given the state of the industry and what is happening with GM and Chrysler and so on. And my hope is that, in the next few months, as the situation becomes somewhat clearer, it could be that ratings will be upgraded and that we will see a somewhat better situation. But right now there is just a lot of murkiness, in terms of the credit quality of the floor plan loans. " CHRG-109hhrg28024--21 Mr. Frank," Thank you, Mr. Chairman. I'll start my time and give credit where credit is due. As this colloquy about the 30-year bond has occurred, when President Bush came to office, there was some concern, and Mr. Greenspan had it, about how the Federal Government would deal with this problem with surpluses and a disappearing debt, and the Bush Administration certainly solved that problem. No one has to worry any more, thanks to our recent fiscal policy about the possibility of surplus and not enough debt. So I did want to acknowledge that accomplishment. On the question that I began with, Mr. Bernanke, I wonder, Mr. Greenspan did on several occasions lament the increasing inequality that was happening in America. Again, I want to stress inequality is a good thing in a capitalist economy. The economy doesn't work without it. But it can become excessive in ways that I think don't, are not necessarily for efficiency and can cause other kinds of problems. Do you feel his concern about inequality, both in the abstract and in terms of how we've been in the last few years? " FOMC20051213meeting--49 47,MS. MINEHAN.," Well, at the risk of going back into a discussion that I think President Santomero began and President Poole picked up on, I was struck by the slow pace of hiring that is in your projection. You have job gains going from 85,000 a month in the second half of next year to 50,000 per month in 2007. Having come through the last three or four years, numbers like that in monthly employment data would be cause for concern, and yet we still have growth not that far below potential. We have structural productivity growing, a narrowing of the output gap, and unemployment staying about stable—the difference being this rise in compensation per hour creating enough income to support the demand side of it. You probably have talked enough about this but I found that slowness in the pace of hiring a little disturbing after what we’ve been through. And I wondered what your thoughts were about it. Maybe I’m just asking the same question that Tony was asking in terms of the risks to consumer spending." CHRG-110shrg50369--114 Mr. Bernanke," Well, Senator, as I have argued in a number of speeches, for example, globalization and trade have a lot of benefits, but they also have some costs. They cause dislocation. They cause loss of jobs. And my view is that the best way to deal with that problem is not to shut down trade but, rather, to help those who are affected adjust to their circumstances. Senator Dole. Right. " CHRG-111shrg57321--10 Mr. Cifuentes," Thank you, Mr. Chairman, thank you, Senator Kaufman, for the invitation to be here in this hearing.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Cifuentes with attachments appears in the Appendix on page 144.--------------------------------------------------------------------------- My name is Arturo Cifuentes, and I am a professor at the University of Chile. I recently moved back to Chile after living in the United States for 30 years. I spent probably the last 15 years working in finance. I worked at Moody's--I have to say that--from 1996 until the end of 1999 when ratings really mattered and AAA meant something. This is the second time I am testifying before the Senate. I testified 2 years ago, and I made some observations regarding the problem at hand and some suggestions that I thought could be implemented, and I have articulated, I believe, in my testimony today all the relevant points that I wanted to make. So I am not going to read anything. I am just going to make three points which I believe are relevant in the context of what we are talking about here. The first observation that I would like to make is the following: Moody's and S&P are two different companies. They give ratings. A rating is basically nothing but an opinion about the credit risk of a security. Moody's gives ratings based on expected loss. S&P gives ratings based on probability of default. I do not want to go into the technical matters of what that means, but believe me, they are two different things. And they both profess to give ratings based on different benchmarks, different standards, different models, different approaches. They are two different companies in different buildings, different people. If you take a look, even a casual look, at the ratings given by Moody's and S&P, there is a high degree of agreement between the ratings given by these two companies, which makes you wonder whether the ratings are really independent. That is something probably I think that raises some issues and should be investigated in more detail. There are certain mathematical methods actually to do that in a careful fashion, but you become very suspicious if you see such a degree of agreement between AAAs given by the two rating agencies. Considering the approaches, they should be a little bit different, so you wonder are these two companies dancing independently or is this carefully calibrated footwork to make sure credit ratings are aligning with market share. That is something that I think is a little bit concerning. The other issue that I would like to address here today is something that is more just applicable to the subprime market. The rating agencies have said on many occasions that the ratings they gave to transactions involving subprime loans performed so badly because they rely on data provided by the bankers and the data was not good. So allegedly they were not at fault because they used information that they did not have the opportunity to verify and it turns out to be wrong. I do not believe that is a reasonable explanation. For one thing, that was not the case when I worked at Moody's. We always checked everything that the bankers told us. Whenever we are looking at the securitization for the first time, we look in a certain amount of detail to make sure the data presented to us actually was meaningful and accurate. If that were the case, it seems to me as a market participant that if the ratings were given on information that you did not verify, it seems to me that they should come up with a warning, something along the lines that, ``We are giving a rating based on information that we believe is true but we have not checked,'' or something like that. I think that would have been a reasonable thing to do. And, finally, the third point that I would like to make, because this is a very serious problem, is the situation where we are right now, what we really--Senator Kaufman was talking about democracy and capital markets. I believe the situation we have right now is really bad because what we have right now, it is really a marriage made in hell. You have a situation in which nobody believes in the ratings, and at the same time, the ratings are part of the regulatory framework. So nobody believes in these. Still, you have played by the rules. Now, I cannot tell you how critical that is because the situation right now is that the securitization market is paralyzed, the ABC commercial paper market is more or less paralyzed, or it is a shadow of what it used to be. It is about one-third of the size. And that has significant effects on the fixed-income market. There is a perception--and I am going to stop here--that this market is not regulated. Actually, I would say that this is probably the most regulated market in the world. It is just that it is regulated by the rating agencies, and it did not work out that well. So I think I am going to stop here, and then I am going to be happy to answer any questions that you might have. Thank you very much. Senator Levin. Thank you very much, Dr. Cifuentes. What we will do is have 20-minute rounds. We can have more than one round if we need them. If you all would take a look in the exhibit book at Exhibit 94b,\1\ this is a CDO known as Vertical ABS CDO 2007-1. S&P analysts in 2007 complained about how the Vertical's issuer, UBS, was not cooperating with them, and the deal was unlikely to perform. In a 2007 email, the one that you are looking at there, Exhibit 94b, one analyst for S&P wrote, ``Vertical is politically closely tied to B of A--and is mostly a marketing shop--helping to take risk off books of BoA. Don't see why we have to tolerate lack of cooperation. Deals likely not to perform.''--------------------------------------------------------------------------- \1\ See Exhibit No. 94b, which appears in the Appendix on page 599.--------------------------------------------------------------------------- Now, despite that judgment that the CDO was unlikely to perform, S&P rated it. Several months after that deal was rated, the loans began to show delinquencies, and a little later on, S&P and Moody's downgraded it. Those securities, by the way, are now below investment grade. They are in junk status. One of the purchasers of the Vertical securities is a hedge fund called Pursuit Partners. They sued S&P, Moody's, and UBS over the quick demise of the security. As I mentioned before, S&P and Moody's annuities were dropped from the lawsuit because of the lack of the ability under our current law to sue the rating agencies. But the court ordered UBS to set aside some funds to pay a possible award to that investor. Now, the investor had also uncovered an internal email at UBS in which a banker wrote, ``Sold some more crap to Pursuit,'' referring to the Vertical securities which were then rated as investment grade. That is Exhibit 94n,\2\ by the way.--------------------------------------------------------------------------- \2\ See Exhibit No. 94n, which appears in the Appendix on page 644.--------------------------------------------------------------------------- So, first, Mr. Raiter, let me ask you: Is it common for an S&P analyst to rate a deal even though the analyst thought, as we looked at Exhibit 94b, that the deal was ``not likely to perform''? " CHRG-111hhrg55814--169 The Chairman," But it could be, theoretically, a non-bank entity that's causing systemic risk or acting out of control in some way. That's true, right? " CHRG-111hhrg52400--128 Mr. Price," Thank you. I want to switch gears to Mr. McRaith. You mentioned that you wanted to comment on the Solvency II framework, and I wondered if you have had an opportunity to look at the consequences that will have, or may have, for States. " CHRG-111hhrg48875--159 The Chairman," The gentlewoman from Ohio. Ms. Kilroy. Thank you, Mr. Chairman, and thank you, Mr. Secretary, for returning here. You know, certainly we have talked a little bit about what happened last fall and whether or not things could have--what you're proposing now could have prevented what happened then. And certainly at that time, you know, I was not here. Along with other citizens, we sort of watched and listened to the issues with Lehman, the failure with Lehman, Bear Stearns, and AIG, and we saw government officials scrambling to try to prevent collapse. So, you know, what seemed to me is that Treasury at that time had no Plan B, had no preparation for what to do in that sense, and were winging it, were scrambling. So I appreciate the fact that you are engaging in this kind of process, taking a bigger picture look at it about what we need to do so that we don't get into a situation of housing bubbles and egregious credit default swaps and overleveraged institutions, and even fraud on a dramatic scale, as you said in your earlier remarks. And I certainly look forward to working with you on these issues of systemic risk and capital requirements and over-the-counter oversight, and like some of my colleagues here, take a stronger view on credit default swaps. And I also appreciate the public-private partnership that you announced with addressing the issue of toxic assets and cleaning up that mess. But I think as we heard from Mr. Klein, you know, the AIG bonus uproar did offend a sense of justice that's ingrained in the American people, that those who broke their own company, broke the system and caused such anguish and real hurt out there on Main Street, are also continuing to benefit from that. And what I think we need to hear a lot more is how this will help the taxpayer, how this will help Main Street; the car dealer, the restaurant owner, the dry cleaners, and the hardworking people here who are planning to retire and seeing their 401(k)s that they had hoped to use in a couple of years disappear. So what would you say to them, that this is going to benefit them? " Secretary Geithner," ``This'' being the program of reforms we're announcing today? Ms. Kilroy. Right. " CHRG-111shrg53822--88 PREPARED STATEMENT OF PETER J. WALLISON * Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise Institute May 6, 2009 Chairman Dodd, Ranking member Shelby and members of the Committee:--------------------------------------------------------------------------- * The views expressed in this testimony are those of the author alone and do not necessarily represent those of the American Enterprise Institute.--------------------------------------------------------------------------- I am very pleased to have this opportunity to appear before this Committee to discuss one of the most important issues currently facing our country. The financial crisis will eventually end. The legislation that Congress adopts to prevent a similar event in the future is likely to be with us for 50 years. The terms ``too big to fail'' and ``systemically important'' are virtually interchangeable. The reason that we might consider some financial institutions ``too big to fail'' (TBTF) is that their failure could produce substantial losses or other ill effects elsewhere in the economy--a systemic breakdown of some kind. Thus, if a firm is systemically important, it is also likely to be TBTF. Understanding the virtual identity between these two terms is essential, because we should not be concerned about business failures unless they can have knock-on effects that could involve the whole economy or the whole financial system. There is real danger that policymakers will confuse efforts to prevent simple business failures with efforts to prevent systemic breakdowns. It is to the credit of the Obama administration that they have not claimed that the bankruptcy of General Motors would cause a systemic breakdown, even though GM's failure could cause widespread losses throughout the economy. In this testimony, I will discuss the GM case frequently, as a way of testing whether we have adequate concepts for determining whether a financial firm is TBTF. If GM is not TBTF it raises questions whether any nonbank financial firm--no matter how large--is likely to be TBTF. The discussion that follows will specifically address the four issues that Chairman Dodd outlined in his letter of invitation: Whether a new regulatory framework is desirable or feasible to prevent institutions from becoming ``too big to fail'' and posing the risk of systemic harm to the economy and financial system; Whether existing financial organizations considered ``too big to fail'' should be broken up; What requirements under a new regulatory framework are necessary to prevent or mitigate risks associated with institutions considered ``too big to fail;'' for example, new capital and disclosure requirements, as well as restrictions on size, affiliations, transactions, and leverage; and How to improve the current framework for resolving systemically important non-bank financial companies.Is it desirable or feasible to develop a regulatory framework that will prevent firms from becoming TBTF or posing a risk of systemic harm? A regulatory framework that will prevent companies from becoming TBTF--or causing systemic breakdowns if they fail--is only desirable or feasible if Congress can clearly define what it means by systemic harm or TBTF. If Congress cannot describe in operational terms where to draw the line between ordinary companies and companies that are TBTF--or if it cannot define what it means by ``systemic harm''--it would not be good policy to give the power to do so to a regulatory agency. The standard, ``I know it when I see it'' may work when a systemic event is imminent, but not for empowering a regulatory agency to designate TBTF or systemically important firms in advance. If Congress does so, the likelihood of severe and adverse unintended consequences is quite high. First, if a firm is designated in advance as TBTF (that is, as systemically important), it will have competitive advantages over other firms in the same industry and other firms with which it competes outside its industry. This is true because the TBTF designation confers important benefits. The most significant of these is probably a lower cost of funding, arising from the market's recognition that the risk of loss is significantly smaller in firms that the government will not allow to fail than it is in firms that might become bankrupt. Lower funding costs will translate inevitably--as it did in the case of Fannie Mae and Freddie Mac--into market dominance and consolidation. Market sectors in which TBTF firms are designated will come to be dominated and controlled by the large TBTF firms, and smaller firms will gradually be squeezed out. Ironically, this will also result in consolidation of risk in fewer and fewer entities, so that the likelihood of big firm collapses becomes greater and each collapse more disruptive. In some markets, status as TBTF has another advantage--the appearance of greater stability than competitors. In selling insurance, for example, firms that are designated as systemically important will be able to tell potential customers that they are more likely to survive and meet their obligations than firms that have not been so designated. Accordingly, if there is to be a system of designating certain firms as systemically important, it is necessary to be able to state with some clarity what standards the agency must use to make that decision. Leaving the agency with discretion, without definitive standards, would be courting substantial unintended consequences. The natural tendency of a regulator would be to confer that designation broadly. Not only does this increase the regulator's size and power, but it also minimizes the likelihood--embarrassing for the regulator--that a systemic event will be caused by a firm outside the designated circle. Accordingly, the ability of Congress to define what it means by a TBTF firm would be important to maintain some degree of competitive vigor in markets that would otherwise be threatened by the designation of one or more large firms as systemically important and thus TBTF. Second, apart from competitive considerations, it is necessary to consider the possibility that ordinary business failures might be prevented even though they would not have caused a systemic breakdown if they occurred. Again, the tendency of regulators in close cases will be to exercise whatever power they have to seize and bail out failing firms that might be TBTF. The incentives all fall in this direction. If a systemic breakdown does occur, the regulator will be blamed for failing to recognize the possibility, while if a firm is bailed out that would not in fact have caused a systemic breakdown, hardly anyone except those who are forced to finance it (a matter to be discussed later) will complain. This makes bailouts like AIG much more likely unless Congress provides clear guidelines on how a regulator is to identify a TBTF or systemically important firm. The stakes for our competitive system are quite high in this case, because bailouts are not only costly, but they have a serious adverse effect on the quality of companies and managements that continue to exist. If firms are prevented from failing when they are not TBTF or otherwise systemically important, all other firms are weakened. This is because our competitive market system improves--and consumers are better served--through the ``creative destruction'' that occurs when bad managements and bad business models are allowed to fail. When that happens, the way is opened for better managements and business models to take their place. If failures are prevented when they should not be, the growth of the smaller but better managed and more innovative firms will be hindered. Overall, the quality and the efficiency of the firms in any market where this occurs will decline. Finally, setting up a mechanism in which companies that should be allowed to fail are rescued from failure will introduce significant moral hazard into our financial system. This is true even if the shareholders of a rescued firm are wiped out in the process. Shareholders are not the group whose views we should be worried about when we consider moral hazard. Shareholders, like managements, benefit from risk-taking, which often produces high profits as well as high rates of failure. The class of investors we should be thinking about are creditors, who get no benefits whatever from risk-taking. They are the one who are in the best position to exercise market discipline, and they do so by demanding higher rates of interest when they see greater risk-taking in a potential borrower. To the extent that the wariness of creditors is diminished by the sense that a company may be rescued by the government, there will be less market discipline by creditors and increased moral hazard. The more companies that are added to the list of firms that might be rescued, the greater the amount of moral hazard that has been introduced to the market. The administration's plan clearly provides for possible rescue, since it contemplates either a receivership (liquidation) or a conservatorship (generally a way to return a company to health and normal operations). Accordingly, although it is exceedingly important for Congress to be clear about when a company may be designated as TBTF, it will be very difficult to do so. This is illustrated by the GM case. GM is one of the largest companies in the U.S.; its liquidation, if it occurs, could cause a massive loss of jobs not only at GM itself but at all the suppliers of tires, steel, fabrics, paints, and glass that go into making a car, all the dealers that sell the cars, all the banks that finance the dealers, and all the communities, localities, and states throughout the U.S. that depend for their revenues on the taxes paid by these firms and their employees. In other words, there would be very serious knock-on effects from a GM failure. Yet, very few people are suggesting that GM is TBTF in the same way that large financial institutions are said to be TBTF. What is the difference? This question focuses necessary attention on two questions: what it means to be TBTF and the adequacy of the bankruptcy system to resolve large firm failures. If GM is not TBTF, why not? The widespread losses throughout the economy would certainly suggest a systemic effect, but if that is not what we mean by a systemic effect, what is it that we are attempting to prevent? On the other hand, if that is what we mean by a systemic effect, should the government then have the power to resolve all large companies--and not just financial firms--outside the bankruptcy system? The fact that GM may ultimately go into bankruptcy and be reorganized under Chapter 11 suggests that the bankruptcy system is adequate for large financial nonbank institutions, unless the propensity of nonbank financial institutions to create systemic breakdowns can be distinguished from that of operating companies like GM. Later in this testimony, I will argue that this distinction cannot be sustained. The forgoing discussion highlights the difficulty of defining both a systemic event and a systemically important or TBTF firm, and also the importance of defining both with clarity. Great harm could come about if Congress--without establishing any standards--simply authorizes a regulatory agency to designate TBTF companies, and authorizes the same or another agency to rescue the companies that are so designated. My answer, then, to the Committee's first question is that--given the great uncertainty about (i) what is a systemic event, (ii) how to identify a firm that is TBTF, and (iii) what unintended consequences would occur if Congress were not clear about these points--it would be neither desirable nor feasible to set up a structure that attempts to prevent systemic harm to the economy by designating systemically important firms and providing for their resolution by a government agency rather than through the normal bankruptcy process. Nevertheless, it would not be problematic to create a body within the executive branch that generally oversees developments in the market and has the responsibility of identifying systemic risk, wherever it might appear to be developing within the financial sector. The appropriate body to do this would be the President's Working Group (PWG), which consists of most of the major Federal financial supervisors and thus has a built-in market-wide perspective. The PWG currently functions under an executive order, but Congress could give it a formal charter as a government agency with responsibility for spotting systemic risk as well as coordinating all financial regulatory activity in the executive branch.Breaking up systemically significant or TBTF firms There could be constitutional objections to a breakup--based on the takings and due process--unless there are clear standards that justify it. I am not a constitutional lawyer, but a fear that a company might create a systemic breakdown if it fails does not seem adequate to take the going concern value of a large company away from its shareholders. As we know from antitrust law, firms can be broken up if they attempt to monopolize and under certain other limited circumstances. But in those cases, there are standards for market dominance and for the requisite intent to use it in order to create a monopoly--and both are subject to rigorous evidentiary standards. As I pointed out above, there are no examples that define a systemic risk or why one company might cause it and another might not. Accordingly, providing authority for a government agency to break up companies that are deemed to be systemically risky could be subject to constitutional challenge. In addition, as a matter of policy, breaking up large institutions would seem to create many more problems than it would solve. First, there is the question of breaking up successful companies. If companies have grown large because they are successful competitors, it would be perverse to penalize them for that, especially when we aren't very sure whether they would in fact cause a systemic breakdown if they failed. In addition, our economy is made up of large as well as small companies. Large companies generally need large financial institutions to meet their financing needs. This is true whether we are talking about banks, securities firms, insurance companies, finance companies, or others. Imagine a large oil company trying to insure itself against property or casualty losses with a batch of little insurance companies. The rates it would have to pay would be much higher, if it could get full coverage at all. Or imagine the same oil company trying to pay its employees worldwide without a large U.S. bank with worldwide operations, or the same company trying to place hundreds of millions of dollars in commercial paper each week through small securities firms without a global reach. There are also international competitive factors. If other countries did not break up their large financial institutions, our large operating companies would probably move their business to the large foreign financial institutions that could meet their needs. Leaving our large operating companies without an alternative source of funding could also be problematic, in the event that a portion of the financial markets becomes unavailable--either in general or for a specific large firm. The market for asset-backed securities closed down in the summer of 2007 and hasn't yet reopened. Firms that used to fund themselves through this market were then compelled to borrow from banks or to use commercial paper or other debt securities. This is one of the reasons that the banks have been reluctant to lend to new customers; they have been saving their cash for the inevitable withdrawals by customers that had been paying over many years for lines of credit that they could use when they needed emergency funds. The larger firms might not have been able to find sufficient financial resources if the largest banks or other financial institutions had been broken up. The breakup of large financial firms would create very great risks for our economy, with few very benefits, especially when we really have no idea whether any particular firm that might be broken up actually posed a systemic risk or would have created a systemic breakdown if it had failed.Are there regulatory actions we can take to mitigate or prevent systemic risk caused by TBTF companies? For the reasons outlined below, it is my view that only the failure of a large commercial bank can create a systemic breakdown, and that nonbank financial firms--even large ones--are no more likely than GM to have this effect. For that reason, I would not designate any nonbank financial institution (other than a commercial bank) as systemically important, nor recommend safety and soundness supervision of any financial institutions other than those where market discipline has been impaired because they are backed by the government, explicitly or implicitly. The track record of banking regulation is not good. In the last 20 years we have had two very serious banking crises, including the current one, when many banks failed and adversely affected the real economy. The amazing thing is that--despite this record of failure--the first instinct of many people in Washington it is to recommend that safety and soundness regulation be extended to virtually the entire financial system through the regulation and supervision of systemically important (or TBTF) firms. After the S&L debacle and the failure of almost 1600 commercial banks at the end of the 1980s and the beginning of the 1990s, Congress adopted the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), a tough regulatory statute that many claimed would put an end to banking crises. Yet today we are in the midst of a banking crisis that some say could be as bad as that of the Great Depression, perhaps even worse. If banks were not backed by the government--through deposit insurance, a lender of last resort, and exclusive access to the payment system--their risk-taking would probably be better controlled by market discipline exerted by creditors. But given the government support they receive, and its effect in impairing market discipline, regulation and supervision of their safety and soundness is the only sensible policy. Nevertheless, there are some reasonable steps that could be taken to improve bank regulation and to mitigate the possibility that the failure of a large bank might in the future have a significant adverse effect on other economic actors. For the reasons outlined above, I don't think that restrictions on size are workable, and they are likely to be counterproductive. The same thing is true of restrictions on affiliations and transactions, both of which will impose costs, impair innovation, and reduce competition. Since we have no idea whether any particular firm will cause a systemic breakdown if it fails, it does not seem reasonable to impose all these burdens on our financial system for very little demonstrable benefit. Restrictions on leverage can be effective, but I see them as an element of capital regulation, as discussed below. A good example of the unintended consequences of imposing restriction on affiliations is what has happened because of the restrictions on affiliations between banks and commercial firms. As the Committee knows, the Bank Holding Company Act provides that a bank cannot be affiliated with any activity that is not ``financial in nature.'' For many years the banking industry has used this to protect themselves against competition by organizations outside banking, most recently competition from Wal-Mart. They and others have argued that the separation of banking and commerce (actually, after the Gramm-Leach-Bliley Act was adopted in 1999, the principle became the separation of finance and commerce) was necessary to prevent the extension of the so-called Federal ``safety net'' to commercial firms. That idea has now backfired on the banks, because by keeping commercial firms out of the business of investing in banks, they have made it very difficult for banks to raise the capital they need in the current financial crisis. We should not impose restrictions on affiliations unless there is strong evidence that a particular activity is harmful. All such restrictions turn out to be restrictions on competition and ultimately hurt consumers, who must pay higher prices and get poorer services. Because Wal-Mart was unable to compete with banks, many Wal-Mart customers pay more for banking services than they should, and many of them can't get banking services at all. Nevertheless, capital requirements can be used effectively to limit bank risk-taking and growth, and this would be far preferable to other kinds of restrictions. It would make sense to raise bank capital requirements substantially. The only reason banks are able to keep such low capital ratios is that they have government backing. In addition, capital requirements should be raised as banks grow larger, which is in part the result of higher asset values that accompany a growing market. An increase of capital requirements with size would also have the salutary effect of dampening growth by making it more expensive, and it would provide a strong countercyclical brake on the development of asset bubbles. Higher capital requirements as banks grow larger would also induce them to think through whether all growth is healthy, and what lines of business are most suitable and profitable. In addition, as bank profits grow, capital requirements or reserves should also be increased in order to prepare banks for the inevitable time when growth will stop and the decline sets in. Before the current crisis, 10 percent risk-based capital was considered well-capitalized, but it is reasonably apparent now that this level was not high enough to withstand a serious downturn. In addition, regulation should be used more effectively to enhance market discipline. Bank regulators are culturally reluctant to release information on the banks they supervise. This too often leaves market participants guessing about the risks the banks are taking--and wrongly assuming that the regulators are able to control these risks. To better inform the markets, the regulators, working with bank analysts, should develop a series of metrics or indicators of risk-taking that the banks should be required to publish regularly--say, once every month. This would enable the markets to make more informed judgments about bank risk-taking and enhance the effectiveness of market discipline. Rather than fighting market discipline, bank regulators should harness it in this way to supplement their own examination work. Finally for larger commercial banks, especially the ones that might create systemic risk if they failed, it would be a good idea to require the issuance of a form of tradable subordinated debt that could not by law be bailed out. The holders of this debt would have a strong interest in better disclosure by banks and could develop their own indicators of risk-taking. As the market perceived that a bank was taking greater risk, the price of these securities would fall and its yield would rise. The spread of that yield over Treasuries would provide a continuing strong signal to a bank's supervisor that the market foresees trouble ahead if the risk-taking continues. Using this data, the supervisor could clamp down on activities that might result in major losses and instability at a later time.Can we improve the current framework for resolving systemically important nonbank financial firms? The current framework for resolving all nonbank financial institutions is the bankruptcy system. Based on the available evidence, there is no reason to think that it is inadequate for performing this task or that these institutions need a government-administered resolution system. Because of the special functions of banks, a special system for resolving failed banks is necessary, but as discussed below banks are very different from other financial institutions. The creation of a government-run system will increase the likelihood of bailouts of financial institutions and prove exceedingly costly to the financial industry or to the taxpayers, who are likely to end up paying the costs. The underlying reason for the administration's proposal for a special system of resolution for nonbank financial institutions is the notion that the failure of a large financial firm can create a systemic breakdown. Thus, although many people look at the administration's resolution plan as a means to liquidate systemically important or TBTF firms in an orderly way, it is more likely to be a mechanism for bailing out these firms so that they will not cause a systemic breakdown. The Fed's bailout of AIG is the paradigm for this kind of bailout, which sought to prevent market disruption by using taxpayer funds to prevent losses to counterparties and creditors. As support for its proposal, the administration cites the ``disorderly'' bailout of AIG and the market's panicked reaction to the failure of Lehman Brothers. On examination, these examples turn out to be misplaced. Academic studies after both events show that the market's reaction to both was far more muted than the administration suggests. Moreover, the absence of any recognizable systemic fallout from the Lehman bankruptcy--with the exception of a single money market mutual fund, no other firm has reported or shown any serious adverse effects--provides strong evidence that in normal market conditions the reaction to Lehman's failure would not have been any different from the reaction to the failure of any large company. These facts do not support the notion that a special resolution mechanism is necessary for any financial institutions other than banks. The special character of banks. Although the phrase ``shadow banking'' is thrown around to imply a strong similarity between commercial banks and other financial institutions such as securities firms, hedge funds, finance companies or insurers, the similarity is illusory in most important respects. Anyone can lend; only banks can take deposits. Deposit-taking--not lending--is the essence of banking. By offering deposits that can be withdrawn on demand or used to pay others through an instruction such as a check, banks and other depository institutions have a special and highly sensitive role in our economy. If a bank should fail, its depositors are immediately deprived of the ready funds they expected to have available for such things as meeting payroll obligations, buying food, or paying rent. Banks also have deposits with one another, and small banks often have substantial deposits in larger banks in order to facilitate their participation in the payment system. Because of fear that a bank will not be able to pay in full on demand, banks are also at risk of ``runs''--panicky withdrawals of funds by depositors. Runs can be frightening experiences for the public and disruptive for the financial system. The unique attribute of banks--that their liabilities (deposits) may be withdrawn on demand-is the reason that banks are capable of creating a systemic event if they fail. If bank customers cannot have immediate access to their funds, or if a bank cannot make its scheduled payments to other banks, the others can also be in trouble, as can their customers. That is the basis for a true systemic event. The failure of a bank can leave its customers and other banks without the immediate funds they are expecting to use in their daily affairs. The failure of a large bank can cause other failures to cascade through the economy, theoretically creating a systemic event. I say ``theoretically'' because the failure of a large bank has never in modern times caused a systemic event. In every case where a large bank might have failed and caused a systemic breakdown, it has been rescued by the FDIC. The most recent such case--before the current crisis--was the rescue of Continental Illinois Bank in 1984. The foregoing description of how a large bank's failure can cause a systemic breakdown raises a number of questions about whether and how a systemic breakdown can be caused by the failure of a nonbank financial institution. These financial institutions--securities firms, hedge funds, insurance companies, finance companies, and others--tend to borrow for a specific term or to borrow on a collateralized basis. In this respect, they are just like GM. In common with all other large commercial borrowers, nonbank financial institutions also fund themselves with short-term commercial paper. Unless they are extremely good credits, this paper is collateralized. If they should fail, their creditors can recoup their losses by selling the collateral. Their failures, then, do not cause any immediate cash losses to their lenders or counterparties. Losses occur, to be sure, but in the same way that losses will occur if GM should file for bankruptcy--those who suffer them do not lose the immediate access to cash that they were expecting to use for their current obligations, and thus there is rarely any contagion in which the losses of one institution are passed on to others in the kind of cascade that can occur when a bank fails. It is for this reason that describing the operations of these nondepository institutions as ``shadow banking'' is so misleading. It ignores entirely the essence of banking--which is not simply lending--and how it differs from other kinds of financial activity. Because of the unique effects that are produced by bank failures, the Fed and the FDIC have devised systems for reducing the chances that banks will not have the cash to meet their obligations. The Fed lends to healthy banks (or banks it considers healthy) through what is called the discount window--making cash available for withdrawals by worried customers--and the FDIC will normally close insolvent banks just before the weekend and open them as healthy, functioning new institutions on the following Monday. In both cases, the fears of depositors are allayed and runs seldom occur. The policy question facing Congress is whether it makes sense to extend FDIC bank resolution processes to other financial institutions. For the reasons outlined above, there is virtually no reason to do so for financial institutions other than banks. Before proceeding further, it is necessary to correct some misunderstandings about the effectiveness of the FDIC, which has been presented by the administration and others as a paragon in the matter of resolving banks. The facts suggest a different picture, and should cause policymakers to pause before authorizing the FDIC or any other agency to take over the resolution of nonbank financial institutions. The FDIC and the other bank regulators function under a FDICIA requirement for prompt corrective action (PCA) when a bank begins to weaken. The objective of PCA is to give the FDIC and other supervisors the authority to close a bank before it actually becomes insolvent, thus saving both the creditors and the FDIC insurance fund from losses. It has not worked out that way. Thus far in 2009, there have been 32 reported bank failures for which the FDIC has reported its losses. In these cases, the losses on assets have ranged from 8 percent to 45 percent, with both an average and a weighted average of 28 percent. In 2008, there were 25 bank failures, with losses averaging 25 percent. There may be reasons for these extraordinary losses, including the difficulty of dealing with the primary Federal or state regulator, but the consistency of the losses in the face of the PCA requirement casts some doubt on the notion that even the best Federal resolution agency--dealing with failing insurance companies, securities firms, hedge funds and others--would be able to do a more efficient job than a bankruptcy court. While the failures of the FDIC as a resolution agency are not well known, the weakness of the bankruptcy system as a way of resolving failing financial institutions has been exaggerated. The evidence suggests that the Lehman's bankruptcy filing--as hurried as it was--has resulted in a more orderly resolution of the firm than AIG's rescue by the Fed. As reported by professors Kenneth Ayotte and David Skeel, things moved with dispatch after Lehman filed for bankruptcy under Chapter 11 of the code. Thus, as Ayotte and Skeel note: Lehman filed for Chapter 11 on September 15, 2008. Three days later, Lehman arranged a sale of its North American investment banking business to Barclays, and the sale was quickly approved by the court after a lengthy hearing . . . Its operations in Europe, the Middle East, and Asia were bought by Nomura, a large Japanese brokerage firm. By September 29, Lehman had agreed to sell its investment management business to two private equity firms.\1\--------------------------------------------------------------------------- \1\ Kenneth Ayotte and David A. Skeel, Jr., ``Bankruptcy or Bailouts?'' (March 2, 2009). U of Penn, Inst for Law & Econ Research Paper No. 09-11; Northwestern Law & Econ Research Paper No. 09-05, pp 9-10. Available at SSRN: http://ssrn.com/abstract=1362639.Chapter 11 allows bankrupt debtors to remain in possession of their assets and continue operating while their creditors reach agreement on how best to divide up the firm's assets. It also permits firms to return to financial health if their creditors conclude that this is more likely to result in a greater recovery than a liquidation. In other words, Chapter 11 provides a kind of bailout mechanism, but one that is under the control of the creditors-the parties that have suffered the real losses. Neither the taxpayers nor any other unrelated party is required to put in any funds to work out the failed company. There are many benefits of a bankruptcy that are not likely to come with a system of resolution by a government agency. These include certainty about the rights of the various classes of creditors; a well-understood and time-tested set of procedures; the immediate applicability of well-known stay provisions that prevent the disorderly seizure of collateral; equally well-known exemptions from stay provisions so that certain creditors holding short-term obligations of the failed company can immediately sell their collateral; and well worked out rules concerning when and under what circumstances preferential payments to certain creditors by the bankrupt firm have to be returned to the bankrupt estate. Still, the examples of Lehman Brothers and AIG have had a significant impact on the public mind and a hold on the attitudes of policymakers. It is important to understand these cases, and the limited support they provide for setting up a system for resolving large nonbank financial institutions. The market reactions after the failures of AIG and Lehman are not examples of systemic risk. Secretary Geithner has defended his proposal for a resolution authority by arguing that, if it had been in place, the rescue of AIG last fall would have been more ``orderly'' and the failure of Lehman Brothers would not have occurred. Both statements might be true, but would that have been the correct policy outcome? Recall that the underlying reason for the administration's plan to designate and specially regulate systemically important firms is that the failure of any such company would cause a systemic event--a breakdown in the financial system and perhaps the economy as a whole. If this is the test, it is now reasonably clear that neither AIG nor Lehman is an example of a large firm creating systemic risk or a systemic breakdown. In a widely cited paper and a recent book, John Taylor of Stanford University concluded that the market meltdown and the freeze in interbank lending that followed the Lehman and AIG events in mid-September 2008 did not begin until the Treasury and Fed proposed the initial Troubled Asset Relief Program later in the same week, an action that implied that financial conditions were much worse than the markets had thought.\2\ Taylor's view, then, is that AIG and Lehman were not the cause of the meltdown that occurred later that week. Since neither firm was a bank or other depository institution, this analysis is highly plausible. Few of their creditors were expecting to be able to withdraw funds on demand to meet payrolls or other immediate expenses, and later events and data have cast doubt on whether the failure of Lehman or AIG (if it had not been bailed out) would have caused the losses that many have claimed.--------------------------------------------------------------------------- \2\ John B. Taylor, ``The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong'' Working Paper 14,631, National Bureau of Economic Research, Cambridge, MA, January 2009), 25ff, available at www.nber.org/papers/w14631 (accessed April 8, 2009).John B. Taylor, Getting Off Track: How Government Actsion and Ingterventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Institution Press, 2009, pp 25-30.--------------------------------------------------------------------------- In another analysis after the Lehman and AIG events, Ayotte and Skeel concluded that the evidence suggests ``at a minimum, that the widespread belief that the Lehman Chapter 11 filing was the singular cause of the collapse in credit that followed is greatly overstated.''\3\ They also show that that there was very little difference between the market's reaction to Lehman and to AIG, although the former went into bankruptcy and the latter was rescued.--------------------------------------------------------------------------- \3\ Ayotte and Skeel, p 27.--------------------------------------------------------------------------- Advocates of broader regulation frequently state that financial institutions are now ``interconnected'' in a way that they have not been in the past. This idea reflects a misunderstanding of the functions of financial institutions, all of which are intermediaries in one form or another between sources of funds and users of funds. In other words, they have always been interconnected in order to perform their intermediary functions. The right question is whether they are now interconnected in a way that makes them more vulnerable to the failure of one or more institutions than they have been in the past, and there is no evidence of this. The discussion below strongly suggests that there was no need to rescue AIG and that Lehman's failure was problematic only because the market was in an unprecedentedly fragile and panicky state in mid-September 2008. This distinction is critically important. If the market disruption that followed Lehman's failure and AIG's rescue was not caused by these two events, then identifying systemically important firms and supervising them in some special way serves no purpose. Even if the failure of a systemically important firm could be prevented through regulation--a doubtful proposition in light of the current condition of the banking industry--that in itself would not prevent the development of a fragile market, or its breakdown in the aftermath of a serious shock. The weakness or failure of individual firms is not the source of the problem. In terms of a conventional systemic risk analysis, the chaos that followed was not the result of a cascade of losses flowing through the economy as a result of the failure of Lehman or the potential failure of AIG. In the discussion that follows, I show first that Lehman did not cause, and AIG would not have caused, losses to other firms that might have made them systemically important. I then show that both are examples of nonbank financial firms that can be successfully resolved--at no cost to the taxpayers--through the bankruptcy process rather than a government agency. AIG Should Have Been Sent into Bankruptcy. AIG's quarterly report on Form 10-Q for the quarter ended June 30, 2008--the last quarter before its bailout in September--shows that the $1 trillion company had borrowed, or had guaranteed subsidiary borrowings, in the amount of approximately $160 billion, of which approximately $45 billion was due in less than 1 year.\4\ Very little of this $45 billion was likely to be immediately due and payable, and thus, unlike a bank's failure, AIG's failure would not have created an immediate cash loss to any significant group of lenders or counterparties. Considering that the international financial markets have been estimated at more than $12 trillion, the $45 billion due within a year would not have shaken the system. Although losses would eventually have occurred to all those who had lent money to or were otherwise counterparties of AIG, these losses would have occurred over time and been worked out in a normal bankruptcy proceeding, after the sale of its profitable insurance subsidiaries.--------------------------------------------------------------------------- \4\ American International Group, 10-Q filing, June 30, 2008, 95-101.--------------------------------------------------------------------------- Many of the media stories about AIG have focused on the AIG Financial Products subsidiary and the obligations that this group assumed through credit default swaps (CDSs). However, it is highly questionable whether there would have been a significant market reaction if AIG had been allowed to default on its CDS obligations in September 2008. CDSs--although they are not insurance--operate like insurance; they pay off when there is an actual loss on the underlying obligation that is protected by the CDS. It is much the same as when a homeowners' insurance company goes out of business before there has been a fire or other loss to the home. In that case, the homeowner must go out and find another insurance company, but he has not lost anything except the premium he has paid. If AIG had been allowed to default, there would have been little if any near-term loss to the parties that had bought protection; they would simply have been required to go back into the CDS market and buy new protection. The premiums for the new protection might have been more expensive than what they were paying AIG, but even if that were true, many of them had received collateral from AIG that could have been sold in order to defray the cost of the new protection. CDS contracts normally require a party like AIG that has sold protection to post collateral as assurance to its counterparties that it can meet its obligations when they come due. This analysis is consistent with the publicly known facts about AIG. In mid-March, the names of some of the counterparties that AIG had protected with CDSs became public. The largest of these counterparties was Goldman Sachs. The obligation to Goldman was reported as $12.9 billion; the others named were Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion), and Wachovia ($1.5 billion). Recall that the loss of CDS coverage--the obligation in this case--is not an actual cash loss or anything like it; it is only the loss of coverage for a debt that is held by a protected party. For institutions of this size, with the exception of Goldman, the loss of AIG's CDS protection would not have been problematic, even if they had in fact already suffered losses on the underlying obligations that AIG was protecting. Moreover, when questioned about what it would have lost if AIG had defaulted, Goldman said its losses would have been ``negligible.'' This is entirely plausible. Its spokesman cited both the collateral it had received from AIG under the CDS contracts and the fact that it had hedged its AIG risk by buying protection against AIG's default from third parties. Also, as noted above, Goldman only suffered the loss of its CDS coverage, not a loss on the underlying debt the CDS was supposed to cover. If Goldman, the largest counterparty in AIG's list, would not have suffered substantial losses, then AIG's default on its CDS contracts would have had no serious consequences in the market. This strongly suggests that AIG could have been put into bankruptcy with no costs to the taxpayers, and if it had not been rescued its failure would not have caused any kind of systemic risk. On the other hand, it is highly likely that a systemic regulator would have rescued AIG--just as the Fed did--creating an unnecessary cost for U.S. taxpayers and an unnecessary windfall for AIG's counterparties. Lehman's Failure Did Not Cause a Systemic Event. Despite the contrary analyses by Taylor, Skeel, and Ayotte, it is widely believed that Lehman's failure proves that a large company's default, especially when it is ``interconnected'' through CDSs, can cause a systemic breakdown. If that were true, then it might make sense to set up a regulatory structure to prevent a failure by a systemically important company. But it is not true. Even if we accept that Lehman's failure somehow precipitated the market freeze that followed, that says nothing about whether, in normal market conditions, Lehman's failure would have caused the same market reaction. In fact, analyzed in light of later events, it is likely that Lehman's bankruptcy would have had no substantial adverse effect on the financial condition of its counterparties. In other words, the failure would not--in a normal market--have caused the kind of cascade of losses that defines a systemic breakdown. After Lehman's collapse, there is only one example of any other organization encountering financial difficulty because of Lehman's default. That example is the Reserve Fund, a money market mutual fund that held a large amount of Lehman's commercial paper at the time Lehman defaulted. This caused the Reserve Fund to ``break the buck''--to fail to maintain its share price at exactly one dollar--and it was rescued by the Treasury and Fed. The need to rescue the Reserve Fund was itself another artifact of the panicky conditions in the market at the time. That particular fund was an outlier among all funds in terms of its risks and returns.\5\ The fact that there were no other such cases, among money market funds or elsewhere, demonstrates that the failure of Lehman in a calmer and more normal market would not have produced any of the significant knock-on effects that are the hallmark of a systemic event. It is noteworthy, in this connection, that a large securities firm, Drexel Burnham Lambert, failed in 1990 and went into bankruptcy without any serious systemic effects. In addition, when Lehman's CDS obligations were resolved a month after its bankruptcy, they were all resolved by the exchange of only $5.2 billion among all the counterparties, a minor sum in the financial markets and certainly nothing that in and of itself would have caused a market meltdown.--------------------------------------------------------------------------- \5\ Ayotte and Skeel, Op. Cit., p 25, note 73.--------------------------------------------------------------------------- So, what relationship did Lehman's failure actually have to the market crisis that followed? The problems that were responsible for the crisis had actually begun more than a year earlier, when investors lost confidence in the quality of securities--particularly mortgage-backed securities (MBS)--that had been rated AAA by rating agencies. As a result, the entire market for asset-backed securities of all kinds became nonfunctional, and these assets simply could not be sold at anything but a distress price. With large portfolios of these securities on the balance sheets of most of the world's largest financial institutions, the stability and even the solvency of these institutions--banks and others--were in question. In this market environment, Bear Stearns was rescued through a Fed-assisted sale to JPMorgan Chase in March 2008. The rescue was not necessitated because failure would have caused substantial losses to firms ``interconnected'' with Bear, but because the failure of a large financial institution in this fragile market environment would have caused a further loss of confidence--by investors, creditors, and counterparties--in the stability of other financial institutions. This phenomenon is described in a 2003 article by professors George Kaufman and Kenneth Scott, who write frequently on the subject of systemic risk. They point out that when one company fails, investors and counterparties look to see whether the risk exposure of their own investments or counterparties is similar: ``The more similar the risk-exposure profile to that of the initial [failed company] economically, politically, or otherwise, the greater is the probability of loss and the more likely are the participants to withdraw funds as soon as possible. The response may induce liquidity and even more fundamental solvency problems. This pattern may be referred to as a `common shock' or `reassessment shock' effect and represents correlation without direct causation.''\6\ In March 2008, such an inquiry would have been very worrisome; virtually all large financial institutions around the world held, to a greater or lesser extent, the same assets that drove Bear toward default.--------------------------------------------------------------------------- \6\ George G. Kaufman and Kenneth Scott, ``What Is Systemic Risk and Do Regulators Retard or Contribute to It?'' The Independent Review 7, no. 3 (Winter 2003). Emphasis added.--------------------------------------------------------------------------- Although the rescue of Bear temporarily calmed the markets, it led to a form of moral hazard--the belief that in the future governments would rescue all financial institutions larger than Bear. Market participants simply did not believe that Lehman, just such a firm, would not be rescued. This expectation was shattered on September 15, 2008, when Lehman was allowed to fail, leading to exactly the kind of reappraisal of the financial health and safety of other institutions described by Kaufman and Scott. That is why the market froze at that point; market participants were no longer sure that the financial institutions they were dealing with would be rescued, and thus it was necessary to examine the financial condition of their counterparties much more carefully. For a period of time, the world's major banks would not even lend to one another. So what happened after Lehman was not the classic case of a large institution's failure creating losses at others--the kind of systemic event that has stimulated the administration's effort to regulate systemically important firms. It was caused by the weakness and fragility of the financial system as a whole that began almost a year earlier, when the quality of MBS and other asset-backed securities was called into question and became unmarketable. If Lehman should have been bailed out, it was not because its failure would have caused losses to others--the reason for the designation of systemically important or TBTF firms--but because the market was in an unprecedented condition of weakness and fragility. The correct policy conclusion arising out of the Lehman experience is not to impose new regulation on the financial markets, but to adopt policies that will prevent the correlation of risks that created a weak and fragile worldwide financial market well before Lehman failed. Thus, Lehman didn't cause, and AIG (if it had been allowed to fail) wouldn't have caused, a systemic breakdown. They are not, then, examples of why it is necessary to set up a special resolution system, outside the bankruptcy process, to resolve them or other large nonbank financial firms. Moreover, and equally important, a focus on Lehman and AIG as the supposed sources of systemic risk is leading policymakers away from the real problem, which is the herd and other behavior that causes all financial institutions to become weak at the same time. The funding question. There is also the question of how a resolution system of the kind the administration has proposed would be financed. Funds from some source are always required if a financial institution is either resolved or rescued. The resolution of banks is paid for by a fund created from the premiums that banks pay for deposit insurance; only depositors are protected, and then only up to $250,000. Unless the idea is to create an industry--supported fund of some kind for liquidations or bailouts, the administration's proposal will require the availability of taxpayer funds for winding up or bailing out firms considered to be systemically important. If the funding source is intended to be the financial industry itself, it would have to entail a very large levy on the industry. The funds used to bail out AIG alone are four times the size of the FDIC fund for banks and S&Ls when that fund was at its highest point--about $52 billion in early 2007. If the financial industry were to be taxed in some way to create such a fund, it would put all of these firms--including the largest--at a competitive disadvantage vis-a-vis foreign competitors and would, of course, substantially raise consumer prices and interest rates for financial services. The 24 percent loss rate that the FDIC has suffered on failed banks during the past year should provide some idea of what it will cost the taxpayers to wind up or (more likely) bail out failed or failing financial institutions that the regulators flag as systemically important. The taxpayers would have to be called upon for most, if not all, of the funds necessary for this purpose. So, while it might be attractive to imagine the FDIC will resolve financial institutions of all kinds more effectively than the way it resolves failed or failing banks, a government-run resolution system opens the door for the use of taxpayer funds to unnecessary bailouts of companies that would not cause systemic breakdowns if they were actually allowed to fail. Sometimes it is argued that bank holding companies (BHCs) must be made subject to the same resolution system as the banks themselves, but there is no apparent reason why this should be true. The whole theory of separating banks and BHCs is to be sure that BHCs could fail without implicating or damaging the bank, and this has happened frequently. If a holding company of any kind fails, its subsidiaries can remain healthy, just as the subsidiaries of a holding company can go into bankruptcy without the parent becoming insolvent. If a holding company with many subsidiaries regulated by different regulators should go into bankruptcy, there is no apparent reason why the subsidiaries cannot be sold off if they are healthy and functioning, just as Lehman's broker-dealer and other subsidiaries were promptly sold off after Lehman declared bankruptcy. If there is some conflict between regulators, these--like conflicts between creditors--would be resolved by the bankruptcy court. Moreover, if the creditors, regulators, and stakeholders of a company believe that it is still a viable entity, Chapter 11 of the Bankruptcy Code provides that the enterprise can continue functioning as a ``debtor in possession'' and come out of the proceeding as a slimmed-down and healthy business. Several airlines that are functioning today went through this process, and--ironically--some form of prepackaged bankruptcy that will relieve the auto companies of their burdensome obligations is one of the options the administration is considering for that industry. (Why bankruptcy is considered workable for the auto companies but not financial companies is something of a mystery.) In other words, even if it were likely to be effective and efficient--which is doubtful--a special resolution procedure for financial firms is unlikely to achieve more than the bankruptcy laws now permit. In addition to increasing the likelihood that systemically important firms will be bailed out by the government, the resolution plan offered by the administration will also raise doubts about priorities among lenders, counterparties, shareholders, and other stakeholders when a financial firm is resolved or rescued under the government's control. In bankruptcy, the various classes of creditors decide, under the supervision of a court, how to divide the remaining resources of the bankrupt firm, and whether the firm's business and management are sufficiently strong to return it to health. In an FDIC resolution, insured depositors have a preference over other creditors, but it is not clear who would get bailed out and who would take losses under the administration's plan. One of the dangers is that politically favored groups will be given preferences, depending on which party is in power at the time a systemically important firm is bailed out. Perhaps even more important, the FDIC's loss rate even under PCA demonstrates that the closing down of losing operations is slow and inefficient when managed by the government. Under the bankruptcy laws, the creditors have strong incentives to close a failing company and stop its losses from growing. As the FDIC experience show, government agencies have a tendency to forbear, allowing time for the losses in a failing firm to grow even greater. Given that bailouts are going to be much more likely than liquidations, especially for systemically important firms, a special government resolution or rescue process will also undermine market discipline and promote more risk-taking in the financial sector. In bailouts, the creditors will be saved in order to prevent a purported systemic breakdown, reducing the risks that creditors believe they will be taking in lending to systemically important firms. Over time, the process of saving some firms from failure will weaken all firms in the financial sector. Weak managements and bad business models should be allowed to fail. That makes room for better managements and better business models to grow. Introducing a formal rescue mechanism will only end up preserving bad managements and bad business models that should have been allowed to disappear while stunting or preventing the growth of their better-managed rivals. Finally, as academic work has shown again and again, regulation suppresses innovation and competition and adds to consumer costs. Accordingly, there is no need to establish a special government system for resolving nonbank financial institutions, just as there is no need to do so for large operating companies like GM. If such a system were to be created for financial institutions other than banks--for which a special system is necessary--the unintended consequences and adverse results for the economy and the financial system would far outweigh any benefits. ______ CHRG-111shrg57322--123 Mr. Sparks," Yes, Senator. Senator Kaufman. And did you ever say, ``I wonder what is going on with those loans''? I mean, ``I wonder how all these people are coming forward that are going to need these types of loans''? " FOMC20080805meeting--34 32,MR. FISHER.," David, in terms of the relatively benign outlook for core inflation now and for headline inflation, I'm wondering what your assumptions are about margin compression and for the ability of corporations to pass through price increases. By the way, I found the core revisions somewhat alarming because they're well above 2 percent, but less alarming than what I think I heard you say about headline inflation projections. If my memory is correct, over the past two years there has been a wider spread between core and headline, and part of that has been due to the ability of firms at least to restrain or not to exploit any perceived pricing power. If you're assuming that core will be relatively well behaved over time, some assumptions must be in there about margins and margin management, and I wonder what they are. Then I have a question for Steve on the international side to follow up on that. " fcic_final_report_full--436 These are related but different problems. While many involve the word “deriva- tive,” it is a mistake to bundle them together and say, “Derivatives or CDOs caused the crisis.” In each case, we assign responsibility for the failures to the people and in- stitutions rather than to the financial instruments they used. Conclusions: Rather than “derivatives and CDOs caused the financial crisis,” it is more accurate to say: • Securitizers lowered credit quality standards; • Mortgage originators took advantage of this to create junk mortgages; • Credit rating agencies assigned overly optimistic ratings; • Securities investors and others failed to perform sufficient due diligence; • International and domestic regulators encouraged arbitrage toward lower capi- tal standards; • Some investors used these securities to concentrate rather than diversify risk; and • Others used synthetic CDOs to amplify their housing bets. CHRG-111shrg61651--56 Chairman Dodd," Senator Corker. Senator Corker. Mr. Chairman, thank you, and thank all of you for your testimony. I think the Volcker Rule is--I think the goal of it is one that all of us would like to achieve, and that is figuring out a way that institutions are not too big to fail. I think the abstract nature of it made it difficult. I want to agree with our Ranking Member. I think there is a lot of regulation in place, if regulators will just do what they are supposed to do to keep much of what has happened from happening. And I do think there ends up being a capturing of those regulatory. They are embedded in your institutions. They get to know you. They are having coffee with you every day. They are going to lunch. And the next thing you know, things happen. So I hope we can figure out a way to keep that from happening in the future. But Mr. Corrigan, I understand that in many ways, if the Volcker-like Rule was put in place, Goldman would be the Br'er Rabbit of this whole deal, that you drop your holding company situation and have less competition. I wonder if you might respond to that. " CHRG-111hhrg55811--354 Mr. Garrett," It seems to me as we begin to get into this--maybe I am wrong--that you can deal with the transparency issues that I came in here to hear you talk about by the repository, you can deal with the other aspect that is in this draft that Chairman Frank has put in and that is dealing with the Lehman situation regarding the segregation of funds and what all brought us to that situation. We already know what is going on in the marketplace right now is that we are moving to this clearinghouse arrangement. We don't have to get into all the definitional problems I think Mr. Hall was raising by this Byzantine structure doing it because we are already moving in the right direction. So if you did just a couple of those things, you seem like you would address a major portion of the problem. We will not, even if we pass this bill, or I think even if we pass the Administration's bill--correct me if I am wrong on this--deal with what got us here by some argument with the AIG situation because--will the AIG type of instruments be covered and be forced to be cleared through a clearinghouse? No, right? Because they are--Mr. Hall? " CHRG-111shrg51395--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Chairman Dodd. I think the greatest challenge in dealing with this financial crisis is understanding its multiple, complex, and interrelated causes. This hearing provides us an opportunity to examine some of the causes that relate to our securities markets and securities regulation. Without presupposing the specific causes of the financial crisis, I think it is appropriate to conclude that a broad failure of risk management in the financial system led us to where we are today. It appears that everybody assumed that someone else was monitoring the risk. Regulators assumed that financial institutions had properly assessed the risk of their own activities or assumed that other regulators were watching what those entities were doing. Financial institutions failed to adequately monitor risks across business units and failed to thoroughly understand the risks associated with new financial products. They did not adequately assess either their exposures to or the health of their counterparties. Very sophisticated investors assumed that someone else had done their due diligence. Less sophisticated investors assumed, unreasonably, that asset prices would only climb. The excessive reliance on credit ratings and the failure of the market to develop a clearinghouse for credit default swaps are just two examples of this widespread market failure. The disastrous consequences of this nearly universal passing of the buck should serve as the guidepost for us and the SEC as we consider reforms. I think there should be clear lines of responsibility for regulators. Only then can Congress hold regulators accountable for their performance. It is also important not to make changes to the statutory and regulatory framework that would further lull market participants into believing that regulators or other market participants are doing their work for them. We cannot build a regulator big enough to be everywhere at all times. Market participants need to do their own due diligence before and after they make an investment decision. They need to bear the costs of an unwise investment, just as they reap the benefit of a wise investment. In the end, I believe our markets will be best served by the combined efforts of diligent regulators and responsible market participants working under rules that are clear and consistent. Uncertainty about the rules impedes the market from working as it should. Ad hoc Government actions lead private capital to sit on the sidelines because a change in rules can radically change a market participant's expected return. A consistent legal framework is an essential component of a competitive capital market. Investors will avoid a market if they believe the rules may change in the middle of the game. A clear example of this dynamic is the world of accounting where many are calling for the suspensions of mark-to-market because of the adverse impact that it is presently having on the books of so many companies. Accounting rules should be designed to ensure that a firm's disclosures reflect economic reality, however ugly that reality may be. Changing the accounting rules now will simply compound investors' wariness about investing in a market where many firms have bad or illiquid assets on their books. I will be interested in hearing from today's witnesses on this topic and how the SEC can improve its efforts to protect our securities markets while also facilitating continued innovation and responsible risk taking. Chairman Dodd, I thank you for calling this hearing. I think you are on to something here. " FOMC20070807meeting--104 102,MR. MISHKIN.," Thank you. Well, except for the fact that we have had a benchmarking of potential GDP downward and greater weakness in housing, my forecast is basically similar to my forecast at the last FOMC meeting and is consistent with the Greenbook forecast—that we would have a return to trend growth a bit later than we had expected but by mid-2008 and 2009. In regard to the issue of inflation, let me just provide a little information on the model that I’m thinking about. You know that I think a key driver of inflation, of course, is inflation expectations, and that there are good arguments to say that they are grounded around 2 percent. We have been seeing numbers continually coming in that are very consistent with that, which gives me more and more confidence that, in fact, inflation is gravitating strongly to this 2 percent level. But I want to talk a bit about the issue of output gaps because I think that it is important, even if you think that inflation expectations are extremely important, not to have a deus ex machina view of the inflation process, which is that inflation is caused by expected inflation and then where does that come from? So I think that resource utilization is important. However, the problem is that what is really important is not just current resource utilization, which is what we tend to put in our econometric specifications, but also the future expected path of resource utilization and output gaps. Of course, one problem here is that it is hard to measure. Also, if you are doing monetary policy right, then there is an expectation that you are going to do the right things to eliminate those output gaps. In fact, that is exactly what is in our forecast and exactly what our policies have been doing. So one reason I think, in the current juncture, that it is not critical to talk about output gaps a whole lot is that basically we are doing the right thing. That context gives me further reason for saying, given our forecast, that a 2 percent inflation number is where we are heading, just not now, and that the trend is solidly in place. But we are going to stay there for the foreseeable future, unless we screw up somehow, and we are not going to do that. [Laughter] One key point that makes me a little different from the Committee on inflation is that I do not see the upside risks as being greater than the downside risks. I really do see the risks as being quite balanced on inflation—again around this 2 percent number. Yes, we do have some temporarily good news, and it is going to be unraveled a bit, but it is still consistent with the 2 percent overall trend. In terms of output gaps and future expectations, I don’t see those getting people thinking that we’re going to have too tight resource utilization. Let me turn to the issue of the financial markets because, obviously, that is the big gorilla sitting at the table. I don’t see what is happening now as a direct spillover from the subprime market. It is very consistent with the way that Bill was talking about this issue. Of course, the media are making the subprime market into the whole story, but I think it is just not the right story. The subprime market is really a very small percentage of the total credit markets. What I think is much more important is that people are questioning and reassessing the quality of the information that exists in financial markets. The point of the subprime market is just that we now trust the credit-rating agencies less. Basically what I think is happening in a way is quite a good thing: We were concerned that the markets were a little too optimistic, that there was too much opacity, and that people weren’t worried about it. Now, in fact, they are worried about it, and I think that is fundamentally a healthy situation. Also, the parts of the market that are having the problem are the most opaque parts, it is not clear that they are particularly important to the things we really care about in terms of our policies, which is what will happen to aggregate demand and, therefore, to both inflation and output. So at this point, I take the view that this could all end very well and could in the long run make the situation healthier, and this view is consistent with what Governor Kohn was pointing out. But I do worry that this reassessment could actually find more—what’s the right word?— skeletons in the closet or bad things happening than were expected. In the past, we’ve seen that, when the quality of information gets questioned and people don’t think the marketplace is providing the right information, headwinds in the economy can become quite significant. The most recent episode that I am thinking about, of course, is the episode of Enron and its aftermath, in which a key reason that the economy was so slow to recover was that the quality of information was impaired. Then, people realized that the markets in fact did have some slight elements of financial instability—again, not too serious because the banking system was in such good shape. We could have a similar situation occurring now. So the sort of bad scenario that I see is an Enron-type scenario, not something much worse than that. But we really have to keep on top of this. It means, I think, that there are greater downside risks to the forecast. The survey of all of us indicates that people are now much more worried about downside risks than they are about upside risks. I think that is absolutely right, and, in fact, it could get a lot worse. So the way I would view the situation is that right now we should be pretty calm, but we want to monitor it very carefully and be ready for some potentially bad things to happen and just hope that they don’t. The kind of scenario that we’re seeing in the Greenbook is one that is going to play out. Thank you." FOMC20071211meeting--38 36,CHAIRMAN BERNANKE., All right. Thank you. Let us turn now to the economic situation and Dave Stockton. fcic_final_report_full--350 Miller insisted that there had to be an alternative, because filing for bankruptcy would be “Armageddon.”  Lehman had prepared a presentation arguing that a Lehman bankruptcy would be catastrophic. It would take at least five years to resolve, cost  to  billion, and cause major disruptions in the United States and abroad.  Baxter told the FCIC, “I knew that the consequences were going to be bad; that wasn’t an issue. Lehman was in denial at that point in time. There was no way they be- lieved that this story ends with a Lehman bankruptcy . . . they kept thinking that they were going to be bailed out by the taxpayer of the United States. And I’m not trying to convince you that that belief was a crazy belief because they had seen that happen in the Bear case.” Baxter’s mission, however, was to “try to get them to understand that they weren’t going to be rescued, and then focus on what their real options were, which were drift into Monday morning with nothing done and then have chaos break out, or alternatively file.” He concluded, “From my point of view, first thing was to con- vince Harvey that it was far better to file than to go into Monday and have complete pandemonium break out. And then he had to have discussions with the Lehman Board because they had a fiduciary duty to resolve what was in the best interests of the company and its shareholders and other stakeholders.”  “The only alternative was that Lehman had to fail,” Miller testified to the FCIC.  He stated that Baxter provided no further details on the government’s plan for the fallout from bankruptcy, but assured him that the situation was under control. Then, Miller told the FCIC, Baxter told the Lehman delegation to leave the Fed offices. “They basically threw us out,” Miller said. Miller remembered telling his colleagues as they left the building, “‘I don’t think they like us.’” Miller continued: We went back to the headquarters, and it was pandemonium up there— it was like a scene from [the  film] It’s a Wonderful Life with the run on the savings and loan crisis. . . . [A]ll of paparazzi running around. There was a guy there . . . in a sort of a Norse god uniform with a helmet and a picket sign saying “Down with Wall Street.” . . . There were hun- dreds of employees going in and out. . . . Bart McDade was reporting to the board what had happened. Most of the board members were stunned. Henry Kaufman, in particular, was asking “How could this happen in America?”  The group informed the board that the Barclays deal had fallen apart. The gov- ernment had instructed the board to file for bankruptcy. SEC’s Cox called. With Tom Baxter also on the line, Cox told the board that the situation was serious and required action. The board asked Cox if he was directing them to file for bankruptcy. Cox and Baxter conferred for a few minutes, and then answered that the decision was the board’s to make. The board again asked if Cox and Baxter were telling them to file for bankruptcy. Cox and Baxter conferred again, then replied that they believed the gov- ernment’s position had been made perfectly clear at the meeting at the Fed earlier in the day.  CHRG-111hhrg51592--16 Mr. Hensarling," Thank you, Mr. Chairman. We know there are a number of causes of our Nation's economic turmoil. Most have their genesis in flawed public policy. To state the obvious, the three major credit rating agencies missed the national housing bubble. This doesn't necessarily make them duplicitous, doesn't necessarily make them incompetent, but it does make them wrong--very, very wrong. Unfortunately, many investors, due to legal imperatives or practical necessity, relied exclusively on ratings from the three largest CRAs, without performing their own conservative due diligence. We now know that the NRSRO term has been embedded in our law, approximately 10 Federal statues, approximately 100 Federal regulations, roughly 200 State laws, and around 50 State rules. I believe the failure of the credit rating agencies would not have generated the disastrous consequences that it did had the failure not been compounded by further misguided government policies which effectively allowed the credit rating agencies to operate as a cartel. By adopting the NRSRO system, the SEC has established an insurmountable barrier to entry into the rating business, eliminating market competition among the rating agencies. People assumed, wrongly, that the government stamp of approval meant accurate ratings. Now, we took a step in the right direction with the Credit Rating Agency Reform Act of 2006, but it was too little, too late. There's a vitally important lesson we must all learn regarding implied government backing. We have seen the results from the government stamp of approval on Fannie Mae and Freddie Mac. We now see the results, the impact of denying a competitive market for credit rating agencies. We must certainly consider this in a development of a potential systemic risk regulator designating specific institutions as too-big-to-fail, creating a self-fulfilling prophecy. Outcomes in the market cannot and should not be guaranteed by the government. It causes people to become reliant, dependent, and engage in riskier behavior than they otherwise would. When people believe that the government will perform their due diligence for them on the front end, or will bail them out on the tail end, this is very dangerous for the investor, and disastrous for the Nation. I yield back the balance of my time. " FOMC20060629meeting--38 36,MR. FISHER.," Mr. Chairman, I want to thank the staff for the global presentation, particularly for the beginning of this analysis on resource utilization, which as you know I find useful. It is noteworthy that we’re beginning a process or, maybe, continuing a process and have not enough information yet to understand or to analyze it in terms of Chinese capacity. Your striking figure in exhibit 12 about steel production and steel capacity—China now has 31 percent of the world’s capacity. I would imagine that you’re going to see that in shipbuilding and several other sectors as we go through time. So I want to thank you for the analysis. Thank you, Karen, as well. The question I have is this: If you go to exhibit 11 and look at your forecast for the second half of 2006 and for 2007 for the emerging economies, what’s striking about these numbers at the bottom right-hand side of the table is that they are occurring as we forecast a slowing in the U.S. economy. I wonder if you might comment on the linkages between the two or on what other work we have to do on that front. One would think that either emerging-market GDP would slow by virtue of our slowing or that they would build up their own domestic consumption. And I’m wondering about the interrelationship we build into our models between the two. Again, thank you for the analysis." CHRG-110shrg50414--92 Secretary Paulson," I wish it were that simple because--and even that would not be easy. But what the Chairman said, when he presented, he said no one has been faced with this situation before. We spent a lot of time thinking about it, and there are different types of asset classes--mortgage derivatives, mortgage-backed securities. There are different whole loans. And so when you look at dealing with this, we are going to have to use different approaches in different situations, and there will be market-based approaches, and that is all--even I cannot sit here and figure out what the auction technique should be and how to use it and in what situations to use it. So what we asked for was broad-based authority to use a series of market-based approaches, and we will be dealing in different approaches in different situations. We cannot sit here and say here is the reverse auction we are going to use in every situation. So we need flexibility. Senator Bennett. My time is up. I understand that. My time is up. I just wanted to leave this last comment. This is the whole core of what you are trying to accomplish, and this is the whole problem with our giving you blank-check authority to accomplish it, because in theory it is easy to describe and it will work, but if you end up paying too little to these institutions, which mark-to-market accounting might drive you to, you are not giving them the support that they need. If you end up paying too much, then there is no upside potential for the taxpayer when the time comes for you to liquidate these, and the details of how you find the right balance here are the ones that all of us need--you, but certainly as much as we--all of us need to understand better as we make our determination whether or not to support your proposal. " CHRG-111hhrg55809--41 Mr. Kanjorski," I agree. And that being the case, are you planning to come forth with a proposal to the Congress of how not only we can have a systemic regulator that can identify ``too-big-to-fail'' but how we start winding them down and preventing them from getting that large? Are we going to go into an industrial plan or financial plan in America where we--once identified, we establish a way of taking these institutions down to a controllable size where their failure would not cause systemic risk? " CHRG-111hhrg48868--1016 Mr. Grayson," Well, listen. These same people could now be working, right now, today, at Citibank. Is it more important to protect them, the ones who caused the $100 billion loss, or protect us? Which is more important to you right now? " FinancialCrisisInquiry--69 GEORGIOU: Right. But you’re customarily paid as a percentage of the issue when you—when you engage in underwriting. And so why couldn’t that percentage of the issue simply be in significant part in the securities themselves, which would permit you to benefit substantially were it to rise, but would also permit you to lose substantially if it went down, just like the investors do? MACK: Again, I would welcome that. I think you would have to give us some leeway because markets are volatile—if markets are to go down, some way of hedging that. Other than that, I wouldn’t mind being paid in equity or in fixed instruments. GEORGIOU: Well, but the problem is that the hedge itself undermines the whole notion of the concept, which is to place responsibility on you, the underwriting, the originator, the party that has the greatest access to the information, for the success or failure ultimately of the security, just like the investor. MACK: But if you are a very large underwriter of either new issues or fixed income, and we’ve just gone through a week of record issuance in the corporate bond market, you very quickly would fill up our balance sheets and you would have us in a situation that we’d have to curtail our business. So there has to be some way to adjust it. It could be a shorter period of holding the securities. That may work. GEORGIOU: Yes. MACK: But again, I’m not opposed to it. CHRG-110hhrg46593--80 Mr. Bernanke," Well, they are both a symptom and a cause. Now that the house prices are falling and that the economy is weakening, people don't have the income to make their payments, the house foreclosures are going up. So that is a symptom of the downturn. But it is also a cause, because it is weakening house prices, it is hurting the value of mortgages, which hurts financial institutions. So it is part of the mechanism which is causing the economy to weaken. Ms. Velazquez. So can you tell me how much of the more than $1 trillion spent by the Treasury and Fed in the bailout has gone to prevent individual foreclosures? " CHRG-111shrg57923--22 Mr. Horne," Thank you. Thank you, Senator Reed, Senator Corker. Thank you this afternoon for spending time with us. My name is Steve Horne. I am Vice President of Master Data Management for Dow Jones, as Senator Reed introduced me earlier. I have spent over 30 years building very complex databases and transforming highly complicated data into usable information. I have testified many times over the last year on the impact of the financial meltdown and the need for comprehensive analytic databases designed to capture the appropriate realtime information necessary to prevent waste, fraud, and abuse of the IPSA Act--and ``realtime'' I think was discussed earlier--including those of the TARP program to ensure that the American taxpayer's money is being used as intended. Legislation that would create such a database has been introduced by Senator Warner--it is S. 910--with a companion bill that has already passed the House, H.R. 1242, by a vote of 421-0. These bills have been strongly endorsed by organizations such as the U.S. Chamber of Commerce, OMB Watch, and the Center for Democracy in Technology. Using the same basic infrastructure of the database that would be created under the legislation that I have described, we at Dow Jones have identified over 400 leading indicators that, when used together, can identify potential systemic risk within the financial system, but also, I want to add, many other parts of the economy, which expands upon what our esteemed presenters have presented today. And the challenge is to combine this disparate data into a structured database to be able to make informed decisions and judgments about the risks that are inherent to the system. Systemic breakdowns that impact individual geographic markets in this country are caused by a combination of factors, including unemployment, bankruptcy, foreclosures, commercial real estate failure, and other factors. For example, in Las Vegas, a huge influx of different socioeconomic groups moved into this market in the past 10 years. One of these groups is retirees. And when the financial meltdown occurred, these Americans were mostly living on fixed incomes: savings, retirement investments, and their Social Security. They bought retirement homes either with cash or with mortgages that were smaller than many, but they still incurred new debt. Over the last 3 years, the income from their retirement accounts went negative. They have had to dip into principal as the only way for them to gain cash. As the foreclosures generally grew around them, the retirees saw the value of their homes decrease in half as well. Those who had mortgages were now upside down, those who did not saw the major investment they had spent a lifetime building dwindle in value. Now, these senior citizens face a much more difficult situation. With a major portion of their principal gone, they cannot afford to live on their fixed income and now may have to go back to work. In Las Vegas, 16-percent unemployment does not bode well for anybody looking for a job. If they own their home, new mortgages are very difficult to get. Reverse mortgages are not an option because of the reduced availability of these programs. And the combination of these factors shows the market for retirees in Las Vegas is in systemic failure right now. So I am expanding upon the concept of systemic failure to talk about the markets as well as the financial systems that support those markets. The example of this process is known in statistical terminology as the ``Compounding Effects of Multiple Indices.'' If we can integrate this data into an actionable database, regulators can quickly implement surgical solutions that will apply the appropriate programs and/or funds to the most serious problems. The database can be applied for potential systemic failure of the commercial real estate market that has been highlighted by the Congressional Oversight Board report that was issued just 2 days ago. And, in addition, we are currently observing markets in North Carolina and Tennessee that are at risk of systemic failure. If the proposed database were in place, the Government would be in a better position to confirm, quantify, and tackle these problems proactively. Unfortunately, the data is in disparate systems that cannot talk to each other. The value of the database that is proposed in S. 910 is in its ability to combine and analyze this data to predict and prevent systemic risk. The transformation of this data into actionable information is neither easy nor inexpensive. However, the implementation of the proposed database will save significant taxpayer dollars in three ways: first, through more efficient targeting of resources and serving the areas of greatest need; second, by enabling the Government to ensure that the appropriate actions are taken before systemic failure occurs; and, third, by helping prevent waste, fraud, and abuse of taxpayer's money. The database proposed should not create additional security concerns. The security methodologies under the IPSA Act and the contractual controls for the use of commercial data are sufficient to protect this information. In addition, language included in H.R. 1242 that passed the House provides for even greater protections for non-public data. The system being proposed is designed to expand to cover global data. Although some of the data from overseas may not be accessible due to laws of specific countries, other international data is in better shape than our own and can be built into accurate analytic systems because of the early adoption of XBRL technology by many countries. In summary, the data and technology exist today to equip financial regulators with the tools necessary to monitor systemic risk. The only thing lacking is Government action to make it happen. I want to thank you again, Senator Reed and Senator Corker, for your time and attention, and I am happy to answer any questions you may have. Senator Reed. Thank you very much, Mr. Horne. Thank you all, gentlemen, for excellent testimony, and let me begin with the comments you made, Dr. Mendelowitz. It is very difficult to review objectively your own decisions and actions. I think that is a very strong rule in every type of human endeavor, and particularly in these endeavors. And that argues, I think, strenuously for some type of independent agency. You can also factor in that there are particular cultures in agencies that obscure--illuminate and obscure analysis of data. Again, I wonder if you might comment on this issue of independence, and I would ask all you gentlemen to do so. Could you please turn your microphone on? " fcic_final_report_full--441 TWO TYPES OF SYSTEMIC FAILURE Government policymakers were afraid of large firms’ sudden and disorderly failure and chose to intervene as a result. At times, intervention itself contributed to fear and uncertainty about the stability of the financial system. These interventions responded to two types of systemic failure. Systemic failure type one: contagion We begin by defining contagion and too big to fail . If financial firm X is a large counterparty to other firms, X’s sudden and disorderly bankruptcy might weaken the finances of those other firms and cause them to fail. We call this the risk of contagion , when, because of a direct financial link between firms, the failure of one causes the failure of another. Financial firm X is too big to fail if policymakers fear contagion so much that they are unwilling to allow it to go bankrupt in a sudden and disorderly fashion. Policymakers make this judgment in large part based on how much counterparty risk other firms have to the failing firm, along with a judgment about the likelihood and possible damage of contagion. Policymakers may also act if they worry about the effects of a failed firm on a par- ticular financial market in which that firm is a large participant. The determination of too big to fail rests in the minds of the policymakers who must decide whether to “bail out” a failing firm. They may be more likely to act if they are uncertain about the size of counterparty credit risk or about the health of an important financial market, or if broader market or economic conditions make them more risk averse. This logic can explain the actions of policymakers  in several cases in : • In March, the Fed facilitated JPMorgan’s purchase of Bear Stearns by providing a bridge loan and loss protection on a pool of Bear’s assets. While policymakers were concerned about the failure of Bear Stearns itself and its direct effects on other firms, their decision to act was heightened by their uncertainty about po- tential broader market instability and the potential impact of Bear Stearns’ sud- den failure on the tri-party repo market. • In September, the Federal Housing Finance Agency (FHFA) put Fannie Mae and Freddie Mac into conservatorship. Policymakers in effect promised that “the line would be drawn between debt and equity,” such that equity holders were wiped out but GSE debt would be worth  cents on the dollar. They made this decision because banking regulators (and others) treated Fannie and Freddie debt as equivalent to Treasuries. A bank cannot hold all of its assets in debt issued by General Electric or AT&T, but can hold it all in Fannie or Fred- die debt. The same is true for many other investors in the United States and around the world–they assumed that GSE debt was perfectly safe and so they weighted it too heavily in their portfolios. Policymakers were convinced that this counterparty risk faced by many financial institutions meant that any write-down of GSE debt would trigger a chain of failures throughout the finan- cial system. In addition, GSE debt was used as collateral in short-term lending markets, and by extension, their failure would have led to a sudden massive contraction of credit beyond what did occur. Finally, mortgage markets de- pended so heavily on the GSEs for securitization that policymakers concluded that their sudden failure would effectively halt the creation of new mortgages. All three reasons led policymakers to conclude that Fannie Mae and Freddie Mac were too big to fail. • In September, the Federal Reserve, with support from Treasury, “bailed out” AIG, preventing it from sudden disorderly failure. They took this action because AIG was a huge seller of credit default swaps to a number of large financial firms, and they were concerned that an AIG default would trigger mandatory write-downs on those firms’ balance sheets, forcing counterparties to scramble to replace hedges in a distressed market and potentially triggering a cascade of failures. AIG also had important lines of business in insuring consumer and business activities that would have been threatened by a failure of AIG’s financial products division and potentially led to severe shocks to business and consumer confidence. The decision to aid AIG was also influenced by the extremely stressed market conditions resulting from other institutional failures in prior days and weeks. • In November, the Federal Reserve, FDIC, and Treasury provided assistance to Citigroup. Regulators feared that the failure of Citigroup, one of the nation’s largest banks, would both undermine confidence the financial system gained after TARP and potentially lead to the failures of Citi’s major counterparties. CHRG-111hhrg53245--90 Mr. Bachus," Executives of the surviving large firms have every reason to believe they are too big to fail. They have no incentive to help bring system risk down to an acceptable level. That is exactly the problem we have today. Mr. Johnson goes on to say that when you have a situation like this, it is either bailout or collapse, but as it begins to affect other institutions, responsible official thinking shifts to bailout at any cost. We certainly have seen that over the past 6 months. Mr. Zandi says, and here is where I think we maybe can all come to a consensus, he said the Treasury and the Fed were seemingly confused as to whether they had the authority or ability to intervene to forestall a Lehman bankruptcy and ensure an orderly resolution of the broker-dealer's failure. The procedure was not in place. Mr. Mahoney today has said give them that procedure, as I understand it. Give them a procedure, but in bankruptcy. Is that right, Mr. Mahoney? " FOMC20080916meeting--144 142,MR. ROSENGREN.," I think it's too soon to know whether what we did with Lehman is right. Given that the Treasury didn't want to put money in, what happened was that we had no choice. But we took a calculated bet. If we have a run on the money market funds or if the nongovernment tri-party repo market shuts down, that bet may not look nearly so good. I think we did the right thing given the constraints that we had. I hope we get through this week. But I think it's far from clear, and we were taking a bet, and I hope in the future we don't have to be in situations where we're taking bets. It does highlight the need to look at the tri-party repo market, look at the money market fund industry, and look at how they're financing. There are a lot of lessons learned, but we shouldn't be in a position where we're betting the economy on one or two institutions. That is the situation we were in last weekend. We had no choice. We did what we had to do, but I hope we will find a way to not get into this position again. " CHRG-111shrg52619--98 Mr. Dugan," Well, we were never the leader in no-document and low-document loans. We did do some of it. The whole Alt A market, by definition, was a lower-documentation market and it was a loan product that mostly was sold into secondary markets. When I got and became Comptroller in 2005, we began to see the creeping situation where there were a number of layers of risk that were being added to all sorts of loans that we--our examiners were seeing, and that caused us to issue guidance on nontraditional mortgages, like payment option mortgages, which we were quite aggressively talking about the negative amortization in it as being not a good thing for the system, and that again we were quite vocal about pushing out of the national banks that were doing it. Senator Menendez. Well, let me ask you, you have twice been criticized by your own Inspector General for keeping, quote, ``a light touch,'' light for too long when banks under your watch were getting in trouble. And I know you have consistently told us that you like to do things informally and in private with your banks. Do you think that changing that strategy makes sense in light of what we have gone through now? " FOMC20060510meeting--52 50,CHAIRMAN BERNANKE., So moved. Thank you. Any objection? All right. Thank you very much. Okay. Our next item on the agenda is the economic situation. FOMC20061212meeting--32 30,MR. MOSKOW.," I have a question for Dave on the first paragraph of the Greenbook, where you said that labor markets have been stronger than we were expecting. Of course, just now you also talked about that and about the employment report on Friday. Then you said, “In constructing our forecast of aggregate activity, we’ve given greater weight to the data on spending and industrial production.” I was just wondering why you decided to do that. You pointed to the labor market as an upside risk, but I was wondering why you decided to give greater weight to the spending and industrial production data." CHRG-111shrg51395--263 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JOHN C. COFFEE, JR.Q.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. Bernanke's Comments: I would strongly agree with Chairman Bernanke's above quoted remarks, and I believe that his final question about the desirability of a systemic risk regulator must be answered in the affirmative (although the identity of that regulators can be reasonably debated). The term ``too big to fail'' is a misnomer. In reality, a systemic risk regulator must have the authority to identify financial institutions that are ``too interconnected to fail'' and to regulate their capital structure and leverage so that they do not fail and thereby set off a chain reaction. SEC/CFTC Merger: Although a merger of the SEC and the CFTC would be desirable, it is not an essential reform that must be accomplished to respond effectively to the current financial crisis (and it would be a divisive issue that might stall broader reform legislation). At most, I would suggest that jurisdiction over financial futures be transferred from the CFTC to the SEC. An even narrower transfer would be to give the SEC jurisdiction over single stock futures and narrow-based stock indexes. Over the counter derivatives might be divided between the two in terms of whether the derivative related to a security or a stock index (in which case the SEC would receive jurisdiction) or to something else (in which case the CFTC should have jurisdiction). The AIG Failure: AIG's failure perfectly illustrates the systemic risk problem (because its failure could have caused a parade of falling financial dominoes). It also illustrates the multiple causes of such a failure. AIG Financial Products, Inc., the key subsidiary, was principally based in London and was the subsidiary of the parent of the insurance company. As a non-insurance subsidiary of an insurance holding company, it was beyond the effective oversight of the New York State Insurance Commissioner, and there is no Federal insurance regulator. Although AIG also owned a small thrift, the Office of Thrift Supervision (OTS) could not really supervise an unrelated subsidiary operating in London. Thus, this was a case of a financial institution that fell between the regulatory cracks. But it was also a case of a private governance failure caused by excessive and short-term executive compensation. The CEO of AIG Financial Products (Mr. Cassano) received well over a $100 million in compensation during a several year period between 2002 and 2006. This gave him a strong bias toward short-term profit maximization and incentivized him to continue to write credit default swaps for their short term income, while ignoring the long term risk to AIG of a default (for which no reserves were established). Thus, there were both private and public failures underlying the AIG collapse. Procedures for Failure of a ``Systematically Critical Firm'': The Lehman bankruptcy will remain in the courts for a decade or more, with considerable uncertainty overhanging the various outcomes. In contrast, the FDIC can resolve a bank failure over a weekend. This suggests the superiority of a resolution-like procedure following the FDIC model, given the uncertainty and resulting potential for panic in the case of a failure of any major financial institution. Both the Bush and Obama Administrations have endorsed such a FDIC-like model to reduce the prospect of a financial panic. I note, however, that one need not bail out all counterparties at the level of 100 percent, as a lesser level of protection would avert any panic, while also leaving the counterparties with a strong incentive to monitor the solvency of their counterparty. ------ FOMC20071206confcall--41 39,MR. FISHER.," Thank you, Mr. Chairman. I have a couple of questions, but first I want to preface them with thanking the staff, you, and others who have improved this proposal. I was a skeptic the last time around and was worried about certain issues and appreciate very much being heard. Like President Lockhart, I am in favor of both the swap and the proposal for the TAF. I do have some questions about the TAF, but I would like to preface them with just a statement to put my questions in perspective. As you know, in my District we went through a period of enormous turmoil—bank failures. You haven’t seen the person, Bob Hankins, seated on my left—I guess your right— before. He is a battle-scarred veteran. He is one of the few people who had to sit down and close and call a loan to two of the major banks in our system. The reason I mention it is that we have had a tremendous period of tranquility over the past fifteen or so years, and one reason I am in favor of this facility is that we are presented with very different circumstances currently. The markets are different, the pressures on us are different, and I believe the threats to the system that are posed by the mistakes that have been made are significant, and we need to figure out new tools to utilize. The improvement in this tool from when it was first crafted and the architecture that was suggested is significant, and I want to applaud and support the effort. I think a couple of things are very important against the background of what I just told you. This is really a question for the staff. Having just gone through as we did with Sandy the auction parameters—on the prepayment row there, it says, “Each Reserve Bank might be provided discretion.” Given our experience, I would say that the words have to be “will be provided discretion.” To me, that is critical. We have been through it before here, and I think the banks have to have the option to make a loan callable. On the minimum-bid rate, I am a little worried about using the OIS, and I wonder if we would consider using the T-bill or something simpler. The reason is that we have to go through a huge educative effort if we use the OIS. I understand that at a recent meeting of the SCRM (Subcommittee on Credit and Risk Management) nobody within our own SCRM knew what the OIS was or they at least had to stretch to think about what it was. If we don’t know what it is— and this is a sophisticated group of people—how do we explain it to the banks, to our own staff, et cetera? I just wonder if we couldn’t use something other than OIS or if there is a compelling logic to using the OIS. I want to come back to Tom Hoenig’s point on the noncompetitive tenders. As you know, I am very sensitive to that issue. I think we are subject to public criticism unless we get down to the smaller banks. I would imagine that we will hear a lot during any comment period after we initiate this project, and we have to be ready with an answer there. I want to make sure that we do take care of the smaller banks. I would like to mention one other issue, and that is with regard to eligible depositories. This is a new facility. We are getting into the business of term lending. We are doing so under unusual circumstances. I wonder whether we shouldn’t have some constraints, at least as this institution evolves. Even if we are calling it temporary, I would be in favor of making it as permanent as possible, once we get the kinks ironed out, by limiting those that can come to us at the beginning and then broadening it out. I am not talking about big banks versus little banks. But I am wondering if we shouldn’t limit this thing just to those with CAMELS ratings of 1 or 2 rather than all comers. I think that might take some of the stigma out of the system, by the way. So those are really the points that I wish to make at this juncture. I support the initiative. I would like to get answers to those questions. I guess I am satisfied by the answer that was given to Bill Poole’s question on the need for this in addition to current ECB capacity. Thank you, Mr. Chairman." CHRG-109shrg26643--43 Chairman Bernanke," That would be a difficult situation because, on the one hand, higher energy prices would put pressure on inflation, but higher energy prices would also hurt consumer budgets and would probably or could possibly lead consumers to spend less. Together with weakening of the housing market, which might also lead to a higher savings rate and slower consumption spending, we would be in a situation with pressures in both directions, and I cannot really offer much more guidance other than to say that we would have to weigh the relative severity of the two risks. " CHRG-111shrg51303--163 Mr. Kohn," I think particularly early on, that was a major part of our actions, but let me be clear again. Our actions were not aimed at AIG and its counterparties. Our actions were aimed at the U.S. financial system and the knock-on effects of imposing losses on counterparties. Would those counterparties or others be willing to do business with other U.S.--systemically important U.S. institutions that might someday end up in the Government's hands? I think it would have accelerated what was a very, very bad situation, caused more of a withdrawal from taking risk, a shift of business toward a very few financial institutions that were clearly going to survive the maelstrom. Senator Corker. We have ended up buying stock, and instead of having our money be backing up this collateral that went to these counterparties that really have made out like bandits, and I can see why--they really have made out like bandits in this particular atmosphere. " CHRG-110hhrg45625--77 Secretary Paulson," Well, I can hardly do that in a few minutes, but I am going to do it in just a minute or two, and let Chairman Bernanke say something. There are a number of tactical suggestions that people are dealing with, accounting ideas, the mortgage cram down, the bankruptcy, which I believe from a policy standpoint does the opposite of what we want to do. We want to encourage lenders to lend for mortgages. I think that is the opposite. But let me deal with the basic one, which is preferreds putting in capital. There are a number of plans that say let us go to the root of the problem, let us just put capital into those institutions which we think are troubled. And that is one about dealing with failure. Okay? And when you put capital in, that is the Japanese solution, they were in a very long recession for many years, but what they did is they came in, put capital in the banks, and then the government is essentially in many ways running them. So you are sticking preferred stock in. What we are trying to do, we are trying to take a different approach which is this is a different situation than anything you can find historically. What we are trying to do is have price discovery on illiquid assets, and then that encourages private capital to follow and it makes it possible for the banks to recapitalize themselves because lenders right now are concerned about putting capital in because they don't trust the balance sheets and they have concerns about what these assets are worth. Mr. Chairman? " CHRG-110hhrg46591--279 Mr. Yingling," I just want to say your analysis of the cause of the problems was exactly right. One of the things that is not talked about much is when the unregulated side did these things--and this happens all the time--they ended up blowing up the regulated side. So this has had a very negative effect on good banks that did not do any of this. I would also say that it just seems to me that some part of the stimulus package ought to be devoted to what caused the problem. That is housing--keeping people in their houses and helping some of those homes be taken, perhaps, by entrepreneurs who would turn them into rental housing. " 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-111hhrg49968--168 Mr. Bernanke," Well, first of all let me say that I do think there is a benefit to going toward a more system-wide regulatory approach because so many things that caused problems in the recent crisis sort of slipped under the radar because there was nobody looking at it. So we do need to have a system whereby the large systemically critical firms are being appropriately overseen, where we have a way to address the potential failure of large financial firms, where we make sure that risks that build up in the system are---- Ms. Moore. Should that be you? Before my time expires? " CHRG-111hhrg54867--205 Secretary Geithner," I would be happy again to talk to the SEC and the U.K. authorities and help--and to the courts involved to help make sure that process is moving quickly. On the basic question you raised about the future, what you need--what Lehman illustrated is we did not have here and was not in London an adequate mechanism for managing that failure in a way that caused less damage. And to fix that, you need to change the law here. You need to change it in the U.K. and make sure that it is done in a consistent way so these globally active firms can be handled-- " CHRG-111hhrg49968--109 Mr. Garrett," And I wonder, everything else we do besides that is almost that, besides the point; is that a correct---- " FOMC20070918meeting--140 138,MR. MISHKIN.," I’ve already said that I don’t see that the risk is on the inflation front right now, although clearly we have to keep monitoring inflation, and that the serious risk is the nonlinear downward spiral that could occur. Of course, the big problem is really the issue of information revelation and price discovery. I want to point out that there are really two sources of this. One is that it’s very difficult for the market to figure out what the value of assets in these structured products is. Clearly, that will take a long time to work out, and it is not something that monetary policy can do anything about. The second source of the problem of price discovery is the fear that, in fact, we might have a severe economic downturn, and we can do something about that. So in this context a cut is not controversial because everybody is coming to the conclusion that we should cut the federal funds rate by 50 basis points and, in particular, that we want to get ahead of the curve to indicate to the markets that we are on top of this and that we are trying to remove the downside tail that we’re particularly worried about. But I want to talk a little about a somewhat longer-run perspective on monetary policy strategy and how we might proceed from here. The way I think about this is that the situations we have to deal with fall into two camps. The normal situation is when things are fairly linear, when we don’t have financial disruptions. In that case, there is a lot of reason to have what has been characterized in the academic literature as policy inertia—that is, the idea that, when you move the federal funds rate, you don’t move it back quickly and, in fact, you have very persistent federal funds rate moves. Indeed, I think that is the right thing to do under normal circumstances. Clearly, there’s an issue that moving a very short-term interest rate will not have an effect unless people expect it to persist. Because the longer-run part of the term structure is more relevant to people’s decisions in terms of spending, there’s a very strong case for pursuing things in a persistent way. Also, there is always a problem that, when you reverse, people may say, “Gee, you didn’t know what you were doing, and you had to change your mind?” So there’s always this issue of flip- flopping that you have to be concerned about. The other situation is exactly the environment we’re in, when you really have to take out insurance against something that has the potential to create a downward spiral that’s hard to control. It’s particularly imperative in that situation that you get ahead of the curve. In fact, there’s a very strong case to make sure in that situation that you emphasize to the markets that you are trying to take out insurance against the downward spiral. But if you are successful, things may start to turn around, and if things go the right way, which is what you hope happens, then you want to reverse course. So in the projections that I provided, I did something that was unusual. I think I was the only person to have a rate reversal in the projections. Oh, you did, too? Okay. So I had us going down 50 at this meeting. I thought there was a possibility—though I hope not—that we might have to go 50 at the next meeting and, if we did, that would certainly be enough, and then we would move back up afterwards. So in this context, I think that we really do have to think in terms of potential reversals and, therefore, to not be scared of overshooting a bit. There tends to be a lot of inertia in the way we do monetary policy—it is well documented. There’s even inertia in general, just in that we have nineteen participants at a table. As an academic, I mentioned to Don Kohn at one point that sometimes I think these meetings have elements of faculty meetings, and that is not always something that you enjoy. [Laughter] Some of you guys may not have experienced that, but it’s a lot of fun. So I think the bottom line here is that we have to be prepared to think about being much more aggressive, not just now but even in the future. However, I do want to point out that this does not mean that we should have an alternative that indicates that we are going to do further cuts in the future. I strongly advocate alternative B because, by aggressive action now, we may start turning the markets around and, if that’s the case, then it will not be necessary for us to quickly do more. So we do not want to say to the markets that we have to keep on going when we’re hoping that we won’t have to keep on going. I think that’s extremely important in thinking about where we are right now. Another issue in terms of an extremely aggressive policy and then possibly doing reversals is the moral hazard context. Again, I think this is a communication issue. I have a slight disagreement with President Plosser in that I think we have to talk about the financial market disruptions because it is very important to indicate that, in being very aggressive, we are not losing sight of our inflation goals and that this is a case of worrying about the downside tail that we have to deal with and really showing that we’re on the ball in that context. So we’re in a slightly different situation from the normal one, and I would advocate keeping the discussion of financial disruptions in our statement the way we have it now. Thank you." CHRG-110shrg50369--72 Mr. Bernanke," I do not have an estimate of the overall effect. I think it would be hard to do. But it is the case that a significant portion of the corn crop is now being diverted to ethanol, which raises corn prices. And there are some knock-on effects; for example, some soybean acreage has been moved to corn production, which probably has some effects on soybean prices, too. So there is some price effect on foodstuffs coming through the conversion to energy use. Senator Allard. Well, you know, the wheat farmers in my State are saying that wheat is at a historic high for them, and so I wonder just, you know, how much of that--I suppose, again, that is a dryland crop, but there is some conversion to dryland corn. But, again, that seems to have some impact on the grains in general, and the poultry people and the livestock people--well, all livestock people--swine, poultry, and beef in particular--all have concerns about that. So I was curious to see how you were evaluating that policy in respect to the total economy, and obviously you do not have too much to say on that because you do not think it is too big a part of the economy. Is that right? " CHRG-111hhrg48674--37 Mr. Bernanke," Congressman, that was very interesting. Could I respond to a couple of points you made? First of all, in the Great Depression, Milton Friedman's view was that the cause was the failure of the Federal Reserve to avoid excessively tight monetary policy in the early 1930's. That was Friedman and Schwartz's famous book. And with that lesson in mind, the Federal Reserve has reacted very aggressively to cut interest rates in this current crisis. And moreover, we have also tried to avoid the collapse of the banking system, which was another reason for the Depression in the 1930's. On the prices of housing and the like, we are not trying to prop up the price of housing. What we are trying to do is get the credit markets working again so that the free market can begin to function in a normal way instead of a seized-up way in which it is currently acting. And finally, on price fixing of so-called toxic or legacy assets, the plan that Secretary Geithner described this morning would have as an important component private asset managers making purchases based on their own profit-maximizing analysis. So that would be true market prices that would free up what is now a frozen market to get transactions flowing again and should restore real price discovery to those markets. Dr. Paul. But so far, every one of these suggestions over the past year was more money, more credit, more government involvement. Nothing seems to be working. Even today, the markets weren't very happy with these announcements. I think the market is still pretty powerful. " CHRG-111shrg51290--29 Chairman Dodd," Thank you, Senator, very much. Senator Bennet? Senator Bennet. Thank you, Mr. Chairman. I appreciate it. Ms. Seidman, you mentioned earlier in passing that even good products are complex or can be complex, which is true in these markets, and good products being ones that actually are collateralized, that actually have some value. When we are thinking about how to create a regulatory structure and a bureaucratic structure that makes sense, on the one hand, there is the issue of wanting the capital markets to be inventive, wanting to be able to lower costs for people that are in their homes and borrowing money or other kinds of things, and on the other hand we find ourselves in a place where we securitized--we didn't, but all these loans were securitized. The bad products became very complex as well as good products and it inspired lots of, or incentivized a lot of behavior that probably wouldn't have happened otherwise because the market in some sense was insatiable and people started to say, well, we don't need to do 70 percent loan to value anymore, let us do 100 percent, just to create a take-up, or a product for that take-up. And I wonder what the implications of all of that are for thinking about the bureaucratic design here so that we can allow the markets to continue to invent, on the one hand, but on the other hand say, is there a degree of complexity that we simply can't sustain or that the regulators will never catch up to, or--I am sorry for the long-winded question--or does it imply something about who needs to be in the room to pass on whether these structures actually make sense or not, these structures being these products? Ms. Seidman. I think that this current situation is really forcing us to take another look at the question of whether innovation and complexity in consumer financial products is something that we ought to value. It is not to say that everybody should have a 30-year fixed-rate mortgage. There are certainly situations in which a 30-year fixed-rate mortgage is not the best instrument for the consumer. And it is not to say that some good products like savings bonds aren't inherently complex. They are. They are extremely complex. But I do think that the notion that allowing continuous redesign and complexity is a good thing needs to be reevaluated. I do think that there are some suggestions that have been made recently about how to sort of come in the middle. The default product suggestion that I mentioned in my testimony is one of them. There would be a standard, relatively simple product that was the product that needed to be offered first in all situations, to avoid the situation that Pat's broker tried to get her into. If a consumer nevertheless decided to buy one of the non-default products, the seller's ability to enforce the contract would be subject to the seller having to prove that whatever disclosures they made initially were understandable to a reasonable man, which is your classic legal standard. I would prefer a system of standardized contracts, but I think that at least in certain areas like mortgages, we probably need multiple standardized contracts in order to cover the waterfront. Senator Bennet. Does anybody else have a comment on that? " CHRG-111shrg55117--63 Mr. Bernanke," I would be happy to look at that with you. It sounds like a direction to consider. I would have to understand better the rationale, but it is certainly worth looking at. Senator Schumer. Thanks, Mr. Chairman. Senator Johnson. Senator Martinez. Senator Martinez. Thank you, Mr. Chairman. Chairman Bernanke, welcome, and I want to join with my colleague Senator Schumer in also acknowledging the fact that you had a very difficult situation back several months ago. Everything is not perfect, but you have tried, I know, sincerely and, I think, avoided a whole lot of problems that on a dark day back in the fall we all were fearful might be right around the corner. I also want, by way of a question and a comment, to also strongly disagree with my colleague from New York, because I believe that the worst thing we could do right now under the current environment is to overregulate, to overreact to circumstances that happened in the marketplace. I have not had a more unanimous negative reaction about anything here in the Congress than what I have heard for the last several days about this regulator scheme that would, I think, take the banking industry at a time when it is in a perilous state and choke it. And I think it would be an overreaction, and I think we ought to take our time before we overregulate the banking industry in a way that I think will drive away investment money and everything else from the industry. I am very sensitive to consumer issues, but I really think we should go slowly on that issue and think thoroughly through it. Along those lines about investment, private investment money into the marketplace, you indicated that investors seemed to be returning. It concerns me greatly that I do not believe there is any significant private investment going on in the mortgage-backed security arena, and, obviously, we have been through a very difficult time there. I wonder if you could tell me what you anticipate there. I come from a State where we have some high-value markets, and even though all of them are depressed, conforming loan limits do not always cut it. Do you anticipate that we will be in a position to see private investment money coming into securitized mortgages so that we can get away from Fannie and Freddie being the only game in town when it comes to mortgages? " fcic_final_report_full--429 VII. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance- sheet losses in its counterparties. These institutions were deemed too big and interconnected to other firms through counterparty credit risk for policy- makers to be willing to allow them to fail suddenly. VIII. Common shock. In other cases, unrelated financial institutions failed be- cause of a common shock: they made similar failed bets on housing. Uncon- nected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock. IX. Financial shock and panic. In quick succession in September , the fail- ures, near-failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned. X. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early . Harm to the real economy continues through today. We now describe these ten essential causes of the crisis in more detail. THE CREDIT BUBBLE: GLOBAL CAPITAL FLOWS, UNDERPRICED RISK, AND FEDERAL RESERVE POLICY The financial and economic crisis began with a credit bubble in the United States and Europe. Credit spreads narrowed significantly, meaning that the cost of borrowing to finance risky investments declined relative to safe assets such as U.S. Treasury securi- ties. The most notable of these risky investments were high-risk mortgages. The U.S. housing bubble was the most visible effect of the credit bubble but not the only one. Commercial real estate, high-yield debt, and leveraged loans were all boosted by the surplus of inexpensive credit. There are three major possible explanations for the credit bubble: global capital flows, the repricing of risk, and monetary policy. Global capital flows Starting in the late s, China, other large developing countries, and the big oil- producing nations consumed and invested domestically less than they earned. As CHRG-111shrg61513--60 Mr. Bernanke," Well, I think for no other reason than just trying to reduce uncertainty in the markets, the sooner that you can come to some clarity on the future of Fannie and Freddie, the better. Of course, I understand that you are dealing with a lot of complex issues in financial reform and health care and in other areas right now. But it would be, obviously, helpful to try to get some clarity on that. That does not mean necessarily that you can get to that new situation quickly. It is going to take some time to move from the current situation to a more stable long-run situation. But certainly I hope Congress is looking at this issue now and thinking about where you want to go. Senator Vitter. OK. We are really not looking at the issue now, at least in a meaningful way. And the schedule, as I understand it, particularly from Treasury, is not until 2011. Is there any good reason, in your opinion, to essentially put that off to 2011? " CHRG-111hhrg48868--82 Mr. Garrett," I appreciate that. Mr. Polakoff, $80 billion left out there; $50 billion of that is on the subprime situation, right? [no verbal response] " CHRG-111hhrg55811--342 Mr. Meeks," Thank you. One of the issues that I have been very focused on is what is taking place right now with the money that is still caught up in the U.K. with Lehman Brothers. And a lot of foundations and institutions and you are talking about money that is really caught up there. So I was wondering in looking at the draft--but I guess I will address this to Mr. Kaswell--that if the key pillars of the discussion draft had been in place at the time of the Lehman's bankruptcy, how would things have--would things be the same? Would they have evolved differently? And particularly, I am interested in the two key pillars of the independent third-party custodians and the central clearing of trades by major-market participants. Would it have made a difference? " FOMC20070131meeting--312 310,MR. MOSKOW.," I just was wondering, since we’re focusing on alternative B, how the staff thinks the markets will react to the current version." CHRG-111shrg57320--64 Mr. Rymer," Yes, sir. Senator Kaufman. But, in retrospect, maybe there is another sentence that would have gone in there? It was a failure by management to police what they were doing. There were all kinds of things that went on that were highly questionable. And the people at the top of the Office of Thrift Supervision really did not do what you would have done faced with a similar situation with a record like this. This was not just a 6-month record. This was years of people knowing what it is doing. And for whatever reason, they did not move forward. Is that a fair--and I am looking for an honest correction if I am saying something that is not---- " CHRG-111shrg55117--84 Mr. Bernanke," We are not aware of any such situation, but it is true, if there were something that was outside of our purview---- Senator Warner. Let me go back to something the Chairman raised, and Senator Schumer and Senator Martinez raised. I do fear that one of the casualties of this crisis may be small business lending, not just in the short term but over a longer period of time, and not just for particularly already performing firms, but I used to be in a startup business, and while I think venture and early stage capital will reemerge, interim financing, startup capital for smaller businesses. I would echo what Senator Schumer said. I would hope that we could see some actual numbers in terms of take-up rates of TALF for small business. I know the Treasury is taking some actions with SBA, although that has always had some mixed results. I just wonder from a general comment whether--I know you don't like to give policy advice, but as we think about trying to get the financial system back in place, obviously large cap financial markets has kind of reopened, but I could see the small business area being really stymied for a long, long time and the startup business also being stymied for a long time. Comments? Suggestions? " FOMC20080430meeting--135 133,MR. FISHER.," For how long? This is a personal view, but it's not clear to me that things are that clear-cut on a sustainable basis. One of the things that seems to be undercutting confidence is the weakness in the dollar, even though in the past few days the dollar has rallied. I'm just wondering if it's clear-cut that we would necessarily have a sustained selloff. I can see an immediate reaction, particularly on the announcement. But it's conceivable, is it not, that if we had a dollar rally that we could have a positive effect on equity prices or on the credit markets? " CHRG-111hhrg51585--82 Mr. Thornberg," I don't have a specific number on that, sir. I think the key point here is--again, I want to focus. These were short-run funds, not long-run investments for pension funds. In most of these cases, these are funds that are tied to spending that is going to occur within the next 12 to 24 months as opposed to over the next 20 or 30 years. Again, I want to emphasize that the problem suffered by many of these local governments is due specifically to choosing Lehman as opposed to Bear or Merrill. That can't be underestimated. In the context of Orange County, I don't believe the failure, the bankruptcy of Orange County, has any relevance in this particular situation; because in the case of Orange County, there were very specific investments made in very, very, risky products and that county individually suffered as a result of that. That was not the sort of a situation that was common across many places. " CHRG-110hhrg46595--282 Mrs. Biggert," Thank you, Mr. Chairman. In my opening statement, I asked the question about what are the reasons that people are not buying the cars. And I just wondered since most of us sitting up here have been doing surveys--or a poll, as we would call them, during the past year, I wondered if any of your companies do surveys annually or whatever to determine what the customer thinks. " FOMC20070807meeting--132 130,MR. KOHN.," Thank you, Mr. Chairman. Like the others, I think keeping the federal funds rate where it is is the right thing to do. We need, as others have said, to watch the situation carefully and see how it evolves. I think we’re trying to do two things with this statement, as others have remarked. One is to make people aware that we’re aware that a major market event has occurred and to say that we’re looking at it and trying to assess its implications for the outlook but that it hasn’t really—not yet, anyhow—caused a major change in our fundamental assessment of where the economy is going. The second thing we are trying to do is make sure that we have a flexible platform we can move from over the next couple of meetings or even, should it become necessary, in the intermeeting period. So one can see this going in lots of different directions—the markets getting much more turbulent with implications for the outlook and we need to move in the intermeeting period or things settling down and we go back to inflation as the predominant risk. The incoming data on demand and production remain consistent with the central forecast. As I and some others noted, we could end up coming out of this and easing policy somewhere down the road, but not right away. I thought the language of alternative B did both of those things. It acknowledged the situation. It reinforced the sense that moderate growth going forward was where we thought things were going because we added the “supported by solid growth in employment and incomes and a robust global economy.” So we have some rationale for that, which we didn’t have before. I also thought that paragraph 4 was a really accurate reading. I was actually a little surprised through the go-round just how, almost universally, people said that the downside risks to output have increased but that they were still most concerned about inflation. So I thought that paragraph 4 turned out to be presciently—on the part of the Chairman, Brian, or whoever drafted it—a really accurate view of where the Committee was. My concern about moving the first piece of that into paragraph 2 is that then we have one risk in paragraph 2. We haven’t done that before, right? The risks to output and to inflation have all been talked about in paragraph 4. Another risk is in paragraph 4, the risk to inflation, and that is an asymmetry of how we discuss risks. It was intended to soften the risk, but I think it strikes me as creating a precedent that in the future will be hard to live with, when some risks are in some paragraphs and other risks are in other paragraphs. Another thing we could do is move the inflation risk into paragraph 3 and not come down one way or another. But I think the Committee wants to come down on the inflation side—in terms of predominant risk or main risk—and the Committee isn’t quite ready to go to balance. So it seems to me that paragraph 4, as written, really captured the center of gravity of the Committee. So I am in favor of that. One word on the moral hazard and the concern about being seen as reacting: I am not worried about it. I think we have kept our eye, through the past twenty years, on the macro environment. We have adjusted policy to stabilize the economy, to bring inflation down, and we were pretty darn successful in all of that. Asset prices go up, and asset prices go down. Anybody who bought a lot of high-tech stock, betting on the Greenspan put, is still waiting to recover their money. [Laughter] I don’t think it ever existed. I really don’t care what people say; I care about what we do, and we just need to keep our eye on those macro implications. Now, as I said in my presentation, I think the connection between the financial markets and the macroeconomy is pretty complicated and runs through confidence and other things, too. But I’m not really worried about a moral hazard from acting. Should markets continue to be turbulent and we see that turbulence in the future—I agree with the Vice Chairman that we have to be forward looking in this—such turbulence has the potential for adversely affecting the economy. I think we should go ahead and act. I think we basically did the right thing in ’87 and ’98, and I don’t think we need to apologize for it. Thank you, Mr. Chairman." FOMC20081029meeting--17 15,MR. ROSENGREN.," But there is nothing that prevents them from withdrawing those assets before that, right? Presumably, if they're in a situation of default, they would withdraw any Treasury securities held here first. " 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-111hhrg53238--124 Mr. Lucas," That is very true, Mr. Chairman. I recently met with a group of bankers from small community banks and financial institutions in my district, and they have serious concerns, as do I, about the impact of the proposed Consumer Financial Protection Agency and what it will do to them. Our community banks are small financial institutions that have had little to do with the cause of the current financial crisis and continue to serve their communities as safe and reliable sources of credit. Their very success depends on the success of their communities. However, under this new regulatory agency, they could, I fear, be disproportionately burdened with additional regulations and fees. In addition, there has been a lot of discussion here today in regard to the threat that too-big-to-fail institutions pose to the stability of our financial institutions as a whole, and how best to address this threat. When considering how best to approach reform, we must not sacrifice the health of our small institutions that did not cause this situation. Now, I address my question in particular to Mr. Yingling and Mr. Menzies. I do not represent a capital-intensive district. I do not have any money market facilities, institutions in my district. I have consumers of products, and I have small businesses. Your two organizations represent the backbone of the financial institutions in my district. Expand for a moment what the effect of this piece of legislation, as now drafted, will be on those institutions. Because, after all, we all know rules have many effects. And they can limit opportunities and they can kill, too. That is the nature of the Federal process. Explain to me what this bill will do to your folks in my district. " CHRG-111hhrg53021Oth--65 Mr. Goodlatte," I see that you have the same problem that I have with this process, then. And I wonder if you could---- " CHRG-111hhrg53021--65 Mr. Goodlatte," I see that you have the same problem that I have with this process, then. And I wonder if you could---- " FOMC20070918meeting--27 25,VICE CHAIRMAN GEITHNER.," Just to reinforce what Bill said—of course, we spent a lot of time thinking through exactly the risks that you are worried about in this context, and we’ll have a lot to reflect on in terms of the nature of the regime and what the legislative authority gives us going forward. But I think that Bill and his people really had just a simple choice, which was— particularly at that point late in August and early in September—whether they should have acted in a way that raised the possibility of having fed funds trade significantly above target over this period. If you look at the experience of the other central banks managing this situation in the past six weeks or so and what happened when they prematurely acted in a way that ended with having their rates trade substantially firm to target and the effects of that on behavior and the market, I am completely confident that our guys erred in the right direction. I also don’t believe, just to reinforce what Bill said, that anybody serious in the markets viewed what the Desk was doing and the behavior regarding where fed funds were traded as having a signaling effect or as constraining the flexibility of the Committee. It is true that you had a bunch of people in mid-August talking about that possibility and wondering whether they should read the very soft trading of fed funds as an indication of the stance of monetary policy going forward, but I think that got sucked out of the market relatively quickly. Again, I think you’re raising absolutely the right questions. We grapple with those questions every day. We basically made the judgment that to adopt a much more aggressive stance in being stingy with the reserves at various points in this period would have created too much risk of fed funds trading firm relative to target at a moment when psychology and confidence were very, very fragile. I really think the experience of other central banks was a good counter example of the cost of the alternative strategy. Now, of course, we will have a chance over time to go back and do a much more detailed review. Another thing I would say about coming in later in the day is that it’s very important to have some stability in the basic framework with which the Desk operates, particularly after what we did the week before August 17 and on August 17. To have a lot of changes at the same time in the standard operating procedures of the Desk would have created more risk of uncertainty about what we were doing. We were trying to find a balance between the imperatives of a relatively steady hand and the risk that you are phrasing in absolutely legitimate questions. We’ll have a chance to reflect on a lot of things after this period, but my own view is that they made exactly the right judgment." FOMC20050920meeting--17 15,MR. KOS.," I know that they’re concerned about the situation, and there was certainly a signaling effect perceived by the market when the Treasury issued that request for large-position reports. We saw some decay accelerating right after that request, so perhaps some of the longs took that as a signal that they should reduce their positions." FOMC20070918meeting--130 128,MR. MISHKIN.," Thank you, Mr. Chairman. Clearly, the key issue in thinking about where the economy is and what we need to do about policy is the financial destruction that is going on right now. When I look at it, I think about the different episodes that we’ve had in the post-World War II period and separate them into two sets of episodes. There’s the episode of 1970 with the Penn Central crisis, there’s the 1987 stock market crash, there’s the 1998 LTCM episode, and then, of course, the World Trade Center terrorist tragedy in 2001. That’s one group. In those contexts, there was a lender-of-last-resort operation. It was active policy on our part, and it did resolve the situation in the financial markets very quickly. The other episode is the early 1990s, when there was much more of a severe structural problem in which the banks got into trouble. Therefore, it took quite a long time for them to fix their balance sheets in order to get players back into the financial markets to make loans to people who had good investment opportunities. When I look at the current episode, I see something in-between. I do not think that in this case the situation can be resolved quickly because I think that the price discovery issues are severe. In particular, we’ve gone to an originate-to-distribute model, which Governor Kroszner mentioned, and we have found some serious flaws in it. The expectation is that we will have new models coming out. In fact, I think that this is actually going to be a long-run profit opportunity for the banks. So if we were allowed to buy bank stocks, I think it would be a good idea. [Laughter] But the key problem is that this is going to take a substantial amount of time, even if things go very well; in that context, there is a substantial negative shock to aggregate demand and, therefore, a substantially weaker economy. However, the issue that most concerns me here is that, even though I think the modal forecast is that growth will be slower than we expected, the downside risk is actually very, very substantial. Though we may not be allowed to mention it in public, we have to mention the “R” word because there is now a significant probability of recession. The problem here is really the interaction of the financial side with the real side. I’m worried that, as the economy becomes more nonlinear, we have the potential for a vicious circle or a downward spiral, whatever phrase you want to use—that, in particular, we have a financial disruption, which means that it’s harder to allocate capital to people with productive investment opportunities and, as a result, you get a contraction in economic activity. A contraction in economic activity makes information revelation or price discovery harder to do. That can then lead to more financial disruption, which leads to a downward spiral in terms of economic activity. So the big issue here for me is that this nonlinear element is very real right now. The question is what to do about it, and that’s what we will be discussing shortly. However, I think it is also important to recognize that inflation risks are just not that severe right now. That’s the good news because it will allow us flexibility to deal with the situation. In particular, we see inflation expectations that are very grounded, something that everybody has mentioned. Also, even in the modal forecast and not worrying about the downside risks, the expected future output gaps are more negative, so we have less pressure going forward there. I was happy that the staff slightly lowered the NAIRU estimate, which was consistent with my views in the past couple of cycles, when I thought that it might be a smidgeon under 5 percent. I think their revision makes sense, and, again, it means that there’s a bit less likelihood of upside risk to inflation. Then, also, there are the downside risks to real growth. When I look at the inflation situation, I do think that inflation expectations are grounded around 2 percent right now. By the way, that’s not necessarily written in stone because things that we might do could actually change inflation expectations; but I think that we have to take inflation expectations as given right now. However, I see that the risks are slightly to the downside from that 2 percent level because of the things that I’ve just mentioned. The key point here is that we have a situation of potential nonlinearities, big tail risk, that could actually get very nasty, and in fact there is a potential for recession. On the other hand, I don’t see that inflation risk is the big problem right now. Thank you." CHRG-110shrg50414--45 Secretary Paulson," I also share the comments that you all made about the importance of the situation and the importance of this hearing. This is a difficult period for the American people. I very much appreciate the fact that congressional leaders and the administration are working closely together so that we can help the American people by quickly enacting a program to stabilize our financial system. We must do so in order to avoid a continuing series of financial institution failures and frozen credit markets that threaten American families' financial well-being, the viability of businesses both small and large, and the very health of our economy. The events leading us here begin many years ago, starting with band lending practices by banks and financial institutions and by borrowers taking out mortgages they could not afford. We have seen the results on homeowners--higher foreclosure rates affecting individuals and neighborhoods. And now we are seeing the impact on financial institutions. These loans have created a chain reaction, and last week our credit markets froze. Even some Main Street non-financial institutions--or, excuse me, some non-financial companies had trouble financing their normal business operations. If that situation were to persist, it would threaten all parts of our economy. Every American business depends on money flowing through our system every day, not only to expand their business and create jobs, but to maintain normal business operations and to sustain jobs. As we have worked through this period of market turmoil, we have acted on a case-by-case basis, addressing problems at Fannie Mae and Freddie Mac, working with market participants to prepare for the failure of Lehman Brothers, and lending to AIG so it can sell some of its assets in an orderly manner. And here I would make the comment, you know, I have heard your comments on executive compensation. I share your frustrations. I feel those frustrations. Practices throughout America also upset me. Let me just say that, with regard to Freddie and Fannie and AIG, in case you or your constituents do not know, in those cases CEOs were replaced, the Government got warrants for 79.9 percent of the equity, golden parachutes were eliminated, strong action was taken. I will also say to the comments made about Freddie and Fannie and the bazooka, you all can be darn glad you gave us the bazooka, because we needed it. Let me tell you something. The root of that problem was in congressional charters started many, many years ago. We were living up to our obligations here. There are ambiguities. There are obligations around those charters. And what we did was we came in, we stabilized the market, mortgage rates went down so that capital could flow through our system. And I can just say I for one--and I know that the other witnesses feel very glad about this--thank goodness that was done and they were stabilized before we had some investment banks report their earnings, or let me tell you, this would be a much more serious situation than it is today. So there is an example of broad authorities working the way they were supposed to work to stabilize our system. Sorry for that ad hoc response, but we have also taken a number of powerful tactical steps to increase confidence in the system, including a temporary guaranty program for the U.S. money market mutual fund industry. These steps have been necessary but not sufficient. More is needed. We saw market turmoil reach a new level last week and spill over into the rest of the economy. We must now take further, decisive action to fundamentally and comprehensively address the root cause of this turmoil. And that root cause is the housing correction, as you have all pointed out, which has resulted in illiquid mortgage assets that are choking off the flow of credit which is so vitally important to our economy. We must address this underlying problem and restore confidence in our financial markets and financial institutions so they can perform their mission of supporting future prosperity and growth. We have proposed a program to remove troubled assets from the system. We would do this through market mechanisms available to thousands of financial institutions throughout America--big banks, small banks, savings and loans, credit unions--to help set values of complex, illiquid mortgage and mortgage-related securities to unclog our credit and capital markets and make it easier for private investors to purchase these securities and for the financial institutions to raise more capital after the market learns more about the underlying value of these hard-to-value, complicated mortgage-related securities on their balance sheets. This Troubled Asset Relief Program has to be properly designed for immediate implementation and be sufficiently large to have maximum impact and restore market confidence. It must also protect the taxpayer to the maximum extent possible and include provisions that ensure transparency and oversight while also ensuring the program can be implemented quickly and effectively. And let me give you another ad hoc comment there. When we all met Thursday night, as you will recall, Chairman, with the leaders of Congress, you all said to us, ``Don't give us a fait accompli. Come in and work with us.'' We gave you a simple three-page legislative outline, and I thought it would have been presumptuous for us on that outline to come up with an oversight mechanism. That is the role of Congress. That is something we are going to work on together. So if any of you felt that I did not believe that we needed oversight, I believe we need oversight. We need oversight. We need protection. We need transparency. I want it, we all want it. And we need to do that in a way that lets this system, lets this program work effectively, quickly, because it needs to work effectively and quickly, and it needs to get the job done. Now, the market turmoil we are experiencing today poses great risk to U.S. taxpayers. When the financial system does not work as it should, Americans' personal savings and the ability of consumers and businesses to finance spending, investment, and job creation are threatened. The ultimate taxpayer protection will be the market stability provided as we remove the troubled assets from our financial system. Don't forget that. This system has to work, and has to work right, and that will be the ultimate market protection. I am convinced that this bold approach will cost American families far less than the alternative--a continuing series of financial institution failures and frozen credit markets unable to fund everyday needs and economic expansion. Again, I am frustrated. The taxpayer is on the hook. The taxpayer is already on the hook. The taxpayer is going to suffer the consequences if things do not work the way they should work. And so the best protection for the taxpayer and the first protection for the taxpayer is to have this work. Over these past days, it has become clear that there is a bipartisan consensus for an urgent legislative solution. We need to build upon this spirit to enact this bill quickly and cleanly, and avoid slowing it down with provisions that are unrelated or do not have broad support. This troubled asset purchase program on its own is the single most effective thing we can do to help homeowners, the American people, and to stimulate our economy. Earlier this year, Congress and the administration came together quickly and effectively to enact a stimulus package that has helped hard-working Americans and boosted our economy. We acted cooperatively and faster than anyone thought possible. Today we face a much more challenging situation that requires bipartisan discipline and urgency. When we get through this difficult period, which we will, our next task must be to address the problems in our financial system through something you have all talked about. We need reform that fixes this outdated financial regulatory structure. You have all heard me talk about that a lot. And we need other strong measures to address other flaws and excesses in the system. And there are plenty, and we have all talked about them, and they cannot be addressed this week. We need to take time to address these. I have already put forward my recommendations on this subject. Many of you have strong views based on your expertise. We must have that critical debate, but we must get through this period first. Right now, all of us are focused on the immediate need to stabilize our financial system, and I believe we share the conviction that this is in the best interest of all Americans. Now let's work together to get it done. Thank you. " 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? " FOMC20070628meeting--80 78,MR. MOSKOW.," Also, on exhibit 8, the net worth chart in the top left-hand corner—I thought I heard you say that this was high by historical standards. So there are two things here—the stock market has been strong, and then housing prices have been very weak. I assume if you run this out into another year, the line is going to keep going down as well. I was just wondering if you could expand on this. Is this higher than you expected it to be at this particular time?" CHRG-111hhrg56778--49 Mr. Foster," One of the concepts in a lot of the regulatory reform is the idea of a living will, that if a holding company gets in trouble, we chop it up into little pieces. That seems like it in principle fits pretty well with the idea of State-based operating units, and I was wondering if that's a correct impression of mine that it would actually be better to have independent business units in each State when it comes time to chop the companies up into little pieces and sell them off. Or the counter argument against that is that actually operations like AIG share IT infrastructure and all this sort of stuff in ways that make it really very difficult to chop up their business units. I was wondering which one is closest to reality. Ms. Frohman. We found in our experience in receiverships where we have a holding company sitting at the top of an insurance group that we work very well, even in the event that the holding company may be in bankruptcy to work out sharing payment systems and master coordination. So it does create an issue, but it hasn't been a problem in the resolution of the insurance enterprises. We jump on that right away. " CHRG-110hhrg46591--247 Mr. McCotter," On that point, I think it is a very accurate point, because one of the other problems that, I think, has become apparent is that it was a failure of government reform, a failure to reform the United States Government to the point where you could have intelligent, proactive, and accountable regulators in place that could try to keep up with the market in instances where there were failures to self-govern, because, as you know, even where there are some misdeeds amongst many good deeds, those some misdeeds can cause a lot of problems. You also referenced something that I find fascinating. Secretary Paulson also mentioned it previously, although not in front of this committee. He talked about how now the interdependence amongst American financial institutions was originally thought to be a guard against the very type of meltdown that we saw; that if we had linked them all together, and that if one were to fail, the new web of financial institutions would help support the overarching framework of the financial services sector. Yet the exact opposite has happened. Has that not been replicated on the global scale as you seem to indicate? So then what we have to look at is not only an internal reform of the United States Government to get more intelligent, proactive and accountable, but we will also have to start looking at our international institutions to guarantee that the interconnectivity between global financial institutions does not lead to what we seem to be on the brink of, which is a continued meltdown based upon some bad actors dragging everyone down with them on top of innocent people. Thank you. " CHRG-109shrg21981--118 Chairman Greenspan," Well, we had believed we were going to run the debt down to zero not that many years ago. That would have solved the problem. Senator Stabenow. I remember your being here with us in 2001, when we were talking about the wonderful problem of having too large of a surplus and the question of what we do about that. I wonder if I might ask one further question. I know my time has expired. " CHRG-111hhrg56776--55 Mr. Bernanke," Congressman, I have given a speech on this. I think the bottom line is, nobody really knows for sure, but that the evidence is really quite mixed. I would say even if they were too low for too long, the magnitude of the error was not big enough to account for the huge crisis we had. I think what caused the crisis were the failures of regulation. I would fault the Fed here, too, because some of those failures were ours in the sense that we did not do enough, and I have admitted this and acknowledged this many times, we did not do enough on mortgage regulation. I think it was the weakness of the regulatory system, not monetary policy, that was most important here. Dr. Paul. Of course, I do not agree with that, but if you assume for a minute that it was too low for too long, and you had perfect regulations, what is the harm done by interest rates being too low for too long? Do you see any damage by interest rates being artificially low for a long period of time? Let's sort that away from regulations for a second. " CHRG-111shrg54675--95 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM ARTHUR C. JOHNSONQ.1. Every weekend the FDIC is closing the doors of banks across the country at a record pace. I am concerned about the failure of small rural banks in areas where there is not another bank. The customers in the area might be left unbanked if a larger institution buys the deposits without opening a branch in the community. What are the options for these customers, and how are your members working to keep rural customers connected to the banking system?A.1. I share your concerns about the consequences of bank failures, regardless of location, but particularly in rural areas. Typically, the failures involve a healthy bank acquiring the deposits and many of the assets of the failed bank. In those situations, the healthy bank is looking to maintain a relationship with the customers--in fact, this is what is attractive to the acquiring bank and the basis for the premium paid to the FDIC for the right to acquire the bank. This financial incentive helps ensure that customers of the failed bank have a stable relationship with the new bank. Moreover, it is typically the case that when branches are closed following an acquisition it is because there is another branch of the acquiring bank nearby that will serve those customers. In situations where there are fewer branches available to serve customers, advances in technology have significantly helped make this transition smooth. Remote deposit capture, for example, is something that more and more banks are offering to their small business and farm customers. This option has proven especially popular in rural America. Small business customers are able to immediately deposit checks in their accounts from their places of business. As improvements in the technology have driven down costs, banks are able to offer it to smaller and smaller businesses and farms. Of course, there is also the availability of Internet banking which has been widely adopted by rural banks. Finally, electronic filing of financial statements by small businesses and farms is another way that banks can perform financial analysis for loan making purposes over great distances. ABA works closely with many State and Federal agencies to ensure that credit is available in rural areas, including the United States Department of Agriculture, the Small Business Administration, the Bureau of Indian Affairs, government sponsored enterprises, and all State-sponsored agricultural and rural credit making agencies to encourage outreach to our members and their customers. ------ fcic_final_report_full--396 Neither Merrill nor its CEO, John Thain, was informed of these deliberations at Bank of America. Lewis told the FCIC that he didn’t contact Merrill Lynch about the situation because he didn’t want to create an “adversarial relationship” if it could be avoided.  