CHRG-111shrg57319--149 Mr. Vanasek," I am not aware of any particular limit that existed, but I could be incorrect. " CHRG-111hhrg56776--188 Mr. Garrett," Well, my understanding is, according to the examiner's report, the New York Fed required no action from Lehman in response to the stress test. Is that an incorrect understanding? " CHRG-111hhrg51592--193 Mr. Capuano," That's fair and reasonable, but that goes to Mr. Pollock's comment, which I thought was very good, of a cartel. Now, Mr. Pollock, you would agree that a cartel doesn't necessarily have to be just three or just 10, a cartel could be 100, if they operated as such; is that incorrect? " CHRG-111shrg57319--373 Mr. Beck," That is not what I said. No. I said I remember and recall this specific event because we did go out--because we securitized loans that were delinquent, which we represent that we won't do and we shouldn't do, and these were loans purchased from third parties and the loan servicing tape that we got from them was incorrect. It was wrong. And when we found that out, we went and purchased these loans back. Senator Levin. You notified everybody? " CHRG-110hhrg38392--177 Mr. Bernanke," Total inflation. Mr. Miller of North Carolina. The information that I have is that from November of 2001 until May of 2007, the wages of production workers, which is about 80 percent all workers, had increased 17.28 percent and total inflation had increased 17.22 percent, which is barely treading water. Is that an incorrect number? " FOMC20050809meeting--194 192,CHAIRMAN GREENSPAN.," You know, initial claims have not moved all that much since the last meeting, so it’s a little hard to make the case. And any word that we change now, since we’re changing so little, is going to be made more of than I think we’d want because there are so many people out there who are being paid to read this statement and interpret our meaning. So, I think we have to be a little careful of that. Unless something in the statement is obviously getting to be incorrect—clearly, we can’t have that—it’s probably better not to make a change." CHRG-111hhrg53245--256 Mr. Donnelly," One of the other things the investor, this fellow, talked about was, and he talked to all of us, was maybe what we ought to do is just throw a couple of cents on every tray and have in effect a quasi-public rating system so that we do not have to speculate on the opinion of Moody's or that they be part of in effect almost become like a public utility, that it is too important getting this right to our economy, to the global economy. We had the Fed chairman in today who said if we had let this get out of hand, the whole global economy would have collapsed. And so much of it was tied in to these incorrect ratings given by Moody's and others. " FOMC20081029meeting--106 104,MR. PLOSSER.," I just want to clear up the question. I think Tim and Nathan may have both answered this, but it's a question that President Lockhart raised earlier. In Mexico's case, for example, where almost all the major banks are foreign owned--EU banks, Spanish banks--those banks clearly have access to dollars through the ECB swap line. There's no reason that the dollar funding needs of those banks, to the extent that they can move these things around, can't be satisfied by access to dollars from the ECB. Is that a correct or an incorrect assumption? " CHRG-111hhrg53244--187 Mr. Hensarling," Okay. It has had some effect. Okay. Well, the chairman has said ``some.'' So I appreciate the chairman's distinction. Clearly, what you didn't mention, as far as positive impacts, was employment. We know that, since this legislation has passed, that unemployment is now at a quarter-of-a-century high, that 2 million jobs have been lost. Some believe that there is cause and effect on adding $1.1 trillion to the national debt. And on page 6 of your testimony, again you state, ``Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth.'' I have noticed, and please tell me if I am incorrect, the latest FOMC report indicates or estimates that we are looking at 9 to 10 percent unemployment not only for the rest of this year, but for the rest of next year, as well. Did I read that report correctly? " CHRG-111hhrg48868--92 The Chairman," Thank you, Mr. Chairman. And let me say to the gentleman from New Jersey, I apologize. I was looking at the transcripts of our previous hearing and the transcript, the official transcript, is probably incorrect. Looking at the official transcript, it cuts off the questioning. I should have wondered because, according to this transcript, the gentleman used far less than 5 minutes and most of us find 5 minutes too constraining. So I will have to correct the transcript. It began with covered bonds and I will have to check and see why transcripts were not better done. So we did have the hearing on July 10th well before they got involved again. The gentleman did ask if they planned to do it again and I guess he got his answer. They may not have planned to do it again, but they did it again. " CHRG-111shrg52966--22 Mr. Cole," I would indeed, and thank you for the opportunity, Senator. First of all, I would say that my understanding is that the report that the GAO has done is really based on review of one institution. Senator Bunning. That is incorrect, but that is fine. " Mr. Cole," OK, and that we received this report with reference to perspectives on risk just in the last couple days. So we would like an opportunity to go over these findings with the GAO, as we typically do in GAO reviews. We have not had that opportunity. But I will say this, that I think that what Ms. Williams quoted from is in the report, but unfortunately, there are other parts that were not quoted, and one in particular is, quote: The effects of a long period of easy liquidity and benign credit conditions have continued to weaken underwriting standards across all major credit portfolios. Finally, we note that investor demands appear to be encouraging large financial institutions to originate more assets and even greater volumes of low-quality assets, and in order to distribute them through the capital markets.In response to that, we took very firm actions, and that---- Senator Bunning. When? " CHRG-111hhrg55814--270 Mr. Tarullo," I think, Mr. Chairman, that Comptroller Dugan has summed it up. Surely we can keep the list private if that is what the Congress wants us to do, but through some combination of self-mandatory disclosures to shareholders and, frankly, just financial analyst observation of their behavior, capital, set-asides and the like for the firms, it is likely that most, if not all, of the institutions so identified would eventually be known to the public. And I think, as someone suggested, you may have a bit of a problem if an incorrect inference is drawn. So while again, there is a reason to try to avoid an increase in moral hazard, we should probably be realistic here about what will and will not be known. Mr. Moore of Kansas. Thank you, sir. Mr. Bowman and Mr. Sullivan, any comments? " FinancialCrisisInquiry--44 MURREN: Thank you. I have one final question, Mr. Chairman. CHAIRMAN ANGELIDES: Absolutely. You have—you have time. MURREN: I was struck, actually, by—you mentioned several times that your behavior, either individually or as a corporation, was really within the context of what is considered standard for the times. And given that we’re now in— in 2010 and we have unemployment at very high rates, foreclosures are high, many people are really suffering right now -- given that these are the standards of the times, could you please comment on your compensation and that of your senior executives? BLANKFEIN: First—you know, first as to the standards, I mean, I’m not—what I meant to convey is I’m not sure -- again, I haven’t surveyed what the standards of the time were. But let me say—and people will go back and test this, I’m sure, and look. I know the standards of times were different than what we are now. And so, the way I was asked that question, how do you rate yourself in terms of negligence of what you should have done—I’m just saying it would have to be compared to what the standards were. Those standards, when you look back in hindsight, should have been elevated. And, by the way, that could also be another source of—of incorrectness. Maybe we should have been a part of those who—who elevated those behaviors. But that’s what I meant to convey. I wasn’t saying that those were fine. I’m saying that when you asked me what the standards were, again, that’s how we—that’s how we would measure ourselves, in terms of what we were thinking. Now, you asked me a question—you asked me... MURREN: FOMC20070628meeting--363 361,MR. LACKER.," I like the statement as is. I was one of those who, when we considered accelerating the release of the minutes, thought that it would take some weight off crafting the statement, which we could shorten. Alas, I was incorrect, and that was sort of hopeless. So I’m giving up. I sort of like the length the statement is now. It does a reasonable job with what it does, with one exception—the last section, the so-called balance-of-risk assessment. I’ve argued this many times when we’ve talked about this. The intention is to convey the likely next direction of interest rate changes. Our general practice has been—there have been some exceptions—to describe the risks to the things we care about, and we invite people to deduce what we think of as the likely next direction of interest rate moves by inverting our policy reaction function somehow. I always thought that was problematic, needlessly obscure, and I liked the times when we crafted that statement fairly directly and explicitly with phrases like “policy firming.” About the balance-of-risk assessments, I hesitate to put something else on the table, but we ought to think about the directive, too, because the balance-of-risk assessment came into the statement because it was in the directive and there was a tilt statement in the directive that originated in the ’80s as a way of providing the Committee’s sense of constraint on the Chairman’s discretion to make intermeeting moves. That’s my understanding of how it arose. Then it came to be about the next meeting when we did intermeeting moves, and now it’s just sitting there in the directive, and I don’t know what good it does in the directive really. You know, we don’t make intermeeting moves. I don’t know what our understanding is about discretion about intermeeting moves. I think that we’re supposed to have a conference call with everybody. So I don’t know why we need this little directive in there, and it seems to me you could just take it out of the directive. About governance, I’m in favor of voting on the whole thing. I remember talking at one point with I think it was you, Mr. Chairman, and others about how it is backward for us to talk about the statement—to do negotiations about the statement—a week before we even talk to each other or read the Greenbook. But I don’t think that’s so problematic. It doesn’t end up putting our feet in cement really, and I think we’ve been able to have sufficient flexibility during the meeting despite what we said the week before. So I don’t view that as terribly problematic." CHRG-111shrg50815--75 Mr. Levitin," Also, the European Union's antitrust enforcement body has actually said that interchange fees are anticompetitive. That is being appealed, but we at least have a broad several countries that have recognized the problems with interchange fees. I think it is important to note, though, that what Professor Zywicki said is incorrect about interchange fees. There is a serious difference between interchange fees on credit cards and the cost of cash or checks or payment devices like that. If a merchant wants to charge more for cash, that is the merchant's prerogative. The merchant cannot surcharge for a credit card. If the merchant does so, the merchant is violating its agreement with its acquirer bank. Also, 45 percent of the cost of interchange fees, that is just going to fund rewards programs. Merchants don't get any benefit from that. That is going for frequent flyer miles for rewards junkies. So at least 45 percent of the cost of interchange has really no benefit for merchants. There is no evidence of ticket lift, contrary to what Mr. Clayton says. If you want to find out how happy merchants are when they have adopted credit cards, talk to McDonald's. McDonald's adopted credit cards thinking that they would get some ticket lift. Everything I hear is they have not been real pleased with it, but they have had to sink in a lot of money and that they are kind of trapped in that now. " CHRG-111shrg50815--51 Mr. Plunkett," Thank you for the question, Senator. A couple more areas we would like to see improvements. First, as we heard, fees have been growing faster than the cost of living. In many cases, penalty fees in particular seem to bear no relationship to the costs incurred by issuers if somebody pays late or goes over limit. So we like Senator Dodd's provision that fees should be reasonably related to the costs incurred by issuers. We like the provisions in that bill and others related to lending to young people. Two things there. Senator Dodd talked about extending credit responsibly to young people or having a cosigner with income who can pay for the loan and not offering the loan to young people without much income. The second issue in the bill, give young people a choice of whether they want to accept--a real choice--whether they want to accept credit card solicitations. So the bill has an opt in. You don't get solicited between 18 and 21 unless you affirmatively choose to allow it. A third issue is bringing down rates after somebody makes a mistake. In many cases, issuers appear to be reserving the right to charge those rates for a long time, you know, many, many, many months. What the Dodd bill says is after 6 months, if you have been on time, if you haven't violated your agreement, rates have to come back down again. Senator Johnson. I believe the time is incorrect. " CHRG-111shrg57322--587 Mr. Viniar," Chairman Levin, Ranking Member Coburn, and Members of the Subcommittee, good afternoon. My name is David Viniar. I have been Chief Financial Officer of Goldman Sachs since 1999. I am responsible for risk management, financial control and reporting, and financing our business, among other duties. I appreciate the opportunity to appear before the Subcommittee and I will comment here on our risk philosophy and our approach to risk management.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Viniar appears in the Appendix on page 216.--------------------------------------------------------------------------- As a global investment bank and financial intermediary, Goldman Sachs integrates advice and capital with its risk management capabilities to serve a broad range of largely institutional clients. In doing so, we often take on principal risk to help clients achieve their objectives. For example, we may facilitate block offerings, provide structured solutions, or extend credit. We routinely evaluate, price, and distribute risk across the spectrum according to the specific risk appetites of our institutional clients. We know that we will sometimes incur losses, but as a core part of our business model, we proactively manage our risk to minimize these losses. When we commit capital to buy or sell financial instruments, extend credit, or invest alongside our clients, we accumulate both long and short positions that give rise to liquidity, credit, and market risks. We deploy a range of risk management capabilities to price the risks of each transaction appropriately, keep the firm's overall exposures within risk limits, and establish offsetting positions, or sell and buy positions, as necessary to control overall exposure. Our approach is to understand the risks we are taking, analyze and quantify them, and keep a firm grip on their current market value. We carry virtually our entire inventory of financial instruments at fair market value, with changes reflected in our daily P&L. Such daily marking of our positions was a key reason we decided to start reducing our mortgage risk as market conditions were deteriorating at the end of 2006. I would like to give you a sense for how we managed our risk during the period leading up to the crisis. Through the end of 2006, we were generally long in exposure to residential mortgages and mortgage-related products. In that December, however, we began to experience a pattern of daily losses in our mortgage-related P&L. P&L can itself be a very valuable risk metric and I personally read it every day. I called a meeting to discuss the situation with the key people involved in running the mortgage business. We went through our positions and debated views on the mortgage market in considerable detail. While we came to no definitive conclusion about how the overall market would develop in the future, we became collectively concerned about the higher volatility and recent price declines in our subprime mortgage-related positions. As a result, we decided to attempt to reduce our exposure to these positions. We wanted to get closer to home. We proceeded to sell certain positions outright and hedge our long positions in an attempt to achieve these results. As always, the clients who bought our long positions or other similar positions had a view that they were attractive positions to purchase at the price they were offered. As with our own views, their views sometimes proved to be correct and sometimes incorrect. We continued to reduce our positions in these products over the course of 2007. We were generally successful in reducing this exposure to the extent that, on occasion, our portfolio traded short. When that happened, even if these short positions were profitable, given the ongoing high volatility and uncertainty in the market, we tended to attempt to then reduce these short positions to again get closer to home. This situation reversed itself in 2008, however, when the portfolio tended to trade long, and as a result, despite the fact that our franchise enabled the firm to be profitable overall, we lost money on residential mortgage-related products in that year. While the tremendous volatility in the mortgage market caused periodic large losses on long positions and large gains on offsetting short positions, the net of which could have appeared to be a substantial gain or loss on any day, in aggregate, these positions had a comparatively small effect on our net revenues. In 2007, total net revenues from residential mortgage-related products, both longs and shorts together, were less than $500 million, approximately 1 percent of Goldman Sachs's overall net revenues. And in 2007 and 2008 combined, our net revenues in this area were actually negative. For Goldman Sachs, weathering the mortgage market meltdown had nothing to do with prescience or betting on or against anything. More mundanely, it had everything to do with systematically marking our positions to market, paying attention to what those marks were telling us, and maintaining a disciplined approach to risk management. Thank you, and I am happy to take your questions. Senator Levin. Thank you very much. Mr. Broderick. TESTIMONY OF CRAIG W. BRODERICK,\1\ CHIEF RISK OFFICER, THE CHRG-111shrg54589--51 Chairman Reed," Thank you very much. Senator Bunning. Senator Bunning. Thank you. For the Chairman of the SEC, can and should the Securities and Exchange Commission require all reporting companies to disclose counterparties and reference entities and assets in their derivative portfolios? Ms. Schapiro. Require public disclosure? If their relationships are material and they have material contracts with counterparties, they should be disclosed--at the risk of saying something incorrect here--in their public filings if they are material to the company. Senator Bunning. I am talking--you are talking about someone to regulate these people. I am talking about---- Ms. Schapiro. For example, if Boeing were to enter into a customized---- Senator Bunning. Customized, or even--yes, a customized one. Ms. Schapiro. If they were regularly engaged in this market, I think that that should bring them under the umbrella of being regulated. But, otherwise, I believe our view would be that we could get at the information through the dealer's requirement to keep records about counterparties, an audit trail of the transaction, all of the terms of reference of the transaction. Senator Bunning. In other words, I am asking about any entities. Ms. Schapiro. Other than just dealers? Senator Bunning. That is correct. Ms. Schapiro. I believe that we think we can get the information through access to all the dealer information about who they were--who their counterparty was. Senator Bunning. I am worried about people slipping through, like we had for the last 10 years. Ms. Schapiro. I share that concern very much with you. I think to the extent anybody did not have a dealer as their counterparty, so a Boeing or another commercial company, and they were engaged in this market with any frequency at all, we could get at that directly. But I believe we could get the information very clearly through our regulation of the dealer and access to the complete books and records of the dealer, where they would show that they were transacting with Boeing. And, of course, if the information is in a trade information warehouse or the transaction is done through a central counterparty, we would have access to the information in that method, in that way as well. Senator Bunning. This is one for all of you. How do we prevent a clearinghouse or an exchange from being too big to fail? And should they have access to Fed borrowing? " CHRG-111hhrg48674--266 Mr. McCotter," Thank you, Mr. Chairman. People in my district woke up one day sometime late last year and found out that the world, as they knew it economically, was going to end because someone had done something wrong to seize up the credit markets. And since that time they have witnessed disorder in the sense of the government's response. They have perceived this to be an unjust appropriation of their money, spent on the very people who caused the problem, and they see a long-term loss of economic freedom due to government intervention. And most importantly, they don't see much benefit to their daily lives from all the things that the government has done. My concern in studying human nature is twofold: one, the concept of ``too big to fail.'' When you tell people they are too big to fail, they will, because they know there is no responsibility to be incurred, no accountability if they do. Where is the stigma for the people who failed and put us in this mess? Where are the measures taken to ensure that they pay a price for their problems that they have put onto us? I don't see any. I don't see any at this point. And the second part of my question is kind of that these people thought they could go on forever doing what they were doing, that it would just keep going, that the dot-com bubble was replaced by a housing bubble, and it would never end. Now we are talking about creating a government bubble to fix the housing bubble, but they never thought they were wrong. I asked you and Mr. Paulson once, ``What happened?'' The answer was, ``Mistakes were made.'' Well, I understand human beings are fallible. But the problem is, if people think they are too big to fail or they are too important, the hubris that enters into the prognostications that they make and the actions that they take leads them to make very, very big mistakes. So my question is this: If these people were wrong and we are suffering the consequences of their bad decisions; if people like Mr. Greenspan, who has admitted he was wrong, have caused us to suffer the consequences of his bad decisions; if--as you have written a book about the Great Depression--the people at the Federal Reserve were wrong and the people at the time had to live with their bad decisions, what in the odd chance happens if you are wrong? What is your worst-case scenario for the decisions and the actions that you have made and taken being incorrect, how will that affect the people who sent me here to work for them? " FOMC20060510meeting--169 167,MR. KROSZNER.," I agree with the 25 basis point move at this time. I think we have seen some beginnings of evidence of heightened inflation risk relative to six weeks ago, and I think it is also very important, as President Yellen mentioned, that looking back historically, we do not want to get too far out ahead and then have some regrets. But we also have to be concerned about how our actions will be interpreted by the market and to think about the longer-run expectations. We have to convey that we do have some uncertainty about where the economy is going, and I think that is well reflected in our discussion here and in alternative B. But it is extremely important to keep our powder dry. I really like the idea of saying that not only will we be looking at the data as we normally do in our due diligence but also we are going to be looking at things because there is uncertainty. We do not have an ideological view that we must make sure that every last concern about inflation is stamped out, without concern about growth, or vice versa. Also, as I said last time, it is hard to know exactly where we need to go to be at the right level. At best, we can be within 25 basis points of where we would hope things would be, but obviously, it is quite literally a moving target since the underlying economy is moving. That said, I think it is very important to emphasize in the statement what First Vice President Stone mentioned: If you look at what we say in line 4, we do specifically mention that some further policy firming may yet be needed to address inflation risks, which is not something that we had specifically singled out before and which I think helps offset the concern about the phrase “inflation expectations remain contained.” Although we have discussed that inflation expectations have moved up somewhat, I think that to say they are no longer contained is incorrect. We have seen a bit of tick-up of actual inflation and a bit of tick- up of some, but not all, measures of inflation expectations. As Vince mentioned, the most recent numbers coming from Blue Chip suggest that the professional forecasters are not saying that inflation expectations are moving up. I am concerned that, if we took out that phrase, which we have had for a while, we would be suggesting that we do think things are becoming unhinged and that might be a self-fulfilling prophecy moving in exactly the wrong direction. So I think the balance that we have now heightens our emphasis on inflation risk in number 4 but does not say that inflation expectations have moved too far beyond (and I do not think they have moved too far beyond) where they were before or that they have become unhinged. I like the balance that is there between the two. I also like keeping in the red phrase in the second part of line 4; but a small amendment to make it perhaps a bit easier to swallow and to make it seem not repetitive with the statement in number 5 is that, rather than saying “in any event,” we simply say, “The Committee thus will respond to changes in economic prospects as needed to support the attainment of its objectives.” Thank you, Mr. Chairman." FOMC20050503meeting--85 83,MS. YELLEN.," Thank you, Mr. Chairman. It has been less than a year since I returned to the policy table, but already there is a sense of déjà vu all over again. [Laughter] The recent pattern of higher inflation and softer spending seems remarkably similar to the May 3, 2005 42 of 116 prices. The latest data on employment, retail sales, and durable goods orders reveal unanticipated weakness on the real side of the economy. Readings on overall and especially core inflation have been uncomfortably and unexpectedly high. If the current situation persists or deteriorates further, we could face some difficult policy choices ahead, but I remain cautiously optimistic that the slowdown in growth and the uptick in inflation will both prove transitory. I believe we can draw some lessons for assessing current conditions and for calibrating policy going forward from last year’s experience. Last year’s jump in energy prices delivered a significant shock to consumers and businesses. For a time, the growth of consumer spending slowed and inflation increased. But after the initial jolt, the growth of consumer spending and economic growth overall rebounded. Higher energy prices again have hit consumers hard in the pocketbook and businesses on the bottom line, but there’s good reason to anticipate a similar recovery in spending this year, especially with oil prices having come down of late. So the lesson from last year’s experience is that we shouldn’t overreact to the present soft patch or short-run fluctuations in real-side data when the fundamentals for growth appear to remain relatively sound. I, therefore, find myself in agreement with the Greenbook’s perspective. Beyond the current quarter, the forecast has been revised only slightly, with the major components of demand projected to continue expanding at a fairly healthy pace. This forecast mirrors the perceptions of our Twelfth District business contacts who, outside of the Bay Area and Los Angeles proper, report that they remain quite upbeat about the economy. For inflation, last summer’s experience similarly advises a cautious policy reaction to the data. The recent uptick in core inflation probably reflects pass-through of cost pressures due to May 3, 2005 43 of 116 just like last summer, underlying pressures on core inflation appear to remain subdued. Several of the good fundamentals driving the outlook for inflation are worth highlighting. First, the data surveyed in Part 2 of the Greenbook suggest that at least some, and possibly considerable, slack remains in labor markets. Corroborating this view, our contacts, even in some of the most rapidly growing areas of the Twelfth District, report little trouble filling job openings except in some skilled trades that are in high demand in construction. I met recently with top executives of SBC West, a major employer in California and Nevada. They indicated no difficulties whatever in hiring at any skill level, with only a few exceptions, such as accounting. Like most of our contacts in the District, they also saw no significant wage pressures. Indeed, nationwide data suggest that labor cost pressures appear quite restrained. For example, as David noted, last week’s ECI data showed no sign of any acceleration in private compensation. The underlying trend in productivity is also solid, and, as I discussed at a previous meeting, I remain optimistic that it will remain so, in which case unit labor costs are likely to remain constrained. Our contacts report continued scope for productivity improvements. For example, the SBC West executives with whom we met explained how new technologies permit tasks to be performed via computers at headquarters that in the past required technicians to make service calls. Of course, “pricing power” is a phrase that is used frequently by our contacts, but the mention of pricing power is focused exclusively on pass-through of cost increases due to energy, materials, and transportation. In construction, agriculture, and transportation, firms report considerable success in passing these cost increases along. In other sectors, the experience has been more mixed. One director who runs a major clothing retailer reported only limited pass-through to consumer prices in the face of competitive pressures and continued gains in productivity. With May 3, 2005 44 of 116 Moreover, to the extent that these costs are being passed through to prices, they appear to provide only one-time boosts to the price level. In terms of policy, I support a 25 basis point increase at this meeting and retaining the “measured pace” description of the likely path for policy going forward, at least for today. Weak real-side data might suggest a pause to evaluate the extent and likely duration of the slowdown. But incoming inflation data could justify more aggressive action. Given the latest uncomfortably high readings on inflation, I think we have to remain vigilant. The constancy of long-run inflation expectations provides some reassurance, although I worry that if we had similar readings on such expectations in the early 1970s, they would have been slow to rise then as well, as bond markets had grown complacent about inflation. Last time, we adopted language that many of us thought made our balance-of-risk statement tautological. In fact, it turns out that the statement is not tautological, and I no longer consider it true. [Laughter] In my view, even with appropriate monetary policy action, the risk to the attainment of sustainable growth is unbalanced to the downside, while the risk to the attainment of price stability is unbalanced to the upside. It is the risk to our dual objectives, but not to each individual objective, that I consider balanced overall. Releasing an unchanged balance-of-risk statement might suggest to some that this Committee has ignored the palpable shift in economic conditions toward higher inflation and slower growth. Indeed, an uncharitable description of the current statement is that it has gone from not serving any purpose to potentially being perceived as factually incorrect. Rather than try to modify the balance-of-risk statement, I think it is perhaps time to retire it, for reasons that I will explain in more detail in the policy go-round. May 3, 2005 45 of 116" 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. fcic_final_report_full--530 December 3, 2008, 151 in which he said in pertinent part: Only 6 percent of all the higher-priced loans [those that were considered CRA loans because they bore high interest rates associated with their riskier character] were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their assessment areas , the local geographies that are the primary focus for CRA evaluation purposes. This result undermines the assertion by critics of the potential for a substantial role for the CRA in the subprime crisis. [emphasis supplied] There are two points in this statement that require elaboration. First, it assumes that all CRA loans are high-priced loans. This is incorrect. Many banks, in order to be sure of obtaining the necessary number of loans to attain a satisfactory CRA rating, subsidized the loans by making them at lower interest rates than their risk characteristics would warrant. This is true, in part, because CRA loans are generally loans to low income individuals; as such, they are more likely than loans to middle income borrowers to be subprime and Alt-A loans and thus sought after by FHA, Fannie and Freddie and subprime lenders such as Countrywide; this competition is another reason why their rates are likely to be lower than their risk characteristics. Second, while bank lending under CRA in their assessment areas has probably not had a major effect on the overall presence of subprime loans in the U.S. financial system, it is not the element about CRA that raises the concerns about how CRA operated to increase the presence of NTMs in the housing bubble and in the U.S. financial system generally. There is another route through which CRA’s role in the financial crisis likely to be considerably more significant. In 1994, the Riegle-Neal Interstate Banking and Branching Effi ciency Act for the first time allowed banks to merge across state lines under federal law (as distinct from interstate compacts). Under these circumstances, the enforcement provisions of the CRA, which required regulators to withhold approvals of applications for banks that did not have satisfactory CRA ratings, became particularly relevant for large banks that applied to federal bank regulators for merger approvals. In a 2007 speech, Fed Chairman Ben Bernanke stated that after the enactment of the Riegle-Neal legislation, “As public scrutiny of bank merger and acquisition activity escalated, advocacy groups increasingly used the public comment process to protest bank applications on CRA grounds. In instances of highly contested applications, the Federal Reserve Board and other agencies held public meetings to allow the public and the applicants to comment on the lending records of the banks in question. In response to these new pressures, banks began to devote more resources to their CRA programs.” 152 This modest description, although accurate as far as it goes, does not fully describe the effect of the law and the application process on bank lending practices. In 2007, the umbrella organization for many low-income or community “advocacy groups,” the National Community Reinvestment Coalition, published a report entitled “CRA Commitments” which recounted the substantial success of its members in using the leverage provided by the bank application process to obtain trillions of dollars in CRA lending commitments from banks that had applied to 151 152 Randall Kroszner, Speech at the Confronting Concentrated Poverty Forum, December 3, 2008. Ben S. Bernanke, “The Community Reinvestment Act: Its Evolution and New Challenges,” March 30, 2007, p2. federal regulators for merger approvals. The opening section of the report states (bolded language in the original): 153 FinancialCrisisReport--294 The lack of performance data for high risk residential mortgage products, the lack of mortgage performance data in an era of stagnating or declining housing prices, the failure to expend resources to improve their model analytics, and incorrect correlation assumptions meant that the RMBS and CDO models used by Moody’s and S&P were out of date, technically deficient, and could not provide accurate default and loss predictions to support the credit ratings being issued. Yet Moody’s and S&P analysts told the Subcommittee that their analysts relied heavily on their model outputs to project the default and loss rates for RMBS and CDO pools and rate RMBS and CDO securities. (b) Unclear and Subjective Ratings Process Obtaining expected default and loss analysis from the Moody’s and S&P credit rating models was only one aspect of the work performed by RMBS and CDO analysts. Equally important was their effort to analyze a proposed transaction’s legal structure, cash flow, allocation of revenues, the size and nature of its tranches, and its credit enhancements. Analyzing each of these elements involved often complex judgments about how a transaction would work and what impact various factors would have on credit risk. Although both Moody’s and S&P published a number of criteria, methodologies, and guidance on how to handle a variety of credit risk factors, the novelty and complexity of the RMBS and CDO transactions, the volume and speed of the ratings process, and inconsistent applications of the various rules, meant that CRA analysts were continuously faced with issues that were difficult to resolve about how to analyze a transaction and apply the company’s standards. Evidence obtained by the Subcommittee indicates that, at times, ratings personnel acted with limited guidance, unclear criteria, and a limited understanding of the complex deals they were asked to rate. Many documents obtained by the Subcommittee disclosed confusion and a high level of frustration from RMBS and CDO analysts about how to handle ratings issues and how the ratings process actually worked. In May 2007, for example, one S&P employee wrote: “[N]o body gives a straight answer about anything around here …. [H]ow about we come out with new [criteria] or a new stress and ac[tu]ally have clear cut parameters on what the hell we are supposed to do.” 1143 Two years earlier, in May 2005, an S&P analyst complaining about a rating decision wrote: “Chui told me that while the three of us voted ‘no’, in writing, that there were 4 other ‘yes’ votes. … [T]his is a great example of how the criteria process is NOT supposed to work. Being out-voted is one thing (and a good thing, in my view), but being out-voted by mystery voters with no ‘logic trail’ to refer to is another. ... Again, this is exactly the kind of backroom decision-making that leads to inconsistent criteria, confused analysts, and pissed-off clients.” 1144 1143 5/8/2007 instant message exchange between Shannon Mooney and Andrew Loken, Hearing Exhibit 4/23-30b. 1144 5/12/2005 email from Michael Drexler to Kenneth Cheng and others, Hearing Exhibit 4/23-10c. In a similar email, S&P employees discuss questionable and inconsistent application of criteria. 8/7/2007 email from Andrew Loken to Shannon Mooney, Hearing Exhibit 4/23-96a (“Back in May, the deal had 2 assets default, which caused it to fail. We tried some things, and it never passed anything I ran. Next thing I know, I’m told that because it had 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-111hhrg56241--35 Mr. Bebchuk," Chairman Frank, Ranking Member Bachus, and distinguished members of the committee, thank you very much for inviting me to testify here today. I would like to devote my introductory comments to making four points. First, there is a growing acceptance, including among business leaders, that compensation structures have provided perverse incentives. They have encouraged financial executives to seek to improve short-term results even at the expense of an elevated risk of an implosion later on. Let me illustrate this problem with the example of Bear Stearns and Lehman Brothers, the two investment banks that melted down in 2008. Many commentators have assumed that the executives of these firms sold their own compensation, their own wealth wiped out together with the firms', and then inferred from this assumed fact that the firms' risk-taking could not have been motivated by perverse incentives created by pay arrangements. In a recent paper, my coauthors and I did a case study of compensation at those two firms between 2000 and 2008, and we find that this assumed effect is incorrect. We estimate that the top five executive teams of Bear Stearns and Lehman Brothers derived cash flows of about $1.4 billion and $1 billion, respectively, from cash bonuses and equity sales during 2000 to 2008, and these cash flows substantially exceeded the value of the executives' initial holdings in the beginning of the period. As a result, unlike what happened with the long-term shareholders, the executive net payouts for 2000 to 2008 were decidedly positive. The second point I would like to make is that we cannot rely solely on existing governance arrangements to produce the necessary reforms. To be sure, some firms have announced reforms of the compensation structures. For example, they indicated that bonuses would be subject to clawbacks. But firms have generally not provided information that would enable outsiders to determine whether the clawbacks would be meaningful and affect behavior or would be merely cosmetic. This is an area where the devil is in the details. Because the changes that firms adopt appear to be at least partly motivated by desire to appear responsive to outside criticism, there is a basis for concern that arrangements with details that are not disclosed might not be sufficiently effective. What else should be done? The point I would like to stress is to improve arrangements, pay arrangements in particular, in governance more generally. We have to strengthen shareholder rights. In addition to introducing say on pay votes, which H.R. 3269 would do, there are other things that need to be done to bring shareholder rights to the same level as the shareholders in the U.K. and other English-speaking countries enjoy. In particular, the following aspects of their existing state first deserves the Commission's attention. Many publicly traded firms still do not have majority voting. Shareholders still like the power to place director candidates under corporate bylaws. Many privately traded funds still have staggered boards, and many such firms have supermajority requirements that make it difficult for shareholders to change governance arrangements. Finally, in addition to strengthening shareholder rights, it remains important to have regulatory supervision of pay structures in financial firms, as the provisions of H.R. 3269 would require. Opponents of regulatory intervention argue that such regulatory supervision would drive a talent away. However, the regulation under consideration focuses on structure, not on pay levels, and firms would still be able to offer packages that are sufficiently attractive in terms of pay levels. One of the established insights in economics is that it is never efficient to compensate agents using perverse incentives; in the financial sector, an especially important context to apply this established insight. Thank you. [The prepared statement of Professor Bebchuk can be found on page 45 of the appendix.] " FOMC20080130meeting--294 292,MR. FISHER.," Well, Mr. Chairman, I've seen the discount rate tally. I've listened carefully to all my fellow Presidents and to Governor Kohn. I suspect I know what your fellow Governors are going to recommend. I'm in a distinct minority at this table. This weekend, by the way, I searched the newspapers for something to read that didn't have anything to do with either a rogue French trader or market volatility or what the great second guessers were blabbing forth at the chat show in Davos; and in doing so I happened upon a delightful article. I hope you saw it in the Saturday New York Times on the search for a motto that captures the essence of Britain. My favorite was nemo ne inclune lacet, which very loosely translated, I think, means ""never sit on a thistle."" [Laughter] Well, that's where I am. I'm going to risk sitting on the thistle of opprobrium for my respective colleagues by making the recommendation that we not change the funds rate and that we stay right where we are. Now, for the record, I would have supported last week's 75 basis point cut for the reasons that it would put us ahead of the curve and bought adequate insurance against a recession. I told you that directly, Mr. Chairman, and I mentioned it to Governor Kohn as well. Judging by the policy rules on page 21 of the Bluebook, as well as by the adjusted rule that our economist Evan Koenig has developed in Dallas, we are, indeed, ahead of the curve from the Taylor rule standpoint as we meet today with the rate of 3.50. As was mentioned earlier, we have not been docile. We have cut rates 175 basis points in a matter of months, and we've taken some new initiatives that I think are constructive and useful. I'd like to see more along the lines of the TAF. To be sure, in the discussion that we had in that emergency meeting, I had the same concerns that President Hoenig expressed in the call, but with the wording change that was put forward by Governor Kroszner I ended up where President Hoenig did. I regret not voicing my discomfort with the penultimate sentence in the statement--the one dealing with appreciable downside risk after the move we took--as I felt that it undercut the potential effect of our decision. During that call, you may recall that I pointed out the pros and cons. I began my intervention on that call by saying that there's a very fine line between getting ahead of the curve and creating a sense of panic. I also expressed concern of the need to be mindful of inflation, as many have at this table today. There are some critics who say we panicked in response to the market sell-off of that Monday. I do not believe that's the case, and I don't believe it's the case because I find it impossible to believe. As I've said repeatedly in this room, other than in theory, markets are not efficient, and on the banks of the Hudson or the Thames or the Yangtze River, you cannot in practice satisfy the stock market or most other markets, including the fed funds futures market, in the middle of a mood swing. When the market is in the depressive phase of what President Lockhart referred to as a bipolar disorder, crafting policy to satisfy it is like feeding Jabba the Hutt--doing so is fruitless, if not dangerous, because it simply will insist upon more. But attempting to address the pathology of the underlying economy is necessary and righteous, and that's what we do for a living, and I think we are best sticking with it. We're talking about the fed funds rate. I liken the fed funds rate to a good single malt whiskey--it takes time to have its ameliorative or stimulative effect. [Laughter] But I'm also mindful of psychology, and that's what I want to devote the remainder of my comment to, and then I'll shut up. My CEO contacts tell me that we're very close to the ""creating panic"" line. They wonder if we know something that they do not know, and the result is, in the words of the CEO of AT&T, Randall Stephenson, ""You guys are talking us into a recession."" To hedge against that risk is something to them unforeseen, even after they avail themselves of the most sophisticated analysis that money can buy. CEOs are, indeed, doing what one might expect. They are tightening the ship. They're cutting head counts to lower levels. They're paring back capex where they can beyond the levels they would otherwise consider appropriate after imputing dire assumptions of the effects of housing. I'm going to quote Tim Eller, whom I consider the most experienced and erudite of the big homebuilders, which is Centex, who told me, ""We had just begun to feel that we were getting somewhat close to at least a sandy bottom. Then you cut 75 basis points and add `appreciable downside risks to economic growth remain' in your statement, and it scares the `beep' out of us."" He didn't use the word ""beep."" These are his words, not mine. Imagine scaring a homebuilder already living in hell. The CEOs and CFOs I speak to from Disney to Wal-Mart, to UPS, to Texas Instruments, Cisco, Burlington Northern, Southwest Airlines, Comerica, Frost Bank, even the CEO of the felicitously named Happy State Bank in Texas, repeated this refrain, ""You must see something that we simply do not see through our own business eyes."" They do see a slowdown. They are worried about the pratfall, as I like to call it, of housing. They're well aware of California's and Florida's economic implosion and broader hits to consumer welfare across the national map. I recited some data points from those calls yesterday. But they do not see us falling off the table. They worry aloud that by our words and deeds we are inciting the very economic outcome we seek to cut off at the pass by inducing them to further cut costs, defer cap-ex, and take other actions to hedge against risk. They can't fathom it but assume that we can. Our Beige Book contacts and the respondents to the business outlook survey in Dallas say pretty much the same thing. One of those actions is to fatten margins by passing on input costs. Now, I mentioned the rail adjustment factor yesterday, and I'm troubled by the comment that I quoted yesterday from the CEO of Tyson Foods. ""We have no choice but to raise prices substantially."" I mentioned that Frito-Lay has upped its price increase target for '08 to 7 percent from 3 percent. Kimberly-Clark notes that it is finding no resistance at all to increasing prices in both its retail and institutional markets, and I mentioned that Wal-Mart's leaders confirm that, after years of using their price leadership power to deflate or disinflate the price of basic necessities-- think about this--from food to shoes to diapers, they plan in 2008 to apply that price leadership to accommodate price increases for 127 million weekly customers. This can't help but influence inflation expectations among consumers. I experienced a different kind of price shock two weekends ago, when I went to buy a television so I could watch President Rosengren's football team demolish President Yellen's. [Laughter] I was told that they had doubled their delivery and installation fees because of a ""fuel surcharge."" Well, I reminded the store clerk that I had been there about the time of the Army-Navy game, around Thanksgiving, and that gas prices had not doubled since the Army-Navy game, and he said, ""Mr. Fisher, we're selling less, and we will take what we can get away with however we can get away with it."" With one-year-forward consumer expectations, according to the Michigan survey, already above 3 percent, everyone from Exxon to Valero to Hunt Oil and our own economists in the Greenbook telling me that oil is likely to stay above $80, and the national average price therefore above $3, this mindset really worries me. I'm going to add one more very troubling little personal anecdote. Driving home from work last week I heard a commercial for Steinway pianos. The essence of the advertisement was that manufacturing costs had increased and that you could buy a piano out of their current inventory at the ""old price"" that was in place in 2007; but come February 1, there would be sizable price increases, so you'd better purchase your piano quickly. It has been thirty years since I have seen advertisements to go out and buy now before the big expected price increases go into effect. Now, this is an isolated, little bitty incident, but I fear this may be just the beginning of the more pervasive use of this tactic. Everyone in this room knows how agnostic I am about the predictive value of TIPS and the futures instruments comparing TIPS with nominals, like the five-year, five-year-forward. I've sent around an eye popping chart that shows the predictive deficiencies of the professional forecasters that were tracked by the Philadelphia Fed. I know that dealers are telling us that inflation is contained, but I have spent many years in the canyons of Wall Street, and I would caution against their disinterest in the predictions that they offer. When I see that every measure of inflation has turned up, learn from studying the entrails of the last PCE that 83 percent of the items therein experienced a price upswing, consider the shortcomings of the few tools we have for evaluating expectations of future inflation, and then hear from microeconomic operators of the economy that, by golly, we're going to take what we can while the getting is good, I can't help but feel that we cannot afford to let our guard down by becoming more accommodative than we have already become with our latest move. Mr. Chairman, you know because we've talked about this that I've anguished over this. In fact, to be politically incorrect in a government institution, I have prayed over it. It is not easy to go against the will of the people you have enormous respect for, but I have an honest difference of opinion. I truly believe we have it right at 3� percent right now. I think that, even with some important language changes, we risk too much by cutting 50 basis points at this juncture and driving the real rate further into what I perceive, even on an expectations-adjusted basis, is getting very close to negative territory. Mr. Chairman, I think we've gone as far as is prudent for now, and that 3� percent, together with the other initiatives we've taken to restore liquidity, is sufficient. So I ask for your forbearance in letting me sit on the thistle of recommending no change. I do want to say as far as the language is concerned, since obviously we're going to go with alternative B despite my vote against it, that I strongly recommend you consider the changes that were given by Presidents Plosser, Yellen, and Poole, and I would strongly advocate particularly at the end adding that we will act as needed to foster price stability and sustainable economic growth. I thank you for paring back alternative B, paragraph 3, in terms of getting away from discussing only energy, commodity, and other import prices. Thank you, Mr. Chairman. " CHRG-111hhrg58044--8 Mr. Price," Thank you, Mr. Chairman. Mr. Chairman, if the past 2 years have taught us anything, it is that risk is unavoidable and ever present. In order for the economy to work, businesses must be able to price their products for the risk that they incur. Risk-based pricing is especially important when trying to determine the reliability of the insured and the exposure of job creators. Credit-based insurance scores have proven to be the most predictive factor in determining the likelihood of a consumer filing a claim. This risk model enables insurers to more accurately underwrite and price for risk, and when this is done well, everyone wins. Democrats want you to believe that everyone should not be judged by their past actions. However, it is the American way to pull one's self up by working hard and making responsible decisions. What makes risk-based pricing and insurance scores important is the ability for people to improve their scores and lower their rates by paying their bills on time and taking responsibility for their financial decisions. What would happen if there was no risk pricing? Everyone would get the same price regardless of how much an insurer has to pay to cover a claim. This would result in significant and dramatic increases in rates to virtually all Americans, less credit available, more expensive credit, and more job destruction. This is clearly not the most wise avenue. I look forward to the testimony and hopefully our response in wisdom. I yield back. " FOMC20080318meeting--93 91,MR. MISHKIN.," Wouldn't you like to know! I believe that actually the Greenbook forecast of a mild recession is reasonable, but the possibility that we could have a severe recession is uncomfortably high, and I find the prospect pretty scary. The reality is that we are in this adverse feedback loop that I and others talked about. I think we're deep into it. The credit markets have been deteriorating. That's led to a sharp weakening of the economy's prospects. This is reflected in the very large change in the Greenbook forecast, with which I do strongly concur, so I don't think that it was out of line to put those in. Of course, that weakening has been feeding back to deteriorating financial conditions. So I think we're really in a tough pickle, and there are costs not just in terms of the economy. One result is that we've just expanded the safety net to a much wider set of institutions, and we are in a brave new world here, and it is very disturbing. So the ramifications in terms of the economy weakening and the adverse feedback loop go beyond just the fact that we might have unemployment. It may have major effects on the way markets work in the future, and that, I think, is something that we should be worried about and should be a consideration as well. The bottom line on real activity for me is that the prospects are very poor, and I find the downside risk just plain scary. That's the first part of my depression. The second part of the depression is that it's bad enough that we had these contractionary aggregate demand shocks from the financial sector, but we also have had very negative supply shocks that are both contractionary and inflationary. So we are getting hit by the double whammy. The news on inflation has generally not been good, even with the recent CPI numbers. But then, of course, they are reversed by the PPI numbers today. I don't put that much weight on the actual current numbers because, as you know, I take a view that the primary drivers of inflation and inflation dynamics are inflation expectations and expectations about future output gaps. So that's the framework in which I'd like to discuss what will happen on the inflation front. We have two problems in terms of inflation expectations right now. One is the supply shock, which I think is having some effects on inflation expectations, and also the view--although I believe it's incorrect, I do think that there's a problem that this view is widely held outside, and President Plosser mentioned this--that we on the FOMC are focused only on growth and are not at all worried about inflation. This is a communication issue that is hard to deal with because, even though I've been advocating being more aggressive in terms of easing, I do worry very much about the issue that we also have to indicate that, if necessary, we'll get out the baseball bat to keep inflation under control. That is not an easy thing to do. So when I look at inflation expectations, which I consider to be a key driver of inflation, I think that the evidence in the data is that we have had not a big increase but a slight increase in inflation expectations, on the order of about 10 basis points. There's a lot of uncertainty about that; it could be a little more than that, but I don't think a whole lot more. Also disturbing is that we certainly have had a big increase in long-run inflation uncertainty. That's reflected not only in terms of inflation compensation but also in the fact that people are buying inflation caps, TIPS are becoming very popular, and so forth and so on. In fact, one of the negative things that happened to me as a result of taking this job is that I had my entire TIAA-CREF in TIPS and unfortunately I had to divest all of it because they are government securities, and that turned out to be bad. But that's only one of the minor costs of being in this position. [Laughter] The issue here is that, although I don't think that inflation expectations have gotten unhinged at this point--and I think that we can say that the phrase ""reasonably well contained"" is okay--there is a greater risk that they could get unhinged. Now, I want to be clear. I'm not talking about the 1970s. It's not ""That '70s Show."" I have not been particularly happy with Allan Meltzer's comments about a bunch of things. The issue here is not that inflation expectations would go to that kind of level, but it could be that inflation expectations go up to 2� or maybe even a little higher and it would be costly to get that down. That's the concern we have to worry about. But let me talk about the other side because, when I think about the inflation dynamics, it's not just inflation expectations. I do not believe in the deus ex machina view of the inflation process. Something has to tie things down, and what ties it down is not current output gaps--which is why I think the standard Phillips curves don't predict very well--but expectations about future output gaps. On that score, I worry that there could be a lot of downside risk to inflation from that. If really bad things happen, which I think unfortunately is a seriously possibility, inflation could fall. A key fact, by the way, is that if you look at past recessions, you do find that inflation falls in the 12 months after recessions. In a couple of cases with supply shocks, there was a rise in inflation at the beginning of the recessions. Seven out of eight are in that category. Particularly if it's a severe recession, it's much more likely for inflation to fall. So it's not true that there's just upside risk; there is downside risk as well, and that's one reason that inflation uncertainty is not an issue just of potential upside. In fact, in the 2003 episode that President Lacker mentioned, the reason there was such a sharp rise in inflation compensation was not that people worried about inflation going up but that they worried that inflation would go down. Nonetheless, there's still a cost to the fact that longrun inflation expectations are not as solidly grounded as they were before. So my view in general is that we are facing an incredibly unpleasant tradeoff. We basically have the risk of the economy turning very sharply and the risk of inflation getting somewhat unhinged. I want to discuss that later. I wasn't going to discuss this, but I just really can't not react to the comments that you made, President Fisher. There's a view out there in the media that monetary policy has been ineffective. This was the statement that I think you made, and I think it is just plain wrong. So I want to discuss it because it's actually really important in thinking about a policy stance right now, and it's important to think about the economics of this. We have had a very nasty set of contractionary shocks from the financial sector, particularly the widening of credit spreads and the restriction of credit. So I want us to think about a counterfactual. Let's think about a situation in which we had what's happened and we did not lower interest rates. What would have been the outcome? Do you think that credit spreads would have lowered? I think credit spreads would have risen. In fact, when you think about what credit spreads are being driven by--I've argued this before--there's a valuation risk--the fact that we can't value assets, and that's this price discovery problem that we really can't do that much about. But there is also a macroeconomic risk, which is a lot of what's going on right now, particularly in terms of the housing market where people don't know where housing prices are going to bottom out. The view that they may keep on going down--and we had a very negative number on housing prices recently--means that even the AAA tranches now look as though they're very vulnerable, and therefore, the credit spreads on them go up a whole lot. My view is that monetary policy has been very effective because things would be much, much worse if we hadn't eased. On the other hand, we just had an incredibly nasty set of shocks as a result of what you described were the problems in these sectors. So I really think that this is very important. To finish up on this, the example of Japan is constructive because the Bank of Japan had a view very similar to the one that you've expressed, which is that they had all these problems in the banking sector, and the problems were not their fault. But they then took the view that they couldn't do anything about it. Monetary policy was not the source of the weak economy, so they were very slow to lower interest rates. The Chairman has talked about this. Every monetary economist who went to the Bank of Japan during this period--I did it when I was with the New York Fed in the mid-1990s--told them that their monetary policy was too tight. They basically said, ""Well, you know, it's not too tight, and it's not our fault that the banks are all screwed up because of poor regulation."" Well, the result was they ended up with deflation, and they lost ten years of growth. I'm being a little more blunt than usual, but I think that the economic arguments here are actually central in our discussion. " FOMC20070321meeting--15 13,MR. DUDLEY.," The distinction I’d make between fundamentals and risk reduction is that the latter occurs when people adjust their portfolios not because they change their view about the quality of a particular asset but because they are reducing the amount of risk exposure to the market that they want to have. So when you have a big event like February 27, obviously volatility goes up, and so value at risk goes up, and you may decide to reduce your risk. So you’re going to sell all sorts of things, and the prices of those things you sell will go down regardless of whether you’ve actually changed your opinion about them in any meaningful way. Why did corn prices on February 27 fall 2 percent? It was probably because corn prices had been in a big bull market, people had risk positions in corn, and so they wanted to get out of those positions." CHRG-111hhrg58044--74 Mr. McRaith," Congressman, we should always be concerned about unintended consequences and certainly the pricing of one risk in a company's pool affects the pricing of another risk in that same pool. However, we should not accept as gospel that 60 percent of people benefit from the use of credit-based insurance scores because we do not know what the baseline is. " CHRG-110hhrg41184--99 Mr. Bernanke," That is an excellent question. Part of what has been happening, Congressman, is that risk perhaps got underpriced over the last few years, and we have seen a reaction where risk is being now priced at a high price. It's hard to say whether the change is fully appropriate or not. Certainly part of the recent change we have seen is a movement towards a more appropriate, more sustainable, pricing of risk. But in addition, we are now also seeing concerns about liquidity, about valuation, about the state of the economy, which are raising credit spreads above the normal longer-term level, and those increased spreads and the potential restraint on credit are a concern for economic growth. And we're looking at that very carefully. " FOMC20050630meeting--119 117,MR. WILLIAMS.," I think that the Greenbook forecast, as I understand it—and maybe Dave June 29-30, 2005 43 of 234 prices and takes into account the kind of models that Josh was discussing. The staff looks at all the empirical evidence, just as they do for every equation on every aspect of the economy. So, monetary theory would tell you to come up with the best, most reasonable forecast and adopt a policy that is appropriate to that path but also consider, as you’re saying, all the risks and the distribution of the risks. It’s along the lines of some of the charts in the Greenbook, which show the distribution of risks and then contemplate the implications for the current set of policy options over that distribution of risks. I think the basic idea in the economic literature is that you first want to get a very reasonable path, and that would be more or less your baseline. It’s not a path, I should say, that just keeps housing prices constant or keeps any asset price constant. It should be the best forecast of these asset prices that you can come up with, but subject, of course, to the fact that these are very hard to predict." CHRG-110hhrg46591--163 Mr. Price," Dr. Stiglitz, private risk-taking? " CHRG-111hhrg52397--146 Mr. Price," Do you know what other governments are doing to determine their systemic risk in the derivatives market or act upon their systemic risk in the derivatives market? " CHRG-111hhrg51592--161 Mr. Joynt," Yes. We would take all market inputs, prices, CDS spreads, anything into account when trying to think about the risks that we analyzed. Individual analysts would receive market price information and spreads. Our central credit policy group would monitor CDS prices, and in fact go back to analysts and individual groups and say, ``Have you thought about and seen what's happening with these prices?'' So I would say we're aware of, it's an important factor, it's an influence, and just to respond to what you originally suggested, we see value in market prices for investors to reflect and think about the risk. I believe those are more volatile than fundamental analysis. They are influenced by market events, volatility, liquidity. And so I think they are complementary. So yes, we use them to help think about the fundamental analysis, as well. " FOMC20080310confcall--13 11,CHAIRMAN BERNANKE.," We would not be setting a price floor for the asset, but we would be trying to reduce the liquidity premium. If there were further deterioration in price associated with the credit risk, that would still show through. " CHRG-111hhrg53238--113 Mr. Zywicki," Sure. I think you point out more generally the fundamental problem here is that there are all kinds of tradeoffs. There are tradeoffs between the particular terms and the price of loans, between--as I talked about--prepayment penalties. Consumers pay an extra 100 to 150 basis points to get a fixed-rate mortgage. All these sorts of tradeoffs to think about price versus terms, accessibility versus risk, all the different sorts of things you are talking about are invariably and inevitably going to turn into political questions where there is no obvious answer. And it is precisely these sorts of tradeoffs between risk and price, for instance, why we have eschewed government central planning and dictating of credit terms in the past, because there is no right answer to these questions and they run the risk of being politicized. " 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-111hhrg58044--18 Mr. Garrett," I thank the chairman, and I thank the ranking member, and I thank the members of the panel who are here. Credit information has obviously become an essential and valuable tool in allowing various market participants to more accurately price for the risk. One of the areas we are examining today is how this information is used by property casualty insurance companies in determining the premiums they charge to their clients. There have been numerous actuarial reports that have studied this. By using consumer-based insurance or CBIS, in determining premium rates for P&C lines, insurance companies are basically more able to accurately price for the risk of the consumer and the rates have significantly decreased for a broad majority of the policyholders. Credit scores are really just one of a number of different data points that insurers consider when determining a consumer's premium. If we were to now limit or restrict certain types of information from being used to allow insurers to more accurately price for risk, two things are going to happen: One, more people will pay higher premiums; and two, fewer people will be able to purchase insurance. Neither of these things are good. In the wake of the recent financial crisis, instead of looking for ways to decrease credit availability and the accurate pricing of risk, I believe Congress should be considering policies that will help expand credit for consumers and small businesses and lower the cost of credit and insurance premiums for the majority of Americans. With our current unemployment rate around 10 percent, we really must work on initiatives to expand economic opportunities for all Americans, not ways for the government to micro-manage our Nation's small businesses and risk trying to restrict the aggregate price of risk. With that, I yield back the balance of my time. " FOMC20060920meeting--101 99,MR. STOCKTON.," The answer to that is “yes,” and I think there is some risk. One feature of our forecast is the fact that we are not projecting large declines nationwide in house prices. We are expecting a deceleration but not any outright declines. One could imagine that more of the adjustment could take place more quickly by a big drop in house prices that in some sense clears out that inventory through higher sales and maybe less production adjustment. On that side, you would probably get a quicker housing cycle than the one that we are projecting. However, it also brings with it some downside risk in that households would realize how much their net worth had fallen, which could have consequences for consumption both directly through the wealth effect and perhaps through sentiment. That correction could be quicker and maybe deeper, but then the rebound could be faster. That is a risk we have certainly contemplated. We were a little nervous about being too adventuresome on the house-price forecasting. We are not very good at forecasting asset values, we never understood how prices got as far out of alignment as we think they are, and we are not sure exactly what the process of correction is going to look like. So we have taken a middle stance between two models: one model that basically forecasts house prices off pure momentum and another one that takes seriously the analytical apparatus, which we showed you a year and a half ago at our special briefing on housing, that looks at the error-correction process of house prices to rents. The latter model actually does forecast outright declines nationwide in house prices by 2008. We are between a momentum model, which expects house prices to slow less than we are forecasting, and this error-correction model, which shows bigger declines." CHRG-110hhrg46596--223 Mr. Kashkari," Well, ultimately, it is the credit cards, and ultimately it is the borrowers who owe on the credit cards, or on auto loans. Similarly, these are consumer credit vehicles to start with. But what the Federal Reserve and Treasury are focused on is these are historically very low credit risk. They are not being priced where they are today because of credit risk; they are being priced where they are today because of illiquidity in the system. " CHRG-109shrg21981--205 RESPONSE TO A WRITTEN QUESTION OF SENATOR BENNETT FROM ALAN GREENSPANQ.1. In 2002, the Home Mortgage Disclosure Act (HMDA) regulations were revised to allow for additional data collection from the lending industry. On March 1, 2005, banks and other covered lenders will be required to submit data to the Federal Reserve that will include more loan-pricing data and new ethnicity data. Concerns have been raised that this new HMDA data, if taken out of context, might allow for misinterpretation. Can you explain what the intent of the new HMDA data is, the context of the data, and what some of the key limitations of that data are, that is, what the data might show and might not show?A.1. The new public disclosure of price information under HMDA is intended to ensure that the HMDA data set continues to be a useful tool to improve market efficiency and legal compliance with the fair lending laws. Since HMDA was last amended by the Congress, technological advances have made it possible for lenders to more accurately gauge credit risk. Lenders will lend to higher-risk individuals whom they previously would have denied credit, albeit at higher prices commensurate with the higher risk. Broader access to credit has been a largely positive development, expanding opportunities for homeownership and allowing previously credit-constrained individuals to tap the equity in their homes. However, expansion of the higher-priced lending market also has been associated with concerns about the fairness of pricing in the market. The price data newly required to be disclosed under HMDA can be used as a screen that identifies aspects of the higher-priced end of the mortgage market that warrant a closer look. Conclusive judgments about the fairness of pricing, however, must consider all of the legitimate factors that underlie pricing decisions, including risk-related factors. Risk-related factors include measures such as the borrower's credit history and debt-to-income ratio, and the loan-to-value ratio of the specific transaction. The expanded HMDA data do not include these factors, or many others that are potentially relevant to a pricing decision. Absent information about all relevant pricing factors, one cannot draw definitive conclusions about whether particular lenders discriminate unlawfully or take unfair advantage of consumers. Thus, any price disparities by race or ethnicity revealed in the HMDA data will not, by themselves, prove unlawful discrimination. Such disparities will, however, need closer scrutiny. In the case of depository institutions, for example, that scrutiny will be supplied by bank examiners, who will have access to information about all of the relevant variables. FOMC20070807meeting--158 156,CHAIRMAN BERNANKE.," Oh, I see what you’re saying. Well, actually the way I phrased it was intentionally not to say that risks have increased but rather to say that the price of risk has increased." CHRG-111hhrg52397--144 Mr. Price," And in that risk to American business, you believe that would drive businesses overseas? " CHRG-110hhrg41184--82 Mr. Castle," So Reg Z may be closer to the World Series, or something of that nature? Would that be a correct statement? Well, I think it's a matter of some concern to us. I hope you understand as your people go about their work, and they have to do their work correctly, how important that it that we have that in order to formulate legislation or determine where we are on legislation. Along those lines, let me ask you another question. In July of 2003, your predecessor, Chairman Greenspan, sent me a letter, which I will submit for the record, expressing deep skepticism about legislators' attempts to limit creditors' use of information regarding borrowers' payment performance with other creditors when pricing risk. Risk-based pricing, as this practice is commonly called, lowers the price of credit for some and provides access to otherwise unavailable credit to many. Mr. Chairman, do you share Mr. Greenspan's view of that? I quote from the letter, ``Restrictions on the use of information about certain inquiries or restrictions not considering the experience of consumers in using their credit accounts will likely increase overall risk in the credit system, potentially leading to higher levels of default and higher prices for consumers?'' " CHRG-111hhrg58044--160 Mr. McRaith," I would add, Congressman, that the companies pursued the profitable risks, and if in fact credit-based insurance scores identify prospectively less profitable risks, the pricing might be geared towards reducing the likelihood of that less profitable risk from enrolling with that company. " CHRG-111hhrg58044--201 Mr. Snyder," I think it is very important. I think the use of credit-based insurance scores in the personal lines of insurance has proven to be very important for the market. It has allowed