When Thain later found out that Bank of America had contemplated put- ting the MAC clause into effect, he was skeptical about its chances of success: “One of the things we negotiated very heavily was the Material Adverse Change clause. [It] specifically excluded market moves . . . [and] pretty much nothing happened to Mer- rill in the fourth quarter other than the market move.”  On Sunday, December , Paulson informed Lewis that invoking the clause would demonstrate a “colossal loss of judgment” by the company. Paulson reminded Lewis that the Fed, as its regulator, had the legal authority to replace Bank of Amer- ica’s management and board if they embarked on a “destructive” strategy that had “no reasonable legal basis.”  Bernanke later told his general counsel: “Though we did not order Lewis to go forward, we did indicate that we believed that going forward [with the clause] would be detrimental to the health (safety and soundness) of his company.” Congressman Edolphus Towns of New York would later refer to the Bank of America and Merrill Lynch merger as “a shotgun wedding.”  Regulators began to discuss a rescue package similar to the one for Citigroup, in- cluding preferred shares and an asset pool similar to Citigroup’s ring fence. The staff ’s analysis was essentially the same as it had been for Citigroup. Meanwhile, Lewis decided to “deescalate” the situation, explaining that when the secretary of the treasury and the chairman of the Fed say that invoking the MAC would cause sys- temic risk, “then it obviously gives you pause.”  At a board meeting on December , Lewis told his board that the Fed and Treasury believed that a failed acquisition would pose systemic risk and would lead to removal of management and the board at the insistence of the government, and that the government would provide assistance “to protect [Bank of America] against the adverse impact of certain Merrill Lynch as- sets,” although such assistance could not be provided in time for the merger’s close on January , .  The board decided not to exercise the MAC and to proceed as planned, with the understanding that the government’s assistance would be “fully documented” by the time fourth-quarter earnings were announced in mid-January.  “Obviously if [the MAC clause] actually would cause systemic risk to the financial system, then that’s not good for Bank of America,” Lewis told the FCIC. “Which is finally the conclusion that I came to and the board came to.”  The merger was completed on January , , with no hint of government assis- tance. By the time the acquisition became official, the purchase price of  billion announced in September had fallen to  billion, thanks to the decline in the stock prices of the two companies over the preceding three months. On January , Bank of America received the  billion in capital from TARP that had been allocated to Merrill Lynch, adding to the  billion it had received in October.  CHRG-111shrg53822--35 Chairman Dodd," That is a very important point because that gets central to the debate, in a sense, whether or not you have sort of the corporate model or you have a risk assessment officer that is watching everything and advises the corporation when they think things are straying off or actually has the authority to reach in and stop something from happening. And that debate is one we have not resolved. That is a very critical moment, as to what kind of authority you actually invest, whether it is the individual or whether it is the council. And I am more attracted to the council idea. Senator Corker? Senator Corker. Mr. Chairman, thank you. Thanks for having this hearing. I appreciate our witnesses coming in and thank them for their testimony, which I read this morning early. I have to tell you that I especially---- Excuse me, Gary. But I especially liked the testimony by our FDIC leader. And I find it to be just an absolute stunning rejection of the policies that have been put forth by our Treasury Secretary. And I very much like what you had to say. There might be some details. But I find it amazing that your embrace of the free market is so different from our Treasury Secretary, who, in essence, has come up here talking about wanting the powers, in perpetuity, to invest taxpayer money in entities that pose systemic risks, forever. In essence, creating another Fannie or a Freddie in the process. So it is an amazing thing to me. And, also, by the way, sharing with the public who those entities are by causing them to pay higher premiums so that everybody understands that they are never going to fail. So I just want to thank you for bringing sanity into this discussion. I very much appreciate your presentation, and very much appreciate your willingness to take something that is more the American way into your thinking here and certainly presenting to us. Now, let me ask you a question. Timing. We have had--I actually appreciate the way our chairman has handled this in that he has not tried to rush through this. I know that he and the ranking member agree on that. I know that this resolution authority, though, is important right now. Okay? The other pieces of it do not have to come into play necessarily. We are not going to solve this problem through regulation we put in place today. But I would love to hear about the resolution authority piece, number one, if you feel it can be done separately and what the timing of that should be. Ms. Bair. Well, I think that just giving us the authority to resolve bank and thrift holding companies could be done more quickly. You do not need to decide what is systemic and what is not, nor who is going to be providing the broader systemic regulation. That would be a huge contribution to the tools that we have in dealing with the current situation. So I think that this could be addressed separately, and it would be very helpful to have. Senator Corker. I do hope there is some--that you will coach us and help us figure out a way to maybe deal with the resolution issue and let the other be dealt with when there is not a crisis; otherwise, we will probably not end up with a cause-neutral solution. Okay? We will be focused on CDS's and everything else. But thank you. Let me ask you this. Many of our institutions have talked about wanting to leave the TARP program, but one of the most beneficial pieces of what we have done is the TGLP program, TLGP program, where, in essence, they are able, through government guarantees, to borrow money. If we cause these folks--if we allow these folks to leave the TARP program, should we also make them leave this other thing that is actually a greater benefit to them, a government guarantee for their debt? Should we also cause them to leave at the same time? Ms. Bair. I would point out that the TLGP program has been a moneymaker for us. We have collected over $7 billion in premiums from it, and we have had no losses. That has helped. Some of the surcharges on that program are now helping to replenish the Deposit Insurance Fund, where we have losses through our normal resolution activity. So I think there have been some benefits to the government and the FDIC for that program. Senator Corker. So now you are moving the free enterprise into government and we are making money---- Ms. Bair. I do not. We would like to get out of that program October 31st, and that is the plan right now. We had an opt-in or opt-out procedure when we instituted the program. I was worried about adverse selection. So I think we would like the institutions that are in the TLGP now to stay in it until October 31st under the current terms. But then after that, we would like to end the program. Senator Corker. Is that possible? Ms. Bair. I sure hope so, Senator. I think we will know more in the third quarter. But that is the current strategy. I will guarantee you that if we cannot end the TLGP for everybody, the fees will go up. Something we had originally talked about, which we did not do because the markets were under such stress, would be to only guarantee a percentage, say 90 percent or 80 percent, to start weaning the private markets off of this and take some percentage of the risk. So there are different ways we can exit if we cannot by October 31st. But our strong preference is just to get out on October 31st. Senator Corker. This is, apparently, going to be my last question. If we end the program on October 31st, my sense is that we, potentially, may need this resolution ability in place prior to then because it would be my sense that there are a lot of institutions in this country that cannot survive without that program being in place. I am just wondering if you might respond to that. Ms. Bair. I think that is a valid observation. The flexibility and the tools we have to deal with this, have been hampered by our lack of ability to deal with structures at the holding company level. So a lot of this open institution assistance has been needed because we do not have other tools available. It would be helpful to give us flexibility. It is the kind of thing you hope you will never have to use. But I think having it now would be extremely helpful. Also, we find with the smaller institutions that just a thread of resolution authority can trigger actions that might not otherwise take place. And so, for a variety of reasons, it will be a helpful tool to have. Senator Corker. We appreciate your willingness to talk with us on the telephone from time to time, and I hope that will continue. And, again, I know that you have spent most of your life in government. I thank you for proposing something that is sane, that actually alleviates the moral hazards that our Treasury Secretary has tried to lay out. I would love to hear of you-all's interpersonal conversation some time, but I will not ask for that now. Thank you very much. " FOMC20081029meeting--46 44,MR. ROSENGREN.," But I'm just wondering, as the OIS rate has come down, when you think of the band that we have for excess reserves, it does seem that the OIS provides a much bigger band, for example, than what we have even for excess reserves. I wonder whether, during periods in which people are considering a reduction of as much as 50 or more basis points, the OIS ends up being a very low lower bound. " CHRG-111hhrg48873--21 Mr. Bernanke," Thank you, Mr. Chairman. The Federal Reserve and the Treasury agreed that AIG's failure under the conditions then prevailing would have posed unacceptable risks for the global financial system and for our economy. Some of AIG's insurance subsidiaries, which are among the largest in the United States and in the world, would have likely been put into rehabilitation by their regulators, leaving policyholders facing considerable uncertainty about the status of their claims. State and local government entities that had lent more than $10 billion to AIG would have suffered losses. Workers whose 401(k) plans had purchased $40 billion of insurance from AIG against the risk that their stable value funds would decline in value would have seen that insurance disappear. Global banks and investment banks would have suffered losses on loans and lines of credit to AIG and on derivatives with AIG FP. The banks' combined exposure exceeded $50 billion. Money market mutual funds and others that held AIG's roughly $20 billion of commercial paper would also have taken losses. In addition, AIG's insurance subsidiaries have substantial derivatives exposure to AIG FP that could have weakened them in the event of the parent company's failure. Moreover, as the Lehman case clearly demonstrates, focusing on the direct effects of a default on AIG's counterparties understates the risk to the financial system as a whole. Once begun, a financial crisis can spread unpredictably. For example, Lehman's default on its commercial paper caused a prominent money market mutual fund to break the buck and suspend withdrawals, which in turn ignited a general run on prime money market mutual funds, with resulting severe stresses in the commercial paper market. As I mentioned, AIG had about $20 billion in commercial paper outstanding, so its failure would have exacerbated the problems of the money market mutual funds. Another worrisome possibility was that uncertainties about the safety of insurance products could have led to a run on the broader insurance industry by policyholders and creditors. Moreover, it was well-known in the market that many major financial institutions had large exposures to AIG. Its failure would likely have led financial market participants to pull back even more from commercial and investment banks, and those institutions perceived as weaker would have faced escalating pressure. Recall that these events took place before the passage of the Emergency Economic Stabilization Act, which provided the funds that the Treasury used to help stem a global banking panic in October. Subsequently, it is unlikely that the failure of additional major firms could have been prevented in the wake of a failure of AIG. At best, the consequences of AIG's failure would have been a significant intensification of an already severe financial crisis and a further worsening of global economic conditions. Conceivably, its failure could have resulted in a 1930's-style global financial and economic meltdown, with catastrophic implications for production, income, and jobs. The decision by the Federal Reserve on September 16, 2008, with the full support of the Treasury, to lend up to $85 billion to AIG should be viewed with this background in mind. At that time, no Federal entity could provide capital to stabilize AIG, and no Federal or State entity outside of a bankruptcy court could wind down AIG. Unfortunately, Federal bankruptcy laws do not sufficiently protect the public's strong interest in ensuring the orderly resolution of nondepository financial institutions when a failure could pose substantial systemic risks, which is why I have called on the Congress to develop new emergency resolution procedures. However, the Federal Reserve did have the authority to lend on a fully secured basis consistent with our emergency lending authority provided by the Congress and our responsibility as the Central Bank to maintain financial stability. We took as collateral for our loan AIG's pledge of a substantial portion of its assets, including its ownership interest in its domestic and foreign insurance subsidiaries. This decision bought time for subsequent actions by the Congress, the Treasury, the FDIC, and the Federal Reserve that have avoided further failures of systemically important institutions and have supported improvements in key credit markets. Having lent AIG money to avert the risk of a global financial meltdown, we found ourselves in the uncomfortable situation of overseeing both the preservation of its value and its dismantling--a role quite different from our usual activities. We have devoted considerable resources to this effort and have engaged outside advisors. Using our rights as creditor, we have worked with AIG's new management team to begin the difficult process of winding down AIG FP and to oversee the company's restructuring and divestiture strategy. Progress is being made on both fronts. However, financial turmoil and a worsening economy since September have contributed to large losses at the company, and the Federal Reserve has found it necessary to restructure and extend our support. In addition, under its Troubled Asset Relief Program, the Treasury injected capital into AIG in both November and March. Throughout this difficult period, our goals have remained unchanged: to protect our economy and preserve financial stability; and to position AIG to repay the Federal Reserve and return the Treasury's investment as quickly as possible. In our role as creditor, we have made clear to AIG's management, beginning last fall, our deep concern surrounding compensation issues at AIG. We believe it is in the taxpayers' interest for AIG to retain qualified staff to maintain the value of the businesses that must be sold to repay the government's assistance. But, at the same time, the company must scrupulously avoid any excessive and unwarranted compensation. We have pressed AIG to ensure that all compensation decisions are covered by robust corporate governance, including internal review, review by the compensation committee at the board of directors, and consultations with outside experts. Operating under this framework, AIG has voluntarily limited the salary, bonuses, and other types of compensation for 2008 and 2009 of the CEO and other senior managers. Moreover, executive compensation must comply with the most stringent set of rules promulgated by the Treasury for TARP fund recipients. The New York attorney general has also imposed restrictions on compensation at AIG. Many of you have raised specific issues with regard to the payout of retention bonuses to employees at AIG FP. My reaction upon becoming aware of these specific payments was that, notwithstanding the business purposes that might be served by this action, it was highly inappropriate to pay substantial bonuses to employees of a division that had been the primary source of AIG's collapse. I asked that the AIG FP payments be stopped but was informed that they were mandated by contracts agreed to before the government's intervention. I then asked that suit be filed to prevent the payments. Legal staff counseled against this action on the grounds that Connecticut law provides for substantial punitive damages if the suit would fail. Legal action could thus have the perverse effect of doubling or tripling the financial benefits to the AIG FP employees. I was also informed that the company had been instructed to pursue all available alternatives and that the Reserve Bank had conveyed the strong displeasure of the Federal Reserve with the retention payment arrangement. I strongly supported President Dudley's conveying that concern and directing the company to redouble its efforts to renegotiate all plans that could result in excessive bonus payments. I have also directed staff to work with the Treasury and the Administration in their review of whether the FP bonus and retention payments can be reclaimed. Moreover, the Federal Reserve and the Treasury will work closely together to monitor and address similar situations in the future. To conclude, I would note that AIG offers two clear lessons for the upcoming discussion in the Congress and elsewhere on regulatory reform: First, AIG highlights the urgent need for new resolution procedures for systemically important, nonbank financial firms. If a Federal agency would have had such tools on September 16th, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now. Second, the AIG situation highlights the need for strong, effective, consolidated supervision of all systemically important firms. AIG built up its concentrated exposure to the subprime mortgage market largely out of the sight of its functional regulators. More effective supervision might have identified and blocked the extraordinarily reckless risk-taking at AIG FP. These two changes could measurably reduce the likelihood of future episodes of systemic risk like the one we faced at AIG. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 70 of the appendix.] " FOMC20070321meeting--97 95,MS. MINEHAN., I wondered about that. Don didn’t get one yesterday. CHRG-111shrg62643--69 Mr. Bernanke," We do not focus on bilateral trade deficits for U.S.-China. We look at the overall, and that is somewhat different. Senator Bayh. My second question has to do with the Greek debt crisis once again, and as you pointed out, the Europeans moved very aggressively and things seem to have calmed down a fair amount there. But I look with some alarm, even if they implement all these austerity measures that they are thinking about, and as you can see there is a fair amount of political turmoil around all that, it looks as if they are still going to be at about 130 percent or so of debt-to-GDP ratio, even after they have implemented all these steps. And just putting my political hat on, it could be pretty hard for them to go substantially beyond that. So that still looks like it is going to be pretty hard to sustain a situation like that. So I do not expect you to comment upon the likelihood of restructuring or anything like that. But you had mentioned that the whole episode, while it caused some disturbance, we have now kind of gone beyond that. So my question would be: In the event of an orderly restructuring of Greek debt at some point, I assume that it would also have only a marginal impact upon our own markets? " CHRG-111hhrg54869--97 Mrs. Capito," All right, thank you. My last question is, so many of these matters--I mean you have dealt with these matters your entire life and done such a wonderful job. They are so darn complicated for the man on the street who is listening to this hearing. Or any time I go to my district and try to talk about the need for new regulation in the financial markets, people's eyes start to glass over. And I know you have made many speeches and many--is there any way, in a concise way, besides, you know, this is going to protect you from losing your retirement in the future--is there any way that you find is most effective to convey the message to the man on the street that this is an issue that really does impact them every day in their life? " FOMC20080724confcall--21 19,MR. LACKER., Right. It is reducing the upper tail. So what sort of evidence or reports have you had from the dealer community that the upper tail of the probability distribution of TSLF bids is causing financial strain for them? CHRG-111shrg57709--98 Mr. Volcker," Right. Senator Warner. You talk about three different areas: proprietary trading, private equity and hedge funds. I mean I know you have talked a little bit about definition on the proprietary trading act. I do wonder. I used to be in the private equity business. There are private equity, subordinated debt, different types of instruments that kind of fall along that continuum of what we now broadly define as private equity. Some of those traditionally had been kind of traditional banking functions. " CHRG-111hhrg48867--244 Mr. Ellison," Well, do you agree that if they had certain requirements on, you know, continuing education, bonding, some standards of behavior, professional standards, that we may not be in this situation to the degree we are in it right now? " CHRG-111shrg57320--367 Mr. Corston," More critical. Senator Levin. Because of the situation there. Now, if you look at the credit issue or rating at the top right-hand corner of that document, they are A-1 or A. Is that correct? " CHRG-111hhrg48873--173 Mrs. Bachmann," Mr. Chairman, thank you for this opportunity. These truly are extraordinary times in our financial services sector since 1 year ago the Federal Reserve opened the Fed's discount window in the amount of $29 billion for Bear Stearns. The American people are looking at the actions of both the Federal Reserve and the Treasury Secretary, and they are wondering if their government is making an historic shift, jettisoning the free-market capitalism in favor of centralized government economic planning. I wonder, Mr. Secretary, if you would comment on that. " CHRG-110hhrg44901--19 Mr. Bernanke," Certainly. The recent financial crisis, which has been quite severe, as you know, has revealed a number of weak points in our economy, in our financial system, and they have required attention because we need to have a stable, well-working financial system in order for the economy to recover. In the longer term, I agree that market discipline is the best source of strength in the financial system. We need to take action to make sure that moral hazard doesn't induce excessive risk-taking. I spoke on this subject last week in a speech, and I indicated three directions forward that we could take to make sure that moral hazard is constrained in the future. The first is, now that the investment banks have received some support, in particular they have received access to, at least temporarily, to the discount window, I believe that we need to have legislated consolidated supervisory oversight over those firms that would ensure that they have adequate capital, adequate liquidity, and adequate risk management so they would not be taking advantage of any presumed backstop that they might otherwise see. Secondly, I talked about the need to strengthen our financial infrastructure. Part of the reason that it was a big concern to us when Bear Stearns came to the brink of failure was that we were concerned that there were various markets where the failure of a major counterparty would have created enormous strains on the financial system. One way to address the problem, and I discussed that at some length in my speech and I would be happy to talk more about it, is to make sure that the financial infrastructure, the systems through which lending and borrowing takes place, as well as the risk management of the lenders is strengthened to the point that the system could better withstand a failure, and therefore there would be less expectation of support in that situation. Finally, I think the issues we have approached like the investment banks, these circumstances were not contemplated in other areas like deposit-insured banks. There is a procedure, a set of rules, prompt corrective action, systemic risk, those sorts of things which tell the regulators how Congress wants them to proceed and create clarity in the market about under what circumstances assistance would be forthcoming. As Secretary Paulson has also indicated, I think we ought to be looking at clarifying the congressional expectations for how we would resolve--were the situation to arrive again, how to resolve such a problem. " FOMC20050809meeting--143 141,MR. STERN.," Thank you, Mr. Chairman. The District economy continues to track the national economy quite closely, as it has for a long time. And as I commented at the last meeting, what is striking about the District economy right now is the breadth of the economic expansion. Virtually all sectors are either strong or improving, and I won’t go through a review August 9, 2005 46 of 110 improving employment conditions, wage increases still remain quite modest, as best I can judge. And inflationary pressures haven’t changed, as best I can assess the situation. As far as the national economy is concerned, we’re now almost four years into the current economic expansion and, overall, things look quite good to me. That in a way is remarkable in and of itself, as I think of the conversations we’ve had around this table over the last four years and the variety of concerns and issues that were raised. To be sure, policy has played a role in supporting this economic performance but, as I’ve commented before, I think once again we are observing the fundamental soundness, resilience, and flexibility of the economy. The situation is starting to resemble in broad terms, in my mind at least, the long expansions of the ’80s and ’90s. In fact, without stretching too far, I think one could perhaps make the case that the situation is even a little better than a few years into those expansions. After all, today we have low interest rates, low inflation rates, well-anchored inflationary expectations, for the most part a fairly well-balanced domestic economy, and what I might call a promising international economy. I call it promising not because I’m thinking about Europe or Japan, but because I’m thinking about China and India and some of their smaller brethren. There are some issues, to be sure. One is oil prices, which have already been mentioned today. The federal budget situation is another one, although I think that’s more a secular than a cyclical problem. And then there are housing prices. All I would say there is that even if there is a bubble, and even if it bursts, the quantitative significance of that remains quite unclear, as far as I’m concerned. I do think we need to pay considerable attention, as we have been, to the inflation situation, but my sense of the situation is that there is no significant deterioration under way or August 9, 2005 47 of 110 forecasting inflation. It has worked remarkably well for a good number of years now. [Laughter] Having said that, I do think it’s appropriate to continue with the policy path we’ve been on. That seems, given the way the economy has evolved, fully appropriate to me." CHRG-110shrg50414--38 STATEMENT OF SENATOR DANIEL AKAKA Senator Akaka. Thank you very much, Mr. Chairman. I appreciate your conducting this hearing today, and I want to add my welcome and thanks to the witnesses who are here today. Mr. Chairman, I understand the need to act to stabilize the markets. However, we must not give the Secretary of Treasury a blank check with no accountability or oversight. We must deliberate and provide a solution that protects taxpayers as much as possible and limits the potential for this new authority to be abused. Seven hundred billion dollars is a huge sum of money. I know the President has said that the whole world is watching Congress now. I remind all of you that the Members of this Committee and the rest of the taxpayers will be closely watching the development of the Troubled Assets Program. The purchase and sale of assets has great potential to be abused and lead to corruption. Members of Congress, the GAO, the Treasury Inspector General, and the public must review the activities of Treasury authorized by this proposed act. We must make sure that this situation, which has been caused partially be greed, will not be exploited to enrich individuals and corporations. In addition to stabilizing the markets, we must do more to help working families. We need to help those who have already suffered the consequences of the current economic downturn. We must do more to try and keep people in their homes. Consumer protections must be improved to better protect families from being exploited by predatory lenders. Mr. Chairman, we are here today due to a massive market failure. In addition to this emergency legislation, we need a complete reexamination of our financial services oversight system in order to strengthen regulation and prevent the need for future bailouts. While most of those issues will be considered in the next session of Congress, I look forward to working with all of you to bring together a fair proposal to stabilize the markets, improve the lives of working families, and overhaul the financial services regulatory system. Thank you very much, Mr. Chairman. " FOMC20080625meeting--148 146,MR. BULLARD.," Thank you, Mr. Chairman. U.S. economic data have been stronger than expected during the intermeeting period. The earlier, very aggressive moves in January and March taken by the FOMC were viewed in part as insurance against the possibility of a very serious downturn brought on by financial market turmoil. That very serious downturn has not materialized. Tail risk has diminished significantly. This means that this Committee has put too much economic stimulus on the table and must think about ways to remove it going forward. Failure to do so will create a significant inflation problem on top of problems in housing and financial markets. Slack might be helpful, as mentioned by Governor Kohn, but those effects are small compared with expectations effects. I think it is too early to tighten at this meeting. Therefore, I am supporting alternative B with the language proposed by President Plosser. But the Committee has to think carefully about how and when to embark on a path for interest rates that will set us up to achieve price stability in a reasonable time frame. My sense is that this will require more-aggressive tightening of policy than currently envisioned in staff simulations. Financial market problems have been described here as a slow burn, and I think that may well be an apt description. Many firms in this sector took on too much risk and, in retrospect, had poor business models. I expect that this will take a long time to unwind. Despite this, the systemic risk component of the situation has diminished considerably. Systemic risk is in part a function of the degree of surprise in the failure of a financial institution that was perceived to be in good health. Surely by now few market participants would be surprised to encounter the failure of certain institutions. Failures, should they occur, can be handled in an orderly way. Certain investors would lose out in such an event, to be sure, but my sense is that the panic element that would be associated with systemic risk would not be present. I believe that we should start to downweight systemic risk concerns substantially going forward because it is no longer credible to say that market participants are surprised to learn of problems at certain financial institutions. Thank you. " CHRG-110hhrg44900--211 The Chairman," Well, if the gentlewoman would yield, I would disagree with her. And I think frankly it's a disservice to suggest that they don't have the authority. They had it under Bear Stearns, and I don't think we should be suggesting--in fact I think there is an agreement here that they do have the authority--it's not as perfect in many ways as they want it to be, but they did for Bear Stearns. I have talked to the agencies, and people have talked about this, but I haven't seen anybody draft anything. There are a whole lot of people ready to write, but they are in favor apparently of somebody else drafting this legislation. Anybody is free, of course, to introduce a bill or do whatever they want. But I do think it's a disservice to suggest that there's a shortfall in authority now. I believe that with the memorandum and with the work we have done together, and with the support that they would get from us, so that no one would think they could end run things, that we are capable of getting through this. And if someone things he or she can write a bill that we can pass that quickly, obviously, everybody has that right. I am very skeptical, and I think beginning a process and getting it bogged down in the Senate or elsewhere is more likely to cause uncertainty than saying, ``Look, we have gotten this far, we will continue to work this way together.'' Other members are free, if they want to write up something and try to offer it. The Departments are free to do it. The Fed is free to do it. I think the fact that no one has done it is a recognition of reality. Ms. Speier. Mr. Chairman, I recognize that I have very little expertise in this area at this point. But I do sense from our two speakers that there is a sense of urgency that we need to act. And I just want to make sure that we are not in a situation in a few months where there is a need to act-- " 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? " FOMC20081216meeting--82 80,MR. KOHN.," Thank you, Mr. Chairman. I want to join the others in thanking the staff for their work. These are very difficult issues, and I think you have brought to bear a lot of what little information we have on these subjects and have kind of kept me out of trouble for the last week. My wife thanks you as well. [Laughter] I think the questions in the first set are largely moot, as a number of people have said. We are already close to the zero bound, and because I think moving there aggressively under the current circumstances is the right thing to do, I don't have any regrets about that. Like President Yellen, I came into this situation, at least a couple of months ago, wondering why zero wasn't the right lower bound. I recognize the market issues that might obtain--sort of as President Bullard said, I wonder whether markets won't adjust as we go on--but so close to zero, the difference between 6� basis points and zero isn't going to matter very much. But I think we ought to keep our eye on how markets are functioning, whether they adjust, and where we should be. Now, once we are at a minimum--and I think we ought to get wherever we are going at this meeting, as soon as possible (a number of people have said that, and I agree)--we can't influence actual expected short-term rates with our actions. We do need to rely on other methods to change relative asset prices--longer-term rates relative to short-term rates, private rates relative to government rates, nominal rates relative to expected inflation--and that is where the communications and the size and the composition of the asset portfolio come in. Both the communications and the portfolio actions can be effective and influential, but I think we need to recognize that we are losing our most powerful policy instrument. The effects of these other aspects of our policies are uncertain, and it will require some trial and error to figure out where we are going. With respect to communications, I do think it would be useful to tell people the conditions under which we expect to keep rates low and the conditions under which we would be prepared to raise interest rates. I think we can tell them if we think it is going to be soon or if it is going to take some time. But I agree with your point at the beginning, Mr. Chairman--and President Plosser and others said this--we should emphasize the conditions rather than the time period. We shouldn't commit to a time path. I think something like this should help long-term nominal rates better reflect our expectations for the path of policy and could be especially important if markets come to anticipate a firming before we actually anticipate firming. It could come into play, particularly in the context of some massive fiscal stimulus, which seems to be coming. I don't think we want the effects of that fiscal stimulus diminished or crowded out by increases in long-term rates that are based on a false assumption about the effect of the fiscal stimulus on monetary policy. I think being clear about where we want inflation to be over the long run will probably help anchor inflation expectations a bit better--keep them from drifting down when inflation itself is very low and keep real interest rates from rising--and thereby reduce the odds of persistent deflation taking hold. We will have an important opportunity to take a step in that direction if we agree to our longer-term forecasts in January. As President Yellen noted, the Subcommittee on Communications is recommending that. I think voting on an inflation target would be a substantially bigger step. That is, we would have to reach agreement on that. It could be a more powerful signal of our intentions, and it might become necessary. I certainly think we ought to discuss it. It has a lot of implications that we need to look at, including where we will be in a couple of years. I think we need to be careful. A number of people--outside commentators, anyhow--have noted that they thought that we kept our eye too much on macro variables in the low inflation period and that gave rise to these asset-price increases. I disagree, but I think it is an open question. I have seen comments from other members of the FOMC wondering whether we should look at more than just the path for consumer prices when we are setting monetary policy. But let's not do something now without thinking about how it is going to play five or ten years down the road. I also agree with your point, Mr. Chairman, about congressional consultation. Having an inflation target won't have any effect if it is repudiated by the Congress. As soon as we make it, it could have a negative effect. I think changes in the size and composition of our portfolio can affect relative asset prices. I guess I think, President Evans, that changes are more likely to be effective at times like these, when markets are illiquid and participants have very, very strong preferences for one sector or another. When private parties seem unwilling to lend to each other, substituting Federal Reserve credit for private credit can be quite effective. Carefully designed programs can reduce the cost of credit and increase the availability of capital to households and businesses. I see where we are as a natural extension of where we have been. Really since August 2007, we have been using our balance sheet to try to stimulate credit markets. At first we sterilized that by selling Treasury securities. Then we sterilized it by the Treasury selling Treasury securities. Then that program ran out, and we thought we could sterilize it by interest on excess reserves, and it didn't work. But I don't think we have crossed a sudden barrier in the last month or two. It is true that the base has begun to rise because we have run out of the other sterilization options. But I do think it is a natural extension of where we have been for a while. That brings me to the monetary base. I find myself more skeptical about the effect of increases in the monetary base per se than what I hear around the room. Such increases I think are supposed to affect asset prices by inducing banks to substitute into higher-yielding assets. Give them a bunch of reserves, and they substitute into higher-yielding assets like loans. But I wonder how effective that is when short-term rates don't decline with the increase in the base because we are pinned at zero--that is, we are in a liquidity trap--and when banks are reluctant to expand portfolios because they are concerned about capital and their leverage ratio. So I don't really understand the channels through which an increase in the monetary base, under these circumstances, is supposed to affect economic activity. We have seen a huge increase in the base over the last couple of months and no effect on the money supply. Now, that is very short term, I agree. Your observation, Mr. Chairman, was that we saw a big increase in the base in Japan. I agree with President Lacker that they weren't as dedicated to that as they might have been, but I just don't see any evidence that the base isn't going to be absorbed in a declining money multiplier rather than an expanding money supply and increased activity. I don't understand the channels. I think the base, as we are setting this out, is determined by the people who use our credit facilities. I think that is very important, and I don't want to upset that. So I would be very, very hesitant to restructure the directive in terms of the quantity of reserves or the monetary base. I would have to understand much better what that means, and I wouldn't want to constrain the use of liquidity facilities with such a restraint. I think the situation in the 1970s and early 1980s was very different. First of all, the October 6, 1979, meeting that went to monetary targeting was a natural evolution of a lot of work that had relied more and more on the money supply as a way of communicating about policy over time. Second, it was about constraining inflation, holding it down. I do agree, Jeff, that ""too much money chasing too few goods"" is something that people kind of understand. I am not sure that they understand the opposite--too little money chasing too many goods, or whatever, as a cause for deflation. I think it would be very, very difficult to communicate what that meant and how that was supposed to work. So it is a very different situation than we had back then. I do think we can help by increasing and directing our asset expansion in particular directions. We have seen evidence, as Bill showed us in the MBS and GSE purchases and the commercial paper facility. Also I favor the consideration of purchases of long-term Treasury bonds. I think that will help to lower longer-term rates in an environment of large liquidity and term premiums. I would consider expanding our purchases of MBS and GSE debt, if it looks as though they might help bring down mortgage rates. I agree with others who have said that they would be very reluctant to specify such operations with a rate target because I don't think we can really control that. So I think that talking about quantities would be much better, as we have done with the MBS. I would also continue to look for other ways to use our discount window to help restart credit markets or substitute for private markets in which the functioning is impaired, and I would be open to a variety of possibilities. I agree that credit allocation is very uncomfortable for the central bank. We are into that. We have been into that for a while. I wish we didn't have to be there. But I don't see any evidence that the private sector is going to start lending anytime soon on its own. If I saw that some of those other markets with which we weren't involved and weren't likely to get involved--like the junk bond market that Bill showed us in that chart--were beginning to open up without our help, that would be fine. But nothing is happening out there in the markets that we are not touching. I don't think that is only because everybody is waiting for us to intervene in those particular markets, because there are a bunch of them that they know we can't or won't intervene in. So we need to remain open to possible further credit market interventions. This raises very difficult governance issues. Our inability to sterilize and the huge increase in our balance sheet raise very difficult questions about how the Board and the Reserve Banks together carry out their shared responsibility for achieving the objectives of the Federal Reserve Act. It is not so much about legalities as it is about how to reach the best decisions and how best to explain those decisions to the world at large. We have always worked in a collaborative and cooperative way, and I think we need to continue to do that. Crisis management strains the normal collaborative and deliberative mode of Federal Reserve operations. Decisions get made on short notice, often over a weekend, but as you said, Mr. Chairman, we can work at improving our collaboration. The FOMC, as a body, will continue to have the major influence on our communications about the outlook, the likely path of rates, and the acceptability of the inflation outcome. The key elements in our communications have always been and will remain under the control of this group, and that is a large part of what we will be doing. I agree that we should, when consistent with fulfilling our obligations to protect financial stability, consult more and earlier on liquidity facilities. I hope that we can emerge from this discussion and subsequent ones with an agreed-upon framework for what we are doing and what motivates it under these unusual circumstances. I think we--the Federal Reserve System, the FOMC, all of us--should consider issuing an explanatory document on these matters that we can all agree to. I wrote this before this meeting. Now that I have heard the meeting, I am not sure it is possible. But I think it might be worth the effort. Thank you, Mr. Chairman. " CHRG-111hhrg48873--289 Mr. Meeks," And I was wondering--and I know that there is time for you to come with your standards that you are talking about with reference to executive compensation and bonuses, but I was wondering if there is a framework of which or reference of which you are working on to make that determination, because that is part of what the problem is here. Folks feel that there has been the greed, or others feel that there has not been a system put in place that they can understand and follow and say, okay, this is what the rules are. Basically when people say, tell me what the rules are, we will play by the rules; don't change the rules in the middle of the game. So is there something that you are putting in place so that the markets and others can understand what the rules will be or what you are governing by so we can have that confidence in the market so we can move again in the direction that we should be? " FOMC20050630meeting--87 85,MS. YELLEN., Yes. So I wondered if that was something that you’re aware of and something that is included in the numbers. CHRG-111hhrg53245--274 Mr. Sherman," I thought we were going to do another round. I wonder if I could have 1 minute then? " fcic_final_report_full--446 The financial panic was triggered and then amplified by the close succession of these events, and not just by Lehman’s failure. Lehman was the most unexpected bad news in that succession, but it’s a mistake to attribute the panic entirely to Lehman’s failure. There was growing realization by investors that mortgage losses were concen- trated in the financial system, but nobody knew precisely where they lay. Conclusion: In quick succession in September , the failure, near-failure, or restructuring of ten firms triggered a global financial panic. Confidence and trust in the financial sys- tem began to evaporate as the health of almost every large and midsize financial in- stitution in the United States and Europe was questioned. We briefly discuss two of these failures. The Reserve Primary Fund The role of the Reserve Primary Fund’s failure in triggering the panic is underappreci- ated. This money market mutual fund faced escalating redemption requests and had to take losses from its holdings of Lehman debt. On Tuesday, September , it broke the buck in a disorganized manner. Investors who withdrew early recouped  cents on the dollar, with the remaining investors bearing the losses. This spread fear among investors that other similarly situated funds might follow. By the middle of the follow- ing week, prime money market mutual fund investors had withdrawn  billion. When the SEC was unable to reassure market participants that the problem was iso- lated, money market mutual fund managers, in anticipation of future runs, refused to renew the commercial paper they were funding and began to convert their holdings to Treasuries and cash. Corporations that had relied on commercial paper markets for short-term financing suddenly had to draw down their backstop lines of credit. No one had expected these corporate lines of credit to be triggered simultaneously, and this “involuntary lending” meant that banks would have to pull back on other activities. FOMC20081216meeting--48 46,MR. WILCOX.," President Lacker, it's a complicated security, but it's wrapped by a guarantee that ultimately the Department of Education will make good on to the tune of 97 cents on the dollar. There's one little detail that is causing another piece of friction in the market, and that is that, if the servicer doesn't perform on the loan, then the Department of Education has the right to not make good on the guarantee. But other than that, it's about 97 percent guaranteed. " CHRG-111hhrg53248--117 The Chairman," And I will now recognize for 5 minutes the gentleman from North Carolina, Mr. Miller, if he would like to take the time. The gentleman from Texas? Let me just take the gentleman from Texas, if he would yield me his first 30 seconds. The gentleman from California is right. But again, let us be clear, we are not at the old OFHEO/ HUD situation. In 2007, this committee passed a bill that included some of the things that had not been in the previous bill, approved by Secretary Paulson, President Bush, and Mr. Lockhart from OFHEO. So we are not now in a situation where the old rules apply. The new rules do apply. There will still have to be further changes, but we are not in the old situation as a result of legislation in 2008. The gentleman from Texas. " CHRG-110hhrg46593--281 Mr. Hensarling," Ms. Blankenship, in your testimony--and let me thank you for coming here and making the committee aware of the lack of access to many of our community financial institutions, their inability to access much of the TARP money. You brought the lack of access to our attention and you also stated that community bankers were not the cause of the financial crisis. And perhaps it is the cynic in me pointing out, maybe that is your problem. There tends to be a habit in the Nation's Capital of rewarding failure and punishing success. You might want to think about that for the next round. Mr. Findlay, I don't know where your voice was 6 weeks ago. I wish we could have heard it more loudly than we have today. I know that at least our chairman has been quoted in The Washington Post at the time the original legislation passed--I believe I have this right, Mr. Chairman--that you did not expect the insurance program to materialize. And I hope that is ``expect'' as opposed to ``hope.'' But I think it holds a lot of promise, and I am glad the chairman had an opportunity to hear your testimony. I see my time is out, and I yield back. I would be happy to yield to the Chair. " fcic_final_report_full--14 Finally, when the housing bubble popped and crisis followed, derivatives were in the center of the storm. AIG, which had not been required to put aside capital re- serves as a cushion for the protection it was selling, was bailed out when it could not meet its obligations. The government ultimately committed more than  billion because of concerns that AIG’s collapse would trigger cascading losses throughout the global financial system. In addition, the existence of millions of derivatives con- tracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic, helping to precipitate government assistance to those institutions. • We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors re- lied on them, often blindly. In some cases, they were obligated to use them, or regula- tory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their down- grades through 2007 and 2008 wreaked havoc across markets and firms. In our report, you will read about the breakdowns at Moody’s, examined by the Commission as a case study. From  to , Moody’s rated nearly , mortgage-related securities as triple-A. This compares with six private-sector com- panies in the United States that carried this coveted rating in early . In  alone, Moody’s put its triple-A stamp of approval on  mortgage-related securities every working day. The results were disastrous:  of the mortgage securities rated triple-A that year ultimately were downgraded. You will also read about the forces at work behind the breakdowns at Moody’s, in- cluding the flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight. And you will see that without the active participation of the rating agencies, the market for mort- gage-related securities could not have been what it became. * * * T HERE ARE MANY COMPETING VIEWS as to the causes of this crisis. In this regard, the Commission has endeavored to address key questions posed to us. Here we discuss three: capital availability and excess liquidity, the role of Fannie Mae and Freddie Mac (the GSEs), and government housing policy. First, as to the matter of excess liquidity: in our report, we outline monetary poli- cies and capital flows during the years leading up to the crisis. Low interest rates, widely available capital, and international investors seeking to put their money in real estate assets in the United States were prerequisites for the creation of a credit bubble. Those conditions created increased risks, which should have been recognized by market participants, policy makers, and regulators. However, it is the Commission’s conclusion that excess liquidity did not need to cause a crisis. It was the failures out- lined above—including the failure to effectively rein in excesses in the mortgage and financial markets—that were the principal causes of this crisis. Indeed, the availabil- ity of well-priced capital—both foreign and domestic—is an opportunity for eco- nomic expansion and growth if encouraged to flow in productive directions. Second, we examined the role of the GSEs, with Fannie Mae serving as the Com- mission’s case study in this area. These government-sponsored enterprises had a deeply flawed business model as publicly traded corporations with the implicit back- ing of and subsidies from the federal government and with a public mission. Their  trillion mortgage exposure and market position were significant. In  and , they decided to ramp up their purchase and guarantee of risky mortgages, just as the housing market was peaking. They used their political power for decades to ward off effective regulation and oversight—spending  million on lobbying from  to . They suffered from many of the same failures of corporate governance and risk management as the Commission discovered in other financial firms. Through the third quarter of , the Treasury Department had provided  bil- lion in financial support to keep them afloat. CHRG-110hhrg46593--18 Secretary Paulson," Mr. Chairman, two things. First, I need to just say a word about AIG, because the primary purpose of the bill was to protect our system from collapse. AIG was a situation, a company that would have failed had the Fed not stepped in. Had we had the TARP at that time, this is right down the middle of the plate for what we would have used the TARP for. As it turned out--because it should have had preferred and a Fed facility. And as it turned out, we needed to come in, again, to stabilize that situation and maximize the chances that the government would get money back. So I just wanted-- " CHRG-111shrg382--43 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System September 30, 2009 Chairman Bayh, Ranking Member Corker, and other members of the Subcommittee, I appreciate the opportunity to testify today on the role of international cooperation in modernizing financial regulation. International cooperation is important for the interests of the United States because, as has been graphically illustrated in the past 2 years, financial instability can spread rapidly across national boundaries. Well-devised international financial regulatory standards can help encourage all nations to maintain effective domestic regulatory systems. Coordinated international supervisory arrangements can help ensure that every large, internationally active financial institution is effectively supervised. Both these forms of international cooperation can, at the same time, promote at least a roughly equivalent competitive environment for U.S. financial institutions with those from other nations. In my testimony this afternoon, I will review the responses of key international regulatory groups to the financial crisis, including both substantive policy responses and the organizational changes in membership and working methods in some of those groups. Next I will describe specifically the role of the Federal Reserve's participation and priorities in these international regulatory groups. I will conclude with some thoughts on the challenges for international regulatory cooperation as we move forward from the G-20 Pittsburgh Summit and the exceptionally active international coordination process that has preceded it.The Response of International Regulatory Groups to the Crisis Over the past few decades, international cooperation in financial regulation has generally been pursued in a number of groups that bring together national authorities with responsibility for regulating or supervising in a particular area, or that served as venues for informal discussion. Several of the functional regulatory groups have undertaken initiatives in response to the recent financial crisis. During this period, the Financial Stability Board (FSB) shifted from being more of a discussion forum to serving as a coordinator of these initiatives. The FSB was also the direct line of communication between these groups and the G-20. The Federal Reserve actively participates in the FSB as well as in the following international groups: In the Committee on Payment and Settlement Systems, we work with other central banks to promote sound and efficient payment and settlement systems. In the Committee on the Global Financial System, we work with other central banks to monitor developments in global financial markets, reporting to the central bank Governors of the G-10 countries. In the Basel Committee on Banking Supervision (Basel Committee), we and the other U.S. bank supervisors work with other central banks and bank supervisory agencies to promote sound banking supervision by developing standards for bank capital requirements and bank risk management, and by promulgating principles for effective bank supervision. The Basel Committee, which doubled its membership earlier this year, now includes supervisors from 27 jurisdictions, including both advanced and emerging markets.\1\--------------------------------------------------------------------------- \1\ The Basel Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. In the Joint Forum, we and other U.S. financial regulators--including bank, securities, and insurance regulators--work with financial regulators from other countries to enhance financial regulation that spans different financial --------------------------------------------------------------------------- sectors. In the Senior Supervisors Group, we and other U.S. supervisors have worked over the past few years with the supervisors of other major financial firms to share information and sponsor joint reviews of risk management and disclosure. In bilateral and regional supervisory groups, we have discussed regulatory issues with Europe, China, India, Japan and other supervisors from the Western Hemisphere. Some of these groups have quite a long history. Both the Committee on the Global Financial System and the Basel Committee date back to the 1970s. These groups are not formal international organizations. They have operated with only a modest support staff--often provided, along with a location for meetings, by the Bank for International Settlements (BIS). The bulk of their activity is conducted by officials from the national regulators themselves. The FSB is a relatively new group, established in the wake of the Asian financial crisis in 1999 as the Financial Stability Forum, with a broad mandate to promote global financial stability. The FSB is an unusual combination of international standard-setting bodies (including those mentioned above) and a range of national authorities responsible for financial stability: treasury departments and ministries of finance, central banks, and financial supervisory agencies.\2\ Major international organizations such as the BIS and the International Monetary Fund (IMF) also participate.\3\ At the request of the G-20 in April 2009, the Financial Stability Forum's name was changed to the Financial Stability Board, its membership was expanded to add the emerging market countries from the G-20, and its mandate was strengthened.--------------------------------------------------------------------------- \2\ International standard-setting bodies participating in the FSB are the Basel Committee, the Committee on the Global Financial System, the Committee on Payment and Settlement Systems, the International Association of Insurance Supervisors, the International Accounting Standards Board, and the International Organization of Securities Commissions. The jurisdictions represented on the FSB are: Argentina, Australia, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, South Korea, Spain, Switzerland, Turkey, the United Kingdom, and the United States. \3\ International organizations in the FSB are the BIS, the European Central Bank, the European Commission, the IMF, the Organisation for Economic Co-operation and Development, and The World Bank.--------------------------------------------------------------------------- The financial crisis has underscored the importance of the original motivation for creating what is now the FSB. The connections among financial market sectors, and between macroeconomic policy and financial markets, mean that efforts to ensure international financial stability must incorporate a breadth of perspectives and include communication among the various international groups in which regulatory cooperation takes place. In its work to increase international financial stability and to promote financial regulatory reform, the FSB has tried to identify priorities and agree upon high-level principles. It has then requested that the relevant standard-setting bodies formulate detailed proposals and report back to the FSB. All these international groups, including the FSB, operate by consensus. Although this institutional feature can create significant challenges in reaching agreement on complex topics, it also serves as a check on potentially undesirable policy directions. The process of developing proposals in the standard-setting bodies allows a variety of ideas to be explored and exposed to critical examination by expert staff. Like any other process, alternative viewpoints emerge and dissenting opinions are voiced. Once a consensus is reached, it is then up to individual members to implement any statutory changes, administrative rules, or guidance under local law. As already noted, the FSB has played a leading role in guiding the official response to the crisis. In April 2008, it made a range of recommendations to increase the resiliency of financial markets and institutions. These recommendations are broadly consistent with similar principles articulated by the President's Working Group on Financial Markets here in the United States. The FSB has acted upon priorities identified by the G-20 leaders and has delivered to those leaders a series of proposals that have been adopted by them, most recently at the Pittsburgh summit last week. With its role now expanded and in the process of being formalized in a charter, the FSB will have the ongoing mandate of identifying and addressing emerging vulnerabilities in the financial system. The activities of some other groups have also broadened in response to the crisis. The Basel Committee was formed in 1974 in an effort by national authorities to fill supervisory gaps exposed by problems in a number of internationally active banks. Beginning in the late 1980s, its focus shifted to setting capital standards for internationally active banks. That emphasis continues today, notably with respect to strengthening capital requirements for securitization exposures and trading book exposures as well as disclosure requirements related to these areas. The Basel Committee has now begun to address a wider range of issues aimed at improving standards for capital, liquidity, cross-border bank resolution, leverage, and macroprudential supervision. In March 2008, the Senior Supervisors Group released its first report on risk-management practices.\4\ The report, based on extensive discussions with large financial institutions, provided near-real-time analysis of the major failures in risk management and internal controls that led to outsized losses at a number of firms, and highlighted distinctions in practices that may have enabled some other institutions to better withstand the crisis. The group is now in the final phases of preparing a second report that will focus on the challenges that emerged as particularly critical last year, notably related to management of liquidity risk, and present the results of the self-assessments by the largest financial institutions regarding their responses to the riskmanagement and internal control issues highlighted by the crisis.--------------------------------------------------------------------------- \4\ See Senior Supervisors Group (2008), Observations on Risk Management Practices during the Recent Market Turbulence (Basel: SSG, March 6), available at Federal Reserve Bank of New York (2008), ``Senior Supervisors Group Issues Report on Risk Management Practices,'' press release, March 6, www.newyorkfed.org/newsevents/news/banking/2008/rp080306.html.--------------------------------------------------------------------------- International regulatory and supervisory bodies have been actively engaged in addressing a wide range of issues, many of which have been highlighted by the recent financial crisis. Let me now discuss in more detail a few of the areas that are most important from the perspective of the Federal Reserve.Capital The financial crisis has left little doubt that capital levels of many financial firms, including many in the United States, were insufficient to protect them and the financial system as a whole. The FSB has called for significantly stronger capital standards, to be agreed upon now and phased in as financial and economic conditions improve. The communiquE issued Friday by the G-20 leaders echoed and amplified the need for improvements in both the quantity and quality of capital. One critical area for improvement is that of increasing capital requirements for many forms of traded securities, including some securitized assets. Some work has already been completed. We place a high priority on undertaking a comprehensive review and reform of these requirements. The Basel Committee is also working on proposals for an international leverage ratio to act as a supplement to risk-based capital ratios. The FSB has also devoted considerable energies to exploring sources of procyclicality in the financial system, which are those practices and structures that tend to amplify rather than dampen the cycles characteristic of financial markets, and to identifying possible strategies to reduce their effects, which were often quite visible during the recent crisis. One such strategy is to include a countercyclical capital buffer in the capital requirements for financial firms. Work on such a buffer is under way, though the technical challenges of devising an effective buffering mechanism are significant. It will be important for the international regulatory community to carefully calibrate the aggregate effect of these initiatives to ensure that they protect against future crises while not raising capital requirements to such a degree that the availability of credit to support economic growth is unduly constrained. The Basel Committee plans a study of the overall calibration of these changes for early next year.Liquidity Liquidity risk is another key international agenda item. Although the Basel Committee had historically focused on capital standards, the crisis clearly demonstrated that adequate capital was a necessary but not always sufficient condition to ensure the ability of a financial institution to withstand market stress. We were reminded that the liquidity of a firm's assets is critical to its ability to meet its obligations in times of market dislocation. In particular, access to wholesale financing very quickly became severely constrained for many institutions that had grown quite dependent on it. The Basel Committee promulgated general guidance on liquidity risk management in June 2008 and is now in the process of incorporating those broad principles into specific quantitative requirements.Cross-Border Bank Resolution In the area of cross-border resolution authority, there is broad international agreement that existing frameworks simply do not allow for the orderly resolution of cross-border failures of large complex banking organizations and that changes are needed. Current frameworks focus on individual institutions rather than financial groups or the financial systems at large. These frameworks have proven problematic even at the national level. Policy differences and legal obstacles can magnify these shortcomings at the international level. The Basel Committee's Cross-Border Bank Resolution Group has developed 10 recommendations for national authorities.\5\ The recommendations, which aim at greater convergence of national resolution frameworks, should help strengthen cross-border crisis management. One key recommendation requires systemically important firms to have contingency plans that will allow for an orderly resolution should that prove necessary. Implementation of these recommendations is likely to require heightened cooperation throughout the international community.--------------------------------------------------------------------------- \5\ See Basel Committee on Banking Supervision, Cross-Border Bank Resolution Group (2009), Report and Recommendations of the Cross-Border Resolution Group (Basel: Basel Committee, September), available at www.bis.org/publ/bcbs162.htm.---------------------------------------------------------------------------Accounting Standards for Financial Institutions The FSB and the Basel Committee have an important role in supporting improved accounting standards for financial institutions. For example, the FSB has developed recommendations for improving the accounting for loan loss provisions. The Basel Committee consults frequently with those who set international accounting standards on these and other topics and provides comments on important accounting proposals affecting financial institutions.Future Initiatives A number of other initiatives are at an earlier stage of policy development. A good deal of attention right now is focused on mitigating the risks of systemically important financial firms. Two of the more promising ideas are particularly worth mentioning. One is for a requirement for contingent capital that converts from debt to equity in times of stress or for comparable arrangements that require firms themselves to provide for back-up sources of capital. The other is for a special capital or other charge to be applied on firms based on their degree of systemic importance. Many of these initiatives still require much work at the technical level before policy proposals will be ready for a thorough vetting in the national and international regulatory community.How the Federal Reserve Pursues Our Objectives in International Groups The Federal Reserve promotes U.S. interests in these international groups by actively participating and by coordinating with other U.S. participants. The international groups that I mentioned earlier all hold regular meetings. The FSB meets at least twice a year, and the Basel Committee typically meets four times a year. Between meetings of the main groups, subgroups of technical experts meet to discuss proposals and lay the groundwork for issues to be discussed at the main groups. The Federal Reserve actively participates in both the main groups and the subgroups. For practical purposes, not all members of a group can sit on each subgroup, although the United States is well represented on all major topics and chairs important subgroups. We have found that success in pursuing our objectives in these groups depends upon having well-developed ideas. One important basis for leadership in international groups is the quality of the intellectual and policy contributions that an organization can offer. To this end, we have tried to use the extensive economic and research resources of the Federal Reserve, as well as our regulatory experience, to produce well-considered proposals and useful feedback on the proposals of others. International groups operate on the basis of consensus. Policies are endorsed only when all members voice their support. This approach can make it challenging to come to agreement on complex topics. But international groups are made up of regulatory agencies or central banks, and they have particular responsibilities based on their own national laws. International groups are not empowered to create enforceable law, and agreements need to be implemented by member countries in the form of statutory changes, administrative rules, or supervisory guidance. Thus, the consensus orientation of the international policy development process is necessary to respect the domestic legal structures within which the various regulatory agencies operate. The President's Working Group on Financial Markets is the primary forum in which regulatory issues are discussed among the principals of the U.S. financial regulatory agencies. These discussions often cover the same issues being discussed in international groups. We strive to maintain a degree of intellectual rigor and collegiality in these discussions where consensus is again the norm, despite the sometimes different perspectives of the various agencies. In the past, there were some notable instances of significant disagreement among the U.S. agencies, but my observation since being appointed to the Federal Reserve is that the coordination process is working quite well. Indeed, it can sometimes be an advantage to have multiple U.S. agencies involved in international processes because of the complementary expertise we each bring to bear. In addition, at the international level, having multiple U.S. agencies at the table provides an appropriate counterweight to our European counterparts, who for historical reasons are usually overrepresented in international groups relative to their weight in the global financial system. Like other central banks, the Federal Reserve did not participate in the G-20 summit, which is attended by heads of state and finance ministers. However, we are involved in a significant part of the relevant preparatory and follow-up work, both through the FSB and in joint meetings of the G-20 finance ministers and central banks.\6\ In preparation for the Pittsburgh summit, as well as for the previous G-20 summits in London and Washington, the Federal Reserve has also collaborated with other U.S. financial regulatory agencies in considering the financial regulatory issues on the agendas for these meetings.--------------------------------------------------------------------------- \6\ The FSB prepared three documents that were presented to G-20 leaders at the summit: ``FSB Principles for Sound Compensation Practices,'' ``Improving Financial Regulation,'' and ``Overview of Progress in Implementing the London Summit Recommendations for Strengthening Financial Stability.''---------------------------------------------------------------------------Challenges for International Financial Cooperation The testimony that my colleagues and I have offered this afternoon reflects the breadth and depth of the tasks associated with improved regulation and supervision of financial markets, activities, and firms. An ambitious agenda has been developed through the interactions of the G-20, the FSB, and international standard-setting bodies, and much work toward completing that agenda is already under way. At the same time, there will inevitably be challenges as we all intensify and reorient the work of these groups. I will now discuss four of those challenges. First, for all the virtues of the consensus-based approach involving the relevant national authorities, some subjects will simply be very difficult to handle fully in this fashion. Crossborder resolution may prove to be one such issue. Although there is undoubtedly potential for achieving improvement in the current situation through the international processes I have described, the complexities involved because of the existence of differing national bankruptcy and bank resolution laws may limit what can be achieved. Second, there will likely be a period of working out the relationships among the various international bodies, particularly in light of the increased role of the FSB. We will need to determine how extensively the FSB and its newly constituted committees should themselves develop standards, particularly where an existing international standards-setting body has the expertise and mandate to address the topic. Similarly, while simultaneous consideration of the same issue in multiple international bodies can sometimes be a useful way to develop alternative proposals, there may also be potential for initiatives that are at odds with one another. Third, the significant expansion in membership of many of the more important of these bodies may require some innovation in organizational approaches in order to maintain the combination of flexibility and effectiveness that the FSB and some of the other groups have, at their best, possessed in the past. The substitution of the G-20 for the G-8 at the level of heads of government is the most visible manifestation of the salutary trend toward involving a number of emerging market economies in key international financial regulatory arrangements. As I mentioned earlier, the FSB and the Basel Committee have recently expanded their membership to the entire G-20. Important as this expansion is for the goal of global financial stability, the greater number of participants does have an impact upon the operation of those groups, and we will need to adapt accordingly. I hasten to add that this is not at all a comment on the capacities of the new members. On the contrary, I have been impressed with the quality of the participation from the new emerging market members. Finally, the financial crisis has understandably concentrated the attention and energies of many of these international regulatory groups on the new standards that will be necessary to protect financial stability in the future. Combined with the enlarged memberships of these groups, however, this focus on negotiating standards may unintentionally displace some of the traditional attention to fostering cooperative supervisory practices by the national regulators who participate in these international bodies. It is important that, even as we represent our national interests in these bodies, we also promote the shared interests we have in effective financial supervision.Conclusion Participating in international regulatory groups has helped the Federal Reserve and other U.S. agencies begin to shape an effective global regulatory response to the financial crisis. We look forward to continuing our collaboration in pursuit of effective, efficient financial regulation. Thank you for inviting me to present the Board's views on this very important subject. I look forward to continuing dialog with the Subcommittee on these issues. I would be pleased to answer any questions you may have. RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORKER FROM MARK SOBELOn Resolution AuthorityQ.1. The Administration's proposal asks for significant and broad resolution authority that is, in effect, TARP on steroids. While some will still advance the theory that the bankruptcy courts with a few tweaks would be enough of a solution, the challenges we have seen with Lehman's resolution abroad question the theory that with no globally astute and integrated resolution regime, the court systems will not function cohesively and instead will be inclined to ring fence and protect for their own taxpayers. Explain to me how would the Administration's proposed resolution process work overseas? Do you think that is the optimal model? Propping up failed institutions around the globe at taxpayer's expense into perpetuity? Is the Treasury Department conducting any economic analysis so the impact of any proposal is fully understood before it is uniformly agreed to and adopted? And if so, when will you be willing to share this information to help us inform our policymaking?A.1. The United States, led by the Federal Depository Insurance Corporation (FDIC), is working closely with international counterparts within the Basel Committee, to study the important issue of resolutions at the international level. The Cross Border Bank Resolution Working Group has conducted serious analysis and published two reports with ten proposals to strengthen international and national frameworks for cross-border resolution of international institutions and, importantly, used the recent crisis as ``lessons learned.'' (Available at: http://www.bis.org/publ/bcbs162.htm) Recognizing that strictly national approaches are inefficient and global approaches may not be viable, the Group has recommended that major financial centers adopt comparable, consistent domestic resolution regimes similar to the FDIC approach. These proposals were issued for comment, with a deadline of December 31, 2009. The United States supports countries having strong and effective national resolution frameworks and an orderly resolution process, all of which will minimize the damage to the financial system and reduce cost to the taxpayer. As Secretary Geithner noted in his testimony before the House Financial Services Committee, the proposed resolution authority would not authorize the government to provide open-bank assistance to any failing firm. That is, the government would not be permitted to put money into a failing firm unless that firm is in FDIC receivership and on the path to being unwound, dismantled, sold, or liquidated. The receivership authority would facilitate the orderly demise of a failing firm, not ensure its survival, and would strengthen market discipline and reduce moral hazard risks, while protecting the financial system and taxpayers. It also is important that there are appropriate checks and balances and that the special resolution regime may be used only with the agreement of the Secretary of the Treasury and two-thirds of the boards of the Federal Reserve and the FDIC. In addition, any losses from a special resolution must be recouped with assessments on the largest non-bank financial firms.On Insurance IssuesQ.2. I want to ask you a couple of questions regarding the G-20 and the Financial Stability Board's cooperative efforts on regulatory reform. I am curious if insurance issues fall under this effort and how so? I ask because it has been a challenge for European regulators' to not having a counterpart in the U.S. Executive branch on insurance issues. They complain that our current system not only represents inefficiency, but is also a barrier to global coordination on regulatory reform efforts. They also fear this is a potential problem in any future crisis and in resolving failed firms that have insurance subsidiaries. Can you tell me specifically if cooperation on insurance regulation falls under the G-20 and FSB mandates, and if yes, does the U.S. Executive branch have adequate authority to take necessary actions under this mandate, or is the United States lacking the proper tools to address insurance issues as part of a comprehensive effort to address crises such as that which we have just lived through?A.2. The Treasury Department's International Affairs Office coordinates the USG position and participation in the Financial Stability Board (FSB), which is mandated to: deepen the resiliency of domestic financial systems; identify and address potential vulnerabilities in international financial systems; and enhance international crisis management. Senior-level officials from the Federal Reserve, Securities Exchange Commission, and the Treasury Department represent the United States in FSB meetings. Other Federal financial regulatory agencies (the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission), as well as the National Association of Insurance Commissioners participate in USG preparation for the FSB meetings and provide input. Treasury Secretary Geithner and Federal Reserve Chairman Bernanke represent the United States at meetings of the G-20 Finance Ministers and Central Bank Governors. At the Pittsburgh Summit in late September, Leaders designated the G-20 as the premier forum for our international economic cooperation. To date, neither the FSB nor the G-20 has offered regulatory guidance solely directed at the insurance sector. Certain cross-cutting issues, however, affect insurance, such as supervisory colleges, heightened prudential regulation for large, interconnected financial institutions, and cross-border resolution. The regulatory reform agenda in these fora largely reflects effective U.S. leadership and is consistent with the approach taken in the Administration's proposals, which are pending action by the Congress. As you have noted, some Europeans suggest that the absence of a Federal regulatory representative complicates their international dealings on insurance supervision, for example on issues of reinsurance collateral or Europe's evolving supervisory regime. The Administration's proposals would give the Treasury Department the authority to represent American interests in international fora regarding prudential measures for insurance. While the Office of National Insurance is not a regulator, it would provide a single coordinated USG voice on prudential matters related to insurance. It would serve as a Federal authority to represent U.S. interests to work with other nations within the International Association of Insurance Supervisors (IAIS) on prudential regulatory issues, cooperation and agreements.Transparency of the FSBQ.3. As it builds out to handle its new mandate, how will it be held accountable, to whom, how will input flow into the process?A.3. The FSB membership consists of national and regional authorities responsible for maintaining financial stability (ministries of finance, central banks, and regulatory authorities), international financial institutions, and international standard setting, regulatory, supervisory and central bank bodies. All members are entitled to attend and participate in the Plenary, which is the decisionmaking body of the FSB. Representation on the Plenary is at the level of: central bank Governor or immediate deputy, head or immediate deputy of the main regulatory agency, and deputy finance minister or deputy head of finance ministry. Representation by the international financial institutions and the international standard setting bodies is at a similar level. The U.S. delegation to the FSB, represented here today by Treasury, the Federal Reserve and the SEC, supports and encourages the publication of FSB reports on its work. Many reports on the FSB's work and the work of member organizations are available to the public on its website at www.financialstabilityboard.org. We are also pleased to make Treasury staff available to brief your Committee, Members, and staff at your convenience on any issue relating to the FSB.Q.4. I think it's important to talk about how our interactions with the FSB and Basel Committee will go with regard to the new regulations that they will recommend. We don't possess a treaty with these bodies, so in order for enactment to take place Congress will have to legislate and/or the independent regulatory agencies will have to adopt and adapt. The question that many are left with is if this will happen? How quickly? Will Congress end up leading the effort or lag? How is it all going to work? I think that the FSB/Basel agreements actually carry the force of law--or for conforming efforts--within the EU (hence the adoption of Basel II). Of course the United States did not adopt because small banks believed they were at a disadvantage. If this is indeed the case, won't a Basel III present a similar situation where the Europeans adopt the findings and we either do not adopt at all or adopt at a much slower pace. Quite frankly, the Europeans do not trust us to implement what we might agree to do, and they do not want to be put in a weakened position vis-a-vis the United States. All that said, I'd be interested in your thoughts on the role that the G-20 will play in the regulation writing process? Will it guide with specifics or simply bless proposals put forward?A.4. The U.S. banking regulators are members of the Basel Committee on Banking Supervision (Basel Committee), as are banking authorities of all of the other G-20 countries. The U.S. banking regulators have adopted the Advanced Approaches of Basel II by issuing regulations after notice and comment. The Basel Committee is currently considering changes to Basel II in light of the weaknesses in it exposed by the financial crisis. The Basel Committee normally issues international standards following a notice and comment process and we expect this to continue for changes to Basel II. The Basel Committee does not currently have plans for a Basel III. Neither the G-20 nor the FSB has any legally binding rulemaking authority. ------ RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORKER FROM KATHLEEN L. CASEYCredit Rating AgenciesQ.1. It's clear that the Credit Rating Agencies have not been quite up to snuff over the last few years but it seems that the Basel accords and the regulatory regimes rely a lot on them. I know that you have discussed the idea of moving to simple leverage ratios, but how do you square the problem of continuing to rely on a system that has failed us in the past? Should we reform the agencies, reduce regulatory reliance or encourage a new system to evolve?A.1. In my view, the Securities and Exchange Commission (``SEC'' or ``Commission'') should continue its efforts to both reform the credit rating industry and reduce the regulatory reliance on credit ratings issued by Nationally Recognized Statistical Rating Organizations (``NRSROs''). Over the past 2 years, pursuant to authority granted by Congress under the Credit Rating Agency Reform Act of 2006 (``Rating Agency Act''), the SEC has adopted some significant reforms relating to credit rating agencies. These reforms are intended to further the Rating Agency Act's explicit goals of enhancing the transparency, accountability, and level of competition in the rating industry. But, in my view, the SEC needs to do more in this area. It is essential that the Commission finish its work with respect to the regulatory use of credit ratings. The Commission should adopt the remainder of its pending proposals to address overreliance on NRSRO ratings by removing the regulatory requirements embedded in numerous SEC rules. The considerable unintended consequences of the regulatory use of ratings--preserving a valuable franchise for the incumbent and dominant rating agencies, inoculating these government-preferred rating agencies from competition, promoting undue reliance and inadequate investor due diligence, and uneven ratings quality--have been evident for some time. It is vital that the Commission remove the government imprimatur from all SEC rules, particularly those relating to money market funds. The market, not the government, should decide which credit ratings have value.On RegulationQ.2. Other countries look to the United States for leadership in financial services regulation. I am especially, and increasingly, concerned about the potential for overregulation in the United States, not only for the effect on U.S. companies and the U.S. economy, but also for the example that it would set for regulators and policymakers in Europe and elsewhere. The financial crisis was not caused by deregulation. If anything, it was caused by too much government intervention with respect to entities such as Fannie Mae and Freddie Mac, artificially low interest rates by a hyperactive Federal Reserve, and so on. Now for my question: What would, in your view, be the dangers of overregulation in the United States? Let's take two issues that are mentioned in your testimony, hedge funds and credit rating agencies. What would be the practical impact on those two industries?A.2. I share your concerns relating to excessive regulation. Overregulation would not protect or benefit investors. Instead, it would only serve to harm the competitiveness of the U.S. capital markets. Such a result hurts every American who is looking for a job, investing his money, or paying taxes. In my view, too much regulation of hedge funds would have the predictable effect of moving fund assets to jurisdictions with a more favorable regulatory approach. Regulators and policymakers cannot lose sight of the fact that capital is highly mobile. We can protect investors and oversee hedge funds in a responsible way that does not harm the competitiveness of U.S. markets. Those goals are not necessarily mutually exclusive. With respect to too much regulation of credit rating agencies, it is my view that before adopting additional regulations that are not market-based, the Commission needs to step back and take stock of all the new rules it has adopted over the past 2 years. The simple fact is that rating agencies are highly regulated today. That is not to say that they will always issue accurate ratings for investors. Government regulation could never deliver such results. And it does not mean that we can second-guess their rating judgments or seek to regulate their rating methodologies. The Rating Agency Act precludes the Commission from such actions, and properly so, in my view. But what it does mean is that we have adopted comprehensive regulations in many key areas. We should seek to establish regulatory certainty. At some point, we need to be able to see if the rules we have on the books are having their intended effect. Too much regulation of rating agencies would not protect investors by improving ratings quality. In fact, it would only increase the regulatory costs and burdens associated with being or becoming an NRSRO, and lead to predictably anticompetitive results. Ironically, these costs are manageable for the incumbent rating agencies, but serve as a competitive barrier to those contemplating entering the NRSRO space. Avoiding too much regulation and enhancing competition would have another important effect: As the Commission noted recently, ``[R]educing the barriers to entry in the market for providing NRSRO ratings and, hence increasing competition, may, in fact, reduce conflicts of interest in substantive ways.'' ------ RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORKER FROM DANIEL K. TARULLOOn the Financial Stability BoardQ.1. At the G-20, there was general agreement to match up the membership of the Financial Stability Board with that of the G-20 and a focus on the ``monitoring of the international economy'' for new points of weakness and instability, I am skeptical that the FSB would be able to actually enforce actions by its member nations in response to any emerging risk it perceives. In April, the Economist magazine even said that domestic political pressures would trump any FSB call to action. The article said ``But if it warns, who will listen? Imagine the scene in Congress in 2015. The economy is booming but Americans cannot get mortgages because some pen pusher in Basel says the banks are taking too much risk. The banks would be freed faster than you can say ``swing voter''.'' Governor, what can we do to ensure that these moments of pro-cyclicality and crisis response are measured and consistent from the top down, end to end across the globe if the crisis is global and systemic?A.1. Did not respond by printing deadline.On Trade FinanceQ.2. U.S. manufacturers continue to struggle in these credit markets to get trade finance and this is yet another example of regulatory treatment creating a self fulfilling prophecy that will slow down the economy. The rules of Basel II discourage banks from extending trade finance by forcing them to assign to it unreasonably high risk weighting and too long a maturity. The G-20 in April promised to ask their regulators to use discretion when applying the rules. There has been some limited flexibility from the U.K.'s Financial Services Authority, banks say that capital restrictions continue to hinder the market and that there is a disconnect between what the G-20 is saying and the effect of banking regulation on trade finance. Because of the nature of the trade finance market would you see the necessity of a program of this nature to be kept in place past the 2 years it is authorized for?A.2. Did not respond by printing deadline.Q.3. Is Basel II hindering the recovery of the trade finance market?A.3. Did not respond by printing deadline.Q.4. Is the G-20 asking regulators to ``use discretion'' enough to alleviate regulations that may make extending trade finance difficult? Or will the G-20 have to address this in a more formal manner? Is that something you would support?A.4. Did not respond by printing deadline.Q.5. Is there anything else that can be done in the international finance community to mitigate the risk of these markets seizing and to ensure liquidity? Is the use of the Export Import Bank and its guarantees appropriate here?A.5. Did not respond by printing deadline.Q.6. Is there anything more that can be done to assist developing countries, like Africa, in assisting with the current high cost of trade?A.6. Did not respond by printing deadline.On Bank RegulationQ.7. As we work on our regulatory structure and debate the merits of more or less regulators and the value or lack of value in friction and different sets of eyes and opinions looking at our regulated entities, I wonder if this plays out even more aggressively on the world stage. We worry about regulatory arbitrage . . . and should . . . but how do you avoid a rush for all regulators agreeing to the most draconian standards and then that be the way the contagion spreads? In other words, does the least common denominator equate to squeezing good risk and entrepreneurship out of the system.A.7. Did not respond by printing deadline.Transparency of the FSBQ.8. As it builds out to handle its new mandate, how will it be held accountable, to whom, how will input flow into the process?A.8. Did not respond by printing deadline.Q.9. I think it's important to talk about how our interactions with the FSB and Basel Committee will go with regard to the new regulations that they will recommend. We don't possess a treaty with these bodies, so in order for enactment to take place Congress will have to legislate and/or the independent regulatory agencies will have to adopt and adapt. The question that many are left with is if this will happen? How quickly? Will Congress end up leading the effort or lag? How is it all going to work? I think that the FSB/Basel agreements actually carry the force of law--or for conforming efforts--within the EU (hence the adoption of Basel II). Of course the United States did not adopt because small banks believed they were at a disadvantage. If this is indeed the case, won't a Basel III present a similar situation where the Europeans adopt the findings and we either do not adopt at all or adopt at a much slower pace. Quite frankly, the Europeans do not trust us to implement what we might agree to do, and they do not want to be put in a weakened position vis-a-vis the United States. All that said, I'd be interested in your thoughts on the role that the G-20 will play in the regulation writing process? Will it guide with specifics or simply bless proposals put forward?A.9. Did not respond by printing deadline." FOMC20061025meeting--42 40,MR. KOHN.," I wondered, President Moskow, if you had a sense of whether Ford was in a kind of death spiral—I might be influenced by the headlines of today and yesterday—at risk of losing the confidence of customers, so it won’t be able to sell cars, and of creditors. I’m wondering whether that would have any effect on the macroeconomy, or whether we just take down the Ford signs, put up Toyota signs, and continue to produce." CHRG-111hhrg53238--90 The Chairman," All right. I am appreciative of that mix. I have to say that the description of chaos that comes if you have the State laws does not seem to be an accurate portrayal of what the situation was before the Comptroller did all that preemption. But my time has expired. The gentleman from Texas. " CHRG-111hhrg51585--2 The Chairman," The hearing will come to order. This hearing is called at the request of two Members of the House: one is a member of this committee, the gentlewoman from California, Ms. Speier; and the other is the gentlewoman from California, Ms. Eshoo. They share representation of San Mateo County, which was one of the victims of the collapse of Lehman Brothers and the inability of Lehman Brothers to make any payments on the debt it owed. They made the entirely reasonable request that we begin the process of examining what we can do for public entities that have lost funding in these situations. We will get to the specific question of the Lehman Brothers failure. But there are a couple of points that I think this illustrates in a broader way that we want to talk about. As is often the case, we find it I think easier to figure out what to do to prevent a recurrence of something unfortunate than to undo the consequences of it. This, to me, is a clear example of why there needs to be in the Federal Government the power to unwind nonbanks. We have, through the FDIC, the power to deal with situations where a bank is unable to meet its obligations. We are in that situation because of deposit insurance. But it became clear last year that there are problems that occur when nonbanks are unable to meet their obligations. Now there are several things we should be doing about that. One, I am confident that before the end of the year, we will have signed by the President legislation that makes it much less likely that these institutions will become indebted to the point where they cannot pay off their debts. There are restrictions that should be imposed that are not now in existence to deal with that. But no system will be fail-safe. And therefore, there needs to be a method of genuine failure. When banks fail, it is disruptive, but not to the degree that it is when nonbanks have failed. Wachovia, Washington Mutual, several banks failed. We had a mechanism in place for dealing with them. But the failure of nonbanks, we have had three different results that I can think of, none of them even close to satisfactory. First came the failure of Lehman Brothers. When Lehman Brothers failed, the Bush Administration tried to find some way to deal with the indebtedness and was unable to do so. There had been a prior successful effort on their part, as they saw it, to do that with regard to Bear Stearns, and they got the Federal Reserve to pick up some of the obligation, although it feels it is well collateralized here, and they got JPMorgan Chase to take the rest. They could find no better institution ready to do that for Lehman Brothers. There was some hope at the time that Barclays Bank would do it. There was some resistance, I am told, on behalf of the British authorities. At any rate, Lehman Brothers failed, and nobody stepped in. It was very soon the conviction of people in the Bush Administration that the failure of Lehman Brothers with no alleviation, no effort to pay off any of its creditors, was the single worst thing that happened in the economy in 2008 and moved from pretty bad to God-awful. As a consequence, when AIG faced the same situation, the decision of the Bush Administration was to prevent any failure. So, whereas in Lehman Brothers, nobody got paid off; in AIG, the decision of the Bush Administration was to pay everybody off. That has also not been the best received decision in the history of the Republic. Then we had the Merrill Lynch example, another nonbank that was failing. And there the Administration encouraged, in 2008, Bank of America to buy it, similar to what had been done with JPMorgan Chase and Bear Stearns. Later in the year, last year, Bank of America discovered that Merrill Lynch was in worse shape than it had thought. So it indicated that it wanted to let it drop. Once again, the Bush Administration, having seen the cataclysmic effects in their minds of Lehman Brothers, said, no, you can't do that. So they--and this is now being debated--encouraged, insisted, cajoled, bribed, whatever because the TARP money was involved. At any rate, as a consequence of these discussions between the Bush Administration and Bank of America, Bank of America bought Merrill Lynch or continued with the purchase. So we have had three approaches to failed nonbanks: Lehman Brothers, where nothing happened; AIG, where everything happened; and Merrill Lynch, which was Bank of America buying it. In no case did we receive a satisfactory outcome. That strongly argues to us later this year to have in place what Secretary Paulson had called for, what the Obama Administration calls for using the bankruptcy power under the Constitution to tailor a statute that empowers some combination of Federal authorities to resolve an institution, and that allows differential levels of payment. We see this in the Chrysler bankruptcy. There will be an effort to, because it is bankruptcy, do that. But that does not resolve the problem for the current creditors, and that is what we would be talking about. So I do note that this underlines the importance of a method of resolving institutions, and we do have undeniably a situation where this public entity, San Mateo County, can say, gee, we made a terrible mistake. We invested with Lehman Brothers when it went bust. We should have done it with AIG, because if we had been AIG creditors, we would have gotten paid. It is only Lehman Brothers creditors that were not paid. There is no principle of any sort that can justify that result, and our job is to try and see if it can be dealt with. The gentleman from Alabama is now recognized for 4 minutes " FinancialCrisisInquiry--708 GEORGIOU: Right. Dr. Zandi, I wonder if you could comment on the disparities of—of the impact of the recession in certain areas, as opposed to others. I mean, I happen to—actually, Ms. Murren and I now live in—both live in Nevada, where we have something like 75 percent of the homeowners owe more money than they—than their homes are worth and the economic—the underemployment rate has been extraordinarily high. January 13, 2010 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? 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. " CHRG-111hhrg53245--8 The Chairman," The Federal requests, we have a couple. And I just want to comment in the meantime that some of the members have a different view of this hearing than I do. We have heard very eloquent arguments against bailouts. Yes, that's what this hearing is for, to see how we can avoid pressures to do them. This is not a case where it is an assumption that we're going to have these large institutions and then figure out what we do if we get into trouble. Yes, precisely our role is to try to avoid the situation that the Bush Administration faced as it felt with regard to Bear Stearns and with regard to Lehman Brothers and Merrill Lynch and AIG. All those happened under the Bush Administration, committed to free enterprise, but they felt that the consequences of the failures there would be disastrous. They had four different ways of dealing with them, none of them satisfactory to a lot of people, including themselves. So that is precisely the point of this hearing, so that one, you make it much less likely that there will be institutions in that situation, because of capital requirements and other things. And, two, that if you do get to that, there are ways of putting them down much less disruptively and much less expensively. So, as I said, this is not a reply of last year. It's enough to try and stop it. Mr. Garrett of New Jersey for 2\1/2\ minutes. " FinancialServicesCommittee--67 Mr. L EIBOWITZ . Yes, I think the two gentleman to my left have hit it right, which is it was a spooked market—I think you even used that term. The market became very illiquid and choppy. And it is very likely that some news out of Europe might have gotten people selling. But I think the behavior that you then saw, selling some stocks down to a penny, that is not permissible behavior. That is a market structure failure that we have it incumbent upon us to correct. On the other hand, markets are allowed to sell off in a reason- able way. And so, if investors were afraid of Greece and the euro and anything else that was going on, they should be selling the market off. What we are really addressing is, is it happening in a reasonable and orderly way? Are investors being disadvantaged by events transpiring on the exchange? It would be hard to justify to a retail investor that he sold the stock at a penny. And so, that clearly has to be addressed. The fact that something triggered a sell-off—if we can’t find an actual cause, meaning a trader or—and there are so many rumors, and that is part of— what we live with that every day in our market. The rumors get transmitted so quickly that we just have to deal with that. Mr. M ANZULLO . Mr. Chairman, could I ask one more question? Mr. S COTT . Yes, you may. Mr. M ANZULLO . Thank you. Your answers take into consideration or are obviously based upon the fact that there really wasn’t anybody out there who ‘‘made a killing’’ that day. Is that correct? There is no bad person out there or somebody that you can say, look what he or she or they did as a group that caused this? Mr. N OLL . I think the investigations and looking at the evidence will take place over the next couple of days and weeks until all the determinations are made of everyone’s behavior, whether it was good or bad or within the rules or not within the rules. As of today, on the NASDAQ systems and in the NASDAQ mar- ket, we have not seen anything that would suggest to us that any- one was behaving in an inappropriate fashion. Mr. L EIBOWITZ . And I would say quite the opposite of making a killing, if algorithmic traders did, in fact, follow the market down, chances are they got hurt pretty badly, because the market just snapped right back and they sold way below where the market ended up. So, while retail investors and others followed it down with them, my guess is whoever led it down, intentionally or not, did not make a killing. Mr. M ANZULLO . Okay. Mr. D UFFY . Congressman, yes, I agree with both of these gentle- men. I have not heard anything extraordinary. But, then again, it is a sensitive topic, and we will let our regulatory departments in- vestigate that with due process. Mr. M ANZULLO . Thank you. Mr. S COTT . Thank you, sir. Now, we will hear from the gentleman from New Jersey, Mr. Garrett. Mr. G ARRETT . Just with one last question. And I appreciate all your time here. CHRG-111shrg61651--33 Mr. Corrigan," The answer is not as much as some people tend to think. I think it is theoretically possible, Mr. Chairman, to construct a very tight regime for a very, very limited class of activities that you could call proprietary trading, where there is absolutely no interaction whatsoever between a group of proprietary traders and clients, and that activity is totally walled off within a given institution. But that would be a situation which I think would provide some liquidity to markets and price discovery, and that is fine. But to take the Goldman Sachs situation, if you took the net revenues associated with the best I can do to imagine a sensible definition, for example, of proprietary trading and hedge funds and private equity funds, we are, in net revenue terms, talking about something over the cycle in the broad order of magnitude of 10 percent of firmwide net revenues. Now I say over the cycle because in good years it could be a little higher, in bad years a little lower. But if you want a reference point, at least using Goldman Sachs as the example, that I think is as good as I can do right now since I do not know what the definitions that other people would have in mind when they talk about these alternative schemes. " 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. " CHRG-111hhrg55814--146 Secretary Geithner," And my answer to that is no. But let me--it's a little more complicated than that. You need two authorities we don't have today. One is for a large institution that is courting failure and whose failure could cause catastrophic damage, you need to be able to act and unwind them with less damage to the economy, without the taxpayers being exposed to loss. We don't have that authority today; thus the traumatic damaging experience of last fall. You also need to make sure that you can protect solvent, liquid institutions in the rest of the system from losing their capacity to operate and fund. In classic financial panics, what happens is the weakness of one spreads to the strong. You need to arrest that to contain panics to fix panics. And that's why in this bill there is some authority reserved for the Fed and the FDIC to contain the risk of panic spreading to healthy institutions. We propose to limit that authority, relative to what exists today. But you need to have both those provisions for it to work. " CHRG-111hhrg55809--152 Mr. Gutierrez," Thank you. Then I would appreciate it if you and your staff could review it, because it is one of the ways I am looking at making sure--it is kind of like if you--I just kind of thought when I get my insurance, if I was speeding or drinking and I had risky behavior in terms of driving my car, I am going to pay more in insurance. And it seems to me that we have seen different kinds of behaviors on different components of our financial system. And maybe everybody should not pay the same. So I would like to see how we can do that. Just one other question. So, you know, I have--you know the Federal Reserve, you are the Chairman. You have these huge responsibilities. You come with this wealth of knowledge to the job that we appreciate as a public servant. And although you have all of these wonderful responsibilities, right, and this wonderful talent that you bring to the job, I would just like to ask you, what do you think about what we should be looking at in terms of compensation and executive compensation of people. Do you think this Congress should do anything about it? How do you look at it? Because there is a lot of anger out there as they look at large financial institutions and executive compensation. Can you give me your sense? I went through Europe. And as I went from city to city, it was in late August with Mr. Kanjorski, and we were talking to the EU members. And it was the most important thing that they were bringing up. Can you give us your view? " CHRG-111hhrg51698--451 Mr. Marshall," Thank you, Mr. Chairman. And, Mr. Pickel, one more thought. You described CDSs as not being at fault for the mess we are in at the moment. But a number of people suggest that the availability of CDSs, the lack of transparency, the lack of required margining, and things like that are the problem. While the instrument itself is a good thing, the interwoven nature of exposure that has occurred with the major institutions where nobody can really tell what is going to happen next has caused investors to sit by the sideline, and has caused our money supply essentially to collapse dramatically. And CDSs are a large part of what has caused this interwoven ``almost unfathomable to the individual institution, let alone outsiders who are trying to figure out what is going on'' nature of our banking system right now. And so, if that is the case, maybe in your response on the record to the Committee, a written response--if you would send a copy to me, I would appreciate it--you could describe a future where we have solved that problem so that people do understand the exposures of these large institutions and, consequently, can comfortably invest or not invest instead of just sitting on the sideline, frightened, because you just cannot tell what the heck is happening. And, largely, it is derivatives and swaps that cause that dilemma for so many investors and for the institutions themselves. If you would. " FOMC20060328meeting--193 191,MR. LACKER.," Well, that seems be the point of the question. I was just wondering what you thought about it." CHRG-111hhrg53234--72 Mr. Kohn," I see this as an incremental change from where we are right now, and, therefore, I am not aware of any dissent on the Board about the particular proposal that the Treasury has made. Before the Treasury made the proposal, there was a lot of discussion of some systemic risk regulator with unspecified authorities and unspecified responsibilities. I think there was concern on the Board, which I shared, that it was impossible to carry the responsibilities out because we didn't have the authorities and because the expectations were way too high in terms of what was possible in a market economy that naturally has ups and downs. But I see the proposal on the table as more modest, which is taking what we currently do, but giving a little more macroprudential shape to it, thinking about the implications and being sure that the core institutions, the ones that have caused the problems that have given rise to what you call the ``bailouts,'' are safe and are not subject to the kinds of risks and the kinds of knock-on effects to the rest of the market that have caused us to intervene this time. " CHRG-111hhrg54867--120 Secretary Geithner," Congressman, you are right; it is tragic and unfair, and the scope of damage caused by that fraud is just extraordinary. And I would welcome a chance to come talk to you or your staff or have us, with the SEC, walk you through what we can do to make that process work better, not just in this case but-- " CHRG-110hhrg45625--49 Mr. Bachus," Thank you, Mr. Chairman. Members of the committee--and I would say this to all Americans, we can't kill the messenger. Secretary Paulson and Chairman Bernanke are alerting us to serious problems in our economy, the threat of a systemic meltdown. And oddly enough, some tend to blame them as messengers, but they are both very capable public servants. They are in their positions because of their expertise and their knowledge. And ironically--and I think they know this, but I am not sure the American people do--they arrived in those positions long after the problems which bring us here today originated--overleveraging, overextension of credit, risk taking. And really for the last year, they have advocated a systemic regulator, a modernization of our financial structure, which we all failed to do for 30 or 40 years. We are all reaping the consequences of that failure. We can pile on criticisms of them, but I think it is far more constructive if you don't like their plan to work with them, to fashion an alternative or to amend their plan. That is what I am doing. The American people, if they knew the situation we were in, they would want us to stay here until we found a solution. And if we are going to find a solution, we are going to do it as Americans, not as Democrats or Republicans, not as the Executive Branch versus the Legislative Branch. There will be plenty of time in the next few years, believe you me, and plenty of time spent on blaming people and finding out what was wrong and preventing it from happening again. But right now, we need our total resources in working with the American people and working with our regulators to address this serious situation and in protecting the taxpayers. And I am convinced that these two witnesses and this body, that our main concern here is the American citizen, middle class America, Main Street, the taxpayers. Thank you, Mr. Chairman. " CHRG-111hhrg55809--150 Mr. Gutierrez," Mr. Bernanke, it is good to see you here again this morning. Mr. Chairman, this week, the FDIC passed another special assessment on our Nation's banks to help shore-up the Deposit Insurance Fund. It is true that most of the losses to this Fund have been the result of failures of small lending institutions. These community banks have also suffered from severe decreases in the values of housing and commercial real estate markets caused by loans financed by some of the largest banks in our system. I have legislation in front of the committee, H.R. 2897, and I would appreciate if you could take a look at it and kind of write us a note back on your more expansive opinion on it. I would appreciate that. And it would require the riskiest banks in our financial system to pay more, not only into the Deposit Insurance Fund, but also into the systemic risk fund. My goal is to create a more efficient pricing regime that would disincentivize banks from becoming or remaining ``too-big-to-fail.'' What are your recommendations for creating a system that would prevent or discourage banks from becoming ``too-big-to-fail'' and what relationship do you think they should have to paying into a fund? Do you think there should be differences? " CHRG-111hhrg54867--11 Secretary Geithner," Thank you, Mr. Chairman, Ranking Member Bachus, members of the committee. It is a pleasure to be back before you today and to talk about how best to reform the system. I am pleased to hear the enthusiasm for reform across both sides of the aisle. And, of course, we all recognize the task we face is how to do it right and how to get it right. Our objective, of course, is to provide stronger protection for consumers and investors, to create a more stable financial system, and to reduce the risk that taxpayers have to pay for the consequences of future financial crises. We have outlined a broad set of proposals for achieving these. We provided detailed and extensive legislative language. We welcome the time and effort you have already put into considering these proposals and the suggestions you have made, many of you individually and collectively, have made to improve them. As the President likes to say, we don't have a monopoly of wisdom on these things. Our test is, what is going to work? That is our test. What will work? What will create a more stable system, better protections, with less risk to the taxpayer? I want to focus my remarks briefly on what I think are the two key challenges before us at the center of any debate on reform. The first is about how you achieve the right balance between consumer protection and choice and competition. And the other is how to deal with the moral-hazard risk people refer to as ``too-big-to-fail.'' So, first, on the consumer challenge, our system of rules and enforcement failed to protect consumers and investors. The failures were extensive and costly. They caused enormous damage not just to those who were the direct victims of predatory practice, fraud, and deception, but to millions of others who lost their jobs and their homes or their savings in the wake of the crisis. And to fix this--and I will just say it simply--we need to have strong minimum national standards for protection. They need to apply not just to banks but to institutions that compete with banks in the business of providing credit. They need to be enforced effectively, consistently, and fairly. And there need to be consequences for firms that engage in unfair, ineffective practices, consequences that are strong enough to deter that behavior. We believe we cannot achieve that within our current framework of diffused authority with the responsibility divided among a complex mix of different supervisors and authorities who have different missions and many other priorities. We think it requires fundamental overhaul so that consumers can understand the risks of the products they are sold and have reasonable choices, and institutions have to live with some commonsense rules about financial credit. Of course, the challenge is to do this without limiting consumer choice, without stifling competition that is necessary for innovation, and without creating undue burden and cost on the system. Our proposal tries to achieve this balance by consolidating the fragmented, scattered authorities that are now spread across the Federal Government and State government. And it is designed to save institutions that are so important to our communities--credit unions, community banks, other institutions that provide credit--from making that untenable choice between losing revenue, losing market share, or stooping to match the competitive practices that less responsible competitors engage in, competitors that had no oversight, that were allowed to engage in systematic predatory practices without restraint. Now, some have suggested that, to ensure no increase in regulatory burden, we should separate rule-writing authority from enforcement. But our judgment is this is a recipe for bad rules that are weakly enforced--a weaker agency. So we think we need one entity with a clear mission, the authority to write rules and enforce them. Now, just briefly on this deeply important, consequential question of moral hazard and ``too-big-to-fail,'' no financial system can function effectively if institutions are allowed to operate with the expectation they are going to be protected from losses. And we can't have a system in which taxpayers are called on to absorb the costs of failure. We can't achieve this with simple declarations of intent to let future financial crises burn themselves out. We need to build a system that is strong enough to allow firms to fail without the risk of substantial collateral damage to the economy or to the taxpayer. And this requires that we have the tools and authority to unwind, dismantle, restructure, or close large institutions that are at the risk of failure without the taxpayers assuming the burden. It requires that banks pay for the costs incurred by the government in acting to contain the damage caused by bank failures. And this requires higher capital standards, tougher constraints on leverage across-the-board, with more rigorous standards applied to those who are the largest, most complicated, posing the biggest risks to the system. Now, this package of measures is central to reform. You can't do each of these and expect it to work. You have to take a broad, comprehensive approach. And the central objective, again, is to make the system strong enough so we can allow failure to happen in a way that doesn't cause enormous collateral damage to the economy and to the taxpayer. As the President said last week, taxpayers shouldered the burden of the bailout, and they are still bearing the burden of the fallout in lost jobs, lost homes, and lost opportunities. We look forward to working with this committee to help create a more stable system. We can't let the momentum for reform fade as the memory of the crisis recedes. Thank you, Mr. Chairman. [The prepared statement of Secretary Geithner can be found on page 54 of the appendix.] " FinancialCrisisInquiry--113 Cause Three: too many eggs in one basket. Look at data for loan growth last decade and look at the fastest area of loan growth. First, mortgages; second, mortgages; construction loans, commercial real estate, multi-family real estate. One element in common: real estate. Cause Four: high balance sheet leverage. Shortly before the crisis, the U.S. banking industry had the highest leverage in 25 years. And then take a look at the securities industry. In the ‘80’s, 20 time levered, in the ‘90’s, 30 times levered. And right before the crisis, almost 40 times levered. Cause Five: more exotic products. Some of these were so exotic that I don’t think the directors, the CEOs, and in some cases, even the auditors fully understood the risks. And I think of this like cheap sangria. A lot of cheap ingredients are bad—or bad sangria, I should say. A lot of cheap ingredients repackaged to sell at a premium. It might taste good for a while, but then you get headaches later and you have no idea what’s really inside. Cause Six: consumers went along. There’s some personal responsibility here. Consumer debt-to-GDP is at the highest level in history. Japan didn’t have that. We didn’t have that during the Great Depression. There is a false illusion of prosperity through this additional borrowing. It’s no secret that everybody from kids to pets to dead people got loan solicitations, but a lot of people took these loans voluntarily. Cause Seven: accountants. The SEC, in 1998 made some rules or some decisions that encouraged banks to take less reserves for their problem assets. And look what happened next. Reserves to loans at U.S. banks declined from 1.8 percent down to 1.2 percent right before the crisis. That was a wrong move. It should change now. And the bank regulators should be back in control in helping us set reserves for problem loans. That was not a close call for many of us in the industry. FOMC20071031meeting--268 266,VICE CHAIRMAN GEITHNER.," Sorry, Mr. Chairman, two points. One is a concern to which I have no solution. The chart that is now called chart 1, which has evolved over time, has a slight disadvantage, because it doesn’t have fans around it because we all didn’t like the fans, of having the sense of a pretty narrow range of likely outcomes for the future. I just wonder whether anybody is uneasy, given the relatively low probability that we are going to end up within those over time. I don’t have a solution to this. I was wondering whether, if you changed the scale—[laughter]. This is a concern with no real suggested solution—I apologize. My second point is more significant. Bill, I think you asked a good question. Mr. Chairman, another question that is interesting is, when asked whether the world should interpret the central tendency of the Committee at a three-year horizon for PCE inflation as the rate that is consistent with the Committee’s long-run view of price stability, how will you answer it?" CHRG-110shrg50409--86 Mr. Bernanke," I believe that to be true, yes. Senator Martinez. I want to commend you for the work you have done in consumer protection. I noted in your testimony in a couple of areas that I think are particularly important. I think that it is terrific to prohibit lenders from making higher-priced loans without due regard for a consumer's ability to make the scheduled payments. And I also think it is great to also include the escrowing of property taxes and insurance as an integral part of what we need to do in order to keep homeowners in their home. And, last, the area of credit cards as well, I think all those are very, very good things for consumers, and particularly at stressful times like this, it is good to have a reckoning of where we are and where we are going and include that in that help to consumers. I know in the next panel we will talk more about the GSE situation. I want to talk about regulatory reform, if I could. Your predecessor and I had an opportunity to discuss this when I was Secretary of HUD, and I recall also coming before this Committee and testifying with Secretary Snow at that time, proposing a new regulatory framework for the GSEs. That was in 2003. I wish we might have done that. But at the same time, we are where we are today. We do have a piece of legislation moving its way through the Congress, which includes the creation of a new affordable housing trust fund. This affordable housing trust fund is funded by a fee on the GSEs' new business purchases. So, in other words, as they increase their book of business, this fund would grow at a percentage of that. I wondered if you have a concern, which I certainly have, about this provision. particularly at a time when the GSEs are suffering such substantial losses and when we are, in fact, taking other Government action in order to ensure their sustainability. " CHRG-110hhrg34673--179 Mrs. Bachmann," Thank you. My final line of questioning goes to the legislation that Congress may very soon pass, and that would be the increase in the minimum wage. We are looking at increasing perhaps at the level of 40 percent minimum wage in the upcoming bill. First, I am wondering if you could estimate how close we are currently to full employment here in the United States. I know, in Minnesota, we have just enjoyed wonderful low levels of unemployment. I think, for 2 months last summer, we were the job creators for about 10 percent of all new jobs across the country. We have a wonderfully strong, diverse economy. I was wondering first if you could comment, sir, on where you believe we are at in terms of full employment in this country, and second, I was wondering if you could share with us what your opinion would be on the impact of raising the minimum wage on employment. First, at the level that we are looking at now to go to $7.25, there were comments made by one of our United States Senators that he may be introducing a bill in perhaps 6 months to raise that minimum wage up to over $9 an hour. So, if you could, just comment on the impact of raising the minimum wage on employment and where you believe we are at in terms of full employment now. " CHRG-111shrg61651--62 Mr. Corrigan," That is correct. Senator Corker. Let me move on. I appreciate very much your testimony. I would say that even under the Volcker Rule, if you had consolidated supervision but didn't have a bank holding company status, you would not be under the Volcker Rule. So consolidated supervision is not what is relevant. But let me move to Mr. Reed. I found your comments interesting, and certainly I respect each of you very, very much, as I do Mr. Volcker. But the comments about separating these, you were Chairman of Citigroup when all of this was put together. I think that is fascinating for all of us to know that you kind of put all this together and now are an advocate of separating, and I just wondered what you might share that you have learned since that time. And I would add another question, since I may run out of time. A lot of people think that Citigroup is one of those organizations--and I was watching the body language when we were talking about failure--that Citigroup is one of these companies, because of payment mechanisms that exist around the world with sovereign governments and others, that Citigroup cannot fail, OK, that they are so interconnected. And I think what all of us are seeking, even Chairman Volcker and others, is figuring out a way that regardless of the interconnectedness, there never will exist again in our country a financial institution that is too big to fail. We don't like that moral hazard. It goes against the American way. And yet there are people who come in, I think, and believe that a Citigroup, I am sorry, they are so interconnected, they have payment systems, and I wonder if guys like you and others laugh at us when we say that we want to create a regime that absolutely ends forever in the American vocabulary that any company is too big to fail. I think that is the goal of many people on this Committee, maybe not everybody, but I think many people. And I ask everything I have just asked with respect. I do find it fascinating, your position. And then, second, I wish you would respond to the issue of ``too big to fail.'' " FOMC20051101meeting--88 86,MR. MOSKOW.," David, I had a question for you about the forecast that activity is going to slow in the second half of ’06 and ’07. You talked about the reasons for the slowdown, which were tighter monetary policy, a slowing in house price appreciation, and diminishing fiscal stimulus. In the Monday morning briefing, you threw in the stock market as well—waning impetus from household wealth in terms of both the stock market and the housing components. I thought the Greenbook had an assumption of 6 percent growth in the stock market per year. I wonder if you could talk about that." CHRG-111hhrg55814--396 Mr. Ryan," Thank you. Just on uncertainty, there is some uncertainty that we don't like. It's uncertainty that causes a pricing impact-- " FOMC20050630meeting--158 156,MS. MINEHAN., I was wondering if interest rates were moving up instead of not moving up how that affects affordability. FinancialServicesCommittee--66 And, again, our markets operated within all the protocols of CME’s systems. So we didn’t have any ‘‘fat-finger’’ issues; we were confident of that. The market was moving quite rapidly. At the same time, there were a lot of macroeconomic events that were happening. So, yes, it was unusual activity. Nobody is going to deny that. It happened, and it happened quickly. But, again, we didn’t bust trades. We looked at some of the algorithmic traders, as has been questioned here. They were basically more liquidity providers at the time in question; they were not aggressors or taking the mar- ket. So they were there on both sides, bid and offer. So they were leading the market because of the nature of the product, sir. And then, as you could see, our stop logic worked, and the listed stocks kept going down for whatever reason. That is still yet to be explained, why they went to the prices they did. We did not trigger, which would have been only—a stop circuit breaker for CME would have been the 20 percent circuit breaker that is instituted amongst all the exchanges, and we were roughly about 9.5 percent at the lowest point in the S&P contract, sir. Mr. M ANZULLO . Let me ask you an unrelated question because something obviously—maybe not obviously, but apparently some- thing spooked the market. Anything to do with the problem in Greece or worldwide activity or inability to predict what is going on with regard to the euro? Do you see any connection there at all, or is it just a coincidence? Mr. D UFFY . I have seen a lot of high volatility, sir, especially coming into that day. So all those events were on the front page, so I am sure they had a contributing factor to the market condi- tions that led up to the precipitous down-move. And, at the same time, you have to remember we saw a couple stocks trading at a penny that were $40 stocks. So one was prob- ably wondering what was going on in the marketplace. Mr. M ANZULLO . Mr. Noll, would you like to comment on that last question? Mr. N OLL . On the volatility in the marketplace at that time? Mr. M ANZULLO . Yes. Mr. N OLL . Yes, I— Mr. M ANZULLO . It doesn’t have to be a precise answer because no one knows. Mr. N OLL . I don’t think we have a precise answer yet, and I am not sure that we will ever get a precise answer as to the nature of what was the root cause of the uncertainty in the marketplace. But I do think what is very clear is that we saw an increasing amount of volatility on the days leading up to May 6th. We have seen the spike in all the measurements of volatility. The day of May 6th itself was already a volatile day before the events we are talking about here happened. So it was already a severe down day. It was also the third day in a row of down equity markets. So I think when we hit these air pockets or this confluence of events, if I could call it that, we were in a position where there was just a massive downdraft in the marketplace, which we recovered from, but nonetheless I think it is important for us to address the causes and to prevent that from happening going forward. Mr. M ANZULLO . Mr. Leibowitz? CHRG-109shrg30354--101 Chairman Bernanke," Thank you, Senator. There are a lot of reasons including, for example, the fact that we are less energy intensive as an economy now than we were 30 years ago. But the one I would like to somewhat self-servingly emphasize, and it relates to my answer to Senator Sununu, is the fact that the Fed has a lot more credibility for keeping inflation low and stable. In the 1970's, when the energy crisis arose, it generated expectations of further increases in wages and prices, and you got into a wage price spiral. The Fed was caught between a rock and a hard place, having to raise rates very significantly in order to try to arrest that inflation, at the same time leading to deep recessions. Over the last 20 years or so, the U.S. economy has become much more stable. And one of the very important reasons for that is the fact that the Fed has gained strong credibility for keeping inflation low. The Michigan Survey just came out, and the front page was describing inflation expectations of the American public. And they have a lot of confidence that the Fed will keep inflation low, despite the fact that gas prices are up at the pump. To the extent that the Fed's credibility is strong and people think that inflation will be low in the long-term, when energy price increases hit, it causes a temporary burst of inflation. But if nobody expects it to continue, then it will just moderate away. And we do not get into this pattern of having to raise rates a lot and getting into a stagnant, inflationary situation. So, I think monetary policy is not the only factor. There are other factors. But I think it does have a lot to do with the better performance we have seen the last 4 or 5 years. Senator Allard. Has the tax stimulus package had an impact on this? " CHRG-111hhrg52400--114 Mr. Price," Thank you, Mr. Chairman. I want to--and I appreciate the opportunity for this hearing. I think this has been an excellent panel, and the information that you have provided has been very, very helpful. I think it is important to appreciate that Federal regulation of insurance is different than instituting a systemic risk regulator for insurance, and I think it's important that we keep that in mind. And we are kind of sometimes combining apples and oranges here. I want to shift gears a little bit and talk about and get some response regarding the financial products consumer safety commission that has been bandied about by the Administration. And it appears to many of us to be a kind of a command and control apparatus for different industries, including the insurance industry. And I wonder--and I know oftentimes Congress and the Administration can go too far; in fact, that seems to be the order of the day, is going too far--I wonder if, starting with Mr. Spence and kind of heading on down the table, do you have any thoughts about what would be too far for the insurance industry, or what the effect of this would be on the insurance industry for a products consumer safety commission? " FOMC20050809meeting--45 43,MS. MINEHAN.," To move from the mortgage-backed market to Treasuries, there was an interesting article over the weekend regarding a squeeze on the 10-year note. I’m wondering August 9, 2005 12 of 110" CHRG-111hhrg53238--211 Mr. Menzies," I guess your question presumes that we have some knowledge on whether this is all behind us or not; and that depends upon whether you are from Florida, California, Arizona, Nevada, Ohio, Michigan, or Atlanta, or when you are from the Eastern Shore of Maryland. You can bet I don't know the answer to that question. It also presumes that there is a need to create some regulation to deal with the problem, to deal with the collapse, if you will. And again I would repeat that it is so important to focus on what caused the problem. What caused the $7 trillion of economic loss to the American consumer? We can have all the product legislation in the world and do everything possible to protect the consumer, but the greatest damage to the consumer was the failure of a system because of concentrations and excesses across the board, of a Wall Street vehicle that gathered together substandard, subprime, weird mortgages that community banks didn't make, created a warehouse to slice and dice those entities, make huge profits selling off those items, and have very little skin in the game, very little capital at risk, and to be leveraged, leveraged in some cases, according to the Harvard Business Review this week, 70 to 1. That deserves attention. The too-big-to-fail, systemic-risk, too-big-to-manage, too-big-to-regulate issue must be dealt with. And from the perspective of the community banks, that is the crisis of the day. That is what has destroyed the free market system. " FinancialCrisisReport--4 In April 2010, the Subcommittee held four hearings examining four root causes of the financial crisis. Using case studies detailed in thousands of pages of documents released at the hearings, the Subcommittee presented and examined evidence showing how high risk lending by U.S. financial institutions; regulatory failures; inflated credit ratings; and high risk, poor quality financial products designed and sold by some investment banks, contributed to the financial crisis. This Report expands on those hearings and the case studies they featured. The case studies are Washington Mutual Bank, the largest bank failure in U.S. history; the federal Office of Thrift Supervision which oversaw Washington Mutual’s demise; Moody’s and Standard & Poor’s, the country’s two largest credit rating agencies; and Goldman Sachs and Deutsche Bank, two leaders in the design, marketing, and sale of mortgage related securities. This Report devotes a chapter to how each of the four causative factors, as illustrated by the case studies, fueled the 2008 financial crisis, providing findings of fact, analysis of the issues, and recommendations for next steps. B. Overview (1) High Risk Lending: Case Study of Washington Mutual Bank The first chapter focuses on how high risk mortgage lending contributed to the financial crisis, using as a case study Washington Mutual Bank (WaMu). At the time of its failure, WaMu was the nation’s largest thrift and sixth largest bank, with $300 billion in assets, $188 billion in deposits, 2,300 branches in 15 states, and over 43,000 employees. Beginning in 2004, it embarked upon a lending strategy to pursue higher profits by emphasizing high risk loans. By 2006, WaMu’s high risk loans began incurring high rates of delinquency and default, and in 2007, its mortgage backed securities began incurring ratings downgrades and losses. Also in 2007, the bank itself began incurring losses due to a portfolio that contained poor quality and fraudulent loans and securities. Its stock price dropped as shareholders lost confidence, and depositors began withdrawing funds, eventually causing a liquidity crisis at the bank. On September 25, 2008, WaMu was seized by its regulator, the Office of Thrift Supervision, placed in receivership with the Federal Deposit Insurance Corporation (FDIC), and sold to JPMorgan Chase for $1.9 billion. Had the sale not gone through, WaMu’s failure might have exhausted the entire $45 billion Deposit Insurance Fund. This case study focuses on how one bank’s search for increased growth and profit led to the origination and securitization of hundreds of billions of dollars in high risk, poor quality mortgages that ultimately plummeted in value, hurting investors, the bank, and the U.S. financial system. WaMu had held itself out as a prudent lender, but in reality, the bank turned increasingly to higher risk loans. Over a four-year period, those higher risk loans grew from 19% of WaMu’s loan originations in 2003, to 55% in 2006, while its lower risk, fixed rate loans fell from 64% to 25% of its originations. At the same time, WaMu increased its securitization of subprime loans sixfold, primarily through its subprime lender, Long Beach Mortgage Corporation, increasing such loans from nearly $4.5 billion in 2003, to $29 billion in 2006. From 2000 to 2007, WaMu and Long Beach together securitized at least $77 billion in subprime loans. CHRG-111hhrg53244--317 The Chairman," The gentlewoman from Florida. Ms. Kosmas. Thank you, Mr. Chairman. And thank you for being here. As the chairman said, I represent the Central Florida area, and have been sort of raising the flag for quite a few months since Florida is one of the highest in mortgage foreclosures and also one of the highest now in unemployment. But I have been concerned about what I saw as a deeper problem in the economy looming over Florida as well as the Nation with regard to commercial lending and the renewing or rolling over of commercial loans for larger businesses. Some are smaller businesses. But when we look at our economy in Florida and we recognize that it is a $70 billion tourism trade, and we have situations where resorts, hotels, timeshares, cruise ships, and even our leisure parks are relying of course on commercial credit lines in order to function, and the numbers of people that they employ and the factor of the potential for them to be in jeopardy is quite frightening to me. So I have been trying to raise that red flag for several months here and talking to people about it, while at the same time people are dealing with other issues. I know that the TALF program was intended to provide an opportunity for increased securitized debt in those markets. And I was wondering whether you might be--and some of this I think was addressed by an earlier question but I will ask mine anyway. Do you feel that the TALF program is large enough and sufficient enough? Is it working? And is it working quickly enough, that we could consider that it might alleviate some of these looming credit problems for commercial real estate? " 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-111hhrg48875--197 Mr. Minnick," Yes. Please do because there is an attempt, I think, to give you tools that would accomplish what I heard you say this morning. My second question is, with respect to the new mechanism for creating liquidity of asset-backed securities that you have discussed yesterday and will continue to discuss, I am concerned that given the need for capital, which financial institutions of all types--a critical need right now if they're going to become functional, that this regime not underprice these assets. They need to be fairly priced but not underpriced. And the question I had for you: Under this regulatory scheme, if your initial auctions produce prices that in your judgment are at the low end of fair market value in a freely functioning market, are you prepared to provide additional leverage into the system which would have the impact, I think, of increasing bid prices to a point where the solution to the problem doesn't exacerbate the situation we have today, where these institutions tend to be badly under-capitalized, if they are going to perform effectively? " FOMC20061212meeting--182 180,MS. MINEHAN.," I can understand the logic, but I wonder whether “substantial” does that enough for us. That’s the only question I would pose." CHRG-110hhrg46591--434 Mr. Bartlett," Congressman, to take one more minute. In fact, these executives have, and the executives I work with have a total commitment to get it right, to work with the Congress and with the regulatory agencies to get it right. It was a systemic failure. And I will use one example of one company in Indiana. American General had one of the lowest rates of delinquencies of the subprime market and one of the largest subprime lenders in the country, 2 percent rate of delinquency. And yet they are owned by AIG. The credit derivative swaps was the problem that brought the whole company down. But it wasn't the subprime loans that were being made in Evansville, or throughout the country, from Evansville, Indiana. So it is a systemic failure, not a failure of individual parts. It is the fact that the parts didn't have a mechanism to talk to one another. " CHRG-111hhrg58044--209 Mr. Snyder," What happened in California is that you have a situation with massive cross subsidies, a very inefficient system with a huge overhead cost, and for many years and I think now, overall prices that would be lower if the free market were permitted. " 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-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? " FOMC20070321meeting--201 199,MR. MISHKIN.," Thank you, Mr. Chairman. To get perspective on this, again, I go back to where I think we were in December. We’re really not that much different in our forecast from December, except that we have a little more uncertainty. That means that for the assessment of risk I lean toward keeping the same language from the last meeting and from the December meeting, particularly because of the issue that President Hoenig mentioned—that we need to indicate that we are still very vigilant on inflation and that we’re worried about it. A further issue is that I think the change will be seen as removing some of the bias, which will have a big impact on the markets. That’s where I was before the meeting. However, Vince has been very convincing. Maybe it’s his wonderful vests. [Laughter] You might notice, Vince, that I tried to liven it up by wearing a double-breasted suit. So we have a little action going on here, different from the usual. [Laughter] It’s really the ghost of 2000 that worries me. The argument that we could be in a situation in which we get a shock and need to have the flexibility to deal with it is actually very important. In that case, I have concerns along the lines of President Hoenig’s, but I’m willing to live with the new language in alternative B for the reason that you mentioned. Because I think “predominant” has a little stronger connotation—not because of the dictionary but because it was used in the testimony— I would stay with “predominant.” It is just sort of an offset, and I would keep it on that level. In terms of the big debate about what we do regarding the rationale, I think it is a tough call. I do not like mentioning financial markets, as Governor Warsh said. Then crafting the language is very difficult. So I guess I end up with the KISS principle, which is “keep it simple, stupid,” and I would put a full stop after “quarters.” Thank you, Mr. Chairman." CHRG-111shrg50815--105 Chairman Dodd," I appreciate the point. I mean, an annual fee, that is in terms of the pricing points, that when you pay an annual fee, you know what it is. The question then of when these additional fees kick in, how they kick in, has been the source of the contention. In too many cases, they appear to be for reasons that should be unrelated to the performance of the consumer when it comes to the credit card, and we have talked about them before, the universal default issue, the double-cycle billing. Now, some of these have been changed, I agree with the things, but clearly these fees were not ones that a consumer can price necessarily when they increase them in ways that seem not terribly relevant to the behavior by the consumer. I don't think anybody is suggesting that when a consumer behaves poorly, if you will, in this matter that there are obviously going to be charges associated when that occurs. The question is, it is not so much performing poorly but rather what appears to be, I say to you, that designs to rather get around the fact, because the annual fee wasn't producing the kind of revenues. The competition reduced it, so what other ways can we do this, to find that? And obviously, look, marketing--I know this is probably true no longer, but there was a while not long ago when the parlance of the industry, if you were someone that paid off whatever the obligations were on a monthly basis, you were called a deadbeat, because frankly, you weren't very good financially. Someone who pays that thing off every month, you are not making much money off of them. The ideal consumer is someone who is paying the minimums here each month because that person is going to pay a lot more for that service or product over an extended period of time than the person who pays it off immediately. And it seems to me that by marketing to a lot of people, in a sense, who are in that situation, obviously raises certain concerns. Again, I have got credit cards. I understand the value of them, the importance of them for people, and I want the industry to know this is not a hostile situation we are talking about. We are talking about trying to make it work right for people in a sense at a time of great difficulty, when people are feeling a tremendous pinch. And obviously we have got securitization of this industry, which is another incentive in a way. If you are able to securitize that debt and sell it off someplace, then the incentives for you to want to manage it better are reduced, much as it was in the residential mortgage market. When you can securitize that product and sell it, your interest in having underwriting standards and so forth and to demand greater accountability begin to diminish significantly, and this has been a significant problem. In fact, it is one of the problems the banks have, because they are looking down the road and they are seeing a lot of this debt coming at them, not only in commercial real estate, but also in student loans and in credit card obligations. So obviously one of the reasons they are not lending a lot, I suspect, is because they recognize they have got these obligations coming. Why are they coming? Because they market a lot of products to people who couldn't afford them, in a sense. And had they done a little more work and determined whether or not that person out there was actually going to be able to meet those obligations instead of basically giving them out to anybody and everyone, then we wouldn't be facing this situation, much as we are facing in the residential mortgage market. There are distinctions, obviously, between a mortgage and a credit card obligation, but nonetheless, a little more adherence to those principles would reduce the very problems we are looking at in real estate as well as in commercial transactions such as credit cards. So it is sort of a self-fulfilling prophecy, in a way, we are dealing with in this issue. There is less accountability, marketing to more people who can less likely afford the obligations. Obviously, a lot to be made off of it because obviously someone who has to pay every month something on that over a long period of time increases tremendously the amount they will pay for that. That is why I disagree with you, Mr. Zywicki. I know you don't--I don't disagree with your point, the point I think you were making. I think there is some legitimacy to this. If you load up a load of consumer warnings, there is a point at which no one reads any of it. It is like on prescription drugs or something, or over-the-counter stuff. You begin to read so much that you just--you can't remember any of it. But I do think the idea of saying to people, let me show you that if you purchase a product and make just the minimum monthly payment on this, how much more you are likely to pay for a product, I think that warning to a consumer has value. If you know that, I think you are going to have second thoughts that that item doesn't cost $50, but it is rather going to cost you $150 by the time you are through with it. It has a value. And I don't disagree that if you load it up with a lot of stuff, no one reads any of it, but I think it is an important point. I raised the issue on the securitization and I wonder if you--I will raise the question if any of you want to respond to it. The securitization of credit card loans permitted companies to engage in at least lending practices that are less vigilant. Mr. Clayton, what about that? " CHRG-110hhrg45625--52 Secretary Paulson," Okay. Mr. Chairman, I thank you. A note of levity always helps. First of all, thank you very much. Thank you, Congressman Bachus, and members of the committee. Thank you for the opportunity to appear here today. I appreciate that we are here to discuss an unprecedented program, but these are unprecedented times for the American people and for our economy. I also appreciate that the Congress and the Administration are working closely together and we have been for a number of days now so that we can help the American people by quickly enacting a program to stabilize our financial system. We must do so in order to avoid a continuing serial of financial institution failures and frozen credit markets that threaten American families' financial wellbeing, the viability of businesses both small and large, and the very health of our economy. The events leading us here began many years ago, starting with bad lending practices by banks and financial institutions and by borrowers taking out mortgages they couldn't afford. We have seen the results on homeowners, higher foreclosure rates affecting individuals and neighborhoods, and now we are seeing the impact on financial institutions. These bad loans have created a chain reaction, and last week our credit markets froze up. Even some Main Street nonfinancial companies had trouble financing their normal business operations. If that situation were to persist, it would threaten all parts of our economy. Every business in America relies on money flowing through the financial system smoothly every day, not only to borrow, expand, and create jobs, but to finance their normal business operations and preserve existing jobs. Since the housing correction began last summer, the Treasury has examined many proposals as potential remedies for the turmoil that the correction has caused to the banking system. At the Federal Reserve, we have sought to address financial market stresses with as minimal exposure for the U.S. taxpayer as possible. This Federal Reserve took bold steps to increase liquidity in the markets and we have worked together on a case-by-case basis addressing problems at Fannie Mae and Freddie Mac, working with market participants to prepare for the failure of Lehman Brothers and lending to AIG so it can sell some of its assets in an orderly manner. We have also taken a number of powerful tactical steps to increase confidence in the system, including a temporary guarantee program for the U.S. money market mutual fund industry. These steps have all been necessary but not sufficient. More is needed. We saw the financial market turmoil reach a new level last week and spill over into the rest of the economy. We must now take further decisive action to fundamentally and comprehensively address the root cause of the turmoil. And that root cause is the housing correction which has resulted in illiquid mortgage related assets that are choking off the flow of credit which is so vitally important to our economy. We must address this underlying problem and restore confidence in our financial markets and financial institutions so that they can perform their mission of supporting future prosperity and growth. We have proposed a program to remove troubled assets from the system, a program we analyzed internally for many months and had hoped would never, ever be necessary. Under our proposal, we would use market mechanisms available to small banks, credit unions and thrifts, large banks, and financial institutions of all size across the country. These mechanisms will help set values of complex illiquid mortgage and mortgage-related securities to unclog our credit and capital markets and make it easier for private investors to purchase these securities and for financial institutions to then raise more capital. This troubled asset purchase program has to be properly designed for immediate implementation and be sufficiently large to have maximum impact and restore market confidence. It must also protect the taxpayer to the maximum extent possible, include provisions that ensure transparency and oversight while ensuring the program can be implemented quickly and run effectively as it needs to get the job done. The American people are angry about executive compensation and rightfully so. Many of you cite this as a serious problem and I agree. We must find a way to address this in the legislation, but without undermining the effectiveness of this program. I understand the view that I have heard from many of you on both sides of the aisle urging that the taxpayer should share in the benefits of this program to our financial system. Let me make clear this entire proposal is about benefiting the American people because today's fragile financial system puts their economic wellbeing at risk. When local banks and thrifts aren't able to function as they should, Americans' personal savings and the ability of consumers and businesses to finance spending, investment, and job creation are threatened. The ultimate taxpayer protection will be stabilizing our system so that all Americans can turn to financial institutions to meet their needs financing a home improvement or a car or a college education, building retirement savings, or starting a new business. The $700 billion program we have proposed is not a spending program. It is an asset purchase program. And the assets which are bought and held will ultimately be resold with the proceeds coming back to the government. Depending on the rate at which our housing market and economy recover, the loss to the taxpayer should be minimal, and a number of experts believe the government should actually break even on this program. I am convinced that this bold approach will cost American families far less than the alternative, a continuing series of financial institution failures and frozen credit markets unable to fund day needs and economic expansion. As you can imagine, I have been talking a lot lately and sometimes the words don't--they never do come out that smoothly for me, but it has been a long couple of days. But anyway, I understand this is an extraordinary thing to ask, but these are extraordinary times. I am encouraged by bipartisan consensus for an urgent legislative solution. We need to enact this bill quickly and cleanly and avoid slowing it down with unrelated provisions or provisions that don't have broad support. This troubled asset purchase program on its own is the single most effective thing we can do to help homeowners, the American people, and to stimulate our economy. Earlier this year, Congress and the Administration came together quickly and effectively to enact a stimulus package that has helped hard working Americans and boosted our economy. We acted cooperatively and faster than anyone thought possible. Today we face a much, much more challenging situation that requires bipartisan discipline and urgency. When we get through this difficult period, which we will, our next task must be to address the problems in our financial system through a reform program that fixes our outdated financial regulatory structure and provides strong measures to address other flaws and excesses. I have already put forward my recommendations on this subject. Many of you here also have strong views. And we must have that critical debate, but we must get through this period first. Right now, all of us are focused on the immediate need to stabilize our financial system and I believe we share the conviction that this is in the best interest of all Americans. Now, let us work together and get it done. Thank you. [The prepared statement of Secretary Paulson can be found on page 87 of the appendix.] " FOMC20080625meeting--42 40,MR. FISHER.," Mr. Chairman, if I could ask just one other question--of Larry, I think it was--on the housing exhibits. I am wondering if we are not in the eye of the storm here. We have had the first wave of buckling at the knees--or worse, cascading. If you talk to the homebuilders, they are, of course, the most depressed group imaginable. But they are waiting for another shoe to drop, which is the foreclosures on alt-As. I'm wondering what our opinion is on that. Things have calmed down a bit, but we still have another phase of the storm coming through, which is what I just described. What are our assumptions about that? " fcic_final_report_full--431 Current Fed Chairman Bernanke and former Fed Chairman Greenspan disagree with Taylor’s analysis. Chairman Bernanke argues that the Taylor Rule is a descriptive rule of thumb, but that “simple policy rules” are insufficient for making monetary policy decisions.  