a degree of objective and individually tailored decision making that more accurately assesses risk than was possible before. The risk assessment is good in and of itself because how else would you price an insurance product but to reflect the risk within that product, and the danger of moving away from that, I think we have seen perhaps too much of in other sectors. Secondly, it has had an overall positive availability impact on the market for personal lines. That would be true if you are an individual. In commercial lines, credit information has long been used because everyone understands that one of the first things that is reduced is maintenance of critical equipment and other things like that, and that leads to safety issues, which in turn leads to increased insurance risks. I think it is important up and down the line in terms of assessing for risk and then pricing for risk. " FOMC20081216meeting--459 457,CHAIRMAN BERNANKE.," There is an ongoing discussion about whether prices in markets are in some sense Pareto optimal prices or whether there is liquidity risk, other premiums, that the central bank could do something about. I don't know any way to resolve it. We have the same discussion each time. President Hoenig. " 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. " CHRG-111hhrg56241--61 Mr. Kanjorski," Thank you, Mr. Chairman. I will just open up first with some remarks to the panel, and I appreciate your opinions when I get to conclude. Very often, I have had the occasion over the last 6 to 9 months to make a speech in my district because I am trying to reach constituents to understand the overall complex problem of salaries and wages. Now, as a given factor in my congressional district in Pennsylvania, the average wage is about $13 an hour. And if you multiply that times 2,000 working hours a year, that comes to an annual income of, on average, $26,000. In the last 9 months or a year, I have had several witnesses who have appeared before my subcommittee, and we have gotten to this question of salary and compensation, and what we do about it. I, for one, am not certain that we put enough direct attention to the matter, and could get into difficulty if we start deciding that we are the final arbiter of what a fair salary is, because quite frankly, I will confess, I don't know. If hiring a brain surgeon, I guess, and I need brain surgery, there is no amount too excessive until after the success of the operation. Then I will be annoyed, whatever the bill. The reality is--that is not the topic of our discussion today--but in the hedge fund industry, they report--I remember one witness who was a little annoyed involving a cross examination: What did he make and what is his relationship? He earned about $2.5 billion a year, and I pressed him because I was offended that he only paid a tax rate of 15 percent because of the structure of his salary, putting him in capital gains as opposed to regular tax. After 15 or 20 minutes, with great annoyance, he finally put his hand in his pocket, leaned back and said, ``Congressman why are you picking on me? What did I do to you?'' I said, ``You did nothing; you happen to be a witness and I am trying to extract some information.'' He said, ``Well, I want you to know I am only the 51st highest-income person in this country.'' This astounded me. I thought we had located the highest-income person. I found out he actually was not and is not, and there are some who make a great deal more. I guess the first question that I would ask is, what is too much? What is too high? Is it $5 billion, or $50 billion? And now I pose that question, because we always use numbers, and I go back to my congressional district of $13 an hour wage. The gentleman who was testifying before me, his hourly wage is $1,300,000. That is what he makes every hour of the year. Now, when you do the mathematics of that, he makes 100,000 times the average wage of an average worker in my district. How do we get a sense? Regardless of what compensation we pass here or do on Fannie Mae, they are chickens; what do they get paid, $6 million a year? That is peanuts. I am wondering if we are approaching this from perhaps the incorrect direction. Should we be looking at, first of all, what do we need to get to a balanced budget? Because these people aren't just earning and taking corporate money or profits. These people are not picking up their burden in society in proportion to their income. And as a result now this year, we are ending up with a shortfall that we could make up if we didn't have these extraordinary ways of avoiding income. I am just wondering, should we approach this from changing the tax structure and perhaps get to a level field that way, as opposed to identifying particular people where we may be able to exercise power and those so that we cannot. And I am just curious. Let me throw that out there very quickly. " CHRG-111hhrg52397--312 Mr. Duffy," Congressman, it is important to have liquidity to get price information so you can do risk management and clearing. That normally comes from trading and then it goes into the clearinghouse once the price has been established, and then the risk management process goes on until that position is liquidated. I think that you can do some clearing without trading the product, but you need to have some relevant information from some of the providers that are out there today that are giving you price information as relates to this. There are margin requirements. There are twice daily mark-to-market requirements associated with clearing, so there are some things that are not a custom to the OTC world today that will burden additional costs but will also protect the taxpayer from additional liabilities like they had in the last several months. " FOMC20080430meeting--55 53,MR. STOCKTON.," Before explaining how the global developments that Nathan just described intersect with our domestic inflation forecast, I should briefly review some of the incoming information on prices. For the most part, the recent consumer price data have been running below our expectations. At the time of the March Greenbook, we were estimating that core PCE prices had increased at an annual rate of 2� percent in both the fourth quarter of last year and the first quarter of this year. We now are projecting increases of 2� percent and 2 percent in the fourth and first quarters, respectively. Although we are estimating that core PCE prices rose 0.2 percent in March--just a couple of basis points below our previous forecast--there were noticeable downward revisions to the data stretching back to late last year, principally for medical services and nonmarket prices. Just as we had discounted some of the earlier elevated increases in core PCE prices, we are now inclined to discount the recent more favorable readings. The small increases in medical service prices are not likely to persist. Moreover, some of the recent slowdown is attributable to nonmarket prices, which we view as both noisy and mean-reverting. Still, we don't think all of the good news on core PCE prices of late should be written off; and all else being equal, we would have taken down our forecast for the year as a whole in response to the incoming data. But, of course, all else was not equal. As Nathan has noted, there has been another sizable increase in crude oil prices; the prices of non-oil imports have increased more rapidly than we had expected; and more broadly, both imported and domestically produced materials prices have risen sharply thus far this year. In reaction, we have marked up our forecast for core PCE inflation for the remainder of the year, and that upward revision basically offsets the effects of the recent good news. For now, inflation this year looks likely to repeat the pattern of the past four years. Since 2004, headline PCE prices have risen at about 3 percent per year, and core prices have been up at a rate of about 2� percent. Due to a further steep rise in energy prices, large gains in import prices, and another above-trend increase in food prices, we are projecting headline PCE prices to rise 3� percent this year and core prices to increase 2� percent--similar to the averages over the preceding four years. Moreover, our forecast for 2009 bears a striking resemblance to the out-year forecasts that we have continued to make over the past four years. By now, in answer to the question of why inflation is expected to slow in the forecast, most of you could easily recite the staff's catechism of disinflation. Based on readings from the futures markets, we expect consumer energy prices to flatten out next year and food prices to slow to a rate close to core inflation. With the dollar not expected to fall as much as it has over the past year and other commodity prices expected to move sideways, import prices are projected to slow. Those more favorable developments in combination with a noticeable increase in projected slack cause headline inflation in 2009 to slow to 1� percent and core PCE inflation to edge back to 2 percent. Both of those figures are 0.1 percentage point higher than our March forecasts, reflecting the indirect effects of higher prices for energy and other imports. As we have noted many times, a key element in our projection is the assumption that oil and non-oil commodity prices will flatten out as suggested by the futures markets. To put it mildly, that has not been a winning forecast strategy in recent years, but I'm not sure that we have a superior one to offer you. Obviously, there are some big upside and downside risks to our forecast of domestic inflation. Nathan has already covered some of those related to prices for oil and other imports, so let me say a few words about the outlook for retail food prices. Our outlook for food prices remains relatively sanguine, but there would appear to be more pronounced risks to the upside than the downside. Although most of the value of what's in your morning cereal bowl is advertising, packaging, and transportation, some corn and wheat are in there also, [laughter] and those prices have been rising rapidly. Futures markets are predicting a leveling-out in crop prices, and that expectation is built into our forecast. But worldwide stocks of grains remain tight, and any serious shortfall in production could result in sharply higher prices. In that regard, while the growing season here is just getting under way, corn production is off to a slow start because unusually wet conditions have hampered plantings. Elsewhere, increasing supplies of livestock products and poultry have been a moderating influence on retail food prices in recent months. Again, while futures markets suggest relatively subdued prices going forward, there are a few worrying signs. Although cattle on feedlots have remained near record levels, new placements have fallen off of late, reportedly because of the higher cost of feed. In addition, the portion of feedlot placements composed of females was high last fall and through the winter, which points to a reduction in the size of the breeding herd this year and thus suggests some potential supply risks ahead. In recognition of the upside risks posed by both food and energy prices, we included in the Greenbook an alternative simulation in which oil prices climb to $150 per barrel next year and food prices continue to run at the elevated pace of the past three years. In this scenario, we also assume that another year of elevated headline inflation results in a further erosion of inflation expectations of about � percentage point. Under these conditions, headline PCE price inflation posts another year north of 3 percent, and core inflation moves a bit higher to 2� percent this year and next. It strikes me that this type of persistent upward creep to inflation, which would be difficult to positively identify in real time, is a more likely risk than a sudden upward surge in price inflation. There are, however, some downside risks to the inflation outlook as well. As you know, we upped our price forecast a bit in the last round because we saw the incoming readings on inflation expectations as suggesting that there had been some modest upward movement over the preceding few months. Some of that increase may have resulted from your aggressive easing of policy early this year. But going forward, the situation may be turned around. If our forecast over the next few quarters is in the right ballpark, and on our assumption that the easing of policy is coming to an end, you will be standing pat on policy even as payroll employment falls throughout the remainder of the year, the unemployment rate trends higher, and headline inflation begins to back down. It doesn't seem a stretch to me that in that environment, inflation expectations could come down somewhat, a development not embodied in the baseline forecast. More broadly, one place that inflation expectations might be expected to manifest themselves in a way that would be most damaging to inflation would be in labor compensation. Despite the elevated headline inflation of the past four years, there is little evidence of any noticeable step-up in wage inflation. If that was the case when the unemployment rate was 4� percent, it seems less likely that larger nominal wage gains will be secured when the unemployment rate rises to 5� percent. Indeed, increases in hourly labor compensation have been running well below our models for some time, pointing to some additional downside risks to our inflation outlook. For now, we see substantial risks to the inflation outlook, but those risks still seem twosided to us. Brian will complete our presentation. " CHRG-111hhrg56778--144 Mr. Royce," Let me ask you lastly, Mr. Greenlee, a question. If price controls were putting the solvency of a given insurance subsidiary at risk, would the Fed or the OTS have the authority to intervene and remove the price-fixing requirement on that subsidiary? " FOMC20080109confcall--24 22,MR. ROSENGREN.," Thank you, Mr. Chairman. My views are actually very consistent with your own. I would support lowering the fed funds rate 50 basis points, and, if it were up to me, I would support doing it right now. The employment report last Friday was weaker than I expected. In conjunction with the likelihood of several quarters of economic growth below potential, the risk that the economy is in, or could be going into, a recession is too high. Continued declines in housing prices and stock prices raise my concern that deteriorating household wealth will constrain consumption more than we anticipate. I am also worried that weaker labor markets are likely to exacerbate problems in the housing market. Should housing prices fall further and foreclosures rise more rapidly as a result of weak labor markets, financial markets may experience even more turmoil than we have experienced to date. Commodity and oil prices have risen, but I expect that the weakening in labor markets will be sufficient to restrain inflation. The downside risks to the economy are significant, and I think we should take aggressive action to mitigate that risk. Thank you. " 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-109hhrg31539--125 Mr. Bernanke," Well, Congressman, as you point out, there is uncertainty. We have a baseline forecast which assumes that energy prices don't do another big increase, that expectations remain contained, as they appear to be currently. We have talked about the cost side of labor costs, which seem not at this point to be a problem from a cost perspective. So from all that perspective, again, we have the baseline forecast that the inflation will gradually decline over the next couple of years. At the same time, we talk about risks, and we think there are some risks. The risk that I talk about in my testimony is that, given the tightening of markets, product markets in particular, that some firms may be better able to pass through those energy and commodity prices that you mention, and that that might become possibly embedded in the expectations of the public. So we do see some upside risks, and we have to take that into account as we make policy. " CHRG-109shrg26643--42 Chairman Shelby," Mr. Chairman, your testimony also notes the possibility of some risk which could add to inflationary pressures such as high energy prices feeding into the prices of nonenergy goods and services. Your testimony further notes the risk to our economy due to a slowing housing market you reference. What would be the impact on the economy if both of these effects materialize to a greater degree than is currently anticipated? How would the Federal Reserve be likely to respond to such a scenario if you found the pressure there from a double hit? " 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 " fcic_final_report_full--60 A sset - Ba ck ed Se cu r i t i es Ou tstand i ng In the 1990s, many kinds of loans were packaged into asset-backed securities. IN BILLIONS OF DOLLARS $1 , 000 Other 800 Student l oans 600 M anufactured hous i ng 4 00 200 0 Eq u i pment H ome e q u i ty and other res i dent i a l Cred i t card A utomob il e ’ 85 ’ 86 ’ 88 ’ 89 ’ 91 ’ 92 ’ 93 ’ 95 ’ 9 7 ’ 99 NO TE: Res i dent i a l l oans do not i nc l ude l oans secur i t iz ed by government - sponsored enterpr i ses . SOURC E: Secur i t i es I ndustry and Fi nanc i a l M arkets A ssoc i at i on Figure . these instruments became increasingly complex, regulators increasingly relied on the banks to police their own risks. “It was all tied up in the hubris of financial engineers, but the greater hubris let markets take care of themselves,” Volcker said.  Vincent Reinhart, a former director of the Fed’s Division of Monetary Affairs, told the Com- mission that he and other regulators failed to appreciate the complexity of the new fi- nancial instruments and the difficulties that complexity posed in assessing risk.  Securitization “was diversifying the risk,” said Lindsey, the former Fed governor. “But it wasn’t reducing the risk. . . . You as an individual can diversify your risk. The sys- tem as a whole, though, cannot reduce the risk. And that’s where the confusion lies.”  THE GROWTH OF DERIVATIVES: “BY FAR THE MOST SIGNIFICANT EVENT IN FINANCE DURING THE PAST DECADE ” During the financial crisis, leverage and complexity became closely identified with one element of the story: derivatives. Derivatives are financial contracts whose prices are determined by, or “derived” from, the value of some underlying asset, rate, index, or event. They are not used for capital formation or investment, as are securities; rather, they are instruments for hedging business risk or for speculating on changes in prices, interest rates, and the like. Derivatives come in many forms; the most com- mon are over-the-counter-swaps and exchange-traded futures and options.  They may be based on commodities (including agricultural products, metals, and energy products), interest rates, currency rates, stocks and indexes, and credit risk. They can even be tied to events such as hurricanes or announcements of government figures. Many financial and commercial firms use such derivatives. A firm may hedge its price risk by entering into a derivatives contract that offsets the effect of price move- ments. Losses suffered because of price movements can be recouped through gains on the derivatives contract. Institutional investors that are risk-averse sometimes use interest rate swaps to reduce the risk to their investment portfolios of inflation and rising interest rates by trading fixed interest payments for floating payments with risk-taking entities, such as hedge funds. Hedge funds may use these swaps for the purpose of speculating, in hopes of profiting on the rise or fall of a price or interest rate. CHRG-111shrg57322--822 Mr. Viniar," Sure. The same thing happened with leveraged loans in 2008. We were long in many leveraged loans, unfortunately, and the market clearly started to decline. We were marking things to market. We were marking them down and we sold them. We sold some at prices that people who bought them that continued to go down, and we sold some at distressed prices and since then they have recovered and they have made money on them. But we just felt our risk was just too big and our instructions were that we should reduce our risk, because that market was in very--ended up in severe distress. Senator Coburn. Now, there are some significant risk factors going on in commercial real estate. Do you all have big holdings in commercial real estate mortgages? " FOMC20070807meeting--166 164,MR. FISHER.," I would agree with that. Now, that doesn’t say that pricing has changed. Let me give you an example. Kimberly-Clark last week went to market on $2 billion in debt. They couldn’t move it unless they had a change-of-control provision. No price impact. So it is part of the risk premiums, but we’re not seeing pricing per se. I like the wording that President Geithner has suggested." FOMC20080430meeting--120 118,MR. MISHKIN.," But I do have a concern about the risk to inflation expectations because of the high commodity prices that we see. This is coming from the very adverse supply shock and the fact that we have had headline inflation so high for so long. The good news, by the way, is that it is actually quite remarkable, given how high headline inflation has been, how anchored inflation expectations have been. I think that has to do with confidence in this institution's doing the right thing. It is very important that we retain that confidence. We have to think about that when we decide what we are going to do regarding policy. About where I think inflation is going to be--I have been a 2 percent guy for a long time. I am not changing that. I think that inflation expectations are around 2 percent and that there is no expectation that we will have excess demand in the economy. If anything, it is the opposite of that. I see the risks as balanced--there are some risks on the upside, particularly because of what is happening with commodity prices. On the other hand, there are risks on the downside because of the expected slack and because there is some downside risk in the economy. So on that ground, I basically have the same story that I had before. Thank you. " 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." CHRG-109shrg30354--33 Chairman Shelby," Thank you Mr. Chairman. Mr. Chairman, your testimony notes the possibility of some risk which could add to inflationary pressures, in particular the possibility of higher energy prices feeding into the prices of nonenergy goods and services. Your testimony, Mr. Chairman, also notes the risk to our economy due to a slowing housing market. The question is this: What would be the impact, Chairman Bernanke, on the economy if both of these effects materialized to a greater degree than is currently anticipated? How would the Federal Reserve be likely to respond to such a scenario? These are not out of the question, either. " FOMC20050920meeting--141 139,MS. DANKER.," I’ll be reading the directive wording from page 27 of the Bluebook and the assessment of risk from exhibit 6 in the material that was passed out. For the directive: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 3¾ percent.” Now for the assessment of risk: “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to September 20, 2005 104 of 117 is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" 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-111hhrg48867--185 Mr. Price," No, I understand that. But at some point there has to be a consequence for the decisionmakers here. We have determined, somebody has determined that there is an entity that is a systemic risk. So what ought to occur to that entity? It has to be something. " CHRG-111hhrg48867--183 Mr. Price," Anybody disagree with that being the outcome? So we all agree that systemic risk institutions no longer get explicit government support. Is that correct? " FOMC20060510meeting--122 120,MR. KOHN.," Thank you, Mr. Chairman. I agree with many of the rest of you that inflation risks rose over the intermeeting period, though I think I see a more limited rise than I sensed from some of the comments I have heard. Several factors do suggest higher inflation risk. Stronger growth than expected has left resource utilization a little higher than we thought—only a touch, I think, but still higher. The core CPI and PCE data were disappointing—were higher than anticipated. That, however, did follow several months in which those data came in lower than we had expected. And if you look at the Greenbook’s 2006 projection, it reverses a downward revision from last time. That is not to say it is not worrisome, but we were revising down for a while, and now we have had an upward revision. I think the commodity price increases are hard to understand, especially outside the energy area, where you can think about supply disruptions. Both the energy prices and the commodity prices could feed through to a limited extent into headline inflation. I think they do indicate, at the very least, that global demand has continued to be quite strong. In that regard, they would add to global inflation risks. The decline in the dollar is a bit worrisome. The pass-through to import prices has been very, very small over recent decades. But to the extent that the lower dollar is not passed through to import prices, it would be squeezing the profits of those people who are exporting to the United States, and I think, through either channel, this suggests at least a slight reduction in the competitive pressures on domestic producers— not big, but a slight reduction. We did have a small uptick in inflation expectations looked at through the markets or the Michigan survey. However, those expectations are still in the range of recent years, and I can recall a number of occasions post-Katrina and in the last few springs in which they have ticked up in similar situations and then come back down again, particularly after energy prices leveled out. None of these signs of higher inflation are very significant in and of themselves or if they were taken one by one; but taken together, they cannot be dismissed. They do suggest at least a small rise in inflation expectations and a small rise in inflation risk that could start pushing up underlying inflation further. That said, the data we have received over the intermeeting period should give us a little more confidence that conditions are being put in place or are in train to limit these risks and to keep the upside risk limited. The trajectory of information over the intermeeting period, especially on consumption and housing, points to quite a bit of moderation of growth in the second quarter. We are looking at 3-point- something, and the issue is what the point-something is; it is not 4-point-something or 5-point-something. Housing market information, I think, confirms that there is a slowdown in process that will restrain aggregate demand going forward. Sales have bounced around a lot, but inventories have risen substantially by any measure. That is going to be weighing on prices. The price data are ambiguous and hard to read. If you take a heroic leap and start seasonally adjusting the existing house prices on a month-by-month basis instead of a twelve-month basis, it looks as though they have been flattening out. But we will get better data later. If, indeed, prices are flattening out, we have not yet really seen that effect on consumption. So in that sense, the tightening of policy and the flattening-out of housing prices are still in the pipeline. Higher long-term interest rates: Some of that increase is an endogenous response to global growth and would require a higher path of short-term rates to keep inflation under control, but some of it is in the risk premium. The extent to which the risk premium has risen will damp demand for any given course of monetary policy. The energy-price increase will contribute to moderating growth of domestic demand, provided that we do not allow that energy-price increase to reduce real interest rates. Like some others here, I am kind of encouraged by the data on labor compensation. They are mixed, but I have interpreted them on balance to suggest that pressures on businesses from labor cost developments are muted. The ECI is certainly consistent with that, and so are four-quarter changes in compensation per hour and unit labor costs. The markup of price over unit labor cost actually increased from a very high level to an even higher level. I agree with President Poole that businesses will not voluntarily give up that markup, but we do have a recent experience if you look in the late ’90s. That markup peaked at the end of ’97, I believe, and dropped very, very sharply in ’98 and ’99, despite the fact that the economy was growing with some vigor. You can see that on page 39 of the Greenbook. So perhaps we need to think about that episode and how it happened. Certainly we have a precedent for vigorous growth and declining markup absorbing rising compensation costs. So where does that leave me overall? I agree with the staff. The most likely outcome—given the structure of interest rates, financial conditions, markets, and a flattening of energy prices—is for stable underlying inflation, core PCE to stay in the neighborhood of 2 percent, where it has been since early 2004. But I am a little more nervous about the stability than I was at the last meeting. Thank you, Mr. Chairman." CHRG-110shrg50409--94 Mr. Bernanke," Well, it depends which side of the transaction you are on. You have people on both sides who are trying to make a bet essentially on whether oil prices will go up or down. But, clearly, one of the major economic functions of futures markets is to allow those who want to lay off their risk, like an airline, the opportunity to sell or to buy forward the fuel so that they will not be subject to the risk of price fluctuations. And it is the activities of speculators in those markets that provides the other side of that transaction and makes those markets liquid and allows them to serve that function. Senator Crapo. The airlines are a good example. As you know, a number of the CEOs of a number of airlines have maintained that the price of their jet fuel is being forced unnaturally high because of market speculation in the futures market. Do you believe that they are correct in that? " FOMC20060328meeting--138 136,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Like all of you, we think the underlying trajectory of demand and inflation seems quite favorable, perhaps a bit more so than it did in January. We expect real GDP to grow at a rate slightly above the rate of increasing potential in ’06 and to slow to the range of potential in ’07. We expect the core PCE to rise at a rate in the neighborhood of 2 percent over the forecast period. Differences between our forecast and the Greenbook’s are minor. In our forecast, we assume that inflation expectations remain anchored and the term premium remains low and that we are now at a point where little or no resource slack is left in the domestic economy. The monetary policy assumption we adopt is the path currently priced into the futures markets. The major sources of uncertainty in our forecast are the size of the wealth effect we might see accompanying any slowdown of housing, the flexibility of profit margins, and the sustainability of this present configuration of low risk premiums. We view the risk to the growth forecast as roughly balanced, although the usual suspects provide a source of concern. The risk to our inflation forecast, in contrast, still seems slightly tilted to the upside. On the growth front, as I said, we think the underlying pace of demand growth is pretty strong, and we don’t see any signs yet that would point to evidence of a significant slowdown relative to potential in prospect. We think productivity growth is likely to remain quite high, rising perhaps a bit faster this year than in ’05. With the labor market growing on trend and some increase in labor’s share of national income, we expect consumption growth to remain reasonably strong. Stronger income growth offsets the expected deceleration in housing-price appreciation and the effect that might have on consumption. We expect a slight increase in the contribution of business fixed investment to demand growth, due principally to a rise in spending on equipment and software. We expect, of course, the contribution of residential investment to slow with the forecast period. World GDP growth seems stronger and more broadly based. We expect net exports to be a persistent drag, shaving about ½ percentage point off growth for each of the next two years. Despite this forecast of pretty strong spending growth and high levels of resource utilization, we believe core inflation is likely to remain moderate. Under the assumption of a relatively stable dollar and with the energy-price assumption taken from the futures curve, we expect headline inflation to slow to a rate closer to the core over the forecast period. But this forecast rests on three important foundations. The first is that we succeed in keeping inflation expectations reasonably well anchored. The second is that demand growth not only does not accelerate to a rate substantially above trend but also slows to potential over the forecast period. And the third is that the expected rise in compensation and unit labor costs results in a rise in labor share of income—in other words, that compensation growth accelerates but the increase is absorbed by some compression of profit margins and does not lead to a significant acceleration in core inflation. Now, the sources of potential upside risk to the inflation forecast are several. One, of course, comes from the interaction between our views about productivity growth, compensation, and profit margins. If the pace of productivity growth slows significantly relative to our assumption and if, at the same time, conditions in labor markets continue to improve, unit labor costs are then likely to accelerate. A rise in compensation, however, would not by itself portend a troubling increase in core inflation. The extent of this risk, as I said, depends on the degree to which rising unit labor costs are absorbed in shrinking profit margins rather than triggering output price increases as firms attempt to defend existing margins. And because the labor share of income seems somewhat low and, as historical averages suggest, there’s room for unit labor cost growth to be absorbed in profit margins rather than causing price increases, we need to be attentive to the risk that this process may produce a short-term increase in core inflation, perhaps also in inflation expectations. A second potential risk comes from what we think we know about the pace of demand relative to potential supply globally. A continued increase in commodity prices around the globe and, more recently, some modest increase in capital goods prices may suggest that global pressures on resource constraints are pushing up prices. This raises the risk that the recent weakness in core goods prices in the United States may not be sustained. Service price inflation in the United States has shown signs of slowing. Our central forecast, as I said, is conditioned on little movement in the dollar over the forecast period, but any sizable depreciation of the dollar would still carry the risk of some acceleration in core goods prices. For nearly two years, overall inflation, as what is measured by the PCE or the CPI would suggest, has been running substantially above core, and this is true for a range of alternative measures of underlying inflation. If the underlying inflation rate were closer to 1.5 percent than to 2 percent, we might view these potential sources of upward pressure with more equanimity. Although the probability seems low that these forces will act to produce a significant acceleration of core inflation or a significant deterioration in inflation expectations, we need to be careful about those risks. So with underlying inflation at the upper end of the inferred inflation preference of the Committee, we need to be more attentive to these risks. On the growth side, the most obvious sources of downside risk to growth are a substantial rise in energy prices from current levels, a slowdown in productivity growth, a sharp rise in risk premiums, and a more-adverse effect on saving and consumption from the expected adjustment in housing markets and prices. Like the staff forecast, we think it’s reasonable to expect household saving to rise a bit and consumption growth to slow, in part because of changing expectations about the pace of future appreciation in the value of home equity. But we believe that, absent some large, negative shock to perceptions about employment and earned income, the effects of the expected cooling in housing prices are going to be modest. Of course, this view may prove optimistic. We take some reassurance from the fact that the average growth forecast in the private sector probably anticipates a significant cooling in housing and a significant effect of that cooling on saving and consumption. Developments in asset prices and risk premiums over the past several months seem to support this picture of stronger confidence in the growth and inflation outlook because real rates seem to have risen. Equity prices and credit spreads suggest considerable confidence in the prospect for growth. Implied volatilities remain quite low. We don’t know how much of this is fundamental and how much will prove ephemeral. At the moment, though, overall financial conditions seem pretty supportive of the expansion. So with this forecast of growth in the vicinity of potential, core inflation at around 2 percent, and the risk somewhat to the upside for inflation, we think the principal responsibility of monetary policy remains to preserve the sense that we will act to keep long-term inflation expectations contained at levels consistent with price stability." FOMC20050630meeting--187 185,MS. BIES., The second question I have relates to the nature of the price decline risk. If some of these ARMs can’t be refinanced and foreclosures actually start to occur—where financial institutions take over the property—are there any studies out there that indicate how much foreclosure volume could hit the market before it had a material impact on local house prices? FOMC20050322meeting--150 148,CHAIRMAN GREENSPAN., You would just say: “The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability…” CHRG-111shrg50564--46 Mr. Volcker," No question about that. Senator Warner. You do not want to stifle innovation, but it seems to me that some of these instruments recently were more about fee generation than they were about appropriately pricing risk? " CHRG-111hhrg53244--161 The Chairman," Next--I have to apologize, I forgot that the seniority system here was designed by the choreographer of the Bunny Hop, and it goes this way. And I made a mistake. I told you I was getting old. So I am now at the gentlewoman from Wisconsin. Ms. Moore of Wisconsin. Thank you, Mr. Chairman. And thank you. I was really pleased to see in your testimony, under the regulatory reform section, that you realize that systemic risk is not just too-big-to-fail institutions, but activities and practices that provide systemic risk. Many of us--and, certainly, this article was given to me by Congresswoman Maxine Waters--have been reading the recent Rolling Stone article by Matt Taibbi, ``The Great American Bubble Machine.'' And while it is very critical of a particular firm, I think there are things that we all notice with respect to the housing bubble and the dot-com bubble and the oil bubble that all seem to be activities that seem to be systemic risks. For example, allowing an entity to sort of manipulate the price of an entity, of the housing prices, to ratchet the prices up and then just sort of hedge against their own products. So I guess I would like to ask your opinion about credit default swaps and also the practice of spinning, where executive compensation seems to be a systemic risk factor, as well. So can you tell us what we can do in our regulatory reform to prevent the creation of these bubbles? " FinancialCrisisReport--27 To ensure an ongoing supply of loans for sale, lenders created compensation incentives that encouraged their personnel to quickly produce a high volume of loans. They also encouraged their staffs to issue or purchase higher risk loans, because those loans produced higher sale prices on Wall Street. Loan officers, for example, received more money per loan for originating higher risk loans and for exceeding established loan targets. Loan processing personnel were compensated according to the speed and number of the loans they processed. Loan officers and their sales associates received still more compensation, often called yield spread premiums, if they charged borrowers higher interest rates or points than required in the lender’s rate sheets specifying loan prices, or included prepayment penalties in the loan agreements. The Subcommittee’s investigation found that lenders employed few compensation incentives to encourage loan officers or loan processors to produce high quality, creditworthy loans in line with the lender’s credit requirements. As long as home prices kept rising, the high risk loans fueling the securitization markets produced few problems. Borrowers who could not make their loan payments could refinance their loans or sell their homes and use the sale proceeds to pay off their mortgages. As this chart shows, over the ten years before the crisis hit, housing prices shot up faster than they had in decades, allowing price increases to mask problems with the high risk loans being issued. 36 36 See “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart prepared by Paulson & Co. Inc., Hearing Exhibit 4/13-1j. CHRG-111shrg50814--66 Mr. Bernanke," Well, to the extent that there is more common put in, then depending on existing expectations and pricing, it may or may not affect the prices of the common. It depends on expectations where the price is today---- Senator Corker. But I guess--and I know my time is up, and I think you know I have a great deal of respect and I appreciate the way the interaction has been. So, in essence, we have decided that there are a number of institutions in our country that are too large to fail. We are going to stress test them--and really, to me, it is not so much about capital. It is our ability to calculate risk in the past, and I think we are going to look at that risk in a much different way. And then simultaneous to that, as a Government entity, we are going to be providing capital to these institutions on a go-forward basis. And so the signal to us and to the markets--and I am just clarifying--is that there are institutions in this country that absolutely will not fail, and we will go to whatever lengths necessary with public sector dollars to ensure that that does not occur. " fcic_final_report_full--78 As the scale, revenue, and profitability of the firms grew, compensation packages soared for senior executives and other key employees. John Gutfreund, reported to be the highest-paid executive on Wall Street in the late s, received . million in  as CEO of Salomon Brothers.  Stanley O’Neal’s package was worth more than  million in , the last full year he was CEO of Merrill Lynch.  In , Lloyd Blankfein, CEO at Goldman Sachs, received . million;  Richard Fuld, CEO of Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about  million and  million, respectively.  That year Wall Street paid workers in New York roughly  billion in year-end bonuses alone.  Total compensation for the ma- jor U.S. banks and securities firms was estimated at  billion.  Stock options became a popular form of compensation, allowing employees to buy the company’s stock in the future at some predetermined price, and thus to reap rewards when the stock price was higher than that predetermined price. In fact, the option would have no value if the stock price was below that price. Encouraging the awarding of stock options was  legislation making compensation in excess of  million taxable to the corporation unless performance-based. Stock options had po- tentially unlimited upside, while the downside was simply to receive nothing if the stock didn’t rise to the predetermined price. The same applied to plans that tied pay to return on equity: they meant that executives could win more than they could lose. These pay structures had the unintended consequence of creating incentives to in- crease both risk and leverage, which could lead to larger jumps in a company’s stock price. As these options motivated financial firms to take more risk and use more lever- age, the evolution of the system provided the means. Shadow banking institutions faced few regulatory constraints on leverage; changes in regulations loosened the constraints on commercial banks. OTC derivatives allowing for enormous leverage proliferated. And risk management, thought to be keeping ahead of these develop- ments, would fail to rein in the increasing risks. The dangers of the new pay structures were clear, but senior executives believed they were powerless to change it. Former Citigroup CEO Sandy Weill told the Com- mission, “I think if you look at the results of what happened on Wall Street, it became, ‘Well, this one’s doing it, so how can I not do it, if I don’t do it, then the people are go- ing to leave my place and go someplace else.’” Managing risk “became less of an im- portant function in a broad base of companies, I would guess.”  CHRG-111shrg50815--11 Mr. Levitin," Good morning, Mr. Chairman, Ranking Member Shelby, and members of the Committee. I am pleased to testify today in support of the Chairman's Credit Card Accountability, Responsibility, and Disclosure Act and other legislation that would create a more efficient and fair credit card market and would encourage greater consumer responsibility in the use of credit. Credit cards are an important financial product. They offer many benefits and conveniences to consumers. But credit cards are also much more complicated than any other consumer financial product, and unnecessarily so. Auto loans, student loans, closed-end bank loans, and all but the most exotic mortgages are relatively simple. They have one or two price terms that are fixed or vary according to an index. Not so with credit cards. Credit cards have annual fees, merchant fees, teaser interest rates, purchase interest rates, balance transfer interest rates, cash advance interest rates, overdraft advance interest rates, default or penalty interest rates, late fees, over-limit fees, balance transfer fees, cash advance fees, international transaction fees, telephone payment fees, and probably several other fees of which I am unaware. In addition to these explicit price points, there are also numerous hidden fees in the form of credit card billing practices. The card industry has been ingenious in creating tricks and traps to squeeze extra revenue out of unsuspecting consumers. These billing tricks cost American families over $12 billion a year. Credit card billing tricks make cards appear to be much cheaper than they actually are, and that leads consumers to use cards too much and to use the wrong cards. By disguising the cost of using cards through billing practices, card issuers are able to maintain uncompetitively high interest rates and to generate greater use of cards. That produces additional revenue from interchange fees for the issuers as well as over-limit fees, late fees, and penalty fee revenue. The complexity of credit card pricing makes it impossible for consumers to accurately gauge the price of any particular credit card, and unless consumers can gauge the cost of using a card, they cannot use it efficiently and responsibly. Markets cannot function without transparent pricing because demand is a function of price. The lack of transparency in credit card pricing has resulted in inefficient and irresponsible use of credit, and that has resulted in dangerously over-leveraged consumers, who are paying too much for what should be a commodity product with razor-thin profit margins rather than one with a return on assets that is several multiples of other banking activities. Consumer over-leverage is a factor that should concern all of us, especially today. There is nearly a trillion dollars of credit card debt outstanding. The average carded household owed almost $11,000 in credit card debt last year. That is a drop in the bucket compared with household mortgage debt, but even the most exorbitant subprime mortgage rate is rarely over 10 percent annually, whereas the effective APR on many credit cards--the effective APR--can easily be five times as high. And the harm to families is palpable. A single repricing due to a billing trick can cost a family between an eighth and a quarter of its discretionary income. These levels of credit card debt are not sustainable. Dollar for dollar, a consumer with credit card debt is more likely to file for bankruptcy than a consumer with any other type of debt. And to the extent that consumers are servicing high-interest-rate credit card debt, that is money they cannot use to purchase new goods and services from merchants. The money siphoned off by credit card billing practices does not create value. It cannot be spent in the real economy. The card industry's arguments that Congress should not interfere with their finely calibrated risk-based pricing are malarkey. Only a very small component of credit card pricing reflects risk. Almost all credit card pricing is a function of the cost of funds, the cost of operations, and the ability-to-opportunity price, not the function of risk. Moreover, to the extent that credit card prices reflect a risk premium, it is a pool-based premium. It is not an individualized risk premium. The card industry is not capable of pricing for risk on an individual basis. The technology is not there. This means that there is inevitably subsidization of riskier consumers by more creditworthy ones. Nor is there any evidence that connects the so-called risk-based pricing to lower costs of credit for creditworthy consumers. While it is true that base interest rates have fallen, that is almost entirely a function of the lower cost of funds, and the decline in base interest rates has been offset by increases in other credit card prices. According to the GAO, for 1990 to 2005, late fees have risen an average of 160 percent, and over-limit fees have risen an average of 115 percent. Since the 1990s, credit card pricing has been a game of three-card monte. Pricing has been shifted away from the up-front, attention grabbing price points, like annual fees and base interest rates, and shifted to back-end fees that consumers are likely to ignore or underestimate. The card industry's risk-based pricing story simply doesn't hold up on the evidence and is not a reason to refrain from much-needed regulation of unfair and abusive credit card billing and pricing practices that have had a deleterious impact on the economy and society. Legislation like the Credit Card Accountability, Responsibility, and Disclosure Act is a crucial step in restoring transparency and fairness to the credit card market and to letting American consumers responsibly enjoy the benefits of credit cards. Thank you. Senator Johnson. Thank you, Mr. Levitin. The panel should know that we will limit your remarks to 5 minutes in order to have a proper question and answer period. Mr. Clayton? STATEMENT OF KENNETH J. CLAYTON, SENIOR VICE PRESIDENT AND CHRG-109hhrg31539--190 Mr. Bernanke," It is a trick question. As I said in my testimony, our expectation is that core inflation will be moderating over the next 2 years for a variety of reasons. However, we do see some risks, and one of the risks would be that because product markets are tight, that there would be ability of firms to pass through energy and commodity prices into other goods. " CHRG-111shrg57322--204 Mr. Sparks," There is fee business, which I do not think is what you are talking about, and then there is market-making business. In this particular sector, typically you would have to do trades where you assumed risk. When that was not the case, there is an SEC markup rule with respect to a certain percentage, but that is for risk-free trades, and at this time in this market, that was not a typical thing where you would have a purely risk-free trade. The amount of bid-offer spread, which would be a term we would have used, would be very dependent on the product, the rating, the liquidity of the product, and the--if I did not mention liquidity, it was a huge issue. So, the bid-offer spread could vary at various times, but one of the things people expected us to do was to make a market and to have a bid-offer spread. The great thing about making a market is when you do that, clients can tell from your price relative to the prices that other people are making in that market on similar securities, if you are a better seller or buyer. And so, I actually--I am a believer in markets, and I think that is one of the nice things that price can affect, both your risk and it can also help people know where to go if they want to acquire risk. Senator McCaskill. OK. Let us talk about what people are betting on. And what I would like to ask a couple of questions about are the--you call them different things in different memorandums in here, whether it is Timberwolf or Abacus--the asset selector or the asset selecting agent. I think you called it a different term. Now, this is important because these are the folks that are figuring out what is going to be in the bet, right? What everybody is betting on. So the compilation of what is in this thing you create for people to bet on is done by these asset selectors. Who decides who the asset selector is for a deal? " 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. " FOMC20061025meeting--23 21,MR. STOCKTON.," A little work has been done in this area, but it’s a bit like modeling the stock market. You wouldn’t take it very seriously in the sense that these are asset markets and they’re sometimes moving in ways that are very difficult to model on the basis of, for example, fundamentals—especially in a period when, by our assessment, prices have moved up significantly above what we think can be justified in terms of interest rates and rents. So now we have a situation in which that asset price misalignment is projected in our forecast to just barely begin to unwind but we’re really uncertain about what the timing of that process is going to be. One of the reasons we wanted to show the alternative simulation is that we’ve taken a fairly conservative approach here. Our slowdown in the growth rate of house prices, to roughly 1½ to 1¾ percentage points over the next two years, doesn’t make a big dent—if you remember from the briefing that we did one and a half years ago—in the price-to-rent ratio, which we plotted there and showed that that had increased very significantly. So our best guess is that, as in the past, those nominal prices will flatten out rather than actually decline. But the run-up was so large that we couldn’t rule out this time around that the adjustment of house prices could be more significant and more rapid than in the past. But I don’t know of any reliable empirical model or evidence. We’ve certainly done our share of work in modeling those house prices, and I know our colleagues at the New York Fed have as well. There’s a lot of controversy about whether there even is an asset price misalignment, much less, if there is, how it will unwind. So I don’t have a lot to offer you there, except that we’re going to try to present you with the range of possible outcomes in the sensitivity of our forecast to the baseline assumption that we’ve made. In that regard, I still see more downside risk there than upside risk to our house-price forecast." FOMC20080130meeting--110 108,MR. SHEETS.," Right. Just a word of background. The rationale for the falloff is the expected decline in these commodity prices and the expected slowing of global demand. Now, thinking about the risks, I am reasonably convinced that global demand is going to slow, which I believe will translate into reduced demand for many of these commodities that have driven up inflation. However, that says something only about the demand side of these commodity markets. There is also a lot going on on the supply side. At the last FOMC meeting, we talked about ethanol and the fact that many of these emerging-market countries are wealthier, that they want to eat better than they used to, that the relative price of energy has risen, and that it takes a lot of energy to raise these crops. So there are supply factors as well as demand factors at work in driving up these commodity prices. It is very hard for us to forecast the supply side of these markets. It is driven by things like weather and geopolitical developments and so on and so forth. On the commodities, my sense is that demand is going to shift in to some extent. As long as the supply doesn't shift in as well, we should be able to see a decline, or at least a slower rate of increase, in these prices. A very important point here is that, in order to get less of an impetus coming from commodity prices and inflation in these countries, we don't necessarily need oil prices to come down in level terms. We just need them to stop going up at such rapid rates. If we get slower rates of price increases, that will be disinflationary relative to where we have been. That is how I would characterize the risks around this forecast, mainly on the supply side of these commodity markets. " CHRG-109shrg30354--131 RESONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM BEN S. BERNANKEQ.1. I am very concerned about the potential efforts in this Congress to change the manner in which we regulate derivatives or to impact the manner in which derivatives operate in the economy. As you know, the President's Working Group on Financial Markets has explained why proposals we have faced in the last couple of years for additional regulation of energy derivatives were not warranted, and has urged Congress to be aware of the potential for unintended consequences. Do you share this view? Do you agree with the view of Alan Greenspan and others that derivatives have helped create a far more flexible, efficient, and resilient financial system? Are you aware of any evidence that additional reporting requirements or other regulatory actions would reduce energy prices and price volatility or are energy prices and price volatility determined by the market?A.1. I share the view that additional regulation of energy derivatives is not warranted. More generally, I agree that derivatives have created a more flexible, efficient, and resilient financial system. To be sure, as Chairman Greenspan recognized, derivatives pose a variety of risk management challenges that users must address. In particular, they must effectively manage the counterparty risks associated with derivatives. Thus far, with a few notable exceptions they have done so and, as a result, derivatives have produced the benefits that you have mentioned. I am unaware of any evidence that supports a view that additional reporting requirements or other new regulations would reduce energy prices or energy price volatility. Prices and volatility are indeed determined by the market, and as far as I am aware, energy prices and volatility recently have moved in ways that seem sensibly related to fundamentals.Q.2. Mr. Chairman, in your Sea Island speech in May on the subject of ``Hedge Funds and Systemic Risk,'' you noted that ``[t]he primary mechanism for regulating excessive leverage and other aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors.'' You further observed that, in light of 1998's LTCM episode, the President's Working Group's ``central policy recommendation was that regulators and supervisors should foster an environment in which market discipline--in particular, counterparty risk management--constrains excessive leverage and risk-taking.'' You also noted that the PWG rejected so-called ``direct regulation'' of hedge funds, observing that ``[d]irect regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking but, in the case of hedge funds, the reasonable presumption is that market discipline can work. Investors, creditors, and counterparties have significant incentives to rein in hedge funds' risktaking. Moreover, direct regulation would impose costs in the form of moral hazard, the likely loss of private market discipline, and possible limits on funds' ability to provide market liquidity.'' Can you tell us a little more about what is involved in fostering market discipline in the hedge fund context and why you believe that is a superior approach to ``direct regulation?''A.2. The creditors and counterparties of hedge funds are regulated banks and securities firms. Banking and securities supervisors have been fostering market discipline by issuing supervisory guidance on counterparty risk management, by encouraging private sector initiatives to identify and promote best practices for risk management, and by undertaking supervisory reviews that assess whether banks and securities firms' practices are consistent with supervisory guidance and emerging best practices. As I indicated in my Sea Island speech, I believe that it is a reasonable presumption that market discipline can effectively constrain hedge funds' leverage. The banks and securities firms that provide hedge funds with leverage have strong incentives and capabilities to constrain their leverage so as to avoid counterparty losses. Supervisors of those banks and securities firms can and should take action if competition appears to be dulling those incentives in ways that threaten the counterparties and the financial system. Direct regulation of hedge funds could weaken market discipline if hedge funds' creditors and counterparties came to view direct regulation as an effective substitute for their own due diligence and monitoring of risks. Furthermore, development of an effective regulatory regime for hedge funds would be challenging in light of the diversity of hedge fund investment strategies and the speed with which their risk profiles tend to change. A regulatory regime that was insufficiently risk sensitive could impair hedge funds' ability to bear risks and provide liquidity to financial markets, which would make our financial system less efficient and less resilient." CHRG-111shrg57319--523 Mr. Killinger," I do not recall my exact timing. I do remember making public comments beginning in the middle part of 2005. I remember talking to the board from time to time about that there was growing risk because housing prices are growing faster than the rate of inflation. But also at the same time, I can remember everybody arguing of why that is going to be OK and it is unlikely to be a significant downturn in housing. We were kind of the front edge of trying to assess that there was a concern here. Senator Coburn. Well, that follows into my second question because in January 2005 is when you pushed forward a high-risk lending strategy for board approval. Only 2 months earlier, if you saw that prices would decline in the near future, why would you be pushing through a high-risk strategy on a market that you thought was a bubble? " CHRG-109shrg26643--59 Chairman Bernanke," Once again, of course, it cuts two ways. It would hurt the Iranians quite a bit to stop exporting their oil. It hurt the Russians quite a bit to stop exporting their natural gas. But I agree in the following general sense, that whereas there are substantial reserves of oil and natural gas in the world, a large share of them are in areas where there is geopolitical uncertainty or geopolitical risk, and that means that is a risk factor for the economy. We do not have a wide range of spare capacity in these energy areas so that a major change in the supply of energy available could make prices move a lot and that could have a major impact on the economy. That is a concern that we are going to have, I think, for a number of years. My view, in the long-run, is that with energy prices at current levels, over a longer period of time, there are going to be substantial new substitutes, alternative sources of energy, as well as new ways of conserving and reducing the use of energy. But over the next few years, our room for error is modest and we do face the risk that energy prices may fluctuate with changes in supply. Senator Bayh. Thank you. My closing comment, Chairman Bernanke, would be, you know, interdependence is one thing, increasing dependency is another, and it raises potential risks that we best think about in advance so that we do not face a potentially difficult situation at some point down the road. That is the underlying theme of my remarks. Thank you very much. " CHRG-110shrg50369--25 Chairman Dodd," That is a good additional point. I did not make that. Senator Shelby. Senator Shelby. Thank you, Mr. Chairman. Chairman Bernanke, as I noted earlier, wholesale prices rose by 1 percent in January and 7.4 percent over the past year. This is the fastest increase in 26 years. In your opening statement, you noted greater upside risks to both overall and core inflation than we saw previously. Additionally, the most recent minutes of the Federal Open Market Committee gave anecdotal evidence that in some instances these price increases were passed on to consumers. The FOMC also noted a risk that inflation expectations could become less anchored. Do you have any concern at all that the 225 basis-point cut to the Federal funds rate has limited the options that can be used to combat the upside risk of inflation? " FOMC20050322meeting--162 160,MR. GUYNN.," “Conditional upon the current path of policy, the risks to the attainment of both sustainable growth and price stability are roughly balanced.” To me it combines a number of things I heard around the table. Also, I want to say that I come out of the same cave as Cathy on the B4 cell. Although we didn’t have any quid pro quo when we voted for early release of the minutes, one of the effects that a lot of us hoped for was that we could simplify our statement. It seems to me that we have a chance to do that by dropping that whole last sentence in B4 about energy prices and March 22, 2005 81 of 116 flesh out that risk as well as others that we’ve talked about. To me it’s a great opportunity to simplify the statement a little." FOMC20050202meeting--227 225,MS. DANKER.," I’ll read the directive and the risk assessment language from page 29 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 2½ percent.” “The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal. With underlying inflation expected to be relatively low, the February 1-2, 2005 135 of 177 measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" FOMC20050322meeting--138 136,MS. MINEHAN.," I had similar concerns to Governor Gramlich’s about the “appropriate policy action” language. And given the length of your discourse, Vincent, which certainly was interesting in supporting the language, and the level of detail that you just went into in describing it, I think it’s going to be very hard to explain to others what the heck we’re talking about here. I really think all “appropriate policy action” is saying is that we can do our job. We’ve dealt with situations before where we’ve moved policy but continued to say that the risks were balanced. And with the “accommodative” language, I think we could continue to say that the risks are balanced and the whole statement would still flow logically. I’m also concerned in alternative B about the rise in energy prices not notably feeding through to core consumer prices. Core consumer prices are up a full percentage point on a year- over-year basis, and there has been some feed-through. We think it’s going to slacken, and maybe you want to put that reference in the future, but I’m not sure that this is what we want to say in this statement. I think we’d be better off leaving that sentence out and just going with “pressures on inflation have picked up in recent months and pricing power is more evident.”" FOMC20080805meeting--132 130,MR. KOHN.," Thank you, Mr. Chairman. Like others around the table, I made only small revisions to the central tendency of my forecast going forward as a result of the developments of the intermeeting period, maybe a slight reduction in the path of output and a quicker decline in headline inflation owing to the oil prices. But I think more important than any shift in central tendencies is the sense that the information tends to reinforce--to reduce the uncertainties around--the basic contours of a projection in which the economy operates with a wider output gap and a lower inflation rate on balance over the next 18 months or so than it has over recent quarters. About the output gap, the incoming information strongly suggests that we are on a trajectory that at least for some time will have the economy growing appreciably below the growth rate of its potential. The most obvious evidence is the persistence of a soft labor market--continuing declines in employment and no sign of near-term strengthening in the initial claims data. I agree that the declines in employment, as several of you have pointed out, are not consistent with a recession, but they're certainly not consistent with the economy growing close to its potential. You need another 150,000 or 200,000 jobs rather than minus 60,000, which is where we are now. So I think the economy is likely to grow below potential for some time. Even on the spending side, the decline in consumption in June, when rebate checks were continuing to hit bank accounts, and a further sharp drop in auto sales in July might be early signs that households are beginning to pull back under pressure from higher energy prices, job worries, declining house values, and reduced credit availability. To be sure, one month's consumption data along with auto sales, which are subject to all kinds of idiosyncratic influences, are not enough to justify a major change in outlook. But as President Lacker noted, household spending has for some time been a source of downside risk to the forecast. At some point, household spending could begin to reflect attitudes, and this information at a minimum seems to underline those risks as well as to point to sluggish growth of spending in the third quarter. Soggy economic news has extended to our trading partners, where actual activity and expected activity also have been marked down. The tone of news from abroad has been decidedly downbeat, as those economies feel the effect of weaker purchases from the United States, continuing financial strain, softening housing markets, and higher energy prices. Much as in the United States, attitudes abroad seem weaker than the data; but the euro area did report a record decline in retail sales in June this morning, and my sense is that our trading partners are facing larger downside risks to growth as well as a markdown of central tendencies. The dollar hasn't changed much on balance for four or five months now. With a stable dollar and weaker demand abroad, production in the United States will be getting a lot less cushion from net exports over the next few quarters than it did in the first half of the year. Finally, despite the downward movement in Treasury interest rates and in the expected federal funds rate path, financial conditions for households and businesses have tightened since the last FOMC meeting. Savers and intermediaries have become even more cautious amid concerns about deepening losses spreading beyond subprime mortgages, about the safety of uninsured deposits at regional banks, high volatility in markets, and the possible weakening of the underlying macro situation. Lenders are hunkering down to endure a long period of rising credit problems and great uncertainty. I don't think we need to rely on anecdotes here. Mortgage interest rates have actually risen on balance, as have corporate bond yields across many risk categories; and in many of these cases, the nominal interest rates are at least as high as or in some cases much higher than they were last August when the federal funds rate was at 5�. Banks continue to tighten terms and standards for nearly all categories of loans. Equity prices have fallen, adding to the downward pressure on wealth from declining house prices, and I think these developments underscore the very slow recovery likely in financial markets and the possible downside risks relative to even that very gradual improvement that many of us were expecting. The tightening of conditions is damping credit growth broadly defined and will constrain, at least to some extent, spending going forward, delaying the return to trend or above-trend growth. Thus although uncertainties remain quite elevated, I think we can be a little more confident that the economy will be subject to further quarters of below-trend growth and declining resource utilization. Furthermore, with housing prices still falling fast, inventories of homes still high, and financial markets quite skittish, the downside risks even to a slightly lower central tendency forecast remain high. Greater confidence that output will grow below potential for a time contributes to a little more optimism on my part that inflation will, indeed, come down substantially over the coming quarters. An environment of rising unemployment and declining capacity utilization is not one in which businesses or labor will find it easy to restore real incomes or raise profit margins after the increase in energy prices. With regard to that increase in energy and other commodity prices and how it affects headline inflation, I like to differentiate pass-through from spillover. I think we can expect passthrough. Pass-through to consumer prices of the higher energy and commodity prices is part of the adjustment process by which demand gets damped and by which consumers realize, unfortunately, the lower real income that they get from the adverse terms of trade. So the fact that businesses are able to pass through higher commodity prices and higher petroleum prices I don't find all that worrisome, provided that they're passing through a one-time increase in prices rather than a continuing rise. I think we have some further evidence that at least to date--things could change, I admit--what we are seeing is a pass-through of a one-time rise rather than some continuing increases. For one thing, commodity prices, as shown in Bill's chart, have flattened out or actually declined in the past few months. So presumably that pass-through is a one-time jump, if that's what they're doing, passing through those prices. Second, I think we saw in the GDP chain-type price indexes that the price of domestic value added increased at an annual rate of only 1.1 percent in the second quarter--which suggests to me that, at least through the second quarter, there was very little spillover from these higher commodity and energy prices to the stuff we produce here at home. Also, labor compensation growth, which could be a lagging indicator, at least to date hasn't increased. If anything, it has slowed a little further, which along with relatively robust productivity growth is holding down unit labor costs. Headline inflation--the goods and services that people purchase--has been high. Energy prices are being passed through, but I think to date there's no evidence or very little evidence that it's spilling over into other prices in the economy. So this is about the adjustment to relative prices. Obviously the decline in oil prices, if it holds, will be helpful on the inflation front, both in its direct effect on headline inflation and its indirect effect on inflation expectations. We finally have evidence of two-way risk in oil prices, and that should make us more comfortable with an assumption of stable prices as a reasonable basis for forecasting. Other recent contributors to higher price levels have also become less averse. As I mentioned, other industrial commodity prices have leveled out or declined, and the dollar has been relatively stable in recent months. Although I feel a little more confident about the expectation of lower inflation going forward, I agree that upside risks still prevail. Core inflation has ticked up. Headline inflation will be high for some time and could threaten to spill over through increases in inflation expectations. Oil and commodity price declines are largely an endogenous response to perceptions of weak growth, and if those perceptions turn around, so will those prices. Longer-term inflation expectations remain elevated by some measures and are probably less well anchored than they were a couple of years ago, before oil and commodity prices rose so much. In sum, I see upside risks to both the inflation gaps and the output gaps as having diminished over the intermeeting period, and we'll get to the implications of that for policy in the next part of the meeting. " CHRG-111hhrg51698--326 The Chairman," I have taken more time than I should, but if the Committee will bear with me. I know you guys are good at doing that, but one of the things that everybody brings up is this. These things are hard to price and figure out what the risk is and so forth. You guys believe you have the expertise to be able to do that? " CHRG-111shrg50815--110 Mr. Clayton," So as a practical matter, it is--they hold the risk, and if these trusts unwind, that comes back on the balance sheet. So there are real risks and checks and balances, which is what I think you are referring to, in this area. If the marketplace believes that this doesn't work, the cost of borrowing for that company goes up significantly. So there are real prices to be paid. " CHRG-110shrg46629--59 Chairman Bernanke," Our objective is to achieve enduring price stability and in particular we want to be sure that inflation remains under good control in the medium run. There are several elements of that. One is that I think it is important to recognize that the month-to-month inflation numbers are very noisy. And so a couple of good numbers does not, by itself, mean that the problem is solved and gone away. So part of it is just simply seeing more data and getting a greater sense of assurance that the trend is really in the direction we would like to see it. The other is that as long as there are some very important risks out there to inflation, there is the possibility of inflation--even if it has come down some--there is the possibility that it will go back up in the future. The risks that I talked about in my testimony include high resource utilization, the fact that the economy is working at a very tight use of resources. And second, the fact that energy and food prices have raised headline inflation. Those prices might feed through into core inflation, they might raise inflation expectations. So what we need to see is enough confidence that the risks have subsided so that we can feel confident that in the medium term inflation will be well-controlled. Senator Bunning. Last week, you gave a speech and spoke at length about inflation expectations. You also said that expectations are ``imperfectly anchored.'' What in the world does ``imperfectly anchored'' mean? " FOMC20080805meeting--82 80,VICE CHAIRMAN GEITHNER.," I was just going to say this. I think that you can do crude estimates of likely total losses across the U.S. economy and credit markets in a scenario like the baseline scenario in the Greenbook, and if you use Nellie Liang's study or the stuff done in New York, there's a huge amount ahead still. Even though financial market prices now reflect an expectation for house-price declines that are not significantly more optimistic than David's baseline scenario, I don't think you can say with confidence now that financial institutions have already provisioned for or written down losses to accommodate that. Because the trajectory of house prices will depend in part on financial behavior--the availability of credit--as financial institutions catch up and adjust to that and adjust capital and asset growth, et cetera, there is some risk that you'll push that expected path of house prices down further from where it is. So if institutions have to prepare for the possibility that you're going to have a much weaker economic outcome because there's some probability around that, then there's a risk that they will produce that outcome through the combined effects of their behavior, which is why we're living with such a delicate balance. " FOMC20061025meeting--53 51,MS. PIANALTO.," Thank you, Mr. Chairman. For a while now, I’ve been somewhat more pessimistic than most of the Committee about the downside risk to the real economy. I was beginning to get worried that this might be the perpetual disposition of someone from Ohio. [Laughter] As a prominent member of our business community said to me not too