He further argues that, depending on the construction of the par- ticular Taylor Rule, the monetary policy stance of the Fed may not have diverged sig- nificantly from its historical path. Former Chairman Greenspan adds that the connection between short-term interest rates and house prices is weak—that even if the Fed’s target for overnight lending between banks was too low, this has little power to explain why rates on thirty-year mortgages were also too low. This debate intertwines several monetary policy questions: • How heavily should the Fed weigh a policy rule in its decisions to set interest rates? Should monetary policy be mostly rule-based or mostly discretionary? • If the Fed thinks an asset bubble is developing, should it use monetary policy to try to pop or prevent it? • Were interest rates too low in –? • Did too-low federal funds rates cause or contribute to the housing bubble? This debate is complex and thus far unresolved. Loose monetary policy does not necessarily lead to smaller credit spreads. There are open questions about the link be- tween short-term interest rates and house price appreciation, whether housing starts are the best measure of the housing bubble, the timing of housing price increases rel- ative to the interest rates in –, the European comparison, and whether the magnitude of the bubble can be explained by the gap between the Taylor Rule pre- scription and historic rates. At the same time, many observers argue that Taylor is right that short-term interest rates were too low during this period, and therefore that his argument is at least plausible if not provable. We conclude that global capital flows and risk repricing caused the credit bubble, and we consider them essential to explaining the crisis. U.S. monetary policy may have been an amplifying factor, but it did not by itself cause the credit bubble, nor was it essential to causing the crisis. The Commission should have focused more time and energy on exploring these questions about global capital flows, risk repricing, and monetary policy. Instead, the CHRG-111hhrg54872--132 Mr. John," No. When it comes right down to it, if you don't focus on the safety and soundness aspects of products and proposed regulations of those products, you are very likely to find a situation where a practice is encouraged which may be detrimental to the financial institution and therefore to the customer. " FOMC20060629meeting--46 44,MR. MOSKOW.," Thank you, Mr. Chairman. I have two questions. One is just a quick one on steel since President Fisher mentioned exhibit 12 and you showed this big increase in China’s steel capacity in ’05—much greater than the annual steel production increase—and I have heard about this a lot. But steel prices in the United States are staying surprisingly high according to industry observers, and they are expected to go higher this year. I was just wondering if you could shed some light on what’s happening to the price of steel. The other question I have is broader. It’s really about the overall forecast. This is one of the largest midyear revisions to the forecast that I remember seeing since I’ve been here, in the GDP numbers particularly. Clearly, some of the data that have come in have been softer, but it seems to be more than just that. There seems to be a change in the tone of the Greenbook that suggests some reassessment of the underlying strength of the economy. That is the way I read it. But you know, there is some good news here, too. Productivity growth remains solid. Real interest rates are just in the middle of the neutral zone. Anecdotes I hear are really quite positive. So I felt a disconnect when I read the Greenbook, and I was just wondering if you could elaborate on this a bit to help me understand this change in tone of the Greenbook." CHRG-111shrg61513--106 Mr. Bernanke," One problem is their foreign exchange policy to keep the currency pegged, and in order to do that, they have no alternative but to buy treasuries. The other reason is the global imbalances, the fact that they run this very large--which is related, of course, to foreign exchange policy, which is that they run a very large current account surplus while we run a current account deficit. And it was one of the objectives discussed by the G-20 leaders in the recent financial summits that we should all work to try to get a more balanced trade and capital flow situation. So I think it would be a healthier situation if China saved less and we saved more and as a result they were not accumulating dollar assets so quickly and we had a more balanced financial picture. I do think that those large capital flows and the potential instability of those flows can be a risk to our financial system, and, you know, I think we need to try to get those imbalances rectified. Senator Shelby. Picking up--and it has already been mentioned a couple of times by Senator Vitter and others--about the GSEs, at this point, as has been said here, there is no indication that any GSE reform will take place in the near term. In fact, just yesterday Secretary Geithner indicated and I think you alluded to this--that the Administration is unlikely to provide a plan for reforming these institutions prior to 2011 at the earliest. I know it is difficult and I know it is costly, but while implementing reform will take time, could you describe to the Committee here some of the risks that we face should we not start the process of reform as soon as possible? In other words, if we kick the can down the road, we could cause difficult problems, could we not? " CHRG-111hhrg74855--349 Mr. Stupak," Thank you, Mr. Chairman. Sorry I missed the testimony. I had to take another meeting but I have been asking the last time I asked about the swap clearing for end users so let me ask this question this way. Bona fide hedgers are participating in derivatives markets for commercial purposes and really are not the cause of our excessive speculation as I call it in the energy markets. Electric utilities are not the cause of our current financial crisis, however in the legislation exemption from a swap clearing for end users also allows large financial institutions that serve as your counterparties to also remain off the hook for stricter oversight. So my question was this and whoever wants to chime in, please do, would you support a change in the legislation that allows a bona fide hedger, including electric utilities to remain exempt from clearing requirements but mandating that tier one financial companies clear their swap transactions on a regulated market? All right, Glenn, it looks like you are ready to go. " 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. " fcic_final_report_full--447 The role of Fannie Mae and Freddie Mac in causing the crisis The government-sponsored enterprises Fannie Mae and Freddie Mac were elements of the crisis in several ways: • They were part of the securitization process that lowered mortgage credit quality standards. • As large financial institutions whose failures risked contagion, they were massive and multidimensional cases of the too big to fail problem. Policymakers were un- willing to let them fail because: – Financial institutions around the world bore significant counterparty risk to them through holdings of GSE debt; – Certain funding markets depended on the value of their debt; and – Ongoing mortgage market operation depended on their continued existence. • They were by far the most expensive institutional failures to the taxpayer and are an ongoing cost. There is vigorous debate about how big a role these two firms played in securitiza- tion relative to “private label” securitizers. There is also vigorous debate about why these two firms got involved in this problem. We think both questions are less impor- tant than the multiple points of contact Fannie Mae and Freddie Mac had with the fi- nancial system. These two firms were guarantors and securitizers, financial institutions holding enormous portfolios of housing-related assets, and the issuers of debt that was treated like government debt by the financial system. Fannie Mae and Freddie Mac did not by themselves cause the crisis, but they contributed significantly in a number of ways. THE SYSTEM FREEZING Following the shock and panic, financial intermediation operated with escalating frictions. Some funding markets collapsed entirely. Others experienced a rapid blowout in spreads following the shock and stabilized slowly as the panic subsided and the government stepped in to backstop markets and firms. We highlight three funding markets here: • Interbank lending. Lending dynamics changed quickly in the federal funds market where banks loan excess reserves to one another overnight. Even large banks were unable to get overnight loans, compounding an increasingly re- stricted ability to raise short-term funds elsewhere. • Repo. By September , repo rates increased substantially, and haircuts bal- looned. Nontraditional mortgages were no longer acceptable collateral. • Commercial paper. The failure of Lehman and the Reserve Primary Fund breaking the buck sparked a run on prime money market mutual funds. Money market mutual funds withdrew from investing in the commercial paper mar- ket, leading to a rapid increase in funding costs for financial and nonfinancial firms that relied on commercial paper. CHRG-111hhrg53234--94 Mr. Ellison," And if I may be allowed a final question, I agree, I think that some of the work that Fed has done recently has been very laudable, and I want to let you know that I feel that way. Some of the findings you made regarding credits cards and other things are just great. But I will say that given the Fed's mandate of focusing on monetary policy, I wonder--and I wonder if you wouldn't mind commenting--if there are not some occasions in which consumer protection takes a back seat to some of the other issues that the Fed is required to focus on. " FOMC20081029meeting--81 79,MR. LACKER.," I'm just wondering about the uncertainty that might be created about the lack of clarity about who's in, whether this is the final list, and so on. " FOMC20080916meeting--98 96,MR. KOHN.," He was also going to wonder, Mr. Chairman, whether we needed to harness the mystical powers. [Laughter] " CHRG-111shrg53822--59 Mr. Wallison," I appreciate it very much, Mr. Chairman. I am very pleased to have this opportunity to appear before the Committee. The chairman's letter of invitation asked four questions, and I have attempted to answer them in detail in my prepared testimony. I will try to summarize both the questions and my responses as follows. First, is it desirable or feasible to prevent institutions from becoming ``too big to fail''? I do not believe it is possible to identify in advance those institutions that are ``too big to fail'' because they pose systemic risk. Even if we could do that, the current condition of the heavily regulated banking sector shows that regulation is not an effective way to control growth or risk taking. Only the failure of a large commercial bank is likely to create the kind of systemic breakdown that we fear. Banks are special. Businesses and individuals rely on them for ready cash, necessary to meet payrolls, provide working capital, and pay daily bills. Small banks deposit funds in large banks. If a large bank should fail, that could cause a cascade of losses through the economy, and that is the definition, really, of systemic risk or a systemic breakdown. I doubt, however, that other kinds of financial institutions, insurance companies, securities firms, hedge funds, no matter what their size, can cause a systemic breakdown if they fail. This is because creditors of these firms do not expect to have immediate access to the funds that they have lent. If a large, non-bank financial firm should fail, its creditors suffer its losses over time with no immediate cascade of losses through the economy. The turmoil in the markets after Lehman's bankruptcy was the result of the extreme fragility of the world's financial system at that time and not the result of any losses actually caused by Lehman. The failure of a non-bank financial firm is not much different, in my view, from the failure of a large operating firm like General Motors. If General Motors fails, it will cause many losses throughout our economy, but not even the administration is contending that GM is ``too big to fail.'' The Committee should consider why if GM is not ``too big to fail,'' a large non-bank, financial firm might be; or if GM is ``too big to fail,'' whether we need a government agency that will resolve big operating firms, as some are proposing to resolve big financial firms. Second. Should firms that are ``too big to fail'' be broken up? This would not be good policy. Our large operating companies need large banks and other financial institutions for loans, for insurance, for funds transfers, and for selling their securities. If we broke up large financial institutions on the mere supposition that they might cause a systemic event, we would be depriving our economy of something it needs without getting anything certain in return. Third. What regulatory steps should be taken to address the ``too-big-to-fail'' problem? Since I do not think that non-bank financial institutions can create systemic risk, I would not propose new regulation for them at all. However, regulation of banks can be improved. We should require higher minimum capital levels. Capital should be increased during profitable periods when banks are growing in size. Regulators should develop indicators of risk taking and require banks to publish them regularly. This would assist market discipline. Fourth. How can we improve the current framework for resolving systemically important non-bank financial firms? There is no need to set up a government-run system for resolving non-bank financial institutions the way we resolve banks. They do not pose the risks that banks do. Giving an agency the power to take them over would virtually guarantee more bailouts like AIG with the taxpayers paying the bill. The bankruptcy system is likely to work better with greater certainty and with fewer losses. Within two weeks after its bankruptcy filing, Lehman had sold its investment banking, brokerage and investment advisory businesses to four different buyers. And unlike the $200 billion disaster at AIG, all Lehman's bankruptcy costs are being paid by the shareholders and the creditors of Lehman, not the taxpayers. Because of their special role in the economy, banks must have a special resolution system. I agree with that. But there is no reason to do the same thing for the creditors of non-bank financial institutions. Thank you, Mr. Chairman. Senator Warner. Thank you, Mr. Wallison. Some interesting comments. I am anxious to ask a couple of questions. Mr. Baily? 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--60 Mr. Marshall," What some are searching for here is a compromise position where folks like you could say, by adopting the compromise, the exposure--and not necessarily the market manipulation part of this, which is a separate question. Mr. Damgard is right about that--but the exposure that we have caused by this notional value, which is huge, has diminished substantially. Are you suggesting that it really doesn't matter whether or not you have an elaborate clearing mechanism set up, you are still exposed; there is no way to lessen the exposure systemically? " CHRG-110shrg50415--82 Chairman Dodd," I agree. All right. That would be a total mistake in my view, and I agree with you on that completely. Let me ask three quick questions and ask you to be brief if you could on them. Gene, you mentioned one thing earlier in your opening statement that I just wanted to pursue, and that is consumer protection issues. As I pointed out in my opening statement, in the past they have been sort of treated as nuisances from time to time, to put it mildly, and they have failed, I think, historically. And we have failed up here as well, I might add, in making the inextricable link between safety and soundness of our markets and consumer protection. We have treated them as if they were kind of separate things. One was sort of important, the other far less important. I wonder if you might just comment on that nexus between consumer protection and the safety and soundness of our systems. " CHRG-111hhrg48867--89 Mr. Royce," Thank you, Mr. Chairman. I wanted to just start with the observation that it was Mr. Wallison who warned us many years ago about the systemic risk to the broader financial system. In 1992, we passed the GSE Act in Congress, and as a consequence of passing that Act, we set up goals, affordable housing goals, and when the Federal Reserve looked at the consequences of that, they began to see the same thing that Mr. Wallison saw, and they sought to get Congress involved in this because, as was observed, banks are regulated and so they can only leverage 10 to 1, right? But we were allowing Fannie Mae and Freddie Mac to leverage 100 to 1 and to go into arbitrage, and the reason they were allowed to do that was because there was an attempt to have them meet these goals. Somebody had to buy those subprimes from Countrywide, and it was Fannie and Freddie that had the requirement in terms of the goals to buy these subprime loans and these faulty loans. In 2005, I brought an amendment to the Floor of the House of Representatives to regulate these GSEs or to allow the Fed and allow OFHEO, allow the regulator to regulate them for systemic risk, because the regulator had asked for this ability to regulate them for systemic risk to the wider financial system. And at that time that amendment was voted down. In the meantime, as you know, we also passed legislation here that allowed the government basically to bully the market, to bully the banks in terms of the types of loans that they would make, and to rig the system so that originally what was 20 percent down became 10 percent down, became 3 percent down, became 0 percent down, because we had to meet those goals for very-low-income and low-income affordable housing. Now, the reason I think it is important that Mr. Wallison be here is because through all of this debate, he and the Federal Reserve were the ones coming up here warning us that because of the power they had in the market they were crowding out the competition. They were becoming the majority holder of and purchasers of these mortgage-backed securities, securitization. They were the market. And as a consequence of the risks they were taking and the excessive leverage, we had a situation where it was helping to balloon the market and create a situation where once these standards had been lowered, 30 percent of the market participants were now flippers. In other words, we did it for a good cause, Congress did it for a good cause. We lowered these standards. We pushed affordable housing. But we forgot, or some of us forgot, that flippers would come in and take advantage of those new 3 percent down or 0 percent down programs and would be able to eventually constitute 30 percent of the entire market, which is what happened come 2005, according to the Federal Reserve, 2006, 2007, and that further, of course, you know ballooned up this problem. Now, understanding the potential implications of labeling certain companies as systemically significant, as you explained in your testimony, Mr. Wallison, do you believe it is important to take steps in overhauling our regulatory structure because, you know, the previous Treasury Secretary issued this Blueprint for Regulatory Reform in March of last year, and in many respects, at least from my perspective, that would close systemic gaps in the system. It merged duplicative regulatory bodies. It ended those who were redundant, who weren't necessary anymore as a result of consolidating them, and central in that Treasury plan was that in many respects banks, security firms, insurance companies, actually represent a single financial services industry, not three separate industries, and ought to be regulated as such. And these firms are all competing with one another and, as long as this is true, it makes no sense to regulate them separately from the standpoint of Treasury. While the Treasury Blueprint was not perfect, I believe it was a step in the right direction. It is important this this Congress not talk about systemic risk regulation in a vacuum but, rather, consider the regulatory framework as a whole. So I would ask if you agree with this sentiment: Should Congress be looking at the broader structure that has been in place for 75 years when it debates systemic risk in looking at a way to give--well, anyway, let me ask your response, Mr. Wallison. " CHRG-111shrg55479--6 STATEMENT OF SENATOR CHARLES E. SCHUMER Senator Schumer. Well, thank you, Senator Reed, and let me express my profound gratitude to you for holding this hearing and to Ranking Member Bunning for being here as well on such an important subject. As you acknowledged, Mr. Chairman, corporate governance is of great importance to me, and I introduced the Shareholder Bill of Rights with Senator Cantwell earlier this year. The bill was supported by 20 major pension funds, consumer groups, labor unions, and just yesterday, the House Financial Services Committee passed a ``say-on-pay'' bill similar to the ``say-on-pay'' we have in the Shareholder Bill of Rights. So I am glad to see Congress is moving forward in this process, and today's hearing is a great opportunity to get a chance to explore these issues in more detail. In the last year-plus, we have talked a great deal about the failures of regulation and Government oversight in the financial system. But our dynamic economy and capital markets also depend on internal oversight by vigilant boards of directors who ensure that management is steering the ship in the right direction. Unfortunately, there are far too many cases recently where boards of directors, not just regulators, were asleep at the wheel, or even complicit in practices that caused great harm to our economy and shook public confidence in our capital markets. Executives who encouraged risk-taking that they did not understand were not checked by their boards. Compensation packages that rewarded short-term actions but not long-term thinking were not undone by their boards. Fundamentally, too many boards neglected their most important job: prioritizing the long-time health of their firms and their shareholders and carefully overseeing management. In other words, there was widespread failure of corporate governance that has proven disastrous not just for individual businesses but for the economy as a whole. And there are many in this room on both sides of the aisle who say, you know, the Government cannot get involved in the details of what a company does. And that is right. That is our free market system. But the place that there is supposed to be a check is in the board of directors, and when over the years in too many companies--there are many companies that have good boards and many companies that already have implemented many if not all the reforms in our bill. But in too many companies, the boards did not do the job. And the damage. What if the board of AIG had checked some of its actions? What is the board of Bear Stearns had checked some of its actions? The taxpayers probably would have saved hundreds of billions of dollars. So it affects all of us. It is not just the internals of the company. And so Senator Cantwell introduced our bill. It makes corporate boards accountable to the shareholders whose interests they are supposed to protect. The Shareholder Bill of Rights will go a long way to making sure that these failures do not happen again, and as everyone knows, there are six key components in our bill. I am not going to read them. I am going to save that in the interest of time. Several elements of the bill have already been in place, as I said, by many corporations, and that is important to remember, because for many corporations, these are already best practices. Well-run companies do not fear their shareholders because they recognize that boards, management, and shareholders share the same interests: long-term growth and profitability. The greatest damage occurs not when boards are too active, but when they are not active enough. I think the Shareholder Bill of Rights will go a long way to ensuring that companies are responsive to their shareholders' interests. I thank you and congratulate you, Chairman Reed, for putting together an excellent panel. I look forward to the hearing, the testimony of the witnesses, and I would ask that my entire statement be put in the record. " CHRG-111hhrg55814--14 The Chairman," I will yield myself 5 minutes. We are in a difficult situation. History has apparently been somewhat rewritten. All of the bailouts that the gentleman from Alabama referred to, where we are not going to get money back, were the result of an absence of policies to deal with this set of situations; and, every one of those bailouts was of course requested by the Bush Administration, by Secretary Paulson and Chairman Bernanke. Now, as of April 2008, Secretary Paulson said we needed to do some things to keep this from happening. It happened very quickly, and we were unable to avoid those. The question of simply allowing bankruptcy to be the way to deal with it, there's nothing theoretical about that. That's the Lehman Brothers situation. The Lehman Brothers went bankrupt and the Bush Administration officials had two responses: first, to use Federal Reserve authority without any congressional approval, and even prior notification, to begin the process of providing funds to pay off the creditors of AIG. That was done by the Federal Reserve last September under the Bush Administration with no congressional involvement other than to be told after the fact. Second, they came and asked us for authority to spend some money to provide some forms of cash so other institutions didn't go under. Congress agreed with some conditions, I think, and avoided worse dangers. It could have been administered better. Our whole purpose today was to change that situation and to prevent it. Yes, it is true that we had these previous problems. That's because we didn't have a set of rules. What we do today is to begin deliberation on a proposal that does. There are two problems that were raised with regard to the bailouts: one, the use of taxpayer money; and this is a set of proposals that will prevent taxpayer money from being used. Members say, ``Oh, this requirement that it come from the financial industry, that won't work. Congress will do it instead.'' They have a very different Congress in mind than the one I have served in. I do not believe there is any remote chance that Congress would come to the rescue of the financial industry that this bill will have required and said substitute taxpayer money. If that's their intention, they can try. I think they will be outvoted if they feel that's what has to happen. Secondly, there is the moral argument. There is the argument that once people know that certain institutions are of a certain size, they'll be protected. That's why many of us protected the notion that there will be a list published beforehand. What we have here is this. A group of regulators that will be monitoring institutional behavior, both cumulative institutional behavior, like subprime loans, and the behavior of a large, irresponsible institution like AIG. There will be no notification to the public or privately that a particular institution is in that category without simultaneous restrictions on the institution. There will be no prior notification, so the institution will then be free to attract investment, because it will be shown to be so big. It will become manifested. This institution is covered. The day that the regulator says you must significantly increase your capital, you must reduce your activity. We will be adding to this. It's in here--an ability to take the kind of restrictions that existed under Glass-Steagall nationwide and impose them institution by institution. Now, there is a threshold question. Is it possible to go forward in this situation without any funds ever being used to prevent the kind of cataclysm of failure leading to failure leading to failure that the Bush Administration felt very much we had to avoid. We, I think, minimized this in a couple of ways. First of all, the penalty for being such an institution will be very severe. There will be death panels enacted by Congress this year, I hope, but they will be for those large institutions, which will be put out of business, whose shareholders will be wiped out, whose executors will be fired, whose boards of directors will be replaced. There will also be no guarantee in any case that the creditors are going to receive 100 cents on a dollar. Classes of creditors will be allowed to be exempted entirely from any repayment. Other creditors will have it reduced. You can't do that under bankruptcy. General bankruptcy makes it harder to have that kind of thoughtful selection. We are using the constitutional power of bankruptcy, but in a way that is more thoughtful. Finally, I would say this: This is not the only piece. We are regulating derivatives over the objection of my Republican colleagues. I hope we will be imposing some restrictions on your ability to securitize 100 percent of the loan. We are doing other things. We are requiring other people to register. There will be other restrictions that will keep us from getting to that situation. And, now, I recognize the gentleman from Texas, Mr. Hensarling, for 1 minute. " FOMC20060808meeting--25 23,MS. PIANALTO.," David, in your opening comments you said that the staff got the last two employment numbers right. But they were below the market expectations of what the employment numbers would be. In the Greenbook baseline projections, the employment growth numbers going forward are even lower. They are 80,000 per month for the rest of this year and 40,000 per month in 2007. Those seem like very low numbers; I think that, if those numbers are realized, they’re going to continue to surprise markets and to appear pretty weak. So I was wondering how sensitive to those specific employment numbers the outlook is. I know that the Greenbook has a lower NAIRU alternative simulation; is that supposed to be providing us with some information about the uncertainty in that forecast? Given that lower NAIRU alternative in the Greenbook, I am also curious about what kinds of employment numbers we are looking at that would achieve those outcomes." FOMC20060920meeting--123 121,MS. MINEHAN.," Thank you very much, Mr. Chairman. New England continues to grow modestly, though recent data suggest that some caution is warranted. District employment growth remains slower than that of the nation. Most states in the region are back to their January ’01 levels of employment; but the largest states, Massachusetts and Connecticut, are not. The Philadelphia Fed indexes of overall state activity, which are based largely on employment- and wage-related data, suggest sluggish growth as well, with Maine and Massachusetts at or near the bottom of the index for the country as a whole. Even with slow labor growth, certain categories of positions are very hard to fill—in particular, finance, accounting, certain IT specialties, engineers, biotech, and skilled labor for manufacturing. In fact, one large aircraft manufacturer was quoted as saying that the labor situation as far as he was concerned was insane. Costs for acquiring certain kinds of labor are rising, but in general, we are not seeing increases across the board in overall expected labor costs. But given the kinds of labor that are very much an important part of the businesses in the First District, such increases may not be far off. Housing markets are clearly contracting. We are part of the coastal situation. Through the second quarter, New England house prices escalated at only half the pace of the United States as a whole, and home foreclosures, while still fairly low, ticked up more significantly in the region than elsewhere. Permits have fallen sharply, down 25 percent from last year and 22 percent from the year before, though yesterday’s starts data were a bit better for the Northeast than elsewhere. Slower building is leading suppliers of housing products to project declining business later this year as their sales tend to lag a decline in residential real estate markets. Consumer confidence for the region as a whole dropped off at a faster pace than elsewhere in the nation in August compared with the year before. So there are all those reasons for caution about the growth rate of the New England economy, but not all the data are bad. Consumer prices, in general, are escalating more slowly, even though energy costs are higher. Downtown and suburban office vacancy rates are down, and rents are rising. Hardware and software businesses that were contacted or that are represented on our small-business advisory group report fairly strong revenues and definite concerns about costs. Business confidence measures and surveys were positive both for Massachusetts and Connecticut, reflecting profitable trends and stronger sales and even some strength in manufacturing. As I mentioned at our last meeting, the growth in personal income in the region, despite slow job growth, is on a par with that of the nation. Reflecting this and strong corporate profits, state income, sales, and corporate tax revenues are up, in some cases by relatively large percentages. So even though we have some reasons to be concerned about New England, not everything is negative—though that is sort of hard to find in the local media and you certainly will not hear the politicians talking about it either. Turning to the nation, I would agree that most incoming data since our last meeting have been on the subdued side. Auto sales, trade data, and certainly anything to do with residential real estate markets have been more subdued than was expected. Of course, price measures have been subdued as well, at both the headline and the core levels. But like New England, not everything is slow. I would look at employment growth as fairly solid, even though it has slowed from the beginning of the year. The surprise in wage and salary income may reflect largely the exercise of stock options, but it could also reflect some pressure on overall wage costs because hiring certain kinds of workers is getting difficult. Oil prices are down, and gasoline price declines act as a kind of bonus to the consumer. Consumer spending isn’t too bad. The latest retail sales data aren’t bad at all; and although confidence bounces around a bit, it seems to have recovered—at least as much as gasoline prices have recovered. Industrial production seems pretty good, with strong growth in some equipment categories. Business profits are good. Orders and shipment data suggest that business spending is solid. I am sort of repeating everything you said, David, and I probably should not do that. But I seem to be at the same point as people you mentioned in your presentation might be—a little shocked by the slowness of expected GDP over the next couple of quarters. In fact, when we in Boston look at our baseline forecast, it is a good deal more optimistic largely because we are not seeing as much of a decline in residential investment. I found the briefing yesterday to the Board interesting, when you tracked your own forecast of residential investment. At one time we were lower than you were, but you far surpassed us. In fact, with your decline 50 percent greater than ours in ’06 and quite a bit larger again in ’07, we get a GDP that is 0.3 percentage point higher in ’06 and almost 1 percentage point higher in ’07. We also see a lower NAIRU, and we have a bit higher estimate of potential—so it does not affect the gap as much, but it does affect the headline number of GDP. I understand all the mechanics, but the staff forecast is lower than most private forecasts. I wonder, if growth is that low for that long, whether it might set off a chain reaction of actually higher saving rates than you project and lower confidence that could feed back more strongly than you have anticipated. In that regard, I found the recent estimates of a rising probability of recession interesting. I do not think we’re going to have a recession, but I do wonder about it if, in fact, we do realize the slow growth of the Greenbook forecast. However, how much do we really know about how long residential investment will stay negative without a recession? Mortgage rates are not up that much—only 50 basis points or so from the beginning of the year. Incomes are rising, and nonhousing wealth is rising. At some point, buyers should recognize that housing has gotten more affordable and resume desired purchases, perhaps without further major price declines. Certainly speculative building is off, and investors have backed out of contracts, but how much more of that really will occur? The Greenbook would suggest another year and a half, but shouldn’t builders be acting quickly now to reduce the amount of overbuilding and to preserve price levels? Underlying demographics and other fundamentals have not changed either. So it is hard actually for me to see that residential investment will be that hard hit that long. I take Janet’s comments about the builders in her District. I imagine that, if I had talked directly to builders in the First District, they might have been pretty gloomy, too—again, given some reflection of the coastal situation. I did talk to Nick Retsinas at the Joint Center for Housing Studies, which Harvard runs, and he was not particularly negative. He felt that a correction is occurring but thought that it would be short-lived. Now, he did say that they were going to come out with some revisions and that he was still working on them, so his outlook may get more negative. But I am going to try to keep tabs on where they see things because they do stay in touch with all the large builders across the country. Again, the knock-on effects of lower residential construction may not be all that great. You mentioned that nonresidential construction is up, but the Greenbook says that it will slow soon. A good deal of that is oil related; and as long as people are working, incomes are solid, and financial conditions remain pretty accommodative, consumption ought to remain solid. So I wonder whether the Greenbook baseline is really more of a worst-case scenario for residential construction and GDP, though I realize regional effects of the housing slowdown on employment and spending could be considerable. If growth is faster and if your estimates of the NAIRU and the participation rate are more or less on target, I also wonder about the risks of higher inflation over the forecast period than is the case in the baseline as resource pressures grow. Moderating energy costs are helping here, but they have been volatile in both directions, and I at least would like to see a somewhat longer period below recent highs before declaring victory. In sum, the rather benign baseline forecast may be the best; but as you noted, there are great ranges of uncertainty. There are downside risks to be sure, and it is impossible to rule out a recession given the slow growth forecast of the Greenbook. But I really think the risks to be concerned about lie in the area of stronger growth, more pressure on resources, and higher and more persistent inflation. As many other people have commented, I, too, found the material on inflation persistence of some interest and very well done, though I take the point that it is hard to be confident either about the definition of persistence or about whether it is, in fact, lower or higher. I would argue here that it might be better to assume, as we consider the stance of policy, more rather than less persistence, in part because we are uncertain and in part because the costs of being wrong are somewhat asymmetric. If inflation is less persistent and we assume it is not and take a conservative policy stance, inflation should retreat quickly and help shore up our credibility. Choosing a weaker stance and being wrong about it could be quite costly. Given the uncertainties facing us, the nature of the incoming data, and the fact that we have already paused, it might not be time right now to take out more inflation insurance, but I certainly think it is time to be very vigilant. Thank you." CHRG-110shrg50409--32 Mr. Bernanke," But as I said earlier, I think the housing sector, together to some extent with oil, is at the heart of the current uncertainty, the current situation. I think were it to happen that there would become a general view that the housing situation had stabilized, you would see actually a very strong bounce-back in the economy and the financial markets, and it is the uncertainty about when that happens that remains a problem. Again, it is the Congress' prerogative to decide what to do about the GSEs and other housing-related legislation. But as I tried to indicate before, I think the best thing that we can do to remove this uncertainty and to speed the recovery is to make sure that the housing market and the mortgage finance markets are functioning as well as possible. Senator Bennett. Yes, but very specifically, taking away the word ``deal''--and I agree with you that even though that is the word we have seen in the press, that is probably not the right word. But the structure that you have agreed to in terms of some kind of a back-up for the GSEs, should they get in trouble, do you have the feeling that the announcement of the terms of that structure should remove some of the uncertainty with respect to their future? " CHRG-111shrg56262--28 Mr. Irving," I will make four comments. First of all, I think uncertainty about home prices and how borrowers behave when they are underwater on their mortgage, when the loan-to-value ratio is greater than 100, has increased the risk premium in the market. And the second facet of uncertainty which is causing skittishness about these securities is just uncertainty about Government policy. The Government in some sense has been in the position inadvertently of picking winners and losers in terms of which investments do well and which do not. Those that get the Government support perform better than those that do not, so it becomes less of an intrinsic relative value of the cash-flows and more an assessment of how the Government policy is going to go. The third would be the equity-like price volatility that we have seen exhibited in many of these marketplaces, again causes there to need to be an increased risk premium, that is, prices go down. And then finally, the complexity. We have sort of a rule of thumb on our trading room floor that for every additional sentence I need to describe to my boss the structure of the security I am buying, the price has to be lower by about a point, and---- " CHRG-111shrg54789--13 Chairman Dodd," Two final questions for you. I made the point in my opening statement that I thought if this were done well and right--as I plan to do so--that it is not only going to be beneficial to consumers, but the one argument we do not hear is that it is very beneficial to business, very beneficial to the financial institutions themselves to have a consumer protection agency, number one. And, number two, a witness who will appear in the second panel, Mr. Wallison from the American Enterprise Institute, says in his statement here, ``If we are looking for a primary cause of today's financial crisis, it is here,'' referring to the Community Reinvestment Act. Why don't you respond to the issue of whether or not you believe the Community Reinvestment Act was the primary cause of the financial crisis as well? " FinancialCrisisInquiry--484 MAYO: Yes, three things. Number one, I went back. I did a thousand-page report in 1999, and, right upfront, I talked about what—the real estate situation and how that could fall out and cause a lot of difficulties. So I had to think about why did I put that in there. And I remembered, because every—not every—many management presentations I went to—we as analysts sit in an audience, hear what the company wants to do over the next three, five years. Many management presentations I went to, they said, “We want to expand home equity.” “We want to expand home equity.” “We want to expand home equity.” And so, they all had the same goal. So the goal by itself may have made sense. They just weren’t paying enough attention to what their competition was doing. By the way, the same thing happened with branches. Right? They said, “Oh, I think there’s a good spot for a branch,” they just weren’t anticipating the other two or three banks also opening up a branch on that corner. Right? So that’s what happened in home equity, and that was certainly a tipoff to me. And that is a tipoff that might not have been gotten by the regulators that early, but analysts who January 13, 2010 were going to all these meetings would get that. The second thing would be deposit insurance. I’ve written about this nonstop since 1994. And in the early part of this decade, I thought it would be increased. It wasn’t. I was wrong. And some of my clients, you know, reminded me of that. But that was a tipoff to me about the clout of the industry. And that’s why I used the word “clout” earlier. And if it’s—at the time, it wasn’t Sheila Bair head of the FDIC, but if it’s—I said the revenues of the four banks that presented this morning equaled the GDP of Argentina. If it’s Argentina against Sheila Bair, who’s going to win? And so when you talk to her tomorrow, I know part of her answer. I’ve heard her give the presentation before. She was lobbied, and she was lobbied heavily. And she said she’s saved a lot of the letters from some of the banks that were lobbying her. So how much was that clout of the banks and how much that influenced the regulation, I think that’s an important topic to be highlighted by—perhaps as early as tomorrow. The third point is simply the leverage. It was as clear as day in the middle part of the last decade. I have all my charts there. I’m just using regulatory data. In my mind, people just weren’t incented to care enough. CHRG-110shrg50414--171 Secretary Paulson," Well, I will answer it and then let the Chairman answer it. There were two possible approaches, and this is by far the best in our judgment. One is to come up with something that is aimed solely at propping up a relatively small number of bigger institutions if and when they need it. OK? And the other approach, you know--and, again, we have flexibilities to deal with individual's situations as they arise. But the approach we thought was the better approach was to focus on the securities themselves and the markets of the securities themselves, looking at various security tranches and asset classes, and by establishing markets, working to establish values and markets here, to then induce the flow of private capital. And, again, when you look at all of our financial institutions, when people say why not recapitalize them, one of the reasons that capital is not coming into these institutions is they do not know--investors do not understand the value of some of these securities, and we need more transparency. So that is the approach, and it is--one is an approach to deal with failure, and the other is to try to make the system--to get to the system in advance of that. " CHRG-111shrg57322--842 Mr. Viniar," I don't know enough to answer that. Senator Coburn. They have got about a trillion dollars worth of taxpayer money right now, all of it at risk, and one of the leading causes for over-speculation in the housing market, and you don't have an opinion on it? I mean, I don't want to get you in trouble with whoever your friends are around here, but the point is, we need to fix the real problems, not the symptoms, and you don't have an opinion on whether we ought to address the issues with Fannie Mae and Freddie Mac? " FOMC20060328meeting--100 98,CHAIRMAN BERNANKE.," President Guynn, I wonder if you would say a little more about the Katrina rebuilding—why you think that’s going to be very slow." CHRG-111hhrg51585--20 CONGRESS FROM THE STATE OF CALIFORNIA Ms. Eshoo. Thank you, Mr. Chairman, for that wonderful added note to you, to Ranking Member-- " CHRG-110hhrg34673--88 Mr. Shays," What confuses me is that we are trying to get consumers to consume so that our economy moves forward. So I just wonder how you would wrestle with that, and how do you wrestle with it? " CHRG-111hhrg74090--217 Mr. Dingell," No, no, you are giving me a wonderful answer but it is to the wrong question. Answer my question, please. Ms. Hillebrand. The answer is, we think---- " CHRG-111hhrg52397--204 Mrs. Bachmann," What about the issue of transparency, we hear that a lot and I am wondering, do you see transparency now being available on over-the-counter products? " FOMC20070807meeting--34 32,MR. MOSKOW.," An excellent presentation, Bill. One area that you talked a bit about was the commercial paper market. That made me uneasy because this segment is different from the other segments of the market that you were talking about, and obviously that short-term financing is crucial to companies. I wonder if you could expand on your comments there." CHRG-111hhrg56847--248 Mr. Connolly," It must be nice to be an economist. Your predecessor opined after the inauguration of President Bush that he did not think that the proposed tax cuts at that time would necessarily have a deleterious effect on the situation of the deficit and that it could have a stimulative effect on the economy. Was he right or wrong in that opinion, retrospectively? " CHRG-111shrg55278--113 PREPARED STATEMENT OF ALLAN H. MELTZER Professor of Political Economy, Tepper School of Business, Carnegie Mellon University July 23, 2009Regulatory Reform and the Federal Reserve Thank you for the opportunity to present my appraisal of the Administration's proposal for regulatory changes. I will confine most of my comments to the role of the Federal Reserve as a systemic regulator and will offer an alternative proposal. I share the belief that change is needed and long delayed, but appropriate change must protect the public, not bankers. And I believe that effective regulation should await evidence and conclusions about the causes of the recent crisis. There are many assertions about causes. The Congress should want to avoid a rush to regulate before the relevant facts are established. If we are to avoid repeating this crisis, make sure you know what caused it. During much of the past 15 years, I have written three volumes entitled ``A History of the Federal Reserve.'' Working with two assistants we have read virtually all of the minutes of the Board of Governors, the Federal Open Market Committee, and the Directors of the Federal Reserve Bank of New York. We have also read many of the staff papers and internal memos supporting decisions. I speak from that perspective. I speak also from experience in Japan. During the 1990s, the years of the Japanese banking and financial crisis, I served as Honorary Adviser to the Bank. Their policies included preventing bank failures. This did not restore lending and economic growth. Two findings are very relevant to the role of the Federal Reserve. First, I do not know of any clear examples in which the Federal Reserve acted in advance to head off a crisis or a series of banking or financial failures. We know that the Federal Reserve did nothing about thrift industry failures in the 1980s. Thrift failures cost taxpayers $150 billion. AIG, Fannie, and Freddie will be much more costly. Of course, the Fed did not have responsibility for the thrift industry, but many thrift failures posed a threat to the financial system that the Fed should have tried to mitigate. The disastrous outcome was not a mystery that appeared without warning. Peter Wallison, Alan Greenspan, Bill Poole, Senator Shelby, and others warned about the excessive risks taken by Fannie and Freddie, but Congress failed to legislate. Why should anyone expect a systemic risk regulator to get requisite Congressional action under similar circumstances? Can you expect the Federal Reserve as systemic risk regulator to close Fannie and Freddie after Congress declines to act? Conflicts of this kind, and others, suggest that that the Administration's proposal is incomplete. Defining ``systemic risk'' is an essential, but missing part of the proposal. Trying to define the authority of the regulatory authority when Congress has expressed an interest points up a major conflict. During the Latin American debt crisis, the Federal Reserve acted to hide the failures and losses at money center banks by arranging with the IMF to pay the interest on Latin debt to those banks. This served to increase the debt that the Governments owed, but it kept the banks from reporting portfolio losses and prolonged the debt crisis. The crisis ended after one of the New York banks decided to write off the debt and take the loss. Others followed. Later, the Treasury offered the Brady plans. The Federal Reserve did nothing. In the dot-com crisis of the late 1990s, we know the Federal Reserve was aware of the growing problem, but it did not act until after the crisis occurred. Later, Chairman Greenspan recognized that it was difficult to detect systemic failures in advance. He explained that the Federal Reserve believed it should act after the crisis, not before. Intervention to control soaring asset prices would impose large social costs of unemployment, so the Federal Reserve, as systemic risk regulator would be unwise to act. The dot-com problem brings out that there are crises for which the Federal Reserve cannot be effective. Asset market exuberance and supply shocks, like oil price increases, are nonmonetary so cannot be prevented by even the most astute, far-seeing central bank. We all know that the Federal Reserve did nothing to prevent the current credit crisis. Before the crisis it kept interest rates low during part of the period and did not police the use that financial markets made of the reserves it supplied. The Board has admitted that it did not do enough to prevent the crisis. It has not recognized that its actions promoted moral hazard and encouraged incentives to take risk. Many bankers talked openly about a ``Greenspan put,'' their belief that the Federal Reserve would prevent or absorb major losses. It was the Reconstruction Finance Corporation, not the Fed, that restructured banks in the 1930s. The Fed did not act promptly to prevent market failure during the 1970 Penn Central failure, the Lockheed and Chrysler problems, or on other occasions. In 2008, the Fed assisted in salvaging Bear Stearns. This continued the ``too-big-to-fail'' (TBTF) policy and increased moral hazard. Then without warning, the Fed departed from the course it had followed for at least 30 years and allowed Lehman to fail in the midst of widespread financial uncertainty. This was a major error. It deepened and lengthened the current deep recession. Much of the recent improvement results from the unwinding of this terrible mistake. In 1990-91, the Fed kept the spread between short- and long-term interest rates large enough to assist many banks to rebuild their capital and surplus. This is a rare possible exception, a case in which Federal Reserve action to delay an increase in the short-term rate may have prevented banking failures. Second, in its 96-year history, the Federal Reserve has never announced a lender-of-last-resort policy. It has discussed internally the content of such policy several times, but it rarely announced what it would do. And the appropriate announcements it made, as in 1987, were limited to the circumstances of the time. Announcing and following a policy would alert financial institutions to the Fed's expected actions and might reduce pressures on Congress to aid failing entities. Following the rule in a crisis would change bankers' incentives and reduce moral hazard. A crisis policy rule is long overdue. The Administration proposal recognizes this need. A lender-of-last-resort rule is the right way to implement policy in a crisis. We know from monetary history that in the 19th century the Bank of England followed Bagehot's rule for a half-century or more. The rule committed the Bank to lend on ``good'' collateral at a penalty rate during periods of market disturbance. Prudent bankers borrowed from the Bank of England and held collateral to be used in a panic. Banks that lacked collateral failed. Financial panics occurred. The result of following Bagehot's rule in crises was that the crises did not spread and did not last long. There were bank failures, but no systemic failures. Prudent bankers borrowed and paid depositors cash or gold. Bank deposits were not insured until much later, so bank runs could cause systemic failures. Knowing the Bank's policy rule made most bankers prudent, they held more capital and reserves in relation to their size than banks currently do, and they held more collateral to use in a crisis also. These experiences suggest three main lessons. First, we cannot avoid banking failures but we can keep them from spreading and creating crises. Second, neither the Federal Reserve nor any other agency has succeeded in predicting crises or anticipating systemic failure. It is hard to do, in part because systemic risk is not well-defined. Reasonable people will differ, and since much is often at stake, some will fight hard to deny that there is a systemic risk. One of the main reasons that Congress in 1991 passed FDICIA (Federal Deposit Insurance Corporation Improvement Act) was to prevent the Federal Reserve from delaying closure of failing banks, increasing losses and weakening the FDIC fund. The Federal Reserve and the FDIC have not used FDICIA against large banks in this crisis. That should change. The third lesson is that a successful policy will alter bankers' incentives and avoid moral hazard. Bankers must know that risk taking brings both rewards and costs, including failure, loss of managerial position and equity followed by sale of continuing operations.An Alternative Proposal Several reforms are needed to reduce or eliminate the cost of financial failure to the taxpayers. Members of Congress should ask themselves and each other: Is the banker or the regulator more likely to know about the risks on a bank's balance sheet? Of course it is the banker, and especially so if the banker is taking large risks that he wants to hide. To me that means that reform should start by increasing a banker's responsibility for losses. The Administration's proposal does the opposite by making the Federal Reserve responsible for systemic risk. Systemic risk is a term of art. I doubt that it can be defined in a way that satisfies the many parties involved in regulation. Members of Congress will properly urge that any large failure in their district or State is systemic. Administrations and regulators will have other objectives. Without a clear definition, the proposal will bring frequent controversy. And without a clear definition, the proposal is incomplete and open to abuse. Resolving the conflicting interests is unlikely to protect the general public. More likely, regulators will claim that they protect the public by protecting the banks. That's what they do now. The Administration's proposal sacrifices much of the remaining independence of the Federal Reserve. Congress, the Administration, and failing banks or firms will want to influence decisions about what is to be bailed out. I believe that is a mistake. If we use our capital to avoid failures instead of promoting growth we not only reduce growth in living standards we also sacrifice a socially valuable arrangement--central bank independence. We encourage excessive risk taking and moral hazard. I believe there are better alternatives than the Administration's proposal. First step: End TBTF. Require all financial institutions to increase capital more than in proportion to their increase in size of assets. TBTF gives perverse incentives. It allows banks to profit in good times and shifts the losses to the taxpayers when crises or failures occur. My proposal reduces the profits from giant size, increases incentives for prudent banker behavior by putting losses back to managements and stockholders where they belong. Benefits of size come from economies of scale and scope. These benefits to society are more than offset by the losses society takes in periods of crisis. Congress should find it hard to defend a system that distributes profits and losses as TBTF does. I believe that the public will not choose to maintain that system forever. Permitting losses does not eliminate services; failure means that management loses its position and stockholders take the losses. Profitable operations continue and are sold at the earliest opportunity. Second step: Require the Federal Reserve to announce a rule for lender-of-last-resort. Congress should adopt the rule that they are willing to sustain. The rule should give banks an incentive to hold collateral to be used in a crisis period. Bagehot's rule is a great place to start. Third step: Recognize that regulation is an ineffective way to change behavior. My first rule of regulation states that lawyers regulate but markets circumvent burdensome regulation. The Basel Accord is an example. Banks everywhere had to increase capital when they increased balance sheet risk. The banks responded by creating entities that were not on their balance sheet. Later, banks had to absorb the losses, but that was after the crisis. There are many other examples of circumvention from Federal Reserve history. The reason we have money market funds was that Fed regulation Q restricted the interest that the public could earn. Money market funds bought unregulated, large certificates of deposit. For a small fee they shared the higher interest rate with the public. Much later Congress agreed to end interest rate regulation. The money funds remained. Fourth step: Recognize that regulators do not allow for the incentives induced by their regulations. In the dynamic, financial markets it is difficult, perhaps impossible, to anticipate how clever market participants will circumvent the rules without violating them. The lesson is to focus on incentives, not prohibitions. Shifting losses back to the bankers is the most powerful incentive because it changes the risk-return tradeoff that bankers and stockholders see. Fifth step: Either extend FDICIA to include holding companies or subject financial holding companies to bankruptcy law. Make the holding company subject to early intervention either under FDICIA or under bankruptcy law. That not only reduces or eliminates taxpayer losses, but it also encourages prudential behavior. Other important changes should be made. Congress should close Fannie Mae and Freddie Mac and put any subsidy for low-income housing on the budget. The same should be done to other credit market subsidies. The budget is the proper place for subsidies. Congress, the regulators, and the Administration should encourage financial firms to change their compensation systems to tie compensation to sustained average earnings. Compensation decisions are too complex for regulation and too easy to circumvent. Decisions should be management's responsibility. Part of the change should reward due diligence by traders. We know that rating agencies contributed to failures. The rating problem would be lessened if users practiced diligence of their own. Three principles should be borne in mind. First, banks borrow short and lend long. Unanticipated large changes can and will cause failures. Our problem is to minimize the cost of failures to society. Second, remember that capitalism without failure is like religion without sin. It removes incentives for prudent behavior. Third, those that rely on regulation to reduce risk should recall that this is the age of Madoff and Stanford. The Fed, too, lacks a record of success in managing large risks to the financial system, the economy and the public. Incentives for fraud, evasion, and circumvention of regulation often have been far more powerful than incentives to enforce regulation that protects the public. FOMC20070918meeting--111 109,MR. EVANS.," Thank you, Mr. Chairman. To date, economic conditions in the Seventh District have changed little since our last meeting. We continue to expand at a modest rate, as reported in the Beige Book two weeks ago. Even after accounting for continuing declines in the housing sector, most of my contacts thought the national economy had softened. Outside of housing, they generally reported a modest deceleration rather than an abrupt change in conditions. Retailers thought that continued high energy prices were holding back consumers, but demand was not seen as deteriorating sharply. A similar slowing was reported on the hiring front. For instance, Kelly and Manpower experienced softer demand for temporary workers, but again this was not characterized as a general pullback in hiring. Many contacts added that finding skilled workers remained difficult, as President Fisher mentioned. In terms of the business outlook going forward, several directors and other contacts noted that many in the business community were apprehensive about the prospects for growth. They were concerned that these worries might soon begin to weigh more heavily on actual spending. For example, in the motor vehicle sector, both Ford and General Motors cautioned that the August sales numbers overstated the underlying strength in demand for vehicles. They thought some selective incentive programs had boosted the sales figures. I asked all my contacts about the effects of the turmoil in credit markets. Though it is still early, none of them thought that the recent financial turbulence was causing creditworthy nonfinancial firms to have unusual difficulty in finding adequate financing. As several people have said, many business people suggested that the situation is much better than what they hear from financial commentators on Wall Street. Of course, we heard many examples of difficulties from financial market contacts, and several have spoken about that already. Turning to the national outlook, three broad developments since our August meeting have influenced my views on the economic situation. First, financial conditions have become more restrictive. Second, the incoming data suggest a greater decline in housing and a somewhat weaker labor market. Third, inflation prospects have improved to the point where my outyear projections are within a range that many participants would view as consistent with price stability. These projections embed a path for the federal funds rate that is similar to the Greenbook assumption. With regard to financial conditions, I think it is useful to consider the situation relative to an assessment of a neutral or an equilibrium federal funds rate. Taking into account the slower growth of structural productivity, a neutral rate is likely between 4½ and 4¾ percent. The Greenbook-consistent rate is in this range. Until recently, one argument for keeping the target funds rate at 5¼ percent had been to offset otherwise accommodative conditions. As recently as June, we had very low risk premiums and ample liquidity for all types of private borrowing, including large commitments for private equity deals. Now, of course, overall financial conditions have tightened and in some markets have turned very restrictive. Clearly, this restrictiveness is a downside for growth. Whether it is as large as ½ percentage point, as the Greenbook assumes, is uncertain. In any event, the ongoing repricing of risk also adds a good deal of uncertainty to the forecast. You all know it is very difficult to forecast the impact of such financial turbulence. Recent history and Dave Stockton remind us of this. In the early 1990s, restrictive credit due to depositories’ capital adequacy problems had a significant impact on real economic activity. In contrast, in the fall of 1998, we thought financial conditions would impinge a good deal on the real economy, but 1999 turned out to be a very strong year for growth. Bottom line—and we all recognize this—we need to be careful how we react to the current financial situation. Turning more specifically to the outlook for growth, our Chicago forecasts have tended to be somewhat more optimistic than the Board staff forecast, and we remain so. That said, the incoming data have been softer than we expected. So we marked down our assessment of residential investment again, but not as much as the Board staff did—again, and the decline in payroll employment caused us to lower our near-term outlook somewhat. As long as the financial difficulties are contained, and that is our working assumption, we expect growth to return to potential by the second half of 2008, and we have a higher potential output growth rate than the Board staff. However, I admit that the risks seem weighted to the downside of this projection. With regard to inflation, the improvement in core PCE inflation earlier this year appears to have a bit more staying power than we thought it might. If aggregate demand does weaken, as expected, then there is less risk of inflationary pressures arising from constraints on resource utilization. Energy prices, though, are a concern. My contacts do not seem to have much difficulty passing cost increases through to their customers. Overall, however, we have core PCE inflation edging down to 1.8 percent next year and remaining near that rate in 2009. I see the risk to this inflation forecast, conditioned on the outlook for growth, as being fairly well balanced. Thank you, Mr. Chairman." CHRG-111shrg61651--47 Mr. Scott," To come back to what the ``too big to fail'' problem is, I think it is the degree of interconnectedness. So what you have to ask yourself, in addressing your question, is: Will we have the insolvency of a large institution which we have to rescue because it is too interconnected to let it fail? That might not be affected by the size of the total institution. It is a function of its positions with other parties. So, in answering the question, should a resolution authority not be permitted to bail out an institution, I think it would have to have a very high degree of confidence that you would not have a situation in which an institution failed that was highly interconnected because if you did not bail it out, then you risk a chain reaction of failures. So I think it is really important to understand the degree of interconnectedness of our institutions, and I think we have done a woeful job at uncovering that and that a lot more attention needs to be focused on what these connections are. For instance, I think we thought when AIG was rescued that it had to do with their counterparty positions. But then we are told by some of their counterparties, one of whom is sitting at this table, that they were totally protected in the event of an AIG failure. And I am not questioning that, but what I am questioning or asking is if you are going to design a resolution authority that says we will never rescue an institution, you have to have a high degree of confidence that you will never be in a position where these large connected positions could create a chain reaction of failures if you did not rescue the institution. Senator Shelby. Mr. Reed, do you believe that regulators lacked necessary authority and power to rein in reckless activities or do you think that regulators simply failed to use their available tools? And do you believe that regulators have been held accountable for their failure? " FOMC20070131meeting--60 58,MR. WASCHER.," Well, real wages wouldn’t be different, but the adjustment could come either through flexible nominal wages or faster increases in prices. In the FRB/US model, which is used to generate these simulations, trend unit labor costs do cause an increase in the rate of price inflation, which is what you see here, and that helps equilibrate the labor market." CHRG-111hhrg52406--183 Mr. Gutierrez," Thank you very much. It is wonderful to have you all here. Mr. Pollock, good to see you again, although you did come as a witness for the minority side, but we will still be friendly with one another. And it is good to have you all here. We are going to try to get it right this time. I thank this wonderful panel, all of you, for being here. And I look forward to talking to you all once again. Thank you so much. I ask unanimous consent that written statements by the American Financial Services Association and the Insurance Marketplace Standard Association be entered into the record. Without objection, it is so ordered. Thank you so much. Well, I am going to work really hard on this, because I want to get everybody's name right. We now have our third panel. We welcome you all: Mr. Travis Plunkett, legislative director, Consumer Federation of America; Ms. Kathleen E. Keest, senior policy counsel, Center for Responsible Lending; the Honorable Ralph Tyler, commissioner, Maryland Insurance Administration, on behalf of the National Association of Insurance Commissioners, welcome; Mr. Gary E. Hughes, executive vice president and general counsel of the American Council of Life Insurers, we are happy to have you here; Ms. Catherine J. Weatherford, president and chief executive officer, NAVA, the Association of Insured Retirement Solutions; and Mr. Cliff F. Wilson, Southeast Arizona Insurance Supervisors, on behalf of the National Association of Insurance and Financial Advisors. We welcome you all, and we will start with Mr. Travis Plunkett for 5 minutes please. STATEMENT OF TRAVIS PLUNKETT, LEGISLATIVE DIRECTOR, CONSUMER FEDERATION OF AMERICA (CFA) " FOMC20070131meeting--154 152,MR. HOENIG.," Thank you, Mr. Chairman, now that I have everyone’s attention, [laughter] I’m going to start with some information on the District and then talk briefly about the national economy from my perspective. Let me begin by saying that the District’s activity did slow over the second half of 2006 in line with the national economy itself. The slowdown was most apparent in housing and manufacturing. However, the most recent data that we have from November and December indicate a pickup in some of the activity. Moreover, reports from our directors and our business contacts suggest a considerable degree of optimism among them going forward, more than we expected actually. One area in which we are seeing signs of improvement is housing itself. While new construction activity does remain subdued in our region, sales activity has picked up, and the inventory situation appears to be improving in our major markets. Nonresidential construction remains strong and is offsetting some of the weakness on the residential side. District employment growth has risen in recent months, and labor markets remain tight for us. In addition to continuing shortages of skilled workers in a large number of technical and professional areas, we have recently received reports that the hospitality and recreational sectors are experiencing difficulty in finding lower-skilled workers as well. We have also received numerous reports from directors in District businesses indicating higher year-end wage and salary increases. The situation in agriculture is somewhat mixed. The sharp increases in crop prices, especially corn, driven by exports of ethanol and exports of corn itself, have caused the USDA to boost estimates of 2007 farm income rather significantly. However, higher crop prices are also eroding profitability of livestock producers and processors in our region, which is a fairly important sector. One important sector in which activity appears likely to slow in 2007 is energy. The District economy has benefited tremendously over the past few years from the rise in energy prices, which has spurred increased production of traditional products—and that includes oil, gas, and coal—as well as alternative fuels like ethanol and biodiesel. According to reports from a couple of our directors, however, the recent decline in energy prices has already led to a reduction in drilling activity and is likely to cause some cutbacks in new investment in alternative fuels as well. Turning to the national outlook, I, like others, have noted the recent strength in the economy and have raised my estimates of growth for the fourth quarter and somewhat raised them for the first quarter. I continue to expect growth to rise over 2007 modestly toward what I think is potential, in the neighborhood of 3 percent. However, now I expect it to occur a little more quickly than I did at the December meeting. Accordingly, recent economic information has led me to reassess the balance of risks to the outlook. I believe the downside risks from the further slowing of housing have diminished somewhat. Moreover, I share the view that the recent weakness in manufacturing activity reflects a better balancing of production and inventories rather than a fundamental weakness. Going forward, the improved outlook for energy prices should support consumer spending by improving consumers’ disposable income, and we may see additional fiscal stimulus resulting from the more-favorable budget positions of the state and local governments. Finally, in terms of the inflation outlook, my views have not changed materially since the last meeting. I’ve been encouraged by the recent inflation data, and I continue to expect inflation to decline over the forecast period. I expect the core CPI to be in the 2.3 percent range and core PCE inflation to be about 2 percent for 2007. However, as others have noted, core inflation is too high, and considerable uncertainty remains about whether the recent progress will be sustained. Particularly, it is not clear how the opposing trends of lower energy prices and greater resource pressures may play out over the next few quarters. Consequently, it seems to me that there is upside risk to the inflation outlook. Thank you." CHRG-111hhrg48868--11 Mr. Bachus," Thank you, Chairman Kanjorski. As Chairman Kanjorski said, he and I requested the GAO to do an investigation on the motivations behind the government intervention and bailout of AIG and who it was actually intended to help. And I'll be very interested to find out the results of that study. For several weeks now, and even today, we continue to play kind of a game that children used to play, pin the tail on the donkey. Trying to put the blame somewhere else. And in truth, there's plenty of blame to go around. AIG, their company engaged in very reckless, risky behavior, and I think we all have a right to be angered that such a fine company at one time is in the mess that it is in and the effect that it has had on our economy. That's justified anger, so we could certainly pin the donkey on AIG and those within that company, most all of them long gone, who caused that. Washington, the regulators, they failed to do their job. We ought to blame them. That's justified. This Congress, some of our policies have contributed to some of that behavior, the failure to regulate, the failure of oversight by this Congress. We're to blame. The one faction who probably aren't to blame but seem to be paying the tab is the American people. They're paying for it. All this bad behavior by the company, all this bad behavior by our failure to regulate, all the failure of us to take action in numerous different areas, we all should bear the blame. But I think at this point that anger shouldn't distract us from really the true issue and our goal today, and that's to try to recover as much of the taxpayers' money as we possibly can. That ought to be our motive. And the blame game needs to be secondary, because we're all to blame. Now the only possible successful outcome to this is to manage our way out of the current problems. Now how do we do that? Do you think Congress can manage AIG? I don't think so. Take a walk through the Capitol Visitor's Center--3 times over budget, 5 years late. We can't manage AIG. How about the regulators? There are a lot of empty desks at Treasury. I don't think that the Fed or the Treasury has done a very good job. How about a poll on TV? Should we just take some poll results and act from there? I don't think so. As unpopular as it may be, I think the best opportunity that we have is to let that new team at AIG--we're all upset over the bonuses. The bonuses were awarded and signed as contracts in 2007, long before Mr. Liddy and the new team was in place. And we're justifiably angry at him for maybe not doing a better job of getting out of it. But he came in after the collapse of AIG with a $1 salary and you can vilify this new management team if it makes you feel better, but resolving a company as large and as complex as AIG is no easy task. It was in a mess, and it will require a lot of good fortune. It will require an economic recovery, and that's what they're doing now. They're unraveling the deals. They're shutting down this Financial Products Division that has caused all of us heartbreak and harm, and that's going to take time. The people who set the policies that brought AIG to the brink of total collapse are gone. We need to give this new management team the time it needs to get the job done. They were assigned that job in September, and when we did it, and when the Fed did it, they said it would take 2 years or 3 years to do it. The government trying to get more involved than it is, is just going to be a sad experience. We need to let, as I say, we need to--and I'll close by again saying it. The solution here is not the government running this company. It's a private team. And they're going to need all the help they can get. 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-111hhrg56847--3 Mr. Ryan," Thank you, Mr. Chairman. And thank you for opening this hearing. I too want to start off by welcoming our newest member, Congressman Charles Djou of Hawaii. We look forward to working with you to tackle our fiscal and economic challenges. And it is exciting to see you and your family here and being sworn into Congress. And we are really looking forward to working with you. Welcome to the Nation's capital. And welcome to you, Chairman Bernanke. It is appropriate you are coming here before our committee today to talk about the state of the economy because the health of the U.S. and global economy is increasingly intertwined with the budget and our fiscal issues that we deal with here in this committee. Over the past few months we have watched as a sovereign debt crisis in Europe has boiled into a real troubling problem. We are seeing that the continent's economic recovery is being threatened and we see even global financial stability in general is being threatened. In some ways, we are seeing a replay of a similar dynamic which impaired global financial markets in 2008. The fear then was the systemic exposure to bad mortgage-related assets, but the fear now is driven by exposure to sovereign credit and the possibility of a debt-induced economic slump. Ominously, interbank lending rates, like LIBOR, are on the rise and credit spreads have widened as investors have become much more risk averse. Volatility is up and the stock market is down. What we are watching in real-time is the rough justice of the marketplace and the severe economic turmoil that can be inflicted on profligate countries mired in debt. At the moment, the U.S. is at the periphery of the European debt crisis and has even reaped some short-term benefits like lower long-term interest rates as a result of the renewed global flight to safety. But Americans are left to wonder. Could we one day find ourselves at the epicenter of such a crisis? Could a European style debt crisis one day happen right here in the United States? The answer is undoubtedly yes. And the sad truth is that inaction by policymakers to change our fiscal course is hastening this day of reckoning. A brief look at the budget numbers shows that our current fiscal situation and its trajectory going forward is very dire. The budget deficit this year stands at $1.5 trillion, or just over 10 percent of GDP. Under the President's budget, the budget we are living under right now, the CBO tells us that the level of U.S. debt will triple by the end of the decade, meaning that in just a few short years, the U.S. is poised to join that group of troubled countries whose public debt absorbs a large and growing share of their economic output. A fiscal crisis in the U.S. is no longer an economic hypothetical but a clear and present risk to our economy, to society's most vulnerable citizens, and America's standing in the world. As the example of Greece has shown, market forces and investor sentiment do not offer countries the luxury of time and delayed promises to get their fiscal house in order. Empty rhetoric is no substitute for results. Foreigners now own roughly half of the U.S. publicly held debt and their willingness to fund our borrowing at record low interest rates will not continue forever. The size of our current and future funding needs makes us quite vulnerable to a shift in market sentiment and higher than expected interest rates. The reemergence of the bond vigilantes and exposure to the rough justice of the marketplace would certainly make our bad fiscal situation even worse. The main point here is the need for policymakers to reassure credit markets that the U.S. is engaged in charting a clear course back to sustainable deficit and debt levels soon. It is clear to me that this means reining in government spending, not simply ramping up taxes. In particular, we need to reform our entitlement programs, which threaten to grow themselves right into extinction, collapse our safety net, overwhelm the entire Federal budget and sink the economy in the process. The budding sovereign debt problems in other parts of the world provide us with a great cautionary tale that it is always best to take action to shore up budget deficits before market forces demand it. So what has this Congress and administration done to respond? Two new entitlement programs and no budget. The majority's failure to even offer a budget and its commitment to continue spending money we don't have, creating brand new entitlements and plunging our Nation deeper into debt tells me, and tells the bond markets more importantly, that Washington still doesn't recognize the severity of our fiscal and economic challenges. I look forward to your testimony today, Chairman Bernanke, and remain hopeful that policymakers will heed your warnings and chart a sustainable course to avert the next crisis. Thank you. " FOMC20070131meeting--49 47,MR. DUDLEY.," You could think of the situation as credit availability to that sector diminishing, which could have feedback effects on price. That’s the risk." FOMC20060328meeting--229 227,MR. OLSON.," Thank you, Mr. Chairman. I, too, support the ¼ point increase, and I’m persuaded today by the theme I hear repeated that we want to maintain confidence in the Federal Reserve. I was particularly taken with President Stern’s statement that his read on the people he’s talking to is that the Fed would not allow inflation to get loose. I wonder about what it would take to contain long-term inflationary expectations. Clearly it is not simply a U.S. phenomenon because the yield curve and inflationary expectations around the world are very similar. It seems to me that, in looking at the Taylor construct, we may be at the upper end, with one more move, of where we want to be in terms of a policy response. It’s possible to read in one of the charts that the market is anticipating to some extent that we may actually overshoot and come back. But recognizing the importance of our being diligent with respect to inflation, I think that it’s going to be a much tougher decision next time as to whether or not we should raise. Dino’s comment about our having a sort of binary decision right now is exactly right. We ought to maintain the statement that we have. My preference would be to have taken out the sentence regarding further moves, but I think it’s the right sentence to leave in at this time." CHRG-110hhrg46591--52 Mr. Stiglitz," I agree that one needs to approach this comprehensively. I think that looking at the past and what has caused this problem is only part of what needs to be done, because there are all kinds of crises we could have had and that we will have in the future. We are looking at this in a way parochially as Americans. This has been a global crisis. Countries that didn't have our particular institutions have also had problems. And so I think we really need to think about this looking forward, taking into account the changes in the financial markets that have occurred, what are the risks, and how do we manage those risks. And I guess a final point, I think one of the real difficulties is the very large role of the special interest at play in shaping our current financial structures, regulatory structures, the failures of the current financial regulators are going to make it very difficult to go forward. That is something you just have to take into account, that they are going to try to shape the regulations to allow them to keep doing what they did in the past because it worked for them. " fcic_final_report_full--439 Solvency failure versus liquidity failure The Commission heard testimony from the former heads of Bear Stearns, Lehman, Citigroup, and AIG, among others. A common theme pervaded the testimony of these witnesses: • We were solvent before the liquidity run started. • Someone (unnamed) spread bad information and started an unjustified liquid- ity run. • Had that unjustified liquidity run not happened, given enough time we would have recovered and returned to a position of strength. • Therefore, the firm failed because we ran out of time, and it’s not my fault. In each case, experts and regulators contested the former CEO’s “we were solvent” claim. Technical issues make it difficult to prove otherwise, especially because the an- swer depends on when solvency is measured. After a few days of selling assets at fire- sale prices during a liquidity run, a highly leveraged firm’s balance sheet will look measurably worse. In each case, whether or not the firm was technically solvent, the evidence strongly supports the claim that those pulling back from doing business with the firm were not irrational. In each of the cases we examined, there were huge financial losses that at a minimum placed the firm’s solvency in serious doubt. Interestingly, in each case, the CEO was willing to admit that he had poorly man- aged his firm’s liquidity risk, but unwilling to admit that his firm was insolvent or nearly so. In each case the CEO’s claims were highly unpersuasive. These firm man- agers knew or should have known that they were risking the solvency and therefore the survival of their firms. Conclusions: • Managers of many large and midsize financial institutions in the United States and Europe amassed enormous concentrations of highly correlated housing risk on their balance sheets. In doing so they turned a building housing crisis into a subsequent crisis of failing financial institutions. Some did this know- ingly; others, unknowingly. • Managers of the largest financial firms further amplified these big bad bets by holding too little capital and having insufficiently robust access to liquidity. Many placed their firms on a hair trigger by becoming dependent upon short- term financing from commercial paper and repo markets for their day-to-day funding. They placed failed solvency bets that their housing investments were solid, and failed liquidity bets that overnight money would always be there no matter what. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. “Investment banks caused the crisis” FOMC20081216meeting--445 443,MR. DUDLEY.," No, I don't think that is quite right. We are in basically a market disequilibrium, where the traditional buyers of these securities have vanished. In a normal market environment, it would be completely reasonable to lend against these securities on a leveraged basis. But the people who would do that lending--banks and dealers--are balance sheet constrained, and that is why they are not willing to make those loans. If we had a normal banking and dealer situation today in which they were willing to extend loans to their counterparties, they would be providing the leverage. But that is just not happening. " FOMC20070131meeting--313 311,MR. REINHART.," As we related in the Bluebook and as a number of you said, market participants understand the risk assessment, and they don’t expect policy action or a change in the risk assessment. So it’s hard to see that there would be any reaction at all. I wonder what our new Account Manager would say as well." CHRG-111hhrg53246--33 Mr. Garrett," I appreciate it. They do some good, but obviously, the failures in the past, present company excepted because you were not there at the time, is something that just raises that question. I don't have much time, so let me go on to the next point, because I know you are going to sing the praises of things that have been done well. A lot of people could have a disparate opinion as to what brought us here. Some people would say it is GSEs and their leveraging issues, other people would say it is the credit rating agencies and they have problems; other people would say it was the regulators or the OTS and what have you that simply missed things and what have you. A lot of people can point out different things. We have not come to a conclusion as to what the problem ultimately was that brought us here. Can you point to one example where it was standardized derivative products that was ultimately part of the cause that brought us here? " fcic_final_report_full--425 House Price Appreciation in Selected Countries, 2002-2008 The United States was one of many countries to experience rapid house price growth 2002 INDEX = 100 United States United Kingdom Spain 200 192 150 158 118 100 ’02 ’04 ’08 ’02 ’04 ’08 ’02 ’04 ’08 200 150 Australia France Ireland 168 152 142 100 ’02 ’04 ’08 ’02 ’04 ’08 ’02 ’04 ’08 SOURCES: Standard and Poors, Nationwide, Banco de España, AusStats, FNAIM, Permanent TSB • The report largely ignores the credit bubble beyond housing. Credit spreads de- clined not just for housing, but also for other asset classes like commercial real estate. This tells us to look to the credit bubble as an essential cause of the U.S. housing bubble. It also tells us that problems with U.S. housing policy or mar- kets do not by themselves explain the U.S. housing bubble. • There were housing bubbles in the United Kingdom, Spain, Australia, France and Ireland, some more pronounced than in the United States. Some nations with housing bubbles relied little on American-style mortgage securitization. A good explanation of the U.S. housing bubble should also take into account its parallels in other nations. This leads us to explanations broader than just U.S. housing policy, regulation, or supervision. It also tells us that while failures in U.S. securitization markets may be an essential cause, we must look for other things that went wrong as well. • Large financial firms failed in Iceland, Spain, Germany, and the United King- dom, among others. Not all of these firms bet solely on U.S. housing assets, and they operated in different regulatory and supervisory regimes than U.S. com- mercial and investment banks. In many cases these European systems have stricter regulation than the United States, and still they faced financial firm fail- ures similar to those in the United States. CHRG-109shrg26643--64 Chairman Bernanke," It depends really on which type of investor is more sensitive to changes in yields. Central banks have actually been less sensitive to changes in yields than private sector investors. So, I cannot say a priori which situation would be one of more concern. I think it is really not so much the portfolio situation; it is the fact that we are accumulating foreign debt over time, year by year. We can do that because foreigners are willing to finance that debt, but I do not think that we can continue to finance the current account deficit at 6 or 7 percent of GDP indefinitely, and it is desirable for us to bring down that ratio over a period of time. Senator Sarbanes. Now it is your view, I take it, that they are doing this because these are attractive investments; is that right? " CHRG-111hhrg54868--88 Mr. Scott," Okay. I will be willing to pay that price. Thank you. Mr. Dugan, I wanted to go to one specific thing. You and I have discussed this, I believe, in my office. And I wanted to know, have we made any progress? Because I think there is so much more our banks can do that they are not doing in terms of lending. But there is a practice that is going on within the banking system that I think that we do need to address. I spoke to you about that, and I wanted to know if we have moved on that. And that is this, that we have been receiving some complaints from some of our constituency that when they have multiple services at these banks where one will have their savings account, their checking account, and then they will go borrow maybe a home equity loan, and then--or another loan, but without any acquiescence to the customer, the bank has the right, apparently, which I think is wrong, to without any--with total disregard to the customer, to go into one of the other accounts, get money out of that account to pay for something in the other account. It puts that customer and that consumer at a very disadvantage without having a notification, without knowing. He may think he has so much money there, but the bank has already gone in and got it to pay something else, maybe the home equity loan. And I was wondering, I know you were concerned about that, and I wanted to find out if you moved on that and what we need to do to stop that. " fcic_final_report_full--476 The forest metaphor turns out to be an excellent way to communicate the difference between the Commission’s report and this dissenting statement. What Summers characterized as a “cigarette butt” was 27 million high risk NTMs with a total value over $4.5 trillion. Let’s use a little common sense here: $4.5 trillion in high risk loans was not a “cigarette butt;” they were more like an exploding gasoline truck in that forest. The Commission’s report blames the conditions in the financial system; I blame 27 million subprime and Alt-A mortgages—half of all mortgages outstanding in the U.S. in 2008—and a number that appears to have been unknown to most if not all market participants at the time. No financial system, in my view, could have survived the failure of large numbers of high risk mortgages once the bubble began to deflate, and no market could have avoided a panic when it became clear that the number of defaults and delinquencies among these mortgages far exceeded anything that even the most sophisticated market participants expected. This conclusion has significant policy implications. If in fact the financial crisis was caused by government housing policies, then the Dodd-Frank Act was legislative overreach and unnecessary. The appropriate policy choice was to reduce or eliminate the government’s involvement in the residential mortgage markets, not to impose significant new regulation on the financial system. **** The balance of this statement will outline (i) how the high levels of delinquency and default among the NTMs were transmitted as losses to the financial system, and (ii) how the government policies summarized above caused the accumulation of an unprecedented number of NTMs in the U.S. and around the globe. FOMC20070816confcall--116 114,MR. LOCKHART.," I agree with President Fisher regarding “appreciably,” and I’m wondering if we could not say that the Committee judges that the downside risks to growth have increased somewhat." CHRG-111shrg57923--24 Mr. Mendelowitz," Five years. Senator Reed. And serves independent of us. They have proven that the last few months rather aggressively. I wonder if anyone else has a comment on independence. Professor? " CHRG-111shrg57319--109 Mr. Vanasek," Yes. Senator Coburn. I am just wondering if the people that worked for you in risk management had a way around you to senior executives, or did it all go through you? " CHRG-111shrg57709--59 Mr. Wolin," Senator, I just wonder whether I could add something on the questions that you raised with respect to the size constraints. Senator Shelby. Yes, sir. " FOMC20051213meeting--55 53,MS. MINEHAN.," Yes. I wondered about that as a downside risk. The numbers jumped out at me, even recognizing your take on labor force participation. Thank you." CHRG-111shrg55479--10 Chairman Reed," Thank you both. We have been joined by Senator Warner. I wonder if you have any opening comments, Senator. Senator Warner. I will--have I missed testimony already? " CHRG-111shrg50814--41 Mr. Bernanke," Well, Senator, as I discussed in my testimony, the whole period from mid-September to early October was an intense financial crisis that was, in turn, triggered to some extent by a weakening economic condition both in the United States and around the world. To some extent, Lehman was a result of the broad financial crisis that was hitting a number of firms. You know, quite a number of large firms came under pressure during that period. And so in some sense, Lehman was a symptom as well as a cause. But I do think that the failure of Lehman was a major---- Senator Bunning. But there was picking and choosing between winner and loser here. You picked Bear Stearns to save and you let Lehman Brothers go down the tubes. " FinancialCrisisInquiry--387 MAYO: Chairman Angelides, Vice Chairman Thomas, members of the commission, thank you for inviting me to testify today. I work at Calyon Securities and in affiliation with COSA, but January 13, 2010 I’m here to represent my own views. I’ve submitted almost 200 pages of supporting material. I hope you received that. Two decades ago, I worked down the street at the Federal Reserve. At the time, we were helping banks recover from crisis. We took great meaning from our work. I hope the commission’s efforts lead to a banking system that we don’t have to revisit every two decades to save. This is important. I’ve been covering an industry on steroids. Performance was artificially enhanced, and we’re now paying the price with the biggest bailout of U.S. banks in history. And it’s also resulting in the biggest wealth transfer from future generations to the current generation. My children, 9, 7, and 4, and their generation will have to pay the price. I’m shocked and amazed more changes have not taken place. There seems an unwritten premise that Wall Street, exactly how it exists today, is necessary for the economy to work. That’s not true. The economy worked fine before Wall Street got this large and this complex. Wall Street has done an incredible job at pulling the wool over the eyes of the American people. This may relate to the clout of the banks. The four banks that testified this morning have annual revenues of $300 billion. That’s equal to the GDP of Argentina. My perspective? I’ve analyzed banks since the late 1980’s. I value the independent reputation of COSA. And I’ve been negative on banks since 1999, and I’ve published over 10,000 pages of research to back up my view. I’ve identified 10 causes of the crisis. If you can turn to Slide 3 -- and I’ll go through each cause. Cause One: excessive loan growth. We could not accept the reality that we’re in a slower-growing economy, a more mature market. Loans grew twice as fast as they should have grown, twice as fast as GDP. Cause Two: higher yielding assets. The U.S. banking industry acted like a leverage bond fund. More borrowings with the proceeds invested in more risky assets. Look at Treasury securities. As a percentage of securities, they went January 13, 2010 down from 32 percent down to 2 percent. That’s the least risky asset. Instead, banks took more risky securities and more risky loans whether it’s home equity or construction loans. Look at construction loans. The percentage of construction loans to total is double the level where it was even in the early ‘90’s. Cause Three: too many eggs in one basket. Look at data for loan growth last decade and look at the fastest area of loan growth. First, mortgages; second, mortgages; construction loans, commercial real estate, multi-family real estate. One element in common: real estate. Cause Four: high balance sheet leverage. Shortly before the crisis, the U.S. banking industry had the highest leverage in 25 years. And then take a look at the securities industry. In the ‘80’s, 20 time levered, in the ‘90’s, 30 times levered. And right before the crisis, almost 40 times levered. Cause Five: more exotic products. Some of these were so exotic that I don’t think the directors, the CEOs, and in some cases, even the auditors fully understood the risks. And I think of this like cheap sangria. A lot of cheap ingredients are bad—or bad sangria, I should say. A lot of cheap ingredients repackaged to sell at a premium. It might taste good for a while, but then you get headaches later and you have no idea what’s really inside. Cause Six: consumers went along. There’s some personal responsibility here. Consumer debt-to-GDP is at the highest level in history. Japan didn’t have that. We didn’t have that during the Great Depression. There is a false illusion of prosperity through this additional borrowing. It’s no secret that everybody from kids to pets to dead people got loan solicitations, but a lot of people took these loans voluntarily. Cause Seven: accountants. The SEC, in 1998 made some rules or some decisions that encouraged banks to take less reserves for their problem assets. And look what happened next. Reserves to loans at U.S. banks declined from 1.8 percent down to 1.2 percent right January 13, 2010 before the crisis. That was a wrong move. It should change now. And the bank regulators should be back in control in helping us set reserves for problem loans. That was not a close call for many of us in the industry. Cause Eight: I know Jamie Dimon said regulators were not at fault. No, that’s not true. Regulators share some blame here, too. Banks—U.S. banks always paid insurance premiums for their deposit insurance. Ever since the FDIC was created after the Great Depression they always paid deposit insurance until 1996. For a decade banks paid no premiums for their deposit insurance. OK. Well, maybe—somebody else might be upset about this, too. OK? It’s a sign that banks for a decade not paying any deposit insurance premiums is ridiculous. And tomorrow when Sheila Bair testifies, that would be a great question to ask her. Why did they not pay deposit insurance for a decade? That’s analogous to getting car insurance and not—not paying premiums until you have an accident or getting life insurance and not paying premiums until you die. It just doesn’t work for an insurance scheme. Cause Nine: Government—government facilitated allocation of capital to the housing market, so government’s involved here, too. And Cause 10: Incentives. I think if there’s one word—after you spent all these months going through this, one word’s going to come up as being a key cause. And that one word is incentives. People do what they’re incented to do. And if you look at the banking industry compensation, what the industry pays out is pretty constant as a percentage of revenues. But guess what? That doesn’t reflect for the risk of those revenues. So if you hold a lot of treasury securities or if you make construction loans of if you own CDOs, it makes a big difference in terms of the degree of risk you’re taking. January 13, 2010 So in summary, I consider this an industry on steroids. Performance was enhanced by excessive loan growth, excessive securities risk, securities yields, bank leverage. Excesses were condoned. Yes, they were conducted by bankers, but they were also conducted by accountants, regulators, government and consumers. The side effects were ignored, and there was little financial incentive to do anything about it. So we ignored the long-term risks. And I say we collectively. The solution, I say, is partly a function of A, B, C. A is for accounting. Let’s have greater transparency and more consistency. The B is for bankruptcy. We should allow firms to fail. The prudent should not have to subsidize the imprudent. And a terrible precedent for the decade was saving long-term capital in 1998. And the C is for both capital and capitalism. During the crisis we all realized that banks are as vital as our most precious utility. Imagine walking into the kitchen in the morning, turning on the faucet and not getting water. We were close to that in the banking industry. That can never happen again. So we need to have enough capital for the banks. The other part of the C is capitalism. And capitalism is about having good information to make decisions. It’s about allowing firms to fail. It’s about having markets over government allocate capital with prudent oversight and regulation. To me the crisis was not caused by capitalism. It was caused by a lack of capitalism. And one more point on capitalism—capitalism is about money, but it’s also about meaning. And for this I look no further than my cousin Andy, who is a captain in the Army. Andy is going from the Army in Iraq to business school in the fall. And here’s what he wrote to me. He said that he hopes that we as the world leader in capital markets can make sound investments that help less fortunate people provide for their family. To him he’ll continue his pursuit of peace and prosperity as he goes into business. And to cousin Andy, Captain Andy, as I would like to call him—he gave a reminder the larger purpose of financial services. And that is to improve people’s lives by helping to allocate scarce resources to where they can best be used. January 13, 2010 I would like to hear the CEOs remind people of this ultimate purpose more often. And I appreciate the commission’s efforts to find out the root cause of this crisis, to bring greater awareness to this mission and to facilitate its execution. I look forward to your questions when they’re done. CHRG-111shrg57322--976 Mr. Blankfein," Senator---- Senator Kaufman. I mean, the key thing to this thing is, if you were still selling securities, mortgage-backed securities, RMBSs, residential mortgage-backed securities, after you really had decided that this was a down market and were evidenced by selling short, I think that is what people are wondering about. " 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-111shrg56415--45 Mr. Tarullo," Right. When it comes to safety and soundness, every regulator---- Senator Corker. I mean, I think it would be wonderful. Let us face it. In the desire for policymakers to make sure people at every income level led the life of middle-class citizens, we promoted loan making that helped destroy our system. That wasn't the whole picture, but that certainly was a part of it. Are each of you as regulators saying that you are going to put out strong standards that really counter policymakers' desire to make sure that everybody in America has a home and a ham in their pot? Is that basically what you are saying you are going to do, because I think that is the only way, by the way, we are going to keep this from happening again, is it not? " CHRG-111shrg54533--22 Secretary Geithner," Senator, I would ask you to give me a chance to reflect on that more carefully and get back to you in writing with a more thoughtful response. But I will work with your staff, you and your staff and try to make sure we understand that risk and see if we can be responsive to that concern. Senator Akaka. Thank you. Too many Americans, Mr. Secretary, lack basic financial literacy. Without a sufficient understanding of economics and personal finance, individuals cannot appropriately manage their finances, evaluate credit opportunities, successfully invest for long-term financial goals, or even cope with difficult financial situations. One of the root causes of the current economic crisis was that people were steered into mortgage products with costs or risks that they could not afford. Mr. Secretary, the proposal indicates that the Consumer Financial Protection Agency will have important financial education responsibilities. How will the CFPA interact with the Financial Literacy and Education Commission and the President's Advisory Council on Financial Literacy? " fcic_final_report_full--291 COMMISSION CONCLUSIONS ON CHAPTER 14 The Commission concludes that some large investment banks, bank holding companies, and insurance companies, including Merrill Lynch, Citigroup, and AIG, experienced massive losses related to the subprime mortgage market be- cause of significant failures of corporate governance, including risk management. Executive and employee compensation systems at these institutions dispropor- tionally rewarded short-term risk taking. The regulators—the Securities and Exchange Commission for the large invest- ment banks and the banking supervisors for the bank holding companies and AIG—failed to adequately supervise their safety and soundness, allowing them to take inordinate risk in activities such as nonprime mortgage securitization and over-the-counter (OTC) derivatives dealing and to hold inadequate capital and liquidity. CHRG-111hhrg53242--2 Mr. Hensarling," Thank you, Mr. Chairman. For many of us here, we continue to feel like we are in an ``Alice in Wonderland'' moment, as we look at a piece of legislation that seems to want to give five unelected government bureaucrats the power to essentially ban consumer financial products, decide which mortgages Americans can have, and whether or not they qualify for a credit card. I had the opportunity yesterday in the House to introduce the guest clergy to offer the prayer. I saw once again over the Speaker's chair were the words, ``In God we trust.'' I fear for many on this committee, they now may want to change the words to, ``In government we trust.'' They have a lot more faith in government than I do. As I look again at the financial turmoil that we have in our economy, I think about Fannie Mae and Freddie Mac. Government really wasn't to be trusted there with that particular policy. I think about oligopolies that were in the credit rating agency. Government was not to be trusted there. I think about AIG and the head of OTS telling us that he had the supervisory capacity, he had the regulatory authority, but he just missed it when it came to AIG's credit default swap exposure. I am particularly concerned, as I look at this Draconian piece of legislation, how it will impact jobs in an economy that is seeing the highest unemployment rate in a quarter of a century--2.6 million people have lost their jobs since President Obama was sworn in. I am concerned about a credit contraction that can be caused by this regulator of consumer products. I am concerned about what may happen to derivatives that are used by those who want to finance our small businesses and our jobs to lower their risk. I am wondering what is going to happen to the cost, the greater cost of clearing these. The lack of the ability to customize them is going to cause many financial firms to no longer have the ability to lessen their risk, leading to less credit and fewer jobs in an economy that is drowning in unemployment. So Mr. Chairman, we have to take a very, very careful look at this rather radical Draconian piece of legislation before it is passed through this committee. I look forward to hearing from our witnesses, and I yield back the balance of my time. " FOMC20070321meeting--109 107,MR. POOLE.," Thank you, Mr. Chairman. Regarding the small handful of contacts with whom I’ve talked, my trucking industry contact finds things slightly better in February and March, but things had been very, very slow before that. The company has reduced its truck fleet by 300. My contact says that pricing is flat for the first time in six years; there is a tremendous amount of price competition. He says that he’s getting four times the usual number of bids. So the customers are shopping around hard looking for price concessions. He said things were just marginally better. Both the UPS and FedEx contacts had a similar message—that activity is coming in substantially below what they had anticipated. The overnight letter business is declining—it is down about 4 percent; the next-day package business is up about 4 percent. Those are the express products. The net of those is about zero or maybe 1 percent, and they had been expecting something on the order of 3 percent. So they’re revising down their expectations for this year but apparently not changing their underlying capital investment plans. However, my UPS contact, in particular, said that they are really scrambling now to reduce outlays. Essentially, their commitments for expenses are pretty well set in the short run, and so revenue shortfalls go directly to the bottom line. Therefore they are scratching around to reduce expenses. They are not replacing staff when there’s attrition, and they are cutting out unnecessary travel—all the usual kinds of things. They have reduced staff, focusing particularly on management positions, which they have reduced by 1,600. I’ve been reflecting on what we make out of the slower-than-expected capital spending, and let me summarize my position this way. I’m just uneasy about the outlook. If the Greenbook GDP outlook is wrong, I’m guessing we’re going to come in below it. I’m mindful, of course, of the standard errors going in both directions and so forth, and we could certainly have upside surprises. I’m just saying that I’m uneasy about that. I’m also uneasy about the inflation forecast—it could be on the high side or could hang higher—and I worry particularly because it’s the one that produces the most difficult policy situation for us, with output coming in below expectations and inflation hanging above target. That’s the toughest. That’s the classic policy dilemma situation. It causes the most pain. So that’s the one I concentrate on. It doesn’t seem to me that we’re likely to have a traditional recession. Money growth remains on the high side. In the past six months, M2 has been running about 7 percent, and MZM about 8 percent—that doesn’t look like a recession. If you think about the expansion phase of the cycle, with the exception of housing there were no big imbalances. We didn’t have the sort of dot- com and telecom over-investment that we had in the late 1990s. So what might be going on here? Well, it’s clear that businesses have an intense desire to see increasing profits quarter after quarter after quarter; and when you get a revenue slowdown, they go after costs, even if it might not be perhaps long-run profit maximizing, but they feel an intense pressure. Then you get a Keynesian kind of mechanism in which some people get laid off and some things get delayed and so forth, and that produces some declines in income, and it could lead to a prolonged soft spot in the economy. That’s the kind of process that I think may be under way. If that’s what’s happening, we’re going to have to be patient and let it work out. So that’s where I am right now. Thank you." CHRG-111shrg56415--47 Mr. Dugan," Yes. Senator Corker. And are each of you going to write standards that are dramatically different from those that got us into the situation? I mean, each of you agreed with Senator Gregg's questions, but I wonder if we are actually going to take action to make that occur. Ms. Bair. First of all, I want to clarify, there is plenty of bad underwriting. I want to emphasize that, the kinds of new credit problems we are seeing now are more economically driven. There was plenty of bad underwriting in both mortgage lending as well as commercial real estate. We have tightened the standards tremendously. I think we are being criticized in other quarters. Please note that we issued commercial real estate guidance in 2006. Senator Corker. Well, I---- Ms. Bair. The Federal Reserve Board has issued rules that apply to both banks and non-banks for mortgage lending that significantly tighten the standards. That already has taken place. Also, we are working on capital rules that will require greater capital charges against higher-risk loans, such as those with high LTVs. The bank regulators are doing all that, and have for some time. You still have a fairly significant non-bank sector, one that can come back as the capital markets heal. That is why I hope that, going forward, in terms of whatever reforms you come up with, that those reforms will reflect the fact that there are two different sectors, two different providers of credit in this country. We can keep tamping down on the banks as we have been. But if the non-bank sector is left, by and large, unregulated, that is not going to fix the problem. " CHRG-111hhrg55809--203 Mr. Bernanke," Well, under open-market operations, we normally transact in these markets. We buy and sell both treasuries and agencies; we are authorized to do that. And given the situation we are in with interest rates close to zero, it is now becoming a recognized approach of monetary policy to expand assets and a balance sheet as an additional way of providing support to the economy. And I think it is justified, not only narrowly by the authorizations for open-market operations but by the mandate that Congress gave us to try to maximize employment and achieve price stability. These are the only tools we have to try to achieve those objectives. I want to assure you that we have every means of exiting from the situation and avoiding inflation, even if we do not sell any of these assets. Mr. Miller of California. You can do it in other ways, then. " FOMC20080430meeting--122 120,VICE CHAIRMAN GEITHNER.," Mr. Chairman, I was wondering if Brian or Bill wanted to talk President Plosser out of his concern about MZM at some point. " CHRG-111hhrg54868--149 Mr. Green," Thank you. Mr. Price, did you get your concern addressed? Because I see that the two of you are very much concerned about this. Would you need an additional 30 seconds? You are good? Okay. Thank you. Let me thank all of you for appearing today. And I would like to first mention to you that ``too-big-to-fail'' in my world is the right size to regulate. Not only is it the right size to regulate, but as you approach becoming ``too-big-to-fail,'' I think you are the right size to regulate. I absolutely think that we must find a way to avoid another AIG. I cannot imagine doing nothing and allowing circumstances to manifest themselves again such that we will have another AIG. It would be unconscionable for us to do nothing. And it would be unconscionable for us to, under the guise of doing something, do nothing. It would be unconscionable for us to allow the paralysis of analysis to prevent us from doing anything. We do have to act. And I think that when Mr. Cleaver, in his defense, talked about doing something, I would hope that it would be presumed that he was talking about doing the right thing, as it has been said. I rarely find him suggesting that we do the wrong thing, in his defense. So having said this, let me just ask a few questions to see if we can agree on some things that are floating around that are not necessarily entirely true. CRA: Did the CRA cause the economic crisis that we are having to contend with? Chairwoman--by the way, I would have had Chairwoman, not Chairman, but if you-- Ms. Bair. Just not ``Chair Bair.'' I don't like that. " fcic_final_report_full--440 A persistent debate among members of the Commission was the relative importance of a firm’s legal form and regulatory regime in the failures of large financial institu- tions. For example, Commissioners agreed that investment bank holding companies were too lightly (barely) regulated by the SEC leading up to the crisis and that the Consolidated Supervised Entities program of voluntary regulation of these firms failed. As a result, no regulator could force these firms to strengthen their capital or liquidity buffers. There was agreement among Commissioners that this was a con- tributing factor to the failure of these firms. The Commission split, however, on whether the relatively weaker regulation of investment banks was an essential cause of the crisis. Institutional structure and differential regulation of various types of financial in- stitutions were less important in causing the crisis than common factors that spanned different firm structures and regulatory regimes. Investment banks failed in the United States, and so did many commercial banks, large and small, despite a stronger regulatory and supervisory regime. Wachovia, for example, was a large insured de- pository institution supervised by the Fed, OCC, and FDIC. Yet it experienced a liq- uidity run that led to its near failure and prompted the first-ever invocation of the FDIC’s systemic risk exception. Insurance companies failed as well, notably AIG and the monoline bond insurers. Banks with different structures and operating in vastly differing regulatory regimes failed or had to be rescued in the United Kingdom, Germany, Iceland, Bel- gium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark. Some of these nations had far stricter regulatory and supervisory regimes than the United States. The bad loans in the United Kingdom, Ireland, and Spain were financed by federally-regulated lenders–not by “shadow banks.” Rather than attributing the crisis principally to differences in the stringency of regulation of these large financial institutions, it makes more sense to look for com- mon factors: • Different types of financial firms in the United States and Europe made highly concentrated, highly correlated bets on housing. • Managers of different types of financial firms in the United States and Europe poorly managed their solvency and liquidity risk. CHRG-111hhrg54868--148 Mr. Scott," Chairman Bair, and just before I get to Mr. Green, as we both pointed out, we both represent Georgia. There is a particular problem with Georgia. And some of us feel very strongly, as the gentleman from Georgia, Mr. Price, has said that there is more that the FDIC can do to help us in Georgia. And there are things that they might not be doing that are helping to cause the problem in Georgia. There are just too many banks closing in the State of Georgia, and we want to put a stop to that. I would appreciate it, and I am sure the people of Georgia would appreciate it very much if the FDIC could review how they are dealing with the banks in Georgia to work with a plan to see if we can't stop this very terrible pattern. Because it is just not fair nor right. Thank you. Thank you for that. I wanted to get that out. I now recognize the gentleman from Texas, Mr. Green, for 5 minutes. " CHRG-110shrg50418--36 STATEMENT OF SENATOR EVAN BAYH Senator Bayh. Thank you for your leadership, Mr. Chairman. Senator Stabenow, it is good working with you again. That is what friends and neighbors are for. But, of course, where I am from, we kind of consider Michigan to be part of Greater Indiana, so however we define it, it is good to be working with you. And to our witnesses, it is good to see you here today. At least one of the witnesses, Mr. Chairman, was born in the State of Indiana. Ron, it is good to see you again. These are historic times. We face what the Chairman of the Federal Reserve has described as the greatest financial panic since the 1930s. That has contributed at least in part to the greatest real downturn in the economy since at least the early 1980s, possibly before then, and this is really the first significant economic downturn since the advent of globalization, which means rather than having some parts of the world growing more rapidly to serve as a countervailing force to weakness here, instead, weakness in one part of the world begets further weakness and it runs the risks of an accelerating downside to economic growth around the world. So these are unprecedented times. This has led our government to take a variety of unprecedented steps, none of which will be found in your Economics 101 textbook. We have intervened in the banking sector, taking significant equity stakes in the largest banks of our country. We have intervened in the insurance sector, virtually taking over one of the largest insurance companies, not only here but anywhere in the world. We have essentially taken over Fannie Mae and Freddie Mac, the GSEs. We have moved to stabilize the money market system. We are looking at the credit card situation and student loans. We are even now debating whether entire States and municipalities may need financial assistance from our government to weather these unprecedented and unpredicted times. All of this has led to a great deal of instability, fragility, and an unpredicted situation, and so my own view, Mr. Chairman, is that there is so much that we don't know, but this is not the time to add greater instability to this situation, more unknown to this situation. I am reminded of decisions that were made earlier in the year when the decision was made to rescue Bear Stearns because the thought was that the systemic risk was too great. Subsequent to that, the decision was made to not intervene on behalf of Lehman Brothers because the systemic risk was perhaps--was at that time thought to be not so great. Well, with the benefit of hindsight, I think if we had to do it over again, perhaps that situation would be addressed a little bit differently and the taxpayers, the overall economy, and the financial system would have been better served. My point simply is, if we allow tens of thousands of ordinary people to lose their jobs, thousands of small businesses, suppliers, dealerships, and others to be imperiled, three of the largest corporations in the company to run the risk of going down, it will have unintended consequences, none of them positive and some of them quite possibly severe. This is probably not the right moment in our economic situation to allow such a state of affairs to take place. Now, having said that, as my colleagues have outlined, that doesn't mean we should just do anything. I am delighted, Mr. Chairman, that we have the major stakeholders here. All of you need to step up and make contributions to setting this right. Otherwise, we are not going to be able to get the job done and the help might not be forthcoming. Fortunately, and the final thing I will say is that we do have a model to build off of, and one of my colleagues had mentioned this previously, and that was in 1979 with the Chrysler Corporation. In that particular case, all the stakeholders did step up. The right decisions were made. And the net result was that the taxpayers, or the jobs were saved. The company was saved. The taxpayers were repaid ahead of time, and I think, Tom, you mentioned that taxpayers actually generated a profit. That is not why we are in the business, but it does go to show that if we do this correctly, Senator Stabenow, it can be a win-win-win situation. Mr. Chairman, I am grateful for your leadership in helping to bring that outcome about. " CHRG-111shrg62643--156 Chairman Dodd," Thank you very much, Senator Menendez. Let me, if I can, Judd Gregg, who I have a lot of respect for, raised the issue that uncertainty in fiscal policy was the, as he sees it, is one of the reasons for the lack of activity here. I am wondering if it is also--I mean, it seems to me that you are getting businesses with this low-growth capacity, where they are just--the demand isn't there. It seems to me that is as much of a factor here as anything else. I wonder if you might comment on that. Again, I am not trying to engage you into taking a side on this debate one way or the other. I think there is clearly some uncertainty out there, as you have described it. But it seems to me, as well, if people aren't--there isn't the capacity, the growth capacity, there is no demand. Therefore, people are not--the economy is not growing. How much of this can describe that? " CHRG-111shrg57320--385 Mr. Doerr," Well, if you went back to what Mr. Dochow mentioned of high-net-worth borrowers and it is limited to that, I can see some circumstances where a person has $100,000 worth of securities that they own free and clear, you might not worry about what their income is. But other than a situation like that, stated income is probably not right. " CHRG-109hhrg23738--163 Mr. Greenspan," Thank you. Mr. Davis of Alabama. I want to ask you about the phenomenon of globalization, because one of the things that strikes me is that when you have talked about it and when a lot of people in this room have talked about, it has been in terms of an either-or kind of dynamic. You have had people on the left, if you will, or even the extreme right, who have taken the position that globalization is counterproductive, is unfortunate; and you have taken the opposition position, I think the responsible position, that globalization is a good thing, that redounds in our favor. But it strikes me that, frankly, for those of us who were voting on these agreements, it is not an either-or proposition in terms of globalization or nonglobalization. There is a third place, and that third place is the kind of pro-trade policies we are going to have. It strikes me that there are two kinds of pro-trade policies that one could have. One kind would spur other countries toward reform. One kind would spur other countries to allow the right to organize or to adopt a regimen or regime that prevented child labor or to take discrimination against women more seriously. And, frankly, another kind of pro-trade policy essentially leaves these governments and these countries as they are. I have not heard you talk a lot about that kind of distinction. So I want you for just a moment--and I will have another question; I will ask you to respond to them both, one after the other. But I would like you for a moment to talk about whether or not it would be somehow detrimental to our economy and detrimental to the concept of globalization if we had included conditions in some of these agreements that would deal with the absence of child labor laws, that would deal with the absence of sex discrimination laws, or would deal with the right to organize. Question number one. Second set of questions has to do with the phenomenon of tax cutting. It, too, has been advanced in terms of an either-or dynamic: people on my side of this room, who say the tax cuts have been too big, they have been too outsized; you, and people on the other side of the room, have said that, ``Well, the tax cuts have been good; they have been the right size to provide stimulus to our economy.'' I am wondering again if there is not a third approach: if we could not have had a series of tax cuts that were distributed and aimed more toward the middle class, more toward the people whose wages have been stagnant the last several years, and I am wondering if we could have cut taxes much more dramatically for the middle class if we could have provided more tax relief for those Americans who are struggling day in and day out without imperiling the stimulative impact of the tax cuts as a whole. So can you comment on those two sets of questions? " CHRG-110hhrg45625--20 Mr. Barrett," Thank you, Madam Chairwoman. Thank you, Ranking Member Bachus. I firmly subscribe to the belief that Main Street and Wall Street are inextricably linked. Instability in the financial markets leads to instability in taxpayers' retirement accounts, pension funds, and people who are concerned about if and how their jobs, student loans, and car loans will be affected. The caliber that flows through our financial markets is vital to the continued success of our businesses large and small. We should all agree that a failure of our credit markets could and would be catastrophic. However, I am not convinced that the Treasury's plan to purchase $700 billion worth of illiquid assets is the solution. And I am not sure that this proposal gets to the root of the problem. I fear that it will only treat the immediate symptoms. While I understand that these are symptoms, and the symptoms that would shut down the credit markets are potentially disastrous, I worry if we go forward with this plan we will have to come back again and again with more and more money to treat symptoms that may pop up. We instead need to treat the cause of the problem which may be long and possibly painful. The whole crisis started around a type of credit, subprime mortgages, and it still resolves around this debt. Mortgage-backed securities and other debt instruments are the root of this problem. We need to do something to restore access to credit, which means more debt. But the proposal brought to us involves even more debt, the government borrowing another $700 billion. Consumers, like the government, have borrowed too much. We must cut government spending. We must also institute pro-growth policies to help our economy grow so that Americans and their government can get out of debt. It makes sense that when people have good jobs they do not need to borrow as much, whether to buy a mortgage, a home, credit card, pay for school supplies, or even gasoline. Too much of our recent economic growth has been built on debt. We see that businesses have been massively overleveraged as American consumers have. If debt was at a safe level, we would never have been in this fix in the first place. When consumer spending makes up 70 percent of GDP, I think that indicates an unsustainable form of economic growth, especially when it is financed by credit card debt and increasingly unaffordable mortgages. We need to start producing, whether that is energy, computers, or intellectual property. I think the road map to get us there is pretty clear. We must shore up our balance sheet, we need to reduce our capital gains taxes to spur investment, we need to reduce our corporate taxes which are among the highest in the world, and we must move toward energy independence as high energy prices are increasingly a dangerous drag on this economy. We should take this opportunity to do the right thing and help America grow in the long run. I appreciate that there is a panic in the market, but policies derived from panic are never sound. I strongly believe in the superiority of the free market and the ability of the markets to correct themselves. However, the government does not and has not always had a role in ensuring the market's function to correctly and efficiently make sure that we are free of fraud and malfeasance to minimize market failures. For example, we are all familiar with the important role that the FDIC plays in insuring bank accounts. I think that we should be more actively exploring other options where the government can take a role in helping the credit markets find order, but allow the free market to do most of the heavy lifting and provide more capital. One option that should be explored in greater detail is to allow the private entities, private equity, hedge funds, and other partnerships to participate in a competitive bidding process for the distressed assets that will be off-loaded by banks and other financial institutions rather than having the Treasury as the only potential buyer. This proposal should include a traditional auction which might include the government as well as other qualified buyers, with the assets going to the highest bidder. There is no doubt that we find ourselves in a precarious situation, but like many of my colleagues, I think it would be a mistake to rush into a huge new expenditure. Just as the markets are now panicking, the government does not need to do so, too. Thank you, Madam Chairwoman. I yield back. Ms. Waters. Thank you. The gentleman from Missouri, Mr. Cleaver.STATEMENT OF THE HONORABLE EMANUEL CLEAVER, A REPRESENTATIVE IN CHRG-110hhrg46594--489 Mr. Sachs," Congressman, we are quite overwhelmed right now in our economy and management to be able to manage a very delicate operation with thousands of firms and suppliers and a catastrophic headline of a bankruptcy of one of these companies. My view is it would be an unbelievable gamble under normal times and unthinkable right now. So I just wouldn't go that way at all for this under the conditions of recession verging on collapse. We don't have the bandwidth right now to handle another crisis of that magnitude and to negotiate that. If in 6 months or 9 months the situation is spiraling downward, and the $25 billion was not enough, you are going to come to one of those. But this is not the time to come to it right now. " CHRG-111hhrg56778--100 Mr. Garrett," And so what I take from this, and I heard some of the testimony from the rest of you earlier on, is this all sort of supports my opening statement, which is good at the end of the day, right, is that it's not a gap situation here and I appreciate your testimony on this. There's not a gap in the structure of what we have here. It sounds like you all are talking to each other doing the oversight in that responsibility; obviously, we have some concerns. I don't know where you were specifically at the time, but folks who had the responsibility at that time at OTS in this areas, so it sounds like the overall structure is there. So it's not a gap issue. And it sounds as though that since the problems weren't on the insurance side, per se, it's really something that we need to come back with and we need to do this in a whole bunch of other areas. We haven't had any hearings on the SEC, and I know that's not your bailiwick. But we have to go back on a whole bunch of these other areas just to make sure that the actual execution or implementation of what's already out there, whether it's the SEC or whether it's you folks at the Fed. Or whether it's you folks on the State level, or, just actually implementing it in each case to the highest degree possible to try to avoid what we have in this past situation. Does that sound right? " CHRG-111shrg57320--99 Mr. Rymer," Yes, sir. It is clear to me that they should have. I think the FDIC, by requesting back-up examination authority in 2005, 2006, 2007, and 2008, indicated that they had concerns and those concerns were principally driven by its own LIDI analysis. Not to go into too much detail, but the LIDI analysis is looking a little bit broader, at broader indicators than just the internal operations of the bank. It is looking at competitive factors and macroeconomic factors in an attempt to identify the risk that a failure would cause a loss to the DIF. So there is no question in my mind that the FDIC's request for back-up authority, simply given the sheer size of WaMu, was, to me, enough reason for FDIC to ask for back-up authority. Senator Levin. And Mr. Thorson, are you familiar with these documents? " FOMC20070810confcall--7 5,MR. LACKER.," The other one is, How late in the day do you think you can do an RP operation? Then a third question I have has to do with the RP market in general. I’ve heard about asset-backed paper going into RP programs instead of outrights, and I’m wondering whether that’s affecting trading in the RP market and whether there are RP spreads for different collateral. What are you hearing about that?" CHRG-110hhrg46596--111 Mr. Neugebauer," But the question is, then, were we trying to--you say this is a healthy bank program. Many of these banks said they would not have ever probably participated in this, but, you know, it is kind of like, if the candy jar was out there, I think we should go and get some of those. So we have banks probably that are very healthy, very stable, still they were making loans, participating in the market, but now we have encouraged them to participate in this program. And so I kind of wonder how that is addressing the market. " FOMC20081007confcall--11 9,MR. LACKER.," I want to ask you about the LIBOR spread. It's pretty striking, but I'm wondering, Do you have data on the quantity of borrowing that's going on in that market and what that LIBOR figure really represents? We have a bank in our District that reports on the LIBOR panel but reports borrowing at 100 to 150 basis points below it. " FOMC20060328meeting--112 110,CHAIRMAN BERNANKE.," Speaking of the largest hole ever dug in history, I wonder if you would have a view on the current account implications of some of this offshoring that you’ve been talking about. Are you concerned about that?" FOMC20050809meeting--40 38,CHAIRMAN GREENSPAN., The big question is who is buying the securitized versions of these. I can understand that there are originators who get the fee and then sell it on to X. I always wonder: Who is X? FOMC20080916meeting--40 38,MR. FISHER.," Mr. Chairman, I was going to say that we had this discussion before. We did approve the swap lines. I wonder if you could just summarize for us what you view as the downside risk to our doing this. " FOMC20081029meeting--270 268,MR. KOHN.," Thank you, Mr. Chairman. Like President Yellen, I support alternative A, the 50 basis point cut. I think it's the right response to the very, very substantial change in the economic outlook since the last meeting. We would have cut the nominal federal funds rate by 1 percentage point and real federal funds rates by something less than 1 percentage point depending on what you think is happening to inflation expectations. But surely inflation expectations are coming down--and coming down substantially. I think the incoming information, the weakness before the shock hit in mid-September (which to me suggests that we didn't have any insurance against that weakness at the time), the extraordinary tightening of financial conditions, and the downshift in spending that we've seen since mid-September all suggest that a 1 percentage point cut in the real rate, and even a little less than a 1 percentage point cut, would seem a very modest and moderate response to the shock. It's probably a down payment. If the staff is right, we will need more. I built more into my own forecast. But even if the economy is not as weak as the staff has built into the Greenbook, I think a substantial cut in the federal funds rate is entirely appropriate. All of us--without exception, I think--said that there were downside risks to their forecasts, and a number of us have cited the possibility of a very deep recession here. So I think we need to take action. We are starting with a situation in which the economy is declining. We are in recession. The unemployment rate is rising. Inflation is falling. There is a global recession in train. It seems to me, from a risk-management perspective, that the costs of not doing enough--the costs of being reluctant to lower rates and making that situation worse--are far larger than the costs of going a little too far because things turn around faster. I think we are in a situation in which it is almost impossible at this point to go too far. Mr. Chairman, we may have to take it back at some point in the future, but right now I think the 50 basis points is absolutely justified by the conditions in which we find ourselves. I was drawn, as the Vice Chairman was, to the staff simulation having to do with a more rapid financial recovery. I myself think that's a very small probability. But even if that's what happens, we'll know by December whether the financial markets are recovering faster. We can stop at 1 percent, if we're getting that recovery; and the outcomes, as the Vice Chairman noted, really aren't that bad in that recovery. So I think that even the small probability of a very sharp turnaround in the markets is still consistent with cutting rates another 50 basis points at this meeting. The fact that we are already low is not a reason to hold back. I don't agree with the ""keeping the powder dry"" kind of argument. I think the lessons of history, including from Japan, are that the closer you get to the zero lower bound the more aggressive you should be. If you let weakness build, that weakness will overwhelm your policy tools. The most effective use of the limited scope for policy easing is to be preemptive and stop weaknesses from building. I think a 50 basis point easing will have beneficial effects. I don't think that the markets will react very much. We won't see those beneficial effects. But if I can compare it with doing 25 or nothing at all, I think doing 25 or nothing at all would have adverse effects. With 25 or nothing, you'll get longer-term rates up, you'll get stock prices down, and you'll get an erosion of confidence at a time when we don't need it--that the central bank doesn't get how serious this situation is. I agree that the last easing was largely offset by the loss of confidence and the rise in uncertainty. I also agree that it might not feed through as directly and completely as it often does because banks are trying to rebuild and lenders are trying to rebuild profit margins. But I still think it will be effective. As I say, I convinced myself of that by asking about what would happen with the alternatives, and I think the alternatives would be far worse. We need to keep fine-tuning the TARP and the liquidity provision. We need fiscal stimulus. I agree with all of that. We need to move on lots of dimensions. But these things will not be sufficient in and of themselves to counter this. Monetary policy is a fairly blunt instrument, but we need to stimulate the spending wherever we can to do this. Some have expressed concern about circumstances forcing us to ease between meetings. We have done 50. Will that take us further? I think we need to make clear in our statement and our minutes--particularly in our minutes--that we do expect a weak economy going forward, at least a moderately softer economy, and that the process may call for further easing. I think it will call for further easing at the next FOMC meeting, but we can get to the next FOMC meeting and see. But it should take a substantial and unexpected deterioration relative to that path to justify an intermeeting action. So I think we are absolutely right to have a prejudice toward taking actions at meetings, when we can sit around and discuss things. The odds are high that we will need to go further, but we should do that at a meeting if we can. If we do have a very strong and substantial deterioration even relative to our weak outlook and we do end up moving between meetings, surely that move would not put us at a level that is unjustified by the circumstances. So I think we can deal with the intermeeting situation and not have the pressures of the market, the pressures of expectations, get us to a level at which we're ultimately uncomfortable. In short, I think it's a very serious situation. We need to do all we can to counter this situation. Now is not the time to hold back. Thank you, Mr. Chairman. " FOMC20080929confcall--39 37,CHAIRMAN BERNANKE.," Thank you very much. I'm going to excuse Bill if he wants to go. There he goes. [Laughter] All right. Let me turn now to the second item, which is a briefing by Scott Alvarez, who as I said worked all night on the Wachovia situation. If President Lacker would like to add anything, he is certainly welcome to do so. Scott. " CHRG-110hhrg44901--68 Mr. Baca," Well, let me ask you the other question before my time runs out. You mentioned the housing sector together with the oil is the heart of the current economic uncertainty. How would we eliminate the uncertainty and cause people to have a greater degree of confidence? And should we do something to address the market speculation in oil to help drive down the gas prices? " CHRG-110shrg50416--95 Chairman Dodd," Thank you, Senator, very much. Senator Corker? And let me just say for the record, too, I want to thank Bob Corker. During those 13 days, there were a number of people--obviously, everyone was involved, but some more adamantly and directly than others, and Bob Corker was one of them. I just say, we would not have gotten to that final result without your help and support, so I appreciate it personally and I want to say publicly how much I appreciate your involvement. Senator Corker. Thank you, Mr. Chairman. I very much enjoyed it and want to work with other Members of this Committee all the way through this process. I know the implementation is equally important to the legislation, and then coming back in January to regulate appropriately. We have a 20th century regulatory system and I think we understand that and we will be focused on the 21st. I look forward to being hopefully equally constructive, and I thank you. I do want to maintain the focus on the fact that certainly housing prices have shown problems in our financial industry. I think the exuberance, if you will, that we had in the housing industry for so many years, you know, most people could probably see that at some point, this had to fall. I mean, it was crazy, what was happening,especially in some of the States like California and others where people were paying three and four times just over a few years what they were paying before. We knew there was going to be a decline, and I hope we will maintain our focus on the fact that, really, this whole issue around foreclosures today has to do with the way financial markets work now. It is no longer the case of people going into their local financial institution and having a loan with their local banker that they see at the Rotary Club or other places and maintaining that relationship, and if they get behind, they have the opportunity to talk with them about that. That just doesn't exist now, and so that is one of the frustrations, I know. The other huge issue, obviously, are these exotic derivatives and other kinds of things that exist that no one knew existed, and candidly, we wouldn't be having this hearing today, I don't think, if it weren't for that. So that is really, when we are talking about the root of the problem, it is sort of the chicken and egg, I guess, but I hope that that is where we will maintain our focus over the next year or so. Now, having said that, this foreclosure issue, I listened to Senator Schumer's comments, and candidly, in fairness, I do think most of what we are doing is hope. I mean, the way the disconnect exists right now between the borrower and the lender is so confusing that the average citizen who gets up every day having to work and raise kids, I mean, it is hope, and I understand that, and I think at some point we will be looking at this in a different way than we are right now. I appreciate so much your efforts, Ms. Bair. In the conversations we have had, I think you have addressed the FDIC insurance issues appropriately all the way through. I did hear you mention stabilizing. I think foreclosure is a problem and I think we need to figure out a way to deal with that. Stabilizing, I don't know. That bothers me some. I think, unfortunately, there is a ways for that to fall now. We still have not hit bottom and I think anything we do that is stabilizing in ways that don't make sense really just caused the market to be sluggish for a long, long time. And I am wondering if just very briefly you might respond to that. Maybe you were just talking about foreclosures. Stabilizing--the word ``stabilizing'' bothers me some because I think we move into a prolonged time of sort of fictitious prices that don't allow us to hit bottom as quickly as we should, and I wonder if you might expand on that. Ms. Bair. Yes. The markets need to correct. We do need to find the bottom. And markets will eventually find the bottom. What I am concerned about is that we are going to overshoot because we are in this self-reinforcing cycle now where economic decisions to modify loans are not being made. It may be in everyone's economic self-interest to modify that loan, but it is still going into foreclosure because of skewed economic incentives, in large part stemming from the different interests in the securitization trust. So loans that economically should not be going into foreclosure are, which is creating more downward pressure on home prices, which is creating more distress in the housing market, which is creating more need for foreclosures---- Senator Corker. So it is really more on the foreclosure point---- Ms. Bair. It is absolutely. Senator Corker. OK. Ms. Bair. That is exactly right. Senator Corker. And I think we have had a lot of discussions. I know even Chairman Dodd alluded to some of the meetings we had. There are some politically--there have been in the past some politically unacceptable ways of dealing with that for both sides to come together, but I think at present, we all understand even prescriptive things are not going to solve this until we get to a point where the lender has some ability to quickly deal with this issue, and I don't want to expand on that right now. We might do that some more privately. Ms. Duke, we are going to be dealing with a lot of unintended consequences. I mean, at the end of the day, any time there is government intervention, there are unintended consequences, and I think that is going to be one of the biggest issues we deal with during implementation and even beyond. I know you have already been asked one question about that from Senator Menendez, but we are having some issues where, let us face it, manufacturing is a very important part of our country's employment. We have had stress on manufacturing for years now. We have actually had a little bit of a breakthrough over the last 6 or 8 months just because the value of the dollar is changing some now. But at the end of the day, you all are doing some good things and you are taking A1/P1 paper here, I think, beginning very shortly. You have just set up a facility to do that. What that means is that manufacturers that have A2/P2 paper are getting nailed, and all of a sudden, they have got like a 500 basis point problem that they are dealing with. I have talked to Chairman Bernanke about that. I wonder if you could just bring us up to date as to what might be happening, because we have one manufacturer that has A1/P1 and all of a sudden they are good because you are taking them. We have A2/P2, and all of a sudden they are at a 500 basis point disadvantage and basically getting ready to lay people off. And I am sure you have some way of solving that very soon. I am looking forward to hearing what that is. Ms. Duke. Senator, I wish I could tell you I had a way to solve it immediately. The objective behind the commercial paper programs and the A1/P1 are to get the markets for commercial paper moving again. The objective is that once they start moving, then that will move the other parts of the market, as well. But we are monitoring all parts of the financial markets and looking for ways to unclog the pipes, if you will, on all parts of the market. We are aware of A2/P2. We are aware of a number of different markets where they are having difficulty. The other thing I would say, unfortunately, for many years, risk was not priced, and so I think for all borrowers and all issuers, even when financial flows return to normal, pricing is going to be higher than it was a couple of years ago, but we are working---- Senator Corker. For both A1/P1 and A2/P2? Ms. Duke. For all borrowers. And as I said, we are watching them. We are operating within our own restrictions in terms of credit risk that we can take. We are addressing that in terms of collateral that we take at our discount window borrowings in every way that we can. Senator Corker. We think you have the ability to take the A2/P2. I hope that very soon you will figure out a way to deal with that appropriately, and I very much understand what you are saying about the risk and I think it is very good that you send that signal out now, that at the end of the day, risk wasn't being priced and borrowing costs probably are going to have greater spreads in them than they have had in the past. Just briefly with Mr. Montgomery, I know we are running out of time and Ms. Bair has a board meeting. Mr. Montgomery, I think it is really great that we are increasing through FHA the amount of lending that is occurring. I hope that that is not occurring because banks are dumping their worst loans on the FHA and that we are going to have another hearing down the road dealing with that. I don't know if you would take 15, maybe 10 seconds to respond to that, but I just want to throw that flag out there and thank you for your actions but hoping that you are not taking us down the road of other problems down the road. " 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-111hhrg52400--203 Mr. Grayson," Thank you, Mr. Chairman. I don't want to talk to you all or ask you any questions today about whether we should have a Federal regulator versus State regulators for insurance. I do want to talk to you and ask you questions about the subject of systemic risk. You are a panel of members who are here to represent the insurance industry. And I would like to start with a very simple question. Assume that systemic risk reflects the idea that the failure of one particular company would cause its creditors to also fail to go bankrupt, and reverberate throughout the financial system to the point where there is a dry-up of credit nationwide, or even worldwide. The first question I want to ask you--we will start with Mr. McRaith--is which companies does that describe? In other words, which existing companies pose systemic risk if they fail? " CHRG-110hhrg44901--111 Mr. Cleaver," That question actually was a setup for the next question. And to some degree it may have been asked in various forms. Each night since this has started I have been taking piles of stuff home and reading it and essentially dropping a rock down in a well, and I have been waiting to hear the sound of a splash and I haven't. I am wondering if you have. I mean, is there a bottom? And if so, how long before we hear a splash? My concern, the airline industry is now hemorrhaging and crying. It appears as if, you know, one--we are having a domino effect. And you know I think as the cries go up, more and more people are becoming afraid. I used to say that we had a transportation-based economy. Now I am wondering if we have a confidence-based economy. Help us, please. " CHRG-111shrg61651--45 Mr. Johnson," If I may, Senator, in the whole discussion of resolution authority, if I could just speak from the perspective of my previous job at the International Monetary Fund, that the hottest issue is the cross-border resolution. I think all the firms that are represented here and most of them sitting behind me are cross-border firms with massive, complicated international pressures. One thing we learned from the failure of Lehman is that regulators have just different statutory frameworks. There is a massive conflict over that. And the only way around that, at least on an interim basis, is to have a conservatorship, which is not exactly failing. That is the Government putting in money into AIG type situation. Unless you have cross-border authority---- Senator Shelby. That is what these two Senators I mentioned have in mind, but they can speak for themselves. " fcic_final_report_full--437 The dangerous imprecision of the term “shadow banking” Part II of the majority’s report begins with an extensive discussion of the failures of the “shadow banking system,” which it defines as a “financial institutions and activi- ties that in some respects parallel banking activities but are subject to less regulation than commercial banks.” The majority’s report suggests that the shadow banking sys- tem was a cause of the financial crisis. “Shadow banking” is a term used to represent a collection of different financial in- stitutions, instruments, and issues within the financial system. Indeed, “shadow banking” can refer to any financial activity that transforms short-term borrowing into long-term lending without a government backstop. This term can therefore in- clude financial instruments and institutions as diverse as: • The tri-party repo market; • Structured Investment Vehicles and other off-balance-sheet entities used to in- crease leverage; • Fannie Mae and Freddie Mac; • Credit default swaps; and • Hedge funds, monoline insurers, commercial paper, money market mutual funds, and investment banks. As discussed in other parts of this paper, some of these items were important causes of the crisis. No matter what their individual roles in causing or contributing to the crisis, however, they are undoubtedly different. It is a mistake to group these is- sues and problems together. Each should be considered on its merits, rather than painting a poorly defined swath of the financial sector with a common brush of “too little regulation.” BIG BANK BETS AND WHY BANKS FAILED The story so far involves significant lost housing wealth and diminished values of se- curities financing those homes. Yet even larger past wealth losses did not bring the global financial system to its knees. The key differences in this case were leverage and risk concentration. Highly correlated housing risk was concentrated in large and highly leveraged financial institutions in the United States and much of Europe. This leverage magnified the effect of a housing loss on a financial institution’s capital re- serve, and the concentration meant these losses occurred in parallel. FOMC20080130meeting--78 76,MR. EVANS.," Thank you, Mr. Chairman. I have a couple of questions that are somewhat different. On the labor front, I'm curious if you could offer some thoughts on how deterioration in the labor market might be coming about--whether or not it would be from the hiring front or the job-destruction front. As the research literature has evolved over a long time, I think it has moved a bit away from job destruction playing the key role and more toward reductions in hiring. I wonder how this informs the way you look at the data. Any insights you have into that would be quite helpful. Then I wonder if you could just talk a bit more about the interesting memo that was distributed on inflation compensation and the implications for expectations. As I read it, it seemed to indicate that inflation expectations, if anything, were coming down from the five-year forward but that inflation compensation was higher. So does that mean that the variance of inflation is higher? Are people talking about the possibility of disinflation during this period? I would expect it to come with that type of compensation. Your thoughts on that would be great. " CHRG-111shrg55117--31 Mr. Bernanke," Well, the stress test did that, to some extent. We did a 2-year, forward-looking analysis and we included commercial real estate, all different categories of assets, and tried to project loss rates, and we concluded for the banks that, quote, ``passed the test,'' we concluded that without new public money and with these heavy losses still to come, that they would at the end of 2 years still be well capitalized. And so that was essentially as much of an endorsement as we could give. I don't think we can unequivocally say that no public money will come in under any circumstances because there could be situations of systemically critical firms which, you know, for one reason or another are on the verge of failure and we need to consider whether or not the cost to the broad system of allowing a disorderly failure outweighs the cost of putting more Government capital in. So I don't think it would be reassuring to the market to say that there is no more capital under any circumstances. But what we are trying to do is point out that there are institutions which seem to be in a situation where they are unlikely to need any further Government assistance. Senator Bennett. Looking at the economy as a whole, getting into is this a ``V'' shape, a ``U'' shape, a ``W'' shape, or an ``L'' shape kind of thing, we have seen inventory liquidations, and that was inevitable. When the whole world economy fell off the cliff, there were a lot of people who had excess inventory and they liquidated it and thereby did not help stimulate the economy. Now the liquidation seems to be over in many areas in the world, so new manufacturing, new products have to be produced to meet the demand. My sense is that in the contracted world we are facing, the demand is not at the level that it was before and that argues for more of an ``L'' shaped kind of circumstance. Yes, we have hit bottom, but what signs do we see that we are going to come back up, particularly if the American consumer, which is the driving force really for the whole world, because the economic model of the Chinese and the Indians and the Koreans and so on and Japanese are following, let us produce to sell to America. If the Americans can't afford to do it or the Americans aren't willing to do it at the same levels they were before, the whole world economy remains in kind of an ``L'' shaped circumstance. Could you respond to all that and give us your sense of where we are with respect to inventory liquidation and further manufacturing and consumption? " CHRG-111hhrg53245--119 Mr. Zandi," Right. If I were king for the day, I would design it differently. I would think that a model where the regulatory function was in a separate entity, that was a systemic risk regulator that was separate from the Federal Reserve would make the most sense. I think in the context of where we are starting from and just the practicality of the situation, I think the most logical place for that to reside is the Federal Reserve. " CHRG-111shrg50814--42 Mr. Bernanke," Two points, Senator. First, we did not choose to let Lehman fail. We had no option because we had no authority to stop it. But second, I do believe that the failure of Lehman Brothers and its impact on the world financial market confirms that we made the right judgment with Bear Stearns, that the failure of a large international financial institution has enormously destructive effects on the financial system and consequently on---- Senator Bunning. In other words, there are too many--there are some banks that are too big to fail? " CHRG-111shrg55479--112 Mr. Castellani," It is very important. Senator Corker. ----and I just wonder if, since I think we have got pretty good input from you all in these other areas, what are your thoughts, in whatever order you want to give them, on the risk committee issue? " CHRG-111hhrg53244--321 Mr. Grayson," Thank you, Mr. Chairman. Chairman Bernanke, I am looking at the report that you handed out this morning. And I was wondering if you could take your copy and turn to page 26. " CHRG-111hhrg51698--320 The Chairman," What do you say to the folks that are saying the world is going to come to an end and that these CDSs have been a big help in all of this, and what we are doing here is going to make matters worse because these things have been wonderful and provided liquidity? What do you say to that? " CHRG-111shrg57709--150 Mr. Volcker," I do not want them to be diverted from those activities. Senator Reed. And I wonder, Mr. Chairman, can you--and you have, but can you once again sort of stress how this proposal would focus them on those activities? " CHRG-110hhrg46596--147 Mrs. Biggert," Well, you know, I applaud the exercise of authorities other than the capital injection. But I wonder why the government didn't implement a program where it is the insurer of first resort, and not secondary. " FOMC20060629meeting--26 24,MR. LACKER.," Thank you very much. I appreciate that. I have one separate question for David Wilcox. In exhibit 9, “Pass-Through of Energy Prices,” the middle panel reports on some empirical work. When I try to find the counterpart in the model economy for the empirical exercise you do, it’s hard to picture it not having embedded within it a policy reaction function. So I wonder, are you happy with our interpreting these numbers as measures of our credibility in some sense, or do you have changes relating to this consideration over time? I mean, isn’t that what you’re measuring here?" FOMC20070807meeting--28 26,MR. DUDLEY.," I guess I would characterize the situation as people having lost faith in the structured-finance product, especially the high-grade AA/AAA product that they thought was safe and therefore not subject to much market risk or liquidity risk. They found out otherwise, and so there is a total reevaluation of that market. As a consequence, since the vehicle that was used to turn non-investment-grade corporate debt and into investment-grade debt is sort of broken, now they have to sell a lot of non-investment-grade debt directly and find people who are willing to hold it. So I think about the situation as that demand has lessened at a time when supply, just by bad luck and timing, is exploding. The market should clear, because the fundamentals in the corporate sector are good as opposed to bad, but at a much higher price." CHRG-111shrg57322--945 Mr. Blankfein," Well, I would say that, increasingly, and this is a change in the sociology of the business that took place over the last 15 or 20 years, I am not sure it was precipitated by the fall of Glass-Steagall or it caused Glass-Steagall to fall as U.S. institutions had to become more competitive with global institutions, but somewhere along the line, clients used to ask you for advice--if you were an investment bank and then went to other institutions and asked them for financing---- Senator Kaufman. Right. Mr. Blankfein [continuing]. And to take principal risk. Senator Kaufman. Right. " CHRG-111shrg55479--138 EXHIBIT VI 2008 Business Roundtable Survey[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] PREPARED STATEMENT OF J.W. VERRET Assistant Professor of Law, George Mason University School of Law July 29, 2009The Misdirection of Current Corporate Governance Proposals Chairman Reed, Ranking Member Bunning, and distinguished Members of the Subcommittee, it is a privilege to testify in this forum today. My name is J.W. Verret, and I am an Assistant Professor of Law at George Mason Law School, a Senior Scholar at the Mercatus Center at George Mason University and a member of the Mercatus Center Financial Markets Working Group. I also direct the Corporate Federalism Initiative, a network of scholars dedicated to studying the intersection of State and Federal authority in corporate governance. I will begin by addressing proxy access and executive compensation rules under consideration and close with a list of contributing causes for the present crisis. I am concerned that some of the corporate governance proposals recently advanced impede shareholder voice in corporate elections. This is because they leave no room for investors to design corporate governance structures appropriate for their particular circumstances. Rather than expanding shareholder choice, these reforms actually stand in the way of shareholder choice. Most importantly, they do not permit a majority of shareholders to reject the Federal approach. The Director of the United Brotherhood of Carpenters said it best, ``we think less is more, fewer votes and less often would allow us to put more resources toward intelligent analysis.'' The Brotherhood of Carpenters opposes the current proposal out of concern about compliance costs. The proposals at issue today ignore their concerns, as well as concerns of many other investors. Consider why one might limit shareholders from choosing an alternative means of shareholder access. It can only be because a majority of the shareholders at many companies might reject the Federal approach if given the opportunity. Not all shareholders share similar goals. Public Pension Funds run by State elected officials and Union Pension Funds are among the most vocal proponents of shareholder power. Main street investors deserve the right to determine whether they want the politics of Unions and State Pension funds to take place in their 401(k)s. The current proposals also envision more disclosure about compensation consultants. Such a discussion would be incomplete without mentioning conflicts faced by proxy advisory firms. Proxy advisory firms advise institutional investors on how to vote. Current proposals have failed to address this issue. The political clout enjoyed by these firms is evidenced by the fact that the CAO of RiskMetrics, the dominant firm in the industry, was recently hired as special advisor to the SEC Chairman. To close the executive compensation issue, I will note that if executive compensation were to blame for the present crisis, we would see significant difference between compensation policies at those financial companies that recently returned their TARP money and those needing additional capital. We do not. Many of the current proposals also seek to undermine, and take legislative credit for, efforts currently underway at the State level and in negotiations between investors and boards. This is true for proxy access, the subject of recent rule making at the State level, and it is true for Federal proposals on staggered boards, majority voting, and independent Chairmen. The Sarbanes-Oxley Act passed in 2002 and was an unprecedented shift in corporate governance designed to prevent poor management practices. Between 2002 and 2008, the managerial decisions that led to the current crisis were in full swing. I won't argue that Sarbanes-Oxley caused the crisis, but this suggests that corporate governance reform does a poor job of preventing crisis. And yet, the financial crisis of 2008 must have a cause. I salute this Committee's determination to uncover it, but challenge whether corporate governance is the culprit. Let me suggest six alternative contributing factors for this Committee to investigate: i. The moral hazard problems created by the prospect of Government bailout; ii. The market distortions caused by subsidization of the housing market through Fannie Mae, Freddie Mac, and Federal tax policy; iii. Regulatory failure by the banking regulators and the SEC in setting appropriate risk-based capital reserve requirements for investment and commercial banks; iv. Short-term thinking on Wall Street fed by institutional investor fixation on firms making, and meeting, quarterly earnings predictions; v. A failure of credit-rating agencies to provide meaningful analysis, caused by an oligopoly in that market supported by regulation; vi. Excessive write downs in asset values under mark-to-market accounting, demanded by accounting firms who refused to sign off on balance sheets out of concern about exposure to excessive securities litigation risk. Corporate governance is the foundation of American capital markets. If this Committee tinkers with the American corporate governance system merely for the appearance of change, it risks irreparable damage to that foundation. I thank you for the opportunity to testify, and I look forward to answering your questions. ______ CHRG-110shrg50420--83 Chairman Dodd," Thank you very much, Senator. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Mr. Dodaro, thank you for your testimony. Some of my questions have been pursued by some of my colleagues, but there is one specifically. You know, I look at the TARP, your report on the TARP program, and I wonder, the two things that we were looking for in addition to obviously rescuing the financial institutions and trying to help Main Street was transparency and accountability, and they seemed to have been victims in this process of not being fulfilled in the TARP program. So I wonder, isn't that a lesson for those of us who are arguing for some greater conditionalities in that process? As we look at the automakers and the possibilities of helping them out, isn't conditionality a very key element of what we should be looking for moving forward? " CHRG-109shrg21981--15 STATEMENT OF SENATOR DEBBIE STABENOW Senator Stabenow. Thank you, Mr. Chairman, and welcome, Mr. Chairman. It is wonderful to see you, again, and I want to join my colleagues in thanking you for your leadership and service over the last 16 years. We truly have appreciated and relied on your judgments and your thoughts, and I have appreciated, also, the opportunity to talk with you both privately in my office, as well as on other occasions, about what we are facing in terms of out-of-control deficits. I know you have warned us, since I was in the House of Representatives, and, by the way, I was very proud of the fact, coming into the U.S. House in 1997, that we balanced the budget for the first time in 30 years. We, unfortunately, now have gone from the largest surpluses in the history of the country projected in 2001 to the largest deficits, and that is deeply, deeply disturbing, and I am very interested in your current thinking as it relates to our economic environment with the deficit and the sustainability of that and, in fact, the ethic and responsibility that we all have to address that. I view that as a major moral issue. The President would have us believe that Social Security, in 13 years, is going bankrupt even though we know that is not accurate. We do know that there is a gap, 40 or 50 years down the road, and I am confident that working with my colleagues that we will address that. But what we are hearing from the President is that his suggestion as a way to fix it is to hoist an additional $5 trillion of national debt on American families over the next 20 years, and he calls it an ownership society. I would argue that what every man, woman and child will own is an additional $17,000 in debt, on top of what we already have as a birth tax right now of $15,000. Every time a child is born, that is our gift to them, in terms of the current national debt. So, I am extremely concerned about where we are going and the sustainability of that. Right now, it will require decades for this debt to be fully offset, and the projected savings being talked about in terms of the savings and the market growth, in terms of privatization of Social Security, ironically, is the same growth that would take care of the Social Security gap if, in fact, it materialized. And so I would be interested in your thoughts about that as well. I am very interested in your discussion in terms of the national debt, our chronic deficit and, also, what has been raised by my colleagues as troubling trade deficits, which are exploding, and particularly when we look at China and what is happening in terms of our inability to enforce trade laws and to address the trade imbalances that we have that are causing great havoc in my home State with manufacturers and others that are asking us for a level playing field so that they can keep and create more jobs. So, I thank you, Mr. Chairman. " CHRG-111hhrg56241--147 Mr. Green," It is not the right thing to do. All right. I will help you. It is irresponsible. Friends, we at some point have to become adults about what we are dealing with. We are talking about perverse incentives that create systemic failure. Give me an example, please, ma'am, of a perverse incentive that creates systemic failure, please. Ms. Minow. Certainly. In the subprime industry, the individuals were paid on the number of transactions rather than the quality of transactions. So they had a perverse incentive to create as many transactions as possible. " FOMC20080805meeting--5 3,MR. EVANS.," Thank you, Mr. Chairman. Bill, at our recent intermeeting call, I wasn't expecting the characterization of the financial stresses to sort of backtrack to the point that it feels like March. Maybe somebody said it was as scary as March. I have noticed in a lot of our speeches that many have noted that financial conditions have not returned to normal, and I have always kind of wondered what ""normal"" would be. With hundreds of billions of dollars of losses at major financial institutions, I guess I am wondering whether we can reasonably expect that this distress and adjustment will be alleviated over some reasonably short period of time. We are 12 months in. Isn't this likely to take 12 more months or longer? Financial institutions have a lot to digest. What do you think financial institutions and markets have to do to signal a return to acceptable functionality? What are we looking for, and what changes in fundamentals are likely to occur that would deliver sustainable liquidity improvements? " FinancialServicesCommittee--15 So I commend you. I thank you for taking the time out to take the call on Thursday and to be here today on such short notice. Now, we are going to charge you with the opportunity within the next 5 minutes of reducing your statement to 5 minutes, as best as possible, and tell us in its entirety what caused this problem; what can be done about this problem; and how we can get started. We now would like to hear from Chairman Schapiro. Accompanying Chairman Schapiro is Mr. Robert W. Cook, Direc- tor of the Division of Trading and Markets, United States Securi- ties and Exchange Commission. STATEMENT OF THE HONORABLE MARY L. SCHAPIRO, CHAIR- MAN, U.S. SECURITIES AND EXCHANGE COMMISSION, AC- COMPANIED BY ROBERT W. COOK, DIRECTOR, DIVISION OF TRADING AND MARKETS, U.S. SECURITIES AND EXCHANGE COMMISSION Ms. S CHAPIRO . Thank you, Mr. Chairman. I hope I won’t dis- appoint you. Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, I appreciate the opportunity to testify con- cerning the market disruption that occurred last Thursday. As you mentioned, I am joined today by Robert Cook, the Director of the Division of Trading and Markets at the SEC, who has been deeply involved in the analysis of the market events. The sudden evaporation of meaningful prices for many major ex- change-listed stocks in the middle of the trading day is unaccept- able and clearly contrary to the vital policy objective of maintaining fair and orderly financial markets. The SEC is working around the clock to identify the causes of this sudden spike and to make changes which will help prevent disruptions of this type in the fu- ture. On May 6th, the Dow Jones Industrial Average dropped more than 573 points in just 5 minutes. As quickly as the market dropped, it suddenly and dramatically reversed itself, recovering 543 points in approximately a minute and a half. Many individual securities experienced much larger swings in their trading activity and certain trades were executed at absurdly low prices. Pursuant to exchange rules, after closing, the equity markets worked out a common standard to cancel trades effected at prices sharply divergent from prevailing market prices. The exchanges de- termined to cancel any trades from 2:40 p.m. to 3:00 p.m. at prices 60 percent away from the last trade at or before 2:40 p.m. Today, the SEC has more than 100 people working tirelessly on this issue. We are sorting through literally millions of trades and carefully comparing timing and activity across markets to isolate the cause or causes of the spike. We will take action to change any aspects of our market structure which may have contributed to the extreme volatility. We have made progress in our ongoing review and can provide some preliminary findings. FinancialCrisisInquiry--20 Finally, today’s financial markets are global and interconnected. Our regulatory regime needs to be as well. The U.S. must work with countries across the globe to coordinate and synchronize risk. At Morgan Stanley, we’re grateful for everything the federal government and the American taxpayer did to support our industry and to help bring stability back to the markets. We recognize our industry has much to do and to regain the trust and confidence of taxpayers, investors, and public officials. Thank you. CHAIRMAN ANGELIDES: Thank you, Mr. Mack. Mr. Moynihan? MOYNIHAN: Thank you, Chairman Angelides, Vice Chairman Thomas, and other members of the commission. I welcome the opportunity to help provide some information on important matters you’re investigating. As you know, I assumed my role of CEO of Bank of America on January 1 st , and prior to that time, I ran the consumer areas of the company. In leading our consumer business, I had a first-hand knowledge and a recognition of the hardships that many hard-working families and small businesses experience across America. Together, the financial services companies, our elected leaders, and regulators must continue to work to understand what occurred in the financial crisis and apply these lessons so that it simply does not happen again. Over the course of the crisis, we, as an industry, caused a lot of damage. Never has it been clearer how poor business judgments we have made have affected Main Street. This commission’s work is important because the lessons are not going to be simple. This crisis had a multitude of causes that are not easily summarized. It is important that we understand the breadth of the causes so we can learn the right lessons and apply the appropriate policy to remedy them for the future. CHRG-111hhrg48868--514 Mr. Capuano," Fair enough. I understand that these people who got these bonuses--and I want to be clear--I'm not against bonuses per se. What I'm against is bonuses to people who helped cause the problem and particularly bonuses that come out of taxpayer's dollars, etc., etc. I'm not against bonuses. We're not talking about anybody who got a $1,000 bonus, we're talking about people who got hundreds of thousands of millions of dollars. And do you believe honestly in your heart, with all of the unemployment that has gone on in the financial services sector right now, right this very minute, do you really believe that these are the only people who are capable of doing this job? " CHRG-111hhrg54868--79 The Chairman," Right. But not with respect to banks, which is where the credit card issue came in. You cited an example of the credit card situation where you were in fact debarred from taking action, when Mr. Miller asked you, because the Federal Reserve, a safety and soundness bank regulator, explicitly allowed the banks to do it. And according to your position, that status quo would continue. " CHRG-111hhrg48867--297 Mr. Green," Let's pursue this. If you conclude that an entity can cause systemic risk, as you came forward with your clarion call, then do you not want to see some action taken to prevent that cause from moving forward, from becoming the cause of the systemic risk? " FOMC20071031meeting--98 96,MR. ROSENGREN.," I had a follow-up question on nonresidential structures. You talked about drilling and mining, and I was wondering about the other parts of commercial real estate. Was anything in there? I don’t know if you had a chance to look at it, but the reason I ask is that, if you thought financing was starting to become a problem and you do have very weak nonresidential investment going forward, you would expect to start seeing it there. So I’m wondering if anything was in that breakout. I have a second question, which is that you didn’t mention durable goods. But if I thought that credit problems, particularly subprime and other things, were starting to create issues, I would expect to start seeing more imprints in the data for some of the durable goods. So was seeing durable goods a little stronger in the consumption figures a surprise at all?" CHRG-110shrg50410--64 Chairman Dodd," Thank you very much. Senator Bunning. Senator Bunning. Well thank you, Mr. Chairman. First of all, let me tell you, Secretary Paulson, and my good friend Chris Cox, the Honorable Chris Cox, that I am going to be here after you leave. You are going to be gone. And we are going to be responsible to the taxpayers. The taxpayers have reacted and the market has reacted to your plan, Secretary Paulson, by driving down Fannie Mae shares 26 percent today, right now. And Freddie Mac's are down 29 percent as of this moment, just in case you are interested on how the market is reacting to your wonderful plan on bailing out Freddie and Fannie. Oh, but you may not do it because it is only as a backstop. Well, do you know in the same bill that you would like to attach this to there is a tax on Fannie and Freddie from $500 million to $800 million per year for a housing trust fund? Do you know that? You do not. Well, it is in the bill---- " FOMC20060328meeting--67 65,MR. FISHER.," I have a question for David and a customer request for Karen. My question to David concerns the elasticity of labor supply within our own borders, and my specific question is the impact of immigration on the NAIRU. I assume that we have had some benefit in lowering the NAIRU based on immigration, and I am wondering, David, if you have begun to calculate what the effect of these anti-immigration bills might be on the elasticity of labor supply. And my customer request to Karen: One thing that I noticed particularly in reading through the Greenbook, beginning with the domestic section, is that we are hit between the eyes right off the bat with the question of capacity utilization and resource utilization. The international section discussed net exports and growth figures. Is there a way, Karen, that we can over time get a sense of what we get right to at the beginning of the domestic section: the degree to which resources are being utilized outside the United States in a way that affects the decisionmaking of businessmen and businesswomen in the United States? You know that I worry about this dynamic. But I am curious as to whether we can get a measurement of the capacity of others to supply inputs into our economy or processes that not only facilitate economic growth but also affect inflation beyond just the prices of imported goods. I do not see that as much in the international section. I see at least the attempt to get to it, whether or not we agree analytically, in the domestic section. Those are my one question and my one request, if possible." CHRG-111hhrg48875--235 Mrs. Biggert," Okay. And I don't even have 5 minutes left, so I will move on to the next question. I think that Mr. Castle mentioned the council rather than just having the regulator for the systemic risk over that. I would wonder if--it seems like so much of our problem was the fact that the regulators didn't really catch it, and it could have been a lot of regulators, and they didn't communicate with each other. And so I think it is a failure of communication. But we have seen sort of the same thing in Homeland Security. We saw it in Hurricane Katrina with--I know that we had--I was involved with FLEC, and we asked all of the agencies--with the Treasury, to ask all of the agencies come together. And they discovered that there was a lot of duplication in what they were doing, and how important the communication was. How about having, rather than just the agencies in a council, also having--making it a private-public partnership, where you would have representatives from, let's say, the large financial institutions, and then maybe the small financial institutions and the insurance, and have it be where they rotate representatives in there? Because it seems to me when we have asked the questions, like of Chairman Greenspan, we didn't get the answers. And he really, you know, didn't know, and he said he didn't know, everything that was going on. And these are the people who are really in the industry and dealing with that. And it is not--you know, it is set up so that they can bring their concerns, and then that can be addressed. And maybe there are a lot of others who realize that, under different regulation, that they are having the same concerns. " CHRG-111hhrg48867--270 Mr. Grayson," I am wondering if there is any way to meet systemic risk threats that does not involve transferring hundreds of billions of dollars from the taxpayers to failed banks. Mr. Ryan? " CHRG-111shrg57320--309 Mr. Doerr," Well, we might consider that. Senator Levin. What would it take? I mean, given, I think, what we understand the risks are here, I am just wondering whether or not it shouldn't be more than just guidance. " FOMC20080130meeting--157 155,CHAIRMAN BERNANKE.," I wonder if I could entice anybody for a cup of coffee. [Laughter] Why don't we take a fifteen-minute break, and then we'll commence with the goround. Thank you. [Coffee break] " CHRG-110hhrg41184--72 Mr. Bernanke," Well, I think there were mistakes in terms of regulation and oversight. But I think there also were private sector mistakes as well. Mr. Price of Georgia. A lot of other situations going on. " CHRG-110hhrg45625--156 Mr. Bernanke," Well, first, I am not comparing the current situation with the Great Depression, but a lot of what you said, there is some relevance. In particular, the Great Depression was triggered by a series of financial crises. Stock market crash, collapse of the banks, and the effects on credit and on money were a very big part of what happened then. Now we have a very, very different financial system. It is much more sophisticated and complicated, it is much more global. We also have a much bigger and more diversified economy. But what that episode illustrates, as do many other episodes in history, is that when the financial system becomes dysfunctional, the effects on the real economy are very palpable. Now you point to other things, like preventing free trade and excessive regulation, etc. Those things also have adverse effects on the economy. But I would say that the financial crisis was fairly central in that Depression episode. It is not a question of abandoning free markets. I think right now we have to deal with the fact that mistakes were made by both the private and public sectors. We need to put that fire out. Going forward, we need to figure out a good balance between market forces that allows for innovation and growth, but with an appropriate balance and market-disciplined regulatory structure that is appropriate and will work to avoid these kind of situations arising in the future. " CHRG-109shrg26643--69 Chairman Bernanke," To the extent that their currency is undervalued, it does, yes. Senator Sarbanes. Yes. In fact, we are becoming more and more dependent. Tennessee Williams has that wonderful line in ``A Streetcar Named Desire'' where Blanche DeBois says dependent upon the kindness of strangers, and there are some who look at the American economy and are increasingly concerned that that is what is happening. I quoted Warren Buffett earlier in my opening statement saying right now the rest of the world owns $3 trillion more of us than we own of them. In my view, it will create political turmoil at some point. Pretty soon, I think there will be a big adjustment. Aren't the Chinese accumulating a leverage over our decisionmaking as a consequence of increasing so substantially these holdings of our Government debt? " FOMC20080109confcall--32 30,MR. EVANS.," Thank you, Mr. Chairman. I would not have thought to call an intermeeting videoconference. I tend to think of the in-person meetings as those where we make the decisions and do the analysis. But since you made us think about it, I agree with your assessment of the economy. I think that things are noticeably softer. I don't think there is much accommodation in place at a funds rate of 4� percent. To influence aggregate demand noticeably we probably need accommodation on the order of what you are talking about, which is about 100 basis points from a neutral federal funds rate. That range is probably on the order of 4� to 4�, so that would put such accommodation at 3� percent. We have to recognize that monetary policy, if it is going to have any influence on aggregate demand, is going to do so with a lag. That is what all our analysis assumes and suggests, and so if we want to influence aggregate demand to limit midyear weakness, I think we need to take action sooner rather than later. In terms of the data developments that you talked about, one thing that is taking place right now is that uncertainty is being resolved. The weakness that we are seeing I am currently interpreting tentatively as sort of an unraveling of things that we haven't seen so far, not necessarily a deeper weakness. The December data have been weaker. The employment data were poor, and the unemployment rate was a lot higher. In constructing my outlook for the economy in 2008 and beyond, I had been more optimistic than many that consumer spending would hold up in part because of the positive labor market situation. Taken at face value, the December employment report puts a crack in that supporting foundation. It is now likely, it seems to me, that consumer spending will soften with these labor developments. Dave Stockton went through a bit of analysis of the indicators that might lead to a recession. President Lacker and you, Mr. Chairman, mentioned regime-switching as well. I just want to mention that in Chicago we have been publishing our Chicago Fed National Activity Index for a number of years. We started out right at the onset of the 2001 recession, as it turns out. As you know, Mr. Chairman, this index is very closely related to your data-rich environment analysis with Jean Boivin and Stock and Watson. If you do an analysis where you try to assess these regime-switching events, this indicator has done a fairly good job of picking that out when it goes below a threshold of, say, minus 0.7. That is some of the probabilistic analysis that I did with this back then. If you take some of the developments in the employment report at face value, I think that this is headed for a probability of recession this year that is higher than 50 percent. So we have to be a little concerned about that. Anyway, that is the economic situation that I worry about a good bit. What about inflation? Clearly there are risks, and the risks are evident. Core inflation rates are projected to be higher in the near term. Headline inflation has been significantly above core for long enough to make people wonder about underlying inflation, but inflation expectations have remained contained. With energy prices traversing high levels over a short time, the possibility of pass-through during a period of economic weakness cannot be dismissed. We also have to be concerned about the reputational cost of inflation going up. But, again, I agree with you, Mr. Chairman, that if we do end up with significantly weaker economic activity, it would limit the inflation risk. What is hard in this period is balancing the risks of going slowly on monetary policy if we really think that the risk of a recession is higher. I agree with what you said and Governor Mishkin's thinking about being aggressive in the near term to respond to weakening aggregate demand and then making sure that we take back any excessive accommodation at the appropriate time. I know that's hard, but I think that's what we should do. I would actually favor action today on the order of 50 basis points because I think that's about the only way to get to 3� in a quick enough period of time by our next meeting. That's what I would prefer. Anyway, those are my comments. " FOMC20060629meeting--64 62,MR. WILCOX.," As I mentioned earlier, the predominant thing that’s causing core PCE to decelerate next year compared with this year is the flattening out of energy prices. Resource utilization is a tiny influence at this point." CHRG-110hhrg41184--209 Mr. Bernanke," Well, the idea of the freeze is to find a strategy by which lenders can work out larger numbers of loans. They are facing an unusual situation. Usually each loan, each foreclosure, each delinquency, is different; it depends on personal circumstances. Here we have a situation where literally hundreds of thousands of families or individuals may be facing foreclosure based on broad macroeconomic phenomenon--basically the decline in house prices and concerns with subprime lending. And the issue is, are there ways to be more efficient in working out loans and at larger scale? A freeze, which is what has been suggested by the HOPE NOW approach, is one way to do that. That could be a way to get more time to work out those loans. Again, it is a voluntary approach that they have come to through discussion. It doesn't address by any means all people in this situation. For example, there are a lot of loans that default even before the interest rate resets. " CHRG-111hhrg52400--258 Mr. Skinner," To be honest, on reinsurance in particular, where we have had some perennial problems on collateral charges, not very successful at all. The European Commission holds out that this is entirely discriminatory against European companies operating inside the United States, where there is as much as $40 billion worth of collateral held in States across the United States. There has been a move to move towards a rating process. That rating process, in itself, seems quite discriminatory, with the higher ratings being required--very high ratings required for foreign companies--and very much less, or so it seems, for domestic companies, which we--if you're operating in a global reinsurance market, business-to-business, it doesn't make much sense. Obviously, I understand the necessity of covering risk, but we have just done away with collateral inside the EU. We think it's a blunt instrument. We wonder why, you know, that it is still a cause celebre here. Whenever the NAIC comes to the European Union and says, ``This is what we're going to do,'' we're still shocked by it, we still think it's not a very modern approach, or a very modern technique, and we prefer to look at risk management which, after all, at the end of the day, tells you just what those companies are doing, how they're behaving, and how they're predicting their risks, which is far more essential than how much money they have in the bank. Ms. Bean. Thank you. One last question for Mr. McRaith. In 1999, the NAIC chose to become a Delaware corporation. And, at the time, the executive vice president of the NAIC, Kathy Weatherford, explained that Delaware laws were conducive to corporations. Why does the NAIC believe they should be able to choose where to incorporate, based on what was in the best interest of the NAIC, but insurance companies with nationwide offerings shouldn't have the option of a Federal charter to streamline their operations and better serve their customers? " FOMC20050809meeting--47 45,MR. MADIGAN.," I think that’s right. This has been an evolving pattern over the past several futures settlements. There was a pattern in the last few months of pronounced tightness in the particular issue that we’re talking about, which is the February 2012 note. And it is the case that currently the cheapest-to-deliver issue into the September contract has an even smaller outstanding size. So this situation will bear some watching." CHRG-111shrg54589--94 Mr. Hu," I am only using this situation to illustrate matters related to the concerns you have; that is, you know, do we really--as a public policy matter---- Senator Bunning. That is right. " Mr. Hu," ----shouldn't we be concerned about these creditors who used to really care about ensuring that their borrowers stay out of bankruptcy, that they can sometimes have much less of an incentive to do that, and that in today's world---- Senator Bunning. We had better correct that. " FinancialServicesCommittee--33 Mr. L UCAS . I look forward to letting the chips fall where they may. Thank you. I yield back, Mr. Chairman. Chairman K ANJORSKI . Thank you very much, Mr. Lucas. And now, we will here from the gentleman from Georgia, Mr. Scott. Mr. S COTT . Thank you very much, Mr. Chairman. First, let me commend you, Chairman Schapiro and Chairman Gensler. Your presentation certainly gives us all confidence that you have your hands around the problem. While you are looking for the causes, you have certainly shown that you have put certain measures in place to give confidence to investors to keep on invest- ing with confidence. It seems to me though that what we really have here is a way we are trying to find to stop a freefall in a free market in a free economy while it is very important to keep the markets free. That is the strength of our markets, the freedom. So as we move with controls, my question has to evolve around this element that you are presenting as the most basic means of con- trolling this free market so at the same time making sure it is still free to function in the beauty and the strength that it has. And your instrument for doing this apparently is the circuit breaker. And the circuit breaker basically is a function of time incre- ments. It is a function of pricing. And I wonder, how would you de- termine that? Who will determine that? Will it be an increment of 15 minutes if it goes down 5 percent, or would it be 2 or 3 hours if it goes down 10 or 20 percent? And will it apply across each ex- change? We have seven of those operative. Or would it apply just to individual stocks? How simply would that circuit breaker work and allow still for the freedom of trading? Ms. S CHAPIRO . Congressman, that is a great question. And I think it is important to note that we very much believe in the mar- ket and in the market mechanism, but I don’t think anyone would argue that when the market went down 900 points in a very, very short period of time, and 500 points in a matter of a couple of min- utes, that the real forces of supply and demand were operating. We clearly had a problem that was related to the fact, in my view, that we had markets operating under different sets of rules. We also had some issues about liquidity leaving the marketplace. Certain types of orders exacerbated that. The use of something called stub quotes that allowed transactions to be executed at a penny contributed to that. But clearly, something didn’t work unre- lated to market forces that we normally applaud and think make our markets better. The circuit breakers that we are talking about with the ex- changes would be designed based on longtime experience in other markets around the world which already have circuit breakers on a stock-by-stock basis as well as the experience of, for example the New York Stock Exchange which already has the equivalent of a circuit breaker, which I am sure they will talk about in their testi- mony in the next panel. Bringing in collective experience of all those markets together with the ultimate approval of the SEC for any rules that would institute circuit breakers, I think gives us some confidence that we will be able to get it right, and if we don’t, we will have to revisit it and make adjustments. CHRG-110hhrg38392--74 Mr. Pearce," Thank you, Mr. Chairman. Thank you, Chairman Bernanke. It is a positive report of our economy and on the world economy in general. On page 5, you make a statement that if energy prices level off, if anticipated. I will now ask you what would cause you to anticipate the prices to level, what factors? " CHRG-111hhrg53238--200 Mr. Himes," The reason I am going down this path is, look, this is a complicated topic, and we have to get it right. There is merit on both sides and many different sides, and we have to get it right. But to me it is a no-brainer, and as people with some economic training here, it is a no-brainer that you need a fully informed consumer. And you repeat here there is no evidence that the financial crisis was spawned by a systematic lack of understanding. No evidence that consumer ignorance was a substantial cause. Nobody is saying that it was spawned by consumer ignorance. Was not a substantial contributing factor to this crisis the lack of education, the lack of knowledge, the lack of information that consumers had? " fcic_final_report_full--328 Even after both Fannie and Freddie became public companies owned by share- holders, they had continued to possess an asset that is hard to quantify: the implicit full faith and credit of the U.S. government. The government worried that it could not let the . trillion GSEs fail, because they were the only source of liquidity in the mortgage market and because their failure would cause losses to owners of their debt and their guaranteed mortgage securities. Uncle Sam had rescued GSEs before. It bailed out Fannie when double-digit inflation wrecked its balance sheet in the early s, and it came through in the mid-s for another GSE in duress, the Farm Credit System. In the mid-s, even a GSE-type organization, the Financing Cor- poration, was given a helping hand. As the market grappled with the fundamental question of whether Fannie and Freddie would be backed by the government, the yield on the GSEs’ long-term bonds rose. The difference between the rate that the GSEs paid on their debt and rates on Treasuries—a premium that reflects investors’ assessment of risk—widened in  to one-half a percentage point. That was low compared with the same figure for other publicly traded companies, but high for the ultra-safe GSEs. By June , the spread had risen  over the  level; by September , just before regulators parachuted in, the spread had nearly doubled from its  level to just under , making it more difficult and costly for the GSEs to fund their operations. On the other hand, the prices of Fannie Mae mortgage–backed securities actually increased slightly over this time period, while the prices of private-label mortgage–backed securities dra- matically declined. For example, the price of the FNCI index—an index of Fannie mortgage–backed securities with an average coupon of —increased from  in January  to  on September , , two days prior to the conservatorship. As another example, the price of the FNCI index—Fannie securities with an average coupon of —increased from  to  during the same time period. In July and August , Fannie suffered a liquidity squeeze, because it was un- able to borrow against its own securities to raise sufficient cash in the repo market. Its stock price dove to less than  a share. Fannie asked the Fed for help.  A senior adviser in the Federal Reserve Board’s Division of Banking Supervision and Regula- tion gave the FCIC a bleak account of the situation at the two GSEs and noted that “liquidity was just becoming so essential, so the Federal Reserve agreed to help pro- vide it.”  On July , the Federal Reserve Board in Washington authorized the New York Fed to extend emergency loans to the GSEs “should such lending prove necessary . . . to promote the availability of home mortgage credit during a period of stress in fi- nancial markets.”  Fannie and Freddie would never tap the Fed for that funding.  Also on July , Treasury laid out a three-part legislative plan to strengthen the GSEs by temporarily increasing their lines of credit with the Treasury, authorizing Treasury to inject capital into the GSEs, and replacing OFHEO with the new Federal Housing Finance Agency (FHFA), with the power to place the GSEs into receiver- ship. Paulson told the Senate that regulators needed “a bazooka” at their disposal. “You are not likely to take it out,” Paulson told legislators. “I just say that by having something that is unspecified, it will increase confidence. And by increasing confi- dence it will greatly reduce the likelihood it will ever be used.”  Fannie’s Mudd and Freddie’s Syron praised the plan.  FOMC20070807meeting--50 48,MR. LACKER.," David, when you were describing the implications of the GDP revisions for your assessment of the output gap, you said that you essentially marked down potential by the same amount as realized growth recently based on your assessment of pressures in product markets. In case we wanted to try it at home, I was wondering if you could say a little more about what data that assessment of pressures in product markets relies on?" FinancialCrisisInquiry--510 WALLISON: If I told you it was half, would it have differed—would that have caused your view of what the problems might be to change the order of the various causes of the financial crisis that you describe? FinancialServicesCommittee--12 Frequently, when we have extreme market volatility, the cry goes out, somewhere quick, ‘‘Let’s shoot the computers.’’ I have never really agreed with that particular position, although I do have an open mind that perhaps some reprogramming may be in order. Specifically, I do believe that we at least need to look and examine the desirability of having stock-specific circuit breakers across all of our markets, and certainly, there is an open question on the impact of canceling trades. How many folks ended up with unintended short positions while arguably adding needed liquidity in a sinking market? But at the end of the day, I think we should tread very, very carefully in this space. Improved technology, rule MNS, have brought great benefits to trading: more competitive markets; cheap- er trades; and really a democratization of investment opportunities. But more importantly, I believe that we need to look beyond simply the mechanics of the panic and look to its likely underlying cause, that being the international debt crisis that is first manifesting itself in Greece. A number of media outlets have spoken to this. We had a CBS–AP report, ‘‘Greek Debt, Trader Error Eyed in Market Selloff,’’ on May 6th: ‘‘Traders were not comforted by the fact that Greece seemed to be working towards a resolution of its debt problems. Instead, they focused on the possibility that other European countries would also run into trouble.’’ Wall Street Journal: ‘‘Many traders worried about the economic situation in Europe. The Dow had already been moving lower as television screens displayed scenes of rioting on Greek streets.’’ Fox Business quoted a managing director of Nye Capital Part- ners: ‘‘The tone and tenor of the global debt crisis has taken over the market. Everything else has taken a back seat.’’ So there is an open question among many in our investing public whether or not we are on the road to becoming Greece ourselves, given that the deficit has increased tenfold in just 2 years, and the President has put forth a budget that will triple the national debt in 10 years. There is fear that Greece is the preview of coming at- tractions to the United States, and no matter how many well-de- signed exits you have, no matter how many well-trained ushers you have, no matter how well-designed your exit plan, if people in the theater sense that something is smoldering, you cannot ultimately remove the conditions of panic. Thank you, Mr. Chairman. I yield back. Chairman K ANJORSKI . Thank you, Mr. Hensarling. We will now hear from the gentleman from Georgia, Mr. Scott, for 1 minute. Mr. S COTT . Thank you, Mr. Chairman. I think what we have here is a clear example of how we as a society have become more the servants of the machine that was created to serve us. Our tech- nology has now far surpassed our human ability to keep up with it. I think we have to move with caution, to make sure we get the right causes of this problem, to understand that our foremost obli- gation at this point is to make sure we have investor confidence, that the American people have confidence in our system. CHRG-111hhrg56778--32 Chairman Kanjorski," I realize that you can make the technical argument that we did not have jurisdiction, but obviously you did not assume jurisdiction of the larger problem when you saw it. As a result, somebody, particularly the American taxpayers, have suffered a $200 billion loss and are on the line for a great deal more in losses if there is further failure in that operation. Is that not correct? I am going to add: Have you changed your processes since you handled the AIG situation? Ms. Gardineer. One of the things that we have done is we have reviewed the processes and what we were doing at AIG. We have provided enhanced examiner guidance based on the lessons learned through our experience with the consolidated supervision of that company. By doing that, we focused on the risk management associations, sharing of information between the non-functionally regulated and functionally regulated areas. So we have taken steps to increase our supervision and enhance that supervision through examiner education. " FOMC20080724confcall--10 8,MR. EVANS.," Thanks, I appreciate that. I do wonder why we didn't have more of a robust discussion about that at the time because it seems more than just a detail, given that it was part of the representations that at least some of us--or at least I--made to our directors. But thanks. " CHRG-111shrg57709--143 Mr. Wolin," It is indeed. Senator Bunning. You know, and so all I am saying is that we can do those wonderful things that you are proposing. We cannot force the regulator to enforce it. And I want to make sure, if we do overhaul our financial regulatory regime that there is guts in what we do. " CHRG-109hhrg22160--269 Mr. Greenspan," That is the choice of the Congress. I mean, the point is, the wonderful thing about our system is we have elected representatives who have to make these judgments. And if they don't reach you, somebody else made them, and they are easy decisions. You only get the tough ones. " CHRG-111shrg49488--56 Mr. Clark," I think so. In a sense, it was safety and soundness, and I think it is fair to say as we were exiting the business, Canadian banks were going into the business. So it was not as if our regulator was saying do not do this. Senator Collins. That is what I was wondering. " FOMC20050630meeting--137 135,MR. MOSKOW.," Thank you, Mr. Chairman. I wanted to make a few comments and then ask a question. First, I’d say that with all of the concerns about froth in housing markets, I found these presentations to be very informative, and I want to congratulate the people who spent a lot of time preparing them. I thought they were all very good presentations. But I also found the information comforting. We’ve all talked about the possibility of local housing bubbles and regional housing bubbles, and clearly there are some in the United States. But we never really looked at it on a national basis before. The net result for me was that I come away from the analysis not feeling any worse than I did before and probably a little better. First, I thought it was very helpful to see quantified—I think this was in Josh’s memo—the size of the potential bubble. He talked about a 20 percent drop in housing prices. But that was equal to only about 30 percent of GDP as compared to the drop in equity prices we had, which was more than twice that. Also, I had the feeling that appropriate monetary policy, as John said, could mitigate much of the distress that might occur. Moreover, the credit risk associated with home mortgages seems to be spread out across many institutions. Governor Bies said that a lot of analysis is being done now, and we’ll want to see the results of the analysis that the Board and the Comptroller are doing. But on the whole, the financial institutions seem to be in pretty good shape. The role of securitizing mortgages is to lay off risks to parties who are willing and able to bear the risks. Capital levels of the financial institutions are relatively high, so it appears that these markets are performing their roles well. And in the event of a sharp drop in housing prices, the odds of a spillover to financial institutions seem limited. And as I mentioned, it was helpful to hear the June 29-30, 2005 48 of 234 housing prices. So I come away somewhat less concerned about the size and consequences of a housing bubble than I was before. The question I had relates to what Governor Yellen was asking about—financial innovation. I was going to make a similar point. The fact is that there has been a great deal of financial innovation in housing markets in the United States. The average person can borrow very easily on his home these days. And I was wondering if there have been—or if it is possible to do—any international comparisons on this. I wondered whether the price-rent ratios in other countries that may not have had the same degree of financial innovation we’ve had differ substantially from ours." 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-110shrg50409--58 Chairman Dodd," Thank you very much. Senator Bunning. Senator Bunning. Thank you, Mr. Chairman. Since I did not give an opening statement, I want to give an opening statement in all deference to Chairman Bernanke. I know we have a lot of ground to cover today, but I want to say a few things on the topic of this hearing and the next. First, on monetary policy, I am deeply concerned about what the Fed has done in the last year and in the last decade: Chairman Greenspan's easy money in the late 1990s and then followed the tech bust, inflated the housing bubble, and created the mess we are in today. Chairman Bernanke's easy money in the last year has undermined the dollar and sent oil prices to a new high every day, and an almost doubling since the rate cuts started. Inflation is here and hurting us and the average American, and it was brought out very clearly by the Senator from Pennsylvania. Second, the Fed is asking for more power, but the Fed has proven they cannot be trusted with the power they have. They get it wrong, do not use it, or stretch it farther than it was ever supposed to go in the first place. As I said a moment ago, their monetary policy is the leading cause of the mess we are in. As regulators, it took until yesterday to use the power we gave them in 1994 to regulate all mortgage lenders. Then they stretched their authority by buying $29 billion worth of Bear Stearns assets so JPMorgan could buy Bear Stearns at a deep discount. Now the Fed wants to be a systemic risk regulator, but the Fed is a systemic risk. Giving the Fed more power is like giving a neighborhood kid who broke a window playing baseball in the street a bigger bat and thinking that will fix the problem. I am not going to go along with that, and I will use every power in my arsenal as a Senator to stop any new powers going to the Fed. Instead, we should give them less to do so they can get it right, either by taking their monetary responsibility away or by requiring them to focus only on inflation. Third, and finally, since I expect we will try to get it right to question the next hearing, let me say a few words about the GSE bailout plan. When I picked up my newspaper yesterday, I thought I woke up in France. But, no, it turned out it was socialism here in the United States of America, and very well, going well. The Treasury Secretary is now asking for a blank check to buy as much Fannie and Freddie debt or equity as he wants. The Fed purchase of Bear Stearns assets was amateur socialism compared to this. And for this unprecedented intervention in our free markets, what assurance do we get that it will not happen again? Absolutely none. We are in the process of passing a strong regulator for the GSEs, and that is important. But it allows them to continue in the current form. If they really do fail, we should let them go back to what they were doing before? I doubt it. I close with this question, Mr. Chairman. Given what the Fed and Treasury did with Bear Stearns, and given what we are talking about here today, I have to wonder what the next Government intervention into the private enterprise will be. More importantly, where does it all stop? Thank you. " FOMC20050809meeting--90 88,MR. LACKER.," Yes, I have a question and a comment. The question is whether the revision in the nonmarket core PCE price index should cause people to revise the number they carry around in their heads for the documented upward bias in the PCE." CHRG-110hhrg34673--177 Mrs. Bachmann," And that is something that, I think, haunts all of us as we are looking toward the future, especially toward 2030. We are concerned about that. I appreciate your response on that. My next question deals with a happier subject of productivity, and that is something where the United States has been phenomenal in the area of productivity. You are quite familiar with the President's economic report that noted that between 2000 and 2005, here in America, we had a productivity increase of about 3 percent, which far outpaced the productivity growth levels in the other G7 nations. Whereas many of them suffered a slowdown in productivity growth, the United States, in fact, accelerated and is at an enviable level. I am just wondering, sir, if you have insight into perhaps what some of the factors are that led to this remarkable productivity growth given that Western European nations as well as the other G7 nations have the same access to technological improvements as, say, the broad capital markets that we have. I am just wondering if you could state for this committee why we have seen better results here in the United States than we have seen in the other G7 countries. " 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. " 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-109hhrg22160--242 Mr. Greenspan," I said that because of the difficulty of making judgments as to how markets would behave when you are moving funds out of the U.S. treasury into a private account, even though it is forced savings--meaning, you can't do anything with it--and from a technical point you have not changed the national savings rate, have not changed the balance of supply and demand of securities, and have not therefore presumably affected the price level of bonds, there is still the issue of how that is perceived by the marketplace, which is not all that easy to make a judgment on. My general concern is that if we knew for sure that the contingent liabilities that now exist are viewed in the private marketplace as similar to the real debt of the federal government, then technically moving funds in a carve-out of the way that the President is talking about would have no effect on interest rates, no effect, indeed, which would then be an accounting system which would be based on accrued receipts. The problem is caused by the fact that we are running unified budget---- Mr. Moore of Kansas. Moving aside from the interest rates concern right now, which I understand is a huge concern, if we were to borrow $2 trillion or $1 trillion right now--and I am saying right now, over the next several years--to finance these partially private accounts and divert money out of present retirement benefits being paid to Social Security recipients, wouldn't that just pass a debt along to our children and grandchildren? And is that fair? " CHRG-111hhrg54867--118 Secretary Geithner," Thank you for raising that. You are right; it was central to the failures, and the failures this time around were much worse than you saw in the failures of ratings in the past, much more damaging. The SEC I think released just--or is about to release or just released a set of broad recommendations for trying to address many of the problems you referred to, including reducing the risks that there are conflicts of interests or incentive problems that lead them to--or create greater risk of these ratings being wrong in the future. But in addition, we have suggested that we try to eliminate what we call rating dependence in the regulatory capital regime and other parts of the regulatory system, so we are not creating greater incentives for institutions to rely on these ratings. And as the chairman has proposed and many others have considered, we think a critical part of the reform of securitization markets generally is to make sure that people who sell these securities retain some of the risk in them. And that will help get the incentives right. And, of course, as always, we are open to suggestions of how to make sure we strengthen these reforms over the rating agency process. " CHRG-110hhrg44903--111 Mr. Cox," Beginning with the failure of Bear Stearns hedge funds, there were market rumors in Europe about loss of secured funding sources that caused us to take a look at all of their secured funding sources. We found out, in fact, that their secured funding had increased. Using the capital and liquidity standards that the SEC program put in place, including the Basel II standards, including liquidity standards that require that you be able to go a full year without access to unsecured funding, the capital and liquidity cushions for Bear Stearns going into the week of March 10th were above regulatory requirements. But what we discovered during that week, and what banking regulators of all kinds in the United States and in other countries have not seen up to that point was that there could be this run on the bank phenomenon, where customers withdraw their free cash balances, where people novate their contracts and so on. The result in the Bear Stearns case was that it lost 89 percent of its liquidity in 3 days. " CHRG-110shrg50418--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. Only 6 weeks ago, Congress hastily passed a bill that gave the Secretary of the Treasury authority to spend $700 billion to address the credit crisis. The key component of the Treasury plan was the purchase of so-called troubled assets held by financial institutions. At that time I expressed grave concerns with the wisdom of the approach and questioned whether it would be an appropriate use of taxpayer dollars. Instead, at that time I called for a serious examination of the origin and scope of the ongoing financial crisis so that we might then craft a thoroughly considered and narrowly tailored solution. Unfortunately, we, the Congress, skipped that step. The Treasury Department has since abandoned the plan, as you all know, to purchase troubled assets and is now using the funds to purchase direct equity stakes in financial institutions. We were told that this would be the best way to stabilize faltering institutions and stimulate lending. Although interbank lending has improved slightly in recent weeks, the series of ad hoc Government measures intended to relieve stress in the credit markets have actually increased mortgage rates and placed additional strains on demand. This has occurred despite intentions to the contrary. Today, as we consider altering the Treasury bailout program to provide cash assistance to the domestic auto manufacturers, I am concerned that once again we are about to employ the ``ready, fire, aim'' approach to problem solving. Before we take that step, I believe we need to determine a number of things. First, we must examine whether diluting the TARP program will fatally weaken an already flawed construct. Second, I believe we must determine the current financial condition of the domestic auto manufacturers and how they got that way. Finally, Mr. Chairman, I believe we must determine both the short- and long-term outlook for these firms. These are all fact-based considerations, and we should look at the facts. Therefore, we can and I think we must build a thorough record so that we can make fact-based decisions here in the Congress. And while I recognize that the current economic situation has exacerbated the problems of the Detroit auto makers, I think we in the Congress must examine in greater detail the causes of their longstanding problem. For example, industry analysts contend that the firms trail their major competitors in almost every category necessary to compete and make a profit. In fact, even when the firms were setting record sales records, they were barely making money. I believe we need to understand why this has been the case. We need to know what the firms are doing to enhance their ability to compete in the future. How do they plan to deal with current management, labor, cost and quality control, and product development shortfalls, which they know they have? How do they plan to address changes in the marketplace such as long-term reductions in annual sales? How do they intend to reverse the continued loss of market share to foreign car companies? Yes, and how are they going to adapt to an international market that demands greater efficiency and flexibility? I also, Mr. Chairman, have questions about the amount of resources needed to address the current situation. Is $25 billion--a lot of money to me--is that enough? Is this the end or just the beginning? Some reports state that the firms appearing today may each need at least $20 billion, some $50 billion apiece. If that is true, we should be told that today. Finally, how is the money going to be used? That is a good question. Will it be used to improve their business model, which has been a failure, and product lines? Or is this just life support? I understand that each firm may use their entire share to pay preexisting claims to stay afloat. In other words, the money would be used just to keep the lights on. If that is the case, there would be nothing left to make changes that might actually help turn the firms around. I believe this begs the question: Are we here in the Senate being asked to facilitate a stronger, more competitive auto manufacturing sector or to perpetuate a market failure? Today's witnesses need to assure this Committee and the American people that they are able to do what they have failed to do in the last 10 years. I look forward to their answers. " CHRG-111hhrg55811--79 Mr. Hu," In the interest of full disclosure, I am afraid I am the one who came up with the term ``empty creditors.'' In particular, the Goldman situation--CIT situation you referred to might be of the ``empty creditor with a negative economic interest'' variety. This variety poses particularly difficult issues relating directly to your broader question in terms of this anti-abuse provision. This anti-abuse provision appears for the first time in this bill in this discussion draft. The SEC is right now just starting to analyze this particular provision. And your particular example of the Goldman Sachs/CIT situation illustrates some of the questions we are thinking about and we are working our way through. For instance, this anti-abuse provision talks about watching out for products that destabilize the system or an individual market participant and possibly banning them. What if it turns out that something--a particular kind of swap--is beneficial to the system in the sense of allowing banks, for instance, to hedge against risks or financial institutions to make loans and so forth, and yet perhaps be harmful to a particular market participant? The bill's provision doesn't answer that. It also raises issues--difficult issues that we are starting to analyze--as to what extent should some of the benefits flowing from a particular product be balanced against the potentially destabilizing effects of the products? Naturally, these issues raise profound questions that we are starting to look at, and we will be engaging in many consultations with other concerned regulatory agencies. But you raise a very, very good issue, Congresswoman Waters. Ms. Waters. I yield back. Thank you very much. " Mr. Watt," [presiding] The gentleman from Texas, Mr. Hensarling. " CHRG-110shrg50369--82 Mr. Bernanke," One of the concerns that I have is that there is some interaction between the credit market situation and the growth situation--that is, if the economy slows considerably, which reduces credit quality, that worsens potentially the condition of credit markets, which then may tighten credit further in a somewhat adverse feedback loop, if you will. I think that is an undesirable situation. I would feel much more comfortable if the credit markets were operating more nearly normally and if we saw forecasted growth--not necessarily current growth but forecasted growth--that looked like it was moving closer toward a more normal level. So what I would like to see essentially is a reduction in the downside risks which I have talked about, particularly the risk that a worsening economy will make the credit market situation worse. Senator Bayh. Well, let me ask you--but I have got only 1 minute so I am going to need to hurry. I did have two questions. What aspect of the credit markets will you look to? And, in particular, I have been interested--you talked about the flight from risk. There have been some aspects of the credit market that seem to me to be almost without risk, and yet people are fleeing from those as well. These auction rate securities, very short term, the underlying assets, particularly in the municipal sector, virtually no risk of default, and yet that seems to have seized up as well. What do you think will lead people to begin to assume rational levels of risk again? And what indicia will you look to in the credit markets to reassure yourself that this situation is beginning to work itself through? " FinancialCrisisInquiry--744 CHAIRMAN ANGELIDES: So you—because one of these always—I wondered to the extent that there’s still the January 13, 2010 global and savings imbalance if you accept that that’s the reason and the only reason which I’m not prejudging it. It dooms you to the same result unless you believe there are other things that occurred that could have been controlled. CHRG-110hhrg46595--69 Mr. Wilson," I am just wondering, if I can, Mr. Chairman, if that should be part of the language. Because if we get the Big Three propped up, and we hope they will be and will be successful, we also need to be concerned about the major suppliers. Thank you. " CHRG-111hhrg51698--259 Mr. Slocum," Right. The case that caused Public Citizen to look at this on our radar screen was last year when British Petroleum, a major oil company, agreed to a $300 million settlement when it attempted to manipulate the entire U.S. market for propane, and they did it when their energy traders were communicating with their propane pipeline and storage affiliates. But the only reason that regulators knew about it was because an internal employee at BP blew the whistle. The ability of regulators to examine that kind of activity is limited, which is why I suggested to the Committee that in legislation we should consider examining whether or not this is a problem. " CHRG-110hhrg46593--133 Secretary Paulson," I went through that in my testimony. We had the situation worsen in the United States, and we had a couple of banks fail or approximately fail. We had a whole series of banks in Europe go down. We had the credit spreads widen further and further. The situation froze up to the point that there was a market, serious change. " FOMC20070321meeting--41 39,MR. MOSKOW.," I just want to get back to the subprime market for a quick question. There have been a lot of newspaper stories about people who default on the first payment in these mortgages, which is a bit of a puzzle to me, unless it’s just pure fraud. I was just wondering if you had any information about whether there has been an increase in fraud here or whether there are other reasons for people defaulting on the very first payment on their mortgage." CHRG-111hhrg55811--258 Mr. Hu," We also have wonderful staff, very hardworking. In addition, we are hiring new people precisely because we need to better understand the new capital markets, these products, the need to keep up. I am totally confident that with sufficient resources, we are going to be able to make sure--not only make sure that these clearinghouses survive, but make damn sure these clearinghouses survive. " 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-110hhrg45625--223 Mr. Meeks," Let me--well, furthermore, then in that regard--because when you have a situation where there is so much money that is gone, the banks want to make sure that shareholders are back, money is back in regards to the shareholders. Some are saying that therefore lending right now is not the best way to get back to their stability. They have to reinvest in shareholders. So the $700 billion that we are talking about--because many are telling me that is the low end and we are really talking about over a trillion dollars here. " CHRG-111shrg50814--91 Mr. Bernanke," Senator, they are very aware of the situation. I talk frequently with Europeans. We were just at the G-7, the Secretary and I, in Rome and we discussed all these issues---- Senator Tester. Right. " Mr. Bernanke," ----and they are quite interested in addressing them. Senator Tester. Injection of capital is something that we have been talking about now for 6 months or so. Can you give me any sort of prediction, under the assumption that Europe does what they need to do and the Asian markets do what they need to do, can you give me any sort of prediction on how much money it will cost, how much capital do we need to inject into the marketplace? " FOMC20080430meeting--198 196,MR. MISHKIN.," Thank you, Mr. Chairman. Well, I'm in a very uncomfortable position here because I usually like to be very decisive, and I think in all past cases I've had a strong view before going into the meeting in terms of what is the appropriate alternative that the Committee should take, at least that I should take. I'm in a very uncomfortable position because I'm actually sitting exactly on the fence between alternative B and alternative C. As you know, sitting on the fence and having a fence right in that anatomically uncomfortable position is not a good place to be. [Laughter] So let me go through the current situation and argue why I'm in this uncomfortable position. The first point to make is that inflation expectations are actually reasonably well contained. It is true that I have a concern that high headline inflation could make containing inflation expectations and preserving the nominal anchor more difficult. But it is important to note that we have been in a situation in which we've had very high headline inflation and, in fact, core inflation and inflation expectations have behaved very well. So it's very important to emphasize that this is not the 1970s, and I really get disturbed when people point to that as a problem. We do have to worry about inflation expectations possibly going up, but it's not a situation that, if we make a mistake, they go up a whole lot. They could go up, and it might be costly to get them down, but it would not be a disaster. The second issue is that, although we may have turned the corner, we are still in a situation of very fragile financial markets, and we have been disappointed before. I am getting more optimistic. I'm hopeful and think it's very possible that we'll look back at the middle of March and say that was the worst of it. But there is a possibility, and it's not a small possibility, that things could go south again, and that would argue for the need for aggressive cuts in the future. The third thing that I point out about the situation is that the modal forecast given by the Greenbook--and consistent with my modal forecast and with the modal forecasts of most of the participants--suggests that we may have to cut a bit further in the future. So the problem is that, given the conditions that we face, we need a lot of flexibility to deal with potential downside risks. I think the downside risks have diminished, but they could go back up again. So there could be a situation in which we need to ease aggressively in the future. Of course, we've convinced the markets that we are non-gradualists, but so far we've been non-gradualists in only one direction, which is to ease. In fact, we'd like to be in a situation where we could aggressively ease in the future if we had to but not risk having inflation expectations go up. That's a very serious problem that many participants have pointed out. So how would I like the markets to perceive us? Well, I'd like the markets to perceive us as being willing to be very aggressive in terms of easing, if necessary; but I'd also like them to perceive us as having the Volcker characteristics of being six feet, six inches, tall and having a big baseball bat and, if inflation and inflation expectations are starting to unhinge, being willing to take out the baseball bat and do whatever is necessary. You really would like to position yourself to have those characteristics. So let me first talk about the case for alternative C of not changing and then go to the case for alternative B. In the case for C, the advantage of pausing at this point is that it would actually indicate to the markets by our actions that we're serious about keeping inflation under control and that it's more likely that we would bring out the baseball bat. In that sense, it could enhance credibility, and a very important, positive element of that is that it would be easier for us to be flexibly aggressive if we needed to be so in the future. That is one reason that I think there is a strong case for alternative C. But I also think there is a strong case for B. First, the evidence that inflation expectations are unhinged or are likely to get unhinged is not very strong. I do not put a lot of stock in consumer surveys. But I tend to look at financial markets as being the canary in the coal mine. Though being a New Yorker, I actually have been in a coal mine [laughter] � at the Museum of Science and Industry in Chicago. It's really cool. All of you should go there someday when you go visit Charlie. " fcic_final_report_full--333 Paulson told the FCIC that he was “naive” enough to believe that the action would halt the crisis because it “would put a floor under the housing market decline, and provide confidence to the market.” He realized he was wrong on the next day, when, as he told the FCIC, “Lehman started to go.”  Former Treasury Assistant Secretary Neel Kashkari agreed. “We thought that after we stabilized Fannie and Freddie that we bought ourselves some time. Maybe a month, maybe three months. But they were such profound interventions, stabilizing such a huge part of the financial markets, that would buy us some time. We were surprised that Lehman then happened a week later, that Lehman had to be taken over or it would go into bankruptcy.”  The firms’ failure was a huge event and increased the magnitude of the crisis, ac- cording to Fed Governor Kevin Warsh and New York Fed General Counsel Tom Bax- ter.  Warsh also told the FCIC that the events surrounding the GSE takeover led to “a massive, underreported, underappreciated jolt to the system.” Then, according to Warsh, when the market grasped that it had misunderstood the risks associated with the GSEs, and that the government could have conceivably let them fail, it “caused in- vestors to panic about the value of every asset, to reassess every portfolio.”  FHFA Director Lockhart described the decision to put the GSEs into conservator- ship in the context of Lehman’s failure. Given that the investment bank’s balance sheet was about one-fifth the size of Fannie Mae’s, he felt that the fallout from Lehman’s bankruptcy would have paled in comparison to a GSE failure. He said, “What happened after Lehman would have been very small compared to these . trillion institutions failing.”  Major holders of GSE securities included the Chinese and Russian central banks, which, between them, owned more than half a trillion dollars of these securities, and U.S. financial firms and investment funds had even more extensive holdings. A  Fed study concluded that U.S. banks owned more than  trillion in GSE debt and securities—more than  of the banks’ Tier  cap- ital and  of their total assets at the time.  Testifying before the FCIC, Mudd claimed that failure was all but inevitable. “In , the companies had no refuge from the twin shocks of a housing crisis followed by a financial crisis,” he said. “A monoline GSE structure asked to perform multiple tasks cannot withstand a multiyear  home price decline on a national scale, even without the accompanying global financial turmoil. The model allowed a balance of business and mission when home prices were rising. When prices crashed far beyond the realm of historical experience, it became ‘The Pit and the Pendulum,’ a choice be- tween horrible alternatives.”  “THE WORSTRUN FINANCIAL INSTITUTION ” When interviewed by the FCIC, FHFA officials were very critical of Fannie’s manage- ment. John Kerr, the FHFA examiner (and an OCC veteran) in charge of Fannie ex- aminations, minced no words. He labeled Fannie “the worst-run financial institution” he had seen in his  years as a bank regulator. Scott Smith, who became associate director at FHFA after that agency replaced OFHEO, concurred; in his view, Fannie’s forecasting capabilities were not particularly well thought out, and lacked a variety of stress scenarios. Both officials noted Fannie’s weak forecasting models, which included hundreds of market simulations but scarcely any that contemplated declines in house prices. To Austin Kelly, an OFHEO examination specialist, there was no relying on Fannie’s numbers, because their “processes were a bowl of spaghetti.” Kerr and a colleague said that that they were struck that Fannie Mae, a multitrillion-dollar company, employed unsophisticated technology: it was less tech- savvy than the average community bank.  CHRG-111shrg57320--48 Mr. Thorson," Right. Senator Coburn. In both of your assessments, as you looked at this and you look at OTS--and this is a huge example of regulatory failure. Where was it? Is it in their guidelines? Is it in their management? Is it in their upper management? Is it in their auditing of their own processes? Where is the failure that allowed them to allow their largest ``customer''--which I reject--to continue to do things that were to the detriment of the institution they were supposed to be safeguarding? " CHRG-110hhrg46593--271 Mr. Bartlett," We support the program as outlined by Mr. Findlay; and I put it, actually, in my written testimony. So we think that now that the capital infusion has been put in place, then the Treasury should be looking at other alternatives of additional ways to provide liquidity back in the market of which the asset guaranteed program, the asset purchase perhaps and perhaps the asset guarantee and the insurance program is a better, more leveraged way of providing the same thing. It is important to note that all the money that is needed for liquidity in the market cannot come from the government, not even a small fraction of it. So the government money has to be used to cause the private money to come to the table; and I think that is the basis of this insurance program, which is the right approach. " FOMC20070321meeting--11 9,MS. MINEHAN.," This is a continuation of the same question because I was intrigued by your chart that shows 2006 sixty-day and over delinquencies for subprime ARMs tracking with 2001. I don’t recall the world as we know it coming to an end in the subprime market in 2001, but I also wonder how big the subprime market was and how much it might have been characterized by some of the rather difficult practices that we know went on, particularly from the middle of ’06 through the end of the year." FinancialCrisisInquiry--162 All right. Thank you. I’m going move on now. Mr. Wallison? WALLISON: Thanks very much, Mr. Chairman. Mr. Mayo, as an analyst at banks, how many subprime mortgages did you think were outstanding in our economy, and many of them held by banks, in 2008? What percentage of the total number of mortgages were subprime or Alt A? In other words, non-prime in some way? MAYO: I thought that was like a trillion out of 11 trillion. Is that... WALLISON: So you thought it was about 10 percent? MAYO: Yes. WALLISON: If I told you it was half, would it have differed—would that have caused your view of what the problems might be to change the order of the various causes of the financial crisis that you describe? MAYO: That would be a little bit of a different conclusion, yes. WALLISON: OK. I thought it might. The other question I was puzzling about is your description of capitalism. And you said that capitalism has to involve bankruptcy. No one should be too big to fail. Everyone should be allowed to fail. But then you said but under prudent oversight. What is the purpose of oversight if it isn’t supposed to be keeping people from failing? CHRG-110hhrg46596--487 Mr. Foster," Okay. And then my final question is about the municipal bond market. One of the most painful aspects of the shutdown is that this is $2.7 trillion of the whole size of the market, and hundreds of billions of dollars of what would be called stimulus projects--you know, these are things that municipalities want to spend money on--are being held up by the lock-up in the municipal bond market. And I was wondering if you have any specific ideas in mind about how you might go about helping to unlock this market? " CHRG-111hhrg52261--87 Mr. Robinson," That is correct, Congressman. If there is a common thread that I could recommend that might answer some of these questions, it is, how broad a measure would be needed to cover all kinds of problems. It is answering a simple question like, Who underwrites the risk and who prices it? Because you could have somebody saying, Well, I thought the loan originator was. Well, I thought they were. Well, who is? Whether it is a credit default swap or a mortgage. And I think as we try to solve these issues--and there is no question that there are issues to be solved--that instead of perhaps picking a number to define too-big-to-fail, say, All right, you are big; what are your exposures and how much capital do you have to handle what statisticians would call the tail events--things that you don't think happen? And if they cannot answer those questions clearly and they perhaps have no idea, then that might aim you towards the real root cause of the issue. And that might be a good step, I would recommend. " CHRG-111hhrg48868--730 Mr. McCotter," I would like to see Secretary Geithner repeal that commitment to that $30 billion and then precondition any allowing of that money to go to AIG on first recouping the bonuses from the individuals who have done it. And I do think it would be in their best interest, not only the taxpayers in terms of equity, but as has been pointed out before, there will be transparency in the process. The request and potential subpoena of the list of individuals who have received and kept that money will come to this Congress because the taxpayers will need to know. I do think and appreciate the threats that may be made against them and have been made, but there is a very good way to get one's name off the list. It is to give back the bonus to the taxpayers of the United States. I think that when you made this decision, I can't believe that you made it alone. I think you would have consulted with both Treasury and/or the Federal Reserve Board. We talk about how losing these people would have caused AIG potentially to go under, right? Enormous damage to AIG towards the attempt at a soft landing, which to me, in and of itself, shows the very weakness of AIG and why we can't continue to try to effectuate a soft landing because you have said that market conditions are going to dictate over the next year or two as to how soft that landing will be. It will also require a whole bunch more of Federal money, I would think, in that 1 to 2 years until the market ``corrects'' because I think what you have done--not you specifically, but you generally, both you and the government, is you mistake why the public has no confidence right now in the economy. We think that if consumers just woke up and decided that we are seeing signs of light, that potentially I could go out and spend some of my hard-earned nest egg, that we would stimulate consumer demand and everything would be fine. But the reason that we are having this discussion today is Americans believe that we have seen institutional failures, both in our economic sphere and right now in the government sphere, because of a failure to be good stewards of their money. And until that institutional confidence is restored in the minds of the American people, there will be no recovery in the next 1 to 2 years. If we continue down the path that institutions that were once deemed too big to fail continue to prove too big to fix and cost taxpayers billions of dollars at a time when they are struggling to keep their homes, their jobs, and their hopes for their children, they will have no institutional confidence in anything and we will continue on the path that we are on. So my question to you is, if we can recover, hypothetically, within the next 1- to 2-year timeframe that you talk about, how much would it potentially cost the taxpayers to keep injecting into AIG during the next 1 to 2 years to have that soft landing because as we found out on March 2nd, I think AIG reported the largest quarterly lost in corporate history, what $61.7 billion, and then promptly received an offer of $30 billion, which you have not drawn upon. If we continue on the path we are on for the next 1 to 2 years, how much money are the taxpayers going to be asked to continue to put into AIG? " CHRG-111hhrg48868--117 Mr. Ario," Thank you for that question. I certainly agree with you that there hasn't been a failure of the State system here. In fact, we are the success story within this overall story and that the insurance companies continue to remain strong, stable, well-capitalized companies. And they are the most likely route that the taxpayer will get paid back here is the value in those insurance companies. There are on an ongoing basis many modernization initiatives that we're involved in. The world changes fast these days, and so we're updating our financial regulation, taking into account some of the issues on securities lending. I do agree with my colleague here, Mr. Polakoff, that it's the same thing on securities lending. It was liquidity issues that caused the problem, not losses in the underlying value. But we're looking at that issue. We're looking at modernizing our product approval and market conduct systems, our producer licensing systems, and so forth. But there is nothing in a systemic nature, I think, that we have to do other than be partners as part of a national systemic risk system that protects the functional regulators within an overall collaborative system. " CHRG-111hhrg48868--95 The Chairman," That's fine. There is no question, you know, it is correct. I would just note, and it is clear that there should have been some conditions, but I was re-reading the transcripts, probably to remind myself of what had happened. We should note that the Federal Reserve and the Secretary of the Treasury at that time, Secretary Paulson and Mr. Bernanke, were being criticized because they had not intervened to stop Lehman Brothers from falling apart and not paying off. So they were, to a certain extent, dammed, but they didn't dam when they didn't because there was a consensus forming--well, first Bear Stearns, there was intervention for Bear Stearns and there was a lot of criticism. People said this is capitalism. You have to let people go belly-up. And then Lehman Brothers went belly up and it turned out bellies didn't look so good to people. So when the next one came up, which was AIG, they intervened. Now that doesn't mean they did it right or wrong, but we ought to give that context. And there was a significant consensus that letting Lehman Brothers fail with no intervention was a problem. But this is a question I want to ask our various witnesses and it is not exactly what they were asked about, but we do--in addition to doing everything we can to get the money back, an important part of our job is to minimize this kind of damage and, in particular, not to have either the Bush Administration, the Obama Administration, or any Administration forced with the choice of either you let Lehman Brothers go completely under and have a problem or you bail out AIG's counterparties and have a problem. We have, under the law, reasonable means for reacting when a bank is going bad. It is called ``resolve'' it. One of those antiseptic words. We can ``resolve'' banks. Wachovia went under during this period, Washington Mutual. Neither of those or other banks caused the kind of disruption, one way or the other, that we saw from Bear Stearns or Merrill Lynch being bought by Bank of America, etc. What Secretary Geithner has asked for, and recently the Speaker and Mr. Paulson were for this, and he has testified about it and Mr. Bernanke has, an argument is that I think, very strong that there should be a statutory framework so that regulators can step in and unwind an institution and not be faced with the O and nothing choice that they had with regard to, I think, people would find both the Lehman Brothers outcome and the AIG outcome somewhat unsatisfactory. I'm wondering again--it wasn't on your agenda, maybe, beyond the scope for some, but on the other hand, from OTS and others, do you have opinions as to whether or not we ought to be moving towards some statutory framework so that you can unwind these troubled institutions without the kind of choices we have had? " CHRG-111shrg61651--78 Mr. Scott," I think addressing Long-Term Capital Management, the first issue is protecting the institution from failing, capital. But then we come to, well, maybe we will not succeed at that, it is failing. Now we have to deal with interconnectedness. We have done all we can, it wasn't enough. If you look at the present world of interconnectedness, it is not about equity. Equity is not an interconnectedness problem. I do not think it is about debt. I do not think that we are worried particularly from an interconnected point of view who is holding the bank debt. We may have other issues about that. It is really counterparty. It is really derivatives, in my view. And the answer to this is clearinghouses. If you go back to the years when Mr. Corrigan was serving very adequately in the Federal Reserve Bank of New York, his major concern was the payment system, and particularly the clearinghouse interbank payment system, because if there was a default, you would have a systematic chain reaction of failures. What did we do about that? Well, we managed to figure out a way that that thing could function without causing that problem. It now settles continuously. You do not have end of the day large net positions that could endanger the system if there is a settlement failure. So we have to address the same problem now in the context of derivatives. And I think that needs to be the focus here, because that is, in my view, the interconnectedness problem today. Senator Merkley. I am over my time. Shall I allow Mr. Johnson to respond, as well? " CHRG-111hhrg56766--58 Mr. Bernanke," Congressman, it remains probably the biggest credit issue that we still have. Yesterday, Chairman Bair talked about a big increase in the number of problem banks, a great number of those banks are in trouble because of their commercial real estate positions, both because the fundamentals, shopping center vacancies, things of that sort, have been worsening, and because of problems in financing, there are a lot of troubled commercial real estate properties, and they are causing problems for a lot of banks, particularly small- to medium-sized banks. We are watching that very carefully. The Fed has done a couple of things here. We have issued with the other agencies guidance on commercial real estate, which gives a number of ways of helping. For example, instructing banks to try to restructure troubled commercial real estate loans and making the point that commercial real estate loans should not be marked down just because the collateral value has declined. That depends on the income from the property, not the collateral value. We have also had this TALF program, which has been trying to restart the CMBS, commercial mortgage-backed securities market, with limited success in quantities, but we have brought down the spreads and the financing situation is a bit better. We are seeing a few rays of light in this area, but it does remain a very difficult category of credit, particularly for the small- and medium-sized banks in our country. " CHRG-111hhrg52397--30 Mr. Neugebauer," Thank you, Mr. Chairman. One of the things that we have sat here for several months talking about is the state of the economy, and I think if we went around this room today and asked everybody what they thought caused where we are, we would get many different answers, which is one of the reasons I have been very concerned about the road that we are going down. I do not know that we have adequately analyzed where in the system that we had the breakdowns. Instead, I think we have embarked on a road to throw a restrictive regulatory blanket over the entire financial markets. And what I think we may end up doing is in many cases, some of the people that we are ``trying to protect or to help,'' there may be unintended consequences for this very restrictive regulatory blanket that we are trying to throw over the financial markets. Derivatives and swaps are important tools, not only for discovering risk in many cases, but also for managing risk. We need to make sure that we do not destroy those tools simply because some do not understand it or some believe that possibly they could have been a cause of the financial breakdown. We do not know that is in fact the case. What we do know is many firms were able to manage their risk through this process by having some of these products actually in place. And so I look forward to the testimony that we are going to hear today, but I also caution my fellow committee members that let's go down this road with thoughtful debate and discussion and make sure that we get it right because this is a very important issue to our country. With that, I yield back. " CHRG-110hhrg38392--6 The Chairman," The gentleman from Texas, Mr. Paul, the ranking member of the subcommittee. Dr. Paul. Thank you, Mr. Chairman, and welcome Chairman Bernanke. I share your concern for the inequality that has developed in our country. I think it is very real, I think it is a source of great resentment, and unfortunately, I think it is one of those things that puts a lot of pressure on Congress to increase the amount of government programs and government spending, which I do not think is the answer. I believe the inequality comes specifically from the type of currency we have. When there is a deliberate debasement of a currency, it is predictable that the middle class is injured, the poor are hurt, and there is a transfer of wealth to the wealthy, and until we understand that, I do not believe we can solve this problem. And if we resort to continued monetary inflation and more government programs, we will only make this inequality worse. This is exactly the opposite of what happens when you have a sound currency and free markets, because it is the sound currency and free markets which creates the middle class and creates prosperity and allows the best distribution of this wealth. Inflation is a monetary phenomenon. It comes from the Federal Reserve system. The Federal Reserve has tremendous pressure put on them, because almost everybody wants low interest rates, except if you happen to be a saver, then you might not like artificially low interest rates. But, of course, that contributes to the lack of savings, which is another problem that we have in this country. We concentrate on inflation by implying, and everybody casually accepts that inflation is a price problem. But the prices that go up are one of the consequences of inflation. Inflation causes malinvestment, it causes excessive debt, and it causes financial bubbles that we have to deal with. But we have a lot of information today available to us to show that there is a lot of monetary inflation going on. For instance if you look at MZM, it is growing at almost a 9 percent rate. M3 is no longer available to us from official sources, but private sources tell us it is growing at a 13 percent rate. Of course, we can reassure ourselves and say that the CPI is growing at a 2.6 percent rate. But if you go back to the old method of calculating the CPI, closer to what the average person is suffering, and one of the reasons why there is inequality going on, is it is growing at over a 10 percent rate. The fact that the dollar is weak on the international exchange markets cannot be ignored. For instance, in just 6 months, the Canadian dollar increased 11 percent against our dollar. This should stir up some concerns. But one concern that I have, that I think is causing more problems and keeps us from coming to a solution, is the divorce between the exchange value of a dollar on the international exchange markets and the effort to lower the value of a dollar in order to increase exports, which can only be done through inflation, at the same time, believing that we can have stability in prices at home, because that is a disconnect that is not possible. If we strive for a lower dollar in exchange markets, we will have price increases here at home and we have to deal with it. I yield back. " CHRG-111hhrg56847--126 Mr. Schrader," Right now, there seems to be an impending crisis in the States in their budgets. We certainly are very mindful, as you have heard in the discussion today about our own fiscal situation here at the national government. But our States are potentially facing huge budget crises. I don't care--almost all the States--not all but almost all. What affect would massive public employee layoffs of teachers, police officers, and firefighters have on the recovery? " CHRG-111hhrg53234--110 Mr. Garrett," I appreciate that. And, who knows, they might. But is there anything more important than this meeting and the Chairman that you are leading right now? But thank you, Mr. Chairman. Just a couple of questions. You know, you are familiar with the proposal the Administration has laid out, and I assume that you at least have the opportunity to know that the Minority party, the Republicans, have thrown out a proposal as well to deal with the situation. I don't know whether you have gotten into the weeds of it at all. " CHRG-111shrg382--36 Mr. Sobel," So the---- Senator Bayh. I know they were searching for a mission. With the recent crisis, they have been resuscitated. God willing, that is a temporary state of affairs. So I am just wondering what role they might play in all this at the end of the day. " FOMC20070816confcall--24 22,MR. MOSKOW.," Thank you, Mr. Chairman. Don, I was just wondering if you could review with us the pros and cons of doing something greater than a 50 basis point cut here. I’m sure you considered that before you made the recommendation." FOMC20070628meeting--16 14,MR. KOHN.," I was just going to remark that the situation was quite different. LTCM followed the Russian debt default. The markets were already in considerable disarray. All those correlations had already begun to turn, and then on top of that you had the fire sale effects of LTCM. You can see some of that in the subprime market, where this thing is concentrated. It is just not spread out now, and the whole market situation was very different at that time." CHRG-111shrg55739--36 Chairman Dodd," Thank you very much. Senator Corker. Senator Corker. Mr. Chairman, thank you, and Senator Reed, thank you for all of your effort in this regard. Mr. Barr, thank you for being here. You are a very pleasant guy and I am hoping that over time, we will get this all in balance. I want to say, though, just in listening to testimony, it just seems a little schizophrenic in that this was the biggest regulatory failure in 30 years, and in essence, regulators outsourced their regulation to three for-profit entities. I mean, that is really what has happened here. We obviously realized they were doing no due diligence and basically taking what the issuers were saying. In testimony in answering just a minute ago, you said that the Federal Government should not be in the business of designing what these guys do. But on the other hand, as it relates to consumer protection, you guys want to design the products that private companies are offering. I just find this almost an out-of-body thing. When we are looking at trying to fix the inconsistencies that led to this, on one hand, we are doing almost nothing but transparency, OK. On the other hand, we are getting into actually telling companies what products they are going to offer. This is just sort of an imbalanced approach, and I don't want to spend long on that, but I wonder if you want to rebut that at all. " CHRG-110shrg50417--28 PENNSYLVANIA Ms. Wachter. Thank you. Chairman Dodd and other distinguished Members of the Committee, it is my honor to be here today to provide my perspective on the ongoing mortgage crisis and how and why stabilizing the housing market is essential to stabilizing the broader U.S. economy. The ongoing crisis in our housing and financial markets derives from an expansion of credit through poorly underwritten and risky mortgage lending. Until the 1990s, such lending was insignificant. By 2006, almost half of mortgage originations took the form of risky lending. The unprecedented expansion of poorly underwritten credit induced a U.S. housing asset bubble of similarly unprecedented dimensions and a massive failure of these loans and to today's system breakdown. Today's economic downturn could become ever more severe due to the interaction of financial market stress with declines in housing prices and a worsening economy feeding back in an adverse loop. We have the potential for a true economic disaster. I do not believe we will solve our banking liquidity problems if the housing downturn continues, and the housing market decline shows no signs of abating. Moreover, despite bank recapitalization and rescue efforts, economically rational loan modifications that would help stabilize the market are not occurring. We must directly address the need for these loan modifications in order to halt the downward spiral in mortgage markets and the overall economy. It is critical to bring stability to the housing market. While today prices may not be far from fundamental levels, just as they overinflated going up, there is great danger for overcorrection on the downside. In our current situation, as prices fall, market dynamics give rise to further expectations of price decline, limiting demand, and supply actually increases due to increased foreclosures, causing prices to decline further. A deflationary environment with demand decreases due to expectations of further price decline was in part responsible for Japan's ``lost decade'' of the 1990s. We cannot rely on a price decrease floor at currently market-justified fundamental levels if we rely on market forces alone, even, it appears, if augmented by the interventions so far of the Federal Reserve and Treasury. In fact, home inventories are not declining, and up to half of the inventory of homes are being sold through foreclosures at fire-sale prices in many markets. The Case-Shiller Price Index reflects the massive deterioration of housing wealth so far. Since the peak in 2006, housing values have fallen over 20 percent. While another 5- to 10-percent fall could bring us to market-clearing levels, actual price declines may far exceed this. And as house prices decline, these declines undermine consumer confidence, decrease household wealth, and worsen the system-wide financial stress. While banks have been recapitalized through the Capital Purchase Program--and there is discussion of the use of this funding for acquisitions--as yet, there is little evidence that bank lending has expanded. In order for the overall economy to recover and for conditions not to worsen, prudent lending to creditworthy borrowers needs to occur. Without financing for everyday needs, for education, small business investment and health, American families are at risk. And today the U.S. economy and the global economy are depending on the stabilization of their financial well-being. Moreover, the plans that are already in place do not appear to be leading to the modification of loans at the scale necessary in order to assure a market turnaround at fundamental levels instead of a severe and ongoing overcorrection. Barriers to economically rational loan modifications include conflicting interests, poor incentives, and risks of litigation to modify loans, particularly to modify loans deriving from mortgage-servicing agreements. Given the freefall in housing markets and its implications for credit conditions and the overall economy, there is a need for policies to address these barriers today. It is both necessary and possible to take effective action now. While housing values may not be far from fundamental levels, as housing values continue to fall, resolving the problem will become increasingly difficult and costly. Thus, solutions that are now possible may not be available going forward. Without expeditiously and directly addressing the housing market mortgage crisis, the Nation is at risk. Thank you. " CHRG-111hhrg56847--105 Mr. Bernanke," In general, I think right now we have a broadly stimulative fiscal policy which at the moment is helping, is needed, that includes lower taxes and probably higher spending as well. But I think in order for that to be sustainable, we need to have a plan in the medium term to bring us back down to a stable trajectory. And that is what is critical. As long as we have the confidence of the markets that we will be able to exit from this situation with a sustainable fiscal program, then I think we will be okay. If the markets take the conclusion from our actions that we are unable to do that, then we face some risk that interest rates will go up, and markets will be unconvinced. " 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-111hhrg51591--110 Mr. Foster," Right. Well, a related suggestion is to have a fund, to pre-fund the systemic risk thing by basically taxing increasingly the large institutions, which is another obvious possibility. Let's see. Another attack on the too-big-to-fail problem has to do with just enforcing compartmentalization. And when you talk to Ed Liddy about this, you know, he is just dismayed at the prospect of anyone trying to run a business that was as diverse as that. And simply, if you had had the individual business units of AIG grow, become profitable, and then at that point just return dividends to shareholders, who want reinvest it wherever they thought it made sense. And by enforcing compartmentalization as a way of dealing with too-big-to-fail, it also makes the regulator's job a lot easier. And I was wondering if you have a reaction to that as a possible solution for the insurance industry. " CHRG-111shrg55479--148 RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER FROM J.W. VERRETQ.1. Professor, in your testimony you suggest alternative contributing factors for the Committee to investigate to determine the ``culprit'' of the financial crisis. The first factor you suggest to investigate is the moral hazard problems created by the prospect of the Government bailout. Do you think that moral hazard problem is stronger cause of the than corporate pay structure? Do you think the distortions to the housing market cause by Fannie Mae and Freddie Mac played a larger role in causing the financial crisis of 2008 than how a company pays its CEO?A.1. Answer not received by time of publication. ------ FOMC20071031meeting--291 289,MR. HOENIG.," I’ve got a long record, and I haven’t been in this situation too often. But I have been in this situation before." fcic_final_report_full--303 Geithner explained the need for government support for Bear’s acquisition by JP Morgan as follows: “The sudden discovery by Bear’s derivative counterparties that important financial positions they had put in place to protect themselves from finan- cial risk were no longer operative would have triggered substantial further disloca- tion in markets. This would have precipitated a rush by Bear’s counterparties to liquidate the collateral they held against those positions and to attempt to replicate those positions in already very fragile markets.”  Paulson told the FCIC that Bear had both a liquidity problem and a capital prob- lem. “Could you just imagine the mess we would have had? If Bear had gone there were hundreds, maybe thousands of counterparties that all would have grabbed their collateral, would have started trying to sell their collateral, drove down prices, create even bigger losses. There was huge fear about the investment banking model at that time.” Paulson believed that if Bear had filed for bankruptcy, “you would have had Lehman going . . . almost immediately if Bear had gone, and just the whole process would have just started earlier.”  COMMISSION CONCLUSIONS ON CHAPTER 15 The Commission concludes the failure of Bear Stearns and its resulting govern- ment-assisted rescue were caused by its exposure to risky mortgage assets, its re- liance on short-term funding, and its high leverage. These were a result of weak corporate governance and risk management. Its executive and employee compen- sation system was based largely on return on equity, creating incentives to use ex- cessive leverage and to focus on short-term gains such as annual growth goals. Bear experienced runs by repo lenders, hedge fund customers, and derivatives counterparties and was rescued by a government-assisted purchase by JP Morgan because the government considered it too interconnected to fail. Bear’s failure was in part a result of inadequate supervision by the Securities and Exchange Commission, which did not restrict its risky activities and which allowed undue leverage and insufficient liquidity. CHRG-111hhrg54868--157 Mr. Green," Did not. The CRA did not cause the current crisis. And I would hope that would echo through the halls of Congress such that at least we can put that to rest. Did overregulation of the market create the problem that we are trying to contend with, an overregulated market? In words that may not be suitable, but did a lack--did laissez-faire, the lack of laissez-faire create the problem? Chairwoman Bair? Ms. Bair. No, a lack of laissez-faire did not cause the problem, no. " CHRG-110shrg50414--231 Mr. Bernanke," Well, if the program works, it will be extremely helpful because we are in a situation now with financial markets freezing up and it is very difficult for us to achieve the objective of full employment in a situation where credit is not available and the financial markets are so unstable. So I think we have taken the view--we have been working very hard over the last year using a variety of tools to try and promote financial stability. That was, in fact, the historic purpose of the Federal Reserve. But I view it as essential to the other objectives you just mentioned. Without financial stability, you are not going to have full employment and price stability. So we think that is very important and we have been working together with the Treasury Secretary very intensely in trying to promote stability in our financial markets. Senator Akaka. Chairman Bernanke, should we worry about the Treasury being given the ability to move $700 billion in and out of the economy and the potential impact that this could have on monetary policy, and also the political independence of the Federal Reserve? " CHRG-111hhrg54869--38 Mr. Volcker," Two relevant questions. On the first question, I am not recommending anything particularly different so far as banks are concerned that already have lender of last resort, they already have deposit insurance, and we have some history of intervening with Federal Reserve money or government money in the case of failure of very large banking institutions. So that I take is a given. And that is common around the world. There isn't a developed country that doesn't have a similar system to protect banks because banks are, I think, the backbone of the system. Now it is also true in the United States the relevant importance of banks has declined in terms of giving credit because more of the credit creation has been going into securities, which is the province of the capital market. What is different is the situation has changed where some of the benefits anyway, the safety net, has been extended outside the banking system. That is what I want to change. But you can't change it just by saying it is not going to happen because you are going to have problems. You have to develop some other possibilities and arrangements to minimize the chances of a crisis. So that is what we are proposing. " CHRG-111hhrg54872--126 Mr. McHenry," Do you think the failure in ACORN, from your analysis, is that a failure of pay? Ms. Burger. I did not take part in the analysis of ACORN. I think that ACORN as an organization over the years has done a lot of great work in low-income communities. There is an investigation going on right now and we should make sure that violations never take place in the future. " CHRG-111hhrg55809--35 Mr. Kanjorski," Well, whether I interpreted it correctly or not, anyway, congratulations. I think we are on a course to now perhaps put together something that can be accomplished here. The only thing that I did not hear you talk about is a factor that came to our attention when we held the hearings on General Motors, Ford, and Chrysler. The testimony was quite clear there, and including the foreign manufacturers, that they all concluded that if we allowed Chrysler to fail it would cause systemic risk and bring down all of the other automobile industry because of the intertwined nature of their dealers and their suppliers; and that was a major consideration in what the Congress did in supporting the bailout of General Motors. Now my question is, I heard you only talk about financial institutions in relationship to systemic risk. Does that mean you see no other systemic risk in our system beyond the financial institutions? Or is it because that happens to be the flavor of the day and we should wait until there is a failure or systemic risk in other industries? " CHRG-111hhrg53241--2 The Chairman," The hearing will come to order. We are here today for the second day of hearings on the Administration's proposal for a change in the regulatory structure, and in particular today, we have advocacy groups of various sorts that have focused on consumer civil rights and community economic concerns. All of the issues that are embodied in this are before us. As was the case yesterday, I think we probably have some particular interest among many of the witnesses today in the proposed consumer agency, but, as I said, all of the various aspects of that are before us. I will begin. We will have 10 minutes of opening statements on each side and then proceed with our panel. The need for regulation seems clear, and I think we should understand that this is, to a great extent, part of a historical pattern. We have a private sector economy in which the private sector generates wealth, and we are all supportive of that. There is constant innovation in the private sector, as there should be. At certain points in history, the level of innovation reaches a point where there is almost a qualitative change in the way in which certain institutions function. Now we should be very clear. None of these institutions, none of these new approaches, would survive if they did not add significant value in the society because they are voluntary. And if they did not add value, nobody would participate and provide any funds for them. The problem comes when they innovate, provide a great deal of benefit, but precisely because they are innovative, occur in a regulatory vacuum. There are no rules, and the free market clearly needs rules to function well. Rules to give investors, the people who will be making the money available, some confidence. Rules to protect the great majority of people in the business who want to be honest and follow all the rules from those who don't. We had a situation in the late 19th Century where the innovation was large industrial enterprises. If you looked at the structure of American enterprise in the 1880's and 1890's, it was very different than it was in the 1940's and 1950's. It was larger. Those large enterprises were good, because you could not have had the degree of industrialization and wealth creation that we have had without them. But they operated in a regulatory vacuum. So after the creation of the large enterprises in the latter part of the 19th Century, you had Woodrow Wilson and Theodore Roosevelt, in reverse order, adopting rules, the Federal Trade Commission, the Federal Reserve system, antitrust acts to try to preserve the benefit of those large institutions without much of the harm. That worked pretty well but it, in turn, led to another situation where the newest innovation in terms of its impact was the stock market, because with large enterprises, you could not have individually financed entities or family financed entities. You needed a stock market. The stock market, obviously, did a lot of good, but it caused a lot of problems because there were no regulations. So in the New Deal you saw regulations both in the banking industry and of the equity industry. That worked for a long period of time. Beginning in the 1980's, into the 1990's, and culminating in this past decade, a new round of innovations came up. Banks became less important, because there were ways for people to aggregate the money and lend it out outside of banks. So bank regulation covered less and less of the activity. Securitization came into being, which meant that the discipline that came from the lender/borrower relationship eroded. Derivatives were created without an adequate regulatory structure. I think we are in the third of those periods that I just mentioned, where innovation that essentially does a lot of good outstripped regulation by definition. And our job is to try to fashion regulations with regard to derivatives; with regard to excessive leverage; with regard to loan originations by people who have no economic interest in their being repaid; with regard to the model in which so many mortgages--such a large part of the economy--are held in a split fashion, where there are those with ownership interest and those with the control of the instrument and they are not always able to work together. And it is not that we have had innovations that are bad. It is that innovations by definition are unregulated. The lack of regulation I believe has caused serious problems. And our job is, as it was for Woodrow Wilson, Franklin Roosevelt, and Theodore Roosevelt, to come up with rules that minimize the damage while maximizing the benefit. Now I know--let me say in closing--there were those who tell us we will be killing off the innovations by doing this. I can save them the time. They don't have to write these speeches. They can go back to 1902 and 1903 and dig out what people said about Theodore Roosevelt and then later about Woodrow Wilson, and they can go back to 1933 and 1934 and be right here in the Congressional Record, and they can get all the speeches about how regulation will inherently kill off these activities. Yes, excessive regulation and incompetent regulation and foolish regulation can do that, but well-done regulation, as it did under Theodore Roosevelt and Woodrow Wilson and as it did under Franklin Roosevelt, can help, and that is what we intend to try to do today. The gentleman from California is recognized for 4 minutes. " CHRG-111hhrg48875--2 The Chairman," The Committee on Financial Services will now convene for the purpose of the hearing with Secretary Geithner. I have an announcement to make regarding the order on the Democratic side when Mr. Geithner and Mr. Bernanke were here the day before yesterday; and, I apologize for not having Mr. Geithner here on Wednesday, but sometimes we have to do other things. The following Members on the Democratic side were here at a time when he and Mr. Bernanke had to leave, and I said at the time that they would get priority in questioning. After myself and the chairman of the subcommittee, we would go to the following Democrats: Let me just read them in the normal, seniority order: Mr. Ellison; Mr. Scott; Mr. Green; Ms. Kilroy; Mr. Donnelly; Mr. Klein; and Mr. Grayson. They will be the first ones to ask questions. . We will now proceed to the opening statements using the rules for hearings with a Cabinet member. The rules are 5 minutes for the chair and the ranking member; 3 minutes for the chair and ranking members of the subcommittee, and I apologize for the disruption of the transition. We will now begin. I think the announcements are over. We have before us the job of dealing with whether or not there is existing in the Federal Government today sufficient authority to deal with systemic risk. There are several aspects to that. We talked considerably about one of them on Tuesday with the Chairman of the Federal Reserve and the Secretary of the Treasury; namely, the need to have somewhere in the Federal Government the ability to use the bankruptcy authority given by the U.S. Constitution to wind down an important, non-bank, financial institution. We have long had in our laws an adaptation to bankruptcy to wind down banks; and, when banks have failed, while it has been sometimes painful, it has not been as disruptive as when the non-bank financial institutions have failed. The two glaring examples are Lehman Brothers, where nothing was done, and AIG, where everything was done. I believe we are looking for an alternative method to avoid those two polar extremes. That is, a bankruptcy authority which can honor some and not honor others. It has some discretion. The question of compensation is part of that, as is the question of whether or not people should continue to be allowed to securitize 100 percent of loans. Today--although obviously members are free to bring up whatever they wish--our focus will be on whether we need to increase the authority of some entity or entities in the Federal Government to restrict excessive leverage. We are talking in the resolving authority about what happens when there is a failure on the part of an institution that is so heavily indebted to so many parties that simply allowing it to fail without intervention could cause magnifying, negative effects. But, obviously, the preferential situation would be to keep that from happening, and this subsumes a lot of other issues, whether or not people are too-big-to-fail, or too-interconnected-to-fail. The goal should be--and obviously no system is going to prevent all failures, because it would then be too restrictive--to minimize the likelihood that entities will get so heavily indebted, so heavily leveraged with inadequate resources in case there is a need to make the payments, that their lack of success threatens the whole system. I believe that we are in a third phase here of a set of phenomena we have seen in American economic history. It is a phenomenon in which the private sector innovates. Innovations which have no real value die of their own weight, but innovations that add value thrive as they should, because we are dependent on the dynamism of the private sector to increase our wealth. But, by definition, when this comes from significant innovation, there aren't rules that contained abuses. The goal of public policy is to come up with rules that set a fair playing field that constrains abuses, and that protects legitimate and responsible entities from irresponsible competition, that can draw them away from good practices, while having as little effect as possible on diminishing the value. Thus, in the late 19th Century, the trusts were created, and they were very important. We would not have industrialized without those large enterprises such as oil, coal, and steel, and a number of other areas. But because they were new, the operated without restraint, so Theodore Roosevelt and Woodrow Wilson were more help, I think, than they get credit for from William Howard Taft. Set rules, the Antitrust Act, the Federal Trade Commission, the creation of the Federal Reserve, those were rules that tried to preserve the large industrial enterprises. Indeed, they were people who tried to get Woodrow Wilson to break them up. And he said, ``No.'' They gave a valuator that we need, but we need rules. That led to a great increase in the importance of the stock market, because you now had enterprises that could not be financed individually. And the job of Franklin Roosevelt and his colleagues during the 1930's was to set rules that allowed us to get the benefit of the finance capitalism, the stock market, but curtailed some of the abuses. I believe that securitization and the great increase in the ability to send money around the world that comes from both the pools of liquidity and the technology, CDOs and credit default swaps, these are a set of innovations on a par with the earlier set, and they have had great value. Securitization, which allows money to be relent and relent and relent without it all having to be repaid, greatly magnifies the value of money; but, there are problems, as there were with the trusts or with the stock market when there are no rules. Our job is to craft rules as did Theodore Roosevelt, Woodrow Wilson and Franklin Roosevelt that allow the society to get the benefit of these wonderful, value-added financial innovations while curtailing some of the abuses. The gentleman from Alabama. " CHRG-111hhrg48868--777 Mrs. Bachmann," We just celebrated that anniversary. And I wonder had we--had the Federal Reserve chosen not to open that discount window and had Bear Stearns failed as a result of that, do you think that would have served as an example to AIG to stop with the risky bets that were going on? " CHRG-110shrg50409--101 Mr. Bernanke," At a given time, yes. Senator Bayh. Is there any limit to the amount that can be utilized through that mechanism, any practical limit? We have the investment banks partaking. If we get the GSEs partaking, I am just wondering how much more there is to be had from that mechanism. " FOMC20081029meeting--261 259,MR. FISHER.," Mr. Chairman, if I could just add one other thing. We are hearing more and more about people switching to LIBOR, trying to shift their lending contracts to LIBOR rather aggressively, obviously, because they are higher rates. But I'm wondering if you're picking that up as well. " CHRG-111shrg49488--91 Chairman Lieberman," Dr. Carmichael, in addition to responding to that, I wonder if you would talk just a little bit about what the opinion is in Australia now about whether this was a good move to go to the so-called twin peaks, in the government, amongst the public, and I suppose in the regulated community. " FOMC20050630meeting--153 151,MR. STOCKTON.," Let me make one other point on the reasons why there may have been an increase in the equilibrium price-rent ratio, because I certainly agree with you and President Yellen that there are some good reasons. Those reasons could well include financial innovation, changes in capital gains taxation, and supply constraints. However, lots of asset price misalignments start out with situations where there are good reasons why those prices are rising rapidly. Productivity innovation and changes in business models, and so forth, were I think probably valid explanations for the increase in stock market prices, but that doesn’t mean—" CHRG-111shrg55479--25 Mr. Verret," Chairman Reed, Ranking Member Bunning, and distinguished Members of the Committee, I appreciate the opportunity to testify in this forum today. My name is J.W. Verret. I teach corporate law at George Mason Law School. I am a Senior Scholar with the Mercatus Center Financial Markets Working Group, and I also run the Corporate federalism Initiative, a network of scholars dedicated to studying the intersection of State and Federal authority in corporate governance. I will begin by addressing proxy access and executive compensation rules under consideration, neither of which address the current financial crisis and both of which may result in significant unintended consequences. Then I will close with a list of factors that did contribute to the present financial crisis. I am concerned that some of the corporate governance proposals recently advanced impede shareholder voice in corporate elections. This is because they leave no room for investors to design corporate governance structures appropriate for their particular circumstances and particular companies. Rather than expanding shareholder choice, the proxy reform and ``say-on-pay'' proposals before this committee actually stand in the way of shareholder choice. Most importantly, they do not permit a majority of shareholders to reject the Federal approach. The Director of the United Brotherhood of Carpenters said it best. Quote, ``We think less is more. Fewer votes and less often would allow us to put more resources toward intelligent analysis.'' The Brotherhood of Carpenters opposes the current proposal out of concern about compliance costs. The proposals at issue today ignore their concerns, as well as concerns of many other investors. Consider why one might limit shareholders from considering alternative means of shareholder access. It can only be because a majority of shareholders at many companies might reject the Federal approach if given the opportunity. Not all shareholders share the same goals. Public pension funds run by State elected officials and union pension funds are among the most vocal proponents of the proposals before this committee. There are many examples where they used their power, their existing shareholder power, toward their own special interests. Main Street investors deserve the right to determine whether they want the politics of unions and State pension funds to take place in their 401(k)s. The current proposals also envision more disclosure about compensation consultants. Such a discussion would be incomplete without mentioning conflicts faced by proxy advisory firms like RiskMetrics, an issue the current proposals have failed to address. In addition, I will note that there is no evidence that executive compensation played a role in the current crisis. If executive compensation were to blame for the present crisis, we would see significant difference between compensation policies at those companies that recently returned their TARP money and those needing additional capital. We do not. Many of the current proposals also seek to undermine and take legislative credit for efforts currently underway at the State level and in negotiations between investors and boards. This is true on proxy access, the subject of recent rule making at the State level, and it is true for Federal proposals on staggered boards, majority voting, and independent chairmen. We have run this experiment before. The Sarbanes-Oxley Act passed in 2002 was an unprecedented shift in corporate governance, designed to prevent poor management practices. Between 2002, when Sarbanes-Oxley was passed, and 2008, the managerial decisions that led to the current crisis were in full swing. I won't argue that Sarbanes-Oxley caused the crisis, but this does suggest that corporate governance reform at the Federal level does a poor job of preventing crisis. And yet the financial crisis of 2008 must have a cause. I commend this Committee's determination to undercover it, but challenge whether corporate governance is, in fact, the culprit. Let me suggest six alternative contributing factors for this Committee to investigate. One, the moral hazard problems created by the prospect of Government bailout. Two, the market distortions caused by subsidization of the housing market through Fannie Mae, Freddie Mac, and Federal tax policy. Three, regulatory failure by the banking regulators and the SEC in setting appropriate risk-based capital reserve requirements for investment in commercial banks. Four, short-term thinking on Wall Street, fed by institutional investor fixation on firms making and meeting quarterly earnings predictions. Five, a failure of credit-rating agencies to provide meaningful analysis caused by an oligopoly in the credit-rating market supported by regulation. Six, excessive write-downs in asset values under mark-to-market accounting, demanded by accounting firms who refuse to sign off on balance sheets out of concern about exposure to excessive litigation risk. Corporate governance is the foundation of American capital markets. Shifting that foundation requires deliberation and a respect for the roles of States in corporate governance. Eroding that foundation risks devastating effects for capital markets. Thank you for the opportunity to testify and I look forward to answering your questions. " CHRG-110shrg50410--24 Secretary Paulson," Eighteen months, and I would like to talk about that for a minute, because we asked what is the right period here. And it seemed to me that we did not want to--I could have asked for it for the end of the year. It did not seem like--we do not know what the markets will be like at the end of the year. It did not seem like a great gift to give to my successor, whoever he or she may be, to have something like this expiring right away. And so as we thought about it, we said 18 months or through the end--I guess we said through the end of 2009, that should give time to get the new regulator established, to work through this current, you know, period of turmoil, to have the new administration--give them some time to assess the situation, give them some time to work with Congress, give you all time. And so that was where we came up with asking for it until the end of 2009. Senator Shelby. How much money are you contemplating here? " FOMC20060629meeting--29 27,MR. WILCOX.," I suppose that would be a policy choice available to you. In thinking about how to do that, you’d want to think about the horizon at which you would want to do this. I sliced into probability space at a horizon of eight quarters. I have no idea whether you’d want to aim to cause these shocks to have zero effect after four quarters or sixteen quarters or when. But I haven’t thought seriously about whether precisely zero is the right effect or not. The effect is a lot smaller now than it was three decades ago, and in many of these model specifications it’s not statistically significantly different from zero." CHRG-110shrg50409--88 Chairman Dodd," Thank you, Senator. Senator Akaka. Senator Akaka. Thank you very much, Mr. Chairman. Let me add my welcome to Chairman Bernanke for being here, and my concerns in our country is to educate the people of America as well as to protect them and empower them in our financial system. Given the recent failures, I am concerned by the increasing lack of trust that individuals have in the banking system. When large numbers of depositors lose trust in their financial institution and demand their money back, the bank can fail as a result, and we know that. In addition, distrust of the banking system causes many immigrants to miss out on savings, borrowing, and low-cost remittance opportunities found at banks and credit unions. My question to you is: What must be done to increase trust in the banking system among depositors as well as among the unbanked? " CHRG-111shrg51395--264 RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM JOHN C. COFFEE, JR.Q.1. Are you concerned that too much reliance on investor protection through private right of action against the credit ratings agencies will dramatically increase both the number of law suits the companies will have to deal with as well as their cost of doing business? Have you thought about alternative ways to ensure adequate investor protections that will not result in driving capital from the U.S. in the same way that the fear of litigation and costs created by Sarbanes-Oxley has resulted in a decline in new listings in American capital markets?A.1. I have two independent responses: First, authorizing a cause of action along the lines that Senator Reed's bill (S. 1073--``The Rating Accountability and Transparency Enhancement Act of 2009'') does should not increase the number or aggregate recoveries in securities litigation to any significant degree. This is because the Reed bill's proposed cause of action against credit rating agencies contains an important safe harbor under which a credit rating agency that conducts due diligence or hires an independent due diligence firm will be protected against suit. In this light, I believe the real impact of this provision will be ex ante, rather than ex post, meaning that it will change the rating agency's behavior so as to avert litigation, rather than affecting the overall incidence or outcome of suits against it. Secondly, I have elsewhere proposed that all securities litigation against secondary defendants (i.e., persons other than the issuer or underwriter) be subject to a ceiling on damages to protect against such litigation causing their insolvency. So limited, securities litigation against secondary participants could deter, but not destroy. ------ CHRG-111shrg56415--38 Mr. Smith," I would only add, Senator, that in the most successful period I know of in home lending in the United States, there were mainly two, maybe three varieties of loans generally in the underwriting standards world, as you say. There was a requirement of a downpayment, for standard documentation, and the people that made the loans kept them. And on the basis of that lending experience, we projected--the magicians on Wall Street did projections about the loans that weren't like that. So, I think there is--as you point out, the issue there is the issue of access to housing, and that is what it is. There is no free lunch and no easy answer. Senator Gregg. Thank you. Thank you very much for your testimony. Senator Johnson. Senator Bennet. Senator Bennet. Thank you, Mr. Chairman, and I would also like to thank the panel for your excellent testimony. Every weekend when I go home to Colorado, what I hear from small businesses is they have no access to capital, no access to credit, and we are in this, as the panel has talked about, in this remarkably difficult period where, on the one hand, the securitized market that blew up or imploded is now gone and has not been replaced, which is probably a good thing from a leverage point of view, but it hasn't been replaced. On the other hand, we have got this looming commercial real estate issue that is still out there. And sort of caught in between all that are our small businesses who need access to capital in order to grow and in order to deal with the unemployment rate that Senator Tester talked about and sort of this folding back on top of itself. And I wondered, Mr. Tarullo, you mentioned in your testimony at the beginning your view that maybe some more direct efforts--I think you described it as temporary targeted programs--might be necessary to get our small businesses access to the credit that they need, and I wonder if you could elaborate a little bit more on that, because I suspect you are right. And in addition to that, I would ask to what extent we think the current accounting regimes are ones that are either helping banks extend credit to small businesses or are intruding on their ability to do that. " FOMC20070918meeting--243 241,MR. ROSENGREN.," I think that this is a very creative solution to thinking about the stigma issue and providing liquidity to the market, so I applaud the effort to try to broaden the tools that we have to think about these kinds of issues. When I was thinking about how this might actually work, I did come up with a couple of operational questions. My thought was that if we had this auction, who would be the most likely to want to take the money out? I could imagine a situation in which you would have five borrowers taking out the full $20 billion. If those five were Countrywide, Washington Mutual, and three European banks, it would certainly give the perception that we were focused on financial institutions that had significant risks. In terms of worrying about markets as opposed to institutions, I think there is a potential perception issue. So my first question related to that is the following: You picked 20 percent of the auction; but if you picked a smaller percentage of the auction that any one institution could take, by broadening out the number of institutions, I think there would be more of a perception that it was designed for markets rather than for institutions. Now, I am aware that the offset to that is that you might not take down the whole auction. So the less that any one institution can take, the greater is the risk that you’re not fully subscribed, or you presumably could change the amount. But I’d like to hear at least some thought as to how you came up with 20 percent. The second issue is that when we think about the discount window, which is primarily for overnight loans, there seems to be a bit of ambiguity in terms of whether you are primary or secondary credit, and in this situation I think it starts becoming important. When I think of an institution like Countrywide having a $4 billion loan, the OTS views them as a 2-rated institution, and I don’t know how we would view them if we were regulating them. I do know that the markets seem to be assessing them as being a good bit different from a 2-rated institution. So when we’re thinking about an institution that we might have concerns about giving 23A exemptions and an institution that might have difficulty raising funds because the market perception is that they are very, very risky, how comfortable are we with the way the discount window thinks about primary and secondary credit for institutions that the financial markets at least think have a high probability of a fall? My third question ties to the European banks. It seems for the European banks that the ECB is better positioned to make the credit evaluation of whether they are risky or not risky and the equivalent of our primary-secondary distinctions. Given that the European banks have the option to borrow, assuming that the swap did go through, it would seem preferable that they borrow in Europe rather than borrow here because I think about the incentives going forward. If a European bank that has financial problems that, say, the German authorities and the German Bank are aware of but we may not be fully aware of borrowed $4 billion from our liquidity window, I wonder what the incentives are for either the institution or the regulator to fully disclose the nature of the problems. I’d like to get your sense of why you think it necessary for U.S. banks to have access in both locations and for European banks to have access in both locations. Those were the three questions that I had." CHRG-111hhrg53240--14 Chairman Watt," Okay. All right. Now, some of the people in the industry have said that if we leave part of this responsibility in the Fed and create this new consumer protection agency, that will lead to conflicts. And I think I started to understand that yesterday, so I am prepared maybe to move it all out of the Fed. That is one possibility of resolving conflicts. Or leave it all in the Fed. But this is all over the place now: It is in the Fed; it is in OTC; it is in a number of different regulatory agencies. And while you have been pretty aggressive about saying that you think that the Fed can do it, I am wondering if you have the same level of confidence in the other regulators who are doing it. Or should we--are you saying that we should continue to leave consumer protection in the Fed, in the OTC, in the other regulators as an alternative for the new agency? Ms. Duke. I am assuming that your question refers to the examination responsibilities, the supervision responsibilities. " FOMC20080430meeting--162 160,MR. MISHKIN.," Just to ask Bill a question--first the tall Bill, but the shorter Bill can answer afterward. [Laughter] On alternative B, you indicated that this would be very much in line with market expectations and, therefore, shouldn't have much impact. I was wondering about the statement aspect, in particular the assessment-of-risk part, because this is not just saying that we are doing 25 basis points; it is also saying that we are now in a different mode of operation regarding the cycle. So where do you think the markets are concerning where the statement would be in this regard? " FOMC20060920meeting--129 127,MR. HOENIG.," Mr. Chairman, I’d characterize the Tenth District’s economy as quite healthy right now. As you know, the Tenth District has benefited perhaps disproportionately from the rise in energy prices over the past few years, and this is providing considerable stimulus to the local and state economies in the District. We are also seeing strong manufacturing activity driven by exports of District products. Although the housing markets across the District can be characterized as soft, we have no reports of serious declines in prices anywhere in the region. Retail sales, excluding autos, also are holding up pretty well for us. The other soft spot for us is agriculture, and that is tied pretty much to the drought that we continue to experience. Regarding the national economy, the economic information received since the last meeting confirms a further slowing of economic activity this quarter. Moreover, weakness in housing and auto production suggests that the fourth quarter could be a little bit weaker as well. At the same time, we have recently experienced the sizable and largely unexpected declines in energy prices that we have talked about here, which, if maintained, could provide some stimulus over the balance of the year to offset some of that weaker information. Currently, I expect growth to slow to a range of 2 percent to 2½ percent in the second half of the year and to rebound to above 2½ percent or to 3 percent next year. Generally speaking, I am more optimistic than the Greenbook, especially with regard to housing and consumer spending, and I’m not nearly as pessimistic as the Greenbook on potential output. As to housing, we are in fact, as all have noted, squeezing out of that sector the speculative excesses that developed with the low interest rates of recent years—and doing so is unavoidable if we want to correct the sector. The adjustment process has obviously been painful for some, and it has not yet run its course. However, we perhaps see ourselves getting a little closer to the bottom than we might think right now, and that’s related to the fact that credit remains available at reasonable rates for most homebuyers, as suggested by the recent information on mortgage applications. So, yes, it is painful, and yes, we are going through it; but I don’t think it is necessarily long lasting in terms of the consumer’s position. For the consumer more generally, the situation is obviously mixed. On the one hand, consumption will likely receive less stimulus going forward from the withdrawal of home equity, and with slower house-price appreciation, wealth effects will likely be lower as well. On the other hand, higher labor compensation and lower energy bills should provide support to the consumer in terms of confidence and the ability to spend. Overall, I continue to believe that there are somewhat more downside risks than upside risks to the outlook over the next quarters, but I think we are moving in a fairly consistent way as far as GDP growth goes. Finally, let me provide my perspective on the inflation outlook. My overall views on inflation have not changed materially since the last meeting. I continue to expect core PCE inflation to moderate from about 2.3 percent this year to 2.1 percent next year on the course we have right now. The big negative on inflation, of course, is the higher trajectory for labor costs, which has been mentioned. Although the recent revisions to compensation are perhaps somewhat unsettling, such concerns are partly offset by the recent more-favorable monthly inflation numbers and by the significant fall in the prices of oil, gasoline, and natural gas in recent weeks. Although the recent inflation data have not caused me to alter my inflation outlook, I am in one sense more confident in the forecast of moderation than I was a month ago or so. On balance, as we look at all this, I agree that we still have some upside risks to inflation that we have to remain aware of as we look to the policy discussion ahead. Thank you." FOMC20050322meeting--218 216,MR. REINHART.," Mr. Chairman, not that I’d like to reopen alternative B, but I was wondering in paragraph 5 whether or not it would be appropriate to refer to “appropriate monetary policy” rather than just “appropriate policy” because it’s obvious that not many of you believe that either fiscal or trade policy is likely be appropriate anytime soon." FOMC20070509meeting--7 5,MR. FISHER.," My second question regards S&P earnings. Is there a way to split out what comes from the rest of the world and what comes from the United States? I know it would be analytically difficult, but I’m just wondering if there is a disparity between the two in what drops to the bottom line." CHRG-110shrg50369--87 Mr. Bernanke," Yes, Senator. First of all, as you know, we cut rates by about 100 basis points during the fall, reacting to the drag on the economy arising from the housing markets and from the credit market situation. Around the turn of the year and early in January, the data took a significant turn for the worse, and it seemed clear that the economy was slowing, and slowing more than anticipated, and that the credit market condition situation was continuing. On January 9, I called a meeting of the Federal Open Market Committee by video conference to discuss the situation. It was agreed by the committee that some substantial additional cuts in the Federal funds rate were likely to be necessary. The thought at the time of that meeting was that it might be worth waiting until the regular meeting at the end of the month where we could have a fuller discussion and see the revised forecast and so on, taking into account the possibility that we could also move intermeeting, if necessary. On January 10, I gave a speech where I informed the public that I thought that substantive additional action might well be necessary, thereby signaling that the conditions had changed and that further rate cuts were likely to happen. In the days that followed that speech, the tone of the data deteriorated considerably further, which made me think that the outlook was, in fact, much weaker and the risks were greater. That was showing up both in the data and in the financial markets. We were seeing sharp declines in equity prices. We were seeing widening of spreads. And we were also seeing, again, adverse data. On January 21, I became concerned that the continued deterioration of financial markets was signaling a loss of confidence in the economy, and I felt the Fed, instead of waiting until the meeting, really needed to get ahead of that and take action. So I called an FOMC conference call, and we agreed at that point to cut the Federal funds rate target by 75 basis points. There was an understanding at that meeting that further additional action was very likely to be needed, but we felt that we could wait another 10 days until the regular meeting to determine exactly how much additional action. At the meeting at the end of January, we had a full review, discussion, forecast round and so on and determined that an additional 50 points was justified. Looking back, as the data have evolved, I think that the 125 basis points was appropriate for the change in the tone of the economy, and I think it was the right thing to do. Senator Bunning. Are the days of constant and gradual Fed rate changes over? In other words, are large and intermeeting rate changes going to become a regular part of the Fed toolbox now? " FOMC20070628meeting--9 7,MS. MINEHAN.," My memory of the Long-Term Capital Management situation was that the dollar amount that went into the original program that the investment banks put together when they started to manage the situation wasn’t that much bigger than the money that Bear Stearns is throwing at its hedge funds, yet the effect on the market seems to be very, very different. Having been around during the Long-Term Capital episode, I know that there were real concerns that the domino effect was going to be enormous because of the market uncertainty and the lack of liquidity and so forth across a wide range of instruments. Is it the range or the nature of the instruments? How would you see the two situations and compare them because clearly this one, for all you can read and understand and even in your own presentation, doesn’t seem to be that much of a systemic issue." CHRG-111hhrg48867--301 Mr. Green," Okay. If you conclude that you want to do something about the GSEs, if they may be the cause of systemic risk, can you not conclude that AIG may have been the cause of systemic risk, as well? " CHRG-111shrg54533--15 Secretary Geithner," Senator, we thought a lot about that, and I think nobody would argue if we were starting from scratch today that we would replicate the current structure that we have of 50 State-level supervisors of banks, one at the Federal level--we are proposing one at the Federal level--and it is a complicated structure and I don't think anybody would advocate starting from that if we were starting from scratch. But I think it is fair to say, and the basic principle that guided our proposals was we wanted to make sure we are focusing on those problems that were central causes of this crisis, and we do not want to put you in the position of having to spend a lot of time on changes that may be desirable, may leave us with a neater system, maybe a more efficient system, but were not central to the cause of the problem. And in our judgment, the central source of arbitrage opportunity, the central problems we had were banks were able to evade stronger standards applied by one supervisor--in this case, it was the Fed's stronger standards that left Countrywide and others to flip their charter to a thrift. The basic problem we faced was in the thrift charter. Now, there are thousands of thrifts across the country that are well managed, were very conservative, demonstrated admirable capacity to meet the needs of their community, but in the case of too many of the celebrated failures that helped magnify this crisis, that arbitrage opportunity was central to the problem. So if you just look at AIG, Countrywide, you have described many of them, you can see examples of that basic problem. So we thought it was necessary to fix that problem, but while it was not essential to take on that more complicated challenge of fundamentally transforming the rest of the system where there is a balance now between State and Federal supervision of State-chartered banks. Now--and again, if you look at the opportunities that exist now, problems created by the potential to shift from a State charter to a national charter, I think because there are stronger, more uniform standards in place now across those banks, those problems--they are material in some cases, but they are much, much less significant. So we are making a pragmatic choice to focus on things that were a central cause of the crisis, leaving aside for the moment changes that many would support but we don't think are necessary to do just now. Senator Schumer. Thank you. " CHRG-110hhrg44903--145 Mr. Cox," I think, first of all, you are absolutely right about the general perspective of investors when it comes to fair value accounting. Investors appreciate it. On July 9th of this year, the SEC hosted a roundtable, it is what we call our hearings, on this topic; and we heard from a wide variety of participants in the marketplace. The general consensus was that fair value has been a help to investors in these difficult circumstances. They want more of it, not less of it, and that it has not been the cause of volatility in the markets or other problems that we have seen in the current market turmoil. We, also at that same roundtable, got into the kinds of issues that Tim is talking about. There are, particularly in Europe as they consider fair value, existential questions about fair value or not. I don't think we are having that debate just now in the United States. The real question is, you know, at the margin when you are away from instruments that the market generates prices for and you have a model that is trying to generate your price, but at the same time that asset is throwing off some cash, do you have to value it at zero? There are practical questions that people want answers to, and we are hoping that we can provide those answers in something like real time in the form of guidance. I don't think that there is, when it comes to fair value, necessarily a conflict between the investor protection mission and the systemic risk mission. I think fair value, properly used, can be very helpful. " CHRG-110hhrg46591--265 Mr. Yingling," Well, it is really a problem with the larger banks in the international markets. As Mr. Washburn said, it is not really a problem with community banks. The great majority of community banks are in solid shape and are willing to lend. This new program can have a positive impact. One thing we have to watch is how many strings are attached, because these are banks that can do just fine by themselves, but they need capital to support growth in lending, and the capital markets to community banks right now are not functioning very well. So you could have a situation where a bank will take some of this capital for a very short period of time, and then when the capital markets open, they will replace it with private capital. " FOMC20081216meeting--206 204,MS. PIANALTO.," Thank you, Mr. Chairman. The reports from my contacts have been very weak for several weeks now. Sadly, I feel as though the data have been catching up with the anecdotal comments that I have been receiving for a while. I have been hearing a lot of comments along the lines of ""orders have fallen off a sheer cliff,"" ""the lights were suddenly switched off,"" and ""my business is dead in the water."" One thing I have noticed is that the negative outlook has spread to more and more corners of the economy, even those corners that had remained robust for a relatively longer period. For example, one of my directors, who runs a manufacturing company and exports 70 percent of his products, is a producer of highly specialized equipment that is used in steel production. He has few competitors and no debt, and until recently he was feeling very comfortable with a two and a half year backlog. Last week he reported that the backlog has essentially vanished. His customers' problems have now become his problems. This has become a typical refrain. We had become used to hearing companies talk about their desire to hold onto liquidity. Now businesses are also focused on how they are going to protect themselves in this weakening economy. Even businesses with a healthy amount of cash are cutting back sharply on investment, hiring, and production plans. In this environment, it is clear that forecasts need to be revised down sharply. Like the Greenbook, my own projection, which seemed pretty dire just a month ago, has also been revised down sharply with the incoming data and anecdotes. The question now is how long and how deep a decline we will experience. At the same time, it also remains difficult to judge how far disinflation will go. My projection sees substantial output gaps and energy prices that are likely to remain low. That has caused me to lower my inflation projection further as well. My inflation forecast now is clearly below desirable levels for much of 2009. Still, it looks as though the risks remain very much to the downside for output and inflation, if only because further downside misses are getting more and more problematic. The insurance metaphor, I think, has been exhausted. We are now more in a situation of treating mass trauma. Perhaps some of our actions will later be judged as having gone too far. But in my view, right now it clearly is better to ensure that the treatment is large enough rather than risk falling short. Thank you, Mr. Chairman. " CHRG-111shrg53822--8 Chairman Dodd," Thank you very much, Mr. Stern. We appreciate it. We appreciate both of you being with us. I will have the clerk turn on the clock. We will take about 5 minutes apiece or so as we move along here. I will not be rigid about it, but I will try to make sure everyone here--we have only a few members here this morning. Let me begin with you, Mr. Stern. You addressed this at least in your opening comments, and I wonder if you might be a bit more specific about it, and that is, this resolution mechanism we are talking about. I mentioned in my opening comments about the Treasury sort of embracing the idea that the FDIC probably has, of the existing regulatory agencies, the expertise and the background given their experience in dealing with banks to move in this direction. I wonder how you might react to it. Is there some idea of a bankruptcy court idea that may be more appealing? Can the FDIC, in your view, fill this function? What are your more specific---- " CHRG-109hhrg22160--206 Mr. Watt," Thank you. Ms. Pryce. The gentleman from Kentucky, Mr. Davis? Mr. Davis of Kentucky. Thank you, Madam Chair. Chairman Greenspan, I appreciated very much your remarks this morning on the importance of greatly increasing our national productivity over the long term. I spent my professional life in the manufacturing sector. Many of the members on the committee, in fact, represent districts that depend on competitive manufacturing and a global economy to sustain our communities. I was wondering if you could make a comment, from a strategic perspective. You have seen in your distinguished career a great ebb and flow in our international competitiveness, changes in adaptation that we have had to make in various regions of the country to compete, especially with Asia. I was wondering if you would share with us the points that you feel are most important from a strategic policy standpoint to assure that we have strong, competitive, and adaptive manufacturing in the future. " CHRG-111hhrg52397--81 Mr. Pickel," Let me comment briefly on AIG. They, through their credit default swaps, were taking exposure to subprime debt, the collateralized debt obligations, certain tranches of those obligations, so they had an appetite for subprime exposure. In fact, through their regulated insurance companies, as Mr. Polakoff testified in the Senate Banking Committee in March, they were also taking on exposure to subprime past the time that the financial products company stopped taking on exposure, well into 2006 and even 2007. So that was the appetite that they had. They also looked at risk in a very narrow way. The head of FP, the Financial Products Division, was quoted as saying he could not imagine ever losing a dollar on these trades. And he was looking at that really only in respect to payouts on the transactions. He was not really looking at the mark-to-market exposure, which ultimately is what undermined AIG. They also traded on their triple A, which other institutions--in fact some of the institutions who have been the source of the greatest problems, Fannie and Freddie, some of the monolines, have traded on their triple A, resisted the providing of collateral, and even worse, agreed in certain circumstances to provide collateral on downgrades. And, frankly, ever since the Group of 30 Report published in 1993, it has been very clear that downgrade provisions, where you provide collateral on downgrades, are to be dealt with very cautiously because of the liquidity problems they can cause. In fact, the banking regulators discourage them, they do not prevent them but they do discourage the use of those types of provisions. So those are our observations on the AIG situation, and I think is very important as we look forward in reform. " 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-111hhrg53248--65 Secretary Geithner," Because we are rarely accused of insufficient ambition. We are taking on a lot of things. We are trying to solve a lot of problems in this area. And we think we want to do that one, don't need to do that right now, cannot credibly begin to think about that reasonably right now because they are now the entire mortgage market in the country because of the deep failures we saw across the banking system. But that in time will come, and I think it will come relatively quickly. " FOMC20070816confcall--60 58,CHAIRMAN BERNANKE.," All right. That’s true. I’m sorry. So I’ll read it. I hope you can get it from there. “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.” It still gives us our base case—“Recent data suggest that the economy has continued to expand at a moderate pace”—and we say that we’re monitoring the situation and are prepared to act as needed to mitigate the effects. Basically what we are doing here is acknowledging increased risks. It’s a little ambiguous as to what the balance of risks is. Clearly, it raises the probability of action—no question. I certainly don’t think, particularly if financial markets are somewhat calmer, that it commits us to action, but it does increase the probability. It is possible that, given what the markets are discounting for future actions, they’ll be disappointed with this statement, and we might even get a de facto tightening. But I think we just need to state an accurate expression of our views at this time." 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-110shrg50414--93 Secretary Paulson," You are right, and you have defined the problem, and the problem is easier to define than to solve. And we believe that we are going to get the right group of experts and we are going to come up with a solution, and it will be different with different asset classes and in different situations. And as I said, this should not be confused--and some people have confused it--for instances where you need to go in and, you know, do things that are extraordinary things to save an institution. So those are two different actions. But for the system to work the way it needs to work, we need a broad group of institutions--banks and S&Ls--to want to participate, and we need them to participate, not just those that are under immediate pressure. And so for this to be effective, it has got to be designed to have it work that way. Senator Bennett. Thank you, Mr. Chairman. " CHRG-110shrg50369--83 Mr. Bernanke," Well, there is reluctance to take risk, and there are also concerns about understanding exactly what a particular financial asset consists of. And there are still some issues of transparency and so on that need to be worked out. I think that a stable situation would be one in which good quality credits like, major municipal borrowers would not have difficulty in getting credit, and the issue would be the same for good quality credits of firms and households as well. So when you see a pulling back, and seeing the problem spread through a variety of markets, which is interfering with the normal flow of credit, then obviously that is not a normal, healthy situation. Senator Bayh. Mr. Chairman, I have just one--my final question. Mr. Chairman, it has been visited by a couple of my colleagues; particularly Senator Reed I thought was excellent in his questioning. It has to do with the credit agencies. We had a couple of very capable individuals come before our caucus to focus on some of these economic concerns, and the issue of the rating agencies came up. And one of them, in response to my question about--markets can operate efficiently, but that presumes they have access to accurate information. In this case, you know, clearly that was not always so. And this is the problem with the credit markets in part you have pointed out here. So what can we do to avoid this again? You have mentioned that you and your people are looking at that. But when I asked the question, this individual said, ``Well, I am not sure any additional action by the Government is necessary. The market will work this out. These rating agencies, their share prices will be punished and, therefore, they will have an incentive to not do this again.'' But whether it is in regard to certain types of Latin American credit or other areas, it seems that the markets have a way of forgetting the lessons of history, focusing on short-term decision making, every 7, 8, 10 years or so, and we kind of end up in some of these problems again. And the consequences to the broader economy here have been so profound and so great, it seems to me, that in addition to relying on the market, perhaps there should be some parameters to ensure that we do not end up in this situation again, which leads us to either regulatory or legislative action. So, just broadly speaking, do you think that some additional actions, either regulatory or legislative, may be in order to ensure that this situation does not repeat itself in the future and that we do not just simply rely upon the punishment of the market to prevent this in the future? " CHRG-111hhrg54869--141 Mr. Green," The cause. " CHRG-111hhrg54869--140 Mr. Volcker," A cause? " CHRG-111hhrg54869--136 Mr. Volcker," What was the cause? " FOMC20081029meeting--48 46,MR. ROSENGREN.," But as we narrow the target for excess reserves and have a narrow band there, you wonder whether the stop-out rate, having a lower band that is a little higher than the OIS, might be an alternative way to think about it, now that we have the excess reserves option as to the lower bound. " CHRG-111shrg53822--92 PREPARED STATEMENT OF RAGHURAM G. RAJAN Eric J. Gleacher Distinguished Service Professor of Finance, University of Chicago, Booth School of Business May 6, 2009Too Systemic to fail: Consequences, Causes, and Potential Remedies\1\--------------------------------------------------------------------------- \1\ The opinions expressed in this piece are mine alone, but I have benefited immensely from past discussions and work with Douglas Diamond, Anil Kashyap, and Jeremy Stein, as well as members of the Squam Lake Group (see http://www.cfr.org/project/1404/squam_lake_working_group_on_financial_regulation.html).--------------------------------------------------------------------------- Perhaps the single biggest distortion to the free enterprise system is when a number of private institutions are deemed by political and regulatory authorities as too systemic to fail. Resources are trapped in corporate structures that have repeatedly proven their incompetence, and further resources are sucked in from the taxpayer as these institutions destroy value. Indeed, these institutions can play a game of chicken with the authorities by refusing to take adequate precautions against failure, such as raising equity, confident in the knowledge the authorities will come to the rescue when needed. The consequences are observationally identical to those in a system of crony capitalism. Indeed, it is hard for the authorities to refute allegations of crony capitalism--after all, the difference is only one of intent for the authorities in a free enterprise system do not want to bail out systemically important institutions, but are nevertheless forced to, while in crony capitalism, they do so willingly. More problematic, corrupt officials can hid behind the doctrine of systemic importance to bail out favored institutions. Regardless of whether such corruption takes place, the collateral damage to public faith in the system of private enterprise is enormous, especially as the public senses two sets of rules, one for the systemically important, and another for the rest of us. As important as the economic and political damage created in bad times, is the damage created in good times because these institutions have an unfair competitive advantage. Some institutions may undertake businesses they have no competence in, get paid for guarantees they have no ability to honor, or issue enormous amounts of debt cheaply only because customers and investors see the taxpayer standing behind them. Other institutions may deliberately create complexities, fragilities, and interconnections so as to become hard to fail. In many ways, therefore, I believe the central focus of any new regulatory effort should be on how to prevent institutions from becoming too systemic to fail.Is it only too ``big'' to fail? Note that I have avoided saying ``too big to fail.'' This is because there are entities that are very large but have transparent, simple structures that allow them to be failed easily--for example, a firm running a family of regulated mutual funds. By contrast, there are relatively small entities--the mortgage insurers or Bear Stearns are examples--whose distress caused substantial stress to buildup through the system. This means a number of factors other than size may cause an institution to be systemically important including (i) the institution's centrality to a market (mortgage insurers, exchanges) (ii) the extent to which systemic institutions are exposed to the institution (AIG) (iii) the extent to which the institution's business and liabilities are intertwined, or are in foreign jurisdictions where U.S. bankruptcy stay does not apply, so that the act of failing the institution will impose substantial losses on its assets, and (iv) the extent to which the institution's business interacts in complex ways with the financial system so that the authorities are uncertain about the systemic consequences of failure and do not want to take the risk of finding out. This last point takes us to the role of regulators and politicians in creating an environment where institutions are deemed too systemic to fail. For the authorities, there is little immediate benefit to failing a systemically important institution. If events spin out of control, the downside risks to one's career, as well as short-term risks to the economy, loom far bigger for the authorities than any long term benefit of asserting market discipline and preventing moral hazard. Moreover, the public is likely to want to assign blame for a recognized failure, while a bailout can largely be hidden from public eye. Finally, the budgetary implications of recognizing failure can be significant, while the budgetary implications of bailouts can be postponed into the future. For all these reasons, it will be the brave or foolhardy regulator who tries to fail a systemically important institution, and give the experience of the events surrounding the Lehman bankruptcy, I do not see this happening over the foreseeable future. If the authorities are likely to bail out systemically--or even near-systemically important institutions--the solution to the problem of institutions becoming ``too systemically important to fail'' has to be found elsewhere than in stiffening the backbone of regulators or limiting their discretion.