long ago, it’s not the weather, it’s the climate. [Laughter] Since our last meeting, I’ve become more comfortable with the idea that substantially weaker-than-forecast growth is less probable—partly because we’re now a little further down the road without any signs that the worst-case scenarios are materializing and partly because my directors and my business contacts seem more positive about the economic outlook. Specifically, as I listened to some of my business contacts in construction, retail, and even real estate, the expectations that things will get substantially worse just aren’t there. Also, the demand for labor seems to be growing at a moderate pace. On the price side, my contacts are not indicating much of an impetus for higher final goods prices. Although projected compensation growth seems to be firming just a bit, my contacts are telling me that they think productivity gains will keep costs in check. With the declining energy and material costs, I don’t hear much about the potential for accelerating pressures on prices. When I combine what I’m hearing from my District contacts with the aggregate data that have come in since our last meeting, I sense that we have weathered the worst in softness on the real side for now. In September I noted that my biggest concern was the possibility that the inflation trend would worsen. It does not appear that this is happening at this point. However, we have yet to see lower rates of core inflation, and I’m sensitive to the fact that core measures of inflation are being held up by the contribution to owners’ equivalent rent from the rising rents and falling utility bills. Although more-stable energy prices will make the latter effect go away, it’s not clear that the rent part of the picture will quickly fade, as rents continue to converge toward still high housing prices. When we look at the distribution of prices in the CPI, excluding energy, food, and owners’ equivalent rent, prices seem to be either rising rapidly or falling. There isn’t much in the middle, and that makes the underlying movements in the inflation trend hard to interpret. It seems to me that the key risk on the real side of the economy has been that the housing market would decline much faster and more deeply than we had forecast and that the effect on consumption spending would be greater than we anticipated. So far, as others have commented, the collateral effect on consumption appears to have been contained. Furthermore, we expected that other forms of spending would hold up as the housing sector slumped, and those expectations appear to be on track for now. I recognize that we’re not out of the woods yet, but the downside risks to the real economy appear somewhat more benign than they did at both the August and the September meetings. In regard to the inflation risks, the probability of accelerating inflation has decreased, in my opinion, but the risk that inflation will remain higher than I personally desire hasn’t really changed. Thank you, Mr. Chairman." CHRG-110hhrg46593--350 Mr. Feldstein," It is very important and impossible to do as long as there remains this risk of continued defaults driving foreclosures, driving house prices down further. So if you looked at an individual mortgage-backed security or even an individual mortgage, it is hard to know what that is worth if there is a risk that, at some point in the future, that is going to default. And that is what makes it so important. " 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. " CHRG-111hhrg53244--201 Mr. Bernanke," I think that could be addressed under the systemic risk regulation rubric that we have been discussing with the Council or with the Fed overseeing large financial institutions, that when you have an asset whose prices is rising quickly, you could require greater capital against it, for example, or greater downpayments. So even if you don't know there is a bubble or not, that still might be a prudent thing to do. So I do think that looking at asset price fluctuations in a supervisory context could be very helpful. " FOMC20051213meeting--84 82,VICE CHAIRMAN GEITHNER.," Our forecast for the national outlook has not changed substantially since the last meeting, and relative to the discussions so far, I guess we’re slightly at the stronger end. The recent data have been encouraging both here and internationally. The underlying pace of demand growth seems pretty good to us—good enough to raise the probability of the expansion continuing at a pace at or slightly above trend. The inflation news has also been reassuring, though December 13, 2005 51 of 100 We believe these conditions justify some further tightening of monetary policy, perhaps another 50 to 75 basis points. We are, therefore, comfortable with the expectations now built into the market. And with that monetary policy assumption, we think the risks to the forecast and to our objectives are roughly balanced. So, relative to September and October, we see somewhat less downside risk to growth, perhaps even some upside risk, and somewhat less upside risk to inflation. As this implies, our view is very close to the Greenbook. Let me mention a few other points. The apparent strength in productivity should make us more comfortable about the sustainability of the expansion and a bit less concerned about the near- term inflation risks because, of course, if the productivity growth stays stronger longer, we can be more confident that consumer spending will stay reasonably strong even if a more substantial slowdown in housing materializes. Scenarios in which more-moderate house price appreciation or some decline in housing prices leads to a sizable increase in the personal saving rate are probably less plausible or less troubling in an environment where consumers are more confident in the outlook for the economy or more confident in their future income growth. The productivity news, combined with continued moderation in the core inflation numbers and the moderation in measures of inflation expectations, make the inflation outlook somewhat more favorable. But against these factors there are others that justify some continued attention. Of course, overall inflation is still high, even though we expect it to moderate. Various measures of underlying inflation are still above what we would be comfortable with over time. There probably is still some energy cost pressure in the pipeline. And the TIPS-derived measures of inflation expectations over the medium term, if you adjust for the carry effect, have not really moved down that much. With compensation growth accelerating, we would expect eventually to see some upward pressure on labor December 13, 2005 52 of 100 surveys and anecdotal reports of pricing behavior, as we read them, suggest that businesses are able to pass on some share of their increased costs. So for these reasons, even with the additional tightening priced into the markets, we probably face some modest upside risk to our inflation forecast and to our objective, and we should continue to lean against this risk in what we do and what we say. We don’t see evidence yet to support a concern that the path of the nominal fed funds rate now priced into the markets risks going too far. Housing may be slowing a bit, but not really much. Other spending indicators look strong—probably stronger than we thought—and the strength is broader than it has been across the components of GDP. Expected real rates don’t suggest a high degree of concern, in our view. It’s just some concern, but not acute concern about the downside risk to future growth. If you try to take out expected inflation from forward rates, it looks as if real rates move up over the 2- to 5-year horizon. Equity prices, credit spreads, and the implied volatility of most asset prices don’t seem to suggest a lot of concern about significant deterioration ahead in the pace of the expansion. Although we don’t think the narrowing of the term spread itself or the low overall level of the yield curve offers clear guidance about monetary policy—clear guidance in terms of arguing for a softer or firmer stance than the other fundamentals might suggest—we’re somewhat more inclined to take the view that this change in the structure of term premia suggests we will have to do more than otherwise would have been the case. So all of this suggests to us that we should continue to tighten further and signal that we think we have still more to do." FOMC20050630meeting--321 319,MR. FERGUSON.," I’ll continue to plow that ground just for one minute. I’m struck a bit by the fact that the stories on the run-up in commodity prices and oil prices are all about China and India. You have a forecast here where China’s growth falls off fairly dramatically. Growth in the rest of the world I would describe as maybe more of a downside risk. You point out the uncertainty in Europe and Japan and you’ve even marked down economic growth in the United States. Yet your commodity prices tend to be rather flat. All this run-up was associated with China, India, and global growth. You have global growth dampening, but we don’t seem to recover much in the way of these commodity prices—oil being one, but others in general. I’m obviously missing something. What is it?" FOMC20080109confcall--19 17,MR. STOCKTON.," So, indeed, I think this combination of weaker economic growth and higher inflation is an unfortunate situation for you as policymakers. I do think there are some upside risks that you face on inflation, and the recent rise in oil prices probably intensifies those upside risks. We are taking some comfort from two other pieces of information in the constellation of the inflation data that the process isn't slipping away to the upside on inflation. One is, as Bill noted, that we haven't really seen any deterioration in the TIPS-based measures of inflation expectations. We have seen an uptick in the Reuters/Michigan survey of households in the last month or so, on both near-term and long-term inflation expectations. That does tend to happen in periods when gasoline prices are spiking up. I would hate to throw that observation out completely, but I guess as we look at this, we don't really see as yet convincing evidence that there has been a deterioration in inflation expectations. The other thing is that we haven't really seen anything in the way of serious deterioration on the labor cost side. So those two things combine, at least in my mind, not to eliminate but probably to limit some of the upside risks that you're facing on the inflation side. But, clearly, anecdotes are there--not just the data but also anecdotes--that suggest that businesses are facing some considerable cost pressures associated with higher energy and other commodity prices. " CHRG-110hhrg38392--89 Mr. Bernanke," Well, we think it remains a risk. It is important to understand that even should demand begin to stabilize--and it has shown signs at times of stabilizing--we have what you might call an ``inventory problem.'' That is, homebuilders have a large number of unsold homes. So, even if demand were to stabilize, homebuilders would have to continue to cut back on construction in order to eventually bring those inventories into line. So that would, of course, reduce economic activity. It might have some impact on the construction employment and so on. The related concern in terms of the downside risk is that, in order to clear out those inventories, we might start seeing falling prices, and for many people the equity in their homes is their major financial asset. So, the question is whether price declines, moderate price declines, have any significant impact on consumer spending? The evidence so far is that there really has been no spillover that we can see. We are certainly watching for any potential impact of changes in housing values on consumers and on their moods, attitudes, sentiments. It is part of what we are doing, and we are following that market very closely. " FOMC20051101meeting--227 225,MS. DANKER.," I’m reading the directive wording from page 24 of the Bluebook: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 4 percent.” And the assessment of risk, unchanged from the September statement, is: “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" CHRG-111shrg50815--120 M. AUSUBEL Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. There is no reason to expect that the new rules will result in the wholesale denial of access to credit cards for any group of consumers that currently has access to credit cards. As such, individuals who currently have access to credit cards are likely to continue to rely primarily on credit cards for their consumer finance needs. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. There is no reason to expect that consumers will have significantly less access to credit or fewer choices because of the Fed's new rule. The principal effect of the new rule will be to limit penalty pricing of credit card consumers, not to limit access to credit or consumer choices. Q.3. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.3. It should be observed that consumer protection, as furthered by the Dodd bill, will help to contribute to the prudency of loans. Consumers will better understand whether they will be able to repay loans, and they will be more likely to avoid loans that they understand they do not have the reasonable ability to repay. Lenders will be unable to rely on penalty interest rates following delinquency, so they will be more likely to avoid making loans that are destined to go delinquent. It is difficult to state an opinion on prudential regulation more generally, without being provided some specificity about the form of prudential regulation being proposed. Q.4. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? A.4. If it is the case that banks are raising interest rates and limiting credit arbitrarily, this is probably due primarily to the financial crisis and the economic downturn. Under normal circumstances, credit card lending is highly profitable and there is little reason for banks to reduce credit lines. Banks do raise interest rates, but usually not across the board, as this would result in the loss of some profitable customers. There is no reason to expect that the new rules will lead to cross-subsidization of any particular group of customers. Q.5. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.5. No. There is no reason to expect that the new rules will lead to cross-subsidization of any particular group of customers. The principal effect of the new rules will be to limit increases in credit card interest rates following late payments. As documented in my written testimony, the typical increases in interest rates bear no reasonable relation to default risk. The penalties imposed on consumers are typically at least double or triple the enhanced credit losses attributable to these consumers. The terminology of ``risk-based pricing'' for the regulated practices is a misnomer; it is more accurately viewed as ``penalty pricing.'' Under the new rules, banks will still be able to charge higher interest rates (upfront) to riskier customers. That is, true risk-based pricing will still be possible within the rules. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM TRAVIS CHRG-109hhrg28024--105 Mr. Royce," Thank you. May it be that the rise in home ownership and the rise in housing wealth that went along with it over the past several years has enabled many consumers to dip into savings from current income, and thus, maintain spending even in the face of these high energy prices, as there are some signs that housing demand is slow, which you mentioned in your testimony, and the rise in home prices clearly are leveling off or starting to dip, in your view, how big of a risk to consumer spending from what might occur, a rapid downward adjustment in home prices, and are there possible offsetting factors in terms of how this will play out in the economy? " FOMC20050630meeting--419 417,MS. DANKER.," I’ll be reading the directive from page 30 of the Bluebook and the balance of risk assessment from the draft statement: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 3¼ percent.” And for the statement: “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" FOMC20060920meeting--142 140,MR. KOHN.," Thank you, Mr. Chairman. Whatever you want to call me is fine. [Laughter] I’m just glad to be here. [Laughter] I don’t think I can follow that up. Given the initial conditions—the doubling and more of energy prices over the past two years, the overexuberant housing market coming to grips with a renormalization of interest rates, a very low personal saving rate, and an uncomfortable increase in inflation this spring—a period of modestly below-trend growth and gradually ebbing inflation, as in the Greenbook forecast, is about as good an outcome as we can expect, as Dave Stockton noted. In that regard, several developments over the intermeeting period have made me a bit more comfortable with the plausibility of such an outlook. The weakness in housing has deepened and is more definitively leading to growth of output below potential. In fact, in my view the behavior of the housing market constitutes the main downside risk to sustained moderate economic growth. We’re in the middle of a housing adjustment, which has been hard to forecast, especially because it involves the unwinding of an unknown amount of speculative demand. With inventories rising and reports of price cuts getting greater prominence, the market isn’t yet showing signs of clearing and stabilizing. In the Greenbook forecast, residential investment, though weak, is supported by continued growth of income and relatively low mortgage rates, while house prices basically level out in nominal terms. As the Greenbook notes, however, this forecast leaves some aspects of the existing disequilibrium intact, most notably the high level of prices relative to rents. Also, the cutback in construction doesn’t completely offset the apparent excess building of the boom period. As a consequence, I see the housing forecast in the Greenbook as very far from the worst-case scenario that President Minehan characterized it as. And, we are just beginning to see the effect of the downshift in house-price inflation on consumption starting to play out. Outside of housing, however, recent developments should help to sustain continued economic expansion. Financial conditions remain quite supportive of both business and household spending. Long-term interest rates have fallen appreciably since midyear, and they are low in both real and nominal terms. Risk spreads are narrow, banks have not pulled back on business credit, and equity prices have risen on balance in recent months. Lenders and investors appear to remain confident that the economy will continue to expand at a decent pace. Higher levels of labor income in the first half of the year, along with a favorable effect on disposable income of a decline in energy prices, will help support consumer spending going forward. Economies elsewhere seem to be expanding at a solid clip. Moreover, they are probably less vulnerable to spillovers from a housing-led slowdown of growth in the United States than they were to weakness in 2001. That weakness was centered in a global market for investment goods and was reflected in global declines in equity prices. The less robust economy should present businesses with a more competitive environment in which it will be harder to pass through cost increases. In addition, the decline in energy prices, along with the leveling out of other commodity prices, will reduce cost pressures on businesses and should feed through in some measure to lower core inflation, especially as slower growth damps pricing power. The drop in energy prices has already restrained inflation expectations a bit. For all these reasons, I’m also a little more comfortable with the forecast of gradually ebbing core inflation. Nonetheless, I still see significant upside risk to such a path for inflation. In part, this reflects my uncertainty as to the reasons for the rise in inflation this spring and summer. Feed- through of energy and other commodity prices must have contributed to some extent, and we can see evidence of this in the greater price increases for some of the more energy-intensive sectors, such as for airfares. A portion of the pickup is in the rent-of-shelter category, likely from a shift to rental housing as expectations of house-price appreciation have been scaled back. But price increases have picked up in a number of other categories, and although energy costs probably accounted for some of this acceleration, we can’t dismiss the possibility that other forces were at work—for example, more general pressure of demand on potential output. A reduction of those types of pressures is still only a forecast. On the cost side, as many have commented, the compensation and unit labor cost data, while flawed in many respects, could be pointing to a risk that higher labor costs will persist, putting pressure on prices that might only be partially and reluctantly absorbed by profit margins. In sum, Mr. Chairman, I’m a bit more comfortable with something like the path for the economy and inflation in the Greenbook forecast, but uncertainties are quite high. They might even justify the “higher than usual” description. The downward path for inflation remains at risk, and as others have noted, the costs of exceeding that path could be disproportionate. Thank you." FinancialCrisisReport--386 In late February, Goldman’s Operating Committee, a subcommittee of its Firmwide Risk Committee, became concerned about the size of the $10 billion net short position. The Firmwide Risk Committee was co-chaired by Mr. Viniar, and Messrs. Cohn and Blankfein regularly attended its meetings. 1560 The concern arose, in part, because the $10 billion net short position had dramatically increased the Mortgage Department’s Value-at-Risk or “VAR,” the primary measure Goldman used to compute its risk. The Committee ordered the Department to lock in its profits by “covering its shorts,” as explained above. The Mortgage Department complied by covering most, but not all, of the $10 billion net short and brought down its VAR. It then maintained a relatively lower risk profile from March through May 2007. Attempted Short Squeeze. In May 2007, the Mortgage Department’s Asset Backed Security (ABS) Trading Desk attempted a “short squeeze” of the CDS market that was intended to compel other market participants to sell their short positions at artificially low prices. 1561 Goldman’s ABS Desk was still in the process of covering the Mortgage Department’s shorts by offering CDS contracts in which Goldman took the long side. The ABS Desk devised a plan in which it would offer those CDS contracts to short parties at lower and lower prices, in an effort to drive down the overall market price of the shorts. As prices fell, Goldman’s expectation was that other short parties would begin to sell their short positions, in order to avoid having to sell at still lower prices. The ABS Desk planned to buy up those short positions at the artificially low prices it had caused, thereby rebuilding its own net short position at a lower cost. 1562 The ABS Desk initiated its plan, and during the same period Goldman customers protested the lower values assigned by Goldman to their short positions as out of line with the market. Despite the lower prices, the parties who already held short positions generally kept them and did not try to sell them. In June, after learning that two Bear Stearns hedge funds specializing in subprime mortgage assets might collapse, the ABS Desk abandoned its short squeeze effort and recommenced buying short positions at the prevailing market prices. The Big Short. In mid-June 2007, the two Bear Stearns hedge funds did collapse, triggering another steep decline in the value of subprime mortgage assets. In response, Goldman immediately went short again, to profit from the falling prices. Within two weeks, Goldman had massed a large number of CDS contracts shorting a variety of subprime mortgage assets. On 1558 3/10/2007 email to Daniel Sparks, “Mortgage Presentation to the board, ” GS M BS-E-013323395, Hearing Exhibit 4/27-17. 12/13/2006 Goldman email, “Subprime Mortgage Risk,” Hearing Exhibit 4/27-2. 1559 1560 8/23/2007 email from Tom Montag, “Current Outstanding Notional SN ames,” GS MBS-E-010621231. 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments, ” GS MBS-E-010135693-715 at 695). 1561 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Self-Review of Deeb Salem, GS-PSI-03157-80 at 72 (hereinafter “Salem 2007 Self-Review ”). 1562 Id. 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-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-111shrg50815--118 STURDEVANT Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. Did not respond by publication deadline. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. Did not respond by publication deadline. Q.3. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.3. Did not respond by publication deadline. Q.4. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? A.4. Did not respond by publication deadline. Q.5. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.5. Did not respond by publication deadline. Q.6. Transactional Users vs. Revolving Users: Mr. Zywicki has said in previous Congressional testimony that prior pricing mechanisms--which relied to a large degree on annual fees--forced transactional users of credit cards to subsidize the actions of consumers who carry revolving debts. I do not believe that the two categories should be treated in the same manner. The new regulations seem to limit the ability of lenders to use tools to distinguish between the borrowers characteristics. Do you believe that borrowers' rates and fees should be determined based on their own actions and not on those of others? Do you think that credit card offerings from the past, which had high APR's and annual fees for all customers were more consumer friendly than recent offerings that use other tools to determine fees and interest rates? A.6. Did not respond by publication deadline. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM TODD FOMC20080805meeting--12 10,MR. PLOSSER.," Thank you, Mr. Chairman. I want to follow up on that a little because it seems to me that, over a year ago now, there was a lot of discussion by various parties that had to do with risk premiums being very low. People were worried that the economy and the financial markets were underpricing risk. Now, all of a sudden, these spreads have increased. If you look at the OIS spread that you referred to, the one-to-two years out, is there a possibility that this is permanent--that in some sense the level of spreads in the pricing of the risk is just now higher and it is going to stay higher, maybe not as high as the peak but at some higher level? If that is true, then using those spreads as a measure of how distressed the market is could be very misleading. As a consequence, it would seem as though you would want to be asking questions not just about the prices and the spreads but also about volumes in these markets. Maybe, Bill, you can elaborate on what volumes are doing--certainly in the near-term, the overnight, and the one-month interbank funding markets? Are volumes back to their levels even though the spreads are higher? I think we have to be a little careful that, if this really is a permanent shift in risk premiums, looking at these things may be the wrong metric for assessing what is going on. If you have any observations about that, I would like to hear them. " FOMC20080625meeting--84 82,MS. PIANALTO.," Thank you, Mr. Chairman. The last two months have brought an interesting shift in my conversations with my business contacts. Their concerns have shifted from problems in financial markets to the rapid increase in input prices. Energy prices are the focus nationwide, but steel prices are also capturing the attention of the business people in my District. Several manufacturers and builders noted that the price they pay for steel has almost doubled since the beginning of this year. Clearly, businesses are worried about signs of growing price pressures, but their reactions to these price shocks tell a more complicated story. Many manufacturers have not been able to pass on price increases, resulting in a clear loss to profit margins. These businesses often report cost-containment or efficiency programs that will affect their hiring and capital decisions for months to come. Interestingly, the consumer price data show a similar dichotomy. My staff noted that our primary measures of core inflation are not providing a consistent story about the path of underlying inflation. In the May CPI report, roughly one-third of the weighted price changes increased at rates above 5 percent, and roughly one-third of prices changed by rates less than 1 percent. For example, while energy costs were up strongly and prices for a number of general service components have been drifting higher, large declines in apparel and vehicle expenses are imparting significant offsets. The 16 percent trimmed mean indicator showed an alarming 4 percent rise in prices, while the median rose just at 2.2 percent. The weight of price changes in the 1 percent to 5 percent range was unusually small, making it difficult to estimate the central tendency of the price change distribution with much confidence. So this makes it difficult to get a good read on where future prices are headed. My District business contacts remain pessimistic about growth prospects. District retail reports focused extensively on the likely effects of gasoline and food prices on the purchasing decisions of consumers. Many manufacturers, builders, and distributors are facing complicated output and investment decisions in the context of input price growth and weaker markets. Overall, most of the business people that I talk with are still quite cautious about their business plans, despite the fact that most of them have found sources of credit and terms that are not too elevated from what they have seen in previous years. In the economic projections that I submitted for this meeting, I raised my near-term forecast for output growth slightly and for headline inflation slightly more. Over the medium term, my outlook continues to be for modest growth because the housing market, in my forecast, recovers slowly, actually more slowly than in the Greenbook. My staff estimated a model for national housing starts that takes into account what has happened in the past in states that have seen major increases in foreclosures. The real estate difficulties that these states faced were much more persistent than anything that we have yet seen in the national data. The bottom line of this analysis is that, if the patterns of past housing cycles from the states that experienced the boom�bust cycles are repeated at the national level, then housing starts should remain relatively weak over the next couple of years. Supporting this analysis, three of the large regional banking organizations in my District are increasing their loan-loss provisions significantly in the second quarter based on the continued deterioration in the housing sector. Based on current projections, these institutions are projecting housing sector credit losses to accelerate in the second half of 2008 and to continue into 2009. Currently, the weak output growth contributes to my forecast of declining inflation rates, especially the core rate, but I also see evidence supporting that view in the ""less worker bargaining power"" scenario that is in the Greenbook. My contacts see very little price pressures coming from labor costs now or in the near future. Finally, implicit in my forecast for output growth and inflation is a fed funds rate path that includes increases later this year and into next year. Although additional risks to growth remain, the primary risk to my forecast concerns input prices and inflation expectations. If commodity prices continue to accelerate, they are going to put upward pressure on both headline and core inflation and downward pressure on output. That environment could lead to a highly undesirable increase in inflation expectations. On the positive side of risk to the outlook, I think that the fed funds rate actions that we have taken, in conjunction with the actions that we took in August to bolster market liquidity, have improved confidence, and I have substantially lowered the odds I had placed on financial market meltdown and on a severe recession. In that sense, since our meeting in April the downside risks to my outlook for economic growth have lessened somewhat, and the risks to my inflation outlook have moved up somewhat. Regarding the issue of providing longer-term forecasts, I have long supported efforts to clarify the underlying objectives of FOMC participants by providing our longer-term economic projections. Of the proposals that were offered by the Subcommittee on Communications, I favor reporting the average values for output growth, unemployment, and total inflation expected over a five-to-ten-year period--option 3. The features of these five-to-ten-year projections that I find attractive are that they indicate where the economy might converge and don't imply too much knowledge of the path to the long run. Thank you, Mr. Chairman. " CHRG-111shrg57923--32 Mr. Engle," Well, I think what I was going to say before is also related to this. The systemic regulator is going to have to use the incentives in the marketplace to achieve his goals. He is not going to be able to just legislate one thing or another, and our use of capital standards, capital controls, are ways of trying to nudge the institutions to take less risk or change their behavior in one way or another. Systemic taxes are very much designed to encourage institutions who have systemic risk to avoid the taxes by shedding the systemic risk if you can define and devise the systemic tax in exactly that way. The reason I think that making data public is useful is quite easily seen in the OTC derivatives market, where every time you enter a contract, you have a counterparty. And this counterparty has a risk that they will not perform. If the derivative turns out to have the value you want it to, then your counterparty may not perform. So we have to consider there being these extra risks, and it is very hard to assess the risk that your counterparty is going to be there if you don't know very much about what the counterparty is doing. So if we had more information on the health of counterparties, in other words, how much exposure they had to these same kinds of contracts, then the prices of the same deal with two different counterparties might not be the same. There would be a risk premium and you could decide whether you wanted to take the weak counterparty or the strong counterparty and you would get a different price in those contracts. That way, you would understand what risks you were taking and the weak counterparties would not be able to amass big positions. The poster child for this example is AIG, who, of course, wrote lots of credit default swaps but didn't have enough capital behind it, and investment bankers and final users bought a great deal of these contracts and insurance products without recognizing that actually they should have gotten a big discount on getting them because they weren't really so likely to pay off because AIG had such a big position. So if you could make public information on a basis which said, for each counterparty, how exposed is this counterparty--how many positions does this counterparty have maybe a week ago on these kinds of contracts? This would give the market a way of evaluating the risk that they were taking with each counterparty. I think it would also encourage trades to move toward exchanges or centralized counterparty where you might not have to produce this information. So I think that the transparency has a dual role in this case. It would encourage the migration of products to centralized clearing, which is something that we think would reduce systemic risk, and it would allow investors to understand the risks and price the risks they are taking better and thereby both of these would reduce systemic risk. Senator Corker. Professor Liechty, I have two more questions. Senator Reed. Go right ahead. Senator Corker. Professor Liechty, how long would it take--you know, we talked a little bit about this in the office, but let us say something like this became law in the summer of 2010. How long would it take before an entity like this was at least providing some of the basic information, not data, but information that would be useful to someone who is looking at systemic risk or other prudential regulators? " CHRG-111shrg50815--117 CLAYTON Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. It is likely that consumers perceived to have higher levels of risk--including those that are new to credit--will bear the brunt of credit reductions resulting from the rule. Thus, as noted in your question, the inability to price risk effectively may well mean less access to credit for very deserving individuals just because card issuers are unsure of the credit risk involved and will not be able to price for that risk as it becomes more apparent. As the credit needs of these individuals are unlikely to disappear--and, in fact, may actually increase due to exigent economic circumstances, e.g., unemployment--these consumers will likely be forced to turn to non-federally regulated lenders including payday lenders and loan sharks. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. The new rule will affect every aspect of the credit card business, from how cards are funded, to how they are priced, to how they are marketed, and to how credit is allocated among customers of differing credit histories and risk. Because the rules are so strong, card lenders may have to increase interest rates in general, lower credit lines, assess more annual fees, and reduce credit options for some customers. The full impact of these changes will likely not be fully known for several years as business practices are changed and as the credit availability works its way through the economy. The new rule may also lead to higher interest rates or fees (such as annual fees) for all cardholders in order to compensate for the inability to price risk effectively. Thus, the least risky borrowers must now bear the cost for higher risk borrowers because the higher-risk borrowers will no longer bear the full cost of the exposure they pose to lenders. It may also be the case that payment allocation requirements will lead to the elimination of low-rate balance transfers that consumers and small businesses previously used to lower overall debt costs. Simply put, the sum total of all these rules will likely lead to reduced access to credit and higher prices to all consumers, in addition to many fewer choices on card products. We do not believe this is a desirable outcome for both consumers and the broader economy. Q.3. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.3. A system linking bank regulation and consumer protection forces more balanced supervision without the turf battles and inefficiency inherent in bifurcated jurisdiction. The two are highly integrated, and that one aspect cannot and should not be divorced from the other. This ensures that, for example, safe and sound lending would not be compromised by fee and rate restrictions envisioned by a consumer regulator only concerned with driving consumer costs down unencumbered by a need to consider the impact such restrictions may have on adequate return. Q.4. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? A.4. The rising interest rates and limitations on credit are due primarily to three factors. First, in the present challenging economic time, lenders are being more careful. Delinquencies on credit card accounts have significantly increased as a result of rising unemployment and uncertainty in the economy. This substantial increase in repayment risk affects the ability of lenders to make new loans, and requires companies to carefully evaluate and minimize their risk across the board so that they may stay in business and continue to make new loans. Second, funding costs have increased dramatically in the secondary market, which funds nearly half (or approximately $450 billion) of all credit card loans made by commercial banks. Investors are extremely sensitive to changes in the terms and conditions of the underlying asset, as has been evident in the current market, where investors have shunned nearly all forms of asset-backed securities over fears in the underlying economy. This drives up the cost of funding new credit, and leads to higher costs to consumers. Third, all businesses are concerned for the future, as borrowers' ability to repay may become severely compromised. This is particularly true with respect to credit card loans, which are open-end lines of credit, unsecured and greatly subject to changing risk profiles of borrowers. Banks need to ensure they will be paid for the risks they have taken in credit card loans; otherwise they will not be able to continue to make loans. As a result, many institutions must raise rates and reduce risk exposure in order to continue to lend. This results in all borrowers having to bear the cost of higher risk generally, a trend that will be exacerbated by the new regulations that limit the ability of lenders to price particular individuals for the risk they pose. Q.5. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.5. Reducing the ability of lenders to manage risk forces them to apply more general models to all account holders. The consequence of applying general models is that all account holders pay somewhat equally. Lower-risk borrowers at all income levels bear the brunt of this burden. Q.6. Role of Securitization: It is my understanding that during the height of the credit boom nearly half of all credit card debt outstanding was held in securitization trusts. Over the last 18 months much of the securitization market has been severely constrained. The Federal Reserve wants to revive the securitization markets through the Term Asset Lending Facility (TALF), but it is not yet operational. How important is a rebound in the securitization market to the availability of consumer credit? In other words, how much greater will the contraction be in the credit card space without securitization? A.6. The rebound in the securitization market is a critical component to the availability of credit in our economy. Credit cards are funded from two primary sources: deposits and secondary market funding, each accounting for about half--approximately $0.5 trillion dollars--of the total funding of card loans to consumers. Funding in the secondary market relies on investors' willingness to hold securities that are backed by credit card receivables. Any change in the terms of issuance can greatly impact the receptivity of investors to holding these securities. If investors perceive that there is greater risk, they are less likely to hold these securities, or may require significantly higher interest rates or other enhancements to compensate them for the risk. This means that less funding will be available, and if available, more costly. This translates into less credit available at higher cost to customers. It is hard to speculate as to the extent of greater contraction caused by a non-functioning securitization market, as lenders will have to turn to a limited number of alternative--and higher priced--funding mechanisms. However, we do believe the additional contraction would be very significant, and is reflected in the Administration's concern over this important aspect of the marketplace. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM JAMES C. FOMC20081216meeting--470 468,MR. KOHN.," A comment and a question. One comment, to follow up on your comment, Mr. Chairman, to President Lacker--I think there's pretty good evidence that there are liquidity strains in the market, beyond just credit strains, impinging on the price of these securities. One piece of evidence I would cite is the difference between on-the-run and the off-the-run Treasury security rates, which have gapped out by 40 or 50 basis points even from--well, I'm not even sure where they are relative to '98, but I think they're at record levels. The unwillingness of people--by ""people"" I mean market makers--to take positions and to do trades--their caution--is affecting the pricing of all kinds of securities well beyond the credit risk, and obviously there's no difference in the credit risk in on-the-run and off-the-run Treasury securities. " FOMC20080430meeting--87 85,MR. EVANS.," Thank you, Mr. Chairman. I was pleasantly surprised that we have not had any major downside surprises since our March 18 meeting. So while I still recognize the economy's downside risks, I've become less comfortable about signing onto the Greenbook's judgment that a nonlinear step-down in activity currently is in train. On balance, our projection still looks for weakness in the near term and then has growth picking up as we move through 2008 and into 2009. We see a noticeable output gap opening this year but not one as large as in the Greenbook. Under this forecast, it is possible that some portion of 2008 might eventually be labeled a recession, but it is not yet conclusive that it will be. Indeed, given the highly unexpected development that events have proceeded as expected, I think the downside risks to growth have abated some. Some of the stress in financial markets has been mitigated by our new lending policies as well as actions by banks in recognizing losses and raising capital. Neither the incoming data nor the reports from my business contacts seem to be consistent with the bleak downside scenarios that I feared might transpire after we saw the December employment report early this year. In this regard, I will simply note a couple of observations from my contacts. A national shopping mall developer reported that his tenants experienced a small improvement in April retail sales compared with March. He was not expecting that. Similarly, Manpower indicated a small improvement in billable hours for temporary workers over the past month and a half, also unexpected. Now, I am not saying that I will be surprised if the outlook deteriorates further. I am saying that the likelihood of that event seems to be smaller today than I expected at our last two meetings. Accordingly, I think that current real interest rates are appropriately accommodative relative to the baseline forecast for economic growth and the risk to that outlook. As seen in chart 6 of the Bluebook, the real funds rate is essentially zero. Of course, this uses a core PCE measure of inflation and thus may overstate the true real rate since headline inflation has been consistently running above this core measure. There is the additional accommodation that is being provided by the range of new lending facilities we had put in place. The extra accommodation is appropriate to offset the large degree of restraint still being exerted from financial markets, and our expansion of the swap lines and the TAF adds to this accommodation. Furthermore, in the event of a nonlinear step-down in economic activity, as in the Greenbook forecast, our policy responses can be adjusted appropriately because we're well positioned now for that. On the price side, on balance, the recent news has been good. My forecast has core PCE inflation falling to just under 2 percent in 2010 largely because of the increasing resource slack in the economy. However, I think there are substantial upside risks to this outlook. All of my business contacts have noted how high and rising energy and commodity prices are creating cost pressures that many are passing on to their customers. As Dave Stockton mentioned, with his inflation catechism, without reviewing the past transcripts I will speculate that we have been projecting a leveling-out of energy prices since the price of oil was $70 a barrel. Weak domestic demand may limit the degree to which producers can pass through these higher costs, but it is unlikely to prevent noticeable increases in some downstream prices. The depreciation of the dollar also imposes risks even beyond the effects operating through the commodity price channel. Now, I do agree that labor costs have not been cited as a problem for inflationary pressures, and so that does add somewhat to trimming out the risks there. Inflation expectations were also an issue. No matter how often we say that core inflation is a more reliable measure of underlying inflationary tendencies, I find it difficult to believe that the public's inflationary expectations will not be affected by large and persistent increases in food and energy prices. The past five years have been unkind on this score. On average over this time, higher food and energy prices have pushed total inflation above core about � percentage point, and it is also sizable over the past ten years. Another challenge for inflationary expectations comes from our policy focus on the downside risks to growth during a time of rising headline inflation. Rightly or not, this could make the public question our attitudes toward inflation. We are accepting considerable inflationary risks when we hope that these concerns will disappear quickly with future adjustments to policy that have not yet been signaled. How we balance these conflicting risks should be an important component of our discussion tomorrow. Thank you, Mr. Chairman. " 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? " FOMC20050809meeting--218 216,MS. DANKER.," I’ll be reading the directive and the risk assessment from page 23 of the Bluebook: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 3½ percent.” The risk assessment portion reads: “The Committee perceives that with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill August 9, 2005 94 of 110" CHRG-110shrg50369--58 Mr. Bernanke," As you say, if it becomes entrenched, if inflation expectations were to rise and that were to lead to a wage-price spiral, for example, or, non-energy, non-food prices rising more quickly, that would be more of a concern. As I said, we are concerned. I do not wish to convey in any way that we are not concerned about it. We are trying to balance a number of different risks against each other. With respect to inflation, as I said, our anticipation is that inflation will come down this year and be close to price stability this year and next year. If it does not, then what we will be watching particularly carefully is whether or not inflation expectations or non-energy, non-food prices are beginning to show evidence of entrenchment, of higher inflation, as you point out. That would certainly be of significant concern to us and one that we are watching very carefully. Senator Menendez. Let me ask you, with consumers reluctant to spend and businesses reluctant to invest and lenders reluctant to lend and home prices going downwards, is the lower interest rates, do you believe, going to be enough to do the trick? " FinancialCrisisReport--67 Mr. Schneider told the Subcommittee that the numbers listed on the chart were not projections, but the numbers generated from actual, historical loan data. 172 As the chart makes clear, the least profitable loans for WaMu were government backed and fixed rate loans. Those loans were typically purchased by the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac which paid relatively low prices for them. Instead of focusing on those low margin loans, WaMu’s management looked to make profits elsewhere, and elected to focus on the most profitable loans, which were the Option ARM, home equity, and subprime loans. In 2005, subprime loans, with 150 basis points, were eight times more profitable than a fixed rate loan at 19 basis points and more than 10 times as profitable as government backed loans. The gain on sale data WaMu collected drove not only WaMu’s decision to focus on higher risk home loans, but also how the bank priced those loans for borrowers. In determining how much it would charge for a loan, the bank calculated first what price the loan would obtain on Wall Street. As Mr. Beck explained in his testimony before the Subcommittee: “Because WaMu’s capital markets organization was engaged in the secondary mortgage market, it had ready access to information regarding how the market priced loan products. Therefore my team helped determine the initial prices at which WaMu could offer loans by beginning with the applicable market prices for private or agency-backed mortgage securities and adding the various costs WaMu incurred in the origination, sale, and servicing of home loans.” 173 (5) Acknowledging Unsustainable Housing Price Increases In 2004, before WaMu implemented its High Risk Lending Strategy, the Chief Risk Officer Jim Vanasek expressed internally concern about the unsustainable rise in housing prices, loosening lending standards, and the possible consequences. On September 2, 2004, just months before the formal presentation of the High Risk Lending Strategy to the Board of Directors, Mr. Vanasek circulated a prescient memorandum to WaMu’s mortgage underwriting and appraisal staff, warning of a bubble in housing prices and encouraging tighter underwriting. The memorandum also captured a sense of the turmoil and pressure at WaMu. Under the subject heading, “Perspective,” Mr. Vanasek wrote: “I want to share just a few thoughts with all of you as we begin the month of September. Clearly you have gone through a difficult period of time with all of the changes in the mortgage area of the bank. Staff cuts and recent defections have only added to the stress. Mark Hillis [a Senior Risk Officer] and I are painfully aware of the toll that this has taken on some of you and have felt it is important to tell you that we recognize it has been and continues to be difficult. 172 Subcommittee interview of David Schneider (2/16/2010). 173 April 13, 2010 Subcommittee Hearing at 53. “In the midst of all this change and stress, patience is growing thin. We understand that. We also know that loan originators are pushing very hard for deals. But we need to put all of this in perspective. “At this point in the mortgage cycle with prices having increased far beyond the rate of increase in personal incomes, there clearly comes a time when prices must slow down or perhaps even decline. There have been so many warnings of a Housing Bubble that we all tend now to ignore them because thus far it has not happened. I am not in the business of forecasting, but I have a healthy respect for the underlying data which says ultimately this environment is no longer sustainable. Therefore I would conclude that now is not the time to be pushing appraisal values. If anything we should be a bit more conservative across the board. Kerry Killinger and Bill Longbrake [a Vice Chair of WaMu] have both expressed renewed concern over this issue. “This is a point where we should be much more careful about exceptions. It is highly questionable as to how strong this economy may be; there is clearly no consensus on Wall Street. If the economy stalls, the combination of low FICOs, high LTVs and inordinate numbers of exceptions will come back to haunt us.” 174 FOMC20061025meeting--191 189,MR. HOENIG.," Thank you, Mr. Chairman. My preference also is to maintain the rate at 5¼ percent. For the near-term outlook, I think an important recent development that has been noted is the decline in energy prices. As I said yesterday, lower energy prices do help cushion the effects of the housing slowdown, and they do reduce the downside risk to growth over the near term. At the same time, by lowering headline inflation, I think they help contain some of the inflationary expectations. So if that rate is maintained, I think we will, in fact, contribute to lower core inflation. By reducing both the downside risk to growth and the upside risk to inflation, the decline in energy prices makes it more likely that we can continue to maintain the fed funds rate at what I’ve described as its current moderately restrictive level until core inflation returns to more a acceptable level. At the same time, I continue to believe that the upside risk to inflation does remain. The recent monthly pattern in core inflation, while encouraging, does not firmly establish a downward trajectory, which I think is very important to establish. Consequently, I would be prepared to leave the fed funds rate at that level and have it naturally firm as mentioned by others, and I would support additional tightening should inflation reverse course. Let me very briefly talk about the statement. While downside risks to growth remain, I would not want to convey to the markets the impression that any near-term easing of policy is likely at all. As markets have only recently understood the message in the last press statement, I believe we can best accomplish this by updating the rationale section using the wording suggested in alternative B, section 2. I’m comfortable with the word “moderate.” I think Vince gave a good definition of it—at or slightly less than potential. I don’t think that word would be harmful at all. But then I would go alternative A for section 3, and I would maintain the wording of the assessment of risk that was used last time. I would not be in favor of modifying the language of the risk assessment in an attempt to get the markets to alter their current views of the expected policy path. Thank you." FOMC20080318meeting--101 99,CHAIRMAN BERNANKE.," Thank you very much. Thank you for all of your comments. Let me just briefly summarize and add a few points. To summarize the discussion, incoming data have been weak, and some view the economy as having entered recession. Housing demand and construction have continued to decline sharply, and house-price declines have been somewhat greater than expected. Housing weakness has implications for employment, for consumer spending, and for credit conditions. It also leads to 21 miles of empty boxcars. [Laughter] Financial conditions have worsened considerably, reflecting weakness in housing prices, and credit markets in particular are highly stressed and illiquid. Wider spreads have offset some or all of the decline in safe rates for many credit products, and credit conditions are tighter for most borrowers. Financial conditions are likely to be a significant drag on economic growth. Some noted the risk that continued financial turmoil could lead to a more serious and prolonged recession, implying possibly large downside risk to growth. With respect to households, consumption growth has flattened out, and there was generally greater pessimism about the labor market and economic prospects. Consumer credit quality may be worsening. Payroll employment growth has turned negative. There was little expectation expressed of strong help from the fiscal stimulus package. Firms are generally more pessimistic and cautious but also remain concerned about cost pressures. Inventories look to be in balance. Exports continue to be an important source of final demand and will continue to contribute significantly to growth, although it's possible that growth abroad may slow. Readings on core inflation have been mixed. Increases in energy and commodity prices are important sources of increased headline inflation, and some producers have adopted a cost-plus mentality. Agricultural prices, in particular, are up a good bit. Inflation breakevens are up somewhat, especially at the five-by-five horizon. The dollar has depreciated, potentially adding to longer-term inflation pressures and adding some risks. However, nominal wage increases are moderate, as are unit labor costs, and U.S. and global economic weakness could moderate gains in commodity prices and create domestic economic slack. Several members warned about the risk of losing inflation credibility. Any comments, thoughts? Let me make just a few comments. Again, I'm very sympathetic to what almost everyone has said around the table, in particular the fact that we're facing a three-front war, if you will, which makes this extraordinarily difficult and delicate. I thought in January that we were in recession. That was my view at that time, and I certainly believe it now. The Greenbook has done a good job of trying to factor in the data and the other types of evidence. I think I'm actually slightly darker on growth than the Greenbook is. The reason is that I don't see where the recovery is coming from in the beginning of next year. In particular, we won't have a recovery until financial markets stabilize, and the financial markets won't stabilize until house prices stabilize, and there is simply no particular reason to choose a time for that to happen. So I do think that the downside risks are quite significant and that this so-called adverse feedback loop is currently in full play. At some point, of course, either things will stabilize or there will be some kind of massive governmental intervention, but I just don't have much confidence about the timing of that. I would like to say a word. I would just agree with Governor Mishkin about the efficacy of our policy. I think that it has had an effect and it has been beneficial. We obviously affect shortterm rates, including commercial paper rates and the like, which have implications for financing and for borrowing. We affect the dollar, which has mixed effects, but on the growth side has some positive effects. It's true, as President Fisher pointed out, that medium-term and long-term rates have not fallen because lower Treasury rates have been offset by higher spreads, but again, the question is the counterfactual. Where would we be if we had not lowered rates? I think that lower rates have both lowered safe rates and offset to some extent the rising concerns about solvency, which have caused the credit spreads to widen. I think this argument can go either way. You can say that our policy is less effective and, therefore, we should do more of it. So there are two ways of looking at that. In addition, there may be some benefits for capital formation of low financing rates and a steep yield curve in keeping bank share prices from entirely collapsing. On inflation, I agree with much of what's been said, and I'm very concerned about it. Let me make one simple point, though, which I don't think has been adequately discussed. Ninety-five percent of the inflation that we're seeing is either the direct or the indirect effect of globally traded commodity prices--food, energy, and other commodities. What is happening is that there is a change in the relative price of, say, oil and the wage of an Ohio manufacturing worker. There's a relative price change going on. That has to happen one way or the other. It can happen either by overall increases in the nominal price of oil, which are reflected in overall increases in headline CPI inflation, or by lower or negative growth in nominal wages. Now, if we have temporary movements in these relative prices, I think all the theory tells us that the best way to let that relative price change happen is to let the shock feed through; let the prices of energy, commodities, and so on rise; accept a temporary increase in headline inflation; and focus on making sure that the increase in headline inflation doesn't feed through into domestic core inflation, say, through wages or domestic prices. A good response to that is, well, we've had a lot of ""temporary"" shocks here and they have gone on for a long time. That's certainly true. But again, it was very difficult to anticipate how these prices have moved. Looking forward, the futures markets have been wrong and wrong, but they are the best we have. In my view, if we think about the likely slowdown in the U.S. economy and the global economy, there are going to be some forces that will prevent commodity prices from continuing to rise the way they have been rising, which ought to take the pressure off the inflation process. That being said, I fully recognize that there has been a bit of movement in some of the indicators. I think I like the use of the index measure. It uses lots of different indicators. I don't think we should overemphasize inflation compensation. For example, the one-year inflation compensation three and four years out has moved up less than the five-by-five, and I think for good reasons. The five-byfive could reflect, again, general uncertainty. It could also reflect more volatility in the relative price changes of oil, for example. If we think there's more volatility in that, if it's up or down, that would create more uncertainty about headline inflation and would feed through into that spread. Frankly, in thinking about inflation, I am concerned about inflation expectations and the general psychology. I'm hopeful at least that it will moderate as commodity prices moderate although, of course, no one can know for sure. I agree with Governor Warsh that, from a financial perspective on the inflation side, the greater dangers are in the currency area. Exchange rates are very poorly tied down by fundamentals, except over very long periods of time--I think Ken Rogoff had a paper in which he said that over maybe 600 years or so the PPP finally works. [Laughter] So a lot of psychology is there. I think that it is an important issue. We need to think about what the Treasury will say and those sorts of things. That is a concern, and I consider that in some sense a greater risk at this point. So there are risks on both sides. I think that the downside risks, including the financial risks, at this point are greater--not to belittle inflation risks, which I think are quite significant. We are obviously going to have to make tradeoffs about how to deal with these. Using both our policy tools and our communication is very important. I agree with Vice Chairman Geithner that we need and I need--and I have a very important role here--to maintain clarity in communication about our attention to inflation, that we are not ignoring that side of the mandate. Finally, let me just say, as I said last night at the dinner with the presidents, that I think we are getting to the point where the Federal Reserve's tools, both its liquidity tools and its interest rate tools, are not by themselves sufficient to resolve our troubles. More help, more activity, from the Congress and the Administration to address housing issues, for example, would be desirable. We are certainly working on those issues here at the Board, and I will be talking to people in Washington about what might be done to try to address more fundamentally these issues of the housing market and the financial markets. So those are my comments. Why don't we turn now to Brian for an introduction to the policy round. " FOMC20080318meeting--86 84,MR. KOHN.," Thank you Mr. Chairman. I agree with the others around the table who have said that the prospects for economic activity have taken another sizable leg down over the intermeeting period. I think we have been, for a time, in that adverse feedback loop between financial markets and spending that everybody--Governor Mishkin and others--has been talking about. That is not an unusual kind of loop to be in during a soft economic period. I think it is probably characteristic of a lot of slow growth and recessionary periods. But certainly it has been more intense this time because the financial turmoil has spread well beyond housing and has intensified significantly over the intermeeting period. The incoming data on spending, employment, and production were weaker than expected. House prices are moving lower by more than we or the markets expected. All of these data have accentuated concerns about the creditworthiness of households and businesses and, hence, about the creditworthiness of the people who lend to them, especially those who lend in the mortgage market. As perceptions of risk and risk aversion rose, there was a flight to safety and liquidity. I think we see that a little in the growth of M2 over the past couple of months, which has been very, very strong and suggests that households are retreating to money market funds, probably the ones that hold government securities, and to insured deposits. In wholesale markets there has been unwillingness to take positions and rising concerns about an array of intermediaries. Bill described this process much better than I could--illiquid markets, extreme volatility, deleveraging, margin calls, forced sales, especially in mortgage-backed securities, wider spreads, equity prices falling, and lending and funding tenors collapsing toward the overnight, again. So financial conditions have tightened for everybody but the government--and some of the European governments have seen them tighten, I guess. Mortgage rates have risen, and business bond yields have risen as well, even with Treasury rates going down. Tighter credit and declining equity and house prices are reducing wealth, and all of this weakens spending further. Now, to this process, the staff has judged that the economy has entered a recessionary state in which we can expect household and business spending to fall short of normal levels, given income and interest rates. I am not sure how much weight to put on this. I am a bit uncomfortable with constructs that don't have a clear story behind them. But I must say that, looking at the sentiment indicators and listening to what I have heard around the table today from almost every Federal Reserve District reporting, I now put more credence in Dave's recessionary state than I did before the meeting started. Obviously, something is going on that is undermining confidence and making people much more cautious than you would think, given the exogenous variables. I do think talking about the recessionary state underlines the extraordinary uncertainty we are dealing with. President Stern pointed out the 1990-91 precedent. There are some precedents for some aspects of this, but we don't have many; and I think it is really difficult to know how financial markets will evolve and how that will feed through to the variables that affect household and business spending--the reaction of households, businesses, and state and local governments to tighter credit conditions. I agree with President Stern, President Evans, and others who said they thought that the financial stresses are deeper and will last longer than we thought and will, therefore, put more restraint on spending. Until markets stabilize on a sustained basis, the risk to satisfactory economic performance by the U.S. economy will remain skewed very much to the downside. Now, Federal Reserve liquidity tools that we have used are necessary to reduce the odds on even more-intense, downward-spiral crises and market liquidity feeding back onto spending. So I think our innovations here have been useful to reduce the downside risks a little and thereby to promote spending. But I agree with the others who say that they don't directly deal with the underlying macro risk, which is really a story about capital, solvency, wealth, and prices. I think monetary policy easing is a necessary aspect of addressing these macroeconomic risks. I agree with President Fisher, President Plosser, and others that there is more going on and that monetary policy easing may not be a sufficient way of addressing these risks. But I do think, as long as the economy is weakening the way it is and we have these risks, that easing monetary policy will be helpful. It will help bolster asset prices. It will make the cost of capital lower than it otherwise would be. It may not be sufficient to turn the thing around, but I do think that without the easing that we have done-- and that I hope that we do today--the situation would be far worse than it otherwise would be. We need to ease to compensate for the substantial headwinds that we are facing. Now, the forecast for inflation has not been marked down despite the greater output gap. As others have remarked, this output gap is offset, to a considerable extent, by the upward pressure on prices from oil and commodities and import prices as the dollar has fallen and prices have risen in our exporting partners--China, for example. I have to confess that I don't really understand what has been happening to commodity prices in recent months. I don't think the rise has been justified by the news on the underlying conditions of supply and demand. It is much larger than the dollar weakness has been, and the dollar�commodity price has always been a weak relationship. So, in fact, commodity prices are rising in a bunch of currencies. This isn't just a dollar weakness problem. I have to believe that there is a speculative element here. Partly as a consequence, I am comfortable with the forecast of a flattening commodity price picture in the future--it might even decline, but at least a flattening out. I do think a shift from financial assets, especially dollar assets, into commodities is going on, and mostly this has been triggered by concerns about the U.S. economy and financial markets. In some sense, that shift is okay. It is driving down the dollar, and that is helping to stabilize the economy. The decline that we saw in oil prices yesterday suggests that, when people get more confidence about where those financial markets are going, some of those commodity prices will actually fall as the concerns about the U.S. economy are alleviated. It is sort of an upside-down relationship, but I do think we saw a bit of it that way. But I also sense that some of the rise in commodity prices and the fall in the dollar reflects concerns about the inflation outlook here. It is not surprising to me, in a very volatile and uncertain environment, that inflation expectations are not as well anchored and that they fluctuate a lot in response to new information. I expect that inflation will come down as commodity prices level off; then the output gap will increase, and that in turn will keep inflation expectations down. Still, navigating this appreciably weaker economic outlook for the real economy and the threats to financial stability, on the one hand, and the tenderness of inflation expectations, on the other, will require some discussion in the next section of our meeting, Mr. Chairman. " FOMC20060510meeting--5 3,MR. KOS.," Well, as somebody said in another setting just the other day, risk premiums are something we don’t know a lot about, and they are difficult to disentangle. I haven’t done the exercise, but with energy prices rising, I don’t know that the carry effects have been huge." fcic_final_report_full--430 China and other Asian economies grew, their savings grew as well. In addition, boosted by high global oil prices, the largest oil-producing nations built up large cap- ital surpluses and looked to invest in the United States and Europe. Massive amounts of inexpensive capital flowed into the United States, making borrowing inexpensive. Americans used the cheap credit to make riskier investments than in the past. The same dynamic was at work in Europe. Germany saved, and its capital flowed to Ire- land, Italy, Spain and Portugal. Fed Chairman Ben Bernanke describes the strong relationship between financial account surplus growth (the mirror of current account deficit growth) and house price appreciation: “Countries in which current accounts worsened and capital in- flows rose . . . had greater house price appreciation [from  to ] . . . The rela- tionship is highly significant, both statistically and economically, and about  percent of the variability in house price appreciation across countries is explained.”  Global imbalances are an essential cause of the crisis and the most important macroeconomic explanation. Steady and large increases in capital inflows into the U.S. and European economies encouraged significant increases in domestic lending, especially in high-risk mortgages. The repricing of risk Low-cost capital can but does not necessarily have to lead to an increase in risky in- vestments. Increased capital flows to the United States and Europe cannot alone ex- plain the credit bubble. We still don’t know whether the credit bubble was the result of rational or irra- tional behavior. Investors may have been rational—their preferences may have changed, making them willing to accept lower returns for high-risk investments. They may have collectively been irrational—they may have adopted a bubble mental- ity and assumed that, while they were paying a higher price for risky assets, they could resell them later for even more. Or they may have mistakenly assumed that the world had gotten safer and that the risk of bad outcomes (especially in U.S. housing markets) had declined. For some combination of these reasons, over a period of many years leading up to the crisis, investors grew willing to pay more for risky assets. When the housing bub- ble burst and the financial shock hit, investors everywhere reassessed what return they would demand for a risky investment, and therefore what price they were willing to pay for a risky asset. Credit spreads for all types of risk around the world increased suddenly and sharply, and the prices of risky assets plummeted. This was most evident in but not limited to the U.S. market for financial assets backed by high-risk, nontradi- tional mortgages. The credit bubble burst and caused tremendous damage. Monetary policy The Federal Reserve significantly affects the availability and price of capital. This leads some to argue that the Fed contributed to the increased demand for risky in- vestments by keeping interest rates too low for too long. Critics of Fed policy argue that, beginning under Chairman Greenspan and continuing under Chairman Bernanke, the Fed kept rates too low for too long and created a bubble in housing. Dr. John B. Taylor is a proponent of this argument. He argues that the Fed set in- terest rates too low in – and that these low rates fueled the housing bubble as measured by housing starts. He suggests that this Fed-created housing bubble was the essential cause of the financial crisis. He further argues that, had federal funds rates instead followed the path recommended by the Taylor Rule (a monetary policy formula for setting the funds rate), the housing boom and subsequent bust would have been much smaller. He also applies this analysis to European economies and concludes that similar forces were at play. FOMC20070628meeting--105 103,MS. YELLEN.," Thank you, Mr. Chairman. Data relating to both economic activity and inflation during the intermeeting period have been encouraging. Economic indicators have strengthened considerably, and recent readings on core inflation have been quite tame. Although a portion of the recent deceleration of core prices likely reflects transitory influences, the underlying trend in core inflation is still quite favorable. I view the conditions for growth going forward as being reasonably solid. The main negative factors are tied to housing. The latest data don’t point to an imminent recovery in this sector, and I fear that the recent run-up in mortgage rates will only make matters worse. In addition, housing prices are unlikely to rise over the next few years and, indeed, may well fall, and the absence of the housing wealth gains realized in the past should damp consumption spending. I agree with the Greenbook that the recent run-up in bond and mortgage rates reflects primarily a shift in market expectations for the path of policy and, therefore, implies only a small subtraction to my forecast for growth in 2008. In my view, the stance of monetary policy over the next few years should be chosen to help move labor and product markets from being somewhat tight today to exhibiting a modest degree of slack in order to help bring about a further gradual reduction in inflation toward a level consistent with price stability. The stance of monetary policy will need to remain modestly restrictive, along the lines assumed in the Greenbook and by markets, in order to achieve that goal. My forecast is for growth to be around 2½ percent in the second half of this year and in 2008, slightly below my estimate of potential growth, and for the unemployment rate to edge up gradually, reaching nearly 5 percent by the end of next year. Under these conditions, core inflation should continue to recede gradually, with the core PCE price index increasing 2 percent this year and 1.9 percent in 2008. This forecast is predicated on continued well-anchored inflation expectations and the eventual appearance of a small amount of labor market slack. In addition, special factors such as rising energy prices and the sustained run-up in owners’ equivalent rent that have boosted inflation should ebb over time, contributing a bit to the expected decline in core inflation. In terms of risks to the outlook for growth, I still feel the presence of a 600-pound gorilla in the room, and that is the housing sector. The risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst. Indeed, the repercussions of falling house prices are already playing out in some areas where past price rises were especially rapid and subprime lending soared. For example, in the Sacramento metropolitan area east of San Francisco, house prices shot up at an annual rate of more than 20 percent from 2002 to 2005. Since then, however, they have been falling at an annual rate of 3½ percent. Delinquencies on subprime mortgages rose sharply last year, putting Sacramento at the top of the list of MSAs in terms of the changes in the rate of subprime delinquencies. Research by my staff examining metropolitan areas across the country indicates that the experience of Sacramento reflects a more general pattern. They found that low rates of house price appreciation, and especially house price decelerations, are associated with increases in delinquency rates even after controlling for local economic conditions such as employment growth and the unemployment rate. One possible explanation for these findings is that subprime borrowers, especially those with very low equity stakes, have less incentive to keep their mortgages current when housing no longer seems an attractive investment, either because prices have decelerated sharply or interest rates have risen. These results highlight the potential risks that rising defaults in subprime could spread to other sectors of the mortgage market and could trigger a vicious cycle in which a further deceleration in house prices increases foreclosures, in turn exacerbating downside price movements. The risks to inflation are also significant. In addition to the upside risks associated with continued tight labor markets, a slowdown in productivity growth could add to cost pressures. Although recent productivity data have been disappointing, I expressed some optimism at the last meeting about productivity growth on the grounds that at least some of the slowdown appeared to reflect labor hoarding and lags in the adjustment of employment to output, especially in the construction industry. Data since that meeting have reinforced my optimism concerning trend productivity growth. In particular, new data in the recently released Business Employment Dynamics report suggest that productivity growth may have been stronger than we have been thinking. This report, which includes data that will be used in the rebenchmarking of the payroll survey in January, shows a much smaller increase in employment in the third quarter of 2006 than is reported in the payroll survey; it, therefore, implies a larger increase in output per worker. A second risk to inflation is slippage in the market’s perceptions of our inflation objective. Although inflation compensation over the next five years is essentially unchanged since our last meeting, long-run breakeven inflation rates implied by the difference between nominal and indexed Treasury securities are up about 20 basis points. However, our analysis suggests that this increase reflects in good part an elevation in risk premiums or the influence of various—let me call them “idiosyncratic”—factors of the type that Bill Dudley mentioned, such as a possible shift in the demand by foreign central banks for Treasuries or special factors affecting the demand for inflation-indexed securities and not an increase in long-run inflation expectations. We base this conclusion on the fact that long-run breakeven inflation rates have also climbed in the United Kingdom—a country where inflation expectations have been remarkably well anchored over the past decade and where inflation has been trending downward. The fact that breakeven inflation rates rose in both countries, despite their different monetary policy regimes, suggests that a common explanation is needed rather than one specific to the United States. I think this conclusion is supported by the Board staff model that attributes about half of the movement in breakeven inflation to risk premiums. That said, our understanding and estimates of risk premiums are imprecise, so we must continue to monitor inflation expectations very carefully—of course, along with everything else. [Laughter]" CHRG-111hhrg52397--148 Mr. Price," Mr. Thompson, I have just a few minutes left. You mentioned that if we mandated a clearing companies would ``leave risks unhedged.'' What is the consequence of that? Mr. Don Thompson. The consequence of that is that a company which is an exporter and is exposed to fluctuations in currency risk may incur losses as a consequence of currency exchange rates that it otherwise might not incur if it were enabled to hedge them in the manner that it wanted to in the OTC markets. " CHRG-111hhrg51698--351 Mr. Neugebauer," Now you advocate for aggregate position limits for noncommercial traders. One of the things this body is struggling with is making sure that we don't push so many people out that we can't actually handle the appropriate amount of liquidity in the marketplace, so that our producers can use this as an effective price discovery and risk management tool. When I think about a bale of cotton in the 19th Congressional District, I think about all of the people who really have some commercial interest in that. All the way from the seed company to the fertilizer and the equipment company, the gins and merchants, and other people relying on the behavior of the cotton commodity price for their livelihood. So kind of two things begin to come to my mind there. When we start picking, who can and cannot participate in hedging a risk that they perceive, or putting together a business model where they can manage those risks? And, also, if we push too many people out of the marketplace, then if you have this many people trying to use a commodity as somewhat of a business hedge, that we don't have enough people to be on the other side. What is the right prescription of who you allow to play and who you don't allow to play? " FOMC20080625meeting--152 150,MR. ROSENGREN.," I support alternative B. At this time, there are significant downside risks to the economy and financial markets, as the collateral damage from the housing problems works through the economy and financial institutions. At the same time, continued increases in oil and food prices raise the risk that some part of these supply shocks will be incorporated into inflation expectations. In the absence of more-compelling evidence about which of these two risks will dominate, I would favor remaining on hold at this meeting. I hope that the economy picks up in the second half of this year and that the financial markets stabilize so policy can become less accommodative, but it is not clear that this will be the outcome. While the inflation outlook has been affected by continued energy shocks, the future path of oil prices remains uncertain, and recent history has many instances in which oil shocks are short-lived and have little effect on longer-run inflation expectations. Until we have more clarity on the path of the economy and inflation, policy should remain on hold, and our language should be consistent with that. " 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-111hhrg53021Oth--29 Mr. Lucas," Thank you, Mr. Chairman. Mr. Secretary, OTC contracts are used to manage, of course, very real risks. And the OTC market's very purpose is to provide customized solutions that meet the individual needs of customers. Denying or effectively limiting access to these risk tools by eliminating, in effect, OTC contracts, which mandated clearing essentially does, jeopardizes the ability to hedge market risk, exposing customers to increasing price volatility. Why isn't reporting of OTC trades enough, sir? " CHRG-111hhrg53021--29 Mr. Lucas," Thank you, Mr. Chairman. Mr. Secretary, OTC contracts are used to manage, of course, very real risks. And the OTC market's very purpose is to provide customized solutions that meet the individual needs of customers. Denying or effectively limiting access to these risk tools by eliminating, in effect, OTC contracts, which mandated clearing essentially does, jeopardizes the ability to hedge market risk, exposing customers to increasing price volatility. Why isn't reporting of OTC trades enough, sir? " FinancialCrisisInquiry--376 DIMON: Well, there’s a consequence that you could lose your job. You could lose your reputation. But I do think that you raise an issue. The first way to correct it is that you actually risk adjust it, actually look at the capital being deployed and you make an evaluation. Did they do the right things for the right reason, for the client, et cetera? So you are constantly trying to evaluate are you doing the right things on trading debts. But it is a little one- sided that way. And the more senior the people become, the more stock they own in the company. So they are responsible for the well being of the whole company and they will pay a price if our company pays a price. I think that’s generally—you’ve seen that a lot of the companies that went belly-up their people did pay a price. January 13, 2010 FOMC20051213meeting--138 136,MS. DANKER.," I’ll be reading the directive wording from the Bluebook and the assessment of risks from alternative B in exhibit 2 from Brian’s presentation. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 4¼ percent.” And the wording for the assessment of risks: “The Committee December 13, 2005 90 of 100 attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.”" CHRG-111hhrg53021Oth--301 Mr. Murphy," Well, I don't want to discourage you from products that we may be able to drive to central clearing, because I think that does reduce systemic risk, that we not require be on an exchange if there is not enough volume for an exchange to want it, or for there to be any real price discovery there. " CHRG-111hhrg53021--301 Mr. Murphy," Well, I don't want to discourage you from products that we may be able to drive to central clearing, because I think that does reduce systemic risk, that we not require be on an exchange if there is not enough volume for an exchange to want it, or for there to be any real price discovery there. " 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. " 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. " FOMC20080625meeting--99 97,CHAIRMAN BERNANKE.," Thank you, and thank you all. First, on the long-term projections, I think there's consensus that we should just go ahead and have a trial run. The staff should review the transcript and make gold out of straw there. We should consult with the subcommittee, and we should think about maybe even a couple of alternatives. Maybe we could try a couple of alternative ways of doing it in October. So let's go ahead and do something along those lines and keep thinking about how best to do it. Let me first, as I usually do, try to summarize the discussion around the table, and I'll add some comments of my own. Beginning with the summary, the incoming data were stronger than expected, notably for consumer spending but for some other components as well. As a result, economic growth in the second quarter, though not robust, was likely positive, continuing the pattern of weak but positive growth since the fourth quarter of 2007. However, to the extent that strength in consumption was transitory or due primarily to fiscal stimulus, some of the growth in the second quarter may have been borrowed from the second half. Participants generally saw growth continuing at a slow pace the rest of the year and improving in 2009. There was, however, some divergence of views, with some expecting a longer period of slow growth. Recent numbers on retail sales suggest that the consumer is holding up better than expected. Consumer finances may be better than feared, and the fiscal stimulus may already be having an effect. However, as many have noted, there are substantial drags on consumption going forward, including falling wealth and income, credit constraints, and the recent rise in energy prices. Sentiment has also fallen noticeably further. Weaker consumption may, thus, restrain growth later this year, particularly after the effect of the stimulus wanes. Labor markets continue to soften but at a relatively moderate pace. The peak in unemployment is projected to be between 5� percent and 6 percent. That's what I generally heard around the table. Prospects for housing continue weak, with falling prices, high inventories, and weak demand. Some saw a possible bottom forming but noted that the recovery of this sector is still some way off. As has been the case for a while, businesses are quite cautious, noting economic uncertainties and surging input costs, with one or two mentions of tighter credit, although that was not a dominant theme today. Real exports continue to grow and are partially offsetting weaker domestic demand, especially in the case of manufacturing. Financial conditions have been mixed since the last meeting, although the improvements from March have largely been maintained and the risk of systemic crisis may have receded to some degree. Funding markets are generally doing better. The concerns about credit losses have led the stock prices of banks, including regional banks and investment banks, to fall sharply. Capital raising continues, though at less favorable terms and with perhaps declining availability. As the economy continues weak and housing contracts further, more credit losses for banks may well be in store, adding to financial market stress and reducing the availability of new credit. Progress in the financial markets is likely to be slow as the deleveraging process will take a while. Stock prices in general are also lower. Financial conditions in the housing market remain important downside risks to growth, with the spurt in oil prices adding to those risks. Uncertainties about the growth prospects are great. However, tail risks may have moderated somewhat. Readings on core inflation have remained relatively moderate. However, the sharp rise in oil prices and some other commodity prices, in part reflecting flooding in the Midwest, is likely to lead to very high levels of headline inflation over the next few months. Gas and food prices have become perhaps the most important economic issue for consumers, and firms are feeling everincreasing cost pressures. Moreover, inflation pressures are global. There are increasing reports of firms being able to pass through these costs, which could lead to an increase in core inflation. On the other hand, slack may restrain core inflation increases. Measures of longer-term inflation expectations have been up a bit on net since April, depending to some extent on the measure chosen. Nominal wage growth is still slowing. Participants debated how much comfort to take from slow wage growth, some arguing that, by the time wages reflected higher inflation expectations, it would be too late. Most saw inflation risks as now to the upside, with the primary concern being the possibility that inflation expectations could rise further as headline inflation rises and more costs are passed through. That's my very, very quick summary. If anyone has any comments, I'd be happy to hear them. If not, let me just say a couple of words on my own views here. This may come as a surprise to some of you, but I am not a fine-tuner. I think that the objective of the Federal Reserve ought to be to avoid a very bad outcome, and so my concerns are primarily with tail risks on both sides of our mandate. I think that the evidence of the last month or so provides a bit of reassurance, on both the real side and the financial side, that the tail risks on the growth side of the mandate have moderated somewhat. That being said, I think they remain and are still significant. In particular, as I mentioned in the summary, I am at this point still suspicious of the strength that we saw in the second quarter. If we look at the fundamentals for consumption--including wealth, income, employment, and energy prices--and look at the plunge in sentiment, which is at remarkably low levels, I think there's a very good chance that consumers will weaken going forward and bring the rest of the economy along with them. In addition, of course, housing remains extremely uncertain. We are at best some distance from stabilization in that market. Even when residential construction begins to stabilize, we'll still see continuing declines in house prices, which will affect consumer spending and, importantly, will affect financial markets as well as the value of mortgages. With respect to financial markets, I agree certainly that the crisis atmosphere that we saw in March has receded markedly, but I do not yet rule out the possibility of a systemic event. We saw in the intermeeting period that we have considerable concerns about Lehman Brothers, for example. We watched with some concern the consummation of the Bank of America�Countrywide merger. We worried about a bank in the Midwest. Other regional banks are under various kinds of stress. We're seeing problems with the financial guarantors, with the mortgage insurers. So I think that those kinds of risk are still there, and we need to be very careful in observing them. Moreover, even if systemic risks have faded, we still have the eye-of-the-storm phenomenon--we may now be between the period of the write-downs of the subprime loans and the period in which the credit loss associated with the slowdown in the economy begins to hit in a big way and we see severe problems at banks, particularly contractions in credit extension. So I'm not yet persuaded that the tail risks are gone. I think it would be very valuable to have some more data, some more observations, to see how the financial markets and the economy are proceeding. But I want to say that I do agree that the developments in financial markets and the surprisingly strong data in the second quarter should lead us to feel somewhat better. I think we should take a little credit for our various efforts to support both the financial system and the economy. Now, what about tail risks on the other side--on inflation? The increase in oil prices that we've seen in the past six weeks is obviously very, very bad news. I think that the combination of the commodity price increases and what we're going to see as very ugly headline inflation numbers is beginning to generate a tail risk on that side of the mandate as well, and I am becoming concerned about that. Indeed, I think that it's now appropriate that we begin, as some of us already have, to move rhetorically toward acknowledging that risk and agreeing that it may be at the point where it even exceeds the risk that we see on the growth side, although I think we're very uncertain about that. Now, the concern I have is the following, which is that there has been a lot of talk about policy action. I don't think that a 25 basis point or even a 50 basis point move, if it's not viewed as being the start of a continued increase, is going to do very much on the inflation side, frankly. We had a good test of that over the intermeeting period. Partly because of our rhetoric and for other reasons, the dollar strengthened. The two-year rate rose 50 or 60 basis points, and oil prices went up $25. I do not think that with a small change in our stance we can do anything about commodity prices, and frankly, it's commodity prices that you're hearing about from your Board members and from people you talk to. It's the real change in the relative price of those commodities that is painful and the real change in the terms of trade coming through the dollar which is painful, and I don't think we can do very much about those in the short term. Our objective, of course, as everyone has noted, is to prevent that from becoming a sustained and persistent source of inflation. So the problem then is that a small amount of movement will not solve the problem. A small to moderate movement, however, might create some serious financial strains given the fragility of the system. I think what we need to do is to decide when we reach that tipping point. There will be a tipping point at which we're sufficiently confident that the system is stabilizing and that we can begin to turn in a serious way to the inflation concern. A partial one step, unless it signals a longer-term tightening program, could give us the worst of both worlds. We will just have to make the judgment about when we have reached the point of having to switch from our previous approach of supporting the economy and financial system to an approach that is aimed more at containing inflation. It's going to be a very difficult and delicate situation, but I want to express again my agreement with those of you who are worried about inflation and my belief that the time might be relatively soon. But it's going to be a very, very delicate decision and one that we have to make with great concern and consideration. A little anticlimactically, I would like to say just a couple of words about the 1970s because they keep coming up and I do think that these comparisons are a bit misleading. First, in the current episode, commodity prices--particularly oil prices--are basically most or almost all the inflation that we're seeing. That was not the case in the '70s. In particular, inflation rose considerably before the first oil price shock in 1973. PCE inflation was 5 percent in 1970, which prompted the wage� price controls, of course, which is an episode we're all familiar with; and in 1972, before the oil shock, average hourly earnings were growing between 7 and 8 percent. There was already a serious inflation problem before the oil price shocks came. Hence, credibility was already damaged at the time of the oil price shocks. That is not the case here. Second, the movement in wages and core inflation following the oil price shocks in the 1970s was very striking. From the time of the oil price shock right before the second quarter of 1973 until the first quarter of 1975, total inflation rose a little over 5 percentage points, reflecting the quadrupling of oil prices. During the same period, core inflation rose more than 6 percentage points. In other words, core inflation responded almost one for one to total inflation. Moreover, average hourly earnings rose more than 2 percentage points, and productivity and cost compensation rose 3� percentage points in that year and a half. So there was a very strong sensitivity of expectations and pass-through to these commodity price shocks. Obviously, we've been seeing oil price increases since 2003, and they have not yet shown anything like that effect on core inflation or on wages. The final observation I'd make about the 1970s is that we shouldn't forget that, even in that very bad situation with very poorly anchored inflation expectations, the slowing of the economy did do something to reduce inflation. In particular, core inflation fell 3� percentage points during 1975 following the 1973�75 recession. So while we cannot do much about oil prices, I do think that there is some hope that weakness in the economy is going to provide some restraint on core inflation, which of course will generate a more stable total inflation rate if and when commodity prices stabilize. So I've been very all over the map here. I apologize. I tried to organize my thoughts in the meeting. My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I'm also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It's going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve. The last thing I'd like to say is on communications. Just talking about communications following this meeting, I'd like to advise everyone, including myself, to lean, not to lurch. That is, we are moving toward more concern about inflation, but we still have concerns about economic growth and financial markets. We should show that shift in emphasis as we talk to the public, but we should not give the impression that inflation is the entire story or that we have somehow decided that growth and financial problems are behind us, because they are not. So if we can convey that in a sufficiently subtle way, I think we will prepare the markets for the ultimate movements that we're going to have to make. Again, I very much appreciate your insights and your attention today. We have a dinner at 7:30, and for that reason I think we should probably bring this to a close. We'll start tomorrow morning with Brian's presentation of the policy options. The statement is essentially the same as the Bluebook's. There won't be any surprises there. So we'll begin with that first thing in the morning. Thank you. [Meeting recessed] June 25, 2008--Morning Session " CHRG-111shrg54589--3 STATEMENT OF SENATOR JIM BUNNING Senator Bunning. Thank you, Mr. Chairman. I appreciate all of our witnesses coming here today for this very important hearing. It is important for everyone to understand the financial nature of derivatives and, thus, the Banking Committee's interest in overseeing them. Let me say at the beginning that I do not know what regulations and restrictions we should put on these products. Figuring that out is the purpose of this hearing. But it should be clear to everyone that the current regulations are not enough. I understand the desire of firms to hedge their risks, whether those risks are interest or exchange rates, commodity prices, credit exposure, or something else. Genuine hedges that are accurately priced can provide the risk management that firms need. But it is not clear that all derivative products are genuine hedges or accurately priced. In fact, some look a lot more like a way to get around regulations and proper risk management, or just plain gambling. Regulators in the public need a better understanding of all the exposures of firms to eliminate uncertainty and the justification for further bailouts. Increased transparency and standardization of derivative contracts will help and must be accomplished. How far standardization requirements should go depends on whether there are true economic benefits to the custom products that outweigh the costs and risks associated with them. So far, specific and credible evidence on that point is thin. Credit derivatives may present the toughest questions. Should these products be treated as insurance with proper reserves? Should the buyer have an insurable interest and have to suffer actual losses or deliver the reference assets? How do we make sure credit protection does not undermine credit research or lead creditors to push debtors into bankruptcy? Should they even exist if not traded on an exchange? Someone has to bear the risk of every financial transaction so we must not allow the wizards of finance to pretend it has disappeared. Finally, just like with banks, we must eliminate the opportunity to avoid or choose favorable regulators or regulations. Similar activity must be regulated the same way by the same regulator. Otherwise, firms will be able to game the system, and regulators will not be able to effectively enforce the rules. Thank you, Mr. Chairman. " CHRG-111shrg57322--720 Mr. Viniar," And it is a risk-reward judgment question at the time. You look at what price you could sell that position. You make an assessment of that versus what it would cost you to put on an offsetting position, and understanding that putting on an offsetting position is never an exact hedge. Senator Kaufman. Right. " FOMC20070628meeting--122 120,MS. PIANALTO.," I also extend my heartfelt congratulations to the Spurs on their fourth and final NBA championship. [Laughter] Now, turning to inflation, I am hearing reports of upward price pressures across a handful of industrial commodities, and notably for metals. But wage pressures remain modest. Nevertheless, for the first time in more than a year, I am hearing from my business contacts that they are concerned about inflation. They are bringing inflation concerns up with me, and they are telling me that they concur with the Committee’s assessment that inflation remains a risk. To be sure, there were many positive signs in the May CPI report. The traditional core CPI beat expectations, and while the trimmed mean estimators that we produce in Cleveland were a little higher than the measure excluding food and energy, even those indicators were consistent with the moderation and the longer-term inflation trend we expect to see. Looking at the core measures enables me to be encouraged by the May CPI report. But that view is a rather hard sell to a public that saw headline CPI inflation rise 8½ percent at an annualized rate last month. Indeed, our readings of the underlying inflation trend and what people are feeling in their wallets have been at odds for many years now. I understand that our policies are not well advised or even equipped to address transitory price movements. But at some point, large and persistent price disturbances, such as we have seen in energy markets, warrant our attention. If these isolated price pressures become more generalized and enter into consumer and business decisionmaking, we could easily find ourselves living in the Greenbook’s “drifting inflation expectations” scenario. In summary, I think the housing market still presents a risk that the economy may not resume a more typical growth trajectory over the forecast period. Nonetheless, that concern is trumped by the risk that we may yet lose the public’s confidence that we are making sustainable progress against inflation. Therefore, I continue to believe that the predominant risk going forward is that inflation will fail to moderate as expected. Thank you, Mr. Chairman." CHRG-111shrg54589--121 PREPARED STATEMENT OF SENATOR MIKE CRAPO Recent events in the credit markets have highlighted the need for greater attention to risk management practices and the counterparty risk in particular. The creation of clearinghouses and increased information to trade information warehouses are positive steps to strengthen the infrastructure for clearing and settling credit default swaps. While the central counterparty clearing and exchange trading of simple, standardized contracts has the potential to reduce risk and increase market efficiency, market participants must be permitted to continue to negotiate customized bilateral contracts in over-the-counter markets. Many businesses use over-the-counter derivatives to minimize the impact of commodity price, interest rate, and exchange rate volatility in order to maintain stability in earnings and predictability in operations. If Congress overreaches and bans or generates significant uncertainty regarding the legitimacy of decisions to customize individual OTC derivatives transactions there will be enormous negative implications on how companies manage risk. At this time I would like to highlight a few examples from end users about what are the possible effects of severely restricting access to customized over-the-counter derivatives on companies' ability to manage risk and on the prices they charge customers.v David Dines, President of Cargill Risk Management: ``While margining and other credit support mechanisms are in place and utilized every day in the OTC markets, there is flexibility in the credit terms, credit thresholds and types of collateral that can be applied. This flexibility is a significant benefit for end users of OTC derivatives such as Cargill in managing working capital. Losing this flexibility is particularly concerning because mandatory margining will divert working capital from investments that can grow our business and idle it in margin accounts. While it depends on market conditions, the diversion of working capital from Cargill from margining could be in excess of $1 billion. Multiply this across all companies in the U.S. and ramifications are enormous, especially at a time when credit is critically tight.'' Kevin Colgan, Corporate Treasurer of Caterpillar: ``Our understanding of currently pending regulation in this area is that it would require a clearing function which would standardize terms like duration and amount. Any standardization of this type would prohibit us from matching exactly the terms of the underlying exposure we are attempting to hedge. This, in turn, would expose us to uncovered risk and introduce needless volatility into our financial crisis.'' Mark Grier, Vice Chairman of Prudential Financial: ``Without customized OTC derivatives, Prudential would be incapable of closely managing the risks created in selling life insurance, offering commercial loans, and proving annuities for retirement.'' John Rosenthal, Chief Hedging Officer of MetLife: ``Standardized derivatives cannot be used effectively to hedge all types of financial risk. Any increased risks would result in higher costs to offer and maintain these products. In either situation the increased costs of an inefficient derivatives market would be reflected in the pricing to our customers. To the extent the costs and/or risks associated with an inability to appropriately hedge these products became prohibitive; these products could be no longer available to customers.'' Janet Yeomans, Vice President and Treasurer of 3M: ``Not all OTC derivatives have put the financial system at risk and they should not all be treated the same. The OTC foreign exchange, commodity, and interest rate markets have operated uninterrupted throughout the economy's financial difficulties. We urge policy makers to focus on the areas of highest concern.'' At this time, I would like to submit into the record the complete letters. It is possible that I will receive additional letters in the next few days and I would also like to enter those letters in the record. While the derivatives market may seem far removed from the interests and concerns of consumers and jobs that is clearly not the case. Legislative proposals to alter the regulatory framework of over-the-counter derivatives is a very technical subject matter and the potential for legislation to have unintended consequences of legitimate transactions is considerable. We need to better understand the following questions: How do businesses use customized OTC derivatives to help stabilize prices and mitigate risk? What are the possible effects of severely restricting access to customized OTC derivatives on businesses ability to manage risk and on the prices they charge customers? What safeguards are in place to ensure that derivatives portfolios are a tool for hedging risk, rather than a source of risk? What does standardized mean, and how much of the OTC markets can and should be shifted on exchanges? ______ CHRG-111hhrg58044--137 Mr. McRaith," Congressman, the availability of data to any one insurance company at this point is so expansive, it is impossible to determine exactly what or to conclude what factors would replace a credit score. Some companies are using all of the sub-components of a credit score right now for pricing and not relying solely upon a credit score in and of itself. What we expect is that eliminating one rating factor will shift costs. There are some people who might pay more. Others might pay less. When you affect the price of one person in a risk pool, you are going to also affect someone else in that same pool. " FOMC20070807meeting--172 170,MR. KOHN.," Yes, I do. I see why you want to take out “volatile,” and I agree with that. Unlike President Lacker, I think it is important to keep credit conditions in there because it’s more than just price. So I was a little concerned that saying “risk premiums have increased and credit conditions have become tighter” puts it all on price. Suppose we didn’t have the phrase in red. We just had “owing to developments in financial markets, credit conditions have become tighter,” or “reflecting recent developments in financial markets, credit conditions have become tighter.”" FOMC20071031meeting--204 202,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. I think the economy is slowing. Even the nonhousing part of the economy is slowing a bit. Housing prices are still obviously sliding down. We don’t really claim to know much about where they’re going to end up or where we are in that process, but it seems that they are falling and probably at an accelerating rate. Our modal forecast—“our” meaning from the submissions—is for an economy that slows further and runs below trend over several quarters. But if you just look at the size of the bars on the submissions, the size of that bar about downside risk to growth is very high, much higher than the bar about upside risk to inflation. There is a huge amount of uncertainty about what equilibrium is and where short-term interest rates should be over time. But I think it is fair to say that we are now at the high end of, if not slightly above, most of those estimates of where equilibrium is. Therefore, it seems to me sensible that most of our submissions had a downward slope to the path of the fed funds rate going forward over this period. The question then is not principally whether to move but when and what signal of a change or no change should come. I think it is a very close call, and everything that I say I say with a lot of unease and discomfort. If the choice is to stay firm but to signal more explicitly than we did in September that we’re likely to move further, that seems to me just a bad choice. I think it is likely to amplify many of the risks that you are all worried about and it probably would make people more tentative about coming in and doing what they’re going to do to let this thing work through the markets because they will be living with our acknowledgement of substantial downside risk without action and uncertainty about whether we’re going to move. I think you might argue that a decision not to move with an explicit asymmetry in the balance of risks to growth would lower the path going forward and add to that uncertainty in some sense. I do not think that the markets are so fragile now that they could not take an adverse surprise of this magnitude, even though it is a very, very large adverse surprise relative to recent history. I don’t think that’s a good argument for moving. I think the best argument is that we’re still in the midst of what is a very delicate and consequential asset-price adjustment in the U.S. economy with a fairly dense, thick, adverse tail on the potential implications about the evolution in housing. The Chairman spoke eloquently early in the year—I think it was early in the year, but maybe it was late last year—about the pattern of history and the acknowledgement that weakness tends to cumulate, and you don’t really have a lot of experience with sustained periods of below-trend growth without falling into a more substantial rise in unemployment rates. Those risks have to be substantially greater when you have an economy going through this kind of asset-price adjustment. I found these charts discouraging, not reassuring, in the sense that we’re anticipating a slowdown in the rate of growth of credit for the economy as a whole that’s comparable to ’01. I think the pressure on bank balance sheets is probably—it’s hard to make these statements with any certainty—greater than it was in ’01. At least a reasonable expectation is that it’s going to be bigger than it was in hindsight in ’01, and I think you have a much more substantial impairment to the functioning of what Kevin calls debt capital markets—the industry around the design of securitization and structured finance, et cetera, which has been so important to the way credit gets originated and moved. That disruption could take a long time to resolve, and I think that just has to amplify the density of the adverse tail and the growth outcome, certainly with more uncertainty at this time. I think that it is hard, but the better course of valor is to move today, and I like the language in alternative A. Let me just go quickly through the arguments against it that I find most compelling. The best argument against is the fear that many of us spoke about—that even though the inflation numbers have been reasonably reassuring and we haven’t seen substantial erosion in inflation expectations that we can measure, there is a bit of deterioration in the feel, in the psychology. We have to be very careful that we don’t add to that through our actions or people’s expectations about how we’re going to behave going forward. But we should take some comfort from the fact that the market is pricing in more than 100 basis points of easing over the next two years. You have to believe that a fair amount of that is already reflected in breakevens, reflected in what people are willing to pay for insurance against adverse inflation outcomes, and reflected in the dollar. It doesn’t mean that if we validate part of those expectations you won’t see erosion, but we should take some comfort from that. Just one more thing. We have been through three years of very substantial relative price shocks in energy prices, commodity prices, and some other things. Those hit an economy that was growing over the period above most estimates of potential, and we have had pretty good performance of underlying inflation and inflation expectations in that context. So even though we look forward and we see what’s happening in commodity prices, energy prices, and the dollar as posing some potential risk of upside pressure on input costs, that is hitting the economy in a very different state. The experience of those last couple of years should give us a fair amount of confidence in the judgments we bring as to how we think about inflation going forward. I think we have less uncertainty around an inflation forecast than we would have had two or three years ago and still substantial uncertainty around the growth forecast inevitably given what the economy is going through. The balances suggest that it is better to move today because of that. As I said, I’m comfortable with the language in alternative A. I would be comfortable with Governor Mishkin’s amendment to A—I think that helps a bit. I have a lot of sympathy for all the arguments against the first sentence in alternative A in any form, but on balance, I would say that we just don’t want to take the risk that, by omitting some statement like it, we cause people to price in a steeper slope to that path going forward. It is something that we should try to avoid, and the best way to achieve that is the language in A. Thank you." 