\2\ There are three obvious possibilities: 1) prevent institutions from becoming systemically important; 2) keep them from failing by creating additional private sector buffers; 3) when they do become truly distressed, make it easier for the authorities to fail them. Let me discuss each of these in turn.--------------------------------------------------------------------------- \2\ For example, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in many ways was meant to ensure regulators took prompt corrective action, by reducing their leeway to forbear. However, FDICIA was focused on the problem of relatively small thrifts, not ``too-big-to-fail'' institutions.---------------------------------------------------------------------------Preventing Institutions From Becoming Systemically Important Many current regulatory proposals focus on preventing institutions from becoming systemically important. These include preventing institutions from expanding beyond a certain size or limiting the activities of depository institutions (through a modern version of the 1933 Glass-Steagall Act). I worry that these proposals may be very costly, and may still not achieve their intent. Here is why. Clearly, casual empiricism would suggest that some institutions have become too big to manage. If in addition they are likely to impose costs on the system because they are ``too big to fail,'' it seems obvious they should be constrained from growing, and indeed should be forced to break up.\3\ Similarly, it seems obvious that the peripheral risky activities of banks should be constrained or even banned if there are underlying core safe activities than need to be protected.--------------------------------------------------------------------------- \3\ The academic literature lends support to such a view for banks because it finds few economies of scale for banks beyond a certain size.---------------------------------------------------------------------------Economic Concerns More careful thought would, however, suggest serious concerns about such proposals. First, consider the economic concerns. Some institutions get large, not through opportunistic and unwise acquisitions, but through organic growth based on superior efficiency. A crude size limit, applied across the board, would prevent the economy from realizing the benefits of the growth of such institutions. Furthermore, size can imply greater diversification, which can reduce risk. The optimal size can vary across activities and over time. Is a trillion dollar institution permissible if it is a mutual fund holding assets? What if it is an insurance company? What if it is an insurance company owning a small thrift? Finally, size itself is hard to define. Do we mean assets, liabilities, gross derivatives positions, net derivatives positions, transactions, or profitability? Each of these could be a reasonable metric, yet vastly different entities would hit against the size limit depending on the metric we choose. Given all these difficulties, any legislation on size limits will have to give regulators substantial discretion. That creates its own problems which I will discuss shortly. Similar issues arise with activity limits. What activities would be prohibited? Many of the activities that were prohibited to commercial banks under Glass-Steagall were peripheral to this crisis. And activities that did get banks into trouble, such as holding sub-prime mortgage-backed securities, would have been permissible under Glass Steagall.\4\ Some suggest banning banks from proprietary trading (trading for their own account). But how would regulators distinguish (illegitimate) proprietary trading from legitimate risk-reducing hedging?--------------------------------------------------------------------------- \4\ Banks like Citibank have found sufficient ways to get into trouble in recent decades even when Glass Steagall was in force.---------------------------------------------------------------------------Regulatory Concerns Regulating size limits would be a nightmare. Not only would the regulator have to be endowed with substantial amounts of discretion because of the complexities associated with size regulation, the regulated would constantly attempt to influence regulators to rule in their favor. While I have faith in regulators, I would not want them to be subject to the temptations of the license-permit Raj of the kind that flourished in India. Indeed, even without such temptations, regulators are influenced by the regulated--one of the deficiencies uncovered by this crisis is that banks were allowed under Basel II to set their levels of capital based on their own flawed models. Moreover, the regulated would be strongly tempted to arbitrage draconian regulations. In India, strict labor laws kicked in once firms reached 100 employees in size. Not surprisingly, there were a large number of firms with common ownership that had 99 employees--every time a firm was to exceed 100 employees, it broke up into two firms. Similarly, would size limits lead to firms shifting activity into commonly owned and managed, but separately capitalized, entities as soon as they approach the limits? Will we get virtual firms that are as tightly knit together as current firms, but are less transparent to the regulator? I fear the answer could well be yes. Similar problems may arise with banning activities. The common belief is that there are a fixed set of risky possibilities so if enough are prohibited to banks, they will undertake safe activities only--what one might call the ``lump of risk'' fallacy. The truth is that banks make money only by taking risks and managing them carefully. If enough old risky activities are banned, banks will find new creative ways of taking on risk, with the difference that these will likely be hidden from the regulator. And because they are hidden, they are less likely to be managed carefully.Political Concerns Finally, the presumption is that the political support for heavy regulation will continue into the future. Yet, as the business cycle turns, as memories of this crisis fade, and as the costs associated with implementing the regulation come to the fore without visible benefits, there will be less support for the regulation. Profitable banks will lobby hard to weaken the legislation, and they will likely be successful. And all this will happen when we face the most danger from too-systemic-to-fail entities. If there is one lesson we take away from this crisis, it should be this--regulation that the regulated perceive as extremely costly is unlikely to be effective, and is likely to be most weakened at the point of maximum danger to the system. I would suggest that rather than focusing on regulations to limit size or activities, we focus on creating private sector buffers and making institutions easier to fail. Let us turn to these now.Adding Additional Private Sector Buffers. One proposal making the rounds is to require higher levels of capital for systemically important institutions. The problem though is that capital is costlier than other forms of financing. In boom times, the market requires very low levels of capital from financial intermediaries, in part because euphoria makes losses seem remote. So when regulated financial intermediaries are forced to hold more costly capital than the market requires, they have an incentive to shift activity to unregulated intermediaries, as did banks in setting up SIVs and conduits during the current crisis. If systemically important institutions are required to hold substantially more capital, their incentive to undertake this arbitrage is even stronger. Even if regulators are strengthened to detect and prevent this shift in activity, banks can subvert capital requirements by taking on risk the regulators do not see, or do not penalize adequately with capital requirements. So while increased capital for systemically important entities can be beneficial, I do not believe it is a panacea.\5\ An additional, and perhaps more effective, buffer is to ask systemically important institutions to arrange for capital to be infused when the institution or the system is in trouble. Because these ``contingent capital'' arrangements will be contracted in good times when the chances of a downturn seem remote, they will be relatively cheap (compared to raising new capital in the midst of a recession) and thus easier to enforce. Also, because the infusion is seen as an unlikely possibility, firms cannot go out and increase their risks, using the future capital as backing. Finally, because the infusions come in bad times when capital is really needed, they protect the system and the taxpayer in the right contingencies.--------------------------------------------------------------------------- \5\ See the comprehensive discussion of capital requirements in the Squam Lake Group's proposal http://www.cfr.org/publication/19001/reforming_capital_requirements_for_financial_institutions.html.--------------------------------------------------------------------------- Put differently, additional capital is like keeping buckets full of water ready to douse a potential fire. As the years go by and the fire does not appear, the temptation is to use up the water. By contrast, contingent capital is like installing sprinklers. There is no water to use up, but when the fire threatens, the sprinklers will turn on.Contingent Debt Conversions One version of contingent capital is for banks to issue debt which would automatically convert to equity when two conditions are met; first, the system is in crisis, either based on an assessment by regulators or based on objective indicators such as aggregate bank losses (this could be cruder, but because it is automatic, it will eliminate the pressure that would otherwise come on regulators), and second, the bank's capital ratio falls below a certain value.\6\ The first condition ensures that banks that do badly because of their own errors, and not when the system is in trouble, don't get to avoid the disciplinary effects of debt. The second condition rewards well-capitalized banks by allowing them to avoid the forced conversion (the number of shares the debt converts to will be set at a level so as dilute the value of old equity substantially), while also giving banks that anticipate losses an incentive to raise new equity well in time.--------------------------------------------------------------------------- \6\ This describes work done by the Squam Lake Group, and a more comprehensive treatment is available at http://www.cfr.org/publication/19002.---------------------------------------------------------------------------Capital Insurance Another version of contingent capital is to require that systemically important levered financial institutions buy fully collateralized insurance policies (from unlevered institutions, foreigners, or the government) that will infuse capital into these institutions when the system is in trouble.\7\--------------------------------------------------------------------------- \7\ This is based on a paper I wrote with Anil Kashyap and Jeremy Stein, which is available at http://www.kc.frb.org/publicat/sympos/2008/KashyapRajanStein.03.12.09.pdf--------------------------------------------------------------------------- Here is one way it could operate. Megabank would issue capital insurance bonds, say to sovereign wealth funds or private equity. It would invest the proceeds in Treasury bonds, which would then be placed in a custodial account in State Street Bank. Every quarter, Megabank would pay a pre-agreed insurance premium (contracted at the time the capital insurance bond is issued) which, together with the interest accumulated on the Treasury bonds held in the custodial account, would be paid to the sovereign fund. If the aggregate losses of the banking system exceed a certain pre-specified amount, Megabank would start getting a payout from the custodial account to bolster its capital. The sovereign wealth fund will now face losses on the principal it has invested, but on average, it will have been compensated by the insurance premium.Clearly, both the convertible debt proposal and the capital insurance proposal will have to be implemented with care. For instance, it would be silly for any systemically important institution to buy these instruments, and they should be deterred from doing so. At the same time, some obvious objections can be answered easily. For instance, some critics worry whether there will be a market for these bonds that fall in value when the whole economy is in distress. The answer is there are already securities that have these characteristics and are widely traded. Moreover, a bank in Canada has actually issued securities of this sort.Making Institutions Easier to Fail. Let us now turn to the other possible remedy--making systemically important institutions easier to fail. There are currently a number of problems in failing systemically important institutions. Let me list them and suggest obvious remedies. (i) Regulators do not have resolution authority over non-bank financial firms or bank holding companies, and ordinary bankruptcy court would take too long--the financial business would evaporate while the institution is in bankruptcy court. This leaves piece-meal liquidation, with attendant loss in value, as the only alternative to a bailout. Regulators need resolution authority of the kind the FDIC has for banks. (ii) Regulators do not have full information on the holders of a systemically important institution's liabilities. They have difficulty figuring out whom the first round of losses would hit, let alone where the second round (as institutions hit by the first round fail) would fall. While in principle they could allow the institution to fail, and ensure the first and second round failures are limited by providing capital where necessary, they do not have the ability to do so at present. Furthermore, because the market too does not know where the exposures are, the failure of a large institution could lead to panic. More information about exposures needs to be gathered, and the authorities need the ability to act on this information (including offering routine warnings to levered regulated entities that have high exposure to any institution), as well as the ability to disseminate it widely if they have to fail an institution. (iii) The foreign operations of institutions are especially problematic since there is no common comprehensive resolution framework for all of a multi-national bank's operations. Failing a bank in the United States could lead to a run on a branch in a foreign country, or a seizure of local assets by a foreign authority in order to protect liability holders within that country. These actions could erode the value of the bank's international operations substantially, resulting in losses that have to be borne by U.S. taxpayers, and making authorities more reluctant to fail the bank. A comprehensive international resolution framework needs to be negotiated with high priority. (iv) The operations of some systemically important institutions are linked to their liabilities in ways that are calculated to trigger large losses if the bank is failed. For instance, if a bank is on one side of swap transactions and it fails, the counterparties on the other side need to be paid the transactions costs incurred in setting up new substitute swap contracts. Even if the market is calm, these seemingly small transactions costs multiplied by a few trillion dollars in gross outstanding contracts can amount to a large number, in the many billions of dollars. If we add to this the higher transactions costs when the market is in turmoil, the costs can be very high. Regulators have to work with the industry to reduce the extent to which business losses are triggered when the institution's debt is forced to bear losses. These cross- default clauses essentially are poison-pills that make large institutions too costly to fail. (v) Finally, the implicit assumption that some of these institutions will not be failed causes market participants to treat their liabilities as backed by the full faith and credit of the government. These liabilities then become the core of strategies that rely indeed on their being fully backed. Any hint that belief in the backing is unwarranted can cause these strategies to implode, making the authorities averse to changing beliefs.\8\ Regulators have to convince the market that no institution is too systemically important to fail. --------------------------------------------------------------------------- \8\ Mohamed El Erian of Pimco phrases this as a situation where what the market thinks of as constant parameters become variables, resulting in heightened risk aversion. One example of this is the failure of Lehman, which resulted in the Reserve Primary money market fund ``breaking the buck''. The strategy of money market funds investing in the debt of systemically important-but-weak banks in order to obtain higher yields imploded, causing a run on money market funds. The problem is that none of this can be achieved if the financial institutions are working at cross-purposes to the regulator--all will be for naught if even while the regulator is working with international authorities to devise a comprehensive resolution scheme, the financial institution is adding on layers of complexity in its international operations. Therefore I end with one last suggestion: Require systemically important financial institutions to develop a plan that would enable them to be resolved quickly--eventually over a weekend. Such a ``shelf bankruptcy'' plan would require institutions to track, and document, their exposures much more carefully and in a timely manner, probably through much better use of technology. The plan will need to be stress tested by regulators periodically and supported by enabling legislation--such as one facilitating an orderly transfer of the institution's swap books to pre-committed partners. And regulators will need to be ready to do their part, including paying off insured depositors quickly where necessary. Not only will the need to develop a plan give these institutions the incentive to work with regulators to reduce unnecessary complexity and improve management, it may indeed force management to think the unthinkable during booms, thus helping avoid the costly busts. Most important, it will convey to the market the message that the authorities are serious about allowing the systemically important to fail. When we emerge from this crisis, this will be the most important message to convey.RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM SHEILA C. BAIRQ.1. Mr. Wallison testified that, ``In a widely cited paper and a recent book, John Taylor of Stanford University concluded that the market meltdown and the freeze in interbank lending that followed the Lehman and AlG events in mid-September 2008 did not begin until the Treasury and Fed proposed the initial Troubled Asset Relief Program later in the same week, an action that implied that financial conditions were much worse than the markets had thought. Taylor's view, then, is that AlG and Lehman were not the cause of the meltdown that occurred later that week. Since neither firm was a bank or other depository institution, this analysis is highly plausible.'' Do you agree or disagree with the above statement? Why, or why not?A.1. Professor Taylor argues that the data on the LIBOR-OIS spread indicate that the market had a stronger reaction to the testimony by Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson of September 23, 2008, on the government policy intervention that would become known as the TARP program than to the bankruptcy of Lehman Brothers on September 15. Professor Taylor's interpretation does not acknowledge that the events of the period happened so rapidly and in such short order that it is difficult to disentangle the effects of specific news and market events. Other evidence suggests that reserves held by banks jumped dramatically immediately after Lehman entered bankruptcy (Federal Reserve Statistical Release H-3), indicating that banks preferred the security of a deposit at the Federal Reserve over the risk-and-return profile offered by an interbank loan. Following the Lehman Brothers bankruptcy filing, Primary Reserve--a large institutional money market fund--suffered losses on unsecured commercial paper it had bought from Lehman. The fund ``broke the buck'' on September 16. This ``failure'' instigated a run and subsequent collapse of the commercial paper market. The events of the week may have had compound effect on the market's perception of risk. For example, it is unclear whether AIG would have deteriorated as fast if Lehman had not entered bankruptcy. Indeed, TARP may not have even been proposed without the failure of Lehman. It also took time for markets to understand the size of the Lehman bankruptcy losses--which were larger than anticipated--and to use this new information to reassess the worthiness of all surviving counterparties. In the FDIC's view, uncertainty about government action and interventions has been a source of systemic risk. As outlined in my testimony, the FDIC recommends a legal mechanism for the orderly resolution of systemically important institutions that is similar to what exists for FDIC-insured banks. The purpose of the resolution authority should not be to prop up a failed entity, but to permit the swift and orderly dissolution of the entity and the absorption of its assets by the private sector as quickly as possible. Imposing losses on shareholders and other creditors will restore market discipline. A new legal mechanism also will permit continuity in key financial operations and reduce uncertainty. Such authority can preserve valuable business lines using an industry-paid fund when debtor-in-possession financing is unavailable because of market-wide liquidity shocks or strategic behavior by potential lenders who also are potential fire sale acquirers of key assets and businesses of the failing institution. Under a new resolution process, uninsured creditor claims could be liquefied much more quickly than can be done in a normal bankruptcy.Q.2. Do you believe that if Basel II had been completely implemented in the United States that the trouble in the banking sector would have been much worse? Some commentators have suggested that the stress tests conducted on banks by the Federal Government have replaced Basel II as the nation's new capital standards. Do you believe that is an accurate description? Is that good, bad, or indifferent for the health of the U.S.-banking system?A.2. Throughout the course of its development, the advanced approaches of Basel II were widely expected to result in lower bank capital requirements. The results of U.S. capital impact studies, the experiences of large investment banks that increased their financial leverage during 2006 and 2007 under the Securities and Exchange Commission's version of the advanced approaches, and recent evidence from the European implementation of Basel II all demonstrated that the advanced approaches lowered bank regulatory capital requirements significantly. Throughout the interagency Basel II discussions, the record shows that the FDIC took the position that capital levels needed to be strengthened for the U.S. Basel II banks. If the advanced approaches of Basel II had been fully in place and relied upon in the United States, the FDIC believes that large banks would have entered the crisis period with significantly less capital, and would therefore have been even more vulnerable to the stresses they have experienced. Supervisors have long encouraged banks to hold more capital than their regulatory minimums, and we view the stress tests as being squarely within that tradition. While stress testing is an important part of sound risk management practice, it is not expected to replace prudential regulatory minimum capital requirements. In many respects, the advanced approaches of Basel II do not constitute transparent regulatory minimum requirements, in that they depend for their operation on considerable bank and supervisory judgment. The FDIC supported the implementation of the advanced approaches only subject to considerable safeguards, including the retention of the leverage ratio and a regulatory commitment that the banking agencies would conduct a study after 2010 to identify whether the new approaches have material weaknesses, and if so, that the agencies would connect those weaknesses.Q.3. If there is an ordered resolution process, whether that's bankruptcy, a new structured bankruptcy or a new resolution authority--what can we do to generate the political will to use it?A.3. For a new resolution process to work efficiently, market expectations must adjust and investors must assume that the government will use the new resolution scheme instead of providing government support. It is not simply a matter of political will, but of having the necessary tools ready so that a resolution can be credibly implemented. A systemic resolution authority could step between a failing firm and the market to ensure that critical functions are maintained while an orderly unwinding takes place. The government could guarantee or provide financing for the unwinding if private financing is unavailable. Assets could be liquidated in an orderly manner rather than having collateral immediately dumped on the market. This would avoid the likelihood of a fire sale of assets, which depresses market prices and potentially weakens other firms as they face write-downs of their assets at below ``normal'' market prices.Q.4. Should we be limiting the size of companies in the future to prevent a ``too-big-to-fail'' situation, or can we create a resolution process that only needs the political will to execute it that will eliminate the need to be concerned about a company's size?A.4. The FDIC supports the idea of providing incentives to financial firms that would cause them to internalize into their decisionmaking process the potential external costs that are imposed on society when large and complex financial firms become troubled. While fewer firms may choose to become large and complex as a result, there would be no prohibition on growing or adding complex activities. Large and complex financial firms should be subject to regulatory and economic incentives that require these institutions to hold larger capital and liquidity buffers to mirror the heightened risk they pose to the financial system. Capital and regulatory requirements could increase as firms become larger so that firms must operate more efficiently if they become large. In addition, restrictions on leverage and the imposition of risk-based premiums on institutions and their activities should provide incentives for financial firms to limit growth and complexity that raise systemic concerns. To address pro-cyclicality, capital standards should provide for higher capital buffers that increase during expansions and are drawn down during contractions. In addition, large and complex financial firms could be subject to higher Prompt Corrective Action limits under U.S. laws. Regulators also should take into account off-balance-sheet assets and conduits as if these risks were on-balance-sheet.Q.5. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations?A.5. In bankruptcy, current law allows market participants to terminate and net out derivatives and sell any pledged collateral to pay off the resulting net claim immediately upon a bankruptcy filing. In addition, since the termination right is immediate, and the bankruptcy process does not provide for a right of a trustee or debtor to transfer the contracts before termination, the bankruptcy filing leads to a rapid, uncontrolled liquidation of the derivatives positions. During normal market conditions, the ability of counterparties to terminate and net their exposures to bankrupt entities prevents additional losses flowing through the system and serves to improve market stability. However, when stability is most needed during a crisis, these inflexible termination and netting rights can increase contagion. Without any option of a bridge bank or similar type of temporary continuity option, there is really no practical way to limit the potential contagion absent a pre-packaged transaction or arrangements by private parties. While this sometimes happens, and did to some degree in Lehman's bankruptcy, it raises significant questions about continuity and comparative fairness for creditors. During periods of market instability--such as during the fall of 2008--the exercise of these netting and collateral rights can increase systemic risks. At such times, the resulting fire sale of collateral can depress prices, freeze market liquidity as investors pull back, and create risks of collapse for many other firms. In effect, financial firms are more prone to sudden market runs because of the cycle of increasing collateral demands before a firm fails and collateral dumping after it fails. Their counterparties have every interest to demand more collateral and sell it as quickly as possible before market prices decline. This can become a self-fulfilling prophecy--and mimics the depositor runs of the past. The failure of Lehman and the instability and bail-out of AIG led investors and counterparties to pull back from the market, increase collateral requirements on other market participants, and dramatically de-leverage the system. In the case of Lehman, the bankruptcy filing triggered the right of counterparties to demand an immediate close-out and netting of their contracts and to sell their pledged collateral. The immediate seizing and liquidation of the firm's assets left less value for the firm's other creditors. In the case of AIG, the counterparties to its financial contracts demanded more collateral as AIG's credit rating dropped. Eventually, AIG realized it would run out of collateral and was forced to turn to the government to prevent a default in this market. Had AIG entered bankruptcy, the run on its collateral could have translated into a fire sale of assets by its counterparties. In the case of a bank failure, by contrast, the FDIC has 24 hours after becoming receiver to decide whether to pass the contracts to a bridge bank, sell them to another party, or leave them in the receivership. If the contracts are passed to a bridge bank or sold, they are not considered to be in default and they remain in force. Only if the financial contracts are left in the receivership are they subject to immediate close-out and netting.Q.6. Chrysler's experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forward--senior creditors get paid 100 cents on the dollar and everyone else gets in line. That imposes the losses on those who chose to take the risk. Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ``laws impairing the obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.'' With that in mind, what changes can be made to bankruptcy to ensure an expedited resolution of a company that does not roil the financial markets and also keeps government from choosing winners and losers?A.6. Bankruptcy is designed to facilitate the smooth restructuring or liquidation of a firm. It is an effective insolvency process for most companies. However, it was not designed to protect the stability of the financial system. Large complex financial institutions play an important role in the financial intermediary function, and the uncertainties of the bankruptcy process can create `runs' similar to depositor runs of the past in financial firms that depend for their liquidity on market confidence. Putting a bank holding company or other non-bank financial entity through the normal corporate bankruptcy process may create instability as was noted in the previous answer. In the resolution scheme for bank holding companies and other non-bank financial firms, the FDIC is proposing to establish a clear set of claims priorities just as in the bank resolution system. Under the bank resolution system, there is no uncertainty and creditors know the priority of their claims. In bankruptcy, without a bridge bank or similar type of option, there is really no practical way to provide continuity for the holding company's or its subsidiaries' operations. Those operations are based principally on financial agreements dependent on market confidence and require continuity through a bridge bank mechanism to allow the type of quick, flexible action needed. A stay that prevents creditors from accessing their funds destroys financial relationships. Without a system that provides for the orderly resolution of activities outside of the depository institution, the failure of a large, complex financial institution includes the risk that it will become a systemically important event. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM GARY STERNQ.1. Mr. Wallison testified that, ``In a widely cited paper and a recent book, John Taylor of Stanford University concluded that the market meltdown and the freeze in interbank lending that followed the Lehman and AIG events in mid-September 2008 did not begin until the Treasury and Fed proposed the initial Troubled Asset Relief Program later in the same week, an action that implied that financial conditions were much worse than the markets had thought. Taylor's view, then, is that AIG and Lehman were not the cause of the meltdown that occurred later that week. Since neither firm was a bank or other depository institution, this analysis is highly plausible.'' Do you agree or disagree with the above statement? Why, or why not?A.1. Members of the Board of Governors of the Federal Reserve System have addressed the factors that contributed to the market dislocation in mid-September 2008. See, for example, the testimony of Chairman Ben S. Bernanke on U.S. financial markets before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, on September 23, 2008, and the testimony of Vice Chairman Donald L. Kohn on American International Group before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C., on March 5, 2009. Based on my understanding of the facts and circumstances around market conditions in mid-September, I will defer to these descriptions of events.Q.2. Do you believe that if Basel II had been completely implemented in the United States that the trouble in the banking sector would have been much worse?A.2. To the degree that a fully implemented Basel II would have left large financial institutions with less capital, the financial crisis could have been more severe. To the degree that large financial institutions would have had improved risk management systems due to Basel II, perhaps the crisis would not have been as severe. In short, we cannot know with any precision how a fully implemented Basel II would have altered bank performance during the recent financial crisis; the effect that a fully implemented Basel II would have had on the depth and severity of the financial crisis would have depended on competing factors such as the two just noted. In any case, and consistent with my remarks during the recent hearing, I believe Basel II should undergo a thorough review to determine if and how policymakers should modify it.Q.3. Some commentators have suggested that the stress tests conducted on banks by the Federal Government have replaced Basel II as the nation's new capital standards. Do you believe that is an accurate description? Is that good, bad, or indifferent for the health of the U.S. banking system?A.3. As noted by the Board of Governors of the Federal Reserve System in ``The Supervisory Capital Assessment Program: Overview of Results'' (May 7, 2009), ``the SCAP buffer does not represent a new capital standard and is not expected to be maintained on an ongoing basis.'' I believe that policy is appropriate.Q.4. If there is an ordered resolution process, whether that's bankruptcy, a new structured bankruptcy or a new resolution authority--what can we do to generate the political will to use it?A.4. Consistent with my testimony, I believe that financial spillovers lead policymakers to provide extraordinary support to the creditors of systemically important financial institutions. To discourage policymakers from providing such support requires them to take action to reduce the threat of these spillovers. I provided examples of these actions in my written testimony.Q.5. Should we be limiting the size of companies in the future to prevent a ``too-big-to-fail'' situation, or can we create a resolution process that only needs the political will to execute it that will eliminate the need to be concerned about a company's size?A.5. As I noted in my written testimony, I do not believe that either reducing the size of financial institutions or creating a new resolution framework for nonbank financial institutions will, by itself, sufficiently address the ``too-big-to-fail'' problem. Neither step will effectively reduce the spillover problem that leads to the provision of government support for uninsured creditors of systemically important financial institutions in the first place. A resolution regime offers a tool to address some spillovers and not others. I detail in my written testimony recommendations to address spillovers.Q.6. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations?A.6. We discussed issues surrounding so-called early termination, closeout netting, and other aspects of the treatment of derivative contracts in bankruptcy and their relation to the ``too-big-to-fail'' problem in our earlier analysis. (See Gary H. Stern and Ron J. Feldman, 2009, Too Big To Fail: The Hazards of Bank Bailouts, pp.118 and 119.) These issues deserve careful scrutiny in light of the AIG and Lehman situations to ensure that current policy and law adequately reflect the ``lessons learned'' from those two cases.Q.7. Chrysler's experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forward--senior creditors get paid 100 cents on the dollar and everyone else gets in line. That imposes the losses on those who chose to take the risk. Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ``laws impairing the obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.'' With that in mind, what changes can be made to bankruptcy to ensure an expedited resolution of a company that does not roil the financial markets and also keeps government from choosing winners and losers?A.7. I see merit in creating a resolution regime for all systemically important financial firms that has similarities to the one currently used by the FDIC to resolve banks. As noted in my written testimony, ``such regimes would facilitate imposition of losses on equity holders, allow for the abrogation of certain contracts, and provide a framework for operating an insolvent firm. These steps address some spillovers and increase market discipline.'' However, as noted previously, these advantages do not address the full range of potential spillovers and thus may not sufficiently facilitate policymakers' decision to impose losses on creditors of systemically important firms. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM PETER J. WALLISONQ.1. If there is an ordered resolution process, whether that's bankruptcy, a new structured bankruptcy or a new resolution authority--what can we do to generate the political will to use it?A.1. The problem with a new resolution authority is that there will be too much political will to use it. My concern is that regulators will use the system to bail out failing financial companies when these companies should be allowed to go into bankruptcy. The result will be that the taxpayers will end up paying for something that--in bankruptcy--would be paid for by the company's creditors.Q.2. Should we be limiting the size of companies in the future to prevent a ``too-big-to-fail'' situation, or can we create a resolution process that only needs the political will to execute it that will eliminate the need to be concerned about a company's size?A.2. There is no reason to be concerned about the size of any company other than a commercial bank, and even then it would not be good policy to try to limit the size of a bank because we are afraid that its failure will cause a systemic problem. Companies and banks get large because they are good competitors and serve the public well. We shouldn't penalize them for that. In addition, our big international operating companies need big international banks to serve their needs. If we cut back the size of banks or insurance companies or securities firms because of fear about systemic risk, we would be adding costs for our companies for no good reason. Finally, I don't think that any financial company other than a large commercial bank can--even in theory--create a systemic problem. Banks alone have liabilities that can be withdrawn on demand and are used to make payment by businesses and individuals. If a bank fails, these funds might not be available, and that could cause a systemic problem. But other financial companies are more like large commercial operating companies. They borrow money for a term. If they fail, there are losses, but not the immediate loss of the funds necessary to meet daily obligations. For example, if GM goes into bankruptcy, it will cause a lot of disruption, but no one who is an investor in GM is expecting to use his investment to meet his payroll or pay his mortgage. That's also true of insurance companies, securities firms, hedge funds and others. If they fail they may cause losses to their investors, but over time, not the cascade of losses through the economy that is the signature of a systemic breakdown. We should not be concerned about losses to creditors and investors. It's the wariness about losses that creates market discipline-which is the best way to control risk-taking.Q.3. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations?A.3. Most financial contracts are exempt from the automatic stay that occurs when a bankruptcy petition is filed. This allows the counterparties of a bankrupt company to sell the collateral they are holding and make themselves whole, or close to it. This prevents losses from cascading through the economy when they occur. They are stopped by the ability of counterparties to sell the collateral they hold and reimburse themselves. As a result, we have only one example of a Lehman counterparty encountering a serious and immediate financial problem as a result of Lehman's failure. That was the Reserve Fund, which was holding an excessive amount of Lehman's short term commercial paper. Other than that, Lehman's failure is an example of what I said above about nonbank financial institutions. They do not cause the kind of cascading losses that could occur when a bank fails. We do not therefore need a special resolution function for these nonbank firms. AIG should have been allowed to go into bankruptcy. I don't see any reason why AIG's failure would have caused the kind of systemic breakdown that was feared. Again, the ability of counterparties to sell their collateral would have reduced any possible losses. Much a ttention has been focues on credit default swaps, but we now know that Goldman Sachs, which was the largest AIG swap counterparty, would not have suffered any losses if AIG had been allowed by the Fed to go into bankruptcy. The reason that Goldman would not have suffered losses is that they had collateral coverage on their swap agreements, and if AIG had failed they would have been able to sell the collateral and make themselves whole. So the treatment of financial contracts in bankruptcy is a strong reason to allow bankruptcy to operate rather than substituting a government agency.Q.4.a. Chrysler's experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forwardsenior creditors get paid 100 cents on the dollar and everyone else gets in line. That imposes the losses on those who chose to take the risk.A.4.a. Exactly right.Q.4.b. Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ``laws impairing the obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.''A.4.b. Again, exactly right.Q.4.c. With that in mind, what changes can be made to bankruptcy to ensure an expedited resolution of a company that does not roil the financial markets and also keeps government from choosing winners and losers?A.4.c. I am not enough of a bankruptcy specialist to make a recommendation. However, the Lehman bankruptcy seems to be going smoothly without any significant reforms. In the 2 weeks following its filing Lehman sold off its brokerage, investment banking and investment management businesses to 4 different buyers, and the process is continuing. Based on the Lehman case, it does not appear to me that any major changes are necessary. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM MARTIN NEIL BAILYQ.1. If there is an ordered resolution process, whether that's bankruptcy, a new structured bankruptcy or a new resolution authority--what can we do to generate the political will to use it?A.1. Presumably the key thought behind this question is what can be done to ensure that some class of creditors, in addition to shareholders, can be forced to incur at least some loss in the event a large systemically important financial institution were to subject to some resolution procedure? One way is to ensure that all such institutions are required to back at least of their assets by uninsured long-term subordinated (unsecured) debt, a security not subject to a ``run'' since its holders cannot ask for their money back until the debt matures. Precisely for this reason, regulatory authorities can safely permit the holders of such instruments to suffer some loss without a threat of wider financial contagion. In addition, Congress can and should exercise vigilant oversight over the activities of any authority that may be given the power to resolve such troubled institutions.Q.2. Should we be limiting the size of companies in the future to prevent a ``too-big-to-fail'' situation, or can we create a resolution process that only needs the political will to execute it that will eliminate the need to be concerned about a company's size?A.2. There is no principled basis, in our view, for imposing arbitrary size limits by institution. However, regulation can and should be designed to ensure that as institutions grow in size and begin to expose the financial system to danger should those institutions fail, the institutions internalize this ``externality.'' This can be accomplished by imposing progressively higher capital and liquidity requirements as financial institutions grow beyond a certain size, as well as more intensive supervision of their risk management practices. In addition, resolution authorities should be instructed to make an effort to break up troubled systemically important financial institutions, unless the costs of such breakups are projected to outweigh the benefits (in terms of reducing future exposure to systemic risk).Q.3. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations?A.3. We do not claim expertise in this area, and leave it to others to comment.Q.4. Chrysler's experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forward--senior creditors get paid 100 cents on the dollar and everyone else gets in line. That imposes the losses on those who chose to take the risk. Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ``laws impairing the obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.'' With that in mind, what changes can be made to bankruptcy to ensure an expedited resolution of a company that does not roil the financial markets and also keeps government from choosing winners and losers?A.4. We agree that the sanctity of contracts is of paramount importance in our constitution and our economy. Bankruptcy law is not an area of our expertise. In the area of financial institutions in particular, however, we reiterate that one way to retain at least some market discipline without threatening the financial system is to require large systemically important financial institutions to issue at least some long-term subordinated (unsecured) debt." CHRG-111shrg52619--90 Mr. Polakoff," I will be as short as possible, Senator. Thank you. We are not in the current situation we are in today because of actions over the last six to 12 months by the regulators, or in a lot of cases the bankers. It is from 3, 4, 5 years ago. I think the notion of counter-cyclical regulation needs to be discussed at some point. When the economy is strong is when we should be our strongest in being aggressive, and when the economy is struggling, I think is when we need to be sure that we are not being too strong. Any of us at this table can prevent a bank from failing. We can prevent banks from failing. But what will happen is people who deserve credit will not get credit because they will be on the bubble. The thing I love about bank supervision is it is part art and it is part science, and I think what we are doing today is going to address the situation today. We have got to be careful we are doing the right thing for tomorrow and next year, as well. Senator Reed. Mr. Smith, and then Mr. Reynolds. " CHRG-110hhrg46594--486 Mr. Foster," And then the issue of dealerships, which you can see mentioned in the press, the disparity and then dealerships per car sold for the Detroit Three versus the imports. I was wondering if there were any numbers worth talking about on that. Ms. Sykora. Because I am from Texas, I talk a little slow, and I didn't get to some of that point in my oral testimony, but in the 1950's, we had 50,000 dealerships and there has been an orderly decline in the number of dealerships through market conditions. But it has always come at a cost. It comes at a cost of convenience to the consumer and competition that keeps prices low for consumers. But I think what is really important to realize here is that dealers aren't a cost problem to the manufacturer. We bear the external costs of providing the distribution network, something that they don't have the resources to do, and that our dealer network actually does increase convenience and competition. " CHRG-111hhrg51698--127 Mr. Damgard," Well, I was speaking specifically of the futures markets. The futures markets did work extremely well, and they worked very well under the rules that this Committee has established for the CFTC, and that doesn't mean that there wasn't speculation and that there weren't bubbles in some of these markets. Having been here for years and years, I have been here at hearings where our producers were angry when the price was high or the price is low, depending on what their producers, and users are just the opposite. We did have enormous volatility in the oil market. The CFTC study, as I recall, determined that most of the speculators were basically decreasing their positions in the first half of last year, number one; and, number two, they also indicated that most speculators had spread positions, which means that they were both long and short, and that suggests that there was an equal amount of pressure on buying and selling. So it may be that the oil speculators are being blamed for more than they should be blamed for. I don't know the answer to why that market went up, but I remember at the time that the criticism was that these funds had all moved out of equities, and they were so-called passive investors. Well, at $145 they got out of the market, so they weren't all that passive. Now we have $40 oil, and we have people that have pension funds that are complaining that somehow the decrease in the value of their pension fund is the direct result of speculators selling the oil price. So, I have gotten used to people complaining about high prices and low prices, and how that relates to the average family. I go back to the point that Mr. Gooch made, that the mortgage market and the drying up of credit are the root cause of what we are going through right now. I represent the futures market, which is the listed derivatives market, and Mr. Duffy and I don't always agree on everything, but I do want to say that people are using that market. They just had another record year. " CHRG-111hhrg56766--217 Mr. Bernanke," That is roughly right. The idea here is if you have a growing economy, you can run deficits and still maintain a flat ratio of debt to GDP, which is a sustainable situation. Normally, that would involve having what is called a primary deficit, that is deficit excluding interest payments from about zero. Normally, that would involve about 2.5 percent to 3 percent of a total deficit, including interest payments. " FinancialServicesCommittee--32 Mr. G ENSLER . I appreciate the question. I very much still am. I think that the over-the-counter derivatives market, which dwarfs the future exchange derivatives market by about 8 to 10 times the size, no small amount, I think we must bring the transparency there. Not for all contracts, however. There will be a whole group of contracts that are customized. There will be a whole group that aren’t listed, even if they are clearable. But I think that for the portion of the market that can be listed and has some characteris- tics that will add transparency, we should have exceptions for block trading. If somebody is doing a lower transaction, then it is just reported afterwards, just as it is in the futures and securities markets now, but I think that the events of last Thursday are important to look at. They don’t change my overall view that we need to bring trans- parency to the off-exchange or over-the-counter derivatives market- place where we can, not in the customized portion of the market but in the more standardized portion of the market. Mr. L UCAS . So ultimately, when you do and your good folks over there and your friends at the SEC grind through all of this and come up with some sort of a determination, we will have a much better feel. I just personally still have to believe that having watched what the Agriculture Committee did and working in con- junction with Financial Services, trying to be a bit more flexible, a bit more rational in how we handle these derivatives, I person- ally think was the route to go. I know ultimately after last week, we will reassess the situation. But I just wanted your perspective on that because while both of you have indicated today there was no ‘‘fat finger,’’ no magic mystery key stroke, no great confusion in somebody’s software, nonetheless, if whatever did occur could have such an effect on the most massive, most liquid market in the world, it does cause concern for me about these other markets, these other instruments that don’t even begin to approach that. Mr. G ENSLER . And that is why I think it is not only important that we have strong risk management in the clearinghouses that the Congress has been supportive of, but also that these exchanges for derivatives have very strong rules. I think the futures market has some very important guidance, the four that I have mentioned earlier in terms of not being able to put prices in in the outset of a ban; and having the pause, the 5-second pause that happened in the futures market last Thursday was, in fact, right at the bottom where the order book got refilled. And the mention that Chairman Schapiro was talking about of trying to do that across the securi- ties markets, I support her initiative on that. Mr. L UCAS . One last brief question. If indeed we do determine what happened, what the odds that it will be something of a pro- prietary nature where you won’t be able to share that with all of us and the public? Mr. G ENSLER . We plan to make our findings public both to Con- gress and this committee. Next week will just be initial findings of staff. If there was a need to talk about individual trading, informa- tion of individual accounts, than we would work with this com- mittee to do that in the appropriate setting. CHRG-111hhrg55809--257 Mr. Bernanke," No, you are absolutely right. Banks do have various ways to raise capital. They can go to the public markets, for example. But one of the tensions we face now in this and other spheres is that there certainly is a desire, both in the United States and abroad, to raise bank capital levels so that they will be safer in the future, but recognizing though that, in the short run, raising capital levels may cause banks to reduce their assets and to reduce lending. We need to find a way to phase that in, sufficiently gradually that it doesn't impede the recovery. So we face that problem in a lot of cases. We want people to save more, but not immediately because the economy is in a recession. So it is the timing that is very important. " FinancialCrisisInquiry--182 Can you turn your mic on, Mr. Rosen? ROSEN: I’m Ken Rosen. I want to thank Chairman Angelides and Vice Chairman Thomas, and the commission for having me here. I want to not read my testimony since you have it. But I’m going to talk a little bit about what I think is the epicenter of the crisis—where this started, how it got there, and where we are today, which is the housing market—the housing and residential mortgage market. Excessively easy credit, extremely low interest rates created a house price bubble. And the house price bubble when it burst has really caused a significant part of the problems that we had—at least the—initially. And of course it caused—helped cause the great recession where we have lost over eight million jobs. I think the most important thing to say is how did we get here. And I would say that low interest rates is part of the blame, but really it’s the poorly structured products that came about in this environment. Innovative products are important, and a good thing. And I’ve written papers on—on this in the 1970s and 80s while we needed innovative mortgage products. And they’re good for some people—some households. Subprime— there is a need for having that. But not to the market share it got. Low down payment loans – Alt-A loans, option arms. All those made some sense for a portion of the population. What happened is we layered all these risks. We went from a conservatively written subprime loan to a subprime loan that had no down payment, and didn’t document someone’s income or employment. So we made a mistake from what was a good idea by financial institutions became a bad idea for the entire overall market. And then we combine that with a second component which was I thought bad underwriting. We lowered underwriting standards dramatically. We started this in California, and it spread everywhere. We—we do this sometimes. Liars loans which are stated income loans, and there was rampant fraud at the consumer level. We’ve heard discussion of this at the institutional level, but I think the consumer basically really did this so they could qualify for the loan. There was some complicity on the part of brokers and originators. I think—I do not think this was at the high level institutions, but it’s at the individual originator level. CHRG-111shrg50814--89 Mr. Bernanke," I think we can improve our situation. I will give you an example---- Senator Tester. But can we get out of the situation? " FinancialCrisisReport--3 Wall Street and The Financial Crisis: Anatomy of a Financial Collapse April 13, 2011 In the fall of 2008, America suffered a devastating economic collapse. Once valuable securities lost most or all of their value, debt markets froze, stock markets plunged, and storied financial firms went under. Millions of Americans lost their jobs; millions of families lost their homes; and good businesses shut down. These events cast the United States into an economic recession so deep that the country has yet to fully recover. This Report is the product of a two-year bipartisan investigation by the U.S. Senate Permanent Subcommittee on Investigations into the origins of the 2008 financial crisis. The goals of this investigation were to construct a public record of the facts in order to deepen the understanding of what happened; identify some of the root causes of the crisis; and provide a factual foundation for the ongoing effort to fortify the country against the recurrence of a similar crisis in the future. Using internal documents, communications, and interviews, the Report attempts to provide the clearest picture yet of what took place inside the walls of some of the financial institutions and regulatory agencies that contributed to the crisis. The investigation found that the crisis was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street. While this Report does not attempt to examine every key moment, or analyze every important cause of the crisis, it provides new, detailed, and compelling evidence of what happened. In so doing, we hope the Report leads to solutions that prevent it from happening again. I. EXECUTIVE SUMMARY A. Subcommittee Investigation In November 2008, the Permanent Subcommittee on Investigations initiated its investigation into some of the key causes of the financial crisis. Since then, the Subcommittee has engaged in a wide-ranging inquiry, issuing subpoenas, conducting over 150 interviews and depositions, and consulting with dozens of government, academic, and private sector experts. The Subcommittee has accumulated and reviewed tens of millions of pages of documents, including court pleadings, filings with the Securities and Exchange Commission, trustee reports, prospectuses for public and private offerings, corporate board and committee minutes, mortgage transactions and analyses, memoranda, marketing materials, correspondence, and emails. The Subcommittee has also reviewed documents prepared by or sent to or from banking and securities regulators, including bank examination reports, reviews of securities firms, enforcement actions, analyses, memoranda, correspondence, and emails. CHRG-111hhrg56778--81 Mr. Greenlee," We follow what's outlined in the Gramm-Leach-Bliley Act, which compels us to rely to the fullest extent possible on primary bank regulators or functional regulators. We will get information at times that will cause us to go back and ask more questions. If there are concerns, we can always go to the audit function of the bank and find out what they think. We always have the right to go ahead and do our own review and look into it under the law. The burden is on us to say why we think this is a threat to the depository; and, at times we will do that if we are sufficiently concerned. " CHRG-110shrg50416--173 RESPONSE TO WRITTEN QUESTIONS OF SENATOR MENENDEZ FROM ELIZABETH A. DUKEQ.1. I am gravely concerned, about a situation whereby banks are taking advantage of AIG's low credit rating to make a windfall off of transactions they have with our nation's mass transit agencies. Is the Treasury willing to appoint a senior official to work with the Fed, the IRS, and these public transit agencies to make sure taxpayer money is protected? Given the urgent nature of this situation I would like an answer to this question by Tuesday October 28. (Please contact my staffer Hal Connolly at 202-224-4744 if you have any further questions)Q.2. Our nation's public transit agencies are potentially liable for payments in the hundreds of millions of dollars to banks due to the downgrading of AIG through LILO/SILO leveraged leases. Does the Treasury and the Fed think it appropriate that these banks are in a position to make a windfall at the expense of these public agencies? Without action by the Treasury banks stand to gain all of the benefits the IRS has declared to be inappropriate. Has the IRS backed away from its previous position on these leases?A.1.-A.2. As you indicate, a number of transit authorities have issued obligations that were guaranteed in whole or in part by American International Group, Inc. (MG) as part of complex, tax-driven lease transactions. It was precisely for the purpose of limiting the potential adverse effects on the economy of the failure of AIG that the Federal Reserve, on September 16, 2008, extended a line of credit to AIG in the amount of $85 billion. The Federal Reserve was concerned that the disorderly failure of MG during the current period of economic turmoil and fragile markets would have wide-ranging systemic effects and exacerbate the already troubled economic situation. Since that time, the Federal Reserve, working with the Department of the Treasury, has taken additional actions to help restore confidence in AIG to allow it to maintain its credit ratings and conduct its business while it engaged in an orderly restructuring. On November 10, 2008, the Federal Reserve restructured its credit facility and agreed to provide two additional liquidity support facilities to AIG. At the same time, the Department of the Treasury provided an emergency injection of capital to the company. While the Federal Reserve has used its authority to provide liquidity to AIG, the Federal Reserve does not have authority to cure the potential technical defaults on the transit authority bonds, which are based on the credit ratings of MG. The credit ratings for AIG are not established by the Federal Reserve, though the actions of the Federal Reserve and the Treasury in providing funding to MG have helped to stabilize those ratings. We understand that the transit authorities are in discussions with lenders to find mutually agreeable ways to cure the potential defaults. We recognize the importance of mass transit to communities, both as a matter of the economic contribution that mass transit makes to urban communities in particular and in the effects it has on the lives of users of mass transit. This is an important issue that we are monitoring carefully." FinancialServicesCommittee--52 Chairman K ANJORSKI . Thank you very much, Mr. Duffy. Now, we will move on to questions. I will take my question pe- riod first. Mr. Noll and Mr. Leibowitz, listening to your testimony, I am not sure anything happened on Thursday. Everything worked. Is that correct? Mr. L EIBOWITZ . Oh, I don’t think any of us would say that every- thing worked. I think, in fact, what Mr. Noll was saying was his systems worked. But I think we would all agree that the market did not. Chairman K ANJORSKI . What caused the market not to work? Mr. L EIBOWITZ . I think what both of us have found is liquidity fled the market through the day as the market was skittish, and then an overwhelming wave of orders came in on the sell side that built on itself. I think having a marketwide circuit breaker in effect would have helped mitigate that problem. But in effect, the market was illiquid just at the wrong time as sellers broke into the mar- ket. Eric? Mr. N OLL . Thank you, Larry. Mr. Chairman, I think there are two things to observe that hap- pened. I would agree with Mr. Leibowitz that in fact the markets did not behave normally on that day. I think my point was really our technology behaved as it was designed to behave that day. I think it is important to observe two things. One is that the marketwide circuit breakers we do in fact have in place today were not triggered, because the market did not fall to the point where they were triggered and therefore cause a marketwide halt. So I think Chairman Schapiro is correct when she says that we should in fact revisit those and reinstitute different types of marketwide circuit breakers that will arrest those marketwide halts as they happen. I think the other point that she made vividly today, which we certainly agree with at NASDAQ, is that we do need a coordinated stock-by-stock circuit breaker across all the markets, which we don’t currently have on our books and we don’t have the authority to implement. So I think we will see that soon coming out of the SEC. Chairman K ANJORSKI . There was no problem on your part on ei- ther of the two exchanges with the fact that the New York ex- change did a slowdown operation, but NASDAQ continued going right on and allowed the sales to pass through to the NASDAQ ex- change. That had no effect; is that correct? Mr. N OLL . I think we would say that was a contributing cause to a confluence of events here. It points to what we would argue, the need for a coordinated stock-by-stock circuit breaker. Mr. L EIBOWITZ . From our standpoint, I think what we have shown or what we see is we don’t think the fact we were moving slowly exacerbated the effect. In fact, the fact that we were trading high-market share, keeping the stock prices in line, might actually have helped, and the fact that other markets that didn’t have cir- cuit breakers at all, like the NASDAQ listed market, had even more damage than in the New York listed market. But I think we can all agree that having uniform marketwide circuit breakers would have helped in all events. FOMC20050630meeting--196 194,MS. JOHNSON.," Well, for one thing, the U.K.’s 1990 cycle was amplified by regulatory changes that preceded it, which led to mortgage lending that was excessive and not well supervised. It was a kind of blind-leading-the-blind situation: The regulator changed the rules and the financial institutions moved into the market and practices and norms changed. A great deal of lending took place. The supervisors were learning as much as the lenders were and—well, let me put it this way—it didn’t go well. In the past, there has certainly been a correspondence between household consumption and housing wealth in the U.K. So when they suffered the big drop in the 1990 rundown of housing prices, they also had a big change in household consumption out of disposable income, and so forth, June 29-30, 2005 67 of 234 Now, a couple of the characteristics of the U.K. market have always led us to think that it’s not a telling example. One is the prevalence of variable-rate mortgages, which causes the process of tightening monetary policy to contain the macroeconomy to have a bit of extra leverage over the discretionary income of households—to an extent that is not the case with fixed-rate mortgages Obviously, there’s a counterpart effect on the earnings of mortgage lenders, and so forth, in the U.S. economy that you need to take account of to fully understand that. But there is that characteristic. And there is the fact that house prices actually fell in the U.K., so they had big negative equity problems, which complicated the process of how to unwind the interaction of household behavior and financial intermediary behavior. To the extent people walked away from the houses, the financial intermediaries were getting collateral that perhaps no longer equaled the value of the loan. On the other hand, some households didn’t walk away; they just remained in a negative equity position for some time. And that had a long, dampening effect on their spending patterns. So there were complex reactions involved. But this time around, at least based on my conversations with U.K. officials, they think they’ve improved a lot of those things. So in that sense, there is something to be learned. Financial institutions now know better how to maintain their balance sheets and how to do this lending. The households know better, too; they’ve learned a bit. U.K. officials think they’ve seen a lessening to some degree of this tight link between housing wealth and consumption so that they’re not both on the run-up and then, when it stops, extrapolating what the consequences would be. On the other hand, I have to admit that I occasionally read my little machine while I sit here, and in the last hour it carried three statements from a member of the Bank of England’s Monetary Policy Committee who must have been making a speech. And all three statements the media chose June 29-30, 2005 68 of 234 [Laughter] And all of the statements were slightly two-handed, along the lines of: Monetary policy should not be driven by housing prices, but we must look at them closely. [Laughter] I think there are lessons to be learned; I’m not saying there aren’t. But certainly the 1990s episode had some characteristics that were far more extreme and that would never happen here because of institutional differences. And the present episode, which has remedied some of those earlier problems, I think is not such a bad deal. They’ve slowed the increase in housing prices. They aren’t having negative equity. They don’t have financial institutions that look like they’re going to become or technically are insolvent. I think in that sense they moved to improve their infrastructure, so to speak. They talk about the issue a lot but I think they feel the situation is okay at this time." FOMC20070628meeting--19 17,VICE CHAIRMAN GEITHNER.," I agree with all of that, but the relative size is much smaller—much narrower in the type of positions to which they’re exposed. The state of the world is dramatically different. Direct exposure of the counterparties to Bear Stearns is very, very small compared with other things. Bill is exactly right. These guys are making a loan against a set of positions—a right to those positions—not equity, and what they realize in the value of those positions over time will be determined. They think there is positive value in that. So the situation is dramatically different. It does not mean that you should view it as particularly reassuring. You know, these people were exceptionally experienced in the mortgage credit business, and there were smart people in LTCM, too. [Laughter]" CHRG-111shrg56262--46 Chairman Reed," Senator Corker. Senator Corker. Thank you, Mr. Chairman, and I am sorry I missed part of the end of the testimony going to another hearing, but I got the general idea. Focusing on commercial real estate right now, I know there has been a lot of discussion. We were just in New York, lots of people concerned about this huge amount of indebtedness that is coming due, huge amounts of loans done 10 years ago. You had 10-year term, 30-year ARM. In essence, you kind of sold the project at that time because it was almost--you almost got full value because underwriting was so loose, so you kind of wondered, what is the problem? These have got to roll over, and the developer kind of sold the deal on the front end. But I guess as we--and I know that is not the case in every case. But what is the key? Some organization that wants to begin originating commercial real estate loans again and securitizing them from just doing those things and market needs to make those be sold by keeping recourse or doing other kinds of things? I just don't get it, really. The real estate values are dropping. You are underwriting at lower levels. The bond holders today are going to take a haircut to get financed out. The developer is going to have a little bit different deal or lose his property, but what is to keep the private market from just functioning right now? I really don't get it, and I don't understand why the focus is on us. " FOMC20051101meeting--95 93,MR. POOLE.," Secondly, and this goes in part to the question President Moskow asked, we have somewhat of a mixed situation in terms of the forecast. When I first came in 1998, there was a November 1, 2005 24 of 114 to go down, and many aspects of the Greenbook forecast were predicated on a decline in the stock market. Of course, eventually the stock market did go down, but it didn’t go down in 1998 or 1999. Now we have, I think, an appropriate standard type of assumption here. The stock market is forecast on a sort of equilibrium basis, and we’re not independently trying to have a stock market forecast. We do the same thing on oil prices. But we don’t do that on some other important parts of the forecast, such as exchange rates and the federal funds rate. To me, the most useful baseline forecast would be to put together the Greenbook on a consistent set of assumptions on those kinds of things. Then I’d value the staff input as to where they believe the federal funds rate, the exchange rate, and everything else will likely come out differently from the expectation in the market. But to me we have a somewhat muddled situation in terms of the internal consistency here. Dave Stockton and I have talked about this several times over the years, but maybe there could be a survey of the Committee on what we would find most useful as the assumptions for things like exchange rates, the stock market, oil prices—all of those things where there are market forecasts available. What would be the most useful to the Committee in terms of the baseline assumption for the Greenbook?" FOMC20080625meeting--138 136,MR. KROSZNER.," It's directly on this point. It seems that in the situation we're in, with very elevated spreads in LIBOR, there are almost no contracts in the real markets that are related directly to fed funds. It's usually through three-month LIBOR, and we know that the spread is now roughly 70 or 75 basis points higher than it used to be. It used to be about 10 basis points, and now it's around 80. For me that's one rough proxy in how I think about this--that the way in which our actions are being translated into market prices is somewhat different from the way it was when the spreads were lower. " CHRG-111shrg55117--76 Mr. Bernanke," It should be in the private sector, but there is some scope for a basic black, if you will, and then the version with sequins on it. Senator Corker. Good. On the resolution authority piece, I know there has been some discussion, and you are going to be highly involved in that. Another piece the administration had come forth with out of Treasury was basically keeping TARP in place in perpetuity, giving the Treasury the ability when they decided to actually invest taxpayer money in companies and also to draw a bright line around those companies that posed a systemic risk and in essence, in my view, sort of creating a more Freddie-Fannie-type view of some institutions that were over a certain size. I wonder if you might have any comments about that. We have watched what the FDIC has proposed, which actually would unwind companies that fail. I think you made testimony earlier--I know you did, I read it--that says that you believe that is the best route to go and I wonder if you might have any comments for those of us who are going to be working on regulation. " 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--438 In effect, many of the largest financial institutions in the world, along with hun- dreds of smaller ones, bet the survival of their institutions on housing prices. Some did this knowingly; others not. Many investors made three bad assumptions about U.S. housing prices. They assumed: • A low probability that housing prices would decline significantly; • Prices were largely uncorrelated across different regions, so that a local housing bubble bursting in Nevada would not happen at the same time as one bursting in Florida; and • A relatively low level of strategic defaults , in which an underwater homeowner voluntarily defaults on a non-recourse mortgage. When housing prices declined nationally and quite severely in certain areas, these flawed assumptions, magnified by other problems described in previous steps, cre- ated enormous financial losses for firms exposed to housing investments. An essential cause of the financial and economic crisis was appallingly bad risk management by the leaders of some of the largest financial institutions in the United States and Europe. Each failed firm that the Commission examined failed in part be- cause its leaders poorly managed risk. Based on testimony from the executives of several of the largest failed firms and the Commission staff ’s investigative work, we can group common risk management failures into several classes: • Concentration of highly correlated (housing) risk. Firm managers bet mas- sively on one type of asset, counting on high rates of return while comforting themselves that their competitors were doing the same. • Insufficient capital. Some of the failed institutions were levered : or higher. This meant that every  of assets was financed with  of equity capital and  of debt. This made these firms enormously profitable when things were go- ing well, but incredibly sensitive to even a small loss, as a  percent decline in the market value of these assets would leave them technically insolvent. In some cases, this increased leverage was direct and transparent. In other cases, firms used Structured Investment Vehicles, asset-backed commercial paper conduits, and other off-balance-sheet entities to try to have it both ways: fur- ther increasing their leverage while appearing not to do so. Highly concen- trated, highly correlated risk combined with high leverage makes a fragile financial sector and creates a financial accident waiting to happen. These firms should have had much larger capital cushions and/or mechanisms for contin- gent capital upon which to draw in a crisis. • Overdependence on short-term liquidity from repo and commercial paper markets. Just as each lacked sufficient capital cushions, in each case the failing firm’s liquidity cushion ran out within days. The failed firms appear to have based their liquidity strategies on the flawed assumption that both the firm and these funding markets would always be healthy and functioning smoothly. By failing to provide sufficiently for disruptions in their short-term financing, management put their firm’s survival on a hair trigger. • Poor risk management systems. A number of firms were unable to easily ag- gregate their housing risks across various business lines. Once the market be- gan to decline, those firms that understood their total exposure were able to effectively sell or hedge their risk before the market turned down too far. Those that didn’t were stuck with toxic assets in a disintegrating market. CHRG-111shrg56415--48 Mr. Dugan," And Senator, if I could just add, if you look at the experience of Canada where they are our neighbors and have a much more conservative standard for underwriting, where they verify income and have loan-to-value ratios that are higher, you can't get a 30-year fixed-rate mortgage, but they have very high levels of home ownership and they didn't have any of these problems. So, they have more of a system that has a basic minimum that cuts across the board. It may not be the right ones for us, but I definitely think it is worth exploring. Senator Corker. And I would really like--I know that I am going to run out of time here and we are not going to be able to--but we talk often, I know, all of us--I would really like to see what it is we need to do on our end. I don't think we as a country have the political will to do the things we need to do to make sure that this doesn't happen again. I absolutely do not see it. I mean, this regulatory reform, again, is just moving chairs around. It is not changing anything about the way that we go about doing this business. And I hope that as we move along, you all will help with that. Mr. Tarullo, again, I thank you for your testimony, also, as always. I am wondering, on 13(3), as we move into regulation, should we--I mean, in essence, we are going to be talking about TARP and resolution and all of those kind of things down the road, but on the 13(3) issue, exigent circumstances, should we move to narrow the Fed's ability to use 13(3) for specific institutions, move away from that so that your assistance is at the system level, but where you are not specifically--I mean, in essence, you can get around--I know that some people here support the Administration's proposal to sort of codify TARP. I don't. I think we should end TARP at the end of the year. But it seems to me that under 13(3), the way you now have it, you all can work around that at the Fed and, in essence, do the same thing at specific institutions, and I am wondering if you feel we ought to limit that. " CHRG-110hhrg44900--103 Secretary Paulson," I wish I could tell you one thing, but there isn't a silver bullet. If there was, and we knew how to address it right now, we would. And what is going on now as I said earlier, is it's just taking us a good while because there is much more leverage than was--what was once healthier--much more leverage than was perceived to be the case. And it was in the form of financial products. And then many of which were complex. There has been recorded progress made. It hasn't been in a straight line, but the progress I would site has been the risk reduction, the de-leveraging, the things that the Chairman has cited, in terms of increased liquidity and management, funding management by the investment banks, the capital that has been raised, being raised. But I believe part of this of course, is confidence. And having been through periods like this, they always are the worst until they are resolved. And before they are resolved, you wonder how they ever are going to be resolved. But confidence has a way of returning to the markets. And over time there have been many investors, wise investors, that have come in during times of great risk, adversity, and made investments and have made money on those investments. I think one of the key things is going to be when you start to see, and we are seeing some, more of these hard-to-sell assets changing hands and private money coming into the markets. But meanwhile, we have, all of us, some real work to do. " FOMC20071031meeting--41 39,MR. ROSENGREN.," Thank you, Mr. Chairman. The Boston forecast is very close to that of the Greenbook. With the constant federal funds rate assumption, the economy is very close to full employment, and core inflation is close to 2 percent at the end of 2008. Such an outcome is consistent with what I would hope to achieve with appropriate monetary policy. However, while this is an expected path that seems quite reasonable, the distribution of risks around that outcome for growth remains skewed to the downside. Our forecast, like that of the Greenbook, expects particularly weak residential investment. Problems in financing mortgages, expectations of falling housing prices, and more-severe financial stress for homebuilders are likely to weigh heavily over the next two quarters. In fact, our forecast for residential investment has become sufficiently bleak that there may actually be some upside risk to it. [Laughter] Somewhat surprising to me has been the lack of spillover to the rest of the economy from the problems in residential investment. I remain concerned that falling housing prices will further sap consumer confidence and cause a pullback in consumption, though to date there is little evidence of a significant effect of the housing problems on consumer spending. Similarly, I would have expected the financing problems that have aggravated the housing situation to have caused a sharper reduction in investment in general and in nonresidential structures in particular. However, so far these remain risks rather than outcomes. Thus, while I am worried about the downside risks, I am reminded that forecasters have frequently overestimated the consequences of liquidity problems in the past. On the financial side, there have definitely been improvements in market conditions, though markets remain fragile. Particularly worrisome has been the announcement of significant downgrades of tranches of CDOs and mortgage-backed securities with large exposure to the subprime mortgage market. Not only have the lower tranches experienced significant downgrades, but a number of the AAA and AA tranches have been downgraded to below investment grade. Some investors cannot retain below-investment-grade securities and are forced to sell these securities in an already depressed market. The number of the downgrades, the magnitude of the downgrades, and the piecemeal ratings announcements all are likely to call into further question the reliability of the ratings process. If many high-grade securities tied to mortgages are downgraded to below investment grade, some investors may conclude that repricing of even high-graded tranches does not reflect a liquidity problem but rather a substantial reevaluation of credit risk. Thus, I am concerned that continued widespread downgrades may make recovery in the securitization market more difficult, particularly for nonconforming mortgages, with a consequent increase in the financing cost of these assets. I also remain concerned that the asset-backed commercial paper market remains fragile. While investors seem to be distinguishing between conduits whose structure or underlying assets are quite risky, my sense is that money managers are watching the market quite closely. I continue to hear concerns over the possibility that some money market funds will experience losses that will not be supported by their parents, resulting in increased investor concern with the safety of money market funds more generally. On balance, the data both on the real economy and on financial markets have improved since our September meeting. That improvement makes it more likely that the economy will continue to recover gradually from the financial turmoil. However, both the real and the financial risks remain skewed to the downside." CHRG-111hhrg56766--10 The Chairman," I thank the gentleman from North Carolina. The gentleman from North Carolina will have 2 minutes and 10 seconds. The gentleman from Texas is now recognized, the ranking member of the Subcommittee on Domestic and International Monetary Policy, for 3 minutes. Dr. Paul. Thank you, Mr. Chairman. Welcome, Chairman Bernanke. I am interested in the suggestion that Mr. Volcker has made recently about curtailing some of the investment banking risk they are taking. In many ways, I think he brings up a very important subject and touches on it, but I think it is much bigger than what he has addressed. Back when we repealed Glass-Steagall, I voted against this, even though as a free market person, I endorse the concept that banks ought to be allowed to do commercial and investment banking. The real culprit, of course, is the insurance, the guarantee behind this, and the system of money that we have. In a free market, of course, the insurance would not be guaranteed by the taxpayers or by the Federal Reserve creating more money. The FDIC is an encouragement of moral hazard as well. I think the Congress contributes to this by pushing loans on individuals who do not qualify, and I think the Congress has some responsibility there, too. I also think there has been a moral hazard caused by the tradition of a line of credit to Fannie Mae and Freddie Mac and this expectation of artificially low interest rates helped form the housing bubble, but also the concept still persists, even though it has been talked about, that it is too-big-to-fail. It exists and nobody is going to walk away. There is always this guarantee that the government will be there along with the Federal Reserve, the Treasury, and the taxpayers to bail out anybody that looks like it is going to shake it up. It does not matter that the bad debt and the burden is dumped on the American taxpayer and on the value of the dollar, but it is still there. ``Too-big-to-fail'' creates a tremendous moral hazard. Of course, the real moral hazard over the many decades has been the deception put into the markets by the Federal Reserve creating artificially low interest rates, pretending there has been savings, pretending there is actually capital out there, and this is what causes the financial bubbles, and this is the moral hazard because people believe something that is not true, and it leads to the problems we have today because it is unsustainable. It works for a while, but eventually, we have to pay the price. The moral hazard catches up with us and then we see the disintegration of the system that we have artificially created. We are in a situation coming up soon, even though we have been already in a financial crisis, we are going to see this get much worse and we are going to have to address this subject of the monetary system and whether we want to have a system that does not guarantee that we will always bail out all the banks and dump these bad debts on the people, and that it is filled with moral hazard, the whole system is. When that time comes, I hope we come to our senses and decide that the free market works pretty well. It gets rid of these problems much sooner and much smoother than when it becomes politicized that some firms get bailed out and others get punished. It is an endless battle. Hopefully, we will see the light and do a better job in the future. " CHRG-111hhrg51585--191 Mr. Green," That is the job, sometimes, of government. It is not a nice thing to have to do; no one relishes having to do it. But there are times when you have to make hard decisions, very difficult decisions, and you do the best that you can. You may not get it right, you may not be perfect. But you do what you can, the best that you can, to be of assistance. Final question: All of these persons with you are here because there is a law that they are trying to cause us to implement as they see it appropriately. Had there been a law at the time Orange County found itself in this dilemma that connoted Orange County could receive some assistance, would you have pursued receiving that assistance from the Federal Government? " 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--524 WALLISON: Every time there’s a bankruptcy, there are externalities. And so we do cause people who are—who cause the externalities to pay for the externalities because the shareholders, the management, and the creditors of the bankrupt company to pay for those. So what is the reason to have any other kind of resolution system? CHRG-110hhrg44900--137 Mr. Lynch," Thank you Mr. Chairman. Mr. Chairman I appreciate you holding this hearing and I want to thank the ranking member as well. I want to thank the Secretary and the Chairman for appearing before us and helping the committee with its work. I want to go back to a point that was raised earlier, Mr. Secretary, in your response to Ms. Maloney and also I think, Mr. Chairman, you address it at page three of your remarks. And basically my question is this. A lot of the lack of confidence, I think, in some aspects of our market come from the complexity and the opaqueness of some of these derivatives that we have actually gone back and tried to drill down into the models on which some of these derivatives are actually based. And in some cases they probably stretch from myself to Mr. Hensarling down there. I am just wondering, is there anything in your proposed reforms that might get at this issue? I mean, some of these derivatives I have to admit, it is just very, very tough to value them or mark them to book as some of my friends in the industry have described it. The credit default swaps that are a huge, huge part of the market out there, these collateral debt obligations, the failure of these risk and recovery models to really predict or to ascertain the value of these things, they are so complex, I honestly believe if we adopted a simple rule that said an investor had to understand these things before they bought them, that this whole market would come to a screeching halt. I honestly believe that, and I am only half joking. But is there anything that you have proposed that would get at that opaqueness and lack of transparency and complexity? Something that would allow investors to have more confidence? I mean, in some of these cases, and synthetic CDOs, we don't even know where the actual ownership lies. So it is just very, very tough for an investor, especially in difficult times to have confidence in their investment when they can't really determine that on their own. " CHRG-111hhrg51698--281 Mr. Schrader," Thank you, Mr. Chairman. I would just be interested in the panel's thoughts on the bill's inclusion of carbon offsets and emission allowances that are being proposed for the CFTC to have jurisdiction over. There is going to be some interesting legislative discussions about who should, indeed, have jurisdiction as this process moves forward. So we heard great things about the CFTC as a regulator it has done a wonderful job. This particular market, as long as it is allowed to regulate certain instruments, has done a great job. Is this the appropriate place, the CFTC, to regulate that market? " FOMC20080430meeting--70 68,MR. FISHER.," Nathan, both you and Dave expressed the frustration that I think all of us have about relying on futures markets in terms of our forecast of lower prices. It just hasn't been very helpful. Do we know or have a sense of how OPEC itself forecasts? Do they just look at futures markets? Second, to what degree do you impute into your own calculations the income elasticity of demand for the rapidly growing countries such as China? We know it is above 1 on oil. Third, linking the two, to what degree would, say, the Saudi royal family or the al-Sabahs of Kuwait be thinking about those high income elasticities of demand with those high growth rates offsetting what used to be their fear of a slowdown in their markets? In 1978, for example, they had only three markets to sell into really: the United States, Japan, and what we used to call Western Europe. Now they have hedges against the weaknesses in those markets. So I'm wondering as we think about alternative ways to wrap our arms around this--and it is a very difficult thing as the current indicator we have has been shifting all over the place and has not been very useful--have we tried to learn how the swing producers look at this and how they calculate and think about where prices are likely to go or whether they just look at the futures markets as well? " CHRG-111hhrg54868--89 Mr. Dugan," I am not sure that we have seen that as a rampant problem in the system. There are some rights related to set off when you have some issues, but I don't believe that banks can routinely use one account to pay the debts of another bank. But I will get back to you on that, on where we are on that, if I could, for the record. Let me just also say that earlier this week, I did spend some time with Georgia community national bankers in Atlanta, and would just echo all of the comments that my colleague just said about the situation in Georgia and some of the issues that they have. " CHRG-110shrg50414--103 Secretary Paulson," Here is what I am saying: that if this--when we protect the taxpayer, the right way is to have the program work and have the assets appreciate when the economy appreciates. I am saying that the model you are looking at is a model where we go to people that absolutely need to sell and say, If you want to sell, give us something. The model we are looking at--and what we believe it takes to be successful here--is to go to a broad group of institutions, a very, very wide range of institutions that own these assets and have them participate. And if we deal with it selectively, as we deal with situations where there is serious trouble, to use a different approach. But, anyway, I appreciate your comments. Senator Reed. Well, Mr. Secretary, the one other way to describe what you just said is to go to some institutions that do not need help and we give them help for free. But let me change the subject, if I may, and I am indulging the Chairman's time. In this reverse auction, it is a very difficult set to price, but one of the principles--would one of the principles be that someone cannot sell to you or bid to you at a price higher than what they paid for? Because today there are firms that are collecting distressed assets at discount prices. If you do not have some protection like that, they will walk in and they could very well sell you something that they paid much less for. " FinancialCrisisInquiry--553 WALLISON: The collateral is posted by the person who has the obligation in order to back the obligation. And so I’m just wondering why a collateral is not required at the beginning of these credit- default swap transactions if the counter party is expecting to have the risk covered by the person who is offering the coverage. FOMC20080916meeting--55 53,MR. PLOSSER.," I just have one clarification. I have no basic objection to this. I wonder whether or not, if the FOMC is going to delegate the decision to this group, it is sort of an openended delegation to do this on an ongoing basis. Does it make sense to define a period of time for which this open-ended delegation is appropriate--that it would expire and would have to be renewed? " FOMC20060808meeting--85 83,MR. MOSKOW.," I have one question about the term “resource utilization.” It was in our statement last time, and we took it out of many of the alternatives. I think David mentioned that resource utilization was a bit tighter since our last meeting. I was wondering whether there was a particular reason for taking it out of many of the options that we have to consider here." CHRG-111hhrg53246--3 Mr. Garrett," Thank you, Mr. Chairman, and thank you, members of the panel. Today's hearing is on the President's financial regulatory reform proposals. You know, your agencies oversee some of the most transparent, efficient, and complex markets in the world that are also responsible for ensuring that our capital markets promote price discovery, capital formation, and investor protection. Now, the Administration's reform proposals task the SEC and the CFTC with developing a regulatory infrastructure for over-the-counter derivatives and reporting to Congress by September 30th on how the agencies will harmonize two very disparate regulatory approaches. So I look forward to hearing from you to see how well those are coming together and where some of your sticking points are going to be, if there are some, I think there will, and whether you will be able to meet that deadline. You know, with regard to the Administration's proposals, I agree with some of them. I think it is evenhanded and certainly less radical than other ideas that have been proposed so far in Congress. Still, there are some aspects of the Administration's proposals that trouble me. And I am worried that in the name of systemic risk reduction, requirements that would force more OTC transactions into central clearinghouses or onto exchanges, as well as strident new margin requirements for both centrally cleared and noncentrally cleared transactions will make hedging just too expensive for many end users of derivatives throughout the broader economy. The perverse outcome, therefore, of efforts to reduce systemic risk in these markets can actually increase risk for many companies if they are no longer able to cost effectively engage in a comprehensive risk management practice. So if you take a step back for a moment, perhaps an even more fundamental question should be asked here: Were standardized derivatives significantly related to the recent meltdown of our financial markets, and if not, why are we prescribing cures for a nonexistent ailment? You know, the failed oversight of one large dealer directly related to broader regulatory failures in the housing finance markets should not cause us to pursue radical fixes for the broader OTC derivative markets and their nondealers participants that had little or really nothing to do with the recent crisis. What we do need is comprehensive regulatory reform, but it needs to be sensible and we need to make sure that we are addressing actual problems in the way that we are doing it and not causing more harm than good. The risk of mobile capital migrating elsewhere as we overshoot the mark in regulatory reform, I think, is a real one and we should take the time to carefully evaluate the proposals presented to us before we move ahead with legislation. So once again, thank you both for coming to the panel today, thanks to the people who have been here numerous times in the past as well. Thank you. " CHRG-110hhrg45625--140 Secretary Paulson," Let me say, first of all, you can take 3 weeks, you can take 4 weeks, you could take a month, and you are not going to solve the issues you want to solve, which you are talking about fundamental issues that have to do with major fundamental reforms. In terms of this issue, I would only say to you that we have dealt with a series of very significant problems and dealt with them, we believe, effectively. We need to move quickly and take a systemic approach to put out this fire, and I don't believe that the situation is such that it is appropriate or that it will work to take 3 or 4 weeks to deal with this situation. I think the situation is such with what is going on in the markets that we need a quicker answer. " 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" FinancialCrisisInquiry--252 DIMON: I can’t move it any closer, but I’ll sit up here. I am saying, at no point in the market before the problem started were these firms priced like they were too big to fail. So if you look at what people lent money to at the firms, no, they were priced like there’s a potential for failure like any other company. Even after things started failing and the government—remember, they did allow firms to fail like Lehman. But there was Indy Mac, WaMu, virtual failures in Wachovia, Bear Stearns. Even after they let things fail, that was true, and even after the government did the stress tests and said they don’t want these things to fail, the market still priced them— their stock price and their debt—like they could fail. At our board level, we never had a conversation, ever, that we should rely on the government to do anything. 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. " FOMC20080310confcall--76 74,CHAIRMAN BERNANKE.," Thank you. On exit strategies, we do get a lot of feedback from the auction itself, of course, in terms of demand and price, and we can monitor the market conditions. Obviously, we'll keep you well apprised of developments in the markets and in the auction. I'm a little worried about having a firm cutoff date ex ante. If we want the dealers to make markets, we need them to feel that there will not be an arbitrary cutoff when the situation is still in a turbulent state. But that's just a thought. President Evans. " CHRG-111shrg55739--117 Mr. Coffee," Let me say you are right, Senator. You probably wanted to hear that. You are right. And I have some charts in my statement that show that the percentage of liar loans, no-document and low-document loans, in subprime mortgages went from in the year 2001 about 28 percent to the year 2006 about 51 percent. That is a very sharp jump, and no one noticed because no one really wanted to look. The loan originators had no interest because they got rid of the entire loan. Senator Bunning. But the Federal Reserve was responsible for overseeing the banks that made those loans, and/or the mortgage brokers, we gave that power to the Fed and just because they did not write any regulations, we ran into all this mischief. And so the housing bubble and the bursting of it was caused by some not doing their homework. " CHRG-111hhrg55814--399 The Chairman," Yes. " Mr. Ryan," --what I fear? What I fear is that uncertainty will cause significant disruptions in the intra-daily markets and-- " CHRG-110shrg38109--165 Chairman Dodd," I appreciate that. Again, I know you appreciate the concerns we hear about and using your language in China, the subsidy notion here. And clearly, when you have lost your job because the company you work for can no longer compete because your competitor is able to adjust that currency to such an extent that it causes your job to disappear, that level of frustration is beyond just an intellectual exercise. If you are walking home that night to face your family because there is no longer the job there, and what it means. I want to return last, if I can, to one point. Again, your candor has been terrific and your comments. The quote that Jack Reed raised in your Omaha speech, where too often this discussion about unionization falls on an ideological fault line. And I appreciate immensely here that you talked about it based on just data here, rather than drawing conclusions about whether you like or dislike unions. But the important role they played, in terms historically of closing income gaps. This is not the first time we are talking about income gaps. In fact, income gaps were far more pronounced during the early part of the 20th century. And what I read from your quote here is that, and I will ask the question here in a sense. You talk about these numbers back in the 1970's and 1980's, and I presume even earlier, some of those income gaps that closed up, you attribute to the fact that there was the ability of people to organize and to negotiate for better wages and working conditions for themselves. I wonder if you might just expound on that a little bit, without getting involved in the ideological discussion. I am not asking you to do that. But it is a very important point, I think, as those of us try to assist in this effort of closing that gap, to realize how important that particular element can play in making it possible for people to move up that economic ladder. " 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." FOMC20080805meeting--146 144,MR. FISHER.," In terms of the wording in paragraph 3, if we do not raise rates, I am wondering why the second sentence that is now in alternative C wouldn't be more appropriate for alternative B, and I am wondering what your thinking is about that. In other words, if we don't take action, that seems to be a more emphatic statement than what you have currently, assuming no change in rate--""The Committee expects inflation to moderate later this year and next year,"" et cetera--whereas if we are trying to send a signal that we are really concerned and we do not change rates, why wouldn't we have used, ""Although the Committee expects inflation to moderate . . . the possibility that inflation may fail to decline as anticipated is of significant concern""? Then, maybe take the word ""also"" out of the fourth paragraph. It just seems to me odd that if we act and describe the risk after acting, the language is even stronger. Whereas if we don't act and we want to emphasize that we are remaining vigilant, why wouldn't we use that stronger language? I am curious as to why you chose the two or what you feel the tradeoff is there. " CHRG-110hhrg45625--55 Mr. Bernanke," Thank you, Chairman Frank, Ranking Member Bachus, and members of the committee, I appreciate this opportunity to discuss recent developments in financial markets in the economy. As you know, the U.S. economy continues to confront substantial challenges, including a weakening labor market and elevated inflation. Notably, stresses in financial markets have been high and have recently intensified significantly. If financial conditions fail to improve for a protracted period, the implications for the broader economy could be quite adverse. The downturn in the housing market has been a key factor underlying both the strained condition of financial markets and the slowdown of the broader economy. In the financial sphere, falling home prices and rising mortgage delinquencies have led to major losses at many financial institutions, losses only partially replaced by the raising of new capital. Investor concerns about financial institutions increased over the summer as mortgage related assets deteriorated further and economic activity weakened. Among the firms under the greatest pressure were Fannie Mae and Freddie Mac, Lehman Brothers, and more recently, American International Group (or AIG). As investors lost confidence in them, these companies saw their access to liquidity and capital markets increasingly impaired and their stock prices drop sharply. The Federal Reserve believes that whenever possible, such difficulty should be addressed through private sector arrangements, for example, by raising new equity capital, by negotiations leading to a merger or acquisition, or by an orderly wind-down. Government assistance should be given with the greatest of reluctance and only when the stability of the financial system and consequently the health of the broader economy is at risk. In the cases of Fannie Mae and Freddie Mac however, capital raises of sufficient size appeared infeasible and the size and government sponsored status of the two companies precluded a merger with or acquisition by another company. To avoid unacceptably large dislocations in the financial sector, the housing market, and the economy as a whole, the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac into conservatorship and the Treasury used its authority granted by the Congress in July to make available financial support to the two firms. The Federal Reserve, with which FHA consulted on the conservatorship decision, as specified in the July legislation, supported these steps as necessary and appropriate. We have seen benefits of this action in the form of lower mortgage rates, which should help the housing market. The Federal Reserve and the Treasury attempted to identify private sector approaches to avoid the imminent failures of AIG and Lehman Brothers, but none was forthcoming. In the case of AIG, the Federal Reserve, with the support of the Treasury, provided an emergency credit line to facilitate an orderly resolution. The Federal Reserve took this action because it judged that in light of the prevailing market conditions and the size and composition of AIG's obligations, a disorderly failure of AIG would have severely threatened global financial stability and consequently the performance of the U.S. economy. To mitigate concerns that this action would exacerbate moral hazard and encourage inappropriate risk taking in the future, the Federal Reserve ensured that the terms of the credit extended to AIG imposed significant cost and constraints on the firms' owners, managers, and creditors. The chief executive officer has been replaced. The collateral for the loan is the company itself, together with its subsidiaries. Insurance policyholders and holders of AIG investment products are, however, fully protected. Interest will accrue on the outstanding balance of the loan at a rate of 3 month LIBOR plus 850 basis points, implying a current interest rate over 11 percent. In addition, the U.S. Government will receive equity participation rights corresponding to a 79.9 percent interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders, among other things. In the case of Lehman Brothers, a major investment bank, the Federal Reserve and the Treasury declined to commit public funds to support the institution. The failure of Lehman posed risks, but the troubles at Lehman had been well known for some time and investors clearly recognized as evidenced for example by the high cost of insuring Lehman's debt in the market for credit default swaps that the failure of the firm was a significant possibility. Thus, we judge that investors and counterparties had time to take precautionary measures. While perhaps manageable in itself, Lehman's default was combined with the unexpectedly rapid collapse of AIG, which together contributed to the development last week of extraordinarily turbulent conditions in global financial markets. These conditions caused equity prices to fall sharply, the cost of short-term credit, where available, to spike upward, and the liquidity to dry up in many markets. Losses at a large money market mutual fund sparked extensive withdrawals from a number of such funds. A marked increase in the demand for safe assets, a flight to quality, sent the yield on Treasury bills down to a few hundredths of a percent. By further reducing asset values and potentially restricting the flow of credit to households and businesses, these developments pose a direct threat to economic growth. The Federal Reserve took a number of actions to increase liquidity and stabilize markets. Notably, to address dollar funding pressures worldwide, we announced the significant expansion of reciprocal currency arrangements with foreign central banks, including an approximate doubling of the existing swap lines with the European Central Bank and the Swiss National Bank and the authorization of new swap facilities with the Bank of Japan, the Bank of England, and the Bank of Canada. We will continue to work closely with colleagues at other central banks to address ongoing liquidity pressures. The Federal Reserve also announced initiatives to assist money market mutual funds facing heavy redemptions and to increase liquidity in short-term credit markets. Despite the efforts of the Federal Reserve, the Treasury, and other agencies, global financial markets remain under extraordinary stress. Action by the Congress is urgently required to stabilize the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy. In this regard, the Federal Reserve supports the Treasury's proposal to buy illiquid assets from financial institutions. Purchasing impaired assets will create liquidity and promote price discovery in the markets for these assets while reducing investor uncertainty about the current value and prospects of financial institutions. More generally, removing these assets from institutions' balance sheets will help to restore confidence in our financial markets and enable banks and other institutions to raise capital and to expand credit to support economic growth. At this juncture, in light of the fast moving developments in financial markets, it is essential to deal with the crisis at hand. Certainly, the shortcomings and weaknesses of our financial markets and regulatory system must be addressed if we are to avoid a repetition of what has transpired in our financial markets over the past year. However, the development of a comprehensive proposal for reform will require a careful and extensive analysis that would be difficult to compress into the short legislative timeframe now available. Looking forward, the Federal Reserve is committed to working closely with the Congress, the Administration, Federal regulators, and other stakeholders in developing a stronger, more resilient, and better regulated financial system. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 82 of the appendix.] " FOMC20080916meeting--171 169,MR. LACKER.," Yes, and that gives me pause. Then, about ""market""--like a lot of economists, I am willing to construe the word ""market"" very broadly to include intermediation mechanisms of all types and the market for commercial credit in, you know, Dillon, South Carolina. [Laughter] But I am not sure that market participants are going to take it that broadly. They are going to take it in the sense of markets in traded financial instruments and organized exchanges and such. I just wonder if they are going to interpret it too closely as Wall Street. " CHRG-110hhrg41184--89 Mr. Bernanke," Congressman, I think I'll let my testimony speak for itself in terms of the monetary policy. I just would say that we do face a difficult situation. Inflation has been high, and oil prices and food prices have been rising rapidly. We also have a weakening economy, as I discussed. And we have difficulties in the financial markets and the credit markets. So that is three different areas the Fed has to worry about--three different fronts, so to speak. So the challenge for us, as I mentioned in my testimony, is to balance those risks and decide at a given point in time which is the more serious, which has to be addressed first, and which has to be addressed later. That is the kind of balancing that we just have to do going forward. " FOMC20080625meeting--267 265,MR. ROSENGREN.," I have three comments for the long term and three comments for the short term. For the long term, in the tradeoff between focusing on markets versus institutions, to the extent that we can have standardized products traded on exchanges, we don't need to spend as much time with institutions, and that takes care of a lot of the counterparty risk. To the extent that the products have to be customized and done in dealer markets, then we have counterparty risk and that becomes an issue. So I applaud what the New York Fed is doing with the credit default swap market in thinking about a way to more systematically reduce counterparty risk. I wonder if we should more forcefully be trying to push it not only to a clearinghouse but also maybe to exchange traded. I know there is a tradeoff between standardized products and nonstandardized products. But if we can get things to be more standard so that they can trade on an exchange, we won't have to spend as much time talking about some of the issues that we've been talking about. Not just a credit default swap market has that characteristic. So if we can push a number of areas in which there's counterparty risk into an exchange, then we can get out of the business of focusing on all the institutions. The second point is that there's a broader role for us as a holding company supervisor. When I look at this list and look at Countrywide, it's not because they're a primary dealer that I would be focused on them. It's because they were 20 to 25 percent of the residential mortgage market; they were a very large player. The OTS has holding company supervision over them. We ought to ask ourselves whether now is the time to think about what organizations we ought to have holding company responsibility for. The OTS has WaMu and had Countrywide. We ought to give some thought to that. Now is the time to think about whether or not that's appropriate and push for it if there are going to be legislative recommendations. In terms of broker-dealers, I think the same thing applies. I don't think that we should be the primary regulator for these organizations. But if we're going to be lending to them in exigent circumstances, having holding company regulatory authority does become important. The third point is that, when you look at this list, there are a lot of foreign institutions. One insight that we've gotten is that an organization as big as UBS could potentially fail. That may not be something that we thought was very likely nine months ago, but it is obviously more likely now than we would have anticipated. Foreign organizations can either establish themselves as a branch or have a domestic holding company. To the extent that foreign supervisors decide to wall off their organizations around their geographic borders and say that, if there is a problem, we're not going to support institutions that are in the United States and you're on your own, I think we need to revisit some of our rules on how much capital we expect foreign holding companies that are intermediary holding companies to hold. We might also want to think about, if there's a lot of activity being done through a branch that has no capital supporting it, how concerned we should be about that. Should we be taking actions to make sure that, if the foreign parent decides that they are going to abandon the branch, we feel very comfortable with that outcome? Given the list of the primary dealers, I think the numbers are fairly large, larger than they were for Bear Stearns, and that's something that we probably should give a bit more thought to. On the short-term issues, I certainly think that we should extend the facilities past the end of the year. That makes perfect sense. A number of us have made the point that the markets are still fragile. Just the announcements about Lehman Brothers over the last month highlight that we're not yet safe, and I think that it makes perfect sense to extend through the end of the year because there could be an end-of-the-year financing problem this year. Second, narrowing tri-party repo collateral also makes sense. But it has implications for what securities people hold, and some of those markets may become much more distressed if we announce that they no longer can be part of a tri- party repo. So we need to give some thought to whether there will be collateral damage and to the unintended consequences from that. Third, I agree with President Lacker that primary dealers wouldn't be where I'd focus. I'd focus on systemically important. That would be key players and key markets whose failure might cause a cascading of counterparty failures. I think we ought to start with that premise and which organizations fit into that category. Some of them will be on the primary dealer list, but they are on the primary dealer list for a reason very different from the reason they are systemically important. So maybe distinguishing between those two would be useful. " CHRG-111hhrg53244--131 Mr. Bernanke," It is a very difficult problem. And even though we have these unusual circumstances, it is really the same problem we always face, which you just pointed out, which is picking the right moment to begin to tighten and picking the appropriate pace of tightening. Since monetary policy takes time to work, the only way we can do that is by trying to make a forecast, make a projection. And we use large amounts of information, including qualitative information, anecdotes we receive, formal models, a whole range of techniques, to try to estimate where the economy is likely to be a year or a year and a half from now. It is a very uncertain business, but it is really all we can do. And based on that, we try to judge the right moment to begin to raise rates. So we will be looking to see more evidence of a sustained recovery that will begin to close the output gap and begin to improve labor markets. And we will be looking for signs of inflation or inflation expectations that would cause us to respond, as well. " CHRG-111hhrg55811--80 Mr. Hensarling," Thank you, Mr. Chairman. I have no doubt that our derivatives market can be improved, made more competitive, made more transparent. But I usually ask myself a threshold question when proposals are put on the table, and that is, is the cure worse than the illness? I don't think we would be here today but for AIG. Again, I haven't convinced myself they weren't a symptom as opposed to a cause. But if you believe they are a cause, just to ensure what we are trying to protect against, are you gentlemen aware, were there other abuses in the derivatives market or other major economic players besides AIG that bring us here today? " fcic_final_report_full--380 The signs for the bank were discouraging. Given the recent withdrawals, the FDIC and OCC predicted in an internal analysis that Wachovia could face up to  billion of additional cash outflows the following week—including, most prominently,  billion of further deposit outflows, as well as  billion from corporate deposit accounts and  billion from retail brokerage customers. Yet Wachovia had only  billion in cash and cash equivalents. While the FDIC and OCC estimated that the company could use its collateral to raise another  billion through the Fed’s dis- count window, the repo market, and the Federal Home Loan Banks, even those ef- forts would bring the amount on hand to only  billion to cover the potential  billion outflow.  During the weekend, the Fed argued that Wachovia should be saved, with FDIC assistance if necessary. Its analysis focused on the firm’s counterparties and other “interdependencies” with large market participants, and stated that asset sales by mutual funds could cause short-term funding markets to “virtually shut down.”  According to supporting analysis by the Richmond Fed, mutual funds held  bil- lion of Wachovia debt, which Richmond Fed staff concluded represented “signifi- cant systemic consequences”; and investment banks, “already weak and exposed to low levels of confidence,” owned  billion of Wachovia’s  billion debt and de- posits. These firms were in danger of becoming “even more reliant on Federal Re- serve support programs, such as PDCF, to support operations in the event of a Wachovia[-led] disruption.”  In addition, Fed staff argued that a Wachovia failure would cause banks to “be- come even less willing to lend to businesses and households. . . . [T]hese effects would contribute to weaker economic performance, higher unemployment, and re- duced wealth.”  Secretary Paulson had recused himself from the decision because of his ties to Steel, but other members of Treasury had “vigorously advocated” saving Wachovia.  White House Chief of Staff Josh Bolten called Bair on Sunday to express support for the systemic risk exception.  At about : P . M . on Sunday, September , Wells’s Kovacevich told Steel that he wanted more time to review Wachovia’s assets, particularly its commercial real estate holdings, and could not make a bid before Monday if there were to be no FDIC assis- tance. So Wells and Citigroup came to the table with proposals predicated on such as- sistance. Wells offered to cover the first  billion of losses on a pool of  billion worth of assets as well as  of subsequent losses, if they grew large enough, cap- ping the FDIC’s losses at  billion. Citigroup wanted the FDIC to cover losses on a different, and larger, pool of  billion worth of assets, but proposed to cover the first  billion of losses and an additional  billion a year for three years, while giv- ing the FDIC  billion in Wachovia preferred stock and stock warrants (rights to buy stock at a predetermined price) as compensation; the FDIC would cover any ad- ditional losses above  billion.  FDIC staff expected Wachovia’s losses to be between  billion and  billion. On the basis of that analysis and the particulars of the offers, they estimated that the CHRG-111hhrg55811--49 Mr. Garrett," So it might take away from this, is that is going to be a paramount requirement and concern of you is the systemic risk aspect of the clearinghouses and their soundness of that, and so that will be--that would trump necessarily, under certain circumstances, potentially over the end-users situation. I only have a little bit of time. You also, Mr. Hu, spoke to the issue of trading swaps--I will use layman's terms--trading swaps, basically, and implementation of the rules with the same manner and such as derivatives, right, in your opening statement. " FinancialCrisisInquiry--692 ROSEN: January 13, 2010 I think that’s probably right. And I’d say 4 million people who became homeowners probably shouldn’t have become homeowners. We put them in a situation which wasn’t really tenable. HOLTZ-EAKIN: And in the fallout from that, we had a large financial crisis. And, Mark, I know you’ve thought a lot about this. From the fall of 2008 going forward, we’ve had a series of interventions—the Capital Purchase Programs, we did stress tests, we had suspension of mark-to-market rules—and, I guess, I want your opinion, out of the array of the financial market interventions, which do you think are deservedly credited with the turnaround we’ve seen to date—I don’t want to overstate it—and which do you put on a lower rung? FinancialCrisisInquiry--12 Excessive leverage by many U.S. investment banks, foreign banks, commercial banks, and even consumers pervaded the system. This included hedge funds, private equity firms banks and non-banks using off-balance sheet vehicles. There were also several structural risks and imbalances that grew in the lead-up to the crisis. There was an over reliance on short- term financing to support illiquid long-term assets, and over time, certain financing terms became too lax. Another factor in the crisis was clearly a regulatory system. I want to be clear I do not believe the regulators. While they obviously have a critical role to play, the responsibility for companies’ actions rest solely on the companies’ management. But we should also look to see what could have been done better in the regulatory system. We have known that our system is poorly organized with overlapping responsibilities. Many regulators did not have the statutory authority they needed to address the failure of large global financial companies. Much of the mortgage business was not regulated or lacked uniform treatment. Basel II capital standards allowed too much leverage in investment banks and other firms and not incorporate liquidity at all. The extraordinary growth and high leverage of the GSEs also added to the risk. We also learned that our system has many embedded pro-cyclical biases, a number of which proved harmful in times of economic stress. Loan loss reserving methodologies caused reserves to be at their lowest levels at a time when high provisioning might be needed the most. Certain regulatory capital standards are also pro-cyclical, and continuous downgrades by credit agencies also required many financial institutions to raise more capital. When all is said and done, I believe it will be found that macro economic factors will have been some of the fundamental underlying cause of the crisis. Huge trade and financing imbalances caused large distortions in interest rates and consumption. As for J.P. Morgan Chase, the last year and a half was the most challenging period in our company’s history. I’m immensely proud of the way our employees continued to serve our customers through this difficult time. Throughout the financial crisis, we never posted a quarterly loss. We served as a safe haven for depositors. We worked closely with the federal government. And we remained an active lender. FOMC20070509meeting--18 16,MR. MOSKOW.," Dave, you talked about the slowdown in structural productivity in your report. You have marked down your estimates for structural multifactor productivity for the second half of this decade from what you had before. Even before that you had a decline from the first half of the decade to the second half. So I wonder if you could expand a bit on those comments." CHRG-111shrg54533--68 Secretary Geithner," Yes. Where those practices threaten basic standards of consumer protection, they would have that authority to set rules to constrain that and to enforce those rules. Senator Merkley. Thank you. Senator Johnson. Staff indicates that you may have your full 5 minutes. Senator Merkley. Thank you. Thank you very much, Mr. Chair. Well, I wanted to go on to ask, in terms of the power that would go to the Fed under this plan, I think I have a ways to go to see the Fed as the right place to set capital adequacy rules, in part because of the situation in the past, for example, they fought against keeping leverage ratios. Is that the right place to center this kind of power? " 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--160 Mr. Bernanke," Well, I don't think it is accurate there has been 30 years of wage stagnation. There has been a pretty substantial increase in real wages and in consumption over the last 30 years or so. Clearly, in the most recent past, energy prices, a slowing economy, and other factors have caused wages to stagnate, which is a serious problem. " CHRG-111shrg57923--103 PREPARED STATEMENT OF STEPHEN C. HORNE Vice President, Master Data Management and Integration Services, Dow Jones & Co. February 12, 2010 Good morning, Chairman Bayh, Ranking Member Corker and Members of the Subcommittee. My name is Steve Horne and I am the Vice President of Master Data Management for Dow Jones. I have spent over 30 years building complex databases, transforming highly complicated data into usable information. Thank you for inviting me to speak with you today. I have testified many times over the past year on the impact of the financial meltdown and the need for a comprehensive analytic database that is designed to capture the appropriate real-time information necessary to prevent waste, fraud and abuse of the TARP program and to ensure that the American taxpayer's money is being used as intended. Legislation that would create such a database has been introduced by Senator Warner, S. 910, with a companion bill that has already passed in the House, H.R. 1242, by a vote of 421-0. Both these bills have been strongly endorsed by organizations such as the U.S. Chamber of Commerce, OMB Watch, and the Center for Democracy in Technology. Using the same basic infrastructure of the database that would be created under the legislation described above, we at Dow Jones have identified over 400 leading indicators that when used together can identify potential systemic risk within the financial system and many other parts of the economy. The challenge is to combine this disparate data into a structured database to be able to make informed judgments about the risks. Systemic breakdowns that impact individual geographic markets in this country are caused by a combination of factors, including unemployment, bankruptcy, foreclosures and commercial real estate failure. For example, in Las Vegas, a huge influx of different socio-economic groups moved into this market over the past 10 years. One of these groups is retirees. When the financial meltdown occurred, these Americans were mostly living on fixed incomes: savings, retirement investments and their social security. They bought retirement homes either with cash or with mortgages that were smaller than many, but they still incurred new debt. Over the last 3 years, the income from their retirement investments went negative and they have had to dip into the principal as the only way for them to gain cash. As the foreclosures generally grew around them, retirees saw the value of their homes decrease in half as well. Those who had mortgages were now upside down, those who did not, saw the major investment they had spent a lifetime building dwindle in value. Now these senior citizens face a much more difficult situation. With a major portion of their principal gone, many cannot afford to live on their fixed income and have to go back to work. In Las Vegas, 16 percent unemployment does not bode well for anyone looking for work. If they own their home, new mortgages are very difficult to get. Reverse mortgages are not an option because of the reduced availability of these programs. The combination of these factors shows the market for retirees in Las Vegas is in systemic failure right now. This example is known in statistical terminology as the ``Compounding Effects of Multiple Indices.'' If we can integrate this data into an actionable database, regulators can quickly implement surgical solutions that will apply the appropriate programs/funds to the most serious problems. We are currently observing markets in North Carolina and Tennessee that are at risk of systemic failure. If the proposed data base were in place the government would be in a better position to confirm, quantify and tackle these problems proactively. Unfortunately, the data is in disparate systems that cannot talk to each other. The value of the data base that is proposed in S. 910 is in its ability to combine and analyze this data to predict and prevent systemic risk. The transformation of this data into actionable information is neither easy nor inexpensive. However, the implementation of the proposed data base will save significant taxpayer dollars in three ways: first, through more efficient targeting of resources and serving the areas of greatest need; second, by enabling the government to insure that the appropriate actions are taken before systemic failure occurs; and, third, by helping prevent waste, fraud, and abuse of taxpayer's money. The data base proposed should not create additional security concerns. The security methodologies under the IPSA Act (Information Protection and Security Act of 2009) and the contractual controls for the use of commercial data are sufficient to protect this information. In addition, language included in H.R. 1242 that passed the House provides for even greater protections for non-public data. The system being proposed is designed to expand to cover global data. Although some of the data from overseas may not be accessible due to laws of specific countries, other international data is in better shape and can be built into accurate analytic systems because of the early adoption of XBRL technology by many countries. In summary, the data and technology exist today to equip financial regulators with the tools necessary to monitor systemic risk. The only thing lacking is government action to make it happen. Thank you again, Chairman Bayh, Ranking Member Corker and the Members of the Committee for your time and attention. I am happy to answer any questions you may have. ______ " CHRG-110shrg50369--31 Mr. Bernanke," I do not anticipate stagflation. I do not think we are anywhere near the situation that prevailed in the 1970's. I do expect inflation to come down. If it does not, we will have to react to it, but I do expect that inflation will come down and that we will have both return to growth and price stability as we move forward. Senator Shelby. Do you still believe that the fundamentals of our economy is still robust, is strong, other than the housing market and some of the financial challenges that we have coming out of that? " CHRG-110hhrg41184--35 Mr. Bernanke," Well, Congressman, as I mentioned in my testimony, the subprime problem was a trigger for all this, but there were other things that then began to kick in, including a pull-back from risk taking, concerns about valuation of these complex products, issues about liquidity and so on which, as you say, caused the problem to spread throughout the system. Right now, we are looking at solutions. The Federal Reserve, for example, is engaging in this lending process trying to reduce the pressure in the short-term money markets. I think, very importantly, the private sector has a role to play. I would encourage, for example, banks to continue to raise capital so they would be well able to continue to lend. They also need to increase transparency, to provide more information to the markets so the market could begin to understand what these assets are and what the balance sheets look like. " FinancialCrisisInquiry--598 ROSEN: I’m Ken Rosen. I want to thank Chairman Angelides and Vice Chairman Thomas, and the commission for having me here. I want to not read my testimony since you have it. But I’m going to talk a little bit about what I think is the epicenter of the crisis—where this started, how it got there, and where we are today, which is the housing market—the housing and residential mortgage market. Excessively easy credit, extremely low interest rates created a house price bubble. And the house price bubble when it burst has really caused a significant part of the problems that we had—at least the—initially. And of course it caused—helped cause the great recession where we have lost over eight million jobs. I think the most important thing to say is how did we get here. And I would say that low interest rates is part of the blame, but really it’s the poorly structured products that came about in this environment. Innovative products are important, and a good thing. And I’ve written papers on—on this in the 1970s and 80s while we needed innovative mortgage products. And they’re good for some people—some households. Subprime— there is a need for having that. But not to the market share it got. Low down payment loans – Alt-A loans, option arms. All those made some sense for a portion of the population. What happened is we layered all these risks. We went from a conservatively written subprime loan to a subprime loan that had no down payment, and didn’t document someone’s income or employment. So we made a mistake from what was a good idea by financial institutions became a bad idea for the entire overall market. And then we combine that with a second component which was I thought bad underwriting. We lowered underwriting standards dramatically. We started this in California, and it spread everywhere. We—we do this sometimes. Liars loans which are stated income loans, and there was rampant fraud at the consumer level. We’ve heard discussion of this at the institutional level, but I think the consumer basically really did this so they could qualify for the loan. There was some complicity on January 13, 2010 the part of brokers and originators. I think—I do not think this was at the high level institutions, but it’s at the individual originator level. And then we had wide-spread speculation. And I submitted an article to you as a commission, which I wrote in 2006 that was published in 2007. Nearly 30 percent of all home sales in the hot markets were just speculators. And this is not a bad thing, but the speculators put down almost no money. They were flipping houses. And our mortgage system was not able to distinguish between a homeowner and a speculator. And I think we really need to do a much better job of that in the future. We already are trying to. We’re— nothing wrong with speculating, but you’ve got to put down hard money -- 30 percent down. Some big number so they’re not destroying the market for the people who want to own and live in houses. There was a regulatory failure, and everybody knew this was happening. Everybody in the country knew this was happening by the middle of 2006 -- late 2006. One of the unregulated institutions—New Century—a mortgage broker—went bankrupt in early 2007. Everybody knew this, but it kept on going on. I tried very hard and others as well to talk to regulators about this—inform them of this—and within institutions—the Fed in particular. There was a big debate going on. Should they do something about it? And it was decided not to. They didn’t think they had the power. They didn’t really believe it was as bad as it was. But there was a big debate with board members about doing something about this. I think really the whole system of a non-recourse loan in both commercial and residential while desirable by the people borrowing has really created this problem. That there is a belief that it’s a—a put option. Things go well, great. If not, I can give it back. And this misalignment of interest at this level—the consumer level, the borrower level—and the misalignment of—of interest throughout the entire system where risk and rewards are disconnected is really how we’re going to fix this. So if I were to summarize I would say too much leverage, poor underwriting and lax regulation. But I want to take you through some of the charts I have. I know I’ve got January 13, 2010 about five more minutes, but tell you where we are today. And I think you have these at the end of the testimony. They’re figures. And let’s take the first one, which is the housing bubble. It says, “Figure One—U.S. Housing, Single Family Starts.” You can see here that we had—hopefully you have it, but if not I’ll describe the numbers. We were producing in single-family starts about 1.1 million a year on average. That’s roughly the average level of single-family starts. And that’s the demographic demand. During the peak moments here, we produced 1.7 million. So we were producing about -- we produced during this whole bubble about a million more new starts then demographic demand would have you produced. And one of the reasons for that was that these—basically people were able to put down $1,000 or $2,000 or $3,000 to control a $100,000 to $200,000 house. It was a—basically a call option. And homebuilders sold them this house. They took an order, and of course they didn’t have to fulfill that order. If prices went up, they take the order and flip the house. So we built about a million too many. We are now building about 500,000 houses, and as you know in many markets this has led to lots of layoffs. I think roughly 15 percent of the decline in employment is in the construction industry. So this is a—a very big negative. But we’ve begun to come back a little bit, and my guess is we’ll slowly recover. I would agree with Mark. It’s going to take three to four years to get recovery here. Maybe a little bit longer. If we skip to this figure three—there was some reference to this earlier—is the house price bubble, which is on the second page there. And the house price bubble I think is really why we’ve had all this fallout. House prices went up in nominal terms dramatically. And in real terms also very dramatically. We’ve had big house price inflations before. In the late 70s we had that happen. But that was accompanied by overall inflation. This time house prices went up, and we did not have overall inflation. So real house prices went up dramatically. And only one other period of time have we ever seen a—a January 13, 2010 drop in house prices that was in a big way, and that was in the 1930s. It really didn’t happen in the post-war period. But we’ve seen a cumulative price decline based on realtor data of about 21 percent based on another index Kay short about 30 percent. So this bubble bursting is what’s caused I think the bad loan issues in the financial sector with mortgages being a big part of it. The chart below that though is what was referred to by Mr. Bass earlier—key thing—housing became unaffordable during 2003, 4 and 5. The affordability—that is the income relative to the payments you had to make wasn’t there. And so that is why we had these new mortgage instruments come about. Because people could not afford to buy the house. And so they had to find an instrument that allowed them to make a lower initial payment. This would not have been a bad thing if they had fully verified the person’s income, they’d have laid down 20 percent, did all the things that made sense. Unfortunately we layered these risks, and that did not happen. So it was the affordability problem that really and partly caused the bubble. But because the bubble itself made people go to these instruments that were at least much more risky. From the investment community side, of course as you said earlier, that people wanted to get higher yields. They weren’t getting them cause the interest rates were so low. So they—investor also wanted these instruments. The fall out is figure five, which is unfortunately not over. In a way you’re investigating what caused this, but we’re still in the middle of this crisis from the point of view of the consumer, and—and Main Street. Wall Street feels great, but Main Street does not feel great. And this just shows you that the delinquency and foreclosure the total non-performing loans continue to mount for all of the—both the risky loans, and also for non-risky loans. Remember, there’s $11 trillion of mortgages. There are about $3 trillion of the risky category. There’s $7 trillion of what is called prime mortgages. And those are going bad January 13, 2010 because house prices have dropped so much, people have lost their jobs, and there’s no end in sight of this. I think 2010 is going to be a bigger year than 2009. And then of course our friends at Fannie Mae and Freddie Mac. Again you can see delinquency rates are rising there dramatically. They are much lower than the—the risky mortgage types even though after some time these numbers are going to continue to rise as far as we can see. The next figure on figure seven shows you the same thing is happening with FHA. Big rises in delinquencies in the FHA mortgage program. So to summarize, we’re not done by any means. The cost to the government so far has been large with the bailouts. But I think that we—we see continual further losses over the next year, year and a half, in the residential mortgage market. So we’re not at all done. I do have some other data which we’ll be able to take in questions. But I— I’m hoping that I will be able to give you some advice in how this happened, and how it—we can make it not happen again. Thank you very much. CHRG-111hhrg53238--45 Mr. Zywicki," Thank you, and let me make clear that even though this hearing estopped banking industry perspectives, I appear only as myself. My affiliation with the banking industry is as a consumer. I am going to address the Consumer Financial Protection Agency today, and I think there are three fatal problems with the CFPA that I think are irremediable and really can't be overcome or approved. The first is that it is based on misguided paternalism. The second is that because it misdiagnoses the underlying problems, it will create unintended consequences that will probably exacerbate rather than improve the situation we have seen in the past few years. And, third, it creates a new apparatus of bureaucratic planning that is simply unfeasible and, at a minimum, unworkable. First, it is based on an idea of misguided paternalism. The causes of the foreclosure crisis, if we focus on that particular issue, really have very little to do with consumer protection. What the causes of foreclosure crises erode from were a set of misaligned incentives that consumers rationally responded to. When consumers rationally respond to incentives, that is not a consumer protection problem. Take an example. Say there is a fellow in California who got a no-doc nothing-down loan. California has an antideficiency law that means that if you walk away from your house, the bank is limited in taking back the house and they can't sue you for any deficiency. Say the guy was going to buy the house, live in it for a couple of years, and then flip it for a profit. Instead, the house goes down in value. He crunches the numbers and says well, it is worth it for me to walk away from the house and give it back to the bank. The bank can't sue me for any deficiency. There is no consumer protection issue in that hypothetical. There is a very, very, very serious safety and soundness issue. That was a very foolish loan by the bank, and it really created a lot of problems for safety and soundness. But that is not a consumer protection issue. And if we consider it a consumer protection issue, rather than consumers rationally responding to incentives, we are going to have problems. Similarly, the other factor that caused a lot of foreclosures was adjustable rate mortgages. Adjustable rate mortgages are not inherently dangerous. There have been many times in the past, over the past 30 years, where adjustable rate mortgages have been 50 or 60 or 70 percent of the new mortgages that were written. Adjustable rate mortgages are a problem when the Federal Reserve engages in the kind of crazy monetary policy it engaged in from 2001 to 2004. When the Federal Reserve engages in crazy monetary policy, that is not a consumer protection issue. And I don't think there is anything in the CFPA that will make the Federal Reserve engage in better monetary policy in the future. So that basing it on the misguided idea that the crisis was spawned by hapless consumers being victimized by ruthless lenders is not going to be a basis for good policy. Second, that leads to a second problem which is a problem of unintended consequences. Consider two issues identified in the Obama Administration's White Paper, prepayment penalties and mortgage brokers and yield spread premiums. Prepayment penalties are an especially good example. They talk about how they are going to get rid of prepayment penalties in subprime mortgages. Well, what we know about prepayment penalties from all the empirical evidence is that there is no empirical evidence that prepayment penalties increase foreclosures. Why is that? Because consumers pay a premium in order to have the right to prepay their mortgage, because that shifts the risk of interest rate fluctuations to the bank. Consumers pay about 20 to 50 basis points more for a mortgage that has a right to prepay, and that is even higher for subprime borrowers for reasons we can talk about. The effect is that by allowing borrowers to pay less for a mortgage, they are less likely to get into financial trouble and less likely to end up in foreclosure. So getting rid of prepayment penalties would increase the price of mortgages and have no discernible impact on foreclosures. In fact, it could end up having the unintended consequence of worsening things. Why? Because the United States is virtually unique in the Western world in having the right generally to prepay your mortgage, which is basically to refinance when your interest rates go down. What a lot of Americans did was when equity ramped up in their house, they exercised that right to prepay and refinance their mortgage and sucked out all the equity in their house. As a result, when their house went down in value, they decided to walk away from the house. In Europe, they have had very big property value decreases as well, but Europe has not had a foreclosure crisis. And one reason is because in Europe nobody can prepay their mortgage. You have a 10- or 15-year mortgage with a balloon payment and an adjustable rate mortgage and no right to prepay. No right to prepay means you can't suck out the mortgage when your house goes up in value. When you can't suck out the mortgage, then you have a better equity if the house goes down in value. So that banning prepayment penalties would likely have the impact of increasing foreclosures by giving more people an opportunity to suck out equity in their homes going forward. With respect to mortgage brokers, the evidence is clear that competition is what matters. If we reduce the number of mortgage brokers, people are going to pay more for mortgages. Finally, let me say the third point, which is the problem of bureaucrat central planning. The CFPA essentially requires an impossibility. It requires identifying certain terms and mortgages as being unsafe. What we know is there are no individual terms and mortgages that are unsafe. Terms in combination may be unsafe. Terms designed with State antideficiency laws may be unsafe. But the idea you can identify certain terms as unsafe is just folly and will stifle innovation and create other problems. Thank you. [The prepared statement of Professor Zywicki can be found on page 211 of the appendix.] " CHRG-111hhrg54869--165 Mr. Cochrane," Thank you for giving me the opportunity to talk to you today. This wasn't an isolated event. We are in a cycle of ever-larger risk taking punctuated by ever-larger failures and ever-larger bailouts, and this cycle can't go on. We can't afford it. This crisis strained our government's borrowing ability, there remains the worry of flight from the dollar and government default through inflation. The next and larger crisis will lead to that calamity. Moreover, the bailout cycle is making the financial system much more fragile. Financial market participants expect what they have seen and what they have been told, that no large institution will be allowed to fail. They are reacting predictably. Banks are becoming bigger, more global, more integrated, more systemic, and more opaque. They want regulators to fear bankruptcy as much as possible. We need the exact opposite. We and Wall Street need to reconstruct the financial system so as much of it as possible can fail without government help, with pain to the interested parties but not to the system. There are two competing visions of policy to get to this goal. In the first, large integrated instructions will be allowed to continue and to grow with the implicit or explicit guarantee of government help in the event of trouble, But with the hope that more aggressive supervision will contain the obvious incentive to take more risks. In the second, we think carefully about the minimal set of activities that can't be allowed to fail and must be guaranteed. Then we commit not to bail out the rest. Private parties have to prepare for their failure. We name, we diagnose, and we fix whatever problems with bankruptcy law caused systemic fears. Clearly, I think the second approach is much more likely to work. The financial and legal engineering used to avoid regulation and capital controls last time were child's play. ``Too-big-to-fail'' must become ``too-big-to-exist.'' A resolution authority offers some advantages in this effort. It allows the government to impose some of the economic effects of failure, shareholders and debt holders lose money, without legal bankruptcy. But alas, nothing comes without a price. Regulators fear--their main systemic fear is often exactly the counterparties will lose money, so it is not obvious they will use this most important provision and instead bail out the counterparties. I think the FDIC, as often mentioned, is a useful model. It is useful for its limitations as well as for its rights. These constrain moral hazard and keep it from becoming a huge piggybank for Wall Street losses. The FDIC applies only to banks. Resolution authority must come with a similar statement of who is and who is not subject to its authority. Deposit insurance and FDIC resolution come with a serious restriction of activities. An FDIC-insured bank can't run a hedge fund. Protection, resolution, and government resources must similarly be limited to systemic activities and the minimum that has to accompany them. Deposit insurance in FDIC resolution address a clearly defined systemic problem, bank runs. A resolution authority must also be aimed at a specific defined and understood systemic problem, and the FDIC can only interfere with clear triggers. The Administration's proposal needs improvement, especially in the last two items. It only requires that the Secretary and the President announce their fear of serious adverse effects. That is an invitation to panic, frantic lobbying, and gamesmanship to make one's failure as costly as possible. It is useful to step back and ask, what problem is it we are trying to fix anyway? Regulators say they fear the systemic effects of bankruptcy. But what are these? If you ask exactly what is wrong with bankruptcy, you find fixable, technical problems. The runs on Lehman and Bear Stearns brokerages, collateral stuck in foreign bankruptcy courts, even the run on money market funds, these can all be fixed with changes to legal and accounting rules. And resolution doesn't avoid these questions. Somebody has to decide who gets what. If Citi is too complex for us to figure that out now, how is the poor Secretary of the Treasury going to figure it out at 2 o'clock in the morning on a Sunday night? The most pervasive argument for systemic effective bankruptcy, I think, is not technical; it is psychological. Markets expected the government to bail everybody out. Lehman's failure made them reconsider whether the government was going to bail out Citigroup. But the right answer to that problem is to limit and clearly define the presumption that everyone will be bailed out--not to expand it and leave it vague. Here I have to disagree with Mr. Volcker's testimony. He said we should always leave people guessing, but that means people will always be guessing what the government is going to do, leading to panic when it does something else. And let me applaud Chairman Frank's statement earlier that no one will believe us until we let one happen. I look forward to, not necessarily to that day, but to the clearer statement--clearer understanding by markets and the government of what the rules are going to be the day afterwards. [The prepared statement of Professor Cochrane can be found on page 57 of the appendix.] " FinancialCrisisInquiry--185 So this bubble bursting is what’s caused I think the bad loan issues in the financial sector with mortgages being a big part of it. The chart below that though is what was referred to by Mr. Bass earlier—key thing—housing became unaffordable during 2003, 4 and 5. The affordability—that is the income relative to the payments you had to make wasn’t there. And so that is why we had these new mortgage instruments come about. Because people could not afford to buy the house. And so they had to find an instrument that allowed them to make a lower initial payment. This would not have been a bad thing if they had fully verified the person’s income, they’d have laid down 20 percent, did all the things that made sense. Unfortunately we layered these risks, and that did not happen. So it was the affordability problem that really and partly caused the bubble. But because the bubble itself made people go to these instruments that were at least much more risky. From the investment community side, of course as you said earlier, that people wanted to get higher yields. They weren’t getting them cause the interest rates were so low. So they—investor also wanted these instruments. The fall out is figure five, which is unfortunately not over. In a way you’re investigating what caused this, but we’re still in the middle of this crisis from the point of view of the consumer, and—and Main Street. Wall Street feels great, but Main Street does not feel great. And this just shows you that the delinquency and foreclosure the total non-performing loans continue to mount for all of the—both the risky loans, and also for non-risky loans. Remember, there’s $11 trillion of mortgages. There are about $3 trillion of the risky category. There’s $7 trillion of what is called prime mortgages. And those are going bad because house prices have dropped so much, people have lost their jobs, and there’s no end in sight of this. I think 2010 is going to be a bigger year than 2009. CHRG-111shrg61651--136 PREPARED STATEMENT OF JOHN REED Retired Chairman, Citigroup February 4, 2010 It is probably too early to fully assess the nature and causes of our recent financial meltdown but the conversation about potential remedies is well underway. Given that fact, a few thoughts could be useful. First, some ``framing.'' One, the crisis was clearly ``man made,'' this was not the result of long standing and cumulative imbalances. Second, there seems to have been a key failure that none of us anticipated, namely, individual institutions which are thought to take steps and exercise judgments to ensure their self-preservation turned out ``not to have'' or been incapable of so doing. (This clearly means that in designing a robust system, we cannot count on that capacity.) Third, a financial system cannot be permitted to impact the real economy to the extent that it has. Fourth, while much has been made of the low interest rate environment that accompanied the build up to the crisis, one would not design a financial system that could not function in such an environment. Second, some casual factors that are worth noting. One, a dominant business philosophy focusing on ``shareholder value''. Two, almost frenetic activity in the creation and distribution of securitized products and derivatives. These turned out to be flawed as credits but further were not fully distributed to ``knowledgeable investors'' but to an incredible extent were inventoried on the balance sheet of ``intermediaries'' (e.g., Merrill Lynch, Citi). Third, the absolute failure of the rating agencies in the performance of their only mission. Fourth, the failure of supervision, In allowing the decapitalization of the sector. In ignoring the implications of ``low doc, no doc'' lending. In ignoring the levels of counterparty risk. In ``missing'' the fact that credit default swaps were insurance products, requiring reserves and oversight. Fifth, the failure of policy in pushing the mortgage market through Freddie Mac and Fannie Mae to an uneconomic extent. Third, if the aim is to create rules and limits, which on the one hand would significantly reduce the likelihood of a repeat of our recent experience, and on the other would support a healthy and creative industry, what would the rules and limits be? First, capital should be significantly increased, maybe doubled. (I personally think the concept of Risk Adjusted Capital is flawed.) Second, the funding structure (liquidity) of each institution should be the subject of annual review (not just ``point in time'', averages and extremes over the year) and assessment by regulators and boards. Third, the industry should be compartmentalized so as to limit the propagation of failures and also to preserve cultural boundaries. Fourth, to the extent possible, traded products should flow through Exchanges. Fifth, there is a good reason to create a Consumer Protection Agency with a clear and separate mandate. ______ CHRG-110shrg50418--88 Mr. Wagoner," Sure. " Chairman Dodd," ----that what you were doing here was actually going to end up in a bubble kind of situation, that could only end up in the situation we are now facing? " CHRG-111shrg57319--497 Mr. Killinger," Well, I think they are different topics and certainly somewhat interrelated. I made a comment in my written testimony that there is no simple or single cause of what went on---- Senator Kaufman. No, I am just saying that was part. I am not saying there is any one single cause. " CHRG-111hhrg55809--105 Mr. Garrett," Another area outside of yours but on the macro issue is the FDIC and the other issues. I don't have to tell you what they are facing right now, and one of their proposals I am reading about is going to the banks and saying, help us out here. The same sort of dilemma there, isn't it, is that the banks are going to push back and say, well, if you are asking us to do that, we just are not going to be able to make as many--our capital level is going to go down; we are going to have a harder time of it, and we are not going to be able to make the loans. So where is the tradeoff in that situation? " CHRG-109hhrg23738--93 Mrs. Kelly," Thank you, Mr. Chairman. Chairman Greenspan, thank you so much for your patience in coming to report to us, this committee. You mentioned the London attacks in your testimony, and earlier this year we had a dialogue about the terrorism insurance area and where you believe that government activity is needed; and you stated at the time there was not an efficient market that was functioning in the area and it really probably cannot because violence is very difficult to quantify. I am wondering if the London attacks recently have done anything to change your view on this issue. " CHRG-110hhrg46596--59 Mr. Heller," I appreciate the opportunity to spend a few minutes here in this hearing to discuss what I am hearing as frustration in the community banking, especially the small community banks across this country. As they go to the Web site, they fill out these applications and wait. They literally wait, wondering when and if these TARP funds will become available. I think this frustration, as I continue to get these phone calls--they want to know what the criteria are. ``We filled out the 2-page application, and we heard nothing.'' What are the thresholds, what are the expectations, what are the criteria to know the difference--is it assets, is it deposits? What is the threshold that is going to determine between a small bank and a big bank whether they receive assistance? Because these small community banks are not lending, they are saying they are not lending. In fact, most of them are just wondering if we are sitting around, waiting to be acquired by people who do receive TARP funds. So I am hoping that we can get answers to some of these questions. Thank you, Mr. Chairman. I yield back. " CHRG-111hhrg54869--239 Mr. Zandi," Well, I could give an answer. Just go back to last September and October. It came to such a point that the--because of the failure of Lehman, because of the near failure of AIG, because of other various events, the Nation's nonfinancial commercial paper market was frozen, literally. So blue chip companies that make everyday products were on the verge of shutting their businesses down. And I know this firsthand, because I was getting calls from senior management of major retailers saying, ``I am not going to get delivery of product to put onto my store shelf because this company can't get credit.'' So that was because of the interconnectedness of the financial system, and it bled right to the nonfinancial world, literally within a few days. " CHRG-110hhrg46596--483 Mr. Foster," Thank you again for your time. I really appreciate it. Let's see. I would also like to say that I think some of these claims that there is some sort of bait-and-switch or bamboozling going on on your part, I think, are really unwarranted. You know, the option of recapitalizing institutions was explicitly discussed during the debate. I know in my testimony in front of this committee, in my debate on the Floor before the thing was voted on, you know, this was an explicitly discussed option. And the Members who have said that somehow you have sprung this on them I think were either not paying attention to the debate or maybe not reading what was actually passed. So that is just a comment. One related thing, though, is that we made the decision in the legislation to specify preferred shares rather than real equity with voting rights. And I was wondering, in retrospect, given the problems that have arisen in trying to get the banks to directly loan out the money that we have injected into them, whether in retrospect we would have been better off following more exactly the Sweden model that this is, basically, and taking real equity stakes. " CHRG-110hhrg44903--31 Mr. Bachus," Thank you, Mr. Chairman. Mr. Chairman, before I ask questions of these two witnesses, I would like to make a statement that I think is very important. There is an article in the American Banker today where Ralph Nader talks about the Deposit Insurance Fund. I won't criticize anyone. But let me say this, during the height of the Savings and Loan debacle, there were 1,800 financial institutions on the trouble list, and 800 or 900 of them failed. People are comparing the financial services banking industry, that to now. And it is not a valid comparison. We only have 90 banks that are even on the troubled list. If we have a situation like Savings and Loan, as far as the number, then 40 percent of those may fail. And so you are talking 40 or 50 banks out of a large universe. Our banks are well capitalized. Our Deposit Insurance Fund is sound. There is absolutely no factual basis for saying that there is not money there to pay. There is a crisis in confidence. There are a lot of people saying things that may be panicking the general public. But factually, it is irresponsible to say that. And I wanted to say that because I think it is very important--we have talked about short sellers, people spreading mischief, and whether it is for sensationalism, to sell magazines, or to grab attention, it is just not true. And we as Americans ought to all be concerned about that, not to say things which cause people-- " CHRG-111hhrg51698--334 Mr. Taylor," Well, probably the best testimony I can offer on that is that there is an ongoing CFTC investigation of what happened in our market on March 3rd and 4th of 2008. And for those who don't know, we had a 1 day event on March 3rd where the market traded from the mid-70 cents to well over a dollar synthetically with no fundamental reason for that happening. So we will know soon, hopefully, when the CFTC does respond or issue their report, what did cause that. But, that to me, at least on the face of the evidence of what happened that 1 day, would suggest that perhaps there were some other forces and factors that were entering our market that caused the distortion to occur. " CHRG-110shrg50414--108 Secretary Paulson," In terms of that, I would say you have pointed to the complexity and the difficulty. I would very respectfully say that if the Federal Government tried to legislate a prescriptive solution, it almost certainly would not work when you are getting into the market mechanisms. Again, you are asking me about free markets and how the Government is going to work better than free markets, and, listen, I have never been a proponent of intervention. And I just think we have an unprecedented situation here, and it calls for unprecedented action. And there is no way to stabilize the markets and deal with the situation other than through Government intervention. And so what we are going to do, we have put forward something we have thought about for a long time in terms of the issue and different ways of dealing with the issue. And so what we are asking for is some broad powers with some good, strong oversight, and we think that is the best way to protect the taxpayer. That is our view. Senator Enzi. I want to get into something a bit more specific on that because I am concerned about the small banks in this reverse auction situation. A lot of the details are left out. As you say, you do not want it to be prescriptive. But the reverse auction that you described in your testimony---- " CHRG-111shrg57320--441 Mr. Bowman," Nothing to add to that. I agree with that. Senator Levin. OK. You have indicated that you have already sent some public comments---- Ms. Bair. Yes. Senator Levin [continuing]. On this that you would share with this Subcommittee. We appreciate that. Any comments further on this subject, Mr. Bowman, we would appreciate from you, as well. I think on that positive note, we will end. Rather than trying to summarize a long hearing, I don't think I will. It is obvious that we had a situation where a bank was riddled with unsafe and unsound lending practices. The regulators saw them, understood them, but did not act to stop them, and that was part of the problem that we have had, a big part of it. Other parts will be taken up next week when we look at the credit rating agencies, what their failures were that contributed to this economic disaster. And then the week after, we will be looking at the investment banks and what their major contribution was to this economic disaster. But today's hearing will now be adjourned with thanks. Ms. Bair. Thank you. " CHRG-111hhrg53021Oth--67 Mr. Goodlatte," I thank you. I wonder if you would be willing to assure the Committees that you would get back to us on that specific question in writing once you have the information in front of you that would enable you to---- Secratary Geithner. Absolutely. I think that when we propose our recommendations on how to solve these jurisdictional questions, a necessary part of the answer will be a response to the question you raised. " CHRG-110hhrg46596--336 Mr. Dodaro," First of all, our first couple of recommendations, particularly the one that focuses on tracking what the individual institutions are doing with the money and providing reporting back as to what is happening at that level, I think would do wonders for transparency. I do agree with Mr. Kashkari, they are posting a lot of information. But the bottom line is, what are people doing with the money? That is what people want to know. " CHRG-111hhrg53021--67 Mr. Goodlatte," I thank you. I wonder if you would be willing to assure the Committees that you would get back to us on that specific question in writing once you have the information in front of you that would enable you to---- Secratary Geithner. Absolutely. I think that when we propose our recommendations on how to solve these jurisdictional questions, a necessary part of the answer will be a response to the question you raised. " FOMC20080916meeting--44 42,MR. STERN.," Yes. I am in favor of this. I just wonder how the marketplace will look at the open-ended nature of this because typically we have dollar magnitudes associated with swaps. It may all go relatively smoothly; on the other hand, it may raise questions about exactly what we think the issues are here. " FOMC20081216meeting--154 152,MR. LACKER.," Yes. So it is sort of a bummer that these go up in the recession if you are trying to measure what is happening to the NAIRU. But I always thought of the phrase ""sectoral reallocation"" as having to do with the theories of the business cycle in which cyclical downturns are caused by an unexpected decline in a given industry that causes resources to shift out of that industry and that it takes time for them to be absorbed into some other industry. From that point of view--if you are trying to measure that component as opposed to policy-induced, widespread declines in activity--I would think you would want not to take out the cyclical part. I am thinking about housing. We devoted a lot of resources to housing in 2005, much less now. Those resources thrown on the market, in fact, are the proximal cause of the initial downturn in employment growth. A lot of ancillary industries are related, so I would think that, if we didn't take out the usual housing cyclical thing, which is really sharp in the early periods, you would see a bigger rise here. " CHRG-111hhrg52407--71 Mr. Scott," Thank you, Mr. Chairman. And thank you all for coming. I can't think of really any more important thing we can do than financial literacy to deal with what has happened in this financial crisis. Because, quite honestly, if we had had an informed, educated constituency consumer base, we wouldn't be in this situation we are in now, where we are literally having to spend trillions of dollars just to find our way back to shore. And education is important; K through 12 is important. But this financial system of ours is so complicated, it is so complex, and even as we are dealing with trying to fix it now, it is getting even more complex and more complicated, for the public not only lacks the education to understand how we got into this situation, they are lacking the education as to what we are doing to fix it. So financial literacy has to come front and center. And I am so glad, Mr. Chairman, that we are hosting this hearing. And I hope that we will be able to lift financial literacy up to the proper level it needs to be as a major component of our financial regulatory reform. So the question that we have to ask is, how can we incorporate financial literacy into our new financial regulatory system in a way that can certainly protect the consumer today, as they stand? And I don't see how we can do this without having some infrastructure and money and resources behind it connecting the Federal Government to this. By that, I mean this: I believe that we have to have something out there, right now, as a part of our reform, to have the consumer to say, ``Here is somewhere I can call to get information now.'' Our system is complex. There are credit cards coming, we have credit card reform; there is banking coming. Plus, we need a monitoring system to make these loan originators, these credit card companies behave themselves. Because if nobody is monitoring them, we are going to be right back in the situation that we have now. So I would like for us to give some thought to trying to come up with a monitoring system, a toll-free 1-800 number with human beings at the end of it anchored here in the government, at the Treasury Department, not a counseling program, but folks like the Urban League and the NAACP and ACORN and the senior citizens group, people who have a relationship with the most vulnerable out there. Because the damage is that these folks out there target people, and we need something that we have that targets them to give a help line. Therefore, we can have a way for people to call in and ask questions about what that situation is. And I am hopeful we can put something like that together and probably put it in Treasury in the reform. I know my time is up, Mr. Chairman, but I just wanted to say that, and commend everybody for coming, and I look forward to working on this going forward. " FOMC20050630meeting--75 73,MR. RUDEBUSCH.," I think both Australia and the United Kingdom, to the extent they have conducted this type of policy, have felt it was fairly successful. They have been able to temper home price appreciation and restore some balance in the economy without any significant macroeconomic fallout. They have had lower home price appreciation but, again, their situations June 29-30, 2005 33 of 234" FOMC20080805meeting--26 24,MR. DUDLEY.," The effects of our actions have been to mitigate the rise in term funding pressures and to somewhat mitigate the forced liquidation of collateral because of the inability to obtain funding. Because of that, our actions have helped prevent the kind of pernicious margin spiral that we saw in March, when volatility was going up and haircuts were going up, which was then causing mark-to-market losses, which were causing forced selling. So I think our actions have mitigated those to some degree. Now, obviously, we don't know what the counterfactual would have been in the absence of our actions, but I believe--and most market participants believe--that our actions have been helpful in those respects. " CHRG-110shrg50414--200 Secretary Paulson," I would say that is a major cause. I have called it the root cause, the housing correction. Senator Bunning. OK. Then why did I read in the paper this morning that we are now going to include student loans and credit card debt? How does that fit the housing? " CHRG-111hhrg52400--261 Mr. Posey," Thank you, Mr. Chairman. I want to thank each and every one of you for your time and your testimony. And your forthrightness, especially, is appreciated. Mr. Skinner, you are right. There has been a big disparity between the requirements for domestic and non-domestic reinsurers. And I think just in the last couple of years, though, we have been so plundered and abused by the reinsurers that have done business in some of our States--all of whom happen to have the exact same rates--that you will see some of those States are dropping those requirements. More than protectionism, the purpose of that was so that if we caught them misbehaving, theoretically we could put them in jail and hold them accountable if they were domiciled in this country. If they were domiciled some other place in the world, that becomes a little bit more problematic. So that was done more as a matter of accountability than it was protectionism, hopefully. When we talk about a systemic regulator, I wonder--and you have come the farthest, Mr. Skinner, and might have the best ideas on this--how in the world could we expect a systemic regulator to regulate derivatives, complex derivatives? I mean, from a practical application, I have not heard anyone yet explain how somebody could evaluate them and then regulate them. I mean, in theory, we say, ``Yes, we need somebody to regulate this stuff and make it right,'' but I haven't heard a practical example given yet of how they would regulate complex derivatives, for example. " CHRG-111shrg53176--29 Chairman Dodd," Thank you very much. Just on that last point Senator Warner has raised, as well, I wonder if you will also look at margin requirements. The difference between exposing weakness, which short selling does and has very great value, versus speculation, which has been, I think--you know, people have talked about mark-to-market. The quickest thing you might do about mark-to-market is get this uptick rule in place, in my view, and then look at the margin requirements as Richard Breeden talked about. Ms. Schapiro. Yes, it is in former Chairman Breeden's testimony. " FOMC20080121confcall--38 36,CHAIRMAN BERNANKE.," We don't know what they are considering, but just to anticipate my response to some of these comments, I think the situation in the United States, the fundamental situation, is much more severe at this juncture than in Europe or the United Kingdom. The basis for this move is not to calm markets per se but rather to get the funds rate closer to where it ought to be on fundamental grounds. But to answer your question, I don't know what the ECB and the Bank of England are contemplating. You had a second question. " FOMC20060629meeting--18 16,MR. WILCOX.," Exhibit 6 turns to the outlook for compensation. The first column of the top left panel shows that recent readings on the productivity and cost measure of compensation have been quite choppy. Increases in the employment cost index, shown in the right-hand column, have been smoother but have been puzzling in their own right, in that they have been running so low. The two gauges differ methodologically in many respects, some of which are itemized in the panel to the right. Despite their differences, both measures suggest that compensation pressures have remained subdued even as the labor market has tightened. We expect that, over the projection period, resource utilization—represented in the middle left panel by the difference between the unemployment rate and our estimate of the NAIRU—will be only a small influence on compensation growth, boosting it a bit this year and restraining it slightly next year as the economy cools. A larger influence on the outlook is represented in the right-hand panel: As shown by the third pair of bars, real compensation has not kept pace with productivity during the past several years. Between now and the end of next year, as shown by the rightmost pair of bars, we expect this situation to reverse and real compensation to increase a little more rapidly than productivity, as competition for scarcer workers causes past productivity gains and higher overall price inflation to feed into compensation. As shown in the bottom left panel, the resulting increase in real compensation causes the markup of price over unit labor cost to decline slightly from its current historically high level and, as shown in the bottom right panel, causes both the ECI and compensation per hour to accelerate somewhat in nominal terms from their recent subdued rates of growth. Nonetheless, with the price markup remaining well above its historical average, we think such increases in labor costs would not prompt new upward pressure on prices. Exhibit 7 turns to the outlook for price inflation. As shown in the middle column of the table in the top left, core PCE prices increased more quickly in March, April, and May than in the preceding two months, boosting our forecast for the increase in core prices in the second quarter as a whole to 3.1 percent at an annual rate. As shown to the right, core inflation and its market-based component have tracked each other quite closely of late on a four-quarter basis and are projected to do so over the forecast period, suggesting no unusual mischief on the part of nonmarket prices. We continue to expect core PCE inflation to ease back next year. The major reason for this moderation is shown in the middle left panel; after bulging again this quarter, energy prices are expected to be roughly flat over the remainder of the projection period. On our assumptions, which I will discuss in more detail in a few minutes, that flattening takes about ¼ percentage point off core PCE price inflation next year. Several measures of inflation expectations are shown in the middle right panel. As you know, consumers’ expectations backed off in early June, according to the University of Michigan survey, and TIPS-based inflation compensation has come down a bit as well in the past few weeks. Nonetheless, as shown in line 5 of the table at the bottom of the page, the two CPI reports we have received since the May meeting boosted our estimate of core PCE inflation over the first half of this year 0.2 percentage point. And as shown in the third and fourth columns, we have essentially carried that bad news forward despite the slightly greater amount of slack in the economy and the slightly lower profile of energy prices from here forward. Exhibit 8 investigates whether the staff inflation models have been moving off track recently. As you know, we consult a broad range of models, but to keep the discussion manageable, I will report on just two of those specifications. As noted in the top panel, the first is a backward-looking model that uses lagged inflation to proxy for underlying or expected inflation. The second specification is a partly forward-looking model that uses a weighted average of both lagged inflation and expected inflation as measured in the Survey of Professional Forecasters. The bottom line from this exercise is that, although both models have certainly made sizable quarterly forecasting errors of late, neither has been substantially and consistently surprised by the performance of inflation over the past several years in a way that would signal an important structural shift. The middle panels report on the performance of the backward-looking model. The left-hand panel shows model simulations jumping off from several different points in the recent past. As you can see, the simulation trajectories are at least broadly reminiscent of the actual data. Nonetheless, it is difficult to determine with the naked eye whether the model errors have been predominantly to one side or the other. As an aid in that diagnosis, the right-hand panel uses a technique known as the Kalman filter—a statistical method for allowing a parameter estimate to evolve over time in response to new information. Here, I’ve applied the Kalman filter to the NAIRU. Here’s the guide to interpreting the right-hand panel: If this particular model agreed with the staff estimate of the NAIRU and if every other aspect of the model were correctly specified, the Kalman filter estimate would follow the same trajectory as the staff NAIRU. And, in fact, that is pretty much what you see: Like the staff estimate of the NAIRU, the Kalman-filter estimate declines noticeably from the early 1990s through the late 1990s and then flattens out. Turning up the power on the microscope, you can see that even since the late 1990s the Kalman-filter estimate has been declining ever so slightly, signifying that inflation has been running just a little lower during the last eight years or so than the model would have expected. The source of this surprise is not identified by the technique: It could, in fact, be a declining NAIRU, but it could equally well reflect a host of other subtle changes in the economic structure. The bottom panels repeat the experiment for the partly forward-looking model. Again, as you can see on the left, the model misses many of the finer points in the actual data but seems to capture at least the general drift, with errors roughly balanced to the high side and the low side. Indeed, as shown to the right, the Kalman filter estimates in this case have moved essentially sideways since the late 1990s, indicating that the model has not been disproportionately surprised to one side or the other. Exhibit 9 turns to the question of whether the recent increases in energy prices have been seeping into the structure of inflation more broadly and, if so, to what extent. The top panel focuses on inflation at the producer level. The panel compares the PPI for finished energy, the red line, with a staff-constructed aggregate of output price indexes for industries in which energy costs represent a relatively high share of total costs. If energy-price pass-through were going to show up anywhere, it would be here. And, as you can see, it does in fact show up. Indeed, this may be the statistical counterpart of at least some of the anecdotes that you have been hearing about energy-price increases being passed on to customers. On the other hand, you have also heard us report that pass-through at the consumer level has become much more muted. The middle panel documents that claim. For purposes of this exercise, we estimated the models for core PCE price inflation over rolling fifteen-year sample periods and then asked the models to tell us, based on those estimates, the predicted effect of a 10 percent increase in the relative price of energy on core PCE inflation after eight quarters. As you can see, the point estimates have been lower in recent years. The bullets in the bottom panel summarize our assessment of this evidence. Currently in the judgmental forecast we assume that a permanent 10 percent increase in the relative price of energy would boost core inflation about 0.2 percentage point after eight quarters. This assumption balances estimates derived from shorter sample periods—like the ones shown in the middle panel—against estimates derived from longer sample periods that include data from the 1970s and 1980s. Our approach is validated by the observation that models that are forced to assume zero energy-price pass-through have been a little surprised by how high inflation has been in the last few quarters. On the other hand, models that assume a larger pass-through than the one we use judgmentally, consistent with the average experience over the past four decades, have been a little surprised by how low inflation has been. Our judgmental assumption tucks us neatly in between. Exhibit 10 focuses on the price of owner-occupied housing and its role in the formulation of monetary policy. As noted in the top box, two main approaches to measuring the price of owner-occupied housing services have been outlined in the economics literature. The first approach aims to measure the user cost of owner- occupied housing. As shown in equation 1, the user cost depends on imputed interest expense, depreciation, and the expected capital gain. For many years, this was essentially the approach that the BLS took to measuring the price of owner-occupied housing in the CPI, except that they ignored the expected capital gain component. Increasingly, however, they and others became dissatisfied with the user-cost approach, partly because it ignored the capital gains component and partly because it guaranteed that an increase in interest rates would cause an increase in measured inflation. Finally, in 1983, they shifted to the rental-equivalence approach which, as summarized in equation 2, aims to measure the rents that owner-occupants would charge themselves in an assumed arms-length transaction. In a world in which all the relevant variables could be measured perfectly and house prices were always perfectly aligned with fundamentals, the two approaches would give the same answer, and equation 3 would hold. That equation shows that rents can increase even if house prices—denoted as Pt—are decreasing. Indeed, this would be expected to happen if interest rates—denoted as it—were increasing, all else being equal. In the real world, rents could also diverge from house prices if the latter were coming down after a period of overvaluation. Thus, the constellation of facts that we see today—a decelerating OFHEO price index together with an accelerating rent index in the CPI—may not be as anomalous as intuition might at first have suggested. The last two bullets in the box address the role of housing prices in the conduct of monetary policy. First, a broad range of analysts agree that something like owners’ equivalent rent (OER) is a theoretically appropriate element of a cost-of-living index. But second, and of more direct to concern to you, whether the FOMC should define its objectives relative to a cost-of-living index that includes OER depends on what costs you are seeking to minimize in your conduct of monetary policy. For example, to name just two possibilities, you may believe that the costs of deviations from price stability derive mainly from the inability of individuals to accurately take account of inflation in their long-term financial planning, in which case you might want to aim to stabilize an index of the overall cost of living, including OER. On the other hand, you may believe that the costs of deviations from price stability have more to do with the misallocation of productive resources stemming from confusions between real and nominal price changes, in which case you might want to focus on something quite different from a cost-of-living index. The bottom two panels turn to the operational question of more-immediate consequence—namely, what we expect to happen to rents in the near term. As shown in the bottom left panel, housing affordability has deteriorated sharply during the past two years, suggesting that rents may come under considerable further upward pressure. On the other hand, the rental vacancy rate, shown as the red line, remains quite high by historical standards, suggesting that any acceleration should be of moderate proportions. On balance, as shown in the bottom right, we have carried forward some of the recent higher readings in these categories but have taken the moderate view, at least for now." CHRG-111hhrg54869--148 Mr. Royce," So you think that the GSEs were one of the causes? " CHRG-110hhrg44900--130 Mr. Bernanke," There were really three reasons why we took the action we did. One was the actual size of the firm and its implications for the broad financial markets. The second one was the fact that the infrastructure was not strong enough to deal with the implications of the failures in the derivatives markets in triparty repo markets and other areas. And the third was that the existing financial conditions were extremely fragile at the time that we made that decision. So I think we made the right choice in the sense that it was necessary at that time and in those circumstances to prevent much wider prices in financial markets and I was reminded of the gentleman from Texas asking about student loans. The problem with student loans came directly from the option rate securities market which fell apart because of the financial stresses. These things directly impact Americans. It is not just a question of Wall Street, it really affects broad based welfare and the economy. So I believe we did the right thing. I would do it again. I think it was necessary to protect the financial system. I don't want to do it again, and so to avoid doing it again, we want to have things in place that will make it unnecessary, and that includes good supervision and includes strengthening the infrastructure, and it includes other measures to make the financial markets more stable. If we do those things, I hope that such events will be extraordinarily rare, as they have been historically. " CHRG-111hhrg48867--198 Mr. Campbell," Thank you, Mr. Chairman. And thank you, panel. Everyone generally is supporting the idea of systemic regulators, as we discussed. And I would like to pursue something Mr. Kanjorski talked about and Dr. Price followed up on, which is, what does this regulator do? If an entity is deemed to be systemically significant and, thereby, either too big or too interconnected to fail, what do we do? Now, Mr. Bartlett suggested, I believe, that there should be regulation--that what the powers that this regulator should have would be regulation to keep it from getting too systemically important or too big to fail. If that is the case, then my question would be, who do you apply it to then? If, instead, we determine that some entity is too big or too interconnected to fail and is systemically important, do we regulate it, or do we break it up? Do we look at this as an antitrust situation--and this would address some of your concerns, Mr. Wallison--do we look at this as an antitrust situation and say that there are two types of antitrusts now: There is monopolistic antitrust, which we have had in law for decades and decades; and now there is a new type of antitrust, a situation where an entity is so big and so interconnected that it can't fail, which means that the government would have to support it, keep it from failing, which means that there is a moral hazard, some of which we are witnessing out there today. And I would welcome comments from any of the panel on those two alternatives that I see or a third one, if you see one. Mr. Silvers? " CHRG-111shrg51290--54 Chairman Dodd," Let me just--one point I wanted to make before the conclusion, we are allowing the words ``subprime'' and ``predatory lending'' to become interchangeable and that is dangerous, in my view. If you have good underwriting standards, subprime lending can work, provided you don't have a lot of bells and whistles on it. This has been one of the great wealth creators for people who are moving up economically to be able to acquire a home and to watch equity build up. It becomes a great stabilizer, not to mention it does a lot for families and neighborhoods. Equity interest in homes is, I think, one of the great benefits. I think we are one of the few countries in the world that ever had a 30-year fixed-rate mortgage for people. Now, that is not always the best vehicle, I understand that, as well. But I wonder if you would agree with me or disagree with me. I just worry about this idea that we are going to exclude the possibility of poorer people becoming home owners. They have to meet standards, obviously. I think you pointed out where Community Investment Act requirements are in place, I think only 6 percent of those institutions ended up in some kind of problems. There has been an assumption that the Community Reinvestment Act gave mortgages to a lot of poor people who couldn't afford them. But, in fact, the evidence I have seen is quite the contrary. Where institutions followed CRA guidelines here and insisted upon those underwriting standards, there were very few problems, in fact. I wonder if you might comment on those two points. Ms. McCoy. If I may, Senator Dodd, the performance of CRA loans has, in fact, been much better. That turned out to be a viable model for doing subprime lending, and there are two other viable models. One are FHA guaranteed loans. That works pretty well. And then the activities, the lending activities of CDFIs such as ShoreBank are an excellent model to look at, as well. Ms. Seidman. Let me just add, first of all, you are certainly right that subprime used to mean a borrower with less than stellar credit. " CHRG-111hhrg48867--188 Mr. Price," So you believe it is appropriate for the government to determine whether or not a CEO knows whether the right and left hand know what they are doing? Ms. Jorde. Well, I think it is important that the company is not so large that their failure will bring back everybody under the house of cards. That is what I am facing as a community banker. I am paying hundreds of thousands of dollars now for FDIC insurance premiums to cover the risks of the systemically largest institutions. And I think that, before we figure out who is going to be the regulator, we need to identify the criteria of what this regulator is going to do-- " CHRG-111hhrg54873--97 Mr. Donnelly," And I know I don't have to tell you folks, but the critical nature of what you do--in my State, the damage caused to our economy was breathtaking, with company after company unable to obtain credit because of the collapse of credit markets. And there is a deep anger in our area toward Wall Street, toward the work done there, that what you did there caused our families to lose jobs. And that is the perspective that we have in middle America, is that--was this done by rating agencies alone? No. But the work that was done caused so much damage that we had moms and dads going home at the end of a day--I represent the recreational vehicle area, the auto area--that they went home and lost their jobs because the credit markets had been destroyed. And so we had a lot of skin in the game. I guess the question I will ask you is, short of the liability discussions that we have had, what skin in the game do you have or should you have or what can we put in there to make sure that your work isn't done for one of the investment banks but is done for accuracy and the American people so that they have some sense of confidence in what you are doing? I mean, what consequence is there to you? The consequence to us is our companies are destroyed and our jobs are lost. Mr. Sharma, would you be willing to help out here? " FinancialCrisisInquiry--783 ZANDI: It’s both. It’s both. I mean, we’ve got a huge gap. And we have a—it will grow quite large. One point to consider—it will—it will grow larger before it narrows in large part because the labor force is declining right now, which is—it’s not unprecedented, but it’s incredibly unusual. You have to go back into the 50s when we were going in an out of wars to see something like this. And the labor force will start growing again, and that will cause unemployment to rise. And then we’ve got to absorb all those folks that are going to come into the labor force. So it’s going to be—it’s the gap and the nature of the recovery. FinancialCrisisInquiry--112 I’m here to represent my own views. I’ve submitted almost 200 pages of supporting material. I hope you received that. Two decades ago, I worked down the street at the Federal Reserve. At the time, we were helping banks recover from crisis. We took great meaning from our work. I hope the commission’s efforts lead to a banking system that we don’t have to revisit every two decades to save. This is important. I’ve been covering an industry on steroids. Performance was artificially enhanced, and we’re now paying the price with the biggest bailout of U.S. banks in history. And it’s also resulting in the biggest wealth transfer from future generations to the current generation. My children, 9, 7, and 4, and their generation will have to pay the price. I’m shocked and amazed more changes have not taken place. There seems an unwritten premise that Wall Street, exactly how it exists today, is necessary for the economy to work. That’s not true. The economy worked fine before Wall Street got this large and this complex. Wall Street has done an incredible job at pulling the wool over the eyes of the American people. This may relate to the clout of the banks. The four banks that testified this morning have annual revenues of $300 billion. That’s equal to the GDP of Argentina. My perspective? I’ve analyzed banks since the late 1980’s. I value the independent reputation of COSA. And I’ve been negative on banks since 1999, and I’ve published over 10,000 pages of research to back up my view. I’ve identified 10 causes of the crisis. If you can turn to Slide 3 -- and I’ll go through each cause. Cause One: excessive loan growth. We could not accept the reality that we’re in a slower-growing economy, a more mature market. Loans grew twice as fast as they should have grown, twice as fast as GDP. Cause Two: higher yielding assets. The U.S. banking industry acted like a leverage bond fund. More borrowings with the proceeds invested in more risky assets. Look at Treasury securities. As a percentage of securities, they went down from 32 percent down to 2 percent. That’s the least risky asset. Instead, banks took more risky securities and more risky loans whether it’s home equity or construction loans. Look at construction loans. The percentage of construction loans to total is double the level where it was even in the early ‘90’s. CHRG-111hhrg48868--902 Mr. Peters," Good. I appreciate it, sir. Thank you. I yield back my time. Mr. Moore of Kansas. [presiding] Thank you. Next, Ms. Kilroy of Ohio. You have 5 minutes, ma'am. Ms. Kilroy. Thank you, Mr. Chairman. I appreciate it. I, like my colleagues, am just absolutely astounded by the situation of paying $165 million in bonuses with a company that is being propped up with the help of the Federal Reserve and with the TARP money, still seeing $62 billion of loss in the last quarter. And, you know, the question that the average American would ask is, how can you pay bonuses when you don't really have the money to pay them, when it is somebody else's money that is being put to work here to pay down these bonuses, which is, just recently commented, bonuses paid to people who have caused cataclysmic losses and damage to both AIG, to its shareholders, and to the economic system? And yet we are told, and I think you said this earlier, that if something happens to AIG, that can have dire consequences for the rest of the country. And you kind of get the feeling that there is a bit of coercion here being put to the American taxpayer by saying, you have to--this is another version of we are too big to fail And I think the American public is really wanting to see something different here. This afternoon, we voted on the GIVE Act, people who are giving service, people who are working hard to make their community better for small stipends. And we have seen people around the country--we have heard earlier about the teachers who are taking cutbacks in their pay, and the auto industry, which is modifying their contracts, and the pensioners who are taking cutbacks. You see this willingness to come forward and to help out. And you are among those as well, serving at the request of President Bush and the former Treasury Secretary for $1 a year. You know, I am reminded that one of our great presidents, John F. Kennedy, said, ``Ask not what your country can do for you--ask what you can do for your country.'' And yet my feeling is some of these traders and others are asking our country to just keep giving them more, and not owning up to the responsibilities that they have. And one of my concerns is a responsibility that has been brought to light, brought to my attention, from the State of Ohio, a case brought by the Ohio Public Employees Retirement System, the State Teachers Retirement System, and the Ohio Police and Fire Pension Fund against AIG, making some very serious allegations about misrepresentations and nondisclosures of material fact made by AIG that has hurt these pension funds with respect to paying contingent commissions and other practices alleged to be direct market manipulation. And I understand that the suit--other parties to the suit have settled; other parties to the suit have paid out a significant amount of money in terms of settlement, but that the meter is still running with respect to AIG's obligations and the attorney fees, which I have been told are somewhere in the vicinity of $3 million a month for AIG to defend against this suit. I am wondering--and I understand that there have been some attempts at settlement, and that those attempts at settlement have kind of come to an end. But in terms of this orderly wind-down that you talk about, is that orderly wind-down going to include considering the millions that could be owed to the pensioners of Ohio, New York, Texas, Florida, New Mexico, Virginia, California, or Michigan, all of whom have had substantial losses in AIG during the class period, during the period involved in this case? " CHRG-111hhrg54867--162 Secretary Geithner," And I think you are right. The people who provide that protection, write those commitments, whatever the form is, they need to hold margin and capital so it allows them to meet those commitments. And that was the big failure in the system. " FOMC20070131meeting--80 78,MR. KOHN.," On the same chart, Joe, I was wondering whether there is any evidence that the foreign demand for our exports, that elasticity, is coming into closer alignment with our demand for imports. That difference has really been driving the trade imbalance, and I was looking for little clues that this wasn’t all special factors, that maybe they’re catching up to us in their appetites for imports." FOMC20080805meeting--71 69,MR. EVANS.," Thank you, Mr. Chairman. Regarding a comment that Bill Dudley made about housing prices, for financial institutions, it's going to matter a lot whether we're looking at a decline from 15 percent to 20 percent or from 15 percent to 30 percent. Housing inventories, unsold homes, are very high, and I guess I'm wondering again--we have gone over this a few times--what factors are likely to get housing advancing if it's not a sharp decline in housing prices? I'm having a hard time understanding why the expectation would not be for a relatively sharp decline. I'm translating the Greenbook/OFHEO numbers to Bill's numbers, and I'm not sure, but it seems to me that financial institutions ought to be thinking that a significant adjustment must still be in train if we're not expecting demand to pick up all of a sudden. The mortgage origination challenges are there. Or is this disequilibrium just going to sit there for an extended period of time? " 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." FOMC20051101meeting--62 60,MR. KOS.," The probability, based on fed funds futures, I think is pretty low right now. My point was more about the way that people in the markets are slowly coming to view the situation. In this cycle, they’ve been looking two to three meetings ahead. But the next few meetings are a bit different, obviously. I believe traders are thinking that the policy moves over the next couple of meetings are more or less baked in the cake. The new Chairman won’t want to be in the position where he has to “stop” and confirm the dovish suspicions of some of the folks out there. So that gets you to the next four meetings, basically. But that fourth one I don’t think is in the fed funds November 1, 2005 12 of 114" CHRG-111hhrg55811--91 Mr. Hu," Congressman, to this question you just asked as well as the previous question, one of the key aspects of AIG, and, in a sense, of the involvement of other financial institutions and credit default swaps, is the whole issue of interconnectedness. When markets panic, they sometimes can freeze up. And part of what caused the financial problem and caused the intervention with respect to AIG subsequent to Lehman was the notion that this interconnectedness was spreading, that people were suddenly refusing to deal with each other and so forth. By having these clearinghouse arrangements so that in effect people don't really have to depend on-- " CHRG-111shrg54589--102 Mr. Whalen," I am not ever worried about two people on one side or another of a market. So if somebody wants to buy and sell, you know, you have heard some very good examples of the utility of credit default swaps. The concern I have is that, again, the small airline, the small company, does not have a traded market and its debt that we can use the price these contracts. So we have, again, the Liar's Poker scenario, which is you have got a trader in one firm and a trader in another, and they have decided that the implied spread on the debt of this company is a good way to price a default contract. OK? The trouble is most people on Wall Street trade these instruments like bond options. They use them for delta hedging various exposures in debt or even equity markets, and, again, these are wonderful examples. They have great utility. But the problem is I suspect the pricing is wrong. In other words, CDS is not priced like default insurance. So when that contract goes into default and the provider of protection has to come up with the money, you have got to ask yourself, going back to the question about the supervision of dealers, is that person doing the work so that they are actually cognizant of what the cost of default is versus the spread on a bond? Lehman Brothers--you could have bought protection on Lehman Brothers a week before it failed at 7 percent. The next week you had to come up with 97 percent worth of cash per dollar of exposure to Lehman. So, you know, it is the pricing issue that I think is at the core here. It is not whether there is utility in CDS. There is obvious utility in all of these strategies. " FOMC20070807meeting--112 110,MR. POOLE.," Thank you, Mr. Chairman. It’s clear that the markets are very skittish. I haven’t heard anyone suggesting that we should be changing the fed funds rate, and I believe we should keep it steady. So what is important now is what we say rather than the federal funds rate. I think that the market is looking to us for leadership, but we have to define exactly what that means in a difficult market situation. I start by saying that we need to view the current market situation not as unique but as a particular example of a class of events. Each one has unique characteristics, but this is part of a not-uncommon thing that happens. It happens every now and then. So what should our response rule be to events like this, not how should we respond to this particular case? I think there are two things that we need to do, given what we know at the moment, which obviously may change. What we know at the moment is, in the current situation, we ought not to give any hint that we are trying to suggest a policy change at our next meeting because I don’t think we have enough information to say that such a hint would be appropriate. Second, we want to make clear to the markets our readiness to respond to the situation should the environment change so that response by us would be helpful. Now, if we were to hint or if the markets were to view what we say as hinting, we could produce a positive market outcome this afternoon. I don’t doubt that. But then what? Where do we go from there? Would we, having given such a hint inadvertently or on purpose, want to actually carry through at our next meeting? That will depend on what we know at the next meeting, but in the meantime we would have created a market dynamic that would not be at all helpful. Reducing the fed funds rate 25 basis points at the next meeting or the one after that is not going to fix the subprime market. That market is changing permanently from a situation of really very poor underwriting, and the market will fix it in due time and sort it out. I favor basically alternative B and the language there, but I am concerned about paragraph 4, that the market could interpret “although the downside risks to growth have increased somewhat” as our effort to give a hint that we see a cut in the rate ahead. So I would like to suggest a little different way of doing that. If you look in paragraph 2 at the sentence that begins with “nevertheless,” I would insert a sentence immediately ahead of that which says, “Consequently, the downside risks to growth have increased somewhat.” That follows the discussion of the situation in the market, credit conditions, and so forth. Then I would leave the last paragraph the same as it was last time. The point of doing that is to make clear that the downside risks to growth have increased somewhat, but nevertheless, the economy seems likely to continue to expand at a moderate pace. That was what I would suggest we do so that we do not inadvertently give a hint. We are aware that the markets are upset. We are making that very clear, but there is no intent to give a hint of policy action in our minds at our next meeting. Thank you." FOMC20070131meeting--126 124,MS. MINEHAN.," Thank you very much, Mr. Chairman. The New England regional economy continues to grow at a moderate pace with relatively slow job growth, low unemployment, and moderating measured price trends. Consumer and business confidence is solid, and while retail contacts reported an uneven holiday season, manufacturers were generally upbeat about business prospects. Skilled labor continues to be in short supply and expensive. In every one of the New England states, there is concern over the long-run prospects for labor force growth, given their mutual low rates of natural increase, out-migration of 25 to 34 year olds, and dependence on immigration for labor force growth. New England is an expensive place in which to live, and concerns abound about how to attract and retain the highly skilled workers that are needed for its high preponderance of high value added industries. Obviously, there’s nothing new or particularly cyclical about the foregoing comments. But I’ve been to quite a few beginning of the year “let’s take stock of things” conferences in all the states recently, so perhaps I’ve become more impressed than usual by the medium-term to long-term challenges facing the region. In the short run, however, the positive overall trend of the regional economy does seem to be a powerful offset to the continuing decline in real estate markets. At our last meeting it seemed as though New England’s real estate problem was more significant than that in the rest of the country. But now it appears that both are similarly affected whether one looks at prices, sale volumes, inventory growth, or declining construction. As with the nation as a whole, there are signs of stabilization; but at least in New England, making any judgment about the imminent revival of real estate markets in midwinter is foolhardy at best. On the national scene, the data have been more upbeat since our last meeting. Apparently the holiday season was a bright one, with consumption likely growing at a pace of more than 4 percent in the last quarter. That’s remarkably strong given the continuing decline in residential real estate and proof—to reiterate what President Stern said—that the U.S. economy continues to be unusually resilient. Supporting consumption are tight labor markets, lower energy prices, tighter though still reasonably accommodative financial conditions, strong corporate profits and some signs of revival in business spending after declines related to housing and motor vehicle expenditures, and continuing strong foreign growth. Even inflation has moderated a bit, with three-month core price increases in both the PCE and the CPI trending down. Our forecast in Boston and that of the Greenbook are virtually indistinguishable. The last quarter of ’06 was stronger than expected. The first quarter of this year will be slightly better as well, but after that, the trajectory remains the same as it has been for the past two or three meetings. An increasing pace of growth in ’07 and ’08 as the housing and motor vehicle situations unwind, a slight rise in unemployment, and a fall in core PCE inflation to nearly 2 percent by the end of the forecast period. In many ways, this is the definition of perfection, a forecast that is seemingly getting better each time we make it, with growth a bit higher, unemployment a bit lower, and inflation ebbing slightly more. The underlying mechanics that produce this outcome are relatively straightforward, but I wonder whether we should have a heightened sense of skepticism about such a halcyon outlook. Let me focus on two reasons for such skepticism. First, all other things being equal, inflation could be less than well behaved. One reason that inflation ebbed in earlier forecasts was that slower growth brought about a small output gap and rising unemployment. Now, the output gap is virtually eliminated, and unemployment remains below 5 percent. Ebbing inflation is solely the product of recent favorable inflation readings, which are assumed to persist: lower energy prices, declining import prices, and falling shelter prices. It’s hard to tell at this point whether the recent readings on core inflation are the result of fundamentally lower inflation pressures or just luck or maybe a combination of the two. I think a similar range of uncertainty applies to oil prices and the strength of the dollar. With virtually no output gap, it seems to me that, while the baseline best guess might be lower inflation, for all of the reasons discussed in the Greenbook one should approach that analysis with some caution. Second, demand could well be stronger. The baseline forecast assumes that consumers somehow get the message some of us have been trying to deliver about the need for an increase in private saving. The saving rate moves from a negative 1 percent to a positive 1 percent, the highest saving rate in several years. As I noted before, I have to ask myself why this is likely to happen over the next coming months when it hasn’t in the wake of the housing situation in 2006. Clearly, the downturn in residential real estate, an important political issue in all our Districts and certainly devastating for subprime borrowers in particular, hasn’t affected consumer spending in general. In fact, household net worth as a share of disposable income remains quite high, buoyed in part by a likely overestimate of real housing values but also by rising equity markets. The timing of the needed increase in the personal saving rate could well be further out in the future, creating some version of the buoyant consumer alternative scenario instead of the baseline. Again, with no output gap, the potential for increased inflationary pressure is obvious. In sum, the Greenbook forecast remains in my view the most likely baseline. There are downside risks, as I mentioned before, for the seven alternative scenarios do anticipate some downside risks; but if the housing situation is beginning to stabilize, I find it hard to believe that broader anxiety about it will affect business spending or the consumer as some of these scenarios contemplate. The bigger risk may well be that business spending picks up in light of consumer strength, unemployment stays low, growth exceeds our current projections, and resource pressures become more intense. I am concerned that risks to inflation have grown somewhat since our last meeting. I think I’m still in a “wait and see” mode, as I do believe there are downside risks to the evolution of housing markets. But if the Greenbook growth forecast is right, the best risk management on our part may have to be to seek tighter policy sooner rather than later." CHRG-111shrg54589--56 Mr. Gensler," Right, so I am agreeing with you, Senator. Senator Bunning. OK. Ms. Schapiro. I do not have much to add to that. I would say that the securities clearinghouses did work very well in the last year over really extraordinary circumstances, but I think the last year also taught us that almost anything can happen that we have not anticipated historically. I think the real key for clearinghouses will be very robust risk management, so that they are very well capitalized, they have effective oversight, and real vigilance from the regulators, whether it is the Fed as a backstop regulator to clearance and payment systems or the functional regulators, the SEC and the CFTC. It will be important for them to have conservative margin requirements and very important for them to have procedures that are well understood, very transparent for how they will resolve the default of a participant in the clearinghouse. Senator Bunning. Ms. White, would you like to comment anyway? Ms. White. The Board believes that CCPs are critical utilities in the financial markets and they need to be regulated and they need to have risk management that would ensure that they carry out their functions in a sound manner. They are, as you pointed out, subject to the possibility of needing liquidity in extreme situations. The Administration has proposed broadening the Fed's ability to provide liquidity in extreme situations, and the Board supports that. Senator Bunning. Thank you very much. " 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-111hhrg48867--96 Mr. Hensarling," Thank you, Mr. Chairman. Just to set the record straight, if I heard my colleague, the gentlelady from California correctly, speaking that Countrywide was not regulated, that will come as news to both the OCC and the OTS who at different times during Countrywide's existence regulated those institutions. Mr. Wallison, you have a lot of your written testimony that you were unable to speak about in your oral testimony. I thank you for being here. I thank you for your very thoughtful op-ed in the Wall Street Journal today. Certainly you bring a wealth of credibility to this panel as being one to have the clarity and call that Fannie and Freddie were presenting a huge amount of systemic risk to our economy. In your testimony, you say that the design of a systemic regulator could cause more Fannie and Freddies to take place in the future. Although I don't remember the exact quote, our President, in his State of the Union address, said something along the lines of before we can correct our economy going forward, we have to understand how we got into this situation in the first place. That is a paraphrase. Can you speak exactly how significant was the role of creating a federally sanctioned duopoly in Fannie and Freddie, giving them affordable housing goals that ultimately brought down their lending standards? What role do you believe that played in the economic debacle we see today? " CHRG-110shrg50409--70 Mr. Bernanke," Well, there is speculation, but speculation under most circumstances is a positive thing. It provides liquidity and allows people to hedge their risks. It provides price discovery. It can help allocate oil availability over time, depending on the pattern of futures prices and so on. What is really a concern--what the CFTC, for example, is concerned with would be manipulation as opposed to speculation. Senator Reed. Well, I will use the term ``manipulation'' in the same situation. " 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 " FOMC20060629meeting--22 20,MR. LACKER.," I have some more questions about latent variables. During my exchange with David at the last meeting, I was asking about inflation expectations. I learned that you didn’t have a single number for expected inflation but that there were multiple measures. You offered to write a number down on an envelope for me but cautioned me against placing too much reliance on it. You went on to say that there was something called “underlying inflation,” and you spent a good deal of time talking about this. You even cited some numbers—said that it was maybe 1 percent or 1½ percent in ’03 and that it had risen perhaps to 2 percent at the last meeting. So I went and checked my New Palgrave: Dictionary of Economics. I couldn’t find “underlying inflation.” [Laughter] I went to the BLS website and the BEA website; it wasn’t there either. I asked some of my theoretical economists if they had seen any papers in the literature that have models with underlying inflation, and I couldn’t find anything. So I’m wondering what it is. I’m wondering what the number is now, how it has changed since May, and whether it might be useful information for the Committee to contemplate when deliberating about inflation policy." CHRG-111hhrg48868--258 Mrs. Maloney," This document really talks about the dire consequences if AIG were allowed to fail, and I am wondering if a similar document was ever reviewed by the executives of AIG when they decided to go into derivatives and other highly risky products that have brought down the company. Do you think they ever looked at anything that assessed that risk? I would like to put this in the record, please. " CHRG-110shrg50420--213 Chairman Dodd," How about these other points here, what did I say, 40 or 48 models, dealerships--I mean, Mr. Fleming told me that in Connecticut we have lost--I forget how many you told me last week. We are losing dealerships anyway, and I wonder if these numbers reflect just the attrition that is occurring as a result of the economic crisis. " FOMC20060328meeting--52 50,MS. YELLEN.," We have noticed a change in the relationship between the core CPI and the chained core CPI, which suggested to us that maybe something is going on relating to substitution bias at the upper level of the index. You focused on the nonmarket component of the PCE, and I wondered if something unusual might be happening with the core CPI relative to other measures." FOMC20060328meeting--40 38,MR. LACKER.," Dave, I was struck by the alternative scenario in which productivity growth is slower because, even with the Taylor rule in place, it makes inflation rise rather than nominal compensation growth fall. So I was just wondering, does that result convey a lack of credibility in the estimated Taylor rule, or what do you think is going on there?" FOMC20070918meeting--177 175,MR. WARSH.," I don’t feel strongly, but would it make more sense to have this change be consistent in time with changes in communication strategy more broadly? Now, recognizing this is not of the same import, but rather than have a question be raised and then have to explain it through our communication folks and others, I wonder whether this might not just be sort of a housekeeping footnote as part of a broader communication rollout." 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.] " CHRG-111hhrg53245--84 Mr. Wallison," In my testimony, Congressman, I looked very carefully at this question of the difference between a systemic risk and mere disruption. We really do not understand what systemic risk is or how it would be created or what kinds of institutions would create it. This is one of the fundamental problems with what the Administration is talking about. In the case of General Motors or Chrysler or Ford, for that matter, or CIT, yes, there would certainly be disruption if a large firm fell. I think the same thing is going to be true of financial institutions other than very large banks. That is why it is such a bad idea to provide to the government the authority to bail out or take control of any kind of institution, because the institutions will always come in and argue that their failure will cause some sort of huge loss in our economy, whereas in fact companies fail all the time. But they don't create a systemic event, just disruption. They get worked out in bankruptcy. Sometimes, they return to full activity. Other times, they are completely unwound. We have to make sure that we know the difference between a mere disruption, which they will claim, and a systemic risk. We do not know how to make that distinction. " CHRG-111hhrg58044--285 Mr. Cleaver," I have a friend who is in the hospital now suffering from cancer. Last summer, he ate a cheeseburger. I have concluded that cheeseburgers cause cancer. I know someone who had two automobile accidents, so therefore, automobile accidents cause bad credit. Point out the illogic in that. Either one, the hamburgers or the accidents. " CHRG-111shrg62643--92 Mr. Bernanke," Those are legitimate concerns, and for that reason the Federal Reserve is going to do the best we can to get these things resolved as quickly as possible. Senator Gregg. So if you want to look at what is really causing--maybe the uncertainty that is causing this $2 trillion to stay on the balance sheets, it is the fiscal policies of the Government. " CHRG-111hhrg49968--94 Mr. Bernanke," Well, it depends a bit on the baseline that you are comparing it against. But I think it is fair to say that the preponderance of the jobs will be private sector jobs. And they would be permanent if the economy has, by the end of this period, come closer to a better employment situation so that we are closer to a more normal labor market situation. So in that respect you are putting people to work 2 years earlier than they otherwise would have been put back to work. And that is the sense in which employment is being created. " CHRG-111hhrg52400--237 Mr. Garrett," I appreciate that. I guess a lot of what we do here is make the questions to other people. I said had we had different regulations in place, would we have prevented the situation, and it would seem as though, in certain cases, maybe not. And Mr. Skinner, one other one quickly. You talked earlier in your testimony with regard to equivalency, and that's something we need to move to, right? You have the OII legislation that's out there. In the--I will call it the bare bones, the basic OII legislation, which does not have--sorry, as I understand it--all of the other regulatory aspects of it, it's basically just an OII office of insurance information, a collection of information. Would that bring us to--just having that, does that bring us to equivalency alone? " CHRG-111hhrg56847--215 Mr. Bernanke," Well, it depends to some extent on the rate of recovery of the economy. The more quickly it recovers, the sooner the medium term will come, in some sense. But right now, the various estimates of the CBO and the OMB under different scenarios show a structural deficit from say 2013 to 2020 of between 4 and 7 percent of GDP, which is not sustainable. So I would say medium term is 3 to 5 years out in the future, and of course, the situation gets much more difficult beyond, say, 2020 when the entitlement spending becomes even greater. " CHRG-111shrg54533--46 Secretary Geithner," Senator, again, this is a critical issue. Again, I think the acid test or the critical test of credibility of any system is: Is it strong enough to withstand the pressures that could come with a failure of a large institution? Because if you do not build the system strong enough to withstand those pressures, then the Government will be forced over time in future crises to intervene to prevent their failure, and that will create the risk of greater crises in the future. So that is critical to the objective of what we are trying to achieve. I believe the best way to do that and the really only effective way to do that is, again, to make sure there are tougher constraints on leverage and risk taking in the future, applied not just to every institution that is a bank does those--takes those kind of risks, but to the largest in particular; that the core markets where institutions come together to transact also have thicker safeguards, thicker cushions to prevent the contagion that can be caused by default of a major institution, and to have better tools for managing an orderly failure of a large institution through resolution authority. I think that mix of proposals I think represents the best hope of limiting the moral hazard risk that comes from any modern financial system where you can have some institutions whose role in markets by definition is so important that, if they get in trouble, it is going to risk undermining the broader health of the economy as a whole. So I think that is the best mix. A lot of people, a lot of thoughtful people have ideas in this area. We will be open to ideas, and we will look at whatever we think the best balance of proposals are to deal with that challenge. Senator Menendez. You know, one of the things you propose and some of my colleagues have already raised is the oversight council, and I think that has a valuable function in watching for developments that pose risk to the banking system and better coordinating the regulators. My concern, again, is that it is basically advisory and it has no power to carry out corrective actions that will be needed in response to the council's own findings. So give me a sense of how do you envision--so the council comes up with a series of findings that say, hey, this poses risk. What happens if an individual regulatory agency disagrees? What happens when, in fact, the council's conclusion that a particular product or activity poses a risk to the financial system, how is the corrective action going to be both considered and acted upon if it is only advisory at the end of the day? " CHRG-111hhrg54869--138 Mr. Volcker," Was the Community Reinvestment Act the cause? " CHRG-111hhrg54868--150 Mr. Green," Did it cause the crisis? Ms. Bair. No, it did not. No. " CHRG-110hhrg41184--68 The Chairman," The gentleman from Georgia. Mr. Price of Georgia. Thank you, Mr. Chairman. Mr. Chairman, we appreciate you being here again today and we know that monetary policy certainly is a balancing act and you have a difficult challenge balancing things. I find it interesting today that some members who are now upset with the current situation were the same ones who were clamoring the most in years past for an expansion of credit. And so I think it may be that those individuals as we clamp down on credit are those who will then be clamoring for us to open it up again in the relatively near future. So it is indeed a balancing act. The Federal Government has come under significant indictment by some for its lack of regulation and I am interested in what degree you believe there is responsibility for our current situation that is due to the lack of regulation. " CHRG-110hhrg46591--74 Mr. Stiglitz," Well, I think that it is imperative to continue with mark to market. When there is no market, as is the case in some assets, obviously you can't mark to market, you have to use some other principle. The issue is what you do with mark to market. I had a very brief reference to countercyclical provisioning which takes into account what happens in these kinds of situations to market values. What I find very interesting is that those who have criticized mark to market didn't criticize it when they overestimated the prices in the bubble and haven't offered to give back the bonuses that were based on those over excessive prices when the market was excessively exuberant. They want an asymmetry where when it is too low, they will get the market up, when it is too high, they will leave it up to high. I think we have to stay with a transparent system but think very carefully about how we use that information in regulatory processes. " 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-111shrg55739--120 Mr. Coffee," Because I am probably the one most associated with saying there has to be some litigation remedy, let me say I do not think it should go that far. I do not think there should be a cause of action for negligence. I do not think misjudgments should produce litigation. I think it should be for being reckless. And when you give a rating with knowing any facts at all, then it is reckless. Senator Bunning. Well, then, that is a cause of---- " CHRG-111hhrg48873--185 Mrs. Bachmann," We have seen both China and Kazakhstan make calls for an international monetary conversion to an international monetary standard as soon as the G-20, and I am wondering, would you categorically renounce the United States moving away from the dollar and going to a global currency, as suggested this morning by China and also by Russia? Mr. Secretary? " CHRG-109hhrg31539--254 Mr. Bernanke," Well, I think there is a risk there. And indeed the recent report from OFHEO about some of the inadequacies of the GSEs' internal controls and their accounting makes us wonder about their ability to manage these very large and complex portfolios. I am not saying there is anything immediately about to happen, but I do think that these portfolios do present a systemic risk and that it would be in our interest to try to address that issue. " CHRG-111hhrg54869--92 Mr. Lynch," Mr. Volcker, thank you for your attendance and for helping the committee with its work. I was listening to your testimony outside and I was wondering, this whole framework that we are considering here--given the complexity of some of this, some of the instruments that are being traded now, the derivatives that we are now going to put on exchanges, and some that are not but necessarily require oversight, where we are entering new territory here which we hope will bring more effective regulation to the entire financial services industry. The question for us in part will be how to pay for that, how to pay for that structure. And I know that the last time we had a great disruption here, the Great Depression, Congress and the financial services industry sat down and they derived a system that--I think it was one three-hundreth of 1 percent of every share traded on the exchanges would go in to pay for the SEC, for example. That number has been reduced over time because of the volume of trades. But would you favor some type of--when we have to grapple with how to pay for all this, would you favor some type of system, some transaction fee, for example, that would help fund all of this? We have many, many of our constituents who don't have any--they don't have an IRA, they don't have money in the stock market. And yet if we use the general taxation authority, they too will be paying for this system that they don't necessarily benefit directly from. And I was wondering if we could have your thoughts on how we might as a Congress pay for some of the regulation that we are about to implement. " CHRG-111shrg53176--108 Mr. Atkins," One note of caution there is that this issue is not just a monolithic type of thing. Every company is different. Every situation might be different. I think you will probably hear that if you write the letter to the SEC. The response will be in various situations, it sometimes might be justifiable and the shareholders might have approved it. " 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-110hhrg44900--58 Mr. Bernanke," I would like to. Thank you. First of all, I agree absolutely that market discipline is the heart of our system. Avoiding the moral hazard, having strong market discipline makes the system work better, and an example would be the counterparty discipline between the banks, investment banks, and the hedge funds, has protected the banks and the banks and the investment banks from any losses from hedge funds. There have been no material losses to banks or investment banks because of failing hedge funds, and because the banks have been doing due diligence, and that's what we want to see. Now in my view, our action to address the Bear Stearns situation was necessary, given the financial conditions at the time, but it's absolutely correct, as President Lacker has pointed out, it does raise moral hazard concerns going forward, and then the question is how do you address those. In my remarks today, I listed three possible approaches or complementary approaches. The first is supervisory oversight of those institutions to make sure that they are in fact doing what they need to do to be safe and sound, are not taking advantage of the implicit backstop. So since we have gone into the investment banks, they have all raised their liquidity, not reduced it. So that is one way to ensure that the moral hazard is minimized. Second, as Secretary Paulson mentioned, if we can strengthen our infrastructure sufficiently so that it could absorb the failure of a large firm--we felt it wasn't able to do so in March. But if it were clearer that the system could withstand the failure of a firm of Bear Stearns' size, then we would be much more comfortable letting it happen, because we would think the system would be preserved. And finally, I think that, as has happened in the commercial banking world, we do have stronger resolution procedures that would allow us to intervene in an early stage perhaps and to try to create an orderly process that doesn't create the market externalities at the same time it would avoid moral hazard because the equity holders, the management and subordinate debt holders would all be subjected to losses in that process. " CHRG-111hhrg56766--261 Mr. Bernanke," I think the confidence issues, particularly the number we saw yesterday, are tied pretty strongly to the labor market situation. " CHRG-111hhrg56847--146 Mr. Bernanke," Let me first say that, in terms of any fiscal package, again, I don't want to adjudicate specific parts of it. And Congress needs to decide which components they want to support and which ones they think will be most effective. But in terms of the time frame, right now I don't think is the time, this very moment is not the time to radically reduce our spending or raise our taxes because the economy is still in a recovery mode and needs that support. However, the risk, of course, of ongoing deficits is the potential loss of confidence in the markets, and the way to reassure the markets is by creating a plausible plan for a medium-term stability in the fiscal situation. We, obviously, can't run deficits at 10 percent of GDP forever. " CHRG-109shrg21981--150 Chairman Greenspan," Oh, absolutely. Senator Corzine. So there are solutions and they are easier to implement if we do them sooner rather than later, which is what was done in 1983, which was to build up these surpluses. Unfortunately, we turned around and spent them for current expenses on the cashflow basis that Senator Bennett talked about, but there was a desire to prefund liabilities that was embedded in the recommendations. We have prefunded them, but because of the reality of the unified budget, we have taken payroll taxes to pay for tax cuts or wars or whatever the expenditure or reduction of revenues has been. If I am not mistaken, just on an accounting basis, payroll taxes come in, they go out for some other purpose with a bunch of borrowing going on. My real question is, because I think the fundamental principles are still sound, that there is need for social insurance on disability, child and survivor benefits, and for seniors. My own view is we may have to deal with the financing structure, and you have had great ideas in the past. This is going to be hard for you to see, but actually the only thing that really counts--and I worry about this very deeply--is that because of a lot of the reasons you have talked about, skill sets and others, real earnings for the bottom decile in our country have actually declined in the last 4 years. They are flat for the 25th percentile. They are up a measly two-tenths of 1 percent for the median percentile, and they are a little bit better for the 75th percentile and the 90th percentile. I wonder what they are for the 1 percent. We did not have it on this chart. I suspect real earnings have gone up pretty well for the most skilled in our society. But aren't we setting up a situation, if we take away guaranteed benefits, that the vast majority of people in this society are going to end up with less savings? Maybe we can have broad changes in our educational skill levels development in our society, but otherwise we are going to end up with a society that has less ability to save and we are talking about the guaranteed benefit. " CHRG-111hhrg48867--279 Mr. Wallison," Yes. I think the Fed panicked on AIG. They should have let it fail. They panicked because, right after Lehman Brothers failed, the market froze, and the Fed thought, at that point, that they had to step in and stop a further disintegration of the market by covering AIG. The facts are not very well-known--but some substantial portion of what AIG was committed to were credit default swaps. Others were other kinds of obligations. Most of the newspaper commentary and media commentary has been about the credit default swaps. Now, when an insurance company fails and your house is insured by that company, what you have to do is go out and get another insurance company. You haven't suffered any loss yet until you have that fire or that burglary or whatever it is. So if AIG had failed, the people who were protected by the credit default swaps, the companies that were so protected would have had to have gone out and gotten other credit default swaps if they still thought they were at risk on particular obligations. So that would not have caused any serious problem. " CHRG-111hhrg52400--43 Mr. Garrett," Thank you, Mr. Chairman. And I begin there, with Mr. Skinner. Thanks for coming on over. You heard a number of people on the panel testify here from the PNC side, and others as well, that the problem that we had in this country was not caused by--they would argue--problems in the insurance industry. We have heard that from other panels, as well. I note in your testimony you said that the legislation you're talking about was going to go into effect in 2012, right? If we were having a panel like this back overseas, would that be the same testimony that we would hear over there, as well, that the problems in the marketplace and everything that's going on in Europe was due in no large part from the insurance industry, as well? " 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." FOMC20061212meeting--13 11,MR. KOS.," If I could answer that question, I’d be rich by now. [Laughter] It’s hard to know. I don’t pretend that I can give you a precise answer. Certainly, the markets have been in this benign situation for some time, and we’ve been struggling with this question for several years—why the term premium has been so low, why spreads have been so low, and why volatilities have been so low for this extended period. I just think that the longer the situation persists, the longer the risks rise—or at least that’s what the worry is. But you all know that." CHRG-111hhrg67816--137 Mr. Pitts," Unfair is defined as any act that causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition. Bringing an enforcement action for violation of a deceptive practice is much more common for the FTC. Why are unfair cases brought so infrequently? " CHRG-110hhrg46596--304 Mr. Roskam," We are not going to settle this in the couple of minutes that we have this afternoon, but it seems to me that the urgency with which the original TARP deliberation took place, we would have been well-served had that same urgency and that same clarity been brought about to require or to provoke--use any verb you want to--but to get a fundamental change in mark-to-market. It would seem to me there were things that were on the table that would have been substantive and very helpful, and we may have been in a very different situation right now. Let me just turn quickly, Mr. Dodaro, could you comment on that element of things? In other words, as the GAO evaluates TARP, can--or is part of your deliberation and your evaluation, regulatory burdens that may be in place, impediments to progress that Congress itself can remove, or the Securities and Exchange Commission or FASB or others? Is that part of your portfolio, so to speak? " CHRG-111hhrg53244--169 Mr. Bernanke," I think the ability to float large amounts in the short to medium term depends on the credibility of a longer-term plan that brings the deficits down. If the markets don't think that you are on a sustainable path, then they will bring forward in time their concern about future deficits. So it is important to have, as I said before, a medium-term sustainability plan. I must say one thing about health care costs, which is that is the most important determinant right now of our long-run fiscal situation. And even under the status quo, we have a very serious problem, and so, we do need to address that problem in some way. Because, given the aging of our population, the increases in medical costs are going to be a huge burden on our fiscal balance. " CHRG-110hhrg41184--73 Mr. Bernanke," There are a lot of factors involved. Mr. Price of Georgia. The stimulus package that Congress recently passed, many of us were concerned about it being temporary and having questionable effect, truly to stimulate the market, the economy, in the long-run. And if we think about the housing situation currently, I think there are two basic options available. One is to try to stimulate housing purchase through some tax policy. And the other is to increase the liability of the taxpayer for becoming the natures mortgage banker. Do you have a sense about which road we ought to head down? " FOMC20050322meeting--109 107,MR. POOLE.," Thank you, Mr. Chairman. One of my business contacts, my Wal-Mart contact, started our conversation by saying that the situation is rather strange—his word. Spending coming out of the Christmas season has been higher than anticipated—with same-store sales about 4 percent higher on a year-over-year basis—and they’re not sure where this strength is coming from. They are anticipating about that same strength, or maybe even a bit more, going forward. He noted that their inflation situation is not a concern. Their prices overall are flat; food prices are up a little and prices of nonfood items are down a little. The labor market is very stable; Wal-Mart is having no problem at all hiring associates at their stores. My UPS contact noted an expansion of their capital spending. He said that business from retail mail order firms is very strong. He indicated that his company has some labor concerns. They March 22, 2005 48 of 116 doing contingency planning for it. They do not believe that the rest of the industry has the capacity to fill in, should UPS be shut down. My FedEx contact noted also an increase in capital spending, up 15 percent for this fiscal year over last fiscal year. He indicated that about two-thirds of that is for expansion of capacity and about one-third for productivity enhancements. Also, he said that they had no concern regarding labor availability. Fuel prices, obviously, are a concern for them. My contact in the trucking industry had contrary information. He said that demand is softer than anticipated and that there has been a switch from prebookings for truck shipping services to last-minute bookings. He also noted that the driver shortage is getting worse and worse. A contact in a major software company said that sales had come in a little soft relative to their expectations but attributed it to Intel coming up short on inventory—I think particularly on notebook computers. Apparently Intel was surprised by demand that was higher than anticipated. Also, I might mention that a contact in the banking industry noted that C&I [commercial and industrial] loans year-over-year are now positive and accelerating and that there appears to be a lot of momentum. Let me turn now to some comments about the economy in general. We have in place a very broad-based and robust recovery. Business fixed investment is taking hold and taking the lead. I think it’s highly likely, of course, that employment and income will grow, which will provide support for consumption, as the Greenbook emphasizes. So even if we had a welcome increase in the saving rate, we’d probably see continued strength in consumption. The Greenbook contains—and we continue to hear elsewhere—a lot of comments on energy prices. In my view, it’s very important that we think of energy prices as being demand-driven. This March 22, 2005 49 of 116 appropriate to think about what the world would look like if energy prices had not increased and how much gets taken off growth. But I’m not sure that that’s quite the right way to look at this, because the situation is being driven fundamentally by demand. It’s not that output is being constrained by energy; it’s that vigorous output growth is driving up energy prices. As for labor compensation, productivity gains are holding down growth in unit labor costs. That’s a source of great stability. Let me make a general point about this expansion that really took hold roughly six quarters ago. Relative to U.S. business cycle history, this expansion has been one of the most orderly and best predicted. The forecast errors are astonishingly small—much lower than the usual standard errors that we see—and I think that has a lot to do with the very well-balanced and orderly nature of the expansion. This expansion is about as surprise-free as we ever see. I think our policy goal should be to maintain the orderly nature of the expansion as far as we can, and, of course, that includes as an essential element maintaining the stable inflation environment. I think the staff forecasts for both real GDP and inflation make a lot of sense. As point forecasts, they’re as good as one can find. I think the risks around the GDP forecast are probably pretty symmetrical, but I do not believe that the risks around the inflation forecast are symmetrical. I view the inflation forecast more as a median of the distribution than a mean. I think the distribution is skewed to the right—that there’s a substantially higher probability that we could have a ½-point upside surprise than a ½-point downside surprise on the inflation outcome. That’s all I’ll say at this time. Thank you." CHRG-110shrg50420--321 Mr. Nardelli," Senator, of the $8.6 billion you referenced, we have put six into this plan. That is why I wanted to be very clear with Senator Menendez that in addition to the 34, there is 25 of this money. We put in about 70 percent of our request. We were told the guidelines would be somewhere around 80. I haven't received the letter, but I have heard of the letter and one of it was that there was not an audit report, but they subsequently found that. Senator Corker. So these are important parts of your capital structure which is now, we are talking roughly in formal applications--I consider this today a formal application--of about $60 billion. The interesting thing to me all along has been that all three of you have come in together. I have read the plans and re-read the plans and I would sort of qualify them this way. Ford's plan is kind of life is wonderful. You have already done a lot of the things that need to be done, and fortunately, whether you were lucky or smart back in 2006, you borrowed money at lower rates and were able to fund yourself. I think it was probably because you all were forward thinking and congratulate you for that. Chrysler doesn't really want to be a stand-alone business. I mean, that is well documented. The fact is that, basically, what your plan is about is you want to hang around long enough so that you can date somebody and hopefully get married soon, before you run out of money. So I have to tell you, I have a little trouble when I look at that plan. I know that you haven't invested in product development. I know you don't have the technologies to really compete as a stand-alone. I know that your dealership levels all across the State might be really valuable to a foreign company coming in, but I have to tell you that it troubles me a little bit knowing that basically all we are really doing is providing a little capital for you all to hang around long enough to get married. And I consider you to be a very honest broker, Mr. Nardelli. I really appreciate the conversations we have had, and so I want to ask you this question. I talked with a board member last night at Cerberus, and I know that they own 80 percent of your company and I know there has been a lot of narrative, and I don't know whether this is true or not, that in essence, what they really wanted out of the purchase from Daimler-Benz was the finance companies and the auto stuff was sort of a bonus, OK. And I talked to the board member last night and said, look, you guys are in asking us for public money today. Cerberus owns 80 percent of this company and has cash, lots of cash, that they are unwilling to put into this company. You mentioned about what a great partner they were. I don't know. I have to tell you, I have some trouble. These other guys have a different problem because they cannot access cash. They don't have a father sitting up here with cash that can inject into their companies. They have to go out on the public markets. You are in a different situation. You are a portfolio company in a private investment firm that has lots of money and they are unwilling to invest that money in your company. And I want to add one other thing to it. We wouldn't be here if it weren't for GM, and we are going to talk about them in just 1 second. We all know this. It is almost like you lucked up. I mean, you guys were getting ready to be bankrupt and all of a sudden GM is in trouble and they have sort of the clout, if you will, and Ford joins in, to come up here and ask for public monies and this is like a flyer for you guys. All of a sudden, this is life again, OK. We might get $7 billion even though our portfolio parent won't inject any more cash in us. And I have a little trouble with that, and I wonder if you might just make me feel better about that. " CHRG-110hhrg41184--191 Mr. Bernanke," Well, it depends on the circumstances. It depends on why the economy is worsening and where the problem is. My attitude is that we need to be flexible and address the situation as it arises. It is very hard to conjecture in advance how you will respond to a situation that will have many dimensions to it. In respect to the particular program you mentioned, I think it is worthwhile to be thinking about possible approaches one might take if the housing situation were to get much worse. At the moment, I think that the remedies I would support are expanded private-sector activities, FHA modernization, GSE reform. " CHRG-110hhrg46593--162 Secretary Paulson," And very seriously different situation-- " CHRG-111hhrg54872--171 Mr. John," That is easy, it is the consumer when it comes down to it. One of the problems we have been facing and the chairman pointed out that there were a few problems with State preemption prior to, I believe in 2005 or 2006 or so. However, we didn't have the same level of extremely activist attorneys general, most of whom are seeking to be senators or governors, who actively seek out situations and actively promote more than reasonable solutions to them. So we are much more likely in the current situation to have attempts by various ambitious State officials to move into and obstruct national markets. " 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-111hhrg56767--145 Mr. Donnelly," Thank you, Mr. Chairman. Mr. Feinberg, when we look back, Goldman was very close to going over the cliff. Morgan Stanley was very close to going over the cliff. They were saved by money from everybody's paycheck in this country. When you talk to them about these bonuses, what I was wondering is, did you ever ask them if they felt, as they were talking to you about these bonuses, any obligation to the people of this country to not conduct themselves this way? " CHRG-111hhrg53245--201 Mr. Sherman," Ms. Rivlin, I wonder--you seem to have a comment? Ms. Rivlin. No, I agree with that, and I was glad to get a chance to counteract the absent Mr. Wallison who thinks we only need to worry about banks. I think the lesson of this crisis is we need to worry about the whole financial sector and a lot of the trouble came from outside the banking system. " FOMC20080318meeting--83 81,MR. FISHER.," At this juncture. Look, Tim, we cut rates 50 basis points last time. I was in a minority of one, and I respect the group around this table more than I respect myself. Here is the point: Everything that we wanted to go down went up, and everything that we wanted to go up went down. So I just wonder about the efficacy of the cuts as opposed to the measures that we have undertaken. " FOMC20051213meeting--38 36,MR. SANTOMERO.," David, could you give us a risk assessment on your consumer spending forecast? In 2006 and 2007, you have consumer spending growth of 3½ percent, while the housing December 13, 2005 18 of 100 with that forecast? You made reference to it in the formal comments, but I wonder if you are quite comfortable with the forecast or a little uncertain about it." CHRG-111shrg56262--88 Chairman Reed," If not, let me thank you all again for excellent testimony. I think Senator Gregg said it very well: great insights together with very specific suggestions and done in a very concise and understandable way. So thank you all for your wonderful testimony. The hearing is adjourned. [Whereupon, at 4:11 p.m., the hearing was adjourned.] [Prepared statements and additional material supplied for the record follow:] CHRG-111hhrg48868--783 Mrs. Bachmann," Mr. Chairman, I think I will be submitting the rest of these questions to Mr. Liddy in writing. I just want to end with the Federal Government did approve, prod, enable AIG in a lot of ways to ensure these risky bets. And what I'm wondering is, why didn't AIG have the institutional fortitude to say no to Uncle Sam? " FOMC20061212meeting--40 38,MS. PIANALTO.," Dave, the two measures of labor compensation that we typically look at—compensation per hour and the employment cost index—over a long period track each other fairly closely, but in the shorter run there’s more variance. Even though we’ve seen the recent downward revisions to compensation per hour, it’s still running higher than the ECI. I was wondering how you have approached weighing these two series in your assessment of the labor market and also how your outlook for inflation would change if you put more weight on the ECI, which is lower than compensation per hour." FinancialCrisisReport--425 In May 2007, Goldman’s Structured Product Group (SPG) continued to work to cover the Mortgage Department’s short position by offering to take the long side of CDS contracts referencing RMBS and CDO securities, but found few buyers. Many market participants had already shorted subprime mortgage assets, driving the price relatively high, and few wanted to buy additional short positions at the prevailing price. In order to turn the situation to its benefit, SPG’s traders attempted to carry out a “short squeeze” of the subprime CDS market in May 2007. 1737 The ABS Desk’s traders were already offering single name CDS contracts in which Goldman would take the long position, in order to cover the Mortgage Department’s short position. 1738 To effectuate a short squeeze, they appear to have decided to offer the short positions on those contracts at lower and lower prices, in order to drive down the market price of subprime CDS shorts to artificially low levels. Once prices fell below what the existing CDS holders had paid for their short positions, the CDS holders would have to record a loss on their holdings and might have to post additional cash collateral with their opposing long parties. Goldman hoped the CDS holders would react by selling their short positions at the lower market price. When the sell off was large enough and the price low enough, Goldman planned to move in and buy more shorts for itself at the artificially low price. This short-squeeze strategy was later laid out in a 2007 performance self-evaluation by one of the traders on Goldman’s ABS Desk who participated in the activity, Deeb Salem. In the self- evaluation he provided to senior management, Mr. Salem wrote: “In May, while we were remain[ing] as negative as ever on the fundamentals in sub-prime, the market was trading VERY SHORT, and susceptible to a squeeze. We began to encourage this squeeze, with plans of getting very short again, after the short squeezed [sic] cause[d] capitulation of these shorts. This strategy seemed do-able and brilliant, but once the negative fundamental news kept coming in at a tremendous rate, we stopped waiting for the shorts to capitulate, and instead just reinitiated shorts ourselves immediately.” 1739 When interviewed by the Subcommittee, Mr. Salem denied that the ABS Desk ever intended to squeeze the market, and claimed that he had wrongly worded his self-evaluation. 1740 He said that reading his self-evaluation as a description of an intended short squeeze put too much emphasis on “words.” 1741 1737 1738 See, e.g., Salem 2007 Self-Review. See, e.g. 4/5/2007 email from Deeb Salem, “let’s sell ~200mm in Baa2 protection . . .,” GS MBS-E-004516519 (Mr. Swenson ’s reply: “Make that 500mm ”). 1739 1740 1741 Deeb Salem 2007 Self-Review [emphasis in original]. Subcommittee interview of Deeb Salem (10/6/2010). Id. FinancialCrisisInquiry--114 Cause Eight: I know Jamie Dimon said regulators were not at fault. No, that’s not true. Regulators share some blame here, too. Banks—U.S. banks always paid insurance premiums for their deposit insurance. Ever since the FDIC was created after the Great Depression they always paid deposit insurance until 1996. For a decade banks paid no premiums for their deposit insurance. OK. Well, maybe—somebody else might be upset about this, too. OK? It’s a sign that banks for a decade not paying any deposit insurance premiums is ridiculous. And tomorrow when Sheila Bair testifies, that would be a great question to ask her. Why did they not pay deposit insurance for a decade? That’s analogous to getting car insurance and not—not paying premiums until you have an accident or getting life insurance and not paying premiums until you die. It just doesn’t work for an insurance scheme. Cause Nine: Government—government facilitated allocation of capital to the housing market, so government’s involved here, too. And Cause 10: Incentives. I think if there’s one word—after you spent all these months going through this, one word’s going to come up as being a key cause. And that one word is incentives. People do what they’re incented to do. And if you look at the banking industry compensation, what the industry pays out is pretty constant as a percentage of revenues. But guess what? That doesn’t reflect for the risk of those revenues. So if you hold a lot of treasury securities or if you make construction loans of if you own CDOs, it makes a big difference in terms of the degree of risk you’re taking. CHRG-111hhrg54869--137 Mr. Green," Was the CRA, the Community Reinvestment Act, the cause? " FinancialCrisisInquiry--599 CHAIRMAN ANGELIDES: Do you actually have a timer there, cause you ended at one second to go? CHRG-111shrg57320--44 Mr. Thorson," Right. Senator Coburn. Mr. Rymer, you note in your testimony some of the parallels between IndyMac, which failed in July 2008, and Washington Mutual. How should the IndyMac failure have informed the FDIC's handling of Washington Mutual? " CHRG-111hhrg54867--286 Mr. Lance," Thank you. But, as I understand it, you will have the ability to appoint new board members if the payment is not made. So I would hope that you would examine that situation by the 1st of November. Number three, regarding the tariff situation on Chinese tires, your opinion, sir? " CHRG-110shrg50414--156 Chairman Dodd," Senator Menendez. Senator Menendez. Thank you. Thank you, Mr. Chairman. As I listen here for a while, I get the sense that while you have given this a lot of thought, by the same token I get some sense that we are flying by the seat of our pants and that in that respect, you know, that you want to come in strong and have the cavalry be there, but you are not quite sure what the cavalry does once it arrives. And that is part of my concern here. The trouble is that these assets are so intertwined and complex that no one seems to be able to figure out what they are worth. And, hence, no one has been willing to buy them, which is why, Mr. Chairman, as you described, they have been in a lockdown mode. But you talked about the maturity price, and I just wonder how, in fact, since they are impossible to value as instruments at this point in time, how does one actually achieve that? If the Secretary pays the market rate, presumably if that was enough to be able to achieve the sale, that would be enough to persuade banks to sell already, so they would have sold. For that plan to work, then it would almost seem that you have to pay some type of a premium. And if that is the case--and I have heard the Secretary say many times we are going to look toward market mechanisms. Well, you know, some of us are concerned that market mechanisms have brought us to where we are today. So how do you know--how do any of these institutions even know how to bid, for example, in the reverse auction, if, in fact, they could not in the first place determine what the value is? And, therefore, how do we make the determination of what, in fact, the hold-to-maturity price is so that the taxpayers do not get left holding the bag? " fcic_final_report_full--454 Securitization and structured products . Securitization—often pejoratively described as the “originate to distribute process”—has also been blamed for the financial crisis. But securitization is only a means of financing. If securitization was a cause of the financial crisis, so was lending. Are we then to condemn lending? For decades, without serious incident, securitization has been used to finance car loans, credit card loans and jumbo mortgages that were not eligible for acquisition by Fannie Mae and Freddie Mac. The problem was not securitization itself, it was the weak and high risk loans that securitization financed. Under the category of securitization, it is necessary to mention the role of collateralized debt obligations, known as CDOs. These instruments were “toxic assets” because they were ultimately backed by the subprime mortgages that began to default in huge numbers when the bubble deflated, and it was diffi cult to determine where those losses would ultimately settle. CDOs, accordingly, for all their dramatic content, were just another example of the way in which subprime and other high risk loans were distributed throughout the world’s financial system. The question still remains why so many weak loans were created, not why a system that securitized good assets could also securitize bad ones. Credit default swaps and other derivatives . Despite a diligent search, the FCIC never uncovered evidence that unregulated derivatives, and particularly credit default swaps (CDS), was a significant contributor to the financial crisis through “interconnections”. The only company known to have failed because of its CDS obligations was AIG, and that firm appears to have been an outlier. Blaming CDS for the financial crisis because one company did not manage its risks properly is like blaming lending generally when a bank fails. Like everything else, derivatives can be misused, but there is no evidence that the “interconnections” among financial institutions alleged to have caused the crisis were significantly enhanced by CDS or derivatives generally. For example, Lehman Brothers was a major player in the derivatives market, but the Commission found no indication that Lehman’s failure to meet its CDS and other derivatives obligations caused significant losses to any other firm, including those that had written CDS on Lehman itself. Predatory lending . The Commission’s report also blames predatory lending for the large build-up of subprime and other high risk mortgages in the financial system. This might be a plausible explanation if there were evidence that predatory lending was so widespread as to have produced the volume of high risk loans that were actually originated. In predatory lending, unscrupulous lenders take advantage of unwitting borrowers. This undoubtedly occurred, but it also appears that many people who received high risk loans were predatory borrowers, or engaged in mortgage fraud, because they took advantage of low mortgage underwriting standards to benefit from mortgages they knew they could not pay unless rising housing prices enabled them to sell or refinance. The Commission was never able to shed any light on the extent to which predatory lending occurred. Substantial portions of the Commission majority’s report describe abusive activities by some lenders and mortgage brokers, but without giving any indication of how many such loans were originated. Further, the majority’s report fails to acknowledge that most of the buyers for subprime loans were government agencies or private companies complying with government affordable housing requirements. FinancialCrisisInquiry--77 THOMPSON: Well, there’s the old adage that if it sounds like too good of idea, maybe it is. And perhaps some of this oversight is management’s responsibility, not necessarily that of the regulator. So, Mr. Dimon, to what extent would you put the onus on you and your management team, not defer that necessarily to the regulator? DIMON: Well, I think I started my opening statements by saying that I blame the management teams 100 percent, and no—no one else. So it does not mean we shouldn’t look at what— what gaps are in the regulatory system. So if I was—if I was the regulator, I would say there should be no gaps in the system. There should be more authority to deal with certain types of more complex situations. New products should always be reviewed and aged. But I don’t think it’s unique to financial services. New products have problems. And, you know, give it a little bit of time before people leverage up on it. And so I think that the— it’s really the responsibility of committees. And I think most of these things can actually be fixed pretty quickly in a thoughtful way, you know, as you go through your work and receive where, you know, all the flaws were. One of the surprising things about all these things—a lot of the things we all talked about—mortgages, SIVs, derivatives—they were all known. They were not a secret out there. No one put it all together. There was no systemic regulator trying to look around the corner and say, “Well, if a money market fund has a problem, that’s going to cause a problem for X.” It’s not a mystery. It’s not a surprise. And we know we have crises every five or 10 years. My daughter called me from school one day and said, “Dad, what’s a financial crisis?” And without trying to be funny, I said, “It’s something that happens every five to seven years.” And she said, “Why is everyone so surprised?” So we weren’t—we shouldn’t be surprised, but we—we have to do a better job looking forward, no regulatory gaps, better disciplines in some of the companies, eliminate some of the off balance sheet stuff that helped facilitate some of the problems. CHRG-110hhrg44900--21 The Chairman," Thank you. Let me begin with the Secretary, because I was pleased to note in your statement that you understand that the regulator at OFHEO, of Fannie Mae and Freddie Mac, believe that they are now adequately capitalized. They were important institutions and I think that was--I'm pleased that you made that statement. I think that is important for people to understand. I said before that we are talking about more regulation done sensibly. Obviously there are still areas that the Secretary indicated where we could improve by simplifying regulation. That doesn't mean that it means more regulation everywhere. But there does seem to me to be emerging a consensus that we need a regulator concerned with threats to the systemic stability of the economy, that come from unconstrained risk-taking in a group of financial institutions outside the commercial banking system. And I was pleased, Mr. Secretary, that you mentioned hedge funds and investment banks. I think it would be a great mistake to talk about type of institution. That would give people an incentive to change their hats. We are talking about the impact of the activity, and we are talking I think, and a consensus appears to be emerging that it is going to be the Federal Reserve. I have to say that there are people who say, well, either you create a brand new regulator, it seems to me, which would be I think a mistake, or you give it to the Federal Reserve. And I agree with both of you, that in order to do that, the Federal Reserve needs more power. A situation in which the Federal Reserve is available and is under pressure to provide funding, but does not have the ability to act well before that time to diminish the need for that and to oppose conditions, that is unacceptable. We are talking, but we should be clear, about an increase in regulatory power. And let me say, you know, there was a time when the notion of requiring hedge funds to register was very controversial. It does seem to me that we have clearly gone beyond that. We are talking about giving the Federal Reserve the power to not just get information but to deal with various things which could include capital requirements and other factors. Now those are very important issues, and I think, as I said, there was a consensus emerging that it should be the Federal Reserve. And I have to say when people say, ``Well,'' they'll have this or that question about whether the Federal Reserve should do it, I invoke, as people have heard me do, the wisdom of a great 20th Century philosopher, Henny Youngman. The maxim was, ``How's your wife? Compared to what?'' And the Federal Reserve compared to what? I don't see any alternative to the Federal Reserve. But my question is this. I think this is an important task, and there's a great deal of agreement, that we should be moving to empower the Federal Reserve to have regulatory authority over a wide range of financial institutions in recognition in part of the fact that they have a systemic impact and that the current situation puts the Fed in an untenable position of being given a set of expectations to respond when it doesn't have the full panoply of tools to respond. But here is the question: How soon? Now we are where we are. It is July of an election year. This is a very complex subject. We don't want to do anything that would interfere with our wonderful financial system. And I mean our wonderful financial system, which has been so productive. We want to curb abuses without interfering with the productive function. Mr. Secretary, you said that they don't now have that authority, and we all agree with that. Is it essential that we move now? My sense is this--and I applaud the signing of the memorandum of understanding between the SEC and the Fed. That kind of cooperation has been useful. The cooperation between your two entities has been useful. I guess there are two options. One is that we have to try and legislate something now. And let me say we should distinguish. Mr. Secretary, you had a broader set of recommendations involving thrift institutions and credit unions, and a whole lot of things that no one in this institution is eager to deal with. So nobody is in any hurry on those. But we have I think taken out of that--and you have elaborated with the resolution issue--the question of macro-stability regulator, of the Federal Reserve being given powers to deal with the problems that could come to a system from someone too big or too unconnected to fail. Here is the question: Working together as we have within existing authorities, with yourselves, with I hope cooperation--that you understand cooperation with us--can we get by until the end of the year? We obviously will start working on this. Is it your view that immediate legislation is necessary? Or are we able to get by, given the cooperation we have had, given the kind of support we try to give you as much as possible, and begin working immediately together, so that early next year, one of the first items on the congressional agenda will be the legislation you talked about? Let me ask each of you to respond. " FOMC20080109confcall--18 16,MR. FISHER.," Dave, you very eloquently summarized in your statement that downside risks are more palpable. Certainly they seem to be more palpable. But the bigger adjustments I see in your numbers, at least for the first quarter of 2008 and for the year 2008--even larger than the adjustments you made on economic growth--are those on inflation. I'm wondering if you could just comment on that, please, and give us a sense of that palpability, as it were. " FOMC20080430meeting--19 17,MR. LACKER.," Yes. Mr. Chairman, you motivated the expansion of the term securities lending facility by the effect it would have by increasing the amount of Treasuries in the market. Vice Chairman Geithner, you appealed to the effect it would have on the asset-backed securities that would be offered on the market. We didn't discuss the asset-backed securities market, except that I had this exchange with our Manager. I am not aware of any evidence that there is something wrong with the fundamentals of those markets. Now, admittedly, it is not clear that many of our arguments for some of these facilities have been based on some careful diagnosis of fundamentals. If this is about those asset-backed securities markets, that is another thing entirely. I was a little confused about that and wondered about the rationale. " FinancialCrisisInquiry--167 BASS: There are three parts to OTC derivatives that you must focus on. One is the CDS market. The second is the foreign exchange derivatives market. WALLISON: I’m only talking about the CDS market and how it continued to function. BASS: OK. When Lehman failed, every single CDS contract was settled perfectly. Money was paid. Balances were transferred. Things closed. WALLISON: Right. BASS: So I wouldn’t say derivatives, per se, caused it or let’s say made it worse. I think that the fact that they were able to take on as much risk as they took on by not posting collateral—the point I’m making is they put too many of them together as opposed to the fact that their use is imprudent. I think there’s a great place for credit derivatives. I think there’s a great place for CDS. But I think that not posting collateral to initiate positions and enabling you to take infinite risks like AIG did and like Lehman did is a problem. WALLISON: CHRG-111hhrg53021--10 Mr. Lucas," Thank you, Mr. Chairman and thank you to both Chairmen for holding this joint hearing to hear the Treasury's proposal to regulate over-the-counter derivatives, as well as examine the legislation that the House Agriculture Committee passed a few months ago. I, as Ranking Member of the House Agriculture Committee and senior Member of the Financial Services Committee, I would like for this occasion to examine the issue from two different perspectives. The Agriculture Committee has been very active in exploring the role derivatives play in the marketplace, and in the overall economy. The Committee has held numerous hearings to gain further information and insight into the complex nature of credit default swaps and how they should be regulated. In February of this year, as the Chairman noted, the Agriculture Committee passed H.R. 977, the Derivatives Markets Transparency and Accountability Act. No one can argue that the concepts of transparency and accountability are wrong, but we must make certain that our actions call for an appropriate level of regulation that will respect the nature of the marketplace and encourage product innovation and economic growth. Derivatives do serve a valid purpose in the marketplace when used with judgment. They are essential for managing risk. We must consider that there are numerous industries that have legitimate price risk and there must be a way to mitigate that. Derivatives provide a legitimate means for managing that risk. The financial problems that we have seen recently are not the result of merely the existence of derivatives, but rather because there are problems in measuring their true performance, or knowing with certainty the depth and breadth of the over-the-counter market, or knowing with confidence the creditworthiness of the counterparty. Simply put, the marketplace can be protected from market failures if regulators are fully aware of the threat. Ignorance of this relatively new financial instrument caused much of the financial failures. We now know that these complex markets need better models and methods for oversight and transparency. However, we must be careful not to overreach and force businesses into very expensive clearing operations that cost capital that they do not have, or force them out of risk mitigation all together. Business will then be forced to manage risk with higher prices, which will ultimately be passed on to consumers. The need to avoid artificial costs for business was the reason I opposed the clearing requirement in H.R. 977. There is considerable concern that section 13, as currently drafted, which relates to the clearing requirement will stifle invasion in the over-the-counter market. CFTC needs more authority to waive the clearing requirements in section 13 so new and safer products can get to the market in a timely fashion. This would recognize the fact that not all contracts can be cleared and that there is a need for customized contracts. These are just a few of the concerns I have on my part as we move forward today. Again, I thank you for the opportunity to discuss the issues regarding these important financial institutions. And Secretary Geithner, I look forward to your testimony and the answers to the questions posed by the panel. Thank you, Chairman. " CHRG-111hhrg53021Oth--10 Mr. Lucas," Thank you, Mr. Chairman and thank you to both Chairmen for holding this joint hearing to hear the Treasury's proposal to regulate over-the-counter derivatives, as well as examine the legislation that the House Agriculture Committee passed a few months ago. I, as Ranking Member of the House Agriculture Committee and senior Member of the Financial Services Committee, I would like for this occasion to examine the issue from two different perspectives. The Agriculture Committee has been very active in exploring the role derivatives play in the marketplace, and in the overall economy. The Committee has held numerous hearings to gain further information and insight into the complex nature of credit default swaps and how they should be regulated. In February of this year, as the Chairman noted, the Agriculture Committee passed H.R. 977, the Derivatives Markets Transparency and Accountability Act. No one can argue that the concepts of transparency and accountability are wrong, but we must make certain that our actions call for an appropriate level of regulation that will respect the nature of the marketplace and encourage product innovation and economic growth. Derivatives do serve a valid purpose in the marketplace when used with judgment. They are essential for managing risk. We must consider that there are numerous industries that have legitimate price risk and there must be a way to mitigate that. Derivatives provide a legitimate means for managing that risk. The financial problems that we have seen recently are not the result of merely the existence of derivatives, but rather because there are problems in measuring their true performance, or knowing with certainty the depth and breadth of the over-the-counter market, or knowing with confidence the creditworthiness of the counterparty. Simply put, the marketplace can be protected from market failures if regulators are fully aware of the threat. Ignorance of this relatively new financial instrument caused much of the financial failures. We now know that these complex markets need better models and methods for oversight and transparency. However, we must be careful not to overreach and force businesses into very expensive clearing operations that cost capital that they do not have, or force them out of risk mitigation all together. Business will then be forced to manage risk with higher prices, which will ultimately be passed on to consumers. The need to avoid artificial costs for business was the reason I opposed the clearing requirement in H.R. 977. There is considerable concern that section 13, as currently drafted, which relates to the clearing requirement will stifle invasion in the over-the-counter market. CFTC needs more authority to waive the clearing requirements in section 13 so new and safer products can get to the market in a timely fashion. This would recognize the fact that not all contracts can be cleared and that there is a need for customized contracts. These are just a few of the concerns I have on my part as we move forward today. Again, I thank you for the opportunity to discuss the issues regarding these important financial institutions. And Secretary Geithner, I look forward to your testimony and the answers to the questions posed by the panel. Thank you, Chairman. " FinancialCrisisInquiry--144 Right. So what I’ve done for you, and in my presentation, is I’ve given the salient facts of—of the time period in question. What I’m happy to supply you with is the full spreadsheet of—of these numbers. And these numbers were aggregated from 10-Ks, -Qs and their off balance sheet reporting, so it was all publicly available data. HOLTZ-EAKIN: OK. BASS: So I’m happy to just supply that with you—for you. HOLTZ-EAKIN: That would be great. Thank you. BASS: I don’t have it here in front of me, but I have a full data set for you. HOLTZ-EAKIN: OK. That would be great. And so this is 2007, we have leverage at 68 to one. And what we heard from the panel this morning again and again in their written testimonies, oral remarks, were everyone became too levered. We’re, you know, going the other way now. But what I did not hear, even in the discussion of their risk management practices, is how the leverage got determined, how internal calculations were done about appropriate levels of leverage, and how they affected their risk management regimes and their expected outcomes. So I was wondering if you could give us your perspective on how that was done in the industry if there have been significant changes in it, and the extent to which this can only be imposed externally. 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. " CHRG-110hhrg44900--177 Mr. Roskam," Thank you, Mr. Chairman. Mr. Chairman, I was involved in a meeting with you and other members a couple of weeks ago where you kind of walked through the decisionmaking that you and your leadership went through in the Bear Stearns situation and kind of in a nutshell, I don't want to over-characterize this, but you're the umpire. You're calling balls and strikes. You called it a strike, did what you felt like you had to do. Others called it a ball. But you made it very clear that you weren't happy about that situation and you made it clear that there's a plan moving forward. In your testimony today, you outlined three points. I just would like you to focus in, and I don't think this will take all 5 minutes, and I'll give you all the time. Could you focus in particularly on the supervision piece as it relates to investment banks, and could you comment on the interplay between statutory change that you might think necessary, the regulatory piece that are rules that you can promulgate in relationship with the Securities and Exchange Commission. But also, could you please comment on the attitude of the investment banks and kind of what is the backdrop of the conversation? Because basically dad came home, right? I mean, at the party, and looked around, and what is the look in their eye as they're interacting with you and the demeanor going forward? " 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. " CHRG-111shrg52966--32 Mr. Cole," Right, and---- Senator Bunning. If you sat on your hands, which the Fed did in overseeing mortgages and mortgage lenders and banks that were under your jurisdiction, then I think that the Fed is a failure in doing what they are supposed to do. For anyone, did the board of directors understand the risk their firms were taking? " FOMC20080130meeting--251 249,MR. MISHKIN.," Also an issue that the Chairman raised yesterday was that the housing market is a big component of our downside risk. The market's concerns about future declines in housing prices are causing a very sharp decrease in demand for housing. That could turn around very quickly as well. Even now we should be thinking about these issues, and Governor Kohn's use of the word ""nimble""--I like ""flexibility,"" but I think ""nimble"" is probably a better word--is really I think key here. It is somewhat of a departure from normal--exactly what the Chairman said. This episode is different from past episodes. So we do need to start thinking about this, and the staff will need to think about exactly these issues. " 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-111shrg54589--128 PREPARED STATEMENT OF HENRY T. C. HU Allan Shivers Chair in the Law of Banking and Finance, University of Texas Law School June 22, 2009The Modern Process of Financial Innovation and the Regulation of OTC Derivatives *Introduction Mr. Chairman and Members of the Subcommittee, thank you for the invitation of June 15 to testify. My name is Henry Hu and I hold the Allan Shivers Chair in the Law of Banking and Finance at the University of Texas Law School. 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 more than two decades, and, after this forthcoming government service, will return to my normal academic duties. My testimony reflects solely my preliminary personal views and does not reflect the views of the SEC or any other entity. The below testimony has not been discussed with, or reviewed by, the SEC or any other entity. I ask that this written testimony also be included in the record.--------------------------------------------------------------------------- * Copyright 2009 by Henry T. C. Hu. All rights reserved.--------------------------------------------------------------------------- This is a seminal time as to the regulation of credit default swaps and other over-the-counter derivatives. \1\ Speaking on March 26, Treasury Secretary Timothy Geithner stated that the markets for OTC derivatives will be regulated ``for the first time.'' Last Wednesday, as a key element in a ``new foundation for sustained economic growth,'' President Barrack Obama proposed the ``comprehensive regulation of credit default swaps and other derivatives that have threatened the entire financial system.'' All OTC derivatives dealers and other firms whose activities create large exposures would be subject to ``robust'' prudential supervision. ``Standardized'' OTC derivatives would be required to be cleared through regulated central counterparties. Record keeping and reporting requirements would apply to both ``standardized'' and ``customized'' OTC derivatives. New steps to better ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties would be adopted. Regulated financial institutions would be encouraged to make greater use of regulated exchange-traded derivatives.--------------------------------------------------------------------------- \1\ As Subcommittee Members are already aware, a ``derivative,'' at least in the classical sense, is an agreement that allows or obligates at least one of the parties to buy or sell an asset. Fluctuations in the asset's value would affect the agreement's value: the agreement's value derives from the asset's value, whether the asset is a stock, commodity, or something else. Many derivatives trade on organized exchanges; people using such ``exchange-traded derivatives'' generally need not worry about who is on the other side of the transaction. The exchange's ``clearinghouse'' is effectively the buyer to every seller and the seller to every buyer. These products typically have standardized contractual terms and exchange-traded derivatives markets have been active in the U.S. since the 19th century. In contrast, the market for ``OTC derivatives'' arose in the late 1970s. These agreements are individually negotiated, such as between financial institutions or between financial institutions and their corporate, hedge fund, or other institutional customers. In the 1970s, a conceptual revolution in finance helped financial institutions to price derivatives, hedge associated risks, and develop new products. At least in the past, there were generally no clearinghouse arrangements. Each participant relies on the creditworthiness (and sometimes the collateral) of the party it deals with. ``Credit default swaps'' are one kind of OTC derivative. At their simplest, they involve bets between two parties on the fortunes of a third party. A protection buyer might, for instance, have lent money to the third party and be concerned about repayment. For a fee (or stream of fees), the protection seller will pay the protection buyer cash upon a specified misfortune befalling the third party. A derivatives dealer enters into such bets with its customers, as well as with other dealers. For more background, see, e.g., Henry T. C. Hu, ``Swaps, the Modern Process of Financial Innovation and the Vulnerability of a Regulatory Paradigm'', 138 University of Pennsylvania Law Review 333 (1989) [hereinafter Hu, ``Modern Process'']; Henry T. C. Hu, ``Misunderstood Derivatives: The Causes of Informational Failure and the Promise of Regulatory Incrementalism'', 102 Yale Law Journal 1457 (1993) [hereinafter Hu, ``Misunderstood Derivatives''].--------------------------------------------------------------------------- Key government officials central to developing the President's proposal are testifying today. It is my understanding that the Subcommittee thought that, rather than similarly discussing the specific components of the proposal, I might offer a more general perspective on the regulation of OTC derivatives, based on some of my past writings. In this context, perhaps the four questions set forth in the Subcommittee's June 15 invitation revolve around a basic issue: what's special about regulating OTC derivatives, in terms of transparency, risk, international coordination, or other matters? In this respect, I am reminded of something that Woody Allen once said: ``I took a speed reading course and read War and Peace in twenty minutes. It involves Russia.'' OTC derivatives are no less complex that Napoleonic Russia. In the next few minutes, I will try to offer some thoughts on how to frame the regulatory task that lies ahead. Because I have had to review the Administration proposal and prepare this testimony in the space of only a few days, these thoughts are preliminary and incomplete. I suggest that it would be useful to consider not just the characteristics of individual OTC derivatives, but also the underlying process of modern financial innovation through which products are invented, introduced to the marketplace, and diffused. This process perspective may further the identification of some issues that are important as a regulatory matter. I start with two contrasting visions that have animated regulatory attitudes ever since the emergence of the modern financial innovation process in the late 1970s. (Part II) This may help ensure that, as the Administration's proposal is reviewed or fine-tuned with respect to such matters as ``encouraging'' a migration to exchange-traded derivatives and distinguishing ``standardized'' from ``customized'' OTC derivatives, consideration is given not only to the private and social costs of OTC derivatives, but to their private and social benefits as well. I will then turn to how the financial innovation process results in decision-making errors, even at the biggest financial institutions. (Part III.A) In a Yale Law Journal article published in 1993, I suggested that, because of compensation structure, cognitive bias, human capital, ``inappropriability,'' and other factors characteristic of that innovation process, ``sophisticated'' financial institutions can misunderstand--or act as if they misunderstand--the risks of derivatives and other complex financial products. \2\ Analyzing how these errors occur may be helpful as the Administration seeks to undertake, for instance, the prudential supervision of derivatives dealers and reforms relating to compensation disclosures and practices, internal controls, and other corporate governance matters, at such dealers and perhaps at publicly held corporations generally.--------------------------------------------------------------------------- \2\ Hu, ``Misunderstood Derivatives'', supra note 1.--------------------------------------------------------------------------- The innovation process also leads to informational complexities well beyond the usual ``transparency'' issues, and to related difficulties. \3\ (Part III.B) Regulator-dealer informational asymmetries can be extraordinary--e.g, regulators may not even be aware of the existence of certain derivatives, much less how they are modeled or used. These asymmetries are especially troubling because of the ease with which the financial innovation process allows for the gaming of traditional classification-based legal rules (e.g., ``cubbyholes''). Responding to these complexities is difficult. As an example, beginning in 1993, I have argued for the establishment of a centralized, continuously maintained, informational clearinghouse as to all OTC derivatives activities and outlined some of the key questions that must be answered in creating such an informational clearinghouse. Especially in the wake of the disasters in 2008, regulators have begun working vigorously with derivatives dealers and others to establish data-gathering systems with respect to credit default swaps and other OTC derivatives.--------------------------------------------------------------------------- \3\ As to the issues outlined in this paragraph, see Hu, ``Modern Process'', supra note 1; Hu, ``Misunderstood Derivatives'', supra note 2; cf. Matthew Leising, ``Wall Street to Clear Client Credit Swaps by Dec. 15'', Bloomberg, June 2, 2009 (on recent interactions between the Federal Reserve Bank of New York and financial institutions).--------------------------------------------------------------------------- Finally, I turn briefly to a particular example of the financial innovation process, one that can help shape governmental responses to credit default swaps (CDS) and securitized products, another financial innovation that is sometimes also considered a derivative. (Part IV) The process of what can be called ``decoupling'' or, more specifically, its ``debt decoupling'' form, can undermine the ability of individual corporations to stay out of bankruptcy and can contribute to systemic risk. I discuss ``empty creditor'' and ``hidden noninterest'' issues. I will leave aside ``empty voter'' and ``hidden (morphable) ownership'' issues on the ``equity decoupling'' side. \4\--------------------------------------------------------------------------- \4\ As to the issues outlined in this paragraph, see, e.g., Henry T. C. Hu & Jay Westbrook, ``Abolition of the Corporate Duty to Creditors'', 107 Columbia Law Review 1321, 1402 (2007); Henry T. C. Hu & Bernard Black, ``Equity and Debt Decoupling and Empty Voting II: Importance and Extensions'', 156 University of Pennsylvania Law Review 625, 728-735 (2008); Henry T. C. Hu & Bernard Black, Debt, ``Equity and Hybrid Decoupling: Governance and Systemic Risk Implications'', 14 European Financial Management 663, 663-66, 679-94 (2008), draft available at http://ssrn.com/abstract=1084075; Henry T. C. Hu, `` `Empty Creditors' and the Crisis'', Wall Street Journal, April 10, 2009, at A13; ``CDSs and Bankruptcy--No Empty Threat'', The Economist, June 18, 2009.---------------------------------------------------------------------------Two Contrasting Visions of the Financial Innovation Process From the beginning of the explosive growth of the derivatives market in the early 1980s, two visions have animated the debate over the regulation of derivatives and new financial products generally. 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. Typically 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 an array of esoteric models laden with incomprehensible Greek letters. But danger lurks. As financial creatures are invented, introduced, and then evolve and mutate, exotic risks and uncertainties arise. In its most fevered imagining, not only do the trillions of mutant creatures destroy their creators in the wholesale capital market, but they escape and wreak havoc in the retail market and in economies worldwide. This first vision, that of Jurassic Park, focuses on the chaos that is presumed to result from financial science. This chaos is at the level of the entire financial system--think of the motivation for Federal Reserve's intervention as to Long-Term Capital Management (perhaps inappropriately named) in 1998 or as to American International Group in 2008--or at the level of individual participants--the bankruptcy of Orange County in 1994 or the derivatives losses at Procter & Gamble (perhaps appropriately named) in 1994. The second vision is the converse of the first vision. The focus is on the order--the sanctuary from an otherwise chaotic universe--made possible by financial science. The notion is this: corporations are subject to volatile financial and commodities markets. Derivatives, by offering hedges against almost any kind of price risk, allow corporations to operate in a more ordered world. As the innovation process goes on, the ``derivative reality'' that corporations can buy becomes ever richer in detail. If the first vision is that of a Jurassic Park gone awry, the second vision is of the soothing, perfect hedges found in a formal English or Oriental garden. There are certainly private and social costs associated with derivatives besides the chaos derivatives sometimes bring. Similarly, there are private and social benefits beyond the risk management possibilities of derivatives. \5\--------------------------------------------------------------------------- \5\ As to some of the other benefits of derivatives, see Darrell Duffie and Henry T. C. Hu, ``Competing for a Share of Global Derivatives Markets: Trends and Policy Choices for the United States,'' preliminary June 8, 2008, draft available at http://ssrn.com/abstract=1140869 (the views in said draft are solely those of the authors and do not reflect those of anyone else). Similarly, beyond OTC derivatives and looking at the regulation of capital markets and institutions overall, the minimization of systemic risk, short- or long-term, should not be the sole touchstone for regulatory policy. In the interests of the proper allocation of resources and long-term American economic growth, care must be taken that our capital markets not only remain firmly rooted in full and fair disclosure, but are perceived to be so rooted by investors worldwide.--------------------------------------------------------------------------- I make a basic point here. In a financial crisis, especially one with deep derivatives roots, it is too easy to focus solely on the dark side of OTC derivatives. Directly encouraging regulated financial institutions to migrate to exchange-traded derivatives has benefits as well as costs. Similarly, the differing regulatory regimes for ``standardized'' and ``customized'' OTC derivatives will trigger differing burdens. As to these and other decisions, careful consideration of the net impact of regulatory efforts will be necessary.The Financial Innovation Process: Decision-Making Errors and Informational ComplexitiesDecision-Making Errors Financial institutions focused solely on shareholder interests would generally take on more risk than would be socially optimal. At least in the past, governments typically constrained risk-taking at financial institutions, but not elsewhere. But as for financial institution decision making with respect to derivatives, much more than a gap between shareholder- and social-optimality is involved. There is a repeated pattern of outright mistakes, harmful to shareholders and societies alike, even at ``sophisticated'' entities. Why? In the 1993 ``Misunderstood Derivatives'' article, I argued that several of the factors stemmed from the underlying process of modern financial innovation. These factors may cause even the best financial institutions and rocket scientists to misunderstand (or behave as if they misunderstand) derivatives. I also offered some possible responses, both in terms of disclosure (including enhanced compensation disclosure) and in terms of substantive measures (including measures to encourage proper consideration of legal risks). One factor is cognitive bias in the derivatives modeling process. Humans often rely on cognitive shortcuts to solve complex problems; sometimes these shortcuts are irrational. For instance, one of the cognitive biases undermining derivatives models is the tendency to ignore low probability-catastrophic events. Psychologists theorize that individuals do not worry about an event unless the probability of the event is perceived to be above some critical threshold. The effect may be caused by individuals' inability to comprehend and evaluate extreme probabilities, or by a lack of any direct experience. This effect manifests itself in attitudes towards tornados, safety belts, and earthquake insurance. My 1993 article indicated that in the derivatives context, financial rocket scientists are sometimes affirmatively encouraged, as a matter of model design, to ignore low probability states of the world. I also showed how this tendency, along with other cognitive biases, may cause risks of a legal nature to be ignored. Certain public AIG statements are arguably consistent with the operation of this cognitive bias, though they do not necessarily prove the existence of the bias. For example, in August 2007, the head of the AIG unit responsible for credit default swaps stated: It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those [credit default swap] transactions. \6\--------------------------------------------------------------------------- \6\ Gretchen Morgenson, ``Behind Insurer's Crisis, Blind Eye to a Web of Risks,'' N.Y. Times, Sept. 28, 2008, at A1.Then again, perhaps he was right. AIG didn't lose one dollar; it lost billions. Similarly, AIG's Form 10-K for 2006 stated: The threshold amount of credit losses that must be realized before AIGFP has any payment obligation is negotiated by AIGFP for each transaction to provide that the likelihood of any payment obligation by AIGFP under each transaction is remote, even in severe recessionary market scenarios. Another factor flows from the inability of financial institutions to capture--to ``appropriate''--all the benefits of their financial research and development. This ``inappropriability'' can lead to the failure to devote enough resources to fully understand the risks and returns of these products. (This has implications for responding to securitization that have not been considered. As to asset-backed securities, inappropriability may well have contributed to the sacrificing of due diligence in favor of excessive reliance on ratings agencies.) One of the other factors flows from the incentive structures in the innovation process. In the derivatives industry, the incentive structure can be highly asymmetric. True success--or the perception by superiors of success--can lead to enormous wealth. Failure or perceived failure may normally result, at most, in job and reputational losses. Thus, there may be serious temptations for the rocket scientist to emphasize the rewards and downplay the risks of particular derivatives activities to superiors, especially since the superiors may sometimes not be as financially sophisticated (and loathe to admit this). Moreover, the material risk exposures on certain derivatives can sometimes occur years after entering into the transaction--given the turnover in the derivatives industry, the ``negatives'' may arise long after the rocket scientist is gone. The rocket scientist may have an especially short-term view of the risks and returns of his activities. I do not know if any of AIG's current or past employees succumbed to any such behavior, by reason of the incentive structure or otherwise. That said, it is a matter that would be worth looking into. According to the testimony of Martin Sullivan, the former CEO of AIG, until 2007, many employees at AIG Financial Products (AIGFP) (the subsidiary generating the losses leading to the AIG bailout) were being paid higher bonuses than he was. The head of AIGFP, Joseph Cassano, apparently made $280 million over 8 years. And when Mr. Cassano left AIG in February 2008, he was given, among other things, a contract to consult for AIG at $1 million a month--at least, if memory serves, until a pertinent Congressional hearing came along. The foregoing factors characteristic of the modern financial innovation process should be considered with respect to regulatory reforms. This applies not only with respect to how the Administration should engage in the prudential supervision of derivatives dealers but perhaps as well to such matters as the Federal role as to compensation disclosure and practices at publicly held corporations generally. These issues are quite complex, perhaps especially with respect to substantive (as opposed to disclosure) aspects of compensation: questions abound for any particular dealer or corporation, as well as for the proper role of the Federal Government in respect to those questions. How and when should ``profits'' on trades be calculated? What are the proper models for valuing complex derivatives and determining profits? How are risks and returns on particular types of instruments to be quantified? How should compensation be risk-adjusted?Informational Complexities and the Creation of an Informational Clearinghouse As noted earlier, a variety of informational complexities stem from the financial innovation process. One of the complexities stems from the fact that, historically, neither the introduction of new OTC derivative products nor individual OTC derivative transactions were required to be disclosed to any regulator. The informational predicate for effective regulation is absent. In ``Misunderstood Derivatives,'' I suggested the creation of an informational clearinghouse involving the centralized and continuous gathering of product information and outlined some of the key questions as to nature and scope that would need to be answered in actual implementation. Market participants would provide specified transaction-specific data in computerized form. Although providing actual market prices (transactional terms) may be sensitive, providing theoretical pricing models are sometimes likely to be far more so. The models the derivatives dealers use can be complex and proprietary. And market prices may depart substantially from valuations predicted by models. Especially after the CDS-related AIG debacle in September 2008, regulators have been moving aggressively to work with derivatives dealers and others to improve OTC derivatives data-gathering, particularly as to CDS. Perhaps there is a possibility of a fully centralized informational clearinghouse. This would necessitate international coordination well beyond the U.S.-U.K.-centric process that culminated in the pioneering 1988 Basel Accord for capital adequacy. A properly designed centralized informational clearinghouse must consider the extent to which proprietary information should really be required and, if or when required, reflect extensive safeguards. Moreover, complicated decisions lie ahead as to what information provided to regulators should be made available to the public.The ``Decoupling'' Process I now turn briefly to a particular example of the financial innovation process, consideration of which should help guide policy decisions with respect to CDS, securitized products, and other derivatives. Certain issues relating to CDS and to securitizations have become quite familiar. For example, everyone is by now aware of how American International Group's CDS activities helped cause AIG's near-collapse in September 2008. And, especially with President Obama's Wednesday speech and its reference to the need for ``skin in the game,'' most of us are familiar with the moral hazard, ratings agency, principal-agent, and other issues which cause securitized products to be mispriced or missold. And, in Part III.A, I have discussed how ``inappropriability'' issues in the financial R&D process should begin to be considered with respect to such matters as the inadequate due diligence done (and excessive reliance on ratings agencies) in connection with securitizations. Instead, I will focus here on the process that can be called ``debt decoupling.'' In August 2007, I began suggesting that the separation of control rights and economic interest with respect to corporate debt through swaps can cause a variety of substantive and disclosure problems, problems that become especially troublesome when economic times are bad. This debt decoupling analysis has been further developed and I rely on this analysis to illustrate these issues. Ownership of debt usually conveys a package of economic rights (to receive payment or principal and interest), contractual control rights (to enforce, waive, or modify the terms of the debt contract), other legal rights (including the rights to participate in bankruptcy proceedings), and sometimes disclosure obligations. Traditionally, law and real world practice assume that the elements of this package are generally bundled together. One key assumption is that creditors generally want to keep a solvent firm out of bankruptcy and (apart from intercreditor matters) want to maximize the value of an insolvent firm. These assumptions can no longer be relied on. Credit default swaps and other credit derivatives now permit formal ownership of debt claims to be ``decoupled'' from economic exposure to the risk of default or credit deterioration. But formal ownership usually still conveys control rights under the debt agreement and legal rights under bankruptcy and other laws. There could, for instance, be a situation involving what, in 2007, I termed an ``empty creditor'': a creditor may have the control rights flowing from the debt contract but, by simultaneously holding credit default swaps, have little or no economic exposure to the debtor. The creditor would have weakened incentives to work with a troubled corporation for the latter to avoid bankruptcy. And if this empty creditor status is undisclosed, the troubled corporation will not know the true incentives of its creditor as the corporation attempts to seek relief in order to avoid bankruptcy. Indeed, if a creditor holds enough credit default swaps, it may simultaneously have control rights and a negative economic exposure. With such an extreme version of the empty creditor situation, the creditor would actually have incentives to cause the firm's value to fall. Debt decoupling could also cause substantive (empty creditor) and disclosure (hidden noninterest and hidden interest) complications for bankruptcy proceedings. Have CDS-based empty creditor situations actually happened in the real world? Yes. On September 16, 2008, as AIG was being bailed out, Goldman Sachs said its exposure to AIG was ``not material.'' But on March 15, 2009, AIG disclosed it had turned over to Goldman $7 billion of the Federal bailout funds AIG received. Perhaps this could be referred to as ``The Curious Incident of the Bank That Didn't Bark.'' As I suggested in an op-ed in the April 10 Wall Street Journal, one reason Goldman Sachs did not express alarm in September is that it was an empty creditor. Having hedged its economic exposure to AIG with credit default swaps from ``large financial institutions,'' Goldman had lessened concerns over the fate of AIG. Yet Goldman had the control rights associated with the contracts that it had entered into with AIG (including rights to demand collateral). Perhaps not surprisingly, Goldman was apparently aggressive in calling for collateral from AIG. (I do not in any way suggest that Goldman did anything improper. Moreover, Goldman had obligations to its own shareholders.) Debt decoupling issues relating to multiple borrowers can also affect the economy. In the securitization context, servicing agents have little or no economic interest in the debt (and limited rights to agree to loan modifications) while senior tranche holders typically have most of the control rights (but, in contrast to junior tranche holders, little incentive to agree to modifications). As a result, the relationships between debtors and creditors tend to be ``frozen'': difficulties in modifying the debtor-creditor relationship can contribute to systemic risk. Front page headlines suggest the importance of loan modification difficulties in the securitization context; analyzing how debt decoupling contributes to these difficulties may be helpful in considering governmental policies as to asset-backed securities. The foregoing involves ``debt decoupling.'' ``Equity decoupling'' also occurs. Ownership of shares traditionally conveys a package (economic, voting, and other rights) and obligations (including disclosure). Law and contracting practice assumed that the elements of this equity package are generally bundled together. But outside investors and others can now decouple this link between voting (as well as other) rights on shares and economic interest in those shares. Financial innovations like equity derivatives and familiar tools like share borrowing used for decoupling purposes have affected core substantive and disclosure mechanisms of corporate governance. But today, I will leave aside analysis of ``empty voting,'' ``hidden (morphable) ownership,'' and related matters.Conclusion The President's proposal appears to offer a good starting point for review, with respect to OTC derivatives and otherwise. I make a modest claim: considering the special nature of the modern process of financial innovation can be helpful in the road ahead. Thank you. ______ CHRG-111hhrg48874--44 Mr. Posey," Thank you, Madam Chairwoman. I hope that we would all agree that the best solution to the crisis would be more private capital into the market. And just to save time, can you shake your head ``yes'' if you agree? And so we all agree. Wonderful. Ms. Duke, are we still approving charters for anybody who wanted to start putting a new institution out there and putting more private capital into the marketplace? Ms. Duke. I'm frankly not aware of how many charters the Federal Reserve has approved recently, but we are still approving charters. " FinancialServicesCommittee--27 Mr. B ACHUS . It seems there should have been some obligation by the brokers not to execute an order on a $30 stock at a penny. That is just good—I think that is a fiduciary relationship. Thank you, Mr. Chairman. Chairman K ANJORSKI . The gentleman’s time has expired. Now, we will hear from the gentleman from Texas, Mr. Hinojosa. Mr. H INOJOSA . Thank you, Mr. Chairman. Thank you for having this hearing. Before I make a statement and ask some questions, I ask unani- mous consent to enter into the record the Joint CFTC and SEC Ad- visory Committee on Emerging Regulatory Issues, dated May 10, 2010. Chairman K ANJORSKI . Without objection, it is so ordered. Mr. H INOJOSA . Thank you. I agree with my colleagues on both sides of the aisle that the Dow Jones Industrial Average plummeting 990 points, losing 22 percent of its total value cost caused a great deal of concern for those of us on the House Floor that Thursday afternoon. The S&P 500 dropped 20 percent, falling from 282 to 225 points, and this was the greatest loss Wall Street had ever received on a single day. I want to ask a question first of Chairman Schapiro. Was market fragmentation a key cause of last week’s 990 point drop in the Dow Jones index? Ms. S CHAPIRO . Congressman, I don’t think there is any question that the fact that we have a highly fragmented market is a contrib- uting factor here and creates challenges. It doesn’t have to be the result that we had last Thursday if the markets, while dispersed and many of them, play by the same rules and have the same trad- ing convention, so that if all of the markets are subject to halting trading in a stock when it reaches a certain price, then I think we would not have had some of the fallout that we had last week. Mr. H INOJOSA . Having a Brady Commission which has made lots of recommendations, tell me, have any of those recommendations been put into effect? Ms. S CHAPIRO . Oh, yes. The actual marketwide circuit breakers that exist today were a direct result of the Brady Commission’s re- port in January of 1988. One of the things we are also looking at jointly between the two agencies is whether those marketwide cir- cuit breakers that have the market shutting for brief periods of time when the DOW goes down 10, 20, and at 30 percent shutting completely need to be updated and modernized, and that is an ef- fort we are undergoing right now. Mr. H INOJOSA . So if you could tell me the similarities then of that October 19, 1987, market crash and give me the similarities, and is that being investigated so, as you said, that it not happen again? Ms. S CHAPIRO . Absolutely. If you look—I actually went back and looked at the Brady Commission report over the weekend and it is interesting that their findings are that there were multiple events that caused the market to decline—I believe it was 26 percent in October of 1987 on that day. And that is similar, I think, to what we will ultimately find here, that there were multiple contributing events. The difference is that trading largely took place at that time on the NASDAQ stock market and the New York Stock Ex- change. There were not multiple trading venues, although there was trading in the futures markets that was delinked from the trading in the equity market. CHRG-111shrg57923--35 Mr. Mendelowitz," Thank you. I really would like to go back to one of the issues you raised a few minutes back about interfering in the market. We rely on markets, in this case financial markets, to allocate capital because they do it efficiently, and we know from history when other societies have tried to rely on command and control systems to do those kind of functions, they failed miserably. But for financial markets or any other kind of market to do its job, which is to allocate scarce resources efficiently, there have to be a number of conditions met that make it possible for the markets to do that, and as you well know, if they are not present, the markets can't. The challenge in financial markets is that it is clear, and this recent crisis is the most glaring example of it, financial markets are prone to the financial equivalent of sudden cardiac arrest, and I would like to take credit for that, but it wasn't my analogy. It was a professor at MIT who came up with it. And that government intervention was needed to deal with this equivalent of sudden cardiac arrest. Now, maybe extending the analogy is a bit much, but there was a time when if you suffered sudden cardiac arrest, there wasn't much the medical profession could do for you. Then we moved to a stage where there are some sort of dramatic interventions at the point of a heart attack. Until now we are at the situation where you stave off sudden cardiac arrest with long-term care. You take statins to lower cholesterol and vulnerability. You are more careful about what you eat. You exercise, a little bit healthier lifestyle. And you, in effect, are able to reduce the risk of the sudden cardiac arrest. What we are talking about with what the NIF can contribute is, in fact, the sort of financial market equivalent of a healthier lifestyle, to preserve the efficiencies that you get out of the financial markets. Senator Corker. Thank you very much. I know I have gone on for a long time and I am sure you have a number of questions. Senator Reed. I don't. If you have additional questions, Bob, go ahead, please. Senator Corker. I have lots of questions. We spent a great deal of time with each of you and I have gotten a chance to know you, and I am sure that Courtney and Michael and Arlene and others will be talking with you over the course of the next week or so. I would ask, Mr. Horne, you mentioned you were looking at housing in North Carolina and Tennessee. I don't know for what reason. Maybe to purchase, I hope. [Laughter.] Senator Corker. But I wondered if you would tell me why and what you found. I wouldn't be a good Senator from Tennessee if I didn't ask. " CHRG-110shrg50414--146 Secretary Paulson," You cannot deal with this immediately. This is a huge market that has built up over a long period of time. It has also been extraordinarily useful in avoiding collapses and problems, letting institutions hedge themselves, as we went through--I could just go through situation after situation where, you know, Enron failed at great cost and human suffering, but the markets held up. So these are really valuable tools. It is a case where they grew too quickly, and when I talked earlier about we had a regulatory system that was static and did not change with the marketplace. And so the first work that has been done--and I think it would have to be done before you could regulate anyway--is all the work that Tim Geithner at the New York Fed has been leading with the industry to work out the transparencies and the protocols and the discipline in this market. And so---- " CHRG-109hhrg31539--147 Mr. Bernanke," Congressman, I agree with you. Growth doesn't cause inflation; what causes inflation is monetary conditions or financial conditions that stimulate spending which grows more quickly than the underlying capacity of the economy to produce. Anything that increases the economy to produce, be it greater productivity, greater workforce, or other factors that are productive, is only positive. It reduces inflation. " CHRG-111hhrg55811--377 Mr. Cleaver," Yes, I appreciate that. You and I are on the same wavelength. That is a concern. When he expressed that, I have frankly thought a great deal about that and wonder whether or not the ``too-big-to-fail'' is really something we are concentrating on. And that even if we conclude that we have come up with a solution to that, we still have a problem because of this interconnectedness. And I think my time is running out just as I was--all right. Thank you, Mr. Chairman. Mr. Moore of Kansas. The Chair next recognizes himself for a question. As we consider where to draw the line of jurisdiction between the SEC and the CFTC, I think Chairman Frank has a very interesting perspective. If you can eat it, it should remain the CFTC and the Agriculture Committee that has jurisdiction; but if it is a financial matter, it should remain with the SEC. In the grey areas like interest rate swaps and currencies I would like to hear from the entire panel whether the SEC or the CFTC should have jurisdiction of these items. Are interest rate swaps and currencies a financial matter that should be under the SEC's jurisdiction? I will start with my fellow Kansan, Mr. Hixson, and just go down the line if we could, please. " 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. " FOMC20050920meeting--16 14,MS. MINEHAN., So they are looking at this situation? CHRG-111hhrg74090--140 Mr. Radanovich," But they have not had preemptive status in this situation before. " fcic_final_report_full--481 PMBS are Connected to All Other NTMs Through Housing Prices But this does not mean that only the failure of the PMBS was responsible for the financial crisis. In a sense, all mortgages are linked to one another through housing prices, and housing prices in turn are highly sensitive to delinquencies and defaults on mortgages. This is a characteristic of mortgages that is not present in other securitized assets. If a credit card holder defaults on his obligations it has little effect on other credit card holders, but if a homeowner defaults on a mortgage the resulting foreclosure has an effect on the value of all homes in the vicinity and thus on the quality of all mortgages on those homes. Accordingly, the PMBS were intimately connected—through housing prices—to the NTMs securitized by the Agencies. Because there were so many more NTMs held or securitized by the Agencies (see Table 1), their unprecedented numbers—even in cases where they had a lower average rate of delinquency and default than the NTMs that backed the PMBS—was the major source of downward pressure on housing prices throughout the United States. Weakening housing prices, in turn, caused more mortgage defaults, among both NTMs in general and the particular NTMs that were the collateral for PMBS. In other words, the NTMs underlying the PMBS were weakened by the delinquencies and defaults among the much larger number of mortgages held or guaranteed as MBS by the Agencies. In reality, then, the losses on the PMBS were much higher than they would have been if the government’s housing policies had not brought into being 19 million other NTMs that were failing in unprecedented numbers. These failures drove down housing prices by 30 percent--an unprecedented decline—which multiplied the losses on the PMBS. Finally, the funds that the government directed into the housing market in pursuit of its social policies enlarged the housing bubble and extended it in time. The longer housing bubbles grow, the riskier the mortgages they contain; lenders are constantly trying to find ways to keep monthly mortgage payments down while borrowers are buying more expensive houses. While the bubble was growing, the risks that were building within it were obscured. Borrowers who would otherwise have defaulted on their loans, bringing an end to the bubble, were able to use the rising home prices to refinance, sometimes at lower interest rates. With delinquency rates relatively low, investors did not have a reason to exit the mortgage markets, and the continuing flow of funds into mortgages allowed the bubble to extend for an unprecedented 10 years. This in turn enabled the PMBS market to grow to enormous size and thus to have a more calamitous effect when it finally collapsed. If the government policies that provided a continuing source of funding for the bubble had not been pursued, it is doubtful that there would have been a PMBS market remotely as large as the one that developed, or that—when the housing bubble collapsed—the losses to financial institutions would have been as great. PMBS, as Securities, are Vulnerable to Investor Sentiment In addition to their link to the Agencies’ NTMs through housing prices, PMBS were particularly vulnerable to changes in investor sentiment about mortgages. The fact that the mortgages underlying the PMBS were held in securitized form was an important element of the crisis. There are many reasons for the popularity of mortgage securitization. Beginning in 2002, for example, the Basel regulations provided that mortgages held in the form of MBS—presumably because of their superior liquidity compared to whole mortgages—required a bank to hold only 1.6 percent risk-based capital, while whole mortgages required risk-based capital backing of four percent. This made all forms of MBS, including PMBS, much less expensive to hold than whole mortgages. In addition, mortgages in securitized form could be traded more easily, and used more readily as a source of liquidity through repurchase agreements. FOMC20051213meeting--128 126,MR. KOHN.," Thank you, Mr. Chairman. I support your proposition to tighten policy by 25 basis points today. And I agree with you that we’ll probably have to move in January, with a good deal of uncertainty about where we’ll go after that. If I could design the market reaction to our announcement—which I know from long experience I can’t—I would leave rates about unchanged when we’re finished, with some probability of tightening past January, but not 100 percent. Like you, I think we’re at a point where the momentum in demand and the level of resource utilization are such that if we’re going to make a mistake, we ought to err a bit on the side of going too far rather than stopping too soon. Exactly what the role of asset prices is in that is a much more difficult issue. I certainly see asset prices playing through to the macroeconomic situation, as you said—in particular, housing prices and the way they have stimulated not only residential construction but consumption more generally. And as I said in my remarks, I think we need to see some sign that that market is cooling December 13, 2005 85 of 100 about imbalances and put a little more emphasis on them, aside from the macro outlook, I think is a much more difficult question. In terms of the language, despite my expansive reading of the word “accommodative” at the last meeting, I support its deletion from the announcement and the wording of alternative B. I don’t think we have to go to a restrictive policy in this firming cycle, which I would define as a policy designed to cause the economy to run below potential in order to reduce inflation. I think I’ve just been reinforced in that judgment by the recent data on costs and prices. But we don’t need to get into linguistic hair-splitting to make our point about what we intend to do. I support taking attention off of a precise definition of “neutral,” which remains a shifting and elusive quarry. And that was inherent in the use of the word “accommodative.” In terms of the wording of the statement itself, I like alternative B as it is currently worded. I agree with you that moving from “is likely” to “may” would signal that we are about to stop, or that we think the odds are at best 50/50 that we’ll move again, and we would have a heck of a rally in financial markets. And as I said, I’d prefer to leave markets unchanged at the end of this. So I would go with “is likely” at this point, given my expectations, and save moving to “may” for the January meeting, if we think the odds are 50/50 for March. As for the word “measured,” I would prefer to keep it in the statement. To me, it means that we think we’ll be moving in 25 basis point increments, and I do believe that’s our intention. I’d be concerned that omitting it would be interpreted as an indication that the Committee would be looking at the possibility of moving in 50 basis point increments, and I don’t think that’s what we intend to do. In the phrase “measured pace,” I thought it was the word “pace” that tended to carry the concept of a series of moves, rather than the word “measured,” which, to me, meant 25. So I’m in favor of December 13, 2005 86 of 100" CHRG-110shrg50420--452 Chairman Dodd," People are watching. That is good. [Laughter.] Senator Corker. He, in essence, sent your applications back asking for more information, OK. So I take that as a rejection. Maybe I was a little bit too harsh. But the fact is that under 136, to receive funds, which you have all said are important to you, you have to be going entities. The Secretary has to certify, and this is pretty important, that each of you are going entities. Well, so I will go back to GM, which is why we are here, and again, I think you put forth a thoughtful plan, is you meet with people who follow you and invest in you. There are three things that basically cause you not to be a viable entity. As a matter of fact, we just got a quote while we were talking. In a 5-year credit default swap right now in your companies, basically, it is predicting that GM will default on its loans, 96 percent chance, OK, and Ford will default, 91 percent chance, and the large suppliers at 80 percent. So, I mean, you are really close to the end in most people's minds. There are three things that have kept GM, according to, I think, you and others, from being competitive. One is you have an unsustainable debt level. That has just occurred over time, and I realize we have had a pretty big peak to trough drop in cars sold, that it is unsustainable. And the fact is that all of you have got to be companies, in order to be successful, that whenever we get through doing whatever it is we might do, people are going to want to invest in you, right? I mean, that is the measure of a going concern. Will somebody else invest dollars in you? So reorganization is an interesting thing, because we know that going through that process, as painful as it is, you guys would come out without all the legacy stuff. To the dealers--I have had a lot of them calling in--probably a lot less dealers, and I am certainly not advocating that. That is just probably a fact of what would occur after bankruptcy. And the fact is, your cost structure would be far different. So I am going to try one more time, and I am going to ask Mr. Wagoner, if we put language in, and I know that we are somewhat paying attention here more so than we did I know the others, and probably because we didn't with the others, we are paying more attention with you--if we put something in--here is what is going to happen. If we put government dollars into General Motors, immediately, immediately, the day that money is deposited, your bond holders all of a sudden, instead of being willing to take 19 to 21 cents on the dollar, it is going to go way up because all of a sudden, we are in the game. And as Senator Bennett mentioned, we are patient and we print money here. I mean, there is no end to it, unfortunately. So that is a problem. That is a real problem. The bond holders, on the other hand, as I mentioned, are not going to take the kind of haircut they would unless Mr. Gettelfinger at UAW takes a bigger haircut, and Mr. Gettelfinger, you and I--I have to tell you, you have been an honest broker in this, too, in the way that you have talked with us and you have done a lot of things in the past, but the past is the past. We have got companies here that are about to go bankrupt and all of the contracts that you have negotiated, if they go bankrupt, are out the window, toast. It is over. All these VEBA arrangements, they are gone. So let me just ask of this as a reasonable thing to sort of put in place a bankruptcy-type situation where we would say that your bond holders would have to take 30 cents on the dollar, which is a 50 percent premium over where they are trading today, by March 31; that the UAW, and there are two representatives here that represent the folks in Tennessee and I have found them great to work with. The problem is that the rest of the citizens in our State and in Montana and in Connecticut and Utah, they have a tough time thinking about us loaning money to companies that are paying way, way above industry standard to workers while they are not getting paid that money. So in essence, they are subsidizing that through their taxpayer dollars. So my question would be, would it be reasonable to ask that the UAW by that time have agreed to pay scales that are equivalent to the transplants, and would it be reasonable that the UAW not just do away with the jobs bank, which is a situation where you continue to pay people whether they are working or not, but they also do away with the sub piece? Now, it is interesting sitting where I sit, because when labor comes in, they say, by the way, will you ask the companies this and make sure that they do that. And when the companies come in, they send me e-mails back saying, by the way, will you make sure that labor does away with these sub payments because they are worse by far than the job banks. They make us very, very uncompetitive. So again, if money goes out the door, we lose that leverage. It is over. The concern that Dr. Zandi has becomes real. It is never going to happen. There is no way the bond holders will do the things they need to do if they know the spigot is unlimited, and there is no way you can survive without a vastly changed capital structure. So if the Senate and the House were to say, we will forward the money to get you through March 31, period, and potentially more will come with a trustee, if your bond holders have gotten rid of their debt at 30 cents on the dollar, because if you bankrupt, it is toast, and if the UAW will get their wages rationalized to where we are paying exactly the same, not a penny more, to what the transplants are making, would that be something that you think would cause your companies to be where they need to be for the long haul? And by the way, I would add to that the VEBA payment of $21 billion is no small deal. That is a big deal. You can't pay that right now. That is not possible. So I would add to that that at least half of that would have to be equitized into the company to get the capital structure where almost every analyst in the world is looking at your company says you have to be to be that kind of going entity that would actually allow people to invest in you in the future, which is what you have got to have to be a successful company. Is that something that would be reasonable? " CHRG-111hhrg53021Oth--326 Chairman Frank," I have a proposal. We have a vote. There are three Members left on the Democratic side. I am wondering if Members could each do a minute and a half, pose a question and have the Secretary respond. Would that be acceptable. The gentleman from North Carolina, gentleman from Texas, gentleman from Illinois. Maybe we can shave it a little bit down to 1\1/2\ or 2 minutes for questions. Mr. Miller of North Carolina. Good morning, Mr. Secretary--or, good afternoon, Mr. Secretary. Most of what you have discussed, justifying derivatives--the purpose of derivatives is they are risk mitigation. They are like insurance. But it appears that there is no requirement with respect to derivatives that any party of the transaction actually have an interest in the underlying asset, the asset from which the derivative is derived. Obviously, if there is no risk to mitigate, it can't be risk mitigation. It doesn't appear to have anything to do with capital allocation. The only justification I have heard is it assists price discovery, and that the more transactions are based upon the value of an asset, the more accurate the price is. But that seems pretty thin given how huge the derivatives market is. Did you give any consideration to whether or not these products should be allowed at all, if they do anything useful for society? Do you think they---- " CHRG-111hhrg53021--326 Chairman Frank," I have a proposal. We have a vote. There are three Members left on the Democratic side. I am wondering if Members could each do a minute and a half, pose a question and have the Secretary respond. Would that be acceptable. The gentleman from North Carolina, gentleman from Texas, gentleman from Illinois. Maybe we can shave it a little bit down to 1\1/2\ or 2 minutes for questions. Mr. Miller of North Carolina. Good morning, Mr. Secretary--or, good afternoon, Mr. Secretary. Most of what you have discussed, justifying derivatives--the purpose of derivatives is they are risk mitigation. They are like insurance. But it appears that there is no requirement with respect to derivatives that any party of the transaction actually have an interest in the underlying asset, the asset from which the derivative is derived. Obviously, if there is no risk to mitigate, it can't be risk mitigation. It doesn't appear to have anything to do with capital allocation. The only justification I have heard is it assists price discovery, and that the more transactions are based upon the value of an asset, the more accurate the price is. But that seems pretty thin given how huge the derivatives market is. Did you give any consideration to whether or not these products should be allowed at all, if they do anything useful for society? Do you think they---- " CHRG-111hhrg53021Oth--143 Secretary Geithner," I think you are right, Congressman, that across the country, not just in your district, you still see businesses and families under enormous financial pressure. And you are still--and we are going to be living, for some time, with the consequences of digging out of this mess we started this year with. And so, in acknowledging and pointing out the fact that we have made very substantial progress in trying to repair the damage caused by this crisis and lay the foundation for recovery, we do not yet have an economy that is growing again. And, it is likely that this is going to take a while to come out of. But, that underscores, and the examples you pointed out, underscores the importance of this government doing everything we can to try to mitigate these pressures. And that is what the Recovery Act is designed to do, and that is what the programs we have done to help get credit flowing again are designed to do. And they are having their necessary desired effect; they are starting to get some traction. But you are absolutely right to emphasize that we have a ways to go. And, again, this is in families across the country that still feel they are under enormous financial strain. " CHRG-111hhrg53021--143 Secretary Geithner," I think you are right, Congressman, that across the country, not just in your district, you still see businesses and families under enormous financial pressure. And you are still--and we are going to be living, for some time, with the consequences of digging out of this mess we started this year with. And so, in acknowledging and pointing out the fact that we have made very substantial progress in trying to repair the damage caused by this crisis and lay the foundation for recovery, we do not yet have an economy that is growing again. And, it is likely that this is going to take a while to come out of. But, that underscores, and the examples you pointed out, underscores the importance of this government doing everything we can to try to mitigate these pressures. And that is what the Recovery Act is designed to do, and that is what the programs we have done to help get credit flowing again are designed to do. And they are having their necessary desired effect; they are starting to get some traction. But you are absolutely right to emphasize that we have a ways to go. And, again, this is in families across the country that still feel they are under enormous financial strain. " CHRG-111hhrg52400--215 Mr. Spence," That's a very good question. What the systemic risk regulator could do would be to try to ensure that examination of insurance companies' exposure was properly managed, whether the aggregation of risks in urban areas were properly managed. There are things they could try to do to improve the situation. But you are correct. Depending on the situation, there may not be much that could be done. " CHRG-111hhrg56766--234 Mr. Green," Would you agree that one of the things that we might do is try to help those countries where they have people working for pennies per day that may not have labor standards that people of goodwill would agree with? We might also try to influence what they do if we trade with them. It would not cause me as a person, a human being, to feel good about an effort that would cause persons to work for pennies a day and allow me to benefit when they are working under conditions that are less than tolerable by my standards. " CHRG-111shrg61513--108 Mr. Bernanke," We have worked together on it. The Federal Reserve has had concerns for a long time, and you were a supporter of very good, strong regulatory oversight of Fannie and Freddie. And unfortunately, you know, we know how it turned out, that they did not have enough capital. You know, I think the current situation is worrisome. It obviously is a costly situation. And it also generates a certain amount of uncertainty in markets as people try to anticipate, you know, what the U.S. housing financial situation is going to be in the future. Housing policy is a very big part of our financial policy in this country, and the lack of clarity about that is an issue. Now, again, let me just say I sympathize with Secretary Geithner in that there is an awful lot going on and financial reform is complex. But I do hope we will be thinking about where we want to take Fannie and Freddie soon so that we can at least provide some clarity to the markets and to the public about, you know, where we think this ought to be. Senator Shelby. Thank you, Mr. Chairman. Senator Reed. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Chairman Bernanke, welcome and congratulations on your confirmation. " CHRG-111shrg52619--63 Mr. Dugan," I think that is a very good question. I think capital is not enough by itself. I think you are right. And as I mentioned in my testimony, in the area of mortgages, I think if we had had or if we would have in the future some sort of more national standard in the area of--and if I think of two areas going back that I wish we had over again 10 years ago, it is in the area of stated income or no-documentation loans, and it is in the area of loan-to-value ratios or the requirement for a significant downpayment. Those are underwriting standards. They are our loan standards, and I think if we had more of a national minimum, as, for example, they have had in Canada and as we had in the GSE statutes for GSE conforming loans, I think we would have had far fewer problems. Now, fewer people would have gotten mortgages, and there would have been fewer people that would have been able to purchase homes, and there would be pressure on affordability. But it would have been a more prudent, sound, underwriting standard that would have protected us from a lot of problems. Senator Corker. I hope as we move forward with this you will continue to talk about that, because I think that is a very important component that may be left by the wayside. And I hope that all of us will look at a cause-neutral solution going forward. Right now we are focused on home mortgages and credit default swaps. But we do not know what the next cause might be. Mr. Tarullo, you mentioned something about credit default swaps, and I am not advocating this, but I am just asking the question. In light of the fact that it looks like as you go down the chain, I mean, we end up having far more credit default swap mechanisms in place than we have actual loans or collateral that is being insured, right? I mean, it is multiplied over and over and over. And it looks like that the person that is at the very end of the chain is kind of the greater fool, OK, because everybody keeps laying off. Is there any thought about the fact that credit default swaps may be OK, but the only people who should enter into those arrangements ought to be people that actually have an interest in the actual collateral itself and that you do not, in essence, put in place this off-racetrack-betting mechanism that has nothing whatsoever to do with the collateral that is being insured itself? Have there been any thoughts about that? " CHRG-111shrg50814--77 Mr. Bernanke," Well, Senator, you are absolutely right. Your point is very well taken. The short story is that for the last decade or so, Americans have been made wealthy by either their stockholdings if they had a 401(k) or by the value of their house. And if the value of your home goes up, you feel richer, but you do not save more because you feel richer. Your house is saving for you in some sense. And as a result, over that period, as asset prices were rising, Americans saved less and borrowed more from abroad. Now, earlier Senator Dodd asked me about asset values. As those asset values have come down, that means there has been a very painful adjustment. People, in order to rebuild their balance sheets, are going to have to save again. And in a way, that is good because we will turn over the next few years to a higher rate of national saving, less foreign borrowing, lower current account deficits, and that is a desirable place to go. The transition, though, is very difficult because as people switch from being high-spending to trying to save, the decline in consumer spending has contributed to this great weakness in the economy, and we have a situation where instead of saving more, we are just getting a deeper and deeper recession. So we have currently an emergency situation that includes both a very severe recession and a significant financial crisis, which must be addressed or else we will not have the kind of growth we need to support saving and investment going forward. So we need to address that in the short term, but as we do that, we also have to keep a very close eye on the need to reestablish fiscal discipline, to increase Americans' savings, to reduce our current account deficit. And in doing all those things, over time we will be able better to address those issues that you referred to. But we are in the middle of a transition where, frankly, if we were to try to balance the Federal budget this year, it would be very contractionary and probably counterproductive. " CHRG-111hhrg51592--71 Chairman Kanjorski," Right. Well, what would you say, just off the cuff, not based on studies, that if the first payment of a mortgage was not made, and if there were no records or support documents of income level, what likelihood would that reflect on the likelihood of default or failure of that type of a mortgage? " FOMC20071211meeting--117 115,MR. MISHKIN.," Thank you, Mr. Chairman. You are all aware that I have a very optimistic personality; and at the last FOMC meeting, I actually had that kind of optimism. I felt that the economy was evolving in a quite reasonable way and, in fact, was responding to our policy changes in a way that I felt was very appropriate in order to minimize the cost of the financial destruction that we’re experiencing. In particular, with the credit markets stabilized, we were in a situation in which our policy moves had reduced a lot of the macroeconomic risk that was out there in terms of credit spreads. Clearly we were still left with the opaqueness spreads or valuation risks that would require price discovery to resolve. It looked as though that was going to progress very slowly and over time we’d get out of the situation we were in and the economy would go through a solid rebalancing, moving away from some sectors that had too much going on—that is, housing—to sectors which we needed to expand—for example, the tradable sector—to deal with some of the global imbalances that we had. So I was actually feeling very positive. I felt that things were going exactly the way that I had hoped. Of course, things don’t always work out that way, and we started to see shortly after the October meeting a substantial deterioration in credit markets. My view is that the deterioration that we’re seeing is appropriately reflected in the substantial revision to the forecast. I’m very comfortable with the way the staff has revised the forecast downward. It’s obviously something that is an art because you have to do it in terms of add factors, but you do want to inform it by science, and I think they have appropriately done so in terms of thinking about what we’ve learned from past experiences that may tell us about how credit disruptions of this type will actually lead to lower spending in many categories. But I want to talk about why my sunny disposition is much less sunny right now and why I’m actually very, very worried—not to say depressed, but at least a little more that way than usual. It is because I think that the kind of negative scenarios that are pointed out in the Greenbook are very real possibilities. In particular, there are two scenarios that they go into separately—the housing correction scenario and the credit crunch scenario. I think that there’s a very strong possibility those would come together because, if housing prices go down more, that creates a much more serious problem in terms of valuation risk, and a serious problem in valuation risk will mean a further credit market disruption, which then can lead to more macroeconomic risk because it leads to this downward spiral. The real economy gets worse. That means that there is more uncertainty. Credit spreads get worse, and you get a very bad scenario happening. That could lead to the credit crunch scenario. Similarly, a credit crunch scenario, I think, would have a very negative effect on the real economy, which would mean that housing prices would go down, which would then make it much more likely that we have the greater housing correction scenario. So that’s the first part of my depression. The second issue is that the Greenbook does not go into the issue of what effect that might have overseas. There has been a lot of discussion in the media about decoupling the U.S. economy from foreign economies, and when it’s just trade that’s going on, I think that is usually completely reasonable. But when it’s financial, then there is very good reason to think of recoupling because a financial disruption in the United States is very likely to spread to financial disruption abroad. We, of course, have already seen that. It’s remarkable that what happened in the subprime sector has in some sectors affected European banks maybe even more than American banks. So the possibility that problems develop in the United States and lead to problems in Europe and other advanced countries and then those problems actually spill over back into the United States again means that there’s a third scenario that could be all tied together. When you look at all of this, I get very nervous. The bottom line is that my modal forecast is certainly down, very much along the lines of what the staff has suggested. But I think there is a significant probability that things will go south. You don’t like to use the R word, but the probability of recession is, I think, nearing 50 percent, and that really worries me very much. I also think that there’s even a possibility that a recession could be reasonably severe, though not a disaster. Luckily all of this has happened with an economy that was pretty strong and with banks having good balance sheets; otherwise it could really be a potential disaster. I don’t see that, but I do see that there is substantial risk that the economy could have a severely negative hit to it that would be very, very problematic. Now, when I look at the issue of inflation, I have a different view from many of the people at this table. I feel strongly that the one thing a central bank can never afford to do is to lose its nominal anchor. If we do that, it’s a disaster. With that viewpoint, I should say that, if shocks occurred such that recession was going to occur and the only way we could stop a recession from occurring was to inflate the economy, we couldn’t allow that to happen. We actually have to preserve the nominal anchor because, in the long run, the pursuit of price stability is what makes good monetary policy and has been a key reason for the remarkable success of monetary policy by the central bankers throughout the world in recent years that I think nobody would have predicted. But when I look at what’s going on in terms of inflation right now, I really do not see the substantial upside risk that a lot of people are talking about. For me the key driver of inflation is, as you know, inflation expectations. The question is whether inflation expectations are grounded, and I think the answer is “yes.” In fact, we’ve had a situation in which higher energy prices have not led to any upward movement in expected inflation as far as I can tell. Neither has the dollar declined—that actually happened when the economy was doing much better. Now we’re facing a situation in which we have some substantial negative shocks to the economy, and those substantial negative shocks actually, if anything, put some downside risk in terms of inflation. I don’t see that inflation will move much from 2 percent. One thing that has happened recently is that we have not seen some of the favorable inflation numbers. President Plosser talked about the fact that we’ve seen less favorable inflation numbers, but that’s because we had temporary factors that were going to make inflation look overly good and drive it below 2 percent. The staff strongly indicated to us in the Greenbook and in past Greenbooks that those temporary factors were not going to persist. They got that one right, but there’s no information from the fact that those temporary factors are no longer present that says that inflation pressures have actually heated up. Indeed, what we see is that inflation seems to be moving around 2 percent. That’s where I think inflation expectations are grounded, and I see no tendency at all for things to get much worse in that regard. I’m not saying that couldn’t change, and so I think we have to be very vigilant. But in the current environment, where I see a very negative potential path of the economy, the idea that inflation is our primary concern right now is not where I am. With that let me end." CHRG-111hhrg56847--19 Mr. Bernanke," Mr. Chairman, currently we are kind of in a transition period. As you know, Freddie and Fannie are in conservatorship. They are playing a very important role at the moment in providing a source of securitization for home mortgages. The private label mortgage backed security market is pretty much nonfunctional. Going forward, though, we need to get to a more sustainable situation. And I would be happy to talk about alternative models of reform. But I think everybody agrees that the current situation, the status quo, is not a sustainable one. We are going to need to reform those institutions going forward. " CHRG-111shrg57322--324 Mr. Birnbaum," No, I just want to understand the question. Senator Tester. I want to know when--look, a lot of these vehicles that were developed were based on housing. You guys are smart guys, and particularly I want to know from you, Mr. Birnbaum, when you saw the downturn, the potential collapse. You said the middle, end of 2006. I was wondering what you base that on, and you said the value of housing at that point in time. Or what did you say? " FOMC20070807meeting--52 50,MR. LACKER.," I guess my question was motivated by my sense that estimates of the current output gap tend to play an important role in your outlook for near-term inflation trends. To the extent that the current estimate of the output gap is derived from current inflation, I am wondering if it provides less independent information than current inflation about future inflation than one might otherwise have thought." CHRG-110hhrg44901--119 Mrs. Biggert," One aspect of the proposal would require creditors to provide transaction-specific mortgage loan disclosures, such as the APR and payment schedule for all home-secured closed-end loans no later than 3 days after application. This proposal sounds very similar to HUD's efforts to reform RESPA. I just wondered if you had worked with HUD in preparing this regulation. " FOMC20080625meeting--18 16,MR. PLOSSER.," Thank you, Mr. Chairman. Just to follow up on that question, I was at a meeting in New York not too long ago and was talking with some people on Wall Street. They suggested that for the primary dealers there was stigma attached to borrowing from the PDCF. I wasn't quite sure what to make of that, and I just wondered if you had any observations or comments about whether you thought that was real or perceived, or is there an interpretation I should give to that? " CHRG-111shrg51395--42 Mr. Turner," It is only 17 pages, so it is a little bit quicker read than Professor Coffee's. Senator Dodd, I think you are right. There are really three root causes of this problem: people made bad loans, gatekeepers sold out, and a lack of regulation or regulators missing in action, quite frankly. And it is not the first time. As an auditor in the Southwest, in Denver, I lived through this with the S&Ls, had to do restructurings, workouts at that point in time. And those issues were all existent then, and we are back to a repeat. So, as Mr. Doe and Mr. Silvers indicated, I think it is especially important that this go-round the Committee get it right. I know that there is some push to try to get something done by an August recess. I would say it is more important to hit this target. We have seen the markets are serviced, a trustee of two large institutional investors. We have seen legislation come out that has not instilled that confidence to date. And we need to get it right this time so we instill that confidence and do not see a market of 5,000, quite frankly. So I would ask you to take your time, whatever is necessary, sooner better than late, but I am not sure this is one that can be both fast and right. Senator Shelby, you asked someone to comment on the mark-to-market accounting. Being the one accountant, the one green eyeshade on this, let me say I could not agree more with you. The mark-to-market accounting that we are debating now is the same issue we debated two decades ago during the S&L crisis, and as the 1991 GAO report stated, the failure of the banks and the S&Ls during that travesty, to turn around, take marks down in a timely manner resulted in lax regulator action, people not getting on top of managing the assets and problems quick enough, and contributed to a significant increase in the cost to the taxpayers of that bailout. And so I would again urge you to push for transparency here, not step on those accounting standards, and let us get the real numbers. When you look at banks like Citigroup, who are trading at a stock price for less than what you can buy a Happy Meal these days at McDonald's, we know that the market clearly is not viewing those financials as credible, and we need to get that credibility back into the system. Certainly, as my fellow panelists mentioned, there are also gaps in regulation. Without a doubt, the credit derivatives market--we all know about that. You certainly have all heard about that as recently as this last week. But it was not so much the failure of a regulatory system, although things need to be fixed, as it was a failure of regulators to act. The Office of the Comptroller of the Currency, the SEC, both had risk management offices. The Federal Reserve had examiners day in, day out at Citigroup, and this was not the first time Citigroup became, for all practical purposes, insolvent and in need of a bailout. When I was at the Commission two decades ago, the exact same thing happened. And you ask, How can the Fed turn around and allow that to happen? I remember being in a meeting with banking regulators and the Chairman of the Fed some time ago, and I was asked, along with the Chairman of the SEC at the time, What is wrong if the banks are allowed to fudge the numbers a little bit? Now I think we know. If you turn around and ask me is that who you are going to make our systemic regulator, I would turn around and say, ``I would hope not.'' Rather, I think the notion that Professor Goldsmith, the former SEC Commissioner, has advocated as the council or commission--I think Damon talked on it as well--is a much better approach. You have got to give us this in investors, someone regulating that we can trust in. The notion of prudential supervision needs to be a notion that dies. What we want is actual regulators doing their job. That is what we are turning around and paying them for. Now, while certainly the SEC has fallen off the track here recently, I must say that over the years it has been very successful in its mission to protect investors and gain their confidence. I think investors would be ill served and very concerned if some other regulator with a mission other than investor and consumer protection, first and foremost, was given that leading role to protect them. As the Committee crafts a solution, I simply believe a focus on a systemic regulator in and of itself and doing regulation around just a systemic regulator does not get the job done. I think a more comprehensive single bill is the right way to go after that. And in doing so, I think you should focus on a few key principles that you need to ensure are established: independence in the system, transparency, accountability, enforcement of law, and making sure those responsible for doing the job have adequate resources. Following these key principles, as more specifically spelled out in the written statement, I think there needs to be a closure of the regulatory gaps such as with credit derivatives; SEC oversight over the investment banks; certainly the mortgage brokers who brought this problem upon us; greater accountability established through governance and investor rights, including private right of actions, as Damon has mentioned, for credit rating agencies; assisting others in the commission of fraud. Regulators simply cannot do it all and will never have enough resources, so we have to give institutional investors a chance to get justice and recover money when there has been fraud involved. We need to enhance transparency and disclosure, not only by the issuers but also by the regulators. The testimony last week where the Fed would not give us the names and the details behind the credit derivatives and who are really getting bailed out at AIG was most concerning and disappointing. There needs to be improvements in self-regulation, and there obviously needs to be better enforcement of the laws and regulation. But in the end, no agency here, neither the CFTC, SEC, the banking regulators, can do it without adequate resources. For example, the Office of Compliance and Inspections at the SEC, you are asking them to inspect 16,000 mutual funds, 11,000-plus investment advisers with 440 people. It simply cannot be done. At a minimum, the SEC needs $100 million to get the type of technology that just brings them up to what we use on the street in the market. If they do not even have those tools, there is no way they can supervise and stay on top of it--$100 million in technology, and then they need about another $85, $90 million, just to bring staffing up to the levels they were 4 to 5 years ago. And they need it now. They do not need it on October 1 of 2010. That needs to go into the budget now, not a year and a half from now. So I would certainly urge--and I know this is not the Appropriations Committee, but I would certainly urge the Senate to find a way to get them the resources. Without that, you are asking them to go into a gunfight with an empty gun, and we all know what happens then. So, with that, I will close and be happy to answer any questions. Thank you. " CHRG-111hhrg54867--7 Mr. Gutierrez," Mr. Secretary, first of all, thank you for appearing. Exactly 1 year ago, we experienced the most agonizing week of the current financial crisis. And this committee began to address the root causes of the social and economic trauma that crippled our economy and caused millions of Americans--and we should remember this--to lose trillions of dollars of their hard-earned wealth. Let me repeat that: Trillions of dollars of hard-earned wealth were lost by the American people. Not so much the guys on Wall Street, they lost, but the people on Main Street lost. Predatory mortgage lending, combined with risky investment practices and poor underwriting standards, financed by some of the largest financial institutions in this country, created the financial and economic debacle that we must now address. Over a decade ago, the Federal Reserve was given the power by this committee--I was here; I got elected in 1993--to stop predatory mortgage practices through the Homeowners' Equity Protection Act. It took the Federal Reserve 12 years to implement the rules and regulations that could have prevented many, if not all, of the worst abuses by predatory lenders and originators, abuses that were a direct and immediate cause of our current crisis. Why did it take so long? While there were many theories to explain this, I believe it took the Fed this ridiculously long time, including the FDIC, which did absolutely nothing either, because it was distracted by their other regulatory obligations and by a sense in Washington, D.C., of do less, do nothing, leave it alone, it is okay. The default of these toxic mortgages and the securitized products based on them caused trillions of dollars in losses and caused the 2008 freeze in credit markets, which nearly destroyed not only our financial system but the entire international financial system. The message to those of us who want to restore the stability to the financial system could be no clearer or louder. If we do not include a strong, effective Consumer Financial Protection Agency within our regulatory reform legislation, Congress will have failed to address the current and any future economic challenges facing our country. We must also address the economic threat inherent in institutions known as ``too-big-to-fail.'' I believe we must work to a comprehensive, risk-based pricing regime which eliminates the incentives for these financial firms to grow to the point of becoming ``too-big-to-fail.'' One of the ways we can prevent an institution from becoming ``too-big-to-fail'' is through a pricing regime which discourages banks from growing so large and interconnected. We must not only increase capital requirements, but we should also require decreased leverage ratios and increased contributions to the Deposit Insurance Fund. Let me ask that this be submitted for the record, my complete statement, because it is clear to me, Mr. Chairman, we are going to have, you know, our classical debate. Our colleagues on the other side have already thrown health care into this, big government. I hear ``socialism'' coming any second. They are going to say, ``No, no, no. Global warming doesn't exist, no. We don't need to do anything about global warming. We really don't need to do anything about this.'' We do need to do something, and Mr. Geithner knows it probably better than anybody else. We can never allow a Lehman Brothers again to have a 30:1 ratio. We can't allow that kind of leverage. And government is the only one that is going to stop it from happening again. Thank you very much, Mr. Chairman. " CHRG-111hhrg52397--218 Mr. Fewer," Congressman, I would try to look at the CDS market from a different viewpoint. The CDS market generally is made up of very liquid CDX index product, most of what is traded, and single name product. That area of the credit link market is very, very conducive to central counterparty clearing. These instruments did not cause the problem of AIG. The collateralized debt obligations did, everyone knows that. It would be a fair comment to say that a proper postmortem of AIG, to really understand what the dynamics were between CDS and the actual CDOs, however, to parcel out CDS from the rest of the derivative world, we should be able to apply the same rules right across the board. And over a period of time, CDS happens to be in the major headlines but over a period of time, I think that the general public will see that whether it is a credit index or an equity index or a interest rate swap, these products can be very well harnessed and managed within the context of proper market protocols. " CHRG-111shrg51303--93 Mr. Kohn," Our authority under the Federal Reserve Act is to make loans. We thought it was a short-term liquidity situation--in mid-September, this is what we thought--and that if we could bridge this situation with liquidity, then the company could make the adjustments to keep itself a going concern. It turned out that the problems were deeper, the financial markets became a lot worse, and the whole situation deteriorated badly. I do not think we had the authority simply---- Senator Corker. Well, it may not--I think this whole issue of authority is pretty incredible, and I think all of us realize that the Fed nor anyone else has the authority not only to deal with AIG but Citigroup or Bank--there is nobody. I mean, I think that is an amazing thing that for some reason only hits my alarm bell, nobody else's. But there is no entity in our country that has the ability to deal with an AIG, a Citigroup, a Bank of America, anybody. I find that pretty incredible. OK? But I want to go back to this still. So the holders of these policies--most of us call it ``credit default swaps,'' but these policies--have had no losses. " CHRG-111hhrg48867--119 Mr. Garrett," Okay. And I appreciate that. And it is on that last point on not acting is maybe where I will make my main point. Mr. Plunkett, I will just say on your point I was with you on most of what you were saying. And you are saying that we can do a lot of this, what we need to do, with the existing regulations and sharing the information. And I think I was following you, and I agree with you on a lot of those points. You lost me when you talked about solving it by regulating salaries or executive compensation. Up to that point, I was right with you. But I appreciate a lot of your testimony. Ms. Jorde, a quick question. The suggestion that was made here with regard to requiring the banks to hold a portion of it on their books on securitization. Wouldn't that be actually problematic for some of your smaller banks who right now have to sell it all and that is how they are able to lend? Just very briefly, could that cause a little bit of a problem for some of the small banks? Ms. Jorde. And that was my point initially, is that to hold a part of it, then you are in effect servicing it. " CHRG-111shrg57322--276 Mr. Swenson," I think the reservation here is on the contributed part versus what caused, and we did not cause the financial crisis specifically to the mortgage desk, which is what I am here to speak about. You have two panels in subsequent meetings to speak about Goldman Sachs and our businesses. I do not think that we did anything wrong. There are things that we wish we could have done better in hindsight, but at the times that we made the decisions, I did not think we did anything wrong. Senator Pryor. Mr. Tourre. " CHRG-111hhrg48868--428 Mr. Liddy," Yes. I had a conversation with Treasury Secretary Geithner about a week ago, and he indicated to me that he had only become aware of the situation about a week prior to that, and we have tried to keep the staffs of various Members of Congress apprised of all of the situation and to be very responsive to whatever queries you may have. I think we have done a good job of that. Very good--you'll be the judge of that. " CHRG-110hhrg46593--332 Mr. Kanjorski," Right. Now, I am rather enamored with your proposals, to tell you the truth. What I do not understand is, this is something that will take weeks or several months to finally put in language, statutory language, and to persuade the American people and the Congress to pass something like this. Why is it not advantageous--or is it advantageous--for us to remain in session, have these types of proposals, reduce them into legislation, so that at least with the new Presidency we are prepared from day one to be able to act, as opposed to waiting around for a blind piece of legislation to appear and then we are all forced to make an either/or selection, knowing full well there are many things we could add to the bill that would make it much more applicable to the situation? " CHRG-111hhrg55814--276 Mr. Garrett," Yes, we all did and this is pretty darn complicated stuff. And that is why I wonder if the next portion, let's take the worst-case scenario that you actually, and I will get back to Ms. Bair on the other question, and the rest of you too can chime in as to whether it should be ex-anti or ex-post as far as the assessment, but it is ex-post in here. I read it to say that what happens is if something goes down, you need to collect money from other companies, institutions, financial institutions over $10 billion, right, again reading this, I could say that does not just apply to financial institutions as I would think of them, as banks and what have you, it could apply across-the-board. It could apply to all the car companies. It could apply to all the biotech companies. It could apply to everyone in this--just about any corporation that is over $10 billion in size, that they would be responsible for, heaven forbid, that BOA has a problem. Did anybody else read it that this cannot go across-the-board as far where they get it from a $10 billion assessment? Ms. Bair. I do not think that is the intent of the discussion draft. Again, the language can be further refined. But I do not think that is anyone's intent, not as it has been explained to me. " FinancialCrisisInquiry--220 GEORGIOU: They take—I’m sorry? ROSEN: They take the riskiest piece of a security, they’ve underwritten it, and they feel confident of that underwriting and they keep that, and they’ve got a premium on the marketplace for their securities because they do that, the securitizations they do in the commercial mortgage area. GEORGIOU: Is there a reason why you wouldn’t identify that bank or... ROSEN: It’s Wells Fargo bank, and they’ve—that’s been their tradition. They believe in their own underwriting, and so they keep the riskiest piece in their own portfolio, risky only in the sense it’s at the, you know, bottom of the capital stack, and so—and they’ve had a premium in the marketplace. They’re not—they don’t do a lot of securitization, but it seems to me that if you get the risk return alignment better, I think it’s less likely you’re going to have some of the stuff that was done in this environment. GEORGIOU: Right. Dr. Zandi, I wonder if you could comment on the disparities of—of the impact of the recession in certain areas, as opposed to others. I mean, I happen to—actually, Ms. Murren and I now live in—both live in Nevada, where we have something like 75 percent of the homeowners owe more money than they—than their homes are worth and the economic—the underemployment rate has been extraordinarily high. CHRG-111hhrg48873--476 Mr. Bernanke," Well, Congressman, that is a very good question. I am sure you appreciate how complex and difficult this whole situation has been. I do think there is a plan. First, I should mention the Federal Reserve has been very aggressive on a lot of fronts, both in terms of lowering interest rates, both short-term and long-term interest rates, and providing liquidity to the system. Secondly, the Treasury now has essentially a five-point plan. It includes supervisory review and putting in capital, buying assets off of balance sheets, the foreclosure mitigation plan, and then the joint program with the Federal Reserve, the TALF, which will help get the securitization markets going. That covers all the major elements needed to get the banking system going again. But then, to make this all work for the future, in order to avoid an AIG or a similar situation, we also have to very seriously undertake a financial reform program. The Federal Reserve has developed some proposals, which I talked about last week. I know Secretary Geithner will be here on Thursday to talk about the Treasury's proposals. So I think there is a plan. If you have ever read books on battles and warfare, you know that a lot of battles are very chaotic at the beginning until the situation becomes clear and the smoke starts to clear. I think we have gotten to the point now where we can see the terrain, and we are taking the steps necessary to stabilize the situation and get out of this downturn we are in. " FOMC20060920meeting--152 150,MR. MISHKIN.," Many of you know I have an upbeat personality—some might actually say loud—but certainly upbeat. The way I look at the forecast and the situation with the economy is quite positive in the sense that what we’re seeing, really, is a return to normalcy and a more balanced economy. The excesses in the housing sector seem to be unwinding in an acceptable way, so I think it is quite reasonable in terms of the Greenbook forecast to think that the spillover here is not going to be a big problem because we’re actually moving resources from a sector that had too much going into it, into sectors that need to have more resources at the present time. So in that sense, I’m actually quite positive. The other thing that I am quite comfortable with in the Greenbook forecast—though, clearly, there’s uncertainty—is that we’re going to see a decelerating core inflation rate. Furthermore, when we look at inflation expectations, they seem to be very well contained and seem also to have responded well to the pause at the last meeting. However, I should say that, although we’ve seen that inflation expectations are well anchored, there’s a question about whether they’re anchored at quite the right level. They seem to be anchored somewhere around 2½ percent on the CPI, and that is probably with a differential between the CPI and the PCE of about ½ percentage point, or 50 basis points. It still seems to be somewhat on the high side in terms of what many people on the Committee have expressed is their comfort zone. So I think that is a concern. There is a significant probability that things may not turn out so rosy on the output front—we should have a concern that things could go somewhat wrong in terms of the housing sector. If that happened, we might see much lower output growth. There is a reasonable probability of recession. It’s mentioned in the Greenbook. I think your numbers are quite reasonable. So in that context, we could actually have lower output, a wider output gap, and some actual deceleration of inflation. I agreed very much with the conclusion that you came to because it’s reasonable to think that the long-run inflation we’re moving to is around 2 percent unless we get one of the scenarios with a lot more softness. That the deceleration is not going to go much below the Greenbook forecast of around 2 percent by 2008 does cause me a bit of concern. I’m not sure that I would describe the risks as unbalanced. For me, in terms of a forecast, probably I would be comfortable saying they’re balanced. However, I think inflation is too high in the forecast and, in that context, does require much more vigilance. Of course, that will be reflected in the discussion later today. Thank you." CHRG-110shrg50410--47 Chairman Dodd," Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Thank you all for your testimony. I hope we have been listening to the Three Wise Men of the Economy here and that what you are telling us is going to steer us in a different direction. But I have some concerns. You know, I have in the past at some of these hearings suggested that we seem to be behind the curve instead of ahead of it; that we seem to be constantly reactive instead of proactive. And I am just wondering, you know, we seem to be in a pattern that is developing where our regulators suddenly realize an emergency on a Friday, and then hastily formulate a rescue plan at the 11th hour during the weekend. We saw this happen with Bear Stearns, and now we are talking about this as it relates to Freddie and Fannie. And we saw what happened at IndyMac. And I am just concerned that what we have here is the equivalent of last-minute cramming regulatory action. And that puts us in a process of expediency over well-thought-out policy. You know, I wonder, Mr. Secretary, how is it that knowing what has happened with reference to companies that have been shaken dramatically, that have securitized loans over the past year, why we thought that Fannie and Freddie would be insulated from the very same market conditions that have crippled other companies that specialize in loan securitization. That is one question. The second question is: I hear you when you say that it is your intention or desire and hope not to use the very power that you are asking for, but I am concerned, you know, all of us here play a fiduciary role to the taxpayers not only of our States, in the country. And as you just mentioned a moment ago, it is counterintuitive to say give us a blank check or a blank authority as the best way to ensure that taxpayers are not on the hook. That is certainly counterintuitive. And the difficulty is, having just seen the Bear Stearns process that we went through, where it has now had about $1 billion of asset loss since March, which now puts us into the area where, in fact, the Federal Government--i.e., the taxpayers--begin to come into play in terms of responsibility for picking up the tab if this decreases further, I know it is not your intention to use it, but by the same token, you know, there is no safeguard under your proposal for us to create some limits of those liabilities should you have to use it. And, finally, I am concerned about that while I know it is not your intention to use it and you think that this is the best way to avoid taxpayer liability, just look at what Wall Street basically did in terms of when the plan was announced. You know, it pushed Fannie's stock up by 20 percent, Freddie by more than 15 percent in early trading. And then it closed down 8, and Fannie was off 5 product at the end of the day. So it almost seems to be saying--they seem to be saying it is just not enough. So did they want some guarantees here? And if you want guarantees, that means more than just the possibility for 18 months. It may mean more. So I hope you can address those issues. Why did we not see this possibility coming? How is it that, in fact, we go back and tell the taxpayers there is absolutely no way you are going to be put on the hook here, and, third, when we have lost $1 billion already in the Bear Stearns process? And then, finally, let me put the last question out there and let you answer it. It would be to Chairman Cox. I appreciate that you said, first and foremost, the SEC is a law enforcement agency. And I appreciate a good part of your written testimony talking about going after market manipulation where in one case the false rumors in Bear Stearns caused the stock to drop by 17 percent and wiped out $1 billion of market capital in the first 30 minutes and had the stock exchange halt the trading in the company's securities. Can we expect you to vigorously pursue more enforcement activities of that type going in the days ahead? Those are the questions I would like to hear answered. " CHRG-111hhrg48674--269 Mr. Bernanke," Well, some have raised the concern about inflation. If we don't get the balance sheet under control and the money supply under control in time, in an appropriate moment, we could risk having higher prices down the road. That is certainly a possibility. It is one that we are very aware of and doing our best to manage. But, you know, nothing is certain. So that is one risk that I see. The other risk I would point out would be just that the efforts that are being made, including our attempts to stabilize key credit markets, prove insufficient and the situation gets further--deteriorates further. Those are the things I can foresee. There must be things I can't foresee, but by definition, I don't know what they are. " FinancialCrisisReport--14 C. Recommendations The four causative factors examined in this Report are interconnected. Lenders introduced new levels of risk into the U.S. financial system by selling and securitizing complex home loans with high risk features and poor underwriting. The credit rating agencies labeled the resulting securities as safe investments, facilitating their purchase by institutional investors around the world. Federal banking regulators failed to ensure safe and sound lending practices and risk management, and stood on the sidelines as large financial institutions active in U.S. financial markets purchased billions of dollars in mortgage related securities containing high risk, poor quality mortgages. Investment banks magnified the risk to the system by engineering and promoting risky mortgage related structured finance products, and enabling investors to use naked credit default swaps and synthetic instruments to bet on the failure rather than the success of U.S. financial instruments. Some investment banks also ignored the conflicts of interest created by their products, placed their financial interests before those of their clients, and even bet against the very securities they were recommending and marketing to their clients. Together these factors produced a mortgage market saturated with high risk, poor quality mortgages and securities that, when they began incurring losses, caused financial institutions around the world to lose billions of dollars, produced rampant unemployment and foreclosures, and ruptured faith in U.S. capital markets. Nearly three years later, the U.S. economy has yet to recover from the damage caused by the 2008 financial crisis. This Report is intended to help analysts, market participants, policymakers, and the public gain a deeper understanding of the origins of the crisis and take the steps needed to prevent excessive risk taking and conflicts of interest from causing similar damage in the future. Each of the four chapters in this Report examining a key aspect of the financial crisis begins with specific findings of fact, details the evidence gathered by the Subcommittee, and ends with recommendations. For ease of reference, all of the recommendations are reprinted here. For more information about each recommendation, please see the relevant chapter. Recommendations on High Risk Lending 1. Ensure “Qualified Mortgages” Are Low Risk. Federal regulators should use their regulatory authority to ensure that all mortgages deemed to be “qualified residential mortgages” have a low risk of delinquency or default. 2. Require Meaningful Risk Retention. Federal regulators should issue a strong risk retention requirement under Section 941 by requiring the retention of not less than a 5% credit risk in each, or a representative sample of, an asset backed securitization’s tranches, and by barring a hedging offset for a reasonable but limited period of time. 3. Safeguard Against High Risk Products. Federal banking regulators should safeguard taxpayer dollars by requiring banks with high risk structured finance products, including complex products with little or no reliable performance data, to meet conservative loss reserve, liquidity, and capital requirements. 4. Require Greater Reserves for Negative Amortization Loans. Federal banking regulators should use their regulatory authority to require banks issuing negatively amortizing loans that allow borrowers to defer payments of interest and principal, to maintain more conservative loss, liquidity, and capital reserves. 5. Safeguard Bank Investment Portfolios. Federal banking regulators should use the Section 620 banking activities study to identify high risk structured finance products and impose a reasonable limit on the amount of such high risk products that can be included in a bank’s investment portfolio. CHRG-110hhrg46593--195 Mr. Yingling," Thank you, sir. I appreciate the opportunity to testify on the current status of the Troubled Asset Relief Program. The TARP program has served to calm financial markets and does have promise to promote renewed economic growth. However, it is also a source of great frustration and uncertainty to banks. Much of the frustration and uncertainty is because of the numerous significant changes to the program and the misperceptions that have resulted on the part of the press and the public. Hopefully, this hearing will help clarify the situation. ABA greatly appreciates the consistent statements by members of this committee, and particularly its leadership, that regulated banks were not the cause of the problem and have generally performed well. Not only did regulated banks not cause the problem, they are the primary solution to the problem, as both regulation and markets move toward the bank model. Thousands of banks across the country did not make toxic subprime loans, are strongly capitalized, and are lending. As you know, TARP started out focused on asset purchases. But then after European countries announced they were putting capital in undercapitalized banks, everything changed. Overnight, nine banks were called to Washington and requested to take capital injections. As this program was extended beyond the first nine to other banks, it was not initially clear that the program was to focus on healthy banks and its purpose was to promote lending. ABA was extremely frustrated with the lack of clarity, and we wrote to Secretary Paulson asking for clarification. The press, the public, Members of Congress, and banks themselves were initially confused. Many people understandably did not differentiate between this voluntary program for a solid institution and bailouts. Bankers, for a few days, were not sure of the purpose, although they were sure their regulators were making it clear it was a good idea to take the capital. Put yourself in the place of a community banker. You are strongly capitalized and profitable. Your regulator is calling you to suggest taking TARP capital is a good idea. You, the banker, can see that it might be put to good purposes in terms of increasing lending, but you have many questions about what will be a decision that will dramatically affect the future of your bank, questions like, what will my customers think? What will the markets think? What restrictions might be added ? Despite the uncertainty, banks are signing up. In my written testimony, I have provided examples of how different banks can use the capital in ways to promote lending. One aspect of the program that needs to be addressed further is the fact that it is still unavailable to many banks. Last night, the Treasury did offer a term sheet for private corporations, and we greatly appreciated that. However, term sheets for many banks, including S corporations and mutual institutions, have not been issued. This is unfair to these banks, and it undermines the effectiveness of the program. In my written testimony, I have discussed the fact that while TARP is designed to increase bank capital and lending, other programs are actually in conflict and are actually reducing capital and lending. In that regard, I once again call to the attention of the committee the dramatic effect of current accounting policies which continue unnecessarily to eat up billions of dollars in capital by not understanding the impact of mark-to-market and dysfunctional markets. Finally, in our written testimony, ABA also supports efforts to address foreclosures and housing. We have proposed a four-point plan: First, greater efforts to address foreclosures; second, efforts to address the problems caused by securitization of mortgages that you have championed, Mr. Kanjorski; third, the need to lower mortgage interest rates, which are not following normal patterns; and fourth, tax incentives for purchasing homes. Thank you. [The prepared statement of Mr. Yingling can be found on page 194 of the appendix.] " CHRG-111hhrg53248--64 Mr. Hensarling," But why not include it in the legislative proposal if it is a central cause and needs to be addressed? " CHRG-111hhrg48867--302 Mr. Wallison," Yes, it is entirely possible that AIG could have been a cause of systemic risk. " CHRG-110hhrg46591--338 Mr. Yingling," Well, we have many community banks that are living with CRA, and they did not cause this problem. " CHRG-110shrg50416--167 Chairman Dodd," Not necessarily Senator Corker. But I do hope that as you are working through this and there is transition occurring, I do hope there is a vision in the very, very near future that these two organizations have nothing whatsoever to do with Government. And I hope that is at least one of the plans that we are working on. I know a lot of people like to attribute everything that is happening to this. That is obviously unfair. But the fact is that this is--as we move ahead, we have the camel's nose under the tent here already, and obviously, the camel occupies the tent now because of where we are. We have the camel's nose under the tent occurring right now with the--I guess we are calling it ``the rescue plan'' now. I hope that we will not edge into areas that we are not supposed to be edging into there, and I look forward to your leadership as hopefully we move these organizations off, cause them to be lofted on their own into the future and we figure out other ways for the private sector to deal with the secondary market. And I hope that finds you retired very soon. Thank you for your service. " CHRG-111shrg54533--69 Secretary Geithner," I think so, because I think that if you give it to too many people, you do not have accountability for when you get it right. And I think that they have got the best incentives to make sure that those basic safeguards are strong enough to help us withstand future crises. Senator Merkley. So let me frame it a little differently. We gave power to the Fed in the past that sat unused and unexercised in situations where, of course, with the power of hindsight--which is always much better than foresight--we would have wished they had exercised that power. Is there a way to have them address their role in monetary policy at the same time having them see this as a major mission, a major responsibility, and that they will not fall asleep at the switch? " CHRG-109hhrg31539--11 The Chairman," Again, welcome back to the Financial Services Committee. Your predecessor was always emphasizing price stability as probably the key element to the charge that Congress gave the Federal Reserve way back when the Federal Reserve was created. And obviously your statement reflected that continuum on that issue. I have always been struck by the economic analysis of core inflation, minus--or not counting food and energy, and I am wondering if you could share that differential with the committee. I say that because to the average person, when they think of inflation, they think of going to the gasoline pump, they think of going to the grocery store, probably has more of an effect on people's daily lives than any other form of inflation, and yet the Federal Reserve talks about core inflation minus those two components. Could you share how that affects the decisions by the FOMC and how that is reflected in the policy? " 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? " FOMC20050630meeting--319 317,MS. JOHNSON.," We know from past history that the oil intensity of GDP stepped down in the period immediately following the oil price shock event, but it did not continue to improve continuously. That chart is very much like a step-function; most of the gains occurred early on when we first experienced the significant changes in relative oil prices. We also know that there’s a lot of difference across countries in oil intensity. Some people conclude that that means we can all be as efficient as the most efficient country, so there’s a lot of room to improve. That’s a little naive because some of those differences reflect industrial structure and the like. Somebody has to produce the aluminum, right? We can’t all save money—save oil and energy—by not producing aluminum. So, some of those differences are more permanent. But some of them involve just a failure to take the steps that others have taken. There’s scope there, too. I think there’s no better solution to this problem than to let prices show through." FOMC20071211meeting--82 80,MS. YELLEN.," Thank you, Mr. Chairman. At the time of our last meeting, I held out hope that the financial turmoil would gradually ebb and the economy might escape without serious damage. Subsequent developments have severely shaken that belief. The bad news since our last meeting has grown steadier and louder, as strains in financial markets have resurfaced and intensified and as the economy has shown clear signs of faltering. In addition, the downside threats to growth that then seemed to be tail events now appear to be much closer to the center of the distribution. I found little to console me in the Greenbook. Like the Board staff, I have significantly marked down my growth forecast. The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real. Conditions in financial markets have worsened. Rates on a wide array of loans and securities have increased significantly since our last meeting, including those on term commercial paper, term LIBOR, prime jumbo mortgages, and high-yield corporate bonds. CDS spreads from major financial institutions with significant mortgage exposure, including Freddie and Fannie, have risen appreciably. In addition, broad stock indexes are down nearly 5 percent. At the same time, measures of implied volatility in equity, bond, and foreign exchange markets have all moved up, reflecting the greater uncertainty about the economy’s direction. The most recent data on spending have been discouraging as well. Data on house sales, prices, and construction have been downbeat, and foreclosures on subprime loans have moved even higher. Even with efforts such as those facilitated by the Administration to freeze subprime rates, foreclosures look to rise sharply next year, which may dump a large number of houses on a market already swamped with supply. This will exacerbate the downward pressure on house prices and new home construction from already elevated home inventories. Indeed, the ten-city Case-Shiller home-price index has declined more than 5 percent over the past year through September, and futures contracts point to another sizable decline over the next twelve months. I am particularly concerned that we may now be seeing the first signs of spillovers from the housing and financial sectors to the broader economy. Although the job market has remained reasonably healthy so far, real consumer spending in September and October was dead in the water, and households are growing more pessimistic about future prospects. The December reading of consumer sentiment showed another decline, and the cumulative falloff in this measure is becoming alarming. Gains in disposable income have been weakened. With consumer sentiment in the doldrums, house prices on the skids, and energy prices on the rise, consumer spending looks to be quite subdued for some time. This view is echoed by the CEO of a national high-end clothing retailer on our board, who recently emphasized to us that the positive chain store sales data in November were in fact artificially boosted by the Thanksgiving calendar shift and that the underlying trend for his business has worsened notably. My modal forecast foresees the economy barely managing to avoid recession, with growth essentially zero this quarter and about 1 percent next quarter. I expect growth to remain below potential throughout next year, causing the unemployment rate to rise to about 5 percent, much like in the Greenbook. This forecast assumes a 50 basis point decline in the federal funds rate in the near future, placing the real funds rate near the center of the range of estimates of the neutral rate reported in the Bluebook. I should emphasize that I do not place a lot of confidence in this forecast, and, in particular, I fear that we are in danger of sliding into a credit crunch. Such an outcome is illustrated by the credit crunch alternative simulation in the Greenbook. Although I don’t foresee conditions in the banking sector getting as bleak as during the credit crunch of the early 1990s, the parallels to those events are striking. Back then, we saw a large number of bank failures in the contraction of the savings and loan sector. In the current situation, most banks are still in pretty good shape. Instead, it is the shadow banking sector— that is, the set of markets in which a variety of securitized assets are financed by the issuance of commercial paper—that is where the failures have occurred. This sector is all but shut for new business. But bank capital is also an issue. Until the securitization of nonconforming mortgage lending reemerges, financing will depend on the willingness and ability of banks, thrifts, and the GSEs to step in to fill the breach. To the extent they do, that will put further pressure on their capital, which is already under some pressure from write-downs on existing loans and holdings of assets. Banks are showing increasing concern that their capital ratios will become binding and are tightening credit terms and conditions. Several developments suggest to me that this situation could worsen. In addition to the problems plaguing the adjustable-rate subprime mortgages, delinquencies have recently started to move up more broadly—on credit card and auto loans, adjustable-rate prime mortgages, and fixed-rate subprime mortgages. My contacts at large District banks tell me that, because the economy continues to be reasonably healthy and people have jobs, things are still under control. But if house prices and the stock market fall further and the economy appears to be weakening, then they will further tighten the lending conditions and terms on consumer loans to avoid problems down the road, and these fears could be self-fulfilling. If banks only partially replace the collapsed shadow banks or, worse, if they cut back their lending in anticipation of a worsening economy, then the resulting credit crunch could push us into recession. This possibility is presumably increasingly reflected in CDS and low-grade corporate bond spreads. Thus, the risk of recession no longer seems remote, especially since the economy may well already have begun contracting in the current quarter. Indeed, the December Blue Chip consensus puts the odds of a recession at about 40 percent. This estimate is within the range of recession probabilities computed by my staff using models based on the yield curve and other variables. Turning to inflation, data on the core measure continues to be favorable. Wage growth remains moderate, and the recent downward revisions to hourly compensation have relieved some worries there. Inflation expectations remain contained. As I mentioned, I expect some labor market slack to develop, and this should offset any, in my view, modest inflationary pressures from past increases in energy and import prices and help keep core PCE price inflation below 2 percent. Continued increases in energy and import prices pose some upside risk to the inflation outlook, but there are also downside risks to inflation associated with a weakening economy and rising unemployment. To sum up, I believe that the most likely outcome is for the economy to slow significantly in the near term, flirting with recession, and I view the risk to that scenario as being weighted significantly to the downside. In contrast, I expect inflation to remain well contained, and I view those risks as fairly balanced." fcic_final_report_full--433 Some combination of the first two factors may apply in parts of the Sand States, but these don’t explain the nationwide increase in prices. The closely related and nationwide mortgage bubble was the largest and most sig- nificant manifestation of a more generalized credit bubble in the United States and Eu- rope. Mortgage rates were low relative to the risk of losses, and risky borrowers, who in the past would have been turned down, found it possible to obtain a mortgage.  In addition to the credit bubble, the proliferation of nontraditional mortgage products was a key cause of this surge in mortgage lending. Use of these products in- creased rapidly from the early part of the decade through . There was a steady deterioration in mortgage underwriting standards (enabled by securitizers that low- ered the credit quality of the mortgages they would accept, and credit rating agencies that overrated the subsequent securities and derivatives). There was a contemporane- ous increase in mortgages that required little to no documentation. As house prices rose, declining affordability would normally have constrained demand, but lenders and borrowers increasingly relied on nontraditional mortgage products to paper over this affordability issue. These mortgage products included interest-only adjustable rate mortgages (ARMs), pay-option ARMs that gave bor- rowers flexibility on the size of early monthly payments, and negative amortization products in which the initial payment did not even cover interest costs. These exotic mortgage products would often result in significant reductions in the initial monthly payment compared with even a standard ARM. Not surprisingly, they were the mortgages of choice for many lenders and borrowers focused on minimizing initial monthly payments. Fed Chairman Bernanke sums up the situation this way: “At some point, both lenders and borrowers became convinced that house prices would only go up. Bor- rowers chose, and were extended, mortgages that they could not be expected to serv- ice in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ulti- mately, further appreciation could not be sustained and house prices collapsed.”  This explanation posits a relationship between the surge in housing prices and the surge in mortgage lending. There is not yet a consensus on which was the cause and which the effect. They appear to have been mutually reinforcing. In understanding the growth of nontraditional mortgages, it is also difficult to de- termine the relative importance of causal factors, but again we can at least list those that are important: • Nonbank mortgage lenders like New Century and Ameriquest flourished un- der ineffective regulatory regimes, especially at the state level. Weak disclosure standards and underwriting rules made it easy for irresponsible lenders to issue mortgages that would probably never be repaid. Federally regulated bank and thrift lenders, such as Countrywide, Wachovia, and Washington Mutual, had lenient regulatory oversight on mortgage origination as well. • Mortgage brokers were paid for new originations but did not ultimately bear the losses on poorly performing mortgages. Mortgage brokers therefore had an incentive to ignore negative information about borrowers. • Many borrowers neither understood the terms of their mortgage nor appreci- ated the risk that home values could fall significantly, while others borrowed too much and bought bigger houses than they could ever reasonably expect to afford. • All these factors were supplemented by government policies, many of which had been in effect for decades, that subsidized homeownership but created hid- den costs to taxpayers and the economy. Elected officials of both parties pushed housing subsidies too far. FinancialCrisisInquiry--487 SOLOMON: Yes. I mean, great management will take bad situations and make them better, but they’ll be bad situations. I think we are dealing with a structural problem, and we’d better hope that management’s fabulous, and it isn’t always fabulous. It’s a—it’s a reality. Even the best business schools can’t turn out fabulous people for enough places. CHRG-111hhrg63105--62 Mr. Chilton," Thanks Congressman. That is a great question. It is insightful. First of all, I want to say what I said in my testimony. Speculators aren't bad. You need them. You don't have markets without them. The concern that some of us had is just the concentration of them, so much that they can influence prices one way or the other, and you don't get to what Mr. Johnson talked about: adequate price discovery. But on these fast trading--they call them high frequency traders--they played a role in the flash crash. They didn't instigate it, but they played a role because they were arbitraging between the futures market and the securities markets for a while. These trades are--talk about being complicated, Congressman, these trades go on, they trade thousands of contracts in a nanosecond. And their whole idea, different from how these markets have been set up sort of when they were in the open pits, they are trying to scoop up market dollars, these little pennies, in nanoseconds. They are trying to skim off the top. Now, they do provide some liquidity to the markets, but that liquidity may be liquidity with other traders. And I am just concerned that we don't want this to become a gambling venue. You want it for the original purpose of the markets, for these commercial ags and other businesses to be able to hedge their risks. So I am very concerned about it, these high-frequency traders, Congressman. I think we should be doing some sort of due diligence, maybe putting their programs, their algorithmic programs, into one of the exchange's testing environments, make sure they are not going to go haywire. I think we should also as part of disruptive trading practice authority, the Chairman and I worked on a lot, have some responsibility. If they help to cause another flash crash, they should be held accountable. If you look at the law right now, we don't have enough teeth in it. We are doing that as a result of the Dodd-Frank law, and we are going to put some more meat on the bones, and that is one area that I think we need to do. " CHRG-110hhrg46591--15 Mr. Manzullo," Thank you, Mr. Chairman, for holding this hearing today. This committee needs to examine ways to ameliorate the impact of this crisis while examining long-term solutions to ensure that a crisis of this magnitude never happens again. As we examine the underlying causes of this crisis, it is clear to me that Fannie Mae and Freddie Mac were right in the thick of things. Some of us in Congress have been fighting the unethical, illegal, and outright stupid underwriting practices at Fannie and Freddie for many years. Our efforts are a matter of public record, at least in the last 8 years, of going so far as to publicly confront Franklin Raines, who took $90 million in 6 years from Fannie Mae, and with regard to his fraudulent, unethical lobbying campaign in 2000 and in regard to the use of unethical accounting practices to inflate the bonuses of Fannie Mae's executives in 2004. In 2005, we finally got a bill to the Floor, a vote in favor of GSE reform, including the tough Royce amendment, to make even more difficult the types of practices to continue that we see have led to this crisis. Any solution to this crisis undoubtedly needs to include a serious reexamination of the role that these GSEs will play in any future housing market. It is obvious that new regulations are necessary both to ease this crisis and to ensure that it never happens again. One thing for sure is that these two organizations need to be dissected, ripped apart, and examined thoroughly. Because once we find out what happened there as the root cause of the problem, we will make sure it never occurs again. Thank you, Mr. Chairman. " CHRG-111hhrg48867--79 Mr. Bachus," Sure, and that was his analogy. That was Mr. Yingling's analogy. But I appreciate that, and I agree with you. I think that is the--but once they start, I don't think the government ought to put them out at taxpayer expense unless we have guaranteed deposits, and that is where it ought to end. We ought to guarantee deposits. Whether that level is $250,000 or $500,000, it ought to end wherever that guarantee ends. " Mr. Kanjorski," [presiding] Thank you very much, Mr. Bachus. I will take my 5 minutes while we are waiting for the Chair to return. First of all, let me thank the panel for their testimony and for their unanimous support of having skin in the game. That really is a revolutionary concept that we would have seven members of panelists, diverse as this panel is, and everybody agreeing. It is time we do put skin in the game. I think it is very responsible for us to do that. Mr. Yingling, I think that you have made an observation to this committee on these issues that we have attempted to, as best as possible, remove ourselves from the temptation of talking to political issues but, in fact, look at these questions in a much more bipartisan way and I hope that continues. And if it does, I would think that to a large extent we may be able to get some progress yet unappreciated by the general public. On that question, though, of systemic risk, I am still one of the slight doubters. It sounds to me that it is structured to be able to say, ``so this shall never happen again,'' and every time I hear that phrase, I shudder because we all know it is not going to happen in the same way. This is capitalism's attempt to escape the confines of control and regulation that proved very healthy for 80 years, until in the last decade the escape was there. And I think it has a lot to do with the unregulated banking system that allowed this leveraging to occur, allowed the situation to get out of hand to the extent that I think most of us saw this potential happening maybe 2005, 2006, that it was going to be clear something was going to happen that was not necessarily intended or desirable for the public. Now my question is, though, so that we do not run down this road very quickly to create a ``systemic risk regulator,'' have you all given deep thought as to what powers a systemic risk regulator would have to have and how deep could they go, and what could they inquire into, and that it would not necessarily be limited just to ``financial institutions,'' it would go into other institutions? Because as you all may recall, just several weeks ago, we had the auto industry in here testifying to the fact that they were going to be a systemic risk situation, because if any one of the three American auto manufacturers were to go down, it would bring the other two down because it constituted systemic risk insofar as they were coordinated and intertwined with their dealers and with their suppliers. And it has almost been a given up until this time that if one company goes down, all three American companies go down, and possibly even the entire industry. Even foreign manufacturers in the United States would be gravely if not totally disadvantaged by that occurrence. Now that being the case, and adding to that, that there is a financial structure that exists in the auto industry; that is, the arms of financing--Chrysler Financial and GMAC and Ford Financial--again, blend right into the fact--I don't know, is this--would you all consider the automobile manufacturing companies just auto manufacturing, or are they financial institutions, or are they an ugly blend of the two that are very difficult to separate, if not impossible to separate? That is just a side question. But now, how far do you want us to go down this path of empowering a ``systemic risk regulator'' who would have to have tremendous information, almost clairvoyance, in terms of determining what the ambitions of certain people in the financial market were, to determine whether at some future event these actions that were contemplated would cause systemic risk? Anybody who wants to-- " CHRG-111shrg57322--845 Mr. Viniar," I am not sure I am answering your question, but we try to resolve conflicts all the time at Goldman Sachs. We, for example, could have two clients who want to buy the same company and they will both ask us to represent them. That is a conflict. We will have to resolve it. We could have a seller and a buyer who ask us. That is a conflict. We could have a situation where there is a company--a client who wants to buy something and our merchant bank wants to buy it, as well. We will have to decide principal versus franchise, and almost every time we will choose the franchise over the principal. So we wrestle with these all the time. We try our best to resolve them and make the right judgment, putting our clients first. Senator Pryor. But when it comes to doing something like selling CDOs, do you see any conflict there, or do you just see that as a function of the market? " CHRG-111hhrg53240--139 Mr. Carr," Congressman, if I could just say for 5 seconds, I think the absence of conflict would be a failure of mission, which is exactly what we have right now. One would expect that given the types of deceptive and exploited practices happening, you would be having lots of conflicts for the last decade. The absence is a problem. " CHRG-111hhrg54869--161 Mr. Miron," Thank you, Mr. Chairman, Ranking Member Neugebauer, and committee members. Let me begin by expressing my thanks for the opportunity to present my views on this matter. The question I will address is whether Congress should adopt Title XII of the proposed Resolution Authority for Large Interconnected Financial Companies Act of 2009. This Act would grant the FDIC powers for resolving insolvent financial institutions similar to those that it currently possesses for revolving banks. My answer to this question is an emphatic, unequivocal ``no.'' Let me explain. The problem that resolution systems attempts to address is that when our financial system fails, the value of the claims on that institution's assets exceed the value of the assets themselves. Thus, someone must decide who gets what, and it is impossible, by virtue of the assumption that we are dealing with a failed institution, to make everyone whole. The size of the pie owned by the failing institution has shrunk so those who are expecting a slice of that pie collectively face the necessity of going somewhat or substantially hungry. The resolution authority decides who gets what, but the reality is that someone has to go wanting. It is in society's broad interest to have clear, simple, and enforceable procedures for resolving failed institutions, principally to ensure that investors are willing to commit their funds in the first place. If the rules about resolution were arbitrary and ever-changing, investors would be loathe to invest and economic investment productivity and growth would suffer. A well-functioning resolution process is part of a system for defining and enforcing property rights, which economists agree is essential to a smoothly functioning capital system. The crucial thing to remember here is that someone has to lose. Just as importantly, it is valuable to society as a whole, although not to the directly-harmed parties, that those invested in the failed institutions suffer economic losses. This releases resources to better uses, provides signals about good and bad investments and rewards those who have made smart decisions. The flip side of the fact that standard resolution systems, like bankruptcy, impose an institution's losses on that institution's stakeholders, is the fact that a standard of resolution authority, such as the courts, puts none of its own resources into that institution. The resolution authority is resolving claims and dividing the pie but is not adding any more pie. Under the bill being considered, however, the FDIC would have the power to make loans to the financial institutions to purchase its debt obligations and other assets, to assume or guarantee obligations and so on. This means the FDIC would be putting its own, that is, taxpayers' skin in the game, a radical departure from standard bankruptcy and an approach that mimics closely the actions that Treasury took under TARP. Thus, this bill institutionalizes TARP for bank holding companies. A crucial implication of this departure from standard bankruptcy is the taxpayer funds foot the bill for the loans, asset purchases, guarantees, and other support that FDIC would provide to prevent failing institutions from going under. These infusions of taxpayer funds come with little meaningful accountability, and it would be hard to know when they have been paid back and often that will not occur. The proposed new authority for the FDIC also generates the impression that society can avoid the losses that failure implies, but that is false. The proposed FDIC actions would merely shift those losses to taxpayers. The new approach is institutionalized bailouts, plain and simple. Thus, under the expansion of FDIC authority to cover nonbank financial institutions, bank holding companies will forever more regard themselves as explicitly, not just implicitly, backstopped by the full faith and credit of the U.S. Treasury. That is moral hazard in the extreme and it will be disastrous for keeping the lid on inappropriate risk taking. The right alternative to expanding FDIC authority is good old-fashioned bankruptcy. It has become accepted wisdom that bankruptcies by financial institutions cause great harm, and it is asserted in particular that letting Lehman Brothers fail was the crucial misstep last fall. In fact, nothing could be further from the truth. As I explain in more detail in my written testimony, the ultimate causes of the financial crisis were two misguided Federal policies; namely, the enormous subsidies and pressure provided for mortgage lending to non-creditworthy borrowers and the implicit guarantees provided by both Federal Reserve actions and the U.S. history of protecting financial institution creditors. These forces generated an enormous misallocation of investment capital, away from plant and equipment towards housing, created the bubble, and established a setting where numerous financial institutions had to fail because their assets were grossly overvalued relative to fundamentals. Lehman's failure was one part of this adjustment, and it was a necessary part. If anything, too few financial institutions failed since the massive interventions in credit housing markets that have occurred in the past year have artificially propped up housing prices, delaying the adjustments. Thus, the better way to resolve nonbank financial institutions is bankruptcy, not bailout. That is not to say existing bankruptcy law is perfect. One can imagine ways it might be faster and more transparent, which would be beneficial, nor should one assume that had bankruptcy been allowed to operate fully in the fall of 2008, the economy would have escaped without any pain. A significant economic downturn, in particular, was both inevitable and necessary given the fundamental misallocation of capital that occurred in the years before the panic, but nothing in the data, historical data or recent experience, suggests these bankruptcies would have caused anything worse than what we experienced and broader bankruptcies would have helped eliminate more hazards going forward. In light of these assessments, I urge the members of this committee to vote against this bill since it codifies an approach to the resolution that is fundamentally misguided. We need to learn from our mistakes and trust bankruptcies, not bailouts, going forward as we should have done in the recent past. [The prepared statement of Mr. Miron can be found on page 66 of the appendix.] " FOMC20080805meeting--181 179,MR. MISHKIN.," Thank you, Mr. Chairman. Just let me talk a little about monetary policy, and I'll be brief there. But then I have to use my opportunity to raise some issues for the Committee when I'm not here. I do support alternative B. As is obvious from my earlier discussion, I believe that the risks are balanced. I have one modification to Janet's language because I think it is just simpler to say that ""the downside risks to growth and upside risks to inflation are of concern to the Committee."" I don't see the need for ""both,"" but we're actually on the same wavelength in terms of this issue. What I'd like to spend some time on--because I feel this is sort of my swan song, but maybe because I'm a classy guy, I'll call this my ""valedictory remarks""--are three concerns that I have for this Committee going forward. I'm not going to be able to participate, but I have a chance now to lay them out. The first is the real danger of focusing too much on the federal funds rate as reflecting the stance of monetary policy. This is very dangerous. I want to talk about that. Second is that I think it's absolutely critical that we keep our options open in the current circumstances, and so I want to talk about that. The third is on the communication issue, but it's not going to be on inflation objectives. I've already talked about that enough in public, so it's clear to you one way or the other. I hope you consider it, but that's something that I don't need to go into here. First of all, let me talk about the issue of focusing too much on the federal funds rate as indicating the stance of monetary policy. This is something that's very dear to my heart. I have a chapter in my textbook that deals with this whole issue and talks about the very deep mistakes that have been made in monetary policy because of exactly that focus on the short-term interest rate as indicating the stance of monetary policy. In particular, when you think about the stance of monetary policy, you should look at all asset prices, which means look at all interest rates. All asset prices have a very important effect on aggregate demand. Also you should look at credit market conditions because some things are actually not reflected in market prices but are still very important. If you don't do that, you can make horrendous mistakes. The Great Depression is a classic example of when they made two mistakes in looking at the policy interest rate. One is that they didn't understand the difference between real and nominal interest rates. That mistake I'm not worried about here. People fully understand that. But it is an example when nominal rates went down, but only on default-free Treasury securities; in fact, they skyrocketed on other ones. The stance of monetary policy was incredibly tight during the Great Depression, and we had a disaster. The Japanese made the same mistake, and I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. I'm holding two houses right now. I'm very nervous. [Laughter] The second issue is that it's absolutely critical that we keep our options open. This relates to the points that I already made in my discussion--I argued that we don't know where this situation of financial stress is actually going to head and that the potential for shoes dropping and bad things happening out there is real. I think it's likely that it won't happen, but it's a significant probability with very serious negative consequences. In that situation, we don't know exactly the direction of where we have to go. I was actually very pleased with President Evans's comments. Charlie has been a good friend for a long time, and he is one of the people I have tremendous respect for as an economist. Although we had a disagreement in our view of monetary policy today, on the issue going forward I was pleased to see that you actually indicated that there is a possibility--we hope it doesn't happen, by the way--that things go south and that we actually have to be much more aggressive on monetary policy and on liquidity issues. I know that there have been some concerns on the Committee about that as well, but no option should be taken off the table if bad things happen, and we cannot get boxed in. I feel very, very strongly about that. I would also say that the same issue comes up in terms of inflation. I have argued very strenuously for nongradualism in a situation like the one we're in. We are in a different world when we are in a situation of financial stress, and it's very possible that we might have to raise rates very quickly. There's a good news case and a bad news case. The good news case is that housing prices stabilize. That could actually turn things around very quickly. I think, Bill, if I'm not incorrect, you mentioned that possibility, and I think you're absolutely right. In that kind of situation, our policy would become very accommodative. I do not think it's too accommodative at all right now. I think it's balanced; it's appropriate. But if the financial markets improve, it will become much too accommodative very quickly, and we then have to respond very quickly in order not to have inflationary consequences. I'd like to see that happen, by the way. The other case, which I would not like to see happen, is that inflation expectations get unhinged. I have seen no evidence that long-run inflation expectations have gotten unhinged, but there is substantial risk. If that happened, we would also have to move up very quickly. So I really implore this Committee to keep your options open. Do not get boxed in. Let's hope and pray-- let's all get around in a circle and hold hands--that oil prices fall, which will also help us not get boxed in. Don, I told you I was going to be a little colorful. He was waiting for this one. I should mention that Don was actually at a conference where he talked about constraints on people's behavior as a result of the transcripts being recorded, and he said, ""But not Rick."" [Laughter] The third issue is something about which I am less constrained, which is communications. I would not have talked about this earlier, but it really does worry me. We have a complicated governance structure in this Committee, which I actually think is the right governance structure. We have two types of groups that vote on this Committee. We have the people who are Presidential appointees and then confirmed by the Senate, who are Board members, and I will soon not be one of them. I'll be a civilian again. Then we have Bank presidents, who are much more tied into the private sector because your boards of directors, which are composed of private-sector people, recommend you. Then we do have some role, but they're the primary people who decide who becomes a Bank president. I think that's a very good framework. It actually serves us very well. I've been on both sides. I've been on the other side of the fence, not as a president but as an executive vice president. It serves us very well because we have a link to the private sector that we normally would not have; importantly, it keeps us real in terms of information; and there's a group of people out there who are not in Washington or New York (because people also have a hard time about New York) but who tend to be very important supporters for us politically. So this is a system that I would very much like to see preserved. It does have a problem because of the different roles here. What I have been very concerned about--and I have had people in the markets speak to me about this--is that recently I had a very prominent central bank governor say to me, ""What in the hell are you guys doing?"" The issue here is that we need to have a situation where Bank presidents and also members of the Board can speak their views. They may have different views, and I very much encourage that in terms of discussion, of where they think the economy is going, which is what we do inside; and I think that does need to be done outside the Committee because it shows that there are different views, that we're thinking about it, that we're trying to learn from each other, and so forth and so on. What is very problematic from my viewpoint are the speeches, discussions, and interviews outside, when people talk about where they think interest rates should head and where the policy rate should head. That's where the criticism has been coming from. I have to tell you that a lot of people whom I respect tremendously are saying to me that it's making us look like the gang that can't shoot straight. I think it's a really serious problem. I understand that we want to keep the priority of speaking our minds, but we have to work as a team, and I think that we're having a problem in this regard. Let me talk about why I think this is dangerous. It's dangerous in terms of policy setting. You can see this is very blunt. Clearly, if you were in a multi-period game, you wouldn't be this blunt. But now I'm not going to be here anymore, so you can hate me--I don't care. [Laughter] But this kind of cacophony on this issue has the potential to damage us in two very serious ways. One is that it weakens the confidence in our institution, and I have to tell you that I love this institution. It's very hard for me to leave this place, but it's something I have to do. If the institution is damaged in terms of the confidence that the public and the politicians have in us, it will hurt us deeply. It will hurt us in terms of policy because it will weaken our credibility, which actually will make it harder to control inflation. So I consider this a very serious cost. The second issue is on the political front. It is very possible that we're going to have a reopening of the Federal Reserve Act with the next Administration and the next Congress. The reason I think it is possible is that we have to restructure our regulatory structure. There's no way to get around it--we are in a brave new world on this. That could lead to an opening of this issue. The problem here is, in that opening, there are a lot of people in the Congress who are very uncomfortable having policymakers who are not Presidential appointees and confirmed by the Senate. Two outcomes could come out of that. One is that they could take the vote away from the presidents, which I think would be a disaster because then you're not going to have good people going into the System. We won't have boards of directors that will be good. We won't have all of the benefits that we think we have from the current system. The other alternative is that we then have presidents who are actually appointed by the President and then confirmed by the Senate. I think, again, that hurts the private linkage. So I feel very strongly about all three of these issues, but I think that you're going to come up with serious challenges in the future that could be very damaging to the System. So I hope you think about this and still like me for being blunt, and also miss me because there will be a little less amusement. Who else would have brought Monty Python into the FOMC? Thank you very much. " CHRG-110hhrg38392--9 The Chairman," I apologize. You haven't given your opening statement yet. And you can comment now if you want to. I was wondering why the time hadn't started yet. If this had been my first hearing, I could explain that mistake a little bit easier. No good explanation comes to mind. You can comment now or just do your opening statement and come back to it.STATEMENT OF THE HONORABLE BEN S. BERNANKE, CHAIRMAN, BOARD OF CHRG-110hhrg46596--485 Mr. Foster," Okay. And the second thing, I guess for both of you, you had mentioned two metrics, the TED spread and the LIBOR-OIS spread, as ways to tell that you have really unlocked at least the interbank lending part of this thing. And there are problems with both of these as metrics. You know, the Treasury rate is being depressed by this flight to safety and so on. And I was wondering, is there really some combination of metrics that will give us a better feeling than these sort of simple things that we are talking about now? " CHRG-111shrg56376--143 Chairman Dodd," Thank you very much for your testimony. I was very fond of Lloyd Bentsen, served with him here. He was a wonderful Member of the Senate and a very good Secretary of the Treasury as well. So thank you for being with us. Welcome, Mr. Hillman. Nice to see you, and thank you for being here. Thank you for your service to the GAO, 31 years. Congratulations on that contribution. STATEMENT OF RICHARD J. HILLMAN, MANAGING DIRECTOR, FINANCIAL CHRG-111hhrg51591--108 Mr. Foster," My next question is, Alan Greenspan and others have this interesting suggestion of dealing with too-big-to-fail by simply imposing increasingly stringent capital requirements so that they would increase non-linearly as you increase in size, and that eventually there would be a motivation for a company that as it grew bigger, to split in two to get higher returns for its investors. And I was wondering if you have a reaction, if that would be appropriate for the insurance company. Yes, Mr. Harrington? " FOMC20051101meeting--157 155,MR. MOSKOW.," Vincent, I had a question on a different part of this. You raised the issue of whether you should use the inflation projection in your calculation of the equilibrium federal funds rate instead of the backward-looking inflation numbers that you use. I was wondering if you could elaborate on that a bit. I certainly would think that the forecast would be a better measure to put in here than the backward-looking figures. What is the argument or the logic for putting the backward-looking inflation numbers in there?" CHRG-110hhrg44901--170 Mr. Ellison," Reclaiming my time, that is where I am going with it. The fact is we have had recorded negative savings rates, and I believe that the stagnancy of wages--will you grant me 2000, will you agree with that, stagnant wages since then--I think that helps to explain part of the problem that Americans are having right now. That is why we are doing the refis, the payday loans, the credit cards, things like that. I just want to know from you to what degree does stagnant wages help contribute to the present situation even with regards to people getting into exotic mortgage products, credit cards, all of these loan products? Does it play a role, in your view? " CHRG-111hhrg55814--400 The Chairman," Mr. Ryan, isn't it likely to cause--and I apologize, if I can go--isn't it likely to cause a transfer from one institution to another? After all, there will be some institutions that will be on this list and some that won't. So, what I am trying to do is to convert the fear that being put on the list is a badge of honor into making it a scarlet letter. And I don't see how it would be disruptive, unless there are a whole lot of institutions there. But if only a few institutions are there, they can put their money elsewhere. " CHRG-110shrg38109--69 Chairman Dodd," Thank you, Senator Casey. Very good questions. I appreciate your focusing attention on that. I want to just mention, before turning to Senator Martinez, your response, Mr. Chairman, to Senator Schumer's questions about Sarbanes-Oxley and competitiveness. I appreciated your answer very much to that question. There are some things clearly that could be done to try and show some balance and making sure we are not overburdening smaller public companies, but your thrust was that this is working pretty well. And, frankly, anecdotally, I suspect most of us here ask the question of every business we talk to: How is this working? And I must tell you, overall the response I get is a good one. I had one company the other day say to me that, ``Even if Congress decided tomorrow to repeal Sarbanes-Oxley, we would decide to stay with all the things that have been required of us. We have found that it has been very worthwhile for our company.'' So, I appreciate your comments about that. Senator Martinez. Senator Martinez. Mr. Chairman, thank you very much. I hate to differ with the Chairman, but I must say that the experience that I hear on the competitiveness and Sarbanes-Oxley issue is far different from that. I hear a great deal of concern about the incredible cost and the burden of competitiveness that it has created. And, in fact, I will begin with this area because I intended to get into it, but our colleague from New York, Senator Schumer, and Mayor Bloomberg recently released a report that I found quite interesting detailing an analysis of market conditions in the United States and abroad and about the concern that there is about whether New York will continue to be the financial capital of the world or whether, in fact, there seems to be others competing for that title, which might include London. And there were some rather dramatic statistics of declines and increases in New York vis-a-vis London. One of the things that was mentioned in the report was the U.S. regulatory framework being too complicated and the implementation of Sarbanes-Oxley having produced heavier costs than were expected at the beginning or when you initiated that effort. Also it was mentioned immigration policies which create problems for those abroad who might wish to come here to do business, to invest in America, and the difficulties that current immigration problems raise for that, and some of them coming to be educated, others coming just as business people and investors. In any event, I wondered if you had an opportunity to see that report and whether its finding cause the same concerns to you that they raised to me. " CHRG-109shrg30354--10 STATEMENT OF SENATOR JIM BUNNING Senator Bunning. Thank you, Mr. Chairman. This is a very important hearing that we do twice a year and I cannot remember when it came at a more critical time for our markets and our economy. It has been a long time since I have seen a stock market that is as sensitive and unstable as this one. Chairman Bernanke, you have only been on the job for 5\1/2\ months but it has been a wild ride. I am disappointed in your leadership of the Fed so far but I am not surprised. During your confirmation process, I warned my colleagues that you were going to be much the same as former Chairman Greenspan, and so far you have been. The string of interest rate increases started by Chairman Greenspan has continued, and just as he did in 2000, I think you are going to overshoot. Also, you have not ended the group think at the Fed. In fact, it seems you have gone so far as to hand-pick new Fed Members that think just as you do. Some commentators point to the situation in the Middle East and North Korea as driving the market down, but those tensions have been around a lot longer than the current market downturn. Others say high energy prices are hanging over the economy. Yes, oil is expensive, but it is still below all-time highs when adjusted for inflation, and our energy expenses are a smaller percentage of our total expenses than in the past. Those are not the market's problems. What is dragging the market down is interest rates and uncertainty about Fed action. The Fed can do three things with its interest rate actions. It can overshoot, it can undershoot, or it can get it just right. It is much easier to mess up than to get it just right. The Fed has raised rates at 17 straight meetings. The Fed funds rate stands at 5.25 percent today and could go higher. There has been no pause to see how the economy reacts to those rate hikes. It has been one increase after another. At the current pace the Fed is going to overshoot and not even know it. By the time the full impact of interest rate increases is evident it will be too late. The U.S. economy will be damaged, and for that matter, the world economy could follow. The decisions of our central banks are often followed by foreign central banks and many have raised rates to keep pace with the United States. So many foreign economies rely on a strong U.S. economy for their growth and stability. The Fed is marching into dangerous territory and not looking back. There is a lot of speculation that the Fed may pause at the next meeting, but that is another way of saying that the Fed is still considering another increase. The markets do not know what the Fed is going to do and they will be on edge until there is certainty. Public statements by Fed Members over the last few months have not helped either. Many Governors have raised concerns that inflation is growing and said that interest rate hikes should continue. Others have said that it may be time to pause but have not dissented in Fed actions. The most recent official Fed statement has even caused more uncertainty. It was softer than the tough talk of the Chairman and others leading up to the meeting yet it does not rule out further rate increases. I still do not understand what all this talk and uncertainty is for. Inflation is not out of control. And I say it definitely, one more time. Inflation is not out of control. And if you think it is, we will further pursue it in the question and answer period. All indicators of inflation show that while it may be higher than in the past few years, it is still far below what we saw in the past few decades. Key indicators like gold are off their highs from earlier in the year and productivity has kept unit labor costs in check. The Fed is chasing an inflation monster that is just not there. I hope the Fed realizes that before it is too late. Thank you, Mr. Chairman. I look forward to asking some questions. " CHRG-110shrg50420--133 Mr. Dodaro," Well, there is no question, to the extent to which unemployment rises, it puts additional strain on all the social safety net programs that you mentioned, Senator, not the least of which is the health care costs and the Medicaid programs that the States are running, which is already growing at a rapid figure aside from these other figures. Now, the specifics on the PBGC is that, you know, basically, the PBGC Corporation has basically said that things are OK right now for the Big Three. But, you know, if there are some issues that emerge down the road, this could become much more problematic. And as I mentioned to Senator Tester, I would like to go back. This is a highly technical area, and I want to make sure I give this Committee the right answer, and by tomorrow I will provide a more detailed answer on the pension area in terms of what the current status is. But I would note that these companies are so large that, if something would happen down the road, they would almost double the number of people who would be receiving guarantees under PBGC, if that would ever get to that point down the road. So there is a significant issue potentially in the future, but I will get you a definitive answer tomorrow. Senator Brown. A steel maker not far from where I live in norther Ohio just announced the layoff of several hundred. It is very directly related to the auto industry. I spoke this week earlier with an auto dealer in southwest Ohio who has 800 employees. He is not about to go out of business, but he going to get squeezed. I do not know anything about his pension plan, but I do know that PBGC has been just buffeted time after time after time after time with job loss in the last 5 years, and it is only going to get worse. Let me just in my last--I know I am about out of time. I want to make a comment about the Chrysler situation just for a moment. I know there are many similarities to 30 years ago with Chrysler. There is the oil spike. There is the difficult credit market. There is a recession. Your suggestion that the differences are--of the similarities and differences I want to just expand on and respond just for a second. For example, some of the differences from 1979, the UAW had not made the concessions anywhere near in 1979 what they have made today. So even though it is only a billion and a half then compared to now, the UAW concessions have been much greater. The 2007 contract, there was nothing comparable to that in 1979. There was not the job loss leading up to 1979 for Chrysler that there has been, the cutting of costs, the downsizing, whatever, that there has been for all of the Big Three leading up to this situation. So we just need to be cautious about making that comparison. There are good reasons to make it, and there are some not so good reasons, and we need to be cautious because of the different situation that way. I think the good reasons are that the Government figured out how to do it, the taxpayers got their money back, and as several people up here have said, it did work, and we need to remember that. " CHRG-111hhrg53021--219 Secretary Geithner," Congressman, if we were proposing that, what you described, you would be right to be concerned and I would not support a proposal described as you did. What we are proposing to do is to take the basic framework that the Congress legislated to allow the country to deal with risks to the financial system posed by the failure of banks and thrifts, and to adapt that framework to give us similar authority to deal with a large complex financial institution. The absence of that framework and that authority was enormously damaging to this country. We are going to take a framework that was carefully designed by the Congress, with good checks and balances, lots of experience over time, and simply adapt that framework to give us similar tools to help manage the unwinding and the failure of large complex institutions. That is the proposal. Again, there is--the virtue of using the model we have, which is the FDIC resolution framework, is that that has been tested, people understand its merits and complexity, and gives us a little bit better basis for finding consensus on the right approach. " CHRG-111hhrg53021Oth--219 Secretary Geithner," Congressman, if we were proposing that, what you described, you would be right to be concerned and I would not support a proposal described as you did. What we are proposing to do is to take the basic framework that the Congress legislated to allow the country to deal with risks to the financial system posed by the failure of banks and thrifts, and to adapt that framework to give us similar authority to deal with a large complex financial institution. The absence of that framework and that authority was enormously damaging to this country. We are going to take a framework that was carefully designed by the Congress, with good checks and balances, lots of experience over time, and simply adapt that framework to give us similar tools to help manage the unwinding and the failure of large complex institutions. That is the proposal. Again, there is--the virtue of using the model we have, which is the FDIC resolution framework, is that that has been tested, people understand its merits and complexity, and gives us a little bit better basis for finding consensus on the right approach. " CHRG-111hhrg53246--118 Mr. Kanjorski," The gentleman's time has expired. Now I recognize the gentleman from California, Mr. Miller. Mr. Miller of California. Thank you very much, Mr. Chairman. FASB has made changes to accounting standards that will have tremendous impacts on securitizations known as FAS 166 and 167, as I said in my opening statement. These changes are occurring at the same time that the Administration is trying to restart the securitized credit markets through programs like TAF to private lending. On the other hand, it is our understanding that the Federal Reserve has serious concerns with this policy shift that could derail efforts to stabilize financial institutions and get credit flowing. And, I guess, is that accurate; and what are their concerns? Ms. Schapiro. Thank you, Congressman. I guess I have a couple of comments on this. I would say that FASB walked down the path of reviewing off balance sheet accounting, really as a result of a concern expressed by the Fed and the Treasury and the President's Working Group, that more transparency and improvement to all balance sheet accounting was absolutely essential; that it had been the lack of transparency; the ability to push all these products off balance sheet had, in fact, been a contributor and perhaps a significant one to the financial crisis. So I am surprised to learn that the Fed is not comfortable with where FASB landed with the guidance that it issued in June. I guess I would also say that these new standards were actually--the assumptions underlying these new standards were actually even incorporated into the stress-testing that was done of the banks. So the Fed has been quite involved and quite aware of what FASB was doing here and had quite a lot of input throughout this process. With respect to what the Fed might do regarding capital rules, I think that is a question, obviously, best perhaps directed to Chairman Bernanke. Mr. Miller of California. That is applying stress tests to basically the banks with that slice of the market. How do you plan to apply it to the rest? Basically applying the stress test to banks is only a slice of the market. Ms. Schapiro. Yes. I brought that up only to indicate that the Fed has had active involvement in these discussions. Mr. Miller of California. Okay. We discussed in Chairman Bernanke's hearing yesterday about the challenges facing the $6 trillion commercial marketplace that we see coming in the future. Many of these accounting regulation changes--aimed most at the residential market--hit the commercial real estate capital market especially hard, which in turn impacts business and provides jobs. Are the accounting policymakers communicating with the financial regulators who oversee the economy and recovery efforts? And I guess that would be Chairman Schapiro. Ms. Schapiro. Very much so. There is very great sensitivity at FASB--and I will say on the international level, the International Accounting Standards Board--that while financial statements are prepared for investors so that they can make rational decisions about the allocation of capital and where and how to invest, that there are other constituents that have interests. And so they have been very open to receiving input from bank regulators, from the SEC, as well as from investor groups and others. Mr. Miller of California. My concern is, if you look at the situation the banks were in at the beginning of the situation with the subprime and the residential marketplace, the reserves were much healthier than they are today and I think they were in a healthier than they are today. And if you look at the commercial-backed mortgage securities, they are starting to hit about the fourth quarter this year; about $5 billion worth of loans are maturing and coming due. And then about January, the default rate on the commercial sector was about one-quarter of 1 percent. It is about 2 percent today. In the coming days, it is expected to rise dramatically. The loans due by about 2012 are about $1 trillion. The growing expectation is that default rates will be between 12 and 15 percent. How do we realistically handle that when most of these loans are 30-year loans, 5-year calls and you have gone from a 7 percent cap rate in 2006 to a 10 percent cap rate today. Whereby a lender is stuck in a situation where they might have a $14 million loan on a piece of property that based on a declining marketplace, as we see in a 10 percent cap rate, might value at $8 million when they should only get 5 on it, how are you going to deal with them trying to extend that loan when you have to apply mark-to-market to it, which would require a $9 million set-aside? Ms. Schapiro. I guess I am not exactly the right person to answer that question. But if I could take a step back and say that the SEC staff conducted a pretty extensive review of fair value and mark-to-market accounting last year and published their report before I arrived at the agency in early January. And what they found through their efforts is that investors value greatly fair-value accounting. It is what allows them to make decisions to invest at all. Mr. Miller of California. I understand that. But the situation we are facing is you are hitting a second round of residential foreclosures that is occurring right now. And that is the people who have good loans, but have lost their jobs. Or they are business people who are no longer able to make their payments who are losing their homes today. You have about 70 percent of the lending marketplace is commercial; you have lenders that are not in a situation they were in 4 years ago as far as liquidity and reserves. I am not talking about a new loan that somebody wants to make for a piece of commercial investor property. I am talking about a current situation that the banking and lending industry is going be in today when these 5-year calls come due. And based on accounting standards, you have to apply mark-to-market--I mean, that is the rule today. And based on that rule alone, the banking industry is going to be absolutely upside down. I don't know how they weather this, or the economy weathers this next round of commercial foreclosures. And my question is--I am not saying new loans--I am saying for existing loans that are coming due, how are we going to deal with them? We can't just say, ``well, mark-to-market requires.'' We are faced with a financial situation that could be devastating. Ms. Schapiro. I guess I don't have a quick answer to your question. I would be more than happy to come up and maybe bring our chief accountant with me and spend some time to talk with you about that. Mr. Miller of California. I would love to, because this is a serious situation for the economy that is going to occur very rapidly, and I don't think banks can handle it. Ms. Schapiro. I would be very happy to do that. Mr. Miller of California. I would love to meet with you. Thank you. " FOMC20080430meeting--8 6,MR. LACKER.," I think the political concern you raised and described is a very, very serious one for this institution. Even if we thought of this ourselves before Senator Dodd and others wrote to us--and apparently it is true that we did--we are never going to be able to convince a broad array of observers that this was not a direct response to a senatorial request. Given that, I think the perception that we included this and maybe added some other securities as a fig leaf sets just a disastrous precedent. It would be the use of our balance sheet to circumvent the checks and balances of the constitutional process for legislating about fiscal matters. I think that the integrity of our independence as an institution relies, to a substantial degree, on our lack of entanglement or our distance from the political fray. I would also question the value of this on the substance. What we are doing with the TSLF, as Bill's chart showed, looks as though it has had a big effect on the GC repo rate. It is hard to see how some additional amount of Treasuries in the market, given the size of the Treasury market, is going to have a gigantic effect. It is also hard to see that there is much strain or dislocation caused by the most recent observation in his graph on the gap between the funds rate and the GC repo rate--which is actually, what, like 10 or 20 basis points or about what it has historically been. So I would question whether we really need this on the substance as well. On the other measures, the TAF is dominated by European institutions. Term funding spreads seem dominated by the term funding demands of European institutions. I don't see why we don't try to shift to European institutions the public policy responsibility for managing those situations. We already have an apparently well-functioning mechanism for supplying dollar balances to foreign official institutions to allow them to do that. I don't see why we don't limit our expansion of funding in that direction--to the swap lines--rather than expanding the TAF. Thank you. " CHRG-111shrg55117--117 Mr. Bernanke," Well, we agree with you that the community banks are very important, and as I was mentioning to one of your colleagues, in many cases where large banks are withdrawing from small business lending or from local lending, the community banks are stepping in, and we recognize that and think it is very important. The Federal Reserve provides similar support to small banks that we do to large banks in that you mentioned liquidity. We provide discount window loans or loans through the Term Auction Facility and smaller banks are eligible to receive that liquidity at favorable interest rates. It is not our department, but the Treasury has been working to expand the range of banks which can receive the TARP capital funds and they have made significant progress in dealing with banks that don't trade publicly. We have worked with smaller banks to try to address some of the regulatory burden that they face, and we have a variety of partnerships, for example, with minority banks to try to give them assistance, technical assistance, and the like. I agree. If I were a small banker, I would be a little bit annoyed because the big banks seem to have gotten a lot more of the attention because it was the big banks and their failures that have really threatened our system. And that is why it is very important as we do financial regulatory reform that we address this too big to fail problem so that we don't have this unbalanced situation where you either have to bail out a big bank or else it brings down the system. That is not acceptable and we have to fix that. But we are working with small banks, and personally, I always try to meet with small bank leaders and the ICBA and other trade associations, and I agree with you that they are very important. They are playing a very important role right now in our economy. Senator Kohl. You say you agree that they are important, that they play an important role in our economy. Are you satisfied that we are doing proportionately as much for small community banks as we are doing for the large banks? " CHRG-111hhrg55811--304 Mr. Johnson," I would agree with you that those reforms would be helpful and meaningful and that they were the triggering episode, but I believe that the opacity of the large intertwined markets which included a lot of derivative exposures added to the fear and the depth and the severity of the downturn. Another trigger could cause that. " CHRG-111hhrg53244--15 Mr. Bernanke," Mr. Chairman, we are watching that situation very carefully. There are a lot of CRE loans which are coming up for refinance, and the capacity to refinance them is limited, which poses the possibility of foreclosures in the commercial space, much as in the residential situation. We are urging banks to continue to make loans to credit-worthy borrowers, and our examiners are presenting a balanced view in their discussions with banks. The other step we have taken to try to address this problem, Mr. Chairman, is that we have recently added to our TALF program both new and legacy commercial mortgage-backed securities. By doing that, we hope to open up the mortgage-backed securities market, which is an important source of funding and finance for the CRE market. " CHRG-110hhrg46596--4 Mr. Issa," Thank you, Mr. Chairman. I appreciate your indulgence in this. I know we are all on kind of a crazy schedule here in this extended, extended, extended Congress. Mr. Chairman, Ranking Member Bachus--if he was here--and members of the committee, I want to thank you for this opportunity to speak today. There is no more important issue before Congress now than ending the financial crisis that besets our country, whether it is in fact the financial crisis that we believed we were dealing with only weeks ago or it is the auto companies that were before you this week. As you know, I have been a critic of the bailout from its inception. I have stressed deliberate action and warned of potential failures. I think I have been vindicated in my objection to that spending of $700 billion of taxpayers' dollars, of which half already appears to have been spent. I am not pleased with that. I wish I had been wrong. After all, these are not private funds that companies can use freely. These are, in fact, the future tax dollars of Americans, and our children will be paying not just the principal but the interest for generations to come. To date, the oversight of the bailout has been severely lacking. Through no fault of the Congress, we were pushed to quickly pass a bill that only generally called for accounting. The Government Accountability Office--as we will hear more about today--the Washington Post and other media outlets, and most importantly, the American people have been critical of the lack of oversight and the inability to apply oversight. People want to know where their money is being spent and if it is having the impact that is intended, and few think that it is. While we know there are many bad actors and causes of financial crisis from lack of lending practices to insufficient regulatory scrutiny, substantial questions regarding the root causes still remain. Yesterday, in our Committee on Government Reform we dealt with Freddie Mac and Fannie Mae, and we came away with more unanswered questions than answered questions. Neither Congress nor officials within the Administration have sufficient expertise to gain a full understanding of the complex issues surrounding both how we got in and how we will get out of this. A Colombia University professor recently stated that any reform must begin with a dispassionate and informed assessment of what went wrong. And I agree. We must pass legislation to create a bipartisan or nonpartisan blue-ribbon panel that can give the American people an objective assessment of the causes and the handling of the financial crisis. Although no one bill would be perfect, and certainly mine is no different, in November, I introduced H.R. 7275, the Financial Oversight Commission Act of 2008. Modeled after the 9/11 Commission, the Financial Oversight Commission is designed to have experts examine the causes of this crisis, evaluate corrective measures taken thus far, and make recommendations for alternative measures. The commission should examine the missteps of we as Congress, the Administration, the private sector, nonprofit organizations, certainly the GSEs and all others have taken, and then make recommendations on the next step forward. Had we done this in the original legislation, we would already be halfway through the commission process. The commission could take up to a year to conduct its entire investigations, make findings, and report the recommendations to Congress and the President. However, as I am sure the Chair would agree, commissions in the first 90 days often accomplish a great deal of what they will accomplish in 1 year by bringing the type of focus and the type of individuals and the type of scrutiny that causes others to begin to volunteer changes. As economic conditions in the financial sector itself are not static, the panel will continue its review and would evaluate ongoing circumstances. In a report to Congress, the commission shall make a complete accounting of the circumstances surrounding the crisis, the private sector, the government role in causing the crisis, and the extent to which the United States preparedness for immediate response to a future crisis. The report should offer a conclusion and recommendations for corrective measures that can be taken to prevent further economic breakdown. Mr. Chairman, Ranking Member Bachus, it is time that we realize that we are a partisan organization; the next President will be a partisan organization; that we had a hand in the creation of this problem, whether it was a large hand or a small hand; whether it was in fact things we told the financial institutions to do or, quite frankly, oversight we failed to assert over them at both the executive and the congressional level. So Mr. Chairman, I strongly recommend that as you deliberate the current, you begin thinking about how we would put together, on a broad basis, a commission that would be a tool of this Congress. I thank you for this opportunity. " CHRG-111shrg54533--6 Secretary Geithner," Mr. Chairman, Ranking Member Shelby, and Members of the Committee, it is a pleasure to be here. I welcome this debate. This is a critically important debate for our country, and I think it is time we get to it. Over the past 2 years, our Nation has faced the most severe financial crisis since the Great Depression. Our financial system failed to perform its critical functions. The system magnified risks. Some of the largest institutions in the world failed. The resulting damage affected the country as a whole, affecting virtually every American. Millions have lost their jobs and their homes. Hundreds and thousands of small businesses have shut down. Students have deferred college and education, and workers have had to shelve their retirement plans. American families are making essential changes in response to this crisis. It is our responsibility to do the same, to make our Government work better. And that is why yesterday President Obama unveiled a sweeping set of regulatory reforms to lay the foundation for a safer, more stable financial system, one that can deliver the benefits of market-driven financial innovation even as it guards against the dangers of market-driven excesses. Every financial crisis of the last generation has sparked some effort at reform, but past efforts have been begun too late, often after the will to act has subsided. We cannot let this happen this time. We may disagree about the details, and we will have to work through these issues. But ordinary Americans have suffered too much. Trust in our financial system has been too shaken, and our economy was brought too close to the brink for us to let this moment pass. In crafting our plan, the administration has sought input from all sources. We consulted extensively with Members of Congress, regulators, consumer advocates, business leaders, academics, and the broader public. And we looked at a range of proposals made by a number of bodies here in the United States over the last several months. We considered a full range of options, and we made the judgment that now was the time to pursue the essential reforms, those that address the core causes of the crisis and those that will help prevent or contain future crises. I want to be clear. Our plan does not address and does not seek to address every problem in our financial system. That is not our intent, and we do not propose reforms that, while desirable, would not move us toward achieving those core objectives of creating a more stable system and addressing those vulnerabilities that are critical to our capacity to prevent future crises. We have laid out the details of our proposals in public, so I just want to spend a few minutes explaining some of the broad principles that guided our proposals. First, if this crisis has taught us anything, it is that risks to our system can come from almost any quarter. We must be able to look in every corner and across the horizon for dangers, and our system was not able to do that. While many of the firms and markets at the center of the crisis were under some form of Federal regulation, that supervision did not prevent the emergence of large concentrations of risk. A patchwork of supervisory responsibility, loopholes that allowed some institutions to shop for the weakest regulator, and the rise of new institutions and instruments that were almost entirely outside the Government's supervisory framework left regulators largely blind to emerging dangers. And regulators were ill equipped to spot systemwide threats because each was assigned to protect the safety and soundness of individual institutions under their watch. None was assigned to look out for the broader system as a whole. That is why we propose establishing a Financial Services Oversight Council to bring together the heads of all the major Federal financial regulatory agencies, and this council will help ensure that we fill gaps in the regulatory structure where they exist and where they emerge. It will improve coordination of policy and help us resolve disputes across agencies. And, most importantly, it will have the power to gather information from any firm or market to help identify and help the underlying regulators respond to emerging risks. The council will not have the responsibility for supervising the largest, most complex, interconnected institutions, and the reason for that is simple. That is a highly specialized, complicated task, and it requires tremendous institutional capacity and organizational accountability. Nor would the council be an appropriate first responder in a financial emergency. You cannot convene a committee to put out a fire. The Federal Reserve is the best positioned to play that role. It already supervises and regulates bank holding companies, including all major U.S. commercial and investment banks. Our plan is to give it a carefully designed, modest amount of additional authority, and clearer accountability for the Fed to carry out that mission, but we also take some important authority and responsibilities away from the Federal Reserve. Specifically, we propose removing from the Federal Reserve and other bank regulators oversight responsibility for consumers. Historically in those agencies, consumer interests were often perceived to be in conflict with the broader mandate of the institutions to protect safety and soundness. That brings me to our second key priority: consolidating protection for consumers and ensuring they understand the risks and rewards associated with financial products sold directly to them. Before this crisis, many Federal and State regulators had authority to protect consumers, but few viewed it as their primary mission. As abusive practices spread, particularly in the market for subprime and nontraditional mortgages, our regulatory framework proved inadequate. And this lack of oversight, as the Chairman said, led millions of Americans to make bad financial decisions that emerged as a core part, a core cause of this crisis. Consumer protection is not just about individuals, but it is also about safeguarding the system as a whole. Now, this Committee, the Congress, and the administration have already taken important steps to address consumer problems in two key markets--those for credit cards and the beginning mortgages--and our view is that those are a sound foundation on which to build more comprehensive reform. We propose the establishment of a Consumer Financial Protection Agency to serve as the primary Federal agency looking out for the interests of consumers of credit, savings, payments, and other financial products. This agency will be able to write rules that promote transparency, simplicity, and fairness, including standards for standardized, simple, plain vanilla products that have straightforward pricing. Our third priority is to make sure that reform, while discouraging abuse, encourages financial innovation. The United States remains the world's most vibrant and most flexible economy in large measure because our financial markets create a continuous flow of new products, services, and capital. That makes it easier for the innovator to turn a new idea into a growing company. Our core challenge, though, is to design a system which has a proper balance between innovation and efficiency on the one hand and stability and protection on the other. We did not get that balance right, and that requires substantial reform. We think the best way to keep the system safe for innovation is to have stronger protections against risk with stronger capital buffers, to have greater disclosure so that investors and consumers can make more informed financial decisions, and a system that is better able to evolve as innovation advances and the structure of our financial system changes in the future. Now, I know that some suggest we need to ban or prohibit specific types of financial instruments as too dangerous, and we are proposing to strengthen consumer protections and investor protections and enforcement by, among other things, prohibiting a range of abusive practices, such as paying brokers for pushing consumers into higher-priced loans or penalties for earlier repayment of mortgages. In general, however, we do not believe you can build a system based on--a more stable system based on an approach of banning on a periodic basis individual products because those risks will simply emerge quickly in new forms. Our approach is to let new products develop, but to bring them into a regulatory framework with the necessary safeguards in place. Our tradition of innovation in the financial sector has been central to our prosperity as a country, so our reforms are designed to strengthen our markets by restoring confidence and accountability. Finally, Mr. Chairman, a fourth priority is to address the basic vulnerabilities and our capacity to manage future crises. We came into this crisis without an adequate set of tools to confront and deal with the potential failures of large, complex financial institutions. That left the Government with extremely limited choices when faced with the failure of the largest insurance company in the world and some of the world's largest investment banks. And that is why, in addition to addressing the root causes of this crisis, putting in place a better framework for crisis prevention in the future, we have to act to give the Government better tools to manage future crises. At the center of this, we propose a new resolution authority modeled on the existing authority of the FDIC to manage the failure of weak thrifts and banks, and that will give us more options in the future that we should have had going into this crisis. This will help reduce moral hazard by allowing the Government to resolve failing institutions in ways that impose costs on owners, creditors, and counterparties, making them more vigilant and prudent. Now, we have to also minimize moral hazard created by institutions that emerge with a scale and size that could threaten stability. No one should assume that the Government in the future will step in to bail these institutions out if they fail. We will do this by making sure financial firms follow the example of families across the country and build bigger protections, bigger cushions, bigger safeguards as a precaution against bad times. We will require all firms to keep more capital and more liquidity on hand as a greater cushion against future losses and risks, and the biggest, most interconnected firms will be required to keep larger cushions, larger shock absorbers against future shocks. Now, the critical test of our reforms will be whether we make the system strong enough to withstand the stress of future recessions and strong enough to withstand the failure of large institutions in the future. These are our basic objectives. We want to make the system safer for failure and safer for innovation. We cannot afford inaction. As both the Chairman and Ranking Member said, I do not think we can afford a situation where we leave in place vulnerabilities that will sow the seeds for future crises, so we look forward to working with this Committee in the weeks and months ahead to put in place a stronger foundation for a more stable financial system in the future. Thank you very much, Mr. Chairman. " CHRG-111hhrg53248--62 Mr. Hensarling," I do have limited time. So it is a central cause, but do you believe to a great extent it has already been remedied? " CHRG-111shrg57320--212 Mr. Dochow," And that is very difficult because you have that balancing act between having a free market, capitalistic system and a safe and sound system. And to have someone just simply rule, this product is good, this product is bad, has some consequences. So it is a very difficult dilemma and---- Senator Kaufman. Yes, and frankly, I am concerned, because I don't want to see over-regulation, and I know you don't, either. But when you have situations like this, like you say, it was a systemic problem, and it was a systemic problem right to the top, we are going to just self-regulate the markets, we don't need any regulation, it was pretty widespread. Let me ask you, though, at some point, Mr. Thorson said earlier that this is like the fact that these numbers, which I will not read again, there were so many of these types of loans, and as the Chairman said, even have specific cases where people went in and redacted the W-2, at some point, doesn't this begin to look like fraud on somebody's part? " CHRG-111shrg54789--180 PROTECTION AGENCY If the CFPA is to be effective in its mission, it must be structured so that it is strong and independent with full authority to protect consumers. Our organizations have strongly endorsed President Obama's proposal regarding what should be the agency's jurisdiction, responsibilities, rule-writing authority, enforcement powers and methods of funding. \73\ His proposal would create a Consumer Financial Protection Agency (CFPA) with a broad jurisdiction over credit, savings and payment products, as well as fair lending and community reinvestment laws. \74\ (Recommendations for improvement to the Administration bill are flagged below.) The legislation has been introduced (without providing the agency jurisdiction over the Community Reinvestment Act) by House Financial Services Chairman Barney Frank as H.R. 3126.--------------------------------------------------------------------------- \73\ Senators Durbin, Schumer, Kennedy and Dodd offered the first legislative proposal to create a consumer financial agency (S. 566), known as the Financial Product Safety Commission. The bill was originally introduced in the last Congress. \74\ ``Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation,'' Department of the Treasury, June 17, 2009, pp. 55-70. The White House has since proposed legislation to effectuate the proposal in this ``White Paper.''--------------------------------------------------------------------------- In its work to protect consumers and the marketplace from abuses, the CFPA as envisioned by the Administration would have a full set of enforcement and analytical tools. The first tool would be that the CFPA could gather information about the marketplace so that the agency itself could understand the impact of emerging practices in the marketplace. The agency could use this information to improve the information that financial services companies must offer to customers about products, features or practices or to offer advice to consumers directly about the risk of a variety of products on the market. For some of these products, features or practices, the agency might determine that no regulatory intervention is warranted. For others, this information about the market will inform what tools are used. A second tool would be to address and rein in deceptive marketing practices or require improved disclosure of terms. The third tool would be the identification and regulatory facilitation of ``plain-vanilla,'' low risk products that should be widely offered. The fourth tool would be to restrict or ban specific product features or terms that are harmful or not suitable in some circumstances, or that don't meet ordinary consumer expectations. Finally, the CFPA would also have the ability to prohibit dangerous financial products. We can only wonder how much less pain would have been caused for our economy if a regulatory agency had been actively exercising the latter two powers during the run up to the mortgage crisis.A. Agency structure and jurisdiction. Under the Administration's proposal, the agency would be governed by a five-member board. Four of these members would be appointed by the President and confirmed by the Senate. The final member would be the director of the consolidated bank supervisory agency proposed by the President. We strongly recommend that the stipulated qualifications for board membership be improved to require that board members have actual experience and expertise with consumer protection in the financial services arena. An agency focused solely on protecting consumers must be governed by leaders who have expertise not just in the financial services marketplace, but with protecting consumers in that marketplace. The Administration proposes to have the agency oversee the sale and marketing of credit, deposit and payment products and services and related products and services, and will ensure that they are being offered in a fair, sustainable and transparent manner. This should include debit, prepaid debit, and stored value cards; loan servicing, collection, credit reporting and debt-related services (such as credit counseling, mortgage rescue plans and debt settlement) offered to consumers and small businesses. Our organizations support this jurisdiction because credit products can have different names and be offered by different types of entities, yet still compete for the same customers in the same marketplace. Putting the oversight of competing products under one set of minimum Federal rules regardless of who is offering that product will protect consumers, promote innovation, provide consumers with valuable options, and spur vigorous competition. As with the Administration, we recommend against granting this agency jurisdiction over investment products that are marketed to retail investors, such as mutual funds. While there is a surface logic to this idea, we believe it is impractical and could inadvertently undermine investor protections. Giving the agency responsibility for investment products that is comparable to the proposed authority it would have over credit products would require the agency to add extensive additional staff with expertise that differs greatly from that required for oversight of credit products. Apparently simple matters, such as determining whether a mutual fund risk disclosure is appropriate or a fee is fair, are actually potentially quite complex and would require the new agency to duplicate expertise that already exists within the SEC. Moreover, it would not be possible simply to transfer the staff with that expertise to the new agency, since the SEC would continue to need that expertise on its own staff in order to fulfill its responsibilities for oversight of investment advisers and mutual fund operations. In addition, unless the new agency was given responsibility for all investment products and services a broker might recommend, brokers would be able to work around the new protections with potentially adverse consequences for investors. A broker who wanted to avoid the enhanced disclosures and restrictions required when selling a mutual fund, for example, could get around them by recommending a separately managed account. The investor would likely pay higher fees and receive fewer protections as a result. For these reasons, we believe the costs and risks of this proposal outweigh the potential benefits. The Administration's plan wisely provides the agency with jurisdiction over a number of insurance products that are central or ancillary to credit transactions, including credit, title, and mortgage insurance. \75\ This principal behind this approach is to provide the agency with holistic jurisdiction over the entire credit transaction, including ancillary services often sold with or in connection with the credit. Additionally, there is ample evidence of significant consumer abuses in many of these lines of insurance, including low loss ratios, high mark ups, and ``reverse competition'' where the insurer competes for the business of the lender, rather than of the insurance consumer. \76\ This Federal jurisdiction could apply without interfering with the licensing and rate oversight role of the States.--------------------------------------------------------------------------- \75\ The agency should also be given explicit authority over ``forced-place'' homeowner's insurance, which banks can require borrowers to purchase if they cannot procure their own coverage. \76\ Testimony of J. Robert Hunter, Director of Insurance, Consumer Federation of America, before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the U.S. House Financial Services Committee, October 30, 2007, pp. 8-9.--------------------------------------------------------------------------- The United States has never sufficiently addressed the problems and challenges of lending discrimination and red lining practices, the vestiges of which include the present day unequal, two-tiered financial system that forces minority and low-income borrowers to pay more for financial services, get less value for their money, and exposes them to greater risk. It is therefore, imperative that the Consumer Financial Protection Agency also focus in a concentrated way on fair lending issues. To that end, the Agency must have a comprehensive Office of Civil Rights, which would ensure that no Federal agency perpetuated unfair practices and that no member of the financial industry practices business in a way that perpetuates discrimination. Compliance with civil rights statutes and regulations must be a priority at each Federal agency that has financial oversight or that enforces a civil rights statute. There must be effective civil rights enforcement of all segments of the financial industry. Moreover, each regulatory and enforcement agency must undertake sufficient reporting and monitoring activities to ensure transparency and hold the agencies accountable. A more detailed description of the civil rights functions that must be undertaken at the CFPA and at other regulatory and enforcement agencies can be found in the Civil Rights Policy Paper available at www.ourfinancialsecurity.org. \77\--------------------------------------------------------------------------- \77\ See http://ourfinancialsecurity.org/issues/leveling-the-playing-field/---------------------------------------------------------------------------B. Rule writing. Under the Administration proposal, the agency will have broad rule-making authority to effectuate its purposes, including the flexibility to set standards that are adequate to address rapid evolution and changes in the marketplace. Such authority is not a threat to innovation, but rather levels the playing field and protects honest competition, as well as consumers and the economy. The Administration's plan also provides that the rule-making authority for the existing consumer protection laws related to the provision of credit would be transferred to this agency, including the Truth in Lending Act (TILA), Truth in Savings Act (TISA), Home Ownership and Equity Protection Act (HOEPA), Real Estate Protection Act (RESPA), Fair Credit Reporting Act (FCRA), Electronic Fund Transfer Act (EFTA), and Fair Debt Collection Practices Act (FDCPA). Current rule-writing authority for nearly 20 existing laws is spread out among at least seven agencies. Some authority is exclusive, some joint, and some is concurrent. However, this hodgepodge of statutory authority has led to fractured and often ineffectual enforcement of these laws. It has also led to a situation where Federal rule-writing agencies may be looking at just part of a credit transaction when writing a rule, without considering how the various rules for different parts of the transaction affect the marketplace and the whole transaction. The CFPA with expertise, jurisdiction, and oversight that cuts across all segments of the financial products marketplace, will be better able to see inconsistencies, unnecessary redundancies, and ineffective regulations. As a marketwide regulator, it would also ensure that critical rules and regulations are not evaded or weakened as agencies compete for advantage for the entities they regulate. Additionally the agency would have exclusive ``organic'' Federal rule-writing authority within its general jurisdiction to deem products, features, or practices unfair, deceptive, abusive or unsustainable, and otherwise to fulfill its mission and mandate. The rules may range from placing prohibitions, restrictions, or conditions on practices, products, or features to creating standards, and requiring special monitoring, reporting, and impact review of certain products, features, or practices.C. Enforcement. A critical element of a new consumer protection framework is ensuring that consumer protection laws are consistently and effectively enforced. As mentioned above, the current crisis occurred not only because of gaps and weaknesses in the law, but primarily because the consumer protection laws that we do have were not always enforced. For regulatory reform to be successful, it must encourage compliance by ensuring that wrongdoers are held accountable. A new CFPA will achieve accountability by relying on a three-legged stool: enforcement by the agency, by States, and by consumers themselves. First, the CFPA itself will have the tools, the mission and the focus necessary to enforce its mandate. The CFPA will have a range of enforcement tools under the Administration proposal. The Administration, for example, would give the agency examination and primary compliance authority over consumer protection matters. This will allow the CFPA to look out for problems and address them in its supervisory capacity. But unlike the banking agencies, whose mission of looking out for safety and soundness led to an exclusive reliance on supervision, the CFPA will have no conflict of interest that prevents it from using its enforcement authority when appropriate. Under the Administration proposal, the agency will have the full range of enforcement powers, including subpoena authority; independent authority to enforce violations of the statues it administers; and civil penalty authority. Second, both proposals allow States to enforce Federal consumer protection laws and the CFPA's rules. As Stated in detail in Section 5, States are often closer to emerging threats to consumers and the marketplace. They routinely receive consumer complaints and monitor local practices, which will permit State financial regulators to see violations first, spot local trends, and augment the CFPA's resources. The CFPA will have the authority to intervene in actions brought by States, but it can conserve its resources when appropriate. As we have seen in this crisis, States were often the first to act. Finally, consumers themselves are an essential, in some ways the most essential, element of an enforcement regime. Recourse for individual consumers must, of course, be a key goal of a new consumer protection system. The Administration's plan appropriately States that the private enforcement provisions of existing statutes will not be disturbed. A significant oversight of the Administration's plan is that it does not allow private enforcement of new CFPA rules. It is critical that the consumers who are harmed by violations of these rules be able to take action to protect themselves. Consumers must have the ability to hold those who harm them accountable for numerous reasons: No matter how vigorous and how fully funded a new CFPA is, it will not be able to directly redress the vast majority of violations against individuals. The CFPA will likely have thousands of institutions within its jurisdiction. It cannot possibly examine, supervise or enforce compliance by all of them. Individuals have much more complete information about the affect of products and practices, and are in the best position to identify violations of laws, take action, and redress the harm they suffer. An agency on the outside looking in often will not have sufficient details to detect abusive behavior or to bring an enforcement action. Individuals are an early warning system that can alert States and the CFPA of problems when they first arise, before they become a national problem requiring the attention of a Federal agency. The CFPA can monitor individual actions and determine when it is necessary to step in. Bolstering public enforcement with private enforcement conserves public resources. A Federal agency cannot and should not go after every individual violation. Consumer enforcement is a safety net that ensures compliance and accountability after this crisis has passed, when good times return, and when it becomes more tempting for regulators to think that all is well and to take a lighter approach. The Administration's plan rightly identifies mandatory arbitration clauses as a barrier to fair adjudication and effective redress. We strongly agree--but it is also critically important regarding access to justice that consumers have the right to enforce a rule. Private enforcement is the norm and has worked well as a complement to public enforcement in the vast majority of the consumer protection statutes that will be consolidated under the CFPA, including TILA, HOEPA, FDCPA, FCRA, EFTA and others. Conversely, the statutes that lack private enforcement mechanisms are notable for the lack of compliance. The most obvious example is the prohibition against unfair and deceptive practices in Section 5 of the FTC Act. Though the banking agencies eventually identified unfair and deceptive mortgage and credit card practices that should be prohibited (after vigorous congressional prodding), individuals were subject to those practices for years with no redress because they could not enforce the FTC Act. Not only consumers, but the entire economy and even financial institutions would have been much better off if consumers had been able to take action earlier on, when the abusive practices were just beginning.D. Product evaluation, oversight, and monitoring. Under the Administration's proposal, the agency would have significant enforcement and data collection authority to evaluate and to remove, restrict, or prevent unfair, deceptive, abusive, discriminatory, or unsustainable products, features or practices. The agency could also evaluate and promote practices, products, and features that facilitate responsible and affordable credit, payment devices, asset-building, and savings. Finally, the agency could assess the risks of both specific products and practices and overall market developments for the purpose of identifying, reducing and preventing excessive risk (e.g., monitoring longitudinal performance of mortgages with certain features for excessive failure rates; and monitoring the market share of products and practices that present greater risks, such as weakening underwriting). Specifically, we would recommend that the agency take the following approach to product evaluation, approval and monitoring under the proposal: Providers of covered products and services in some cases could be required to file adequate data and information to allow the agency to make a determination regarding the fairness, sustainability, and transparency of products, features, and practices. This could include data on product testing, risk modeling, credit performance over time, customer knowledge and behavior, target demographic populations, etc. Providers of products and services that are determined in advance to represent low risk would have to provide de minimus or no information to the agency. ``Plain-vanilla'' products, features or practices that are determined to be fair, transparent and sustainable would be determined to be presumptively in compliance and face less regulatory scrutiny and fewer restrictions. Products, features or practices that are determined to be potentially unfair, unsustainable, discriminatory, deceptive or too complex for its target population might be required to meet increased regulatory requirements and face increased enforcement and remedies. In limited cases, products, features or practices that are deemed to be particularly risky could face increased filing and data disclosure requirements, limited roll-out mandates, post- market evaluation requirements and, possibly, a stipulation of preapproval before they are allowed to enter or be used in the marketplace. The long-term performance of various types of products and features would be evaluated, and results made transparent and available broadly to the public, as well as to providers, Congress, and the media to facilitate informed choice. The Agency should hold periodic public hearings to examine products, practices and market developments to facilitate the above duties, including the adequacy of existing regulation and legislation, and the identification of both promising and risky market developments. These hearings would be especially important in examination of new market developments, such as, for example, where credit applications will soon be submitted via a mobile phone, for example, and consumer dependence on the Internet for conducting financial transactions is expected to grow dramatically. In such hearings, in rule-makings, and in other appropriate circumstances, the Agency should ensure that there is both opportunity and means for meaningful public input, including consideration of existing models such as funded public interveners.E. Funding. The Administration's proposal would authorize Congressional appropriations as needed for the agency. It also allows the agency to recover the amount of funds it spends through annual fees or assessments on financial services providers it oversees. Our view is that the agency should have a stable (not volatile) funding base that is sufficient to support robust enforcement and is not subject to political manipulation by regulated entities. Funding from a variety of sources, as well as a mix of these sources, should be considered, including Congressional appropriations, user fees or industry assessments, filing fees, priced services (such as for compliance examinations) and transaction-based fees. See Appendix 4 for a comparison of current agency funding and fee structures. None of these funding sources is without serious weaknesses. Industry assessments or user fees can provide the regulated entity with considerable leverage over the budget of the agency and facilitate regulatory capture of the agency, especially if the regulated party is granted any discretion over the amount of the assessment (or is allowed to decide who regulates them and shift its assessment to another agency.) Transaction-based fees can be volatile and unpredictable, especially during economic downturns. Filing fees can also decline significantly if economic activity falls. Congressional appropriations, as we have seen with other Federal consumer protection agencies over the last half-century, can be fairly easily targeted for reduction or restriction by well' funded special interests if these interests perceive that the agency has been too effective or aggressive in pursing its mission. If an industry-based funding method is used, it should ensure that all providers of covered products and services are contributing equally based on their size and the nature of the products they offer. A primary consideration in designing any industry-based funding structure is that certain elements of these sectors should not be able to evade the full funding requirement, through charter shopping or other means. If such requirements can be met, we would recommend a blended funding structure from multiple sources that requires regulated entities to fund the baseline budget of the agency and Congressional appropriations to supplement this budget if the agency demonstrates an unexpected or unusual demand for its services.F. Consumer complaints. The Administration proposal would require the agency to collect and track federally directed complaints rewarding credit or payment products, features, or practices under the agency's jurisdiction. \78\ This is a very important function but it should be improved in two significant respects. First, the agency should also be charged with resolving consumer complaints. Existing agencies, particularly the OCC, have generally not performed this function well. \79\ Secondly, the agency should be designated as the sole repository of consumer complaints on products, features, or practices within its jurisdiction, and should ensure that this is a role that is readily visible to consumers, simple to access and responsive. The agency should also be required to conduct real-time analysis of consumer complaints regarding patterns and practices in the credit and payment systems industries and to apply these analyses when writing rules and enforcing rules and laws.