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-111hhrg53245--188 Mr. Johnson," Sir, if I could on the subordinated debt and the more general idea that the market can pick up the risk, I would point out that the evidence says the market pricing of risk, for example look at the CDS for Citigroup prior to the crisis, was going the wrong way. They thought Citigroup was becoming less and less risky. As we know, looking back, it was actually becoming more and more risky. So I am afraid, as one thing to look at, it is okay, but as a panacea or something to put a lot of weight on, I would do that with hesitation. " CHRG-110shrg50414--215 Secretary Paulson," Well, I would say in terms of bringing in the private sector, OK, along with it, I think we have looked at a number of initiatives. We started off, actually, with some initiatives with the private sector, some that got off the ground and others that didn't. I would say with the private sector as frozen as it is and as concerned as it is and with the overall system as fragile as it is, now is the time that we need to do something very strong as a government, and so that is why we have come up with this plan. Senator Bayh. Chairman Bernanke, many of my colleagues, Senator Reed foremost among them, have asked, and I think you put your finger on the essential point here, and that is how do we go about valuing the hold-to-maturity price versus the fire sale price, and I think you would acknowledge--you have acknowledged it is an inexact science at best. So the taxpayers do--there is some downside risk here. What do they get in exchange for bearing that downside risk? Why should they not be allowed to participate in the potential upside, and then that gets to the question once again of possible equity participation. " CHRG-109hhrg28024--32 Mr. Bernanke," No. I wish I had such a crystal ball. We're in a difficult period because, for the foreseeable future, we are operating close to the margins of available global supply of oil and natural gas. And as a result, prices are likely to stay high, and the risk exists, if there are significant disruptions of supply, that we'll get additional spikes or movements in energy prices. Now in the longer term, energy prices at the current level should be sufficient to bring forth a number of alternative sources of supply as well as induce significant conservation on the part of consumers and firms. So I'm actually fairly optimistic about 10, 15, 20 years down the road because these high prices will allow the economy to adjust. But over the next 5 or 10 years, we are in the zone of vulnerability without available alternatives to the extent we would like and with a relatively small margin of error in terms of global supplies. " CHRG-111shrg52966--55 Mr. Sirri," I think there is an element of accuracy to that, but I think there are tools available to us as regulators. Let me give you a specific instance. You are right, a particular complex financial firm will develop a model for risk, but they will have a process around that model for risk. And we care about the processes and the robustness of the processes and controls. So, for example, a model for risk is developed. Who validates it? Who verifies it? Who runs that model? If they report to the trading desk whose assets they are pricing, that is not helpful and that is problematic. If they report to an independent third-party that perhaps reports directly to the CFO or a risk officer, much stronger structure, gives you some comfort. Again, let me take a second one, a price verification group. You may have a firm that trades assets, but they have problems valuing assets, as you do when liquidity dries up. When valuations are struck, how are those valuations struck? There may be a model. Who validates the model? And how do you resolve disputes? If the trader says it is worth more than the risk person says it is worth, how do you resolve that? Is there a process where it could go up to the audit committee? And if it goes to the audit committee, does the After Action Report--the phrase you used--for that instance, does that go to the board of directors? Such processes, if they are in place, tell you that that firm is taking their job seriously. Senator Reed. I would presume, and correct me, that those procedures, those appropriate procedures you described, were not being deployed very successfully at Bear Stearns or Lehman Brothers. Were you aware of kind of those deficiencies contemporaneously with their---- " CHRG-111hhrg58044--143 Mr. Snyder," Well, in one sense it might force the industry to go back to larger classifications and rely more on those, such as territory and other factors which themselves were controversial. With the addition of credit-based insurance scores, you have added a degree of objectivity and individual tailoring that did not exist before, and it allows both not only accurate rating and underwriting of individuals but has improved availability in the market because the confidence companies have that they have the ability to price every risk and therefore, many more risks are being written in the voluntary market. " FOMC20061212meeting--73 71,MS. PIANALTO.," Thank you, Mr. Chairman. My outlook for the economy hasn’t changed much since our last meeting, but I have become more concerned about the risk to the outlook for real growth. So in my comments this morning, I’ll explain why my risk assessment has changed. The homebuilders with whom I spoke over the past several weeks told me that the low interest rates and the new financial products created an environment in which they did five years’ worth of business in the space of three years. They said that most homebuilders recognized that this pace of activity was unsustainable and so they planned accordingly. A few small builders have declared bankruptcy, and others still may do so; but for the most part, builders feel that they are financially prepared to make it through the next one or two years of poor business. So the financial condition of homebuilders is not my chief concern. However, I have become more worried about the potential spillover of housing conditions into consumer spending from wealth effects, income constraints, and creditworthiness. I think I’m going to give the counterpoint to President Lacker on these issues. The Greenbook points out that the OFHEO price index is still increasing a bit, but the builders I met with convinced me that the published prices for new homes don’t accurately reflect market conditions. Sellers are offering nonprice concessions, such as upgrades for appliances, carpets, fixtures, and so forth. Some builders are going to great lengths to keep published prices up. I’ve been told stories of builders in Arizona who have been giving buyers new Lexuses as part of the overall deal so that they don’t have to bring down the prices in their subdivision. Also, it seems as though owners of existing homes are not yet willing to reduce their asking prices by very much. With potential buyers still waiting for prices to fall further, traffic levels and transactions are low. It seems as though markets are not yet close to functioning smoothly, and homebuilders are telling me that it could take another year before buyers and sellers exhibit more confidence. I am concerned that we don’t yet have a good handle on where house prices are headed and how the uncertainties surrounding house prices might affect consumer spending. Second, the support to consumption provided by cash-out refinancing is not likely to be available going forward to the same degree that we’ve had during the past several years. Finally, the financial condition of some households has become pretty fragile, and we all know that rates on adjustable mortgages, including some subprime mortgage loans, continue to reset at higher rates. The adjustable rate mortgages are already causing some well- publicized problems for some households. Builders in my region report that the ability of potential homebuyers to qualify for home mortgages is becoming an issue. One homebuilder from Columbus told me that he is giving away new cars as well, but his motivation provides a twist on the Lexus story. Some of his customers are struggling to qualify for mortgage loans. So he’s giving them new cars so that they can get rid of their current cars and the payment obligations that go along with them. [Laughter] He’s not giving them a Lexus; he’s giving them a Kia. [Laughter] Now, if we could get these homebuilders to adopt a Buy American strategy, we might also be able to solve our domestic auto problem. As I said at the outset, I don’t have a major disagreement with the Greenbook baseline. I think that the outlook for near-term growth has deteriorated a little since October, and the Greenbook reflects that. I just think that there’s greater likelihood that the real economy could prove to be weaker than the baseline in the Greenbook in 2007, and the key risk in my view is the degree of spillover from the housing market into the rest of the economy. The Greenbook’s extended house decline alternative scenario represents this risk, although I have not yet heard stories that are quite as dramatic as the 20 percent decline in home prices in that scenario. Not much has changed, as many others have already commented, in the inflation outlook. The inflation trend continues to be hard to interpret, but I still expect core inflation to drift down gradually over the forecast period. Although there is still a risk that inflation will remain higher than I desire, I think that favorable compensation developments and declines in shelter costs could speed that rate of decline. Thank you, Mr. Chairman." fcic_final_report_full--172 The numbers were stark. Nationwide, house prices had never risen so far, so fast. And national indices masked important variations. House prices in the four sand states, especially California, had dramatically larger spikes—and subsequent de- clines—than did the nation. If there was a bubble, perhaps, as Fed Chairman Alan Greenspan said, it was only in certain regions. He told a congressional committee in June  that growth in nonprime mortgages was helping to push home prices in some markets to unsustainable levels, “although a ‘bubble’ in home prices for the na- tion as a whole does not appear likely.”  Globally, prices jumped in many countries around the world during the s. As Christopher Mayer, an economist from Columbia Business School, noted to the Commission, “What really sticks out is how unremarkable the United States house price experience is relative to our European peers.”  From  to , price in- creases in the United Kingdom and Spain were above those in the United States, while price increases in Ireland and France were just below. In an International Mon- etary Fund study from , more than one half of the  developed countries ana- lyzed had greater home price appreciation than the United States from late  through the third quarter of , and yet some of these countries did not suffer sharp price declines.  Notably, Canada had strong home price increases followed by a modest and temporary decline in . Researchers at the Federal Reserve Bank of Cleveland attributed Canada’s experience to tighter lending standards than in the United States as well as regulatory and structural differences in the financial system.  Other countries, such as the United Kingdom, Ireland, and Spain, saw steep house price declines. American economists and policy makers struggled to explain the house price in- creases. The good news was the economy was growing and unemployment was low. But, a Federal Reserve study in May  presented evidence that the cost of owning rather than renting was much higher than had been the case historically: home prices had risen from  times the annual cost of renting to  times.  In some cities, the change was particularly dramatic. From  to , the ratio of house prices to rents rose in Los Angeles, Miami, and New York City by , , and , re- spectively.  In , the National Association of Realtors’ affordability index—which measures whether a typical family could qualify for a mortgage on a typical home— had reached a record low.  But that was based on the cost of a traditional mortgage with a  down payment,  which was no longer required. Perhaps such measures were no longer relevant, when Americans could make lower down payments and ob- tain loans such as payment-option adjustable-rate mortgages and interest-only mort- gages, with reduced initial mortgage payments. Or perhaps buying a home continued to make financial sense, given homeowners’ expectations of further price gains. During a June meeting, the Federal Open Market Committee (FOMC), com- posed of Federal Reserve governors, four regional Federal Reserve Bank presidents, and the Federal Reserve Bank of New York president, heard five presentations on mortgage risks and the housing market. Members and staff had difficulty develop- ing a consensus on whether housing prices were overvalued and “it was hard for many FOMC participants . . . to ascribe substantial conviction to the proposition that overvaluation in the housing market posed the major systemic risks that we now know it did,” according to a letter from Fed Chairman Ben Bernanke to the FCIC. “The national mortgage system might bend but will likely not break,” and “neither borrowers nor lenders appeared particularly shaky,” one presentation ar- gued, according to the letter. In discussions about nontraditional mortgage prod- ucts, the argument was made that “interest-only mortgages are not an especially sinister development,” and their risks “could be cushioned by large down payments.” The presentation also noted that while loan-to-value ratios were rising on a portion of interest-only loans, the ratios for most remained around . Another presenta- tion suggested that housing market activity could be the result of “solid fundamen- tals.” Yet another presentation concluded that the impact of changes in household wealth on spending would be “perhaps only half as large as that of the s stock bubble.” Most FOMC participants agreed “the probability of spillovers to financial institutions seemed moderate.”  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---- " FOMC20081007confcall--64 62,CHAIRMAN BERNANKE.," Thank you. Actually, going back to President Lacker and President Plosser, President Lacker made the point about the joint statement. The joint statement with respect to inflation says ""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."" I would be content if the preference of others is to take out the word ""materially"" and just say ""have reduced the upside risks to inflation."" That would be perhaps more consistent, but I'm happy either way. So that's just a suggestion. Let me go on now to Bob Rasche. " CHRG-109hhrg22160--184 Mrs. Kelly," The GAO also released a report last year indicating that a functioning market for terrorism insurance would not exist if TRIA were allowed to expire. You further stated to me in this letter that if an efficient pricing mechanism for terrorism risk did not exist--and I am quoting you here--``some level of federal involvement in terrorism insurance may continue to be warranted.'' Without a functioning private market for terrorism insurance in the absence of TRIA, do you think government can replace market signals as an arbiter of terrorism insurance prices? " 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? " FOMC20081216meeting--453 451,MR. DUDLEY.," Yesterday we talked about AAA tranches of student loans, which are 97 percent backed by the Department of Education. They are selling at LIBOR plus 300 or LIBOR plus 400. It is hard to say that those securities are priced there because of credit risk. " 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-111shrg57319--521 Mr. Killinger," Again, I just do not recall the specifics of this at all. Senator Coburn. OK. Exhibit 78a,\2\ in this email exchange from March 10, 2005, with Jim Vanasek, you wrote, ``I have never seen such a high risk housing market as market after market thinks they are unique and for whatever reason are not likely to experience price decline. This typically signifies a bubble.''--------------------------------------------------------------------------- \2\ See Exhibit 78a, which appears in the Appendix on page 790.--------------------------------------------------------------------------- Is it accurate to say that you saw a bubble in housing prices as early as March 2005? " CHRG-110hhrg44901--3 Mr. Bachus," I thank the chairman. Chairman Frank, I am going to follow your lead and restrict my remarks to the real economy, which is the purpose of this hearing, and not some of the recent developments in the past week or two. Chairman Bernanke, looking at the economy, we had an overextension of credit. We had too easy of credit, it wasn't properly underwritten, and the risks were not taken into account. As a result of that, we have had, I think, massive debt accumulation in this country, and we are going through what is inevitable when people borrow more than they can repay. I think a second factor, and it may be in your remarks or questions, you can address this, but a tremendous amount of leverage and risk-taking and other risky and speculative investment practices and a lot of fortunes were made on the way up, but there is pain on the way down. As I see it, it is not an easy thing to go through, but it is a part of a market cycle. The third factor, and this is a factor that I think is the most important, is the high commodity prices, and particularly energy prices that have been a particular hardship on importing nations, and we are obviously an importing Nation. It has been a financial windfall to exporting countries. I have been to Abu Dhabi and Dubai, and the fabulous wealth that has been created out of really a desert society there in the past 40 years is just almost beyond belief. I think T. Boone Pickens, he is running a commercial right now, and he calls this, I think rightly so, the largest transfer of wealth in the history of the world. That, to me, and the effect it is having on Americans day-to-day, is our biggest problem. I believe it is the largest source of instability in our financial markets. I think that the consumers are stressed, they are paying high gas prices, high diesel prices, and they can't pay their other bills. They are even having trouble putting food on their tables. Finally, while we require the American people to live within their budget, we had deficit spending here, and have for some time, and there is a tremendous lack, I think, in Washington of financial discipline. The Federal Government has more obligations than it can fund today, but it continues to obligate itself, it continues to expand and create new programs, and it continues to assume responsibility for funding services that were traditionally in the province of local or State governments or families themselves. Obviously, all of these problems, the problem of tremendous mushrooming of extension of credit and debt accumulation, of overleveraging and risk-taking, of high energy costs, high food costs, high gas prices, and then a Federal Government that spent beyond its means, obviously there is no single approach we can take to getting ourselves out of this. I think the banks have repriced for risk. There has been a lot of--they have raised capital. I will state right here that I know there is a debate in this country on the overall financial stability of our financial system, but I, for one, think that we are well on our way to recovery in the financial system. I think the present stock prices of our banks don't accurately reflect the value of those banks. I think the stock prices are too low. The banks are sound, they are solid. I think the stock prices, right now you may have--I think there is a real--it is just a confidence factor. Anyway, we have had a retrenching and a correction, and I do worry about some attempts that we are doing to short-circuit the correction and the period of adjustment. I think long term they can deepen the damage. But, in contrast, there is something that I think we should do, and we can do now, and that is to address high energy prices. High energy prices mean higher production and transportation costs. Those increases are passed on to the consumers, and we saw that this morning, causing inflationary pressures. Particularly hard hit are those Americans, a million-and-a-half Americans, whose adjustable-rate mortgages are adjusting. Those families are facing a double whammy. To sum up, what I believe is needed now is a concerted bipartisan effort by Congress and the Administration to develop and implement a comprehensive energy and conservation initiative. It needs to be done now. It should have been last year or the year before that. I believe until we get a handle on our dependency on foreign oil, we are going to continue to have real severe problems. Thank you. " 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-111shrg50815--116 LEVITIN Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.2. I am unsure to which ``rules'' the question refers; I assume it refers to the recent unfair and deceptive acts and practices regulations adopted by the Federal Reserve, Office of Thrift Supervision, and National Credit Union Administration under section 5 of the Federal Trade Commission Act. If so, I strongly but respectfully dispute the premise of the question; the scenario that is presented is exceedingly alarmist. The question wrongly implies that all individuals with FICO scores of 620 or lower currently have access to ``traditional'' credit cards. They assuredly do not. First, nearly 10 percent of the United States adult population is ``unbanked,'' and that means almost by definition that they do not have credit cards; card penetration into the unbanked market is de minimis. Thus, at least half of the impact implied by the scenario is not possible. For the remaining 10 percent or so who have FICOs under 620, many do not currently have access to ``traditional'' credit. Instead, they have access to predatory new credit products like ``fee harvester'' or ``secured'' credit cards. Even if these non-traditional products were included in the term ``traditional,'' I think it is also dubious that all or even most of them would cease to be able to get ``traditional'' credit; nothing in the proposed regulations limits issuers' ability to protect against credit risk through either lower credit limits or higher interest rates or other fees. To the extent that these individuals are not able to get credit cards or choose not to accept them because of onerously high interest rates, the answer to where they would turn for financing needs depends on the particular circumstances of the individual, but I believe that many consumers would first cut down or eliminate non-essential expenses, which would reduce their financing needs. Demand for credit is not entirely inelastic. For these consumers' remaining financing needs, many would turn to family and friends for assistance. See Angela Littwin, Testing the Substitution Hypothesis: Would Credit Card Regulations Force Low-Income Borrowers into Less Desirable Lending Alternatives? 2009 Ill. L. Rev. 403, 434-35 (2009) (noting that borrowing from family and friends is the most frequent form of borrowing for low-income women). It is also important to note that empirical evidence suggests that ``credit cards are actually among low-income consumers' least-preferred sources of credit, meaning that there is no ``worse'' alternative to which they would turn if credit card access were reduced.'' Id. at 454. Beyond family and friends, there are also other legitimate, high-cost sources of credit besides credit cards--pawn shops, rent-to-own, and overdraft protection, e.g. There, of course, is a possibility that some low-income consumers will turn to illegitimate sources of credit, such as loan sharks, but this possibility could be tempered by community-based small loan programs. Indeed, given that the Federal Government is currently subsidizing credit card lending through the Term Asset-Backed Securities Lending Facility (TALF), it seems quite reasonable to support other forms of consumer credit lending. Indeed, in Japan, where there is a 20 percent usury cap, credit rationing and product substitution are significantly tempered by a government-supported small loan system. Nor is it clear that the terms on which ``loan sharks'' lend are actually worse than some subprime credit card products. As Woody Guthrie sang in the Ballad of Pretty Boy Floyd: Now as through this world I ramble I see lots of funny men Some will rob you with a Six gun And some with a fountain pen. But as through your life you travel As through your life you roam You won't never see an outlaw Drive a family from their home.Woody Guthrie, American Folksong 27 (1961). Finally, given the terms on which individuals with FICO scores of under 620 are able to obtain ``traditional'' credit, I think it is quite debatable whether ``traditional'' credit is in any way beneficial to them; fee-harvester cards and other subprime credit card products are as likely to harm consumers with poor credit ratings as they are to help them; these cards can improve consumers' credit scores over time, if the consumer is able to make all the payments in full and on time, but by definition a consumer with a FICO of under 620 is someone who is unlikely to be able to do that. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. Again, I respectfully disagree with the premise of the question. The new uniform Unfair and Deceptive Act and Practices regulations adopted by the Federal Reserve Board, the Office of Thrift Supervision and National Credit Union Administration under section 5 of the Federal Trade Commission Act (``Reg AA'') do not prohibit risk-based pricing. Reg AA only prohibits retroactive repricing of existing balances. Card issuers remain free to increase interest rates prospectively with proper notice or to protect themselves immediately by closing off credit lines. That said, I would expect that Reg AA would likely reduce credit availability to some degree, although perhaps not to all consumers. This is not necessarily a bad outcome. Credit is a double-edged sword. It can be a great boon that fuels economic growth, but that is only when credit does not exceed a borrower's ability to repay. Credit can also be a millstone around the neck of a borrower when it exceeds the ability to repay. Overleverage is just as bad for consumers as it is for financial institutions. To the extent that Reg AA reduces credit availability, it might be a good thing by bringing credit availability more in line with consumers' ability to repay. Q.3. Consumer Disclosure: You state that the sheer number of price mechanisms make it difficult for consumers to accurately and easily gauge the cost of credit. You cite things such as annual fees, merchant fees, over-the-limit fees, and cash advance fees. You seem to suggest that credit cards should become much more plain vanilla because people simply can't understand the different uses and costs for those uses. Don't these different pricing mechanisms also provide more choices for consumers as they make purchasing decisions? A.3. That depends on the particular pricing mechanism. Many of them provide dubious choices or value for consumers. Consider over-limit fees, late fees, cash advance interest rates, and residual interest and double cycle billing. (1). LOverlimit fees. A consumer has no right to go overlimit and cannot assume that an over-limit transaction will be allowed. Moreover, overlimit can be the result of the application of fees, rather than of purchases. Therefore, overlimit is not exactly a ``choice.'' (2). LA late fee is no different than interest, just applied in a lump sum. I am doubtful that most consumers would prefer an up-front lump sum late fee rather than a higher interest rate. For the large number of ``sloppy payers'' who pay their bills a few days late, a higher interest rate is much better than a large flat late fee, but because consumers systematically underestimate the likelihood that they will pay late, they are less concerned about the late fee than the interest rate. (3). LMost cards charge a higher interest rate for ``cash advances.'' A cash advance, however, is not necessarily the payment of cash to the consumer. Instead, cash advances include the use of so-called ``convenience checks'' that card issuers send to consumers with their billing statements. (Incidentally, convenience checks present a considerable identity theft problem because they lack cards' security features and the cardholder has no way of knowing if they have been stolen. They expose issuers to significant fraud losses and should be prohibited as an unsafe and unsound banking practice.) Convenience checks permit cardholders to use their card to pay merchants that do not accept cards, like landlords, utilities, and insurers. This allows consumers to pay these bills even when they do not have funds in their bank account. But convenience checks carry the cash advance interest rate plus a fee (often a flat 3 percent with a minimum amount). These terms are usually disclosed on the convenience checks only partially and by reference to the cardholder agreement. It is doubtful that most consumers retain their cardholder agreement, so whether consumers understand the cost of using convenience checks is a dubious proposition. (4). LSimilarly, billing tricks and traps like residual interest or double cycle billing are hardly a ``choice'' for consumers; these are not product differentiations that are tailored to consumer preferences, as few consumers know about them, let alone understand them. Restricting card pricing could limit innovation in the card market, but it is important to recognize that not all innovation is good. There has been very little innovation in the card industry over the last twenty years, either in terms of technology or in terms of product. Cards still operate on the same old magnetic stripe technology they had in the 1970s. The card product still performs the same basic service. To the extent there has been innovation, it has been in the business model, and it has frequently not been good for consumers. Even things like the 0 percent teaser rate are hardly unambiguous goods. While 0 percent teasers are great for consumers who can pay off the balance, they also encourage consumers to load up on credit card debt, and if there is a shock to the consumer's income, such as a death, an illness, a divorce, or unemployment, the consumer is much more exposed than otherwise. I recognize that it is important to protect the ability of the card industry to innovate in the future, and that is why I believe the best solution is to set a default rule that simplifies credit card pricing, but to allow a regulatory agency, such as the Federal consumer financial product safety commission proposed by Senators Durbin, Kennedy, and Schumer and Representative Delahunt (S. 566/H.R. 1705, the Financial Product Safety Commission Act of 2009) to have the power to card issuers to introduce new products and product features provided that they meet regulatory consumer safety standards. Q.4. Bankruptcy Filings: As the recession worsens, many American families will likely rely on credit cards to bridge the gap for many of their consumer finance needs. Mr. Levitin and Mr. Zywicki, you seem to have contrasting points of view on whether credit cards actually force more consumers into bankruptcy, or whether credit cards help consumers avoid bankruptcy. Could both of you briefly explain whether the newly enacted credit card rules will help consumers avoid bankruptcy or push more consumers into bankruptcy? A.4. The newly enacted Federal Reserve credit card regulations will not have any impact on bankruptcy filings presently, as they do not go into effect until summer of 2010. When they do go into effect, their impact on consumer bankruptcy filings will likely be mixed. Credit card debt has a stronger correlation with bankruptcy filings than other types of debt. But this is not necessarily a function of credit card billing practices. Card debt reflects the macroeconomic problems of the American family--rising costs of health care, education, and housing but stagnant wages and depleted savings. The card billing tricks and traps targeted by the Fed's rules amplify this distress, but the Fed's rules will not solve the fundamental problems of the American family. To the extent that they limit the amplifying effect that card billing tricks and traps have on card debt levels, it will help some consumers avoid bankruptcy. If the rules result in contraction of credit availability, it might push consumers into bankruptcy, but that would have to be netted out against the number that are helped by a reduction in the amplification effect, and I am skeptical that there would be much contraction. I agree with Professor Zywicki that credit cards can help some consumers avoid bankruptcy. If a consumer has a temporary setback in income, credit cards can provide the consumer with enough funds to hang on until their financial situation reverses. But credit cards can also exacerbate financial difficulties, and even if the consumer's fortunes pick up, it might be impossible to service the card debt. Moreover, there are many consumers whose financial situations are not going to pick up, and for these consumers, card debt just adds to their distress. Q.5. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.5. Yes, but not by the same regulators. There is an essential conflict between safety-and-soundness and consumer protection. A financial institution can only be safe and sound if it is profitable. And abusive and predatory lending practices can often be extremely profitable, especially in the short term, and can compensate for the lender's other less profitable activities. The experience of the past decade shows that when Federal regulators like the Office of Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve are charged with both safety-and-soundness and consumer protection, they inevitably (and perhaps rightly) favor safety-and-soundness at the expense of consumer protection. These functions cannot coexist in the same agency, and consumer protection responsibilities for financial products should be shifted to a single independent Federal agency (which would not claim preemptive authority over state consumer protection actions) to protect consumer protection. Q.6. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? A.6. Banks are raising interest rates on consumers and limiting credit to cover for their own inability to appropriately price for risk in mortgage, securities, and derivatives markets has resulted in their solvency being threatened. Therefore, banks are trying to limit their credit card exposures and are trying to increase revenue from credit card accounts by raising rates. If banks are unable to competently price for risk for mortgages, where there is often robust underwriting, what confidence should we have in their ability to price for risk for credit cards where every loan is a stated income ``liar'' loan? The current financial debacle should cause us to seriously question banks' claims of risk-based pricing for credit cards. The original pricing failed to properly account for risk and the new arbitrary repricing certainly fails to account for risk on an individualized level. The only risk being reflected in the new pricing is the bank's default risk, not the consumer's. Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? Yes, it probably does because it is being done so arbitrarily. Q.7. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.7. No. The issue is a red-herring. As an initial matter, it is important to emphasize that the Federal Reserve's new regulations do not prohibit risk-based pricing. They only prohibit retroactive repricing of existing balances. In other words, they say that card issuers only get one bit at the risk pricing apple, just like any normal contract counterparty. Card issuers remain free to price however they want prospectively or to reduce or cutoff credit lines if they are concerned about risk. Second, it is important to underscore that to the extent that card issuers engage in risk-based pricing, it is only a small component of the cost of credit. I discuss this at length in my written testimony, but I will note that Professor Zywicki has himself written that 87 percent of the cost of credit cards has nothing to do with consumer risk; it is entirely a function of the cost of operations and the cost of funds. Todd J. Zywicki, The Economics of Credit Cards, 3 Chap. L. Rev. 79, 121 (2000). The remaining 13 percent represents both a risk premium and opportunity pricing. In many cases the opportunity-pricing component predominates. Therefore, there to the extent that credit card issuers do risk based pricing, it only has a marginal impact on the total cost of cards. As Professor Ausubel demonstrated in his written and oral testimony, a significant component of some credit card fees, like late fees, are opportunity costs. Likewise, in my written testimony, the section comparing my own credit cards, three of which are from the same issuer, but which have different rates that do not correspond with credit limits, indicates that there is significant opportunity pricing in the card market. Regulations that make cards fairer and more transparent would be unlikely to have much impact on consumer pricing. Third, it is not clear why cross subsidization should be a particular concern. It is a common fact of life. Consider flat-fee parking lots. Those consumers who park for 5 minutes subsidize those who park for hours. Similarly, at by-the-pound salad bars, consumers who eat only carrots subsidize those who eat only truffles. When cross-subsidization is regressive, it elicits additional concerns, but there are far more serious regressive price structures, not the least of which is the Internal Revenue Code. That said, I believe the cross-subsidization in the scenario to be unlikely because the risk that matters to card issuers is nonpayment risk, not late payment risk, and income and wealth generally correlate with low nonpayment risk. In sum, then, I think the cross-subsidization scenario presented is unlikely, and to the extent it occurs, the cross-subsidization will only be de minimis because of the limited extent of risk-based pricing. The problem presented by the scenario is a red herring concern and not a reason to shy away from regulating credit cards. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM KENNETH J. CHRG-111hhrg55811--269 Mr. Hixson," Thank you. My name is