--------------------------------------------------------------------------- \78\ The CFPA should have responsibility for collecting and tracking complaints about consumer financial services and facilitating complaint resolution with respect to federally supervised institutions. Other Federal supervisory agencies should refer any complaints they receive on consumer issues to the CFPA; complaint data should be shared across agencies . . . , ``A New Foundation'', pp. 59-60, The Obama Administration, June 2009. \79\ Travis Plunkett testimony, July 2007 ``Improving Federal Consumer Protections in Financial Services'', p. 10.---------------------------------------------------------------------------G. Federal preemption of State laws. As the Administration proposal States, the agency should establish minimum standards within its jurisdictions. CFPA rules would preempt weaker State laws, but States that choose to exceed the standards established by the CFPA could do so. The agency's rules would preempt statutory State law only when it is impossible to comply with both State and Federal law. We also strongly agree with the Administration's recommendation that federally chartered institutions be subject to nondiscriminatory State consumer protection and civil rights laws to the same extent as other financial institutions. A clear lesson of the financial crisis, which pervades the Administration's plan, is that protections should apply consistently across the board, based on the product or service that is being offered, not who is offering it. Restoring the viability of our background State consumer protection laws is also essential to the flexibility and accountability of the system in the long run. The specific rules issued by the CFPA and the specific statutes enacted by Congress will never be able to anticipate every innovative abuse designed to avoid those rules and statutes. The fundamental State consumer protection laws, both statutory and common law, against unfair and deceptive practices, fraud, good faith and fair dealing, and other basic, longstanding legal rules are the ones that spring up to protect consumers when a new abuse surfaces that falls within the cracks of more specific laws. We discuss preemption in greater detail in the next section.H. Other aspects of the Administration proposal. As discussed briefly above, the CFPA should also have the authority to grant intervener funding to consumer organizations to fund expert participation in its stakeholder activities. The model has been used successfully to fund consumer group participation in State utility rate making. Second, a Government chartered consumer organization should be created by Congress to represent consumers' financial services interests before regulatory, legislative, and judicial bodies, including before the CFPA. This organization could be financed through voluntary user fees such as a consumer check-off included in the monthly Statements financial firms send to their customers. It would be charged with giving consumers, depositors, small investors and taxpayers their own financial reform organization to counter the power of the financial sector, and to participate fully in rulemakings, adjudications, and lobbying and other activities now dominated by the financial lobby. \80\--------------------------------------------------------------------------- \80\ As his last legislative activity, in October 2002, Senator Paul Wellstone proposed establishment of such an organization, the Consumer and Shareholder Protection Association, S 3143.--------------------------------------------------------------------------- Moreover, we recommend that the Administration's proposal deal more explicitly with incentives that are paid to and whistleblower protections that are provided to employees working in the credit sector. An incentive system similar to one at the top is at work at the street level of the biggest banks. In the tens of thousands of bank branches and call centers of our biggest banks, employees-including bank tellers earning an average of $11.32 an hour-are forced to meet sales goals to keep their jobs and earn bonuses. Many goals for employees selling high-fee and high-interest products like credit cards and checking accounts have actually gone up as the economy has gone down. Risk-taking in the industry will quickly outpace regulatory coverage unless financial sector employees can challenge bad practices as they develop and direct regulators to problems. Whistleblowers are critical to combating fraud and other institutional misconduct. The Federal Government needs to hear from and protect finance sector employees who object to bad practices that they believe violate the law, are unfair or deceptive, or threaten the public welfare. If we previously had more protections for whistleblowers, we would have had more warning of the eventual collapse of Wall Street. Since 2000, Congress has enacted or strengthened whistleblower protections in six laws. They include consumer product manufacturing and retail commerce, railroads, the trucking industry, metropolitan transit systems, defense contractors, and all entities receiving stimulus funds. All of these laws provide more incentives and protections for disclosure of wrongdoing than does the current proposal from the Administration. For example, it does not protect disclosures made to an employer, which is often the first action taken by loyal, concerned employees, and the impetus for retaliation. Also conspicuously absent are administrative procedures and remedies that include best practices for fair and adequate consideration of claims by employees. We recommend the following improvements in any reform legislation before the Committee. Whistleblower protections. Innovation in the industry will quickly outpace regulatory coverage unless bank branch, call-center, and other financial sector employees can challenge bad practices as they develop and direct regulators to problems. The Federal Government needs to hear from and provide best practice whistleblower rights consistent with those in the stimulus and five laws passed or strengthened last Congress to protect finance sector employees who object to bad practices that they believe violate the law, are unfair or deceptive, or threaten the public welfare. Fair compensation. New rules need to restructure pay and incentives for front-line finance sector employees away from the current ``sell-anything'' culture. The hundreds of thousands of front-line workers who work under pressure of sales goals need to be able to negotiate sensible compensation policies that reward service and sound banking over short-term sales.SECTION 5. REBUTTAL TO ARGUMENTS AGAINST THE CFPA Proactive, affirmative consumer protection is essential to modernizing financial system oversight and to reducing risk. The current crisis illustrates the high costs of a failure to provide effective consumer protection. The complex financial instruments that sparked the financial crisis were based on home loans that were poorly underwritten; unsuitable to the borrower; arranged by persons not bound to act in the best interest of the borrower; or contained terms so complex that many individual homeowners had little opportunity to fully understand the nature or magnitude of the risks of these loans. The crisis was magnified by highly leveraged, largely unregulated financial instruments and inadequate risk management. Opponents of reform of the financial system have made several arguments against the establishment of a strong independent Consumer Financial Protection Agency. Indeed, the new CFPA appears to be among their main targets for criticism, compared with other elements of the reform plan. They have basically made six arguments. They have argued that regulators already have the powers it would be given, that it would be a redundant layer of bureaucracy, that consumer protection cannot be separated from supervision, that it will stifle innovation, that it would be unfair to small institutions and that its anti-preemption provision would lead to balkanization. Each of these arguments is fatally flawed:A. Opponents argue that regulators already have the powers that the CFPA would be given. This argument is effectively a defense of the status quo, which has led to disastrous results. Current regulators already have between them some of the powers that the new agency would be given, but they haven't used them. Conflicts of interest and missions and a lack of will have worked against consumer enforcement. While our section above goes into greater detail on the failures of the regulators, two examples will illustrate: No HOEPA Rules Until 2008: The Federal Reserve Board was granted sweeping antipredatory mortgage regulatory authority by the 1994 Home Ownership and Equity Protection Act (HOEPA). Final regulations were issued on 30 July 2008 only after the world economy had collapsed due to the collapse of the U.S. housing market triggered by predatory lending. \81\--------------------------------------------------------------------------- \81\ 73 FR 147, Page 44522, Final HOEPA Rule, 30 July 2008. No Action on Abusive Credit Card Practices Until Late 2008: Further, between 1995 and 2007, the Office of the Comptroller of Currency issued only one public enforcement action against a Top Ten credit card bank (and then only after the San Francisco District Attorney had brought an enforcement action) and only one other public enforcement order against a mortgage subsidiary of a large national bank (only after HUD initiated action). In that period, ``the OCC has not issued a public enforcement order against any of the eight largest national banks for violating consumer lending laws.'' \82\ The OCC's failure to act on rising credit card complaints at the largest national banks triggered Congress to investigate, resulting in passage of the 2009 Credit Card Accountability, Responsibility and Disclosure Act (CARD Act). \83\ While that law was under consideration, other Federal regulators used their authority under the Federal Trade Commission Act to propose and finalize a similar rule. \84\ By contrast, the OCC requested the addition of two significant loopholes to a key protection of the proposed rule.--------------------------------------------------------------------------- \82\ Testimony of Professor Arthur Wilmarth, 26 April 2007, before the Subcommittee on Financial Institutions and Consumer Credit, hearing on Credit Card Practices: Current Consumer and Regulatory Issues http://www.house.gov/financialservices/hearing110/htwilmarth042607.pdf. \83\ H.R. 627 was signed into law by President Obama as Pub. L. No. 111-24 on 22 May 2009. \84\ The final rule was published in the Federal Register a month later. 74 FR 18, p. 5498 Thursday, January 29, 2009. Federal bank regulators currently face at least two conflicts. First, their primary mission is prudential supervision, with enforcement of consumer laws taking a back seat. Second, charter shopping in combination with agency funding by regulated entities encourages a regulatory race to the bottom as banks choose the regulator of least resistance. In particular, the Office of the Comptroller of the Currency and the Office of Thrift Supervision have failed utterly to protect consumers, let alone the safety and soundness of regulated entities. Instead, they competed with each other to minimize consumer protection standards as a way of attracting institutions to their charters, which meant that they tied their own hands and failed to fulfill their missions. (Note: they weren't trying to fail, but that was a critical side effect of the charter competition.) Establishing a new consumer agency that has consumer protection as its only mission and that regulated firms cannot hide from by charter-shopping is the best way to guarantee that consumer laws will receive sustained, thoughtful, proactive attention from a Federal regulator.B. Opponents argue that the CFPA would be a redundant layer of bureaucracy. We do not propose a new regulatory agency because we seek more regulation, but because we seek better regulation. The very existence of an agency devoted to consumer protection in financial services will be a strong incentive for institutions to develop strong cultures of consumer protection. (The Obama Administration, Financial Regulatory Reform: A New Foundation, p. 57) The new CFPA would not be a redundant layer of bureaucracy. To the contrary, the new agency would consolidate and streamline Federal consumer protection for credit, savings and payment products that is now required in almost 20 different statutes and divided between seven different agencies. As the New Foundation document continues: The core of such an agency can be assembled reasonably quickly from discrete operations of other agencies. Most rule-writing authority is concentrated in a single division of the Federal Reserve, and three of the four Federal banking agencies have mostly or entirely separated consumer compliance supervision from prudential supervision. Combining staff from different agencies is not simple, to be sure, but it will bring significant benefits for responsible consumers and institutions, as well as for the market for consumer financial services and products. \85\--------------------------------------------------------------------------- \85\ The Obama Administration, ``Financial Regulatory Reform: A New Foundation'', p. 57. And today, a single transaction such as a mortgage loan is subject to regulations promulgated by several agencies and may be made or arranged by an entity supervised by any of several other agencies. Under the CFPA, one Federal agency will write the rules and see that they are followed.C. Opponents argue that consumer protection cannot be separated from supervision. The current regulatory consolidation of both of these functions has led to the subjugation of consumer protection in most cases, to the great harm of Americans and the economy. Nevertheless, trade associations for many of the financial institutions that have inflicted this harm claim that a new approach that puts consumer protection at the center of financial regulatory efforts will not work. The American Bankers Association, for example, States that while the length of time banks hold checks under Regulation CC may be a consumer issue, ``fraud and payments systems operational issues'' are not. \86\--------------------------------------------------------------------------- \86\ Letter of 28 May 2009 from the American Bankers Association to Treasury Secretary Tim Geithner, available at http://www.aba.com/NR/rdonlyres/4640E4F1-4BC9-4187-B9A6-E3705DD9B307/60161/GeithnerMay282009.pdf (last viewed 21 June 2009).--------------------------------------------------------------------------- Again, as the Administration points out in its carefully thought-out blueprint for the new agency: The CFPA would be required to consult with other Federal regulators to promote consistency with prudential, market, and systemic objectives. Our proposal to allocate one of the CFPA's five board seats to a prudential regulator would facilitate appropriate coordination. \87\--------------------------------------------------------------------------- \87\ The Obama Administration, Financial Regulatory Reform: A New Foundation, p. 59. We concur that the new agency should have full rulemaking authority over all consumer statutes. The checks and balances proposed by the Administration, including the consultative requirement and the placement of a prudential regulator on its board and its requirement to share confidential examination reports with the prudential regulators will address these concerns. In addition, the Administration's plan provides the CFPA with full compliance authority to examine and evaluate the impact of any proposed consumer protection measure on the bottom line of affected financial institutions. While collaboration between regulators will be very important, it should not be used as an excuse by either the CFPA or other regulators to unnecessarily delay needed action. The GAO, for example, has identified time delays in interagency processes as a contributor to the mortgage crisis. \88\ This is why it is important that the CFPA retain final rulemaking authority, as proposed under the Administration's plan. Such authority, along with the above mentioned mandates, will ensure that both the CFPA and the Federal prudential regulator collaborate on a timely basis.--------------------------------------------------------------------------- \88\ ``As we note in our report, efforts by regulators to respond to the increased risks associated with the new mortgage products were sometimes slowed in part because of the need for five Federal regulators to coordinate their response.'' ``Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System'', Testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, February 4, 2009, pp. 15-16.--------------------------------------------------------------------------- For most of the last 20 years, bank regulators have shown little understanding of consumer protection and have not used powers they have long held. OCC's traditional focus and experience has been on safety and soundness, rather than consumer protection. \89\ Its record on consumer protection enforcement is one of little experience and little evidence of expertise. In contrast, as already noted, the States have long experience in enforcement of non-preempted State consumer protection laws. OCC admits that it was not until 2000 that it invoked long-dormant consumer protection authority provided by the 1975 amendments to the Federal Trade Commission Act. \90\--------------------------------------------------------------------------- \89\ See Christopher L. Peterson, ``Federalism and Predatory Lending: Unmasking the Deregulatory Agenda'', 78 Temp. L. Rev. 1, 73 (2005). \90\ See Julie L. Williams and Michael L. Bylsma, ``On the Same Page: Federal Banking Agency Enforcement of the FTC Act To Address Unfair and Deceptive Practices by Banks'', 58 Bus. Law. 1243, 1244, 1246 and n. 25, 1253 (2003) (citing authority from the early 1970s indicating that OCC had the authority to bring such an action under Section 8 of the Federal Deposit Insurance Act, noting that OCC brought its first such case in 2000, and conceding that ``[a]n obvious question is why it took the Federal banking agencies more than 25 years to reach consensus on their authority to enforce the FTC Act'').---------------------------------------------------------------------------D. Opponents argue that a single agency focused on consumer protection will ``stifle innovation'' in the financial services marketplace. To the contrary, protecting consumers from traps and tricks when they purchase credit, savings or payment products should encourage confidence in the financial services marketplace and spur innovation. As Nobel Laureate Joseph Stiglitz has said: There will be those who argue that this regulatory regime will stifle innovation. However, a disproportionate part of the innovations in our financial system have been aimed at tax, regulatory, and accounting arbitrage. They did not produce innovations which would have helped our economy manage some critical risks better-like the risk of home ownership. In fact, their innovations made things worse. I believe that a well- designed regulatory system, along the lines I've mentioned, will be more competitive and more innovative-with more of the innovative effort directed at innovations which will enhance the productivity of our firms and the well-being, including the economic security, of our citizens. \91\--------------------------------------------------------------------------- \91\ ``Too Big to Fail or Too Big to Save? Examining the Systemic Threats of Large Financial Institutions'', Joseph E. Stiglitz, April 21, 2009, p. 10.---------------------------------------------------------------------------E. Opponents argue that the CFPA would place an unfair regulatory burden on small banks and thrifts. Small banks and thrifts that offer responsible credit and payment products should face a lower regulatory burden under regulation by a CFPA. Members of Congress, the media and consumer organizations have properly focused on the role of large, national banks and thrifts in using unsustainable, unfair and deceptive mortgage and credit card lending practices. In contrast, many smaller banks and thrifts have justifiably been praised for their more responsible lending practices in theses areas. In such situations, the CFPA would promote fewer restrictions and less oversight for ``plain-vanilla'' products that are simple, straightforward and fair. However, it is also important to note that some smaller hanks and thrifts have, unfortunately, been on the cutting edge of a number of other abusive lending practices that are harmful to consumers and that must be addressed by a CFPA. More than 75 percent of State chartered banks surveyed by the FDIC, for example, automatically enrolled customers in high-cost overdraft loan programs without consumers' consent. Some of these banks deny consumers the ability to even opt out of being charged high fees for overdraft transactions that the banks chose to permit. Smaller banks have also been leaders in facilitating high-cost refund anticipation loans, in helping payday lenders to evade State loan restrictions and in offering deceptive and extraordinarily expensive ``fee harvester'' credit cards. (See Appendix 1 for more information.)F. Opponents argue that the agency's authority to establish only a Federal floor of consumer protection would lead to regulatory inefficiency and balkanization. The loudest opposition to the new agency will likely be aimed at the Administration's sensible proposal that CFPA's rules be a Federal floor and that the States be allowed to enact stronger consumer laws that are not inconsistent, as well as to enforce both Federal and State laws. This proposed return to common sense protections is strongly endorsed by consumer advocates and State attorneys general. We expect the banks and other opponents to claim that the result will be 51 balkanized laws that place undue costs on financial institutions that are then passed onto consumers in the form of higher priced or less available loans. In fact, this approach is likely to lead to a high degree of regulatory uniformity (if the CFPA sets high minimum standards,) greater protections for consumers without a significant impact on cost or availability, increased public confidence in the credit markets and financial institutions, and less economic volatility. For example, comprehensive research by the Center for Responsible Lending found that subprime mortgage loans in States that acted vigorously to rein in predatory mortgage lending before they were preempted by the OCC had fewer abusive terms. In States with stronger protections, interest rates on subprime mortgages did not increase, and instead, sometimes decreased, without reducing the availability of these loans. \92\ Additionally, as Nobel Laureate Joseph Stiglitz has pointed out, the cost of regulatory duplication is miniscule to the cost of the regulatory failure that has occurred. \93\--------------------------------------------------------------------------- \92\ Wei Li and Keith S. Ernst, Center for Responsible Lending, ``The Best Value in the Subprime Market: State Predatory Lending Reforms'', February, 23, 2006, p. 6. \93\ ``Some worry about the cost of duplication. But when we compare the cost of duplication to the cost of damage from inadequate regulation--not just the cost to the taxpayer of the bail-outs but also the costs to the economy from the fact that we will be performing well below our potential--it is clear that there is not comparison,'' Testimony of Dr. Joseph E. Stiglitz, Professor, Columbia University, before the House Financial Services Committee, October 21, 2008, p. 16.--------------------------------------------------------------------------- It is also clear that the long campaign of preemption by the OTS and OCC, culminating in the 2004 OCC rules, contributed greatly to the current predatory lending crisis. After a discussion of the OCC's action eliminating State authority, we will discuss more generally why Federal consumer law should always be a floor. F.1. The OCC's Preemption of State Laws Exacerbated The Crisis. In 2000-2004, the OCC worked with increasing aggressiveness to prevent the States from enforcing State laws and stronger State consumer protection standards against national banks and their operating subsidiaries, from investigating or monitoring national banks and their operating subsidiaries, and from seeking relief for consumers from national banks and subsidiaries. These efforts began with interpretative letters stopping State enforcement and State standards in the period up to 2004, followed by OCC's wide-ranging preemption regulations in 2004 purporting to interpret the National Bank Act, plus briefs in court cases supporting national banks' efforts to block State consumer protections. In a letter to banks on November 25, 2002, the OCC openly instructed banks that they ``should contact the OCC in situations where a State official seeks to assert supervisory authority or enforcement jurisdiction over the bank . . . . \94\ The banks apparently accepted this invitation, notifying the OCC of State efforts to investigate or enforce State laws. The OCC responded with letters to banks and to State banking agencies asserting that the States had no authority to enforce State laws against national banks and subsidiaries, and that the banks need not comply with the State laws. \95\--------------------------------------------------------------------------- \94\ Office of the Comptroller of the Currency, Interpretive Letter No. 957 n.2 (Jan. 27, 2003) (citing OCC Advisory Letter 2002-9 (Nov. 25, 2002)) (viewed Jun. 19, 2009, at http://www.occ.treas.gov/interp/mar03/int957.doc, and available at 2003 OCC Ltr. LEXIS 11). \95\ E.g., Office of the Comptroller of the Currency, Interpretive Letter No. 971 (Jan. 16, 2003) (letter to Pennsylvania Department of Banking, that it does not have the authority to supervise an unnamed national bank's unnamed operating subsidiary which engages in subprime mortgage lending (unnamed because the interpretive letter is unpublished) (viewed Jun. 19, 2009, at http://comptrollerofthecurrency.gov/interp/sep03/int971.doc, and available at 2003 OCC QJ LEXIS 107).--------------------------------------------------------------------------- For example, the OCC responded to National City Bank of Indiana, and its operating subsidiaries, National City Mortgage Company, First Franklin Financial Corporation, and Altegra Credit Company, regarding Ohio's authority to monitor their mortgage banking and servicing businesses. That opinion concluded that ``the OCC's exclusive visitorial powers preclude States from asserting supervisory authority or enforcement jurisdiction over the Subsidiaries.'' \96\--------------------------------------------------------------------------- \96\ Office of the Comptroller of the Currency, Interpretive Letter No. 958 (Jan. 27, 2003) (viewed Jun. 19, 2009, at http://www.occ.treas.gov/interp/mar03/int958.pdf, and available at 2003 OCC Ltr. LEXIS 10).--------------------------------------------------------------------------- The OCC responded to Bank of America, N.A., and its operating subsidiary, BA Mortgage LLC, regarding California's authority to examine the operating subsidiary's mortgage banking and servicing businesses and whether the operating subsidiary was required to maintain a license under the California Residential Mortgage Lending Act. That opinion concluded that ``the Operating Subsidiary also is not subject to State or local licensing requirements and is not required to obtain a license from the State of California in order to conduct business in that State.'' \97\--------------------------------------------------------------------------- \97\ The OCC's exclusive visitorial powers preclude States from asserting supervisory authority or enforcement jurisdiction over the Subsidiaries (Jan. 27, 2003) (viewed Jun. 19, 2009, at http://www.occ.treas.gov/interp/mar03/int957.doc), and available at 2003 OCC Ltr. LEXIS 11).--------------------------------------------------------------------------- The OCC wrote the Pennsylvania Department of Banking, stating that Pennsylvania does not have the authority to supervise an unnamed national bank's unnamed operating subsidiary which engages in subprime mortgage lending. \98\ (The national bank and operating subsidiary were not named because this interpretive letter was unpublished.)--------------------------------------------------------------------------- \98\ Office of the Comptroller of the Currency, Interpretive Letter No. 971 (unpublished) (Jan. 16, 2003) (viewed Jun. 19, 2009, at http://comptrollerofthecurrency.gov/interp/sep03/int971.doc, and available at 2003 OCC QJ LEXIS 107).--------------------------------------------------------------------------- The OCC even issued a formal preemption determination and order, stating that ``the provisions of the GFLA [Georgia Fair Lending Act] affecting national banks' real estate lending are preempted by Federal law'' and ``issuing an order providing that the GFLA does not apply to National City or to any other national bank or national bank operating subsidiary that engages in real estate lending activities in Georgia.'' \99\--------------------------------------------------------------------------- \99\ Office of the Comptroller of the Currency, Preemption Determination and Order, 68 Fed. Reg. 46,264, 46,264 (Aug. 5, 2003).--------------------------------------------------------------------------- As Business Week pointed out in 2003, not only did States attempt to pass laws to stop predatory lending, they also attempted to warn Federal regulators that the problem was getting worse. \100\--------------------------------------------------------------------------- \100\ Robert Berner and Brian Grow, ``They Warned Us About the Mortgage Crisis'', Business Week, 9 October 2008, available at http://www.businessweek.com/magazine/content/08_42/b4104036827981.htm, (last visited 21 June 2009).--------------------------------------------------------------------------- A number of factors contributed to the mortgage disaster and credit crunch. Interest rate cuts and unprecedented foreign capital infusion fueled thoughtless lending on Main Street and arrogant gambling on Wall Street. The trading of esoteric derivatives amplified risks it was supposed to mute. One cause, though, has been largely overlooked: the stifling of prescient State enforcers and legislators who tried to contain the greed and foolishness. They were thwarted in many cases by Washington officials hostile to regulation and a financial industry adept at exploiting this ideology. Under the proposal, critical authority will be returned to those attorneys general, who have demonstrated both the capacity and the will to enforce consumer laws. In addition to losing the States' experience in enforcing such matters, depriving the States of the right to enforce their non-preempted consumer protection laws raises serious concerns of capacity. According to a recent congressional report, State banking agencies and State attorneys general offices employ nearly 700 full time staff to monitor compliance with consumer laws, more than 17 times the number of OCC personnel then allocated to investigate consumer complaints. \101\--------------------------------------------------------------------------- \101\ See H. Comm. on Financial Services, 108th Cong., Views and Estimates on Matters To Be Set Forth in the Concurrent Resolution on the Budget for Fiscal Year 2005, at 16 (Comm. Print 2004). ``In the area of abusive mortgage lending practices alone, State bank supervisory agencies initiated 20,332 investigations in 2003 in response to consumer complaints, which resulted in 4,035 enforcement actions.''--------------------------------------------------------------------------- Earlier this year, Illinois Attorney General Lisa Madigan testified before this Committee and outlined the numerous major, multistate cases against predatory lending that have been brought by her office and other State offices of attorneys general. However, she included this caveat: State enforcement actions have been hamstrung by the dual forces of preemption of State authority and lack of Federal oversight. The authority of State attorneys general to enforce consumer protection laws of general applicability was challenged at precisely the time it was most needed--when the amount of sub prime lending exploded and riskier and riskier mortgage products came into the marketplace. \102\--------------------------------------------------------------------------- \102\ Testimony of Illinois Attorney General Lisa Madigan Before the Committee on Financial Services, Hearing on Federal and State Enforcement of Financial Consumer and Investor Protection Laws, 20 March 2009, available at http://www.house.gov/apps/list/hearing/financialsvcs_dem/il_-_madigan.pdf (last visited 22 June 2009). This month, General Madigan and seven colleagues sent President Obama a letter supporting a Consumer Financial Protection Agency ---------------------------------------------------------------------------preserving State enforcement authority: [W]e believe that any reform must (1) preserve State enforcement authority, (2) place Federal consumer protection powers with an agency that is focused primarily on consumer protection, and (3) place primary oversight with Government agencies and not depend on industry selfregulation. \103\--------------------------------------------------------------------------- \103\ Letter of 15 June 2009, from the chief legal enforcement officers of eight States (California, Connecticut, Illinois, Iowa, Maryland, Massachusetts, North Carolina, and Ohio) to President Obama, on file with the authors. F.2. Why Federal Law Should Always Be a Floor. Consumers need State laws to prevent and solve consumer problems. State legislators generally have smaller districts than members of Congress do. State legislators are closer to the needs of their constituents than members of Congress. States often act sooner than Congress on new consumer problems. Unlike Congress, a State legislature may act before a harmful practice becomes entrenched nationwide. In a September 22, 2003, speech to the American Bankers Association in Hawaii, Comptroller John D. Hawke admitted that consumer protection activities ``are virtually always responsive to real abuses.'' He continued by pointing out that Congress moves slowly. Comptroller Hawke said, ``It is generally quite unusual for Congress to move quickly on regulatory legislation--the Gramm-Leach-Bliley privacy provisions being a major exception. Most often they respond only when there is evidence of some persistent abuse in the marketplace over a long period of time.'' U.S. consumers should not have to wait for a persistent, nationwide abuse by banks before a remedy or a preventative law can be passed and enforced by a State to protect them. States can and do act more quickly than Congress, and States can and do respond to emerging practices that can harm consumers while those practices are still regional, before they spread nationwide. These examples extend far beyond the financial services marketplace. States and even local jurisdictions have long been the laboratories for innovative public policy, particularly in the realm of environmental and consumer protection. The Federal Clean Air Act grew out of a growing State and municipal movement to enact air pollution control measures. The national organic labeling law, enacted in October 2002, was passed only after several States, including Oregon, Washington, Texas, Idaho, California, and Colorado, passed their own laws. In 1982, Arizona enacted the first ``Motor Voter'' law to allow citizens to register to vote when applying for or renewing drivers' licenses; Colorado placed the issue on the ballot, passing its Motor Voter law in 1984. National legislation followed suit in 1993. Cities and counties have long led the smoke-free indoor air movement, prompting States to begin acting, while Congress, until this month, proved itself virtually incapable of adequately regulating the tobacco industry. A recent and highly successful FTC program--the National Do Not Call Registry to which 58 million consumers have added their names in 1 year--had already been enacted in 40 States. But in the area of financial services, where State preemption has arguably been the harshest and most sweeping, examples of innovative State activity are still numerous. In the past 5 years, since the OCC's preemption regulations have blocked most State consumer protections from application to national banks, one area illustrating the power of State innovation has been in identity theft, where the States have developed important new consumer protections that are not directed primarily at banking. In the area of identity theft, States are taking actions based on a non-preemptive section of the Fair Credit Reporting Act, where they still have the authority to act against other actors than national banks or their subsidiaries. There are 7 to 10 million victims of identity theft in the U.S. every year, yet Congress did not enact modest protections such as a security alert and a consumer block on credit report information generated by a thief until passage of the Fair and Accurate Credit Transactions Act (FACT Act or FACTA) in 2003. That law adopted just some of the identity theft protections that had already been enacted in States such as California, Connecticut, Louisiana, Texas, and Virginia. \104\--------------------------------------------------------------------------- \104\ See California Civil Code 1785.11.1, 1785.11.2, 1785,16.1; Conn. SB 688 9(d), (e), Conn. Gen. Stats. 36a-699; IL Re. Stat. Ch. 505 2MM; LA Rev. Stat. 9:3568B.1, 9:3568C, 9:3568D, 9:3571.1 (H)-(L); Tex. Bus. & Comm. Code 20.01(7), 20.031, 20.034-039, 20.04; VA Code 18.2-186.31 :E.--------------------------------------------------------------------------- Additionally FACTA's centerpiece protection against both inaccuracies and identity theft, access to a free credit report annually on request, had already been adopted by seven States: Colorado, Georgia, Maine, Maryland, Massachusetts, New Jersey, and Vermont. Further, California in 2000, following a joint campaign by consumer groups and realtors, became the first State to prohibit contractual restrictions on realtors showing consumers their credit scores, ending a decade of stalling by Congress and the FTC. \105\ The FACT act extended this provision nationwide.--------------------------------------------------------------------------- \105\ See 2000 Cal. Legis. Serv. 978 (West). This session law was authored by State Senator Liz Figueroa. ``An act to amend Sections 1785.10, 1785.15, and 1785.16 of, and to add Sections 1785.15.1, 1785.15.2, and 1785.20.2 to the Civil Code, relating to consumer credit.''--------------------------------------------------------------------------- Yet, despite these provisions, advocates knew that the 2003 Federal FACTA law would not solve all identity theft problems. Following strenuous opposition by consumer advocates to the blanket preemption routinely sought by industry as a condition of all remedial Federal financial legislation, the final 2003 FACT Act continued to allow States to take additional actions to prevent identity theft. The results have been significant. Since its passage, fully 47 States and the District of Columbia have granted consumers the right to prevent access to their credit reports by identity thieves through a security freeze. Indeed, even the credit bureaus, longtime opponents of the freeze, then adopted the freeze nationwide. \106\--------------------------------------------------------------------------- \106\ Consumers Union, U.S. PIRG and AARP cooperated on a model State security freeze proposal that helped ensure that the State laws were not balkanized, but converged toward a common standard. More information on the State security freeze laws is available at http://www.consumersunion.org/campaigns/learn_more/003484indiv.html (last visited 21 June 2009).--------------------------------------------------------------------------- A key principle of federalism is the role of the States as laboratories for the development of law. \107\ State and Federal consumer protection laws can develop in tandem. After one or a few States legislate in an area, the record and the solutions developed in those States provide important information for Congress to use in deciding whether to adopt a national law, how to craft such a law, and whether or not any new national law should displace State law.--------------------------------------------------------------------------- \107\ New State Ice Co. v. Leibman, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting).--------------------------------------------------------------------------- A few more examples from California illustrate the important role of the States as a laboratory and a catalyst for Federal consumer protections for bank customers. In 1986, California required that specific information be included in credit card solicitations with enactment of the then-titled Areias-Robbins Credit Card Full Disclosure Act of 1986. That statute required every credit card solicitation to contain a chart showing the interest rate, grace period, and annual fee. \108\ Two years later, Congress chose to adopt the same concept in the Federal Fair Credit and Charge Card Disclosure Act (FCCCDA), setting standards for credit card solicitations, applications and renewals. \109\ The 1989 Federal disclosure box \110\ (know as the ``Schumer Box'') is strikingly similar to the disclosure form required under the 1986 California law.--------------------------------------------------------------------------- \108\ 1986 Cal. Stats., Ch. 1397, codified at California Civil Code 1748.11. \109\ Pub. L. 100-583, 102 Stat. 2960 (Nov. 1, 1988), codified in part at 15 U.S.C. 1637(c) and 1610(e). \110\ 54 Fed. Reg. 13855 (April 6, 1989, Appendix G, form G-10(B)).--------------------------------------------------------------------------- States also led the way in protecting financial services consumers from long holds on deposited checks. California enacted restrictions on the length of time a bank could hold funds deposited by a consumer in 1983; Congress followed in 1986. California's 1983 funds availability statute required the California Superintendent of Banks, Savings and Loan Commissioner, and Commissioner of Corporations to issue regulations to define a reasonable time after which a consumer must be able to withdraw funds from an item deposited in the consumer's account. \111\ Similar laws were passed in Massachusetts, New York, New Jersey, and other States. Congress followed a few years later with the Federal Expedited Funds Availability Act of 1986. \112\ California led the way on security breach notice legislation. Its law and those of other States have functioned as a de facto national security breach law, while Congress has failed to act. \113\--------------------------------------------------------------------------- \111\ 1983 Cal. Stat. Ch. 1011, 2, codified at Cal. Fin. Code 866.5. \112\ Pub. L. 100-86, Aug. 10, 1987, 101 Stat. 552, 635, codified at 12 U.S.C. 4001. \113\ More information on State security breach notice laws is available at http://www.consumersunion.org/campaigns/financialprivacynow/002215indiv.html (last visited 21 June 2009).--------------------------------------------------------------------------- It is certainly not the case that States always provide effective consumer protection. The States have also been the scene of some notable regulatory breakdowns in recent years, such as the failure of some States to properly regulate mortgage brokers and nonbank lenders operating in the subprime lending market, and the inability or unwillingness of many States to rein in lenders that offer extraordinarily high-cost, short term loans and trap consumers in an unsustainable cycle of debt, such as payday lenders and auto title loan companies. Conversely, Federal lawmakers have had some notable successes in providing a high level of financial services consumer protections in the last decade, such as the Credit Repair Organizations Act and the recently enacted Military Lending Act. \114\ This is why it is necessary for this new Federal agency to ensure that a minimum level of consumer protection is established in all States.--------------------------------------------------------------------------- \114\ Military Lending Act, 10 U.S.C. 987. Credit Repair Organizations Act, 15 U.S.C. 1679h (giving State Attorneys General and FTC concurrent enforcement authority).--------------------------------------------------------------------------- Nonetheless, as these examples show, State law is an important source of ideas for future Federal consumer protections. As Justice Brandeis said in his dissent in New State Ice Co., ``Denial of the right [of States] to experiment may be fraught with serious consequences to the Nation'' (285 U.S. at 311). A State law will not serve this purpose if States cannot apply their laws to national banks, who are big players in the marketplace for credit and banking services. State lawmakers simply won't pass new consumer protection laws that do not apply to the largest players in the banking marketplace. Efficient Federal public policy is one that is balanced at the point where even though the States have the authority to act, they feel no need to do so. Since we cannot guarantee that we are ever at that optimum, setting Federal law as a floor of protection as the default--without also preempting the States--allows us to retain the safety net of State-Federal competition to guarantee the best public policy. \115\--------------------------------------------------------------------------- \115\ For further discussion, see Edmund Mierzwinski, ``Preemption of State Consumer Laws: Federal Interference Is a Market Failure,'' Government, Law, and Policy Journal of the New York State Bar Association, Spring 2004 (Vol. 6, No. 1, pp. 6-12).---------------------------------------------------------------------------Conclusion As detailed above, a strong Federal commitment to robust consumer protection is central to restoring and maintaining a sound economy. The Nation's financial crisis grew out of the proliferation of inappropriate and unsustainable lending practices that could have and should have been prevented. That failure harmed millions of American families, undermined the safety and soundness of the lending institutions themselves, and imperiled the economy as a whole. In Congress, a climate of deregulation and undue deference to industry blocked essential reforms. In the agencies, the regulators' failure to act, despite abundant evidence of the need, highlights the inadequacies of the current regulatory regime, in which none of the many financial regulators regard consumer protection as a priority. As outlined in the testimony above, establishment of a single Consumer Financial Protection Agency is a critical part of financial reform. As detailed above, its funding must be robust, independent and stable. Its board and governance must be structured to ensure strong and effective consumer input, and a Consumer Advocate should be appointed to report semi-annually to Congress on agency effectiveness. Our organizations, along with many other consumer, community, civil rights, labor and progressive financial institutions, believe that restoring consumer protection should be a cornerstone of financial reform. It will reduce risk and make the system more accountable to American families. We recognize, however, that other reforms are needed to restore confidence to the financial system. Our coalition ideas on these and other matters can be found at the Web site of Americans For Financial Reform, available at ourfinancialsecurity.org. Thank you for the opportunity to testify. Our organizations look forward to working with you to move the strongest possible Consumer Financial Protection Agency through the Senate and into law.Appendices:Appendix 1: Abusive Lending Practices by Smaller Banks and ThriftsAppendix 2: Private Student Loan Regulatory Failures and Reform RecommendationsAppendix 3: Rent-A-Bank Payday LendingAppendix 4: Information on Income (Primarily User and Transaction Fees Depending on Agency) of Major Financial Regulatory AgenciesAppendix 5: CFA Survey: Sixteen Largest Bank Overdraft Fees and Terms ______ FOMC20080109confcall--44 42,MR. KOHN.," Thank you, Mr. Chairman. I certainly share your concern that the current federal funds rate is too high. You said that you thought we had about offset the effects of tighter credit and declining house prices on demand. I'm not so sure that we have actually done enough to make that offset. Certainly, if you look at the staff forecast, we haven't. They have the unemployment rate rising to 5� percent, half a point over the NAIRU, at the current funds rate, which suggests to me that the current funds rate is substantially above neutral, not at neutral. If you look at the market--and, President Fisher, I assure you I am not going to get pushed around by the market--I do think the market is telling you that there are a lot of people out there who think that the funds rate has to drop 100-plus basis points more, and they don't think that will be consistent with a pick up in inflation. Now, they could be wrong. I'm sure they probably are and often are. But I think there is some signal there about the degree of pessimism out there about underlying demand that we shouldn't throw away entirely just because it is coming from the market. So in my view, policy is probably still restrictive rather than neutral. I don't think we fully adjusted to the deteriorating condition we saw in December. What we saw then was that the credit constriction had spread and would be bigger and more prolonged than we had thought previously. We saw a steeper, more intense housing decline, with multiplier�accelerator effects, and wealth effects on the decline in house prices. We saw the beginning of spillovers to other sectors, and I don't think our 25 basis points really adjusted to all that new information. Moreover, the incoming information, although it hasn't lowered the near-term GDP, does imply weaker growth going forward. With regard to the labor market, it is true that it is one month, but it is three different sources of data--the household survey, the establishment survey, and the initial claims--all telling us the same thing. Now, we will get more information over the next couple of weeks on at least the initial claims part of that and the continuing claims. I think we should treat the labor market information as more than just one series for one month. It's three series for one month, and there is probably a little more weight there. In addition, the new orders and the ISM survey, housing, and stock market wealth have declined substantially since the meeting. So I would say, obviously, we have no insurance. I'm not even sure we're at neutral, and I see the downside risks that you, Mr. Chairman, Dave Stockton, and many others have talked about, particularly from the credit markets and credit conditions. I agree that the inflation situation is somewhat concerning. Now, some people have cited the increase in the staff's inflation forecast for 2008 of 0.4 percentage point; but of course that's the energy price situation. I think so far through this cycle the feed-through of energy prices into core inflation has been pretty darn low. The staff has built in a little here. Inflation expectations do remain anchored. To be sure, the core inflation numbers came in a little higher, so they're a little worrisome, too. I think there is going to be less pressure on resources than we thought. The unemployment rate is higher, capacity utilization will be lower, and I think the competitive pressures are going to constrain compensation and prices. As somebody pointed out, the fact that even at a 4� percent unemployment rate we really have seen very little, if any, pickup in labor costs suggests that my concern about that occurring at a 5 and a 5� percent unemployment rate would be very, very low. If the staff is right--and, of course I just heard the Romers lecture me about how the staff was right and the Committee wasn't--[laughter] then a 50 basis point decline would just about put interest rates at neutral. It wouldn't be accommodative, and therefore, I don't think would be particularly inflationary. I agree with everyone else. If I thought that a decline in rates would increase the most likely forecast for inflation--put it on an upward track--that would be unacceptable. Or if I thought a decrease in rates would increase inflation expectations, which would then give legs to an increase in inflation, that would not be acceptable either. But I think a decrease in rates at this time under these circumstances doesn't really have that risk. It does shift the balance of risks a bit. If you take a little of the downside risk out of growth, you are presumably taking some of the downside risk out of inflation, maybe shifting that risk on inflation at the same time. But I think a substantial decrease in interest rates at this time would not shift those risks on inflation so that they would deviate from the general path over the next couple of years that most of us saw in our projections in October. So I'm not as concerned as President Lacker about that. In sum, I agree that we need to reduce rates substantially just to get close to buying insurance. I would do it sooner rather than later. I would have been prepared to support an intermeeting move today. I think the data are weak enough; we are far enough behind the curve. To me, looking at the equity market declines, what we have seen since the middle of December is a bit of a loss in confidence in the financial markets that we will do enough soon enough to keep the economy on an even keel. So I think there has been a palpable deterioration in confidence in the Federal Reserve out in the financial markets. I am concerned that we are going to get three weeks of bad news and that the erosion of confidence will just gather steam. But I see the issues and the negatives also. An orderly FOMC process is to be protected. We are at risk of scaring the markets or looking as though we are lurching. I think we are at risk, if we move, of creating market dynamics such that they would constantly be in volatility and on alert as to when the next intermeeting move is. So there are a bunch of negatives here; and I guess on balance the case for moving--especially if it's not supported generally by the Committee because I think it has to be supported generally by the Committee--is not overwhelming. Obviously, I am prepared to wait and make a substantial move at the meeting, but I agree that you should signal something in your speech tomorrow that we are likely to move against the emerging economic weakness. I don't think, President Fisher, that a speech that the Chairman makes after consulting with the whole FOMC is comparable to the speeches we make as individuals. He doesn't have the risk of misleading the market when he has heard from all of us at the same time. This is a very different situation from the situation that many of us were in during the previous intermeeting period. Thank you, Mr. Chairman. " CHRG-111hhrg48868--400 Mr. Liddy," And sir, that really is the risk trade-off that we made. I don't want that book to blow up and cause to come undone all that we have achieved, all that you all have achieved thus far. You know, do other reasonable people see it in an entirely different way? Yes. Is the American public mad as a hornet about it? Yes. Would I have liked not to have made those payments? Yes. But I don't want that business to erupt on us and cause the difficulties we have tried so hard to avoid. " fcic_final_report_full--463 Figure 1 below, based on the data of Robert J. Shiller, shows the dramatic growth of the 1997-2007 housing bubble in the United States. By mid-2007, home prices in the U.S. had increased substantially for ten years. The growth in real dollar terms had been almost 90 percent, ten times greater than any other housing bubble in modern times. As discussed below, there is good reason to believe that the 1997- 2007 bubble grew larger and extended longer in time than previous bubbles because of the government’s housing policies, which artificially increased the demand for housing by funneling more money into the housing market than would have been available if traditional lending standards had been maintained and the government had not promoted the growth of subprime lending. Figure 1. The Bubble According to Shiller That the 1997-2007 bubble lasted about twice as long as the prior housing bubbles is significant in itself. Mortgage quality declines as a housing bubble grows and originators try to structure mortgages that will allow buyers to meet monthly payments for more expensive homes; the fact that the most recent bubble was so long-lived was an important element in its ultimate destructiveness when it deflated. Why did this bubble last so long? Housing bubbles deflate when delinquencies and defaults begin to appear in unusual numbers. Investors and creditors realize that the risks of a collapse are mounting. One by one, investors cash in and leave. Eventually, the bubble tops out, those who are still in the game run for the doors, and a deflation in prices sets in. Generally, in the past, this process took three or four years. In the case of the most recent bubble, it took ten. The reason for this longevity is that one major participant in the market was not in it for profit and was not worried about the risks to itself or to those it was controlling. It was the U.S. government, pursuing a social policy—increasing homeownership by making mortgage credit available to low and moderate income borrowers—and requiring the agencies and financial institutions it controlled or could influence through regulation to keep pumping money into housing long after the bubble, left to itself, would have deflated. Economists have been vigorously debating whether the Fed’s monetary policy in the early 2000s caused the bubble by keeping interest rates too low for too long. Naturally enough, Ben Bernanke and Alan Greenspan have argued that the Fed was not at fault. On the other hand, John Taylor, author of the Taylor rule, contends that the Fed’s violation of the Taylor rule was the principal cause of the bubble. Raghuram Rajan, a professor at the Chicago Booth School of Business, argues that the Fed’s low interest rates caused the bubble, but that the Fed actually followed this policy in order to combat unemployment rather than deflation. 19 Other theories blame huge inflows of funds from emerging markets or from countries that were recycling the dollars they received from trade surpluses with the U.S. These debates, however, may be missing the point. It doesn’t matter where the funds that built the bubble actually originated; the important question is why they were transformed into the NTMs that were prone to failure as soon as the great bubble deflated. Figure 2 illustrates clearly that the 1997-2007 bubble was built on a foundation of 27 million subprime and Alt-A mortgages and shows the relationship between the cumulative growth in the dollar amount of NTMs and the growth of the bubble over time. It includes both GSE and CRA contributions to the number of outstanding NTMs above the normal baseline of 30 percent, 20 and estimated CRA lending under the merger-related commitments of the four large banks—Bank of America, Wells Fargo, Citibank and JPMorgan Chase—that, with their predecessors, made most of the commitments. As noted above, these commitments were made in connection with applications to federal regulators for approvals of mergers or acquisitions. The dollar amounts involved were taken from a 2007 report by the NCRC, 21 and adjusted for announced loans and likely rates of lending. The cumulative estimated CRA 19 FinancialCrisisInquiry--567 BORN: Simon Johnson has written comparing the situation that we’re facing today with examples he saw as the chief economist of the IMF of crony capitalism in developing countries. If we’re facing that kind of situation and that played a role in the current financial crisis, I’m concerned about how we deal with that going forward. Any ideas, Mr. Solomon? FinancialCrisisInquiry--164 Well, if they’re a significant systemic risk, then that would be a justification for some sort of oversight. WALLISON: And if there is no systemic risk, then there shouldn’t be any oversight. Would you agree to that? MAYO: I’d have to think about that one. WALLISON: OK. MAYO: I think significantly less oversight. Yes, the main reason for regulation is to make sure you make those who cause the externalities pay the cost for those externalities. It would also be to make sure the whole system doesn’t fail. To use the example, not being able to turn your water on in the morning. And it might also be to make sure that there’s no, you know, egregious practices taking place. WALLISON: Every time there’s a bankruptcy, there are externalities. And so we do cause people who are—who cause the externalities to pay for the externalities because the shareholders, the management, and the creditors of the bankrupt company to pay for those. So what is the reason to have any other kind of resolution system? MAYO: I’m going to have to think about this answer a little more. WALLISON: OK. CHRG-111hhrg54873--24 Mr. Donnelly," Thank you, Mr. Chairman. Some of the things we are going to be determining include whether it makes any sense for the very people who are trying to sell the product to be paying for the rating on it, whether we need a blind pool similar to how they do it with judges throughout this country in many places or as Mr. James Simon, whom we heard from, talked about a quasi-public utility. Whether a few pennies from each trade should go in to try to get an independent rating agencies. The fact is that this caused extraordinary damage and harm to our country and to Main Street America. In my very hometown, of South Bend, Indiana, Moody's, in fact, closed their office there. And it was done because of economic hardship, allegedly, a very, very, very profitable company, and that hardship was supposedly caused by the meltdown we had that was caused, in part, by the credit rating agencies. So Main Street America has been extraordinarily damaged by this. And it is our job to make sure it does not happen again. Thank you, Mr. Chairman. " fcic_final_report_full--427 STAGES OF THE CRISIS As of December , the United States is still in an economic slump caused by a fi- nancial crisis that first manifested itself in August  and ended in early . The primary features of that financial crisis were a financial shock in September  and a concomitant financial panic . The financial shock and panic triggered a severe con- traction in lending and hiring beginning in the fourth quarter of . Some observers describe recent economic history as a recession that began in December  and continued until June , and from which we are only now be- ginning to recover. While this definition of the recession is technically accurate, it ob- scures a more important chronology that connects financial market developments with the broader economy. We describe recent U.S. macroeconomic history in five stages: • A series of foreshocks beginning in August , followed by an economic slowdown and then a mild recession through August , as liquidity prob- lems emerged and three large U.S. financial institutions failed; • A severe financial shock in September , in which ten large financial institu- tions failed, nearly failed, or changed their institutional structure; triggering • A financial panic and the beginning of a large contraction in the real economy in the last few months of ; followed by • The end of the financial shock, panic, and rescue at the beginning of ; followed by • A continued and deepening contraction in the real economy and the beginning of the financial recovery and rebuilding period. As of December , the United States is still in the last stage. The financial sys- tem is still recovering and being restructured, and the U.S. economy struggles to re- turn to sustained strong growth. The remainder of our comments focuses on the financial crisis in the first three stages by examining its ten essential causes. THE TEN ESSENTIAL CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS The following ten causes, global and domestic, are essential to explaining the finan- cial and economic crisis. I. Credit bubble. Starting in the late s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestation of which was increased investment in high-risk mortgages. U.S. monetary policy may have con- tributed to the credit bubble but did not cause it. CHRG-111hhrg52261--53 Mr. Hirschmann," The right to fail in an orderly fashion has been one of the key strengths of our economy. Obviously, when everything fails at one time, it requires extraordinary steps. But I think one of the things we need to be careful about is not to design our system so that there is an implied backstop by the Federal Government against the two largest mutual fund companies, the two largest hedge funds, the two largest private equity firms, or the two largest of anything. We need to be able to have the information at the regulator level to understand systemic risk, but not set anybody up to be permanently protected against failure. We can make them fail in a more orderly fashion so they don't burn down the neighborhood, but nobody should be insulated against failure. " CHRG-111shrg61651--108 Mr. Scott," Yes. I think if a regulator believed today that an institution that they were supervising were not able to survive the failure of their significant counterparties, they could do something about it. Now, that being said, the ability to understand that---- Senator Shelby. That is right. " Mr. Scott," ----that is hard. Senator Shelby. Professor Johnson. " CHRG-110hhrg44900--146 Mr. Hensarling," I look forward to working on this legislation. Turning now to the issue that most of us have talked about so far, the Bear Stearns situation. I had a chart, but I know the numbers are pretty small, but you should be familiar with it because it comes from your own folks on your Web site, it is the Federal Reserve balance sheet as of June 25, 2008. As I read and others explain, it indicates that there is only roughly $22 billion, generally speaking, of Treasury bills remaining, and the Fed has already exchanged $255 billion, roughly, for a variety of types of private debt, some of which you could question the quality. Now today the Secretary has made remarks to the need for a new statutory framework and the deal with the unwinding of the situation. I am sure you have seen a number of the articles that talk about this, and the press indicate there are several other brokers out there that might be facing significant problems as well going forward, and you have already indicated you would hate to have to deal with this situation as you had with Bear Stearns in the past. So, Mr. Chairman, it appears to me that if one of these highly interconnected investment banks were to fail in the near future, the Fed's balance sheet then has limited or no room left on it coupled with there being no legislative framework in place going into this, would the Fed, in essence, have to monetize the situation to bail them out? Would the Fed have to deal with new Treasury paper to bail out the bondholders, which is what really occurred with the Bear Stearns situation, if another situation came? I have three questions. First, can you assure, and I think I know the answer to this question, but can you assure us that you will not conduct any similar Bear Stearns transaction if another investment bank or a GSE gets in trouble without the prior explicit authorization of Congress via some sort of enabling legislation? Second, if you decide that there is no alternative than to conduct another bail out or support, however you want to call it, to one of these troubled organizations, will you be willing to monetize the debt to finance such a transaction due to the current limitations on your balance sheet? And third, your claim that your actions with the Bear Stearns transactions are granted to you under section 13 of the Federal Reserve Act, are there any limitations within that section or elsewhere as to your abilities going forward to deal with these situations? " CHRG-110shrg50414--96 Mr. Bernanke," Our terms included, besides 79.9 percent, an interest rate, which is currently over 11 percent and essentially a super lien on most of the assets of the company. So I think that it is a very tough deal that we struck. We did that because we wanted to protect the taxpayer. At the same time, we were concerned about the implications for the markets of the failure of this large company. I would like to say, I think we do have a serious ``too big to fail problem'' in this economy. It is much worse than we thought it was coming into this crisis. And as we go forward, we need to develop methodologies to reduce that ``too big to fail'' issue. Senator Reed. But why wouldn't equity participation rights work in this arrangement to protect the taxpayers and reimburse the taxpayers, particularly with the difficult problems of pricing these securities, the different arrangements that Secretary Paulson suggested might be undertaken, and the need, really, to assure the public that this is not a one-way salvation for Wall Street at the expense of taxpayers? " CHRG-111hhrg54869--142 Mr. Volcker," I don't believe that it was a significant factor in this situation. " FOMC20081029meeting--225 223,CHAIRMAN BERNANKE., But it rises because of the financial situation. I see. CHRG-111hhrg48874--53 Mr. Polakoff," Each situation is different, sir. I mean it could be that the merged institution has-- " CHRG-110shrg50418--214 Chairman Dodd," Senator Corker? You sure you don't want to move up a little bit? You are so far away. Senator Corker. I couldn't abandon my friend the cameraman here. [Laughter.] Senator Corker. Mr. Chairman, thank you for this great hearing. I appreciate all of you being here and understand the tremendous problems this is creating in all of our States. We have one of our most respected business people here tonight. That is one of your dealers who has 300 employees, and we understand about all the many workers and much employment. So I do have some tough questions, but I want you to know I do understand the turmoil that this is creating throughout our country. We have talked a lot about the TARP program and we talked about the fact that we were willing to, quote, ``bailout'' the financial institutions. But one of the things that is occurring in the TARP program that is not happening here is that the OCC that regulates these banks, or the FDIC if that is the case, has to certify to Treasury that these are strong institutions and they actually make recommendations to Treasury as to which institutions are the strong banks, the good banks, and should succeed. I find it really interesting that we, quote, have the big three here, if you will, because I know that all three of you are in different circumstances, and my sense is if the OCC was performing the same ordeal, if you will, on you all, some of you would not be recommended to get credit. My sense is that Ford has done a better job and is in a slightly stronger position, that GM has made some changes but is spiraling downward and in serious trouble, and my sense is, and I could be wrong, I know it is a private company and results aren't available, but that Chrysler just barely has a heartbeat. So I do wonder why we are talking to three companies in very different situations about all being treated the same way. It seems to me that that premise to begin with is very flawed. Now, obviously you all have created a pact. You wouldn't share with Senator Menendez how much each of you have asked. I know that one of you shared with us that you have given those numbers to Levin. But I would like to know exactly what each of you has asked for, and I think that is only fair, and I think dancing around that is incorrect. And then I would like Mr. Gettelfinger, if he would, since he says he went in and looked at these companies, to tell us which of these three should survive and which shouldn't. But I would like to have the numbers first. " CHRG-111shrg53176--70 Chairman Dodd," Right. But let me ask--I mean, I agree with that. And I am going to turn to Senator Shelby. I agree with that. I think it is a very good point, not Madoff enough. Everyone is wondering whether there will be buyers. I think the issue is whether or not there will be sellers. That is really going to be the issue, will you sell. I am just imagining this. And, again, I am just listening to some folks, and we have a panel coming up who can maybe shed some more light on this. My guess is if you are a board of a bank, and you are sitting there, and someone is saying, we think this thing is worth more than what they are offering, my reaction might be, you know what, get rid of this stuff; let's move along. The credit markets are not going to open up until we get this unclogged. And while you may be right, and I am sure it is worth more than what they are offering here, let's move along. I have to believe that thinking may have some influence on the decision of sellers to move the product along. I know it affects balance sheets, though. But the larger good here is, get this moving. So I do not know whether that is going to be the case or not, but that is the counter argument I have heard about whether or not sellers will sell. I do not mean to dwell on all of this, but it is an interesting point. Let me turn to Senator Shelby. I have taken way too much time. Senator Shelby. Thank you. Mr. Breeden, you were chairman of the SEC from 1989 to 1993. Mr. Levitt, you were chairman of the SEC from 1993 to 2001. We know Mr. Atkins was a commissioner there for some 8 years, I believe it was. In looking back at your time at the SEC, what could each of you have done differently that would have helped to prevent the roots of the current crisis from growing? Mr. Breeden? You were there a while back, I know that. " CHRG-110hhrg45625--70 Mr. Bernanke," Certainly, Congressman. Thank you. Just to reiterate the Secretary's point, this is working capital, if you will. It is for purchasing these assets. It is a very large amount of money, but the risk to the taxpayer, although not trivial, is far less than the amount of money that is the purchase amount. With respect to protecting the taxpayer, I think that we should be using whatever possible market mechanisms that reveal the true value to the extent we can of those assets. One of the objectives of the program is to try to figure out what these things are worth. I think there is really a win-win situation possible here in that bringing the demand from the government into these markets will raise the price above the rock bottom fire sale distressed price that is currently prevailing from any of these assets, and yet that the taxpayer pays could still be well below what these assets would be worth in a normal market as the economy recovers. So I am not advocating that the taxpayer overpay. I think the prices should be determined by competitive market mechanisms--the more participation, the better. But I do believe that bringing liquidity into this market will help to clarify the prices and will bring the prices up from these rock bottom fire sale prices. " CHRG-111hhrg51698--578 Mr. Book," First of all, if we look at the function of central clearing, it is worthwhile to point out the principal difference to all the other market participants is that the clearinghouse always has a balanced portfolio and position. There are several lines of defense that the clearinghouse will put into place to collateralize all the risk that the market participants hold. First of all, it is the margining, and part of the margining is a daily mark-to-market, daily articulation of the profits and losses of those holding positions. This is a major difference for many of the current standards in the OTC markets, so that there is always the situation that the market participants are in a position to cover their losses. The clearinghouse will also calculate margins, especially for the CDS market where it is pretty important to cover credit events. We have developed a risk concept that is especially designed to address the situation of credit events. As you know, these contracts contain a binary risk component in the event default occurs. In addition to that, there is a mutual guaranty fund which is funded by the clearing participants. We will set this up in a way that it is segregated from the credit default swaps business. In the end the clearing participants will hold a mutual guaranty fund to cover the risks that are coming out of that position. All of that is really designed to make sure that the positions that are held by the clearing participants are adequately collateralized so that the clearinghouse is always in a position to liquidate the position should there be a default situation. " CHRG-111shrg57320--60 Mr. Rymer," I think that people in leadership positions have to be willing to make the tough calls and be experienced enough to know that today's risky practices may show today profitability, but to explain to management and enforce with regulatory action that risky profitability is going to have a cost. It either has a cost in control processes an institution would have to invest in now, or it is going to have a cost ultimately to the bank's profitability and perhaps eventually to the Deposit Insurance Fund. So that is the tough decision I think that has to be made, that has to be enforced constantly. Senator Kaufman. And, Mr. Thorson, I have been around this place for a long time, not as a Senator but as a staff person, and we can only write the laws so much. But it is truly scary when you read this report--where it seems to me clear that the problem here was that we had good Federal examiners out there saying there is a problem here, and the management not doing it. And I just do not see it in the report, and I think it is key as we move forward--we have good people out there doing the jobs and being the examiners, the career employees that we have. But if you put the wrong people in charge, we can write the laws any way we want to, but if they are not going to go after a company because they are making money. I want to shift to something a little different, but it is all on the same point, and that is, I read your causes of WaMu's failure, and I see WaMu failed because its management pursued a high-risk business strategy without adequately underwriting its loans or controlling its risks. That sounds great. I do not think that is what went on here. I really do not. And I think unfortunately you were not here for the hearing the other day, but I think if you sat there and watched what went on and listened to the Chairman's questioning and went through the exhibits, you would say that is not why they failed. Right, Mr. Chairman? They did not fail because management pursued a high-risk business strategy without adequately underwriting its loans or controlling its risks. Would both of you comment on what you believe happened here? " CHRG-111hhrg54869--37 Mr. Watt," Thank you, Mr. Chairman. Chairman Volcker, thank you for being here. I have been on this committee now for 17 years and there seem to be two acknowledged gurus in the financial services industry. Alan Greenspan was one. When he spoke, I never understood a darn thing that he ever said but he seemed very eloquent in his positions. And you are the second one, and I have heard you speak 3 times now. I understand, I think, what you are saying, but it seems to me that your testimony this morning and the other times that I have heard you address the systemic risk issue leads us back exactly to where we are right now. If we didn't do anything on systemic risk, we already have regulation of--we have all of the banks who are currently under regulations, and I am just trying to understand how--what you are proposing with respect to systemic risk differs from what we have now. That is the one question. And I am going to put both of them out there and then I will shut up and listen to you talk. The second question is, you have done a lot of work. I have read your report on the international monetary situation, and you led a group or participated in an international group that looked at this from an international perspective. And I didn't hear you address any of that this morning. I know we are here to deal with our domestic situation, but how do you see this being intertwined in the systemic issue being addressed on a worldwide basis unless we address it somehow more aggressively than you have proposed on the domestic side? " FOMC20050630meeting--226 224,MR. GRAMLICH.," Well, that’s right. I understand that the link between interest rates and June 29-30, 2005 73 of 234 Affordability rates may tend to be a lot more stable than we would think just from interest rates alone, if it turns out that they do have an impact on prices. The third point: Janet raised what I thought was an interesting idea earlier that some people have picked up on, which is that maybe these credit innovations are endogenous. I recall a briefing that we had just a short time ago where the staff suggested that, in effect, what was happening—and I, frankly, was a little skeptical at the time—was that people were identified by how much they could pay for their house. And that, I think, makes the credit transaction automatically endogenous. That may be a better way to look at the whole situation, and I guess researchers at the Board have already started doing that. I don’t know how complete their research is, but given our myopic society, that may be a much better way to look at it—how much you can pay—and then nobody worries about what the implications are down the road. But that explains the initial buying decision." CHRG-110hhrg46594--313 Mrs. Bachmann," Mr. Chairman, thank you. Once again our committee is convened to hear the pleas of yet one more industry to ask the taxpayers for a bailout. This time from our great industry of the automakers, the Big Three, Ford, GM, and Chrysler. My family and I currently own a GM and a Ford, and one of our favorite cars was the Chrysler minivan. So it is with great love for your vehicles that we want to see you succeed. But it is also appropriate that we again total the taxpayers' current bailout tab, $29 billion for Bear Stearns this year, $200 billion for Freddie and Fannie, $300 billion to expand the Federal Housing Administration, $150 billion for AIG. Who knows where that will end? $700 billion for the Paulson plan plus another $110 billion in sweeteners to pass that plan. Then you have to add on the original bailout bill, which would be the stimulus package; that was $168 billion earlier this year. And then we had also the deficit spending of this Congress in the 110th of $455 billion. That is a whopping $2 trillion. And recognize that only 40 percent of Americans even pay taxes. Secretary Paulson and Chairman Bernanke chose to start this bailout mania over 8 months ago. But since then the American people have been told over and over that the woes of our financial markets will subside. They haven't. Yet after bailing out bad decisionmakers time and again to the tune of over $2 trillion, the financial markets seem to remain in even more turmoil than before. What we are asking now is for the American taxpayer who was never part of these initial contracts to solve the spiraling problem that is facing the City of Detroit. We share in the grief that Detroit has had to deal with and in fact the entire State of Michigan. It is not pretty. No one would want the problems that you have to deal with. But we are looking at other problems as well. And the American people suspect that there are long-term management issues at these companies and productivity problems as well. I don't know that we want government bureaucrats, certainly I wonder if we want to have Members of Congress giving you orders for how to run your companies. It has been reported for years that CEOs at Ford, GM, and Chrysler have not made the necessary changes to rein in labor costs and have not downsized facilities to ensure the company's longer-term viability. Again, I don't want to see Congress second guessing your business decisions, but these are concerns that the American people have. In fact the Big Three are paying out an average of $30 more per hour than your competitors. That is what we are told. And you support a large number of retirees under what are now considered outdated contracts. GM, for instance, we are told actually supports more retirees than they support current workers. The auto industry has also been criticized for failing to invest in enough competitive innovative products that American consumers want to buy. And what we are also told is that the Big Three has failed to look into the future and take steps to prepare for the rise in gas prices, although I don't know how anyone could do that. Taxpayers are again being asked to throw their hard earned money behind a short-term unproductive investment which may perhaps only prolong your companies' failures at a cost that could even be higher down the road. I have received no assurances to date that this money will not simply go down a rabbit hole, none of us have in this committee. Plus, much of the urgency that would force the Big Three to make tough restructuring choices would be reduced if the Federal money is made available to you. It is an interesting conundrum. Like AIG, it is easy to predict that you will be back at the taxpayer's trough in no time at the rate that money is being burned in Detroit. Some say the bailout is needed under the premise that consumers just can't get access to car loans due to the broader credit crunch and that this is causing your companies to suffer. But there are automakers that have remained profitable even through these tough times, Toyota, Honda, and Nissan. They are Japanese-owned, but they operate huge manufacturing firms here in the United States, in Kentucky, Tennessee, and Ohio. These companies also employ thousands of American workers who are paying their taxes and struggling to put food on their families' tables. When we take money from this group of taxpayers to save the three ailing companies before us, it is not only unproductive, it is just plain wrong. This Congress has already spent $2 trillion in bailouts this year, and if we move forward with this proposal I don't know where or when this bailout bonanza will end. I think there are other alternatives that we can consider. For instance, if the Big Three would restructure and reorganize under bankruptcy courts, it is possible that you could be saved without a taxpayer bailout and that you could fix your long-term management and labor problems. If you file for Chapter 11 bankruptcy, it doesn't mean that your company has to go belly up and that all jobs will be lost. It would mean that the company actually might have the ability to make structural changes to keep itself afloat without the threat of outside lawsuits, enter a comprehensive payment plan. The taxpayers just want to know. My question that I would have, Mr. Chairman, would be for Mr. Wagoner from GM, and it would be two things. One, I noticed today you wrote an editorial in the Wall Street Journal on why GM deserves support and you said that we know we can't just slash our way to prosperity. And my question for you would be this: Isn't that just a Draconian way of stating the realities of supply and demand in the marketplace, that your company needs to adjust in good times and in bad? If you are smart and looking for the future, shouldn't your companies be treated the same as other separate companies who have to make those vagaries of life decisions? And also in your testimony, sir, you reference that what exposes us to failure now is the global financial crisis. Well, if the global financial crisis is the sole cause of your current troubles, then why aren't we seeing the other car manufacturers in other countries reaching out to their respective governments with similar requests for cash? And similarly, why aren't we seeing Toyota, Honda and Nissan here at the table today? " CHRG-111hhrg56778--68 Mr. Perlmutter," Do you, in this process, ever come up with a situation similar to the AIG situation Mr. Royce was just asking about, where they got some part of a business? Let's say, they own hotels or they own casinos, or they do credit default swaps. Do you, in that process, as the lead State say, whoa, there's some stuff here that we don't understand or we can't reach those products. " fcic_final_report_full--304 MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS CONTENTS The Federal Reserve: “When people got scared” ................................................  JP Morgan: “Refusing to unwind . . . would be unforgivable” ...........................  The Fed and the SEC: “Weak liquidity position” ...............................................  Derivatives: “Early stages of assessing the potential systemic risk” .....................  Banks: “The markets were really, really dicey” ..................................................  JP Morgan’s federally assisted acquisition of Bear Stearns averted catastrophe—for the time being. The Federal Reserve had found new ways to lend cash to the financial system, and some investors and lenders believed the Bear episode had set a precedent for extraordinary government intervention. Investors began to worry less about a re- cession and more about inflation, as the price of oil continued to rise (hitting almost  per barrel in July). At the beginning of , the stock market had fallen almost  from its peak in the fall of . Then, in May , the Dow Jones climbed to ,, within  of the record , set in October . The cost of protecting against the risk of default by financial institutions—reflected in the prices of credit default swaps—declined from the highs of March and April. “In hindsight, the mar- kets were surprisingly stable and almost seemed to be neutral a month after Bear Stearns, leading all the way up to September,” said David Wong, Morgan Stanley’s treasurer.  Taking advantage of the brief respite in investor concern, the top ten American banks and the four remaining big investment banks, anticipating losses, raised just under  billion and  billion, respectively, in new equity by the end of June. Despite this good news, bankers and their regulators were haunted by the speed of Bear Stearns’s demise. And they knew that the other investment banks shared Bear’s weaknesses: leverage, reliance on overnight funding, dependence on securitization markets, and concentrations in illiquid mortgage securities and other troubled assets. In particular, the run on Bear had exposed the dangers of tri-party repo agreements and the counterparty risk caused by derivatives contracts. And the word on the street—despite the assurances of Lehman CEO Dick Fuld at  an April shareholder meeting that “the worst is behind us”  —was that Bear would not be the only failure. FOMC20070918meeting--290 288,MR. POOLE.," The staff did a fine job of designing and explaining. I want to concentrate on the issues that I have. I’m pleased that we’re not about to launch it. If we had, one of my concerns is that the United Kingdom is left out, which I assume is by choice, but it might still create a whole lot of issues for the United Kingdom. I’m sure there would be a lot of questions in the market— Why didn’t you do it?—or whatever. It might have added pressure there that would not only have complicated the U.K. situation, but it might have ended up complicating our own situation. That might still be an issue if we go this way in the future. I’m concerned that the method of setting the minimum bid rate is not really transparent. As I gather from reading, we’ll tell the market the number, but we won’t say what the reference rate is. Are we going to announce that it’s tied to the overnight swap rate? I had understood that we were not going to." 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--183 Mr. Bernanke," Congresswoman, as I have indicated, I think the real fiscal problems are long-term issues. We have some very substantial obligations for Social Security, for Medicare, and for other entitlement programs. They are largely at this point unfunded. And I think that we need to be moving towards a fiscal situation where we will be able to make those payments, we will be able to meet those obligations. I think that is the real long-term fiscal issue right here. Ms. Waters. I have never heard any alarm or any real concern written about or discussed by you about the deficit. I appreciate the answer that you just gave me, but I guess my question is, are you concerned about the size of this deficit? " CHRG-110hhrg44900--24 Mr. Bernanke," I would associate myself with Secretary Paulson's remarks. We are working together extremely cooperatively, the Secretary and I, and the other agencies. Obviously, we'd like to have additional tools, but these are very complex matters, as the Secretary has indicated. So my hope would be that the Congress would begin soon to think hard about these issues, and we are happy of course to provide whatever support we can. But I think for the time being that the most likely outcome and the expectation is that we will continue to work in a creative way together to try to manage these ongoing situations. " The Chairman," I'm going to break my own rule just to make one statement, because I gather what you're saying is, it is better in this very complex and very important set of issues that we do it right and that we do it very quickly. " FOMC20060920meeting--62 60,MR. FISHER.," First, I want to congratulate David on the excellent memo on inflation dynamics, and I hope that we can circulate it more broadly to the academic community so we can enrich that debate. It was a superb paper. Karen, you know how much I appreciate your comments on the inflation dynamics that you’re seeing in other countries. I have a question on that front—really two questions. First, in listening to the people that we talk to in the energy business, whether it’s Lee Raymond or all the operators of the various companies from Exxon down to the smaller ones, I still hear the issue of how much of this price reversal—just as there was an issue of how much of the price increase—derives from speculative activity, nonphysical demand. To summarize what I heard over the past week or so, my contacts assert that the speculators have shifted to the short side of the boat—so that we have seen this tilt. I’m wondering how much influence you ascribe to speculative activity as opposed to physical demand and supply activity. I know we’ve had this discussion before, but has speculation accelerated the downturn, or is there something else at play?" CHRG-110hhrg46591--34 The Chairman," I thank the gentleman. I would just take a second to note that both of them quite correctly pointed out that credit unions bear absolutely no responsibility for the bad lending practices, and I think they are entitled to that recognition. We will now begin with our witnesses. We will begin with Alice Rivlin, who is a senior fellow at the Metropolitan Policy Program, economic studies, and director at the Brookings Institution. Dr. Rivlin. STATEMENT OF THE HONORABLE ALICE M. RIVLIN, SENIOR FELLOW, METROPOLITAN POLICY PROGRAM, ECONOMIC STUDIES, AND DIRECTOR, GREATER WASHINGTON RESEARCH PROJECT, BROOKINGS INSTITUTION Ms. Rivlin. Thank you, Mr. Chairman, and members of the committee. Past weeks have witnessed historic convulsions in financial markets around the world. The freezing of credit markets and the failure of major financial institutions triggered massive interventions by governments and by central banks as they attempted to contain the fallout and to prevent total collapse. We are still in damage control mode. We do not yet know whether these enormous efforts will be successful in averting a meltdown, but this committee is right to begin thinking through how to prevent future financial collapses and how to make markets work more effectively. Now pundits and journalists have been asking apocalyptic questions: Is this the end of market capitalism? Are we headed down the road to socialism? Of course not. Market capitalism is far too powerful a tool for increasing human economic wellbeing to be given away because we used it carelessly. Besides, there is no viable alternative. Hardly anyone thinks we would be permanently better off if the government owned and operated financial institutions and decided how to allocate capital. But market capitalism is a dangerous tool. Like a machine gun or a chain saw or a nuclear reactor, it has to be inspected frequently to see if it is working properly and used with caution according to carefully thought-out rules. The task of this committee is to reexamine the rules. Getting financial market regulation right is a difficult and painstaking job. It is not a job for the lazy, the faint-hearted, or the ideologically rigid. Applicants for this job should check their slogans at the door. Too many attempts to rethink the regulation of financial markets in recent years have been derailed by ideologues shouting that regulation is always bad or, alternatively, that we just need more of it. This less versus more argument is not helpful. We do not need more or less regulation; we need smarter regulation. Moreover, writing the rules for financial markets must be a continuous process of fine-tuning. In recent years, we have failed to modernize the rules as markets globalized, as trading speed accelerated, as volume escalated, and as increasingly complex financial products exploded on the scene. The authors of the financial market rule books have a lot of catching up to do, but they also have to recognize that they will never get it right or will be able to call it quits. Markets evolve rapidly, and smart market participants will always invent new ways to get around the rules. It is tempting in mid-catastrophe to point fingers at a few malefactors or to identify a couple of weak links in a larger system and say those are the culprits and that if we punish them the rest of us will be off the hook, but the breakdown of financial markets had many causes of which malfeasance and even regulatory failure played a relatively small role. Americans have been living beyond their means individually and collectively for a long time. We have been spending too much, have been saving too little, and have been borrowing without concern for the future from whomever would support our overconsumption habit--the mortgage company, the new credit card, the Chinese Government, whatever. We indulged ourselves in the collective delusion that housing prices would continue to rise. The collective delusion affected the judgment of buyers and sellers, of lenders and borrowers and of builders and developers. For a while, the collective delusion was a self-fulfilling prophesy. House prices kept rising, and all of the building and borrowing looked justifiable and profitable. Then, like all bubbles, it collapsed as housing prices leveled off and started down. Now bubbles are an ancient phenomenon and will recur no matter what regulatory rules are put in place. A housing bubble has particularly disastrous consequences because housing is such a fundamental part of our everyday life with more pervasive consequences than a bubble in, say, dot com stocks. More importantly, the explosion of securitization and increasingly complex derivatives had erected a huge new superstructure on top of the values of the underlying housing assets. Interrelations among those products, institutions, and markets were not well-understood even by the participants. But it is too easy to blame complexity, as in risk models failed in the face of new complexity. Actually, people failed to ask commonsense questions: What will happen to the value of these mortgage-backed securities when housing prices stop rising? They did not ask because they were profiting hugely from the collective delusion and did not want to hear the answers. Nevertheless, the bubbles and the crash were exacerbated by clear regulatory lapses. Perverse incentives had crept into the system, and there were instances where regulated entities, even the Federal Reserve, were being asked to pursue conflicting objectives at the same time. These failures present a formidable list of questions that the committee needs to think through before it rewrites the rule book. Here are my offers for that list: We did have regulatory gaps. The most obvious regulatory gap is the easiest to fill. We failed to regulate new types of mortgages--not just subprime but Alt-A and no doc and all the rest of it--and the lax, sometimes predatory lending standards that went with them. Giving people with less than sterling credit access to homeownership at higher interest rates is actually, basically, a good idea, but it got out of control. Most of the excesses were not perpetrated by federally regulated banks, but the Federal authorities should have gotten on the case, as the chairman has pointed out, and should have imposed a set of minimum standards that applied to all mortgage lending. We could argue what those standards should be. They certainly should include minimum downpayments, the proof of ability to pay, and evidence that the borrower understands the terms of the loan. Personally, I would get rid of teaser rates, of penalties for prepayment and interest-only mortgages. We may not need a national mortgage lender regulator, but we need to be sure that all mortgage lenders have the same minimum standards and that these are enforced. Another obvious gap is how to regulate derivatives. We can come back to that. But much of the crisis stemmed from complex derivatives, and we have a choice going forward. Do we regulate the leverage with which those products are traded or the products themselves? " CHRG-110hhrg46591--5 Mr. LaTourette," Thank you very much, Mr. Chairman. Thank you for having this hearing. I am just a little east of Cleveland, thankfully. If I were from Cleveland, I would not be successful. The witnesses' statements today have a lot of references to things like socialism, Ms. Rivlin's testimony in particular. I think that word ``socialism'' is being bandied about quite a bit today. The notion that right before we left we handed over $700 billion to the Secretary of the Treasury was disconcerting to a lot of us. Some of us voted ``no,'' not once but twice, on that piece of legislation. I think the witnesses also talk about finger pointing as being not very productive, and I agree with that. I think that this hearing needs to look forward rather than back, but I think in order to look forward you do need to look back just a tad in that there are a lot of theories as to how we find ourselves in this situation. Some are indicating that the 1999 legislation, Gramm-Leach-Bliley, is somehow in default. If that is the case, I would hope our witnesses would chat with us about the changes that need to be made to that to prevent this from happening again. Many have indicated that the failure to put a tougher regulator instead of OHFEO over Fannie Mae and Freddie Mac saw the release of up to $1 trillion in subprime mortgages by those GSEs between 2005 and 2007. I think we should see if that is the problem. Credit swaps apparently have no regulators. I wish they would talk a little bit about that. Then, lastly, I did read the Washington Post editorial this morning that talks about mark-to-markets not being a problem. That does run counter to some of the things that people back in northeastern Ohio are indicating to me. I would wish that the witnesses would talk about that as well. Just two quick unanimous consent requests: There is an article appearing in today's Cleveland Plain Dealer that talks about an area called Slavic Village. I would ask unanimous consent that it be included in the record. On October the 19th, Sunday, there was an article in the New York Times called, ``Building Flawed American Dreams.'' I would also ask unanimous consent that it be included in the record as well. I yield back. " FinancialServicesCommittee--59 Mr. B ACHUS . All right. Mr. Leibowitz, what you said I agree with, that the markets and exchanges handled volatility quite well during the financial crisis in 2008. They didn’t react quite as well to the volatility last Thurs- day. What do you see is the difference? Mr. L EIBOWITZ . It is interesting because we actually discussed this at considerable length. And I think it has to do with things happening at a certain point in the day. A lot of the news on the financial crisis came out overnight, where markets had a chance to absorb that news. This is something that happened during the day. And, as Mr. Noll was saying, it was almost, like, set up. The market was in a jittery situation. The VIX was rising. There was nervousness about Europe. And then there was the speculation through the day and the announcement of what was going on in Greece. And it really just happened at a bad time. Had that news come out overnight, my guess is we would not have seen nearly the sort of swing that we saw during the day. Mr. B ACHUS . All right. Thank you. Mr. S COTT . [presiding] Let me follow up on that. Let me ask this question on the circuit breaker concept. Right now, we are in a situation where we have computers which are using very difficult mathematical formulas to trade millions of shares of stock in milliseconds. And our solution to this, as I hear you say, and Chairmen Schapiro and Gensler, is to institute stock- by-stock circuit breakers marketwide in a centralized way. I saw a movie about a couple of weeks ago, and it is a fun movie if you want to see it. It is called ‘‘Eagle Eye.’’ I don’t know if you saw that movie, but if you get a chance, it is very interesting. It just simply points out what happens in concentrating and putting so much control into a computer. So what I want to ask each of you—because, apparently, as I hear your testimony, particularly the New York Stock Exchange, have said that you have circuit breakers. The complaint was that maybe that moved too slow. So, as we debate this issue of circuit breakers, I want each of you to tell us, are there any downsides? Is there anything we have to fear here? Is there an element of freedom that takes out of the free enterprise system the freedom of the market exchange? Let us be very clear. Is there anything we have to fear if this is the solution of putting this much control in a stock-by-stock, marketwide, one central location of a circuit breaker? Mr. N OLL . If I could address that in two parts, Mr. Chairman. I think the issue for us is that technology, in and of itself, is a tool. It is a tool used by market participants and, I think, used very ef- fectively by market participants. We view the functioning of our market and its continuous operation as one of the envies of the world. And, generally, with the exception of that 17-minute period on May 6th, it functions extraordinarily well. And I would argue, even during that period of time, our tech- nology functioned well, but the market participants that were on our market experienced an absence of liquidity. So what we are really concerned about here is when our markets become dysfunc- tional. CHRG-111shrg57322--1105 Mr. Blankfein," And I wouldn't--I don't know the circumstances under which you use an agent and in which you don't. Senator Tester. I understand. It is a big company. ACA was not the first choice of the portfolio management agent. In fact, they described the arrangement as highly unusual. What I was wondering, was the selection of a portfolio management agent in Abacus 2001 due to the fact that the only investor that could be found was IKB and they indicated they were only interested in the CDOs if you used an independent portfolio agent? " CHRG-111shrg53085--153 Chairman Dodd," Thank you very much, Senator. Interesting questions. Let me ask, and I realize this is new and so I don't expect you to have a detailed answer, but I wonder if I might just get a reaction to the proposal made yesterday by the Secretary of the Treasury and the White House on the public-private partnership idea. I realize I am--just a general reaction. I don't expect you to have necessarily detailed information about it. Congressman Mica, do you have a reaction. " CHRG-111hhrg53234--39 Mr. Adler," You heard the gentleman a moment ago ask questions about the potential lack of accountability of the Federal Reserve as a sort of private entity, not completely under government control. Others have been concerned there is too much political interference with the Federal Reserve in the carrying out of its mission. I wonder if you could comment about what additional political interference you think the Federal Reserve might encounter if it undertakes this responsibility as a systemic risk regulator. " CHRG-109hhrg23738--86 Mr. Royce," Okay. Mr. Chairman, a number of people have criticized both the Federal Reserve and the administration for moving the goal posts, as they say, on GSE reform. Essentially, the criticism is that the Fed was not talking about portfolio limits 2 years ago and now is saying, you know, that the limits are a much-needed step in the reform of oversight; and I wondered if you could explain how and why the board of governors came to this conclusion. " CHRG-110hhrg46591--330 Mr. Cleaver," Thank you, Mr. Chairman. Whenever we begin this discussion of regulation, it always creates ideological differences. Mr. Yingling and Mr. Washburn, I am wondering, since someone here on our committee made a comment before the break that the CRA and minorities were responsible for the subprime mortgage debacle, I would like to find out from you, from the banking industry, do you believe that the CRA is a regulatory burden? Mr. Yingling or Mr. Washburn. " CHRG-111hhrg56766--116 Mr. Bernanke," In June. Well, we will be evaluating the situation. There is progress being made in those markets. As I said, the spreads have come down quite a bit and some deals are being done outside of the Federal Reserve's program. " FOMC20050809meeting--51 49,MS. MINEHAN.," So you think it’s a supply issue and not comparable to the Salomon Brothers situation where there was some actual desire to keep stock off the market. August 9, 2005 13 of 110" CHRG-110hhrg34673--140 Mr. Bernanke," I think the ideal situation would be one in which the portfolios did exactly what you said. They were to be the weigh station for securitized mortgages, and they would contain mostly liquid assets for the purpose of purchasing mortgages and then selling them back to the market. " CHRG-111hhrg51698--285 The Chairman," I thank the gentleman. That is why we included it. I don't have any problem with the FERC regulating the cash market, whatever cash market there might be in these credits, but we have enough problems; the FERC has never regulated any futures situation. Why would we get them into that? There are people over in that other Committee that think that they should reinvent the wheel or something. " CHRG-111hhrg54869--2 The Chairman," This hearing of the Committee on Financial Services will come to order. We will be having this hearing today and one tomorrow--well, actually, this is the last of the general hearings that we will be having on this subject. Tomorrow, we will begin legislative hearings because we will have a hearing tomorrow on the legislation submitted by our colleague, Mr. Paul of Texas, which is a piece of legislation dealing with auditing of the Federal Reserve. And we are concluding today, and one topic that has been a very significant concern is that there is universal dislike of the doctrine of ``too-big-to-fail'' and even more, the practice of ``too-big-to-fail.'' Unfortunately, there does not appear to be a single, simple solution to it. Passing a statute that says nobody is ``too-big-to-fail'' doesn't resolve the problem. One of our major goals in drafting legislation has been to come up with a series of measures that will avoid our facing that situation of ``too-big-to-fail.'' We will try to keep institutions from being so overleveraged that they are likely to fail. We will try to prevent imprudent decisions, for instance, that come from 100 percent securitization that come from derivatives that are overly leveraged without sufficient collateral. We will give some collection of Federal agencies the authority to step in when it appears that institutions or patterns of activity are being systemically threatening and order containment of these activities; and we will have, what I guess I am destined to have to continue to refer to as the ``resolution authority'' which, in English, is the ``dissolution authority,'' the ability of regulators to step in and put an institution to death without the kind of tremors that occurred or will occur today. Now there does appear to be broad agreement, I think, in the committee on all sides about those goals. How we do them we will differ about. But it was clear yesterday that no one thinks that the current choice of straight bankruptcy or nothing is workable for the institutions. We have to come up with a method of resolving. We have done that, and we shouldn't deny ourselves the regular sum successes. Where insured depository institutions are involved, we have a system that works pretty well. Wachovia is a pretty big institution. It failed. This didn't cause systemic disruption. It wasn't good for the people who were there. Other insured depository institutions have failed, and we have been able to deal with that. We need to extend that. On the other hand, non-depository institutions, Bear Stearns, Merrill Lynch, AIG, and Lehman Brothers all failed, and all were dealt with--each of these was dealt with in a different way and none were satisfactory to anybody, as nearly as I can see. A forced takeover of Merrill Lynch by Bank of America, the negative consequences of that are still reverberating. Paying nobody in the case of Lehman Brothers, none of the creditors, and causing, according to the Administration officials at the time, a terrible shock to the system; paying everybody in AIG, which no one, except the people who got paid, thinks was a good idea now. And Bear Stearns, which was the smallest of them and actually was probably handled in the least disruptive way but still because it was that hot caused some problems. So one of the things we expect people to address today, I hope they will address today, is what combination of measures we can take to get rid of the doctrine of ``too-big-to-fail.'' There was one proposal that came from some within the Administration that we would have a list of the institutions that would be considered ``too-big-to-fail,'' a list of the systemically important institutions so that we could deal with them, but the general view was that would be considered to be the list of those ``too-big-to-fail,'' and what the Administration thought would be a scarlet letter, would instead be a license to have people invest with you because they would think they were protected. So as I said, it is a high priority for this committee to deal with that and to have as nearly as it is humanly possible, a banishment from people's minds. I will say this. I am resigned to the fact that cultural lag is one of the great constraints on what we do. And I accept the fact that until we reach the point where a large institution is put to death without there being ``pay everybody'' or other inappropriate compensations, people won't believe us. We can arm the regulators to do this, we can arm people to do it, and I accept the fact that not until it is done will people believe it. But I will say this: When people are skeptical, listen to the members of this committee and our colleagues. We will give the regulators the power to step in and make it clear that no one is ``too-big-to-fail,'' that failure will eventuate, that it will be painful for those involved. There will be no moral hazard, no temptation to get that big. Any regulator who failed to use that power in the foreseeable future will, I think, feel a uniform wrath from this place. So I would hope that people would be a little less skeptical. We are not going away. The country's anger about this isn't going away. So we aren't just setting up the tools; we are arming ourselves in a way that I think will be very effective. The gentleman from Alabama is now recognized for 5 minutes. " CHRG-111hhrg58044--85 Mr. Watt," Are you prepared to assert to me that if I have a low credit score, that is likely to cause me to have a fire at my house? " FinancialCrisisInquiry--811 WALLISON: Well, with all respect, it’s very hard to believe that mortgages that were acquired in 2006 and 2007 would have caused them to become insolvent. CHRG-111hhrg48868--1000 Mr. Grayson," Well, I am sure you remember a few of the names. I mean, they did cause your company to crash. " FOMC20050630meeting--169 167,MR. RUDEBUSCH.," With regard to equity prices and bond prices, the reason I included that comparison was to make a couple of points. For one, the comment is often made that we can’t second-guess financial markets or financial market participants. It seems as if that may be true for equity market participants but less true for bond market participants. There I take “inflation scare” or “credibility gap” or “conundrum” all to be another term for a situation in which we have an idea of where the fundamentals are and we’re not sure what bond market participants are thinking. Now, it’s true that there’s a difference in that you have a clear idea about the reaction June 29-30, 2005 56 of 234 with transparency regarding your notion of fundamentals. So there is a clear difference between the markets. The housing market is different from both the bond and the equity markets, and the question is: Where can we draw the lessons? The regional disparity is completely different from both markets, and that’s just a separate issue. In any event, one reason behind the housing price appreciation, perhaps, is that we have very low long rates. This is a bond rate conundrum. Perhaps the misalignment in bond prices is leading to this misalignment in housing prices. So, one could perhaps make the argument that it’s the bond price experience in 1994 that may be the relevant one for today. I think I’ll stop there and leave it at that." 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? " fcic_final_report_full--451 What Caused the Financial Crisis? George Santayana is often quoted for the aphorism that “Those who cannot remember the past are condemned to repeat it.” Looking back on the financial crisis, we can see why the study of history is often so contentious and why revisionist histories are so easy to construct. There are always many factors that could have caused an historical event; the diffi cult task is to discern which, among a welter of possible causes, were the significant ones—the ones without which history would have been different. Using this standard, I believe that the sine qua non of the financial crisis was U.S. government housing policy, which led to the creation of 27 million subprime and other risky loans—half of all mortgages in the United States— which were ready to default as soon as the massive 1997-2007 housing bubble began to deflate. If the U.S. government had not chosen this policy path—fostering the growth of a bubble of unprecedented size and an equally unprecedented number of weak and high risk residential mortgages—the great financial crisis of 2008 would never have occurred. Initiated by Congress in 1992 and pressed by HUD in both the Clinton and George W. Bush Administrations, the U.S. government’s housing policy sought to increase home ownership in the United States through an intensive effort to reduce mortgage underwriting standards. In pursuit of this policy, HUD used (i) the affordable housing requirements imposed by Congress in 1992 on the government- sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, (ii) its control over the policies of the Federal Housing Administration (FHA), and (iii) a “Best Practices Initiative” for subprime lenders and mortgage banks, to encourage greater subprime and other high risk lending. HUD’s key role in the growth of subprime and other high risk mortgage lending is covered in detail in Part III. Ultimately, all these entities, as well as insured banks covered by the CRA, were compelled to compete for mortgage borrowers who were at or below the median income in the areas in which they lived. This competition caused underwriting standards to decline, increased the numbers of weak and high risk loans far beyond what the market would produce without government influence, and contributed importantly to the growth of the 1997-2007 housing bubble. When the bubble began to deflate in mid-2007, the low quality and high risk loans engendered by government policies failed in unprecedented numbers. The effect of these defaults was exacerbated by the fact that few if any investors— including housing market analysts—understood at the time that Fannie Mae and Freddie Mac had been acquiring large numbers of subprime and other high risk loans in order to meet HUD’s affordable housing goals. Alarmed by the unexpected delinquencies and defaults that began to appear in mid-2007, investors fled the multi-trillion dollar market for mortgage-backed 445 securities (MBS), dropping MBS values—and especially those MBS backed by subprime and other risky loans—to fractions of their former prices. Mark-to- market accounting then required financial institutions to write down the value of their assets—reducing their capital positions and causing great investor and creditor unease. The mechanism by which the defaults and delinquencies on subprime and other high risk mortgages were transmitted to the financial system as a whole is covered in detail in Part II. CHRG-111shrg53822--33 Mr. Stern," I think Chairman Bair covered it thoroughly. And I would prefer not--until the results are out, I would prefer not to go further. Senator Warner. I would like to go back, on my own remaining time, to the notion that the Chairman raised in terms of systemic risk and the idea of a council, which I think has some attractiveness but also some challenges. What guidance/advice would you have if we were to, at least, continue to pursue the possibilities of this option, of how we would make sure that information would actually be forced up and truly shared? Number one. Two, how would we ensure, and what structural advice could you give us to ensure that this council would not end up becoming simply a debating society? And number three, when this council or group reach some conclusion, how could we ensure that it could act with some force? I would love you to comment on all three. Ms. Bair. Well, I think accountability will be key. The statute needs to put accountability for systemic risk with this council. It needs to be given real authority to write rules, to set capital standards, to collect information, and make sure it is shared with the other regulators. If you provide that mandate and that accountability, as well as real legal authority, I think you will get the result that you want. There is nothing perfect about supervision, and this is why we have also suggested a resolution mechanism to enhance market discipline as well as protect taxpayers. In addition, we have suggested an assessment system that the resolution authority would have as well to provide disincentives for higher risk behavior. I think with those three steps in combination, you would dramatically improve the situation. Part of the problem is nobody really has the mandate right now for the entire system. There were problems. For instance, capital arbitrage between investment banks and commercial banks--different capital standards. That is exactly the kind of issue this type of council could have not only identified but also addressed. Senator Warner. But one of the things we need to do is make sure that that information that may currently reside in the day-to-day prudential regulator actually would get pushed up and actually shared, which---- Ms. Bair. That is right. Senator Warner.----seems in the past that some of this information has been out there, but it has not been---- Ms. Bair. That is exactly right. There needs to be clear authority to collect and to force the sharing of the information. We give the SEC our bank data; they give us their trading data. You need a mechanism to do that. Right now, sometimes it eventually happens, but it can be a long process, and it is not a coordinated, systematic process. Establishing a council with the mandate and the legal authority to carry out that mandate would dramatically improve the situation. Senator Warner. Mr. Chairman, I know I have gone beyond my time, but if I could have Mr. Stern answer the question, too, sir? " CHRG-111shrg57322--819 Mr. Broderick," This was entirely consistent with the strategy that--with the direction provided by David Viniar and other senior managers of the firm that we be less long in our mortgage business generally. Senator Coburn. OK. But as a risk manager, what are the inciting events for them to do that? You are sitting there looking at it as a risk manager. What caused them to make that turn? Was it, as testified in the first panel, we started seeing a deceleration and an increase in housing prices, or we started seeing subprimes not performing? What was it that led to that conclusion within your firm? " CHRG-111shrg55278--67 Mr. Meltzer," Mr. Chairman, Senator Shelby, thank you for the opportunity to be here. I believe that effective regulation should await evidence and conclusions about the causes of the recent crisis. There are so many assertions about those causes that Congress should want to avoid a rush to regulate. During much of the past 15 years, I have written three volumes entitled The History of the Federal Reserve. Working with several assistants, we have read virtually all of the minutes of the Board of Governors, the Federal Open Market Committee, the Directors of the Federal Reserve Bank of New York, staff papers, internal memos, and so on. I speak from that perspective. I speak also from experience in Japan, where I served as the honorary advisor to the Bank of Japan during the 1990s when they were undergoing their banking and financial crisis. First, I do not know of any clear examples in the history of the Federal Reserve in which the Federal Reserve acted in advance of a crisis or a series of banking and financial failures. I have had the privilege of working with various Secretaries of the Treasury. Here is how the problem presents itself to them. There are a group of people who say, if you don't do the bailout now, you are going to have a crisis and it will go down in the history books with your name on it. There will be a few people who will say--very few, I may say--who will say, let the failing institution fail and make sure that you protect the market from having the failure spread. That is a question that really is at the center of this. It is not whether we should get rid of ``too-big-to-fail.'' I think many people recognize that ``too-big-to-fail'' is a disaster. What we need to worry about is how do we prevent problems from spreading. I am pleased to see that there is a good deal of skepticism among the Members of the Committee about simply appointing another regulator and saying to them, do what Secretaries of the Treasury, Chairmen of the Federal Reserve have done historically. That won't work. There are three things which I think are central to any such discussion. First is the question of incentives. How do we make incentives for prudent behavior on the part of bankers? We let them fail. Second, how do we make sure that bankers will not want to fail? We tell them you can fail and the best way to avoid failure is to hold capital. We need to buildup the capital. In the 1920s, banks everywhere had much more capital than they do now. A bank's window said, some of you may remember, listed the paid-in surplus and capital. By the 1950s, that was gone and it said, ``Member FDIC.'' That was a change in attitude. So we need to worry about capital. And last but something that I have not heard here but which should be part of your discussion is we need a lender of last resort proposal. The Federal Reserve in 96 years has never clearly enunciated what its role as lender of last resort is. It must be a role that the Congress will accept. No role will be viable if the Congress doesn't accept it. But there must be such a rule and that rule should say, hold capital and hold negotiable assets that you can sell to the Federal Reserve at the discount window what they will accept. That is the way in which we keep crises from spreading. We say, you are responsible as a banker and you must hold capital to protect yourself and you must have negotiable assets that you can sell to the Federal Reserve discount window because that is what it is there for. Without that, we won't have safety. What difference will there be if we establish one of these super-regulators? Why will they behave differently than the Treasury Secretaries that I have talked about, Federal Reserve Chairmen? Why will they not say about the Tier 1 risk people, you are too-big-to-fail. We can't allow that to happen. We have to use taxpayer money to bail you out. I don't believe that it will work. The first law of regulation--my first law of regulation is regulators make rules. Markets learn to circumvent them. You have heard lots of examples of that. It is a dynamic process. There is no set of rules which is going to for all time regulate this process. We need to change the incentives and the incentives have to be, you fail, we protect the market. Senator Warner. Thank you all for your testimony. Thank you for your abbreviated testimony. If I ever get a chance to sit here again, I am not going to go first, Chairman Dodd. [Laughter.] Chairman Dodd [presiding]. He has got a future in the Senate, I would say. [Laughter.] " 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." FOMC20060629meeting--6 4,MR. KOS.," Yes, I think one of the interesting points about this period is that very question. Some of the high-risk assets that had been bid up are where we have the most-pronounced price moves, and that does perhaps suggest that positioning is a bigger part of the story because bond markets were relatively tame not just in the United States but also in other, overseas bond markets. So something of a risk adjustment seems to have happened. I think the interesting question is why, but it’s very, very hard to discern that. I, at least, tended to minimize the effect that uncertainty about monetary policy itself has had in causing the volatility in emerging market equities. Certainly if one takes the opposite view, then one has some explaining to do in terms of the previous couple of years when a tightening cycle was occurring. At different times there was uncertainty about the pace and extent of the tightening, and yet those markets continued to rally despite that uncertainty." CHRG-110shrg50420--95 Chairman Dodd," No, no, fine. We will do that. I know already I have talked with Senator Corker and he has asked for a little extended time to pursue a line of questioning and I certainly want to accommodate my colleague with that request. I will just underscore the point that at least three of our witnesses, maybe more, have driven a long way to be here and we thank you for that. Senator Shelby. Mr. Chairman, I wonder if they are going to drive back. [Laughter.] " CHRG-111shrg57319--140 Mr. Vanasek," I think you have to look at the fact that Washington Mutual made up a substantial portion of the assets of the OTS and one wonders if the continuation of the agency would have existed had Washington Mutual failed. So I think they had a very strong mutual interest in the company succeeding. Senator Kaufman. Thank you. Mr. Cathcart, Mr. Vanasek talked about a stated income loan. Can you give us your definition of a stated income loan? " fcic_final_report_full--443 These losses wiped out capital throughout the financial sector. Policymakers were not just dealing with a single insolvent firm that might transmit its failure to others. They were dealing with a scenario in which many large, midsize, and small financial institutions took large losses at roughly the same time. Conclusion: Some financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms were failing for the same reason and at roughly the same time because they had the same problem of large housing losses. This common shock meant the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock. We examine two frequently debated topics about the events of September . “The government should not have bailed out _____” Some argue that no firm is too big to fail, and that policymakers erred when they “bailed out” Bear Stearns, Fannie and Freddie, AIG, and later Citigroup. In our view, this misses the basic arithmetic of policymaking. Policymakers were presented, for example, with the news that “AIG is about to fail” and counseled that its sudden and disorderly failure might trigger a chain reaction. Given the preceding failures of Fan- nie Mae and Freddie Mac, the Merrill Lynch merger, Lehman’s bankruptcy, and the Reserve Primary Fund breaking the buck, market confidence was on a knife’s edge. A chain reaction could cause a run on the global financial system. They feared not just a run on a bank, but a generalized panic that might crash the entire system–that is, the risk of an event comparable to the Great Depression. For a policymaker, the calculus is simple: if you bail out AIG and you’re wrong, you will have wasted taxpayer money and provoked public outrage. If you don’t bail out AIG and you’re wrong, the global financial system collapses. It should be easy to see why policymakers favored action–there was a chance of being wrong either way, and the costs of being wrong without action were far greater than the costs of being wrong with action. “Bernanke, Geithner, and Paulson should not have chosen to let Lehman fail” This is probably the most frequently discussed element of the financial crisis. To make this case one must argue: • Bernanke, Geithner, and Paulson had a legal and viable option available to them other than Lehman filing bankruptcy. • They knew they had this option, considered it, and rejected it. • They were wrong to do so. • They had a reason for choosing to allow Lehman to fail. CHRG-111shrg55117--102 Mr. Bernanke," Thank you. Senator Akaka. Thank you, Mr. Chairman. Senator Reed. Thank you, Senator Akaka. Senator Hutchison has just arrived, and if she is prepared, she will be recognized. Senator Hutchison, are you ready? Senator Hutchison. Thank you, Mr. Chairman. Thank you, Mr. Chairman Bernanke. I wanted to focus again on the health care issue that we are certainly grappling with right now. And, of course, the cost estimates are all over the lot. CBO says there is no way this is going to lower the cost to Government. And what we are concerned about, of course, is that the Government plan then attracts more and more from the private sector plans. I just wanted to ask you how you would assess another big Government health care program, in addition to Medicare and Medicaid that are already causing great concern for the future entitlements that will be required; what you think that does to debt; and is it the right approach right now considering our economy; and let me just add, the disincentive to employers to hire people, which is something that we are trying to do the reverse of right now when we have this high unemployment rate. Just give me your view of whether we should be looking at something different. Is there a problem here that you see on the horizon looking at the big picture and the long term? " CHRG-110shrg50414--2 Chairman Dodd," Good morning. I want to thank our colleagues, thank our witnesses, those who are in attendance. The Committee will come to order, and this morning we meet for a hearing on the ``Turmoil of U.S. Credit Markets: Recent Actions Regarding Government-Sponsored Entities, Investment Banks, and Other Financial Institutions. We want to welcome our distinguished witnesses here this morning. We thank the Secretary of the Treasury, Hank Paulson, who is here; the Honorable Ben Bernanke, of course, the Chairman of the Federal Reserve; Christopher Cox, Chairman of the Securities and Exchange Commission; and Jim Lockhart, the Director of the Federal Housing Finance Agency. The way we are going to proceed this morning is I will make a brief opening statement; turn to my colleague from Alabama, Senator Shelby, former Chairman of the Committee, to make his opening remarks; and given the magnitude of this issue and the seriousness of it, I am going to ask if my colleagues would like to make any brief opening comments quickly; and then we will get to our witnesses. My goal would be that we terminate the hearing sometime around noon, if we can. We all recognize the gravity of the situation and the importance of these witnesses to be able to get back and do the work they are doing. So my hope would be that we try and move along here. But, again, I want to give each of my colleagues a chance to at least say something at the outset of these remarks. But I beseech you to try and keep them brief. All of your full statements will be included in the record, and any supporting documents you care to include in the record will be there as well. So, with that admonition in mind, we will try and make the opening rounds here about 8 minutes apiece. That way we can at least get decent responses and properly ask questions. And I am not going to gavel down tightly, but try to keep it within that framework, if we can. With that, let me share some opening thoughts this morning, and then I will be turning to Senator Shelby. The Committee gathers this morning at an extraordinarily and perilous moment in our Nation's history. The landscape of our Nation's economy has been radically reshaped by the U.S. Government over the course of just a few days in a totally ad hoc manner, it would seem. Companies that have formed the foundation of our financial markets are shrinking and disappearing practically overnight. Their insatiable appetite for risk in many cases has permeated all sectors of the financial services industry and has spread beyond our shores. It has felled giants like Bear Stearns and Lehman Brothers; brought others to their knees like Merrill Lynch, AIG, Fannie Mae, and Freddie Mac; prompted the largest, I might point out, thrift failure in our Nation's history, the Indy Mac Bank; and eliminated the final two independent investment banks, Morgan Stanley and Goldman Sachs. These drastic changes have reverberated far beyond the trading floors and boardrooms of corporate America. Across our great Nation, families are gathering around their kitchen tables each night asking how they will weather this storm and how it will affect them very directly. Hundreds of billions of dollars that Americans invested in retirement accounts and mutual funds have evaporated. Homeowners are watching the value of their homes plummet. Foreclosures are forcing 9,800 families from their homes each and every day in our country. Families worry about how they will afford groceries and gasoline. Six hundred thousand Americans have lost their jobs while millions more have watched their paychecks shrink and their benefits wither away. Perhaps the most dangerous consequence, the one that we do not speak enough about, in my view, of this economic maelstrom is that our collective confidence in our Nation's future has been badly shaken, and that needs to be restored. Less than 6 months ago, our Banking Committee gathered in this very room to listen to the financial leaders of the Bush administration describe what at the time seemed an inconceivable event: the Government's $30 billion intervention in the sale of Bear Stearns to JP Morgan. Now after spending hundreds of billions of dollars more to prop up, bail out, and wind down a multitude of institutions, the U.S. Government effectively runs, supports, or outright owns vast swaths of the financial sector. American taxpayers are angry, and they demand to know how we arrived at this moment and, more importantly right now, how the architects of this economic landscape will put us back on a sound financial footing and restore American confidence and optimism. As I and many Members of this Committee have argued for the past 17 months since I became Chairman of this Committee, the root cause of our economic crisis has been the collapse of our housing market, triggered by what Secretary Paulson himself has called ``bad lending practices.'' These are practices that no sensible banker should have engaged in--and many did not, I might add--reckless, careless, and sometimes unscrupulous actors in the mortgage lending industry that allowed loans to be made that they knew hard-working, law-abiding borrowers would not be able to repay. Financial regulators acted much too late and much too timidly. They failed to enforce the laws that Congress passed requiring them to prohibit these bad lending practices. What is tragic and lamentable is that the ensuring calamity was entirely foreseeable and preventable. This was no act of God. It was not like Hurricane Ike. It was created by a combustible combination of private greed and public regulatory neglect. And now we must confront the present crisis. Barely 72 hours ago, Secretary Paulson presented a proposal that he believes--and others do as well--is urgently needed to protect our economy. This proposal is stunning and unprecedented in its scope--and lack of detail, I might add. It would allow the Secretary of the Treasury to intervene in our economy by purchasing at least $700 billion of toxic assets. It would allow the Secretary to hold onto those assets for years and to pay millions of dollars to hand-picked firms to manage those assets. It would do nothing, in my view, to help a single family save a home, at least not up front. It would do nothing to stop even a single CEO from dumping billions of toxic assets on the backs of American taxpayers, while at the same time do nothing to stop the very authors of this calamity to walk away with bonuses and golden parachutes worth millions of dollars. And it would allow this Secretary and his successors to act with utter and absolute impunity without review by any agency or a court of law. After reading this proposal, I can only conclude that it is not just our economy that is at risk but our Constitution as well. Nevertheless, in our efforts to restore financial security to American families and stability to our markets, this Banking Committee has a responsibility to examine this proposal carefully and in a timely manner. In my view, any plan to address this crisis must embody three principles: First, American taxpayers must have some assurance that their hard-earned money is being used correctly and responsibly; Second, we must put in place proper oversight so that the executors of this plan are accountable and their actions are transparent; And, finally, we must address the root cause of this crisis by putting an end to the rising number of foreclosures sweeping across our Nation. In the longer term, it is clear that our current economic circumstances demand that we rethink, reform, and modernize supervision of the financial services industry. Certain basic principles should form the foundation for reform. We need a leader in the White House who will ensure that regulators are strong cops on the beat and do not turn a blind eye to reckless lending practices. We need to remove incentives for regulators to compete against each other for bank and thrift clients by weakening regulation. We need to ensure that all institutions that pose a risk to our financial system and taxpayers are carefully and sensibly supervised. And we need to accept the premise that consumer protection and economic growth are not in conflict with one another but inextricably linked. If we learn nothing else from this crisis, it is that the failure to protect consumers can cause the collapse of our largest financial institutions, the loss of hundreds of thousands of jobs, and the draining of hundreds of billions of dollars of wealth from hard-working Americans. Today, we are very fortunate to be joined, as I said at the outset, by Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, SEC Chairman Chris Cox, and the Director of the Federal Housing Finance Agency James Lockhart. Regardless of how so many feel about the decisions these leaders have made and the impact they have had, we all ought to be able to agree that these four individuals are good, talented, knowledgeable, and experienced individuals who, I think, want to do the very best for our country. And I agree as well that we need to move, and move quickly if we can, but I feel even more strongly that we need to move carefully and prudently and to make sure that what we do is right. I understand speed is important, but I am far more interested in whether or not we get this right. There is no second act to this. There is no alternative idea out there with the resources available if this does not work. So it is critically important that we get it right. And the purpose of this hearing is to discuss whether or not this is the right approach and how we can prove it if we need to. Senator Shelby. CHRG-110hhrg46595--439 Mr. Sachs," I don't put the Chrysler situation really different--so different from the other two in that regard. I think none of them-- " CHRG-111hhrg48874--144 Mr. Long," No, it needs to be under reasonable payment terms. I mean, every situation is-- " CHRG-111shrg57319--111 Mr. Cathcart," That was not the case in my situation. There was a way around me. Senator Coburn. Explain that to us if you would, please. " CHRG-110hhrg46594--10 The Chairman," Thank you. I just want to acknowledge that this is a matter of great interest, and while we have a number of Michigan representatives here, we have been joined by the gentlewoman from Ohio, Ms. Kaptur, who is here because of the importance to the State of Ohio, and also the gentlewoman from Texas, Ms. Jackson Lee. Any members who want to sit up here--and of course our very distinguished colleague from Michigan, Mr. Kildee, whom I think is waiting a chance to get there. I wonder if it would be all right with Ms. Kilpatrick and Mr. Levin, there is the Republican Conference, could I go now to Mr. Hoekstra, to Ms. Miller and Mr. Hoekstra? Are you in a great hurry if I could get them? Let me also say to Mr. Upton, I consulted with the ranking member. I believe we could save our questions for later. If we have questions, we will get to you on the Floor. We know where to find you. So having testified, feel free to leave. I know you have your conference. It is not a sign of your lack of interest. I will go first to Mr. Hoekstra, then to Ms. Miller, and then we will continue with the others, for 5 minutes, please.STATEMENT OF THE HONORABLE PETER HOEKSTRA, A REPRESENTATIVE IN CHRG-111hhrg52406--118 Mr. Posey," Thank you very much, Mr. Chairman. I was a little bit confused, Professor Warren, by a couple of your answers or discussions with Mr. Bachus. And so I am going to ask a series of questions, because we have a lack of time, and if we run out of time, you can respond to them in writing, if you would be kind enough. You don't have to. If we have time left, we will go down the row, but I don't think we are going to have that kind of time left. If I heard you correctly, you mentioned banning certain products, and I was wondering specifically what products you recommend to be banned. You indicated that some products are complicated to understand, but agree that complicated disclosures are ineffective. I am not sure if you oppose the high risk or if you oppose the way they have been described, and if you could clarify that, please. You mentioned a safe harbor for pure vanilla, and I was just wondering where you draw the line on what is pure vanilla and what is not with the wide variation of experiences and knowledge that the citizens of this great country have. Some people seem to be asserting that our citizens are incapable of managing their own risk, and it makes one wonder, who will decide on our behalf what is an acceptable range? And who is going to tell me what risk I am allowed to take and what risk I am not allowed to take, what I can pay and what I can't pay? Much of the complicated disclosures that everybody has been beating to death today are a result of congressional or State regulations that were as well intended as what is before us now. And the result is, you tell a company they have to disclose something, and if it takes 45 lines to do it, they are going to do it. They don't particularly care if you like it or not. You told them to do it, and that is what it takes to keep them out of court with the lawyers that you are training up there. You know, it sounds like we are talking about an agency that we should probably change their name to; we should probably be talking about a Federal Department of Reward Without Risk or a Guaranteed Reward Without Risk, which is kind of an oxymoron since that is the principle upon which our financial system was built on and the free enterprise system seems to evolve on. And then if that doesn't work, maybe we can have a Federal Department of Prosperity Without Risk or Work. One wonders where this is all going to stop if we continue trying to think the government is going to solve everything by taking responsibility away from people to make their own decisions. I think we all want them to make informed decisions, but where do you draw the line about intruding into my ability to decide what kind of a mortgage I want, what kind of a fee is acceptable to me. There are people who get better credit deals than I do because they have more money, and there are people who have maybe less opportunity because they don't pay their bills. I mean, are you going to take that latitude away from a lender to make those kind of decisions, and ultimately, what kind of consequences do you think the market is going bear? And do you think there are going to be no consequences in the overall cost of the consumer? When we talk about the consumer, first and foremost, before we talk about a single credit card holder or we talk about a person taking out an individual mortgage, I look at a consumer's--400 million people in this country, they are all consumers. They are consumers of what we make here. Some of what we make here is good for them. Some of what we make here is bad for them, but they are all different. And the typical government approach that one size fits all, this is the way you have to do it, and everybody has to live with this, doesn't seem to be a real service, I don't think, to our consumers most of the time. Ms. Warren. Thank you, Congressman. I will start by saying the person who was talking about banning products actually wasn't me; it was Mr. Yingling who embraced that notion. " FOMC20081216meeting--228 226,MR. BULLARD.," Thank you, Mr. Chairman. I will be brief. In the Eighth District, there is a clear and sharp downturn, as in the national picture. There is a clear turn to survival strategies, and you really see that when key CEOs and other figures start talking about lower capital expenditures for 2009, cutting the lower levels in 2008 in half or more. I think that's very consistent with the Greenbook. The effects on our District from any auto restructuring may be substantial, and that is something I have ratcheted up here in the last few months. A common theme among all contacts--and it echoes some of what has been said around the table here--is that rate cuts at this point will have no effect on the macroeconomy. Their thinking is, well, of course, since short-term Treasuries are trading at zero--I think one-month Treasuries actually hit zero here a bit ago--they are not going to have any effect. But as Governor Duke pointed out yesterday, and I think this is an important concern, the impact on bank profitability may be substantial, exactly at the wrong time. First Vice President Cumming picked that up, too. I think that is a concern. I think it suggests favoring an option of de-emphasizing the federal funds rate as a target at this meeting, as we will get to in the policy discussion. But then you might not trigger this prime rate cut that would otherwise normally accompany a major move by the Fed. On the national picture, I expect a sharp downturn in the fourth quarter and the first quarter. Expectations are extremely negative now and extremely fluid. I think that is probably the biggest factor facing us going forward into 2009. The expectations are so fluid that they portend a deflationary environment if we do not control the situation very soon. I am also very concerned about the global aspect because we haven't really seen this kind of coordination across the globe in the rapid movement to probably zero interest rates. I don't think we really know what that means going forward. We are going to be looking at bad news coming in at least until summer, and we have no way at this point to signal a reaction to that bad news via normal policy. That is the gravity of the situation, and in some ways it is the downside of a preemptive policy. Had I been on the Committee earlier this year, I would have supported the preemptive policy to try to avoid this situation. But one downside of it is that you do not have the ability to continually react as bad news comes in. In sum, I think we are moving to a Japanese-style deflationary, zero nominal interest rate, situation at an alarming pace. To stay in the game and control expectations, we need a Volckerlike transformation, something like--although the situation is different--the '79 announcement, which knocked private-sector priors off the idea that they should trigger all reactions to announcements on nominal interest rates. You need a dramatic move that emphasizes this new reality. Continued focus on the federal funds rate at this point would not face that reality. Above all, we have to establish in the minds of the private sector--and maybe in our own minds as well--that we control medium-term inflation. We should take the attitude that we can create the inflation we need to stay near target by one means or another. I think, actually, this may be an excellent time to set the inflation target, although it sounds as though we are drifting away from that. But if I can argue for it for a few minutes here, I think it might have an important effect on the navigation through the recession during 2009. Of course, in normal times, to undertake some action like that, we would want a lot of study, and we would want to have time to talk it through with the Congress and other interested parties, as we would for interest on reserves. But we don't have that luxury right now. We want to take the action now to help control the situation, and I think we could sell that as a work in progress, which can be modified later. But we do want to keep these expectations under control in this very fluid situation. Thank you. " FOMC20080130meeting--150 148,MR. REIFSCHNEIDER.," It might not happen. I mean, you could have a situation in which business sentiment would not take a hit, for example, simultaneously with the stock market tumbling, and you would not see some risk premiums on bonds going up. That would be very unusual. " CHRG-111shrg56376--163 Chairman Dodd," Your questions are so eloquent. Senator Corker. OK. There you go. If you would--and I know Marty is getting--and this is my last, just to advance this a little bit, the procyclical piece to me is a huge problem that you do not necessarily create by your formula, but it is something that has not served us well. The same thing happens in 1990 and 1991, and we just do a really poor job of it. There is nothing in your proposal that, for instance, changes--I mean, much of this is about rearranging the deck chairs and just getting different people--it is almost a family squabble. We sometimes refer to the insurance industry's issue the same way. But what they do is also very important, and, you know, the--for instance, the counterparty risk, I mean, is this--is there anything about any of this that changes their ability to really look to those deficiencies that really are the heart of the problem here, that really are causing us right now to be doing what we are doing? And, Marty, you may answer that, and I will stop. " CHRG-110hhrg44900--44 Mr. Bernanke," Like Secretary Paulson, I have no objection whatsoever to early action and will continue to work with you closely in all directions. It's just our sense, and of course you're in a better place than we are to make the judgment, that the more complex issues like resolution or even financial regulatory restructuring are simply not likely to happen in a short term, and we need to take the time to make sure it's done right and thoroughly worked through. So we will continue to think about what steps might be taken on a shorter-term basis and be in close touch with Congress. But, again, we are--I just want to be clear that, you know, it's not that we don't have any tools. We have plenty of tools, and we are working together very well I think to address a difficult situation. " FOMC20050920meeting--100 98,MR. KOHN.," Thank you, Mr. Chairman. Like President Geithner and many others of you, I do view this as one of those rare situations in which we can truly say the outlook is more uncertain than usual. [Laughter] But that should not deter us from proceeding with our “measured pace” of rate increases. The pre-Katrina data themselves suggested some potentially interesting questions about the outlook, which could have implications for policy going forward. I was especially struck by the weakness in capital spending, despite high and rising profits and strength in other aspects of the so-called fundamentals. It’s possible that business caution has increased again, perhaps out of concern about the effects of the rapid run-up in energy prices on demand since last spring. But at the same time, house prices on the OFHEO index continued to rise at a very rapid pace through the second quarter, supporting household spending and further increases in resource utilization. The expansion was continuing but had become even more unbalanced—more reliant on declining household saving rates induced by rising house prices. Core inflation was coming in lower than expected again. But the potential for future price increases, absent a further tightening of policy, was suggested by upside surprises on one measure of labor costs, rising resource utilization, and the threat that increases in energy costs could feed through to underlying September 20, 2005 76 of 117 I agree with the staff’s assessment that the most likely outcome from Katrina is that the economy will not be materially deflected from the path it was on. After the initial disruptions, fiscal stimulus, rising house prices, and still favorable financial conditions, along with the economy’s natural resilience, should overcome any drag from higher energy prices and should keep activity increasing at a good clip in an economy that is already producing at a high level of resource utilization. Under these circumstances, inflation pressures will not abate. And judging from the tendency for the output gap to continue to shrink this year, we’ll probably need at least a couple of rounds of rate increases to keep the economy near its potential and to prevent inflation from trending higher. Katrina has greatly added to uncertainty, and not just about the extent of the near-term disruption or the effects on energy markets. The more difficult uncertainties relate to how people may react to what has happened, how the government will decide to respond, and how businesses and households will react to these governmental actions and to whatever the path of energy prices turns out to be. How these uncertainties are resolved will affect the economy’s medium-term prospects. But at this point, that added uncertainty doesn’t look particularly asymmetrical in its implications for the path of policy. The risks are still two-sided. Growth could be stronger than anticipated, for example, owing to greater government spending and new tax incentives, with implications for inflation. But on the other side, the rise in energy prices may have less of a persistent effect on core inflation than the staff has predicted. The feed-through of energy prices to core inflation has declined appreciably over time, September 20, 2005 77 of 117 August may have it right that higher energy prices will have more of a negative influence on demand than a positive effect on long-term inflation. The skews in the probabilities for the most likely outcomes were highlighted by the Michigan survey on Friday, pointing to extra weight on the possibility of weaker growth from increasing energy prices that affect consumer psychology and spending but also pointing to potentially higher inflation if expectations do become unanchored. And these skews themselves have offsetting implications for policy. Moreover, uncertainty isn’t going to be reduced by pausing or slowing the pace of tightening. This uncertainty isn’t about the response of the economy to past or future monetary policy actions. Raising the funds rate, as expected, isn’t likely to undermine sentiment or spending. Indeed, pausing, slowing down, or being more ambiguous about our expectations for policy going forward could confuse the public about our view of the situation. In sum, this is a situation in which we should make our best guesses as to the likely outcome, however bad those guesses may be, and act on them, continuing the “measured pace” of tightening for now. Thank you." CHRG-111hhrg53245--153 Mr. Wallison," And a credit default swap is, in shorthand, like an insurance policy. You are insuring someone against a loss. My point was simply that when AIG failed, it did not cause any losses to any of the people who were its counterparties. It is just exactly like you have an insurance policy on your home, and your insurer fails. You would go out and get another insurer, but unless you had already had a fire, you had not suffered a loss. And that is exactly the case with credit default swaps. There is in my view a lot of misinformation around about credit default swaps, suggesting that they are very dangerous. I do not believe they are dangerous. And I do not believe in the case of AIG there was any need to bail out AIG. AIG had one major counterparty, and a lot of others, but the biggest one was Goldman Sachs, $12.9 billion in credit default swaps, with which AIG was protecting Goldman Sachs. When it was learned that Goldman Sachs was in fact the major counterparty, the press went to them and said, ``What would have happened if the government had allowed AIG to fail?'' And Goldman Sachs said, ``Nothing, we were fully protected. We had collateral from AIG. And, in addition, we had bought other protection against a possible failure by AIG. So it would not have been a problem for us.'' And that I think is how we have to look at the AIG question. It was large. It was engaged. It was interconnected, as all financial institutions are always interconnected, but the possibility of loss from AIG was very small. " FOMC20060629meeting--75 73,MR. MOSKOW.," Well, it’s brutal compared with last year at this time because they had an employee-incentive pricing program last year, which they’re not going to have this year. It’s an interesting situation because they say that Chrysler has announced that they’re going to have some higher incentives. I spoke to the CEO of General Motors. He claims that they’re trying to hold the line on these incentives and keep them below the very high level they’ve had these past few years; they are not going to cut prices as they have in previous years. We’ll see whether they’re able to do this, but that’s their stated position now" FOMC20080121confcall--48 46,CHAIRMAN BERNANKE.," All right. Thank you. Let me make a few comments. Thank everyone for your input and your concerns, which I appreciate. This is a very, very difficult situation, and no one can know exactly how this is going to work out. But let me try to respond to a few points that were made. First of all, as I indicated earlier, I would not be proposing this if I didn't think that we were seriously behind the curve in terms of economic growth and the financial situation. I said that on January 9, and since then the markets and the data have only gotten significantly worse. I do believe that we are at least 100 basis points behind the curve in terms of neutrality, and so I am quite comfortable with this order of magnitude of move. Frankly, I think the evidence is very much in favor of it. With respect to what the real rate is, I would combine my response to you with a comment to President Fisher, which is that real rates depend on expected inflation, not past inflation. Inflation is a lagging indicator. We cannot wait until inflation is down before we begin to act. We have to look at the future. We have seen oil prices down $10 already. We just have to make a judgment. With the economy slowing and with oil prices likely to moderate, the best guess is that inflation will be well controlled going forward. If that is not the case, we can begin to address it. But I do believe that, from a forecast viewpoint, we don't have a negative real interest rate, and we don't necessarily have inflation above 4 percent. I would like to address the issue of the lesson of 2001. I don't think that the problem with 2001 was the rate at which the interest rate was cut. The interest rate was cut more than 500 basis points, including three intermeeting moves of 50 basis points each in 2001. Nevertheless, at the end of that episode, inflation was too low, which is evidence I think that in some sense the response was even inefficiently slow. Not that they could have necessarily done better, but clearly it was not the cut itself that led to inflation problems. Governor Kohn's points notwithstanding, and it was very difficult to know ex ante what was right, if there is a concern there it has to do with how quickly the rate was raised starting in 2004 going forward, when the economy was already on a growth path. I think we have learned from that. I think we will be very sensitive to that. Let me just add that I do intend to be talking more about the outlook and about policy. I am sure that I will do my best to communicate where I think we are and how we are going to manage policy going forward. I have talked specifically about the need to be aggressive in the short run, particularly when financial stability is at stake. So again, my fundamental point is that we are behind the curve. We need to do something to get up there. Why does that help markets? Well, I think there are issues of psychology and dynamics and damage that could be done if we let the markets twist and turn for another nine days. But the fundamentals are also involved. The markets essentially--in their incredible efficiency--are bringing into the present concerns about very bad outcomes that might happen in the future. With fair value accounting, mark to market, and all of those things, the risk that house prices might fall 20 or 30 percent, even the small risk, is affecting today's credit ratings and credit markdowns. We can help the markets in a fundamental sense by assuring them that we are aware of these risks and that, though we are not going to necessarily stop a slowdown, we will do our best to minimize the tail risks of a really bad outcome that are right now driving today's market reactions. That would help the monoline insurers in the sense that, if the markets become convinced that those risks are much smaller, then the obligations of the monolines insurers will be less, and the willingness to advance capital might be greater. Again, if I thought that we were where we should be and this was just a question of placating the markets, I would not be here talking to you. But I think that we need to move, and if we move now, we will get a bonus in terms of at least some hope of reducing the fear and the uncertainty that is currently in the markets. So I do think it matters whether we move today or move nine days from now. I recognize the risks, but in the two years that I have been here in this position, we have not moved intermeeting. We waited a long time to move in September after our intermeeting statement. I don't think that we are trigger happy. I don't think we are perceived as trigger happy. I think that we need to be catching up to where the right interest rate is, and that is the essence of the issue. I guess that is all I have to say. As I said, Governor Mishkin is not here. For what it is worth, he authorized me to say that he supports the action and the statement. We are currently at a very critical juncture. We are being watched very carefully. We have to demonstrate our willingness to address these very, very serious risks. I think we ought to go ahead and take this step, and I hope that you can support this action. Are there any other comments? President Hoenig. " CHRG-110shrg50416--139 Mr. Lockhart," It could be long, could be short. Senator Corker. It is my goal that--or it is my hope that you will work yourself out of a job pretty quickly. I know the biggest part of your portfolio is Fannie and Freddie; the others sort of lesser, if you will. Is there any need for--I have a strong prejudice in this regard, but is there any need for Federal involvement in Fannie and Freddie? My sense is absolutely not. I knowwe have had some conversations in our office about that, and I am just wondering what your answer to that might be. And if not, if the markets can deal--I mean, housing finance is not particularly complex. It really is not. Any sense as to how soon we might be out of the business, if you will, of having these Government-sponsored entities and you maybe being on the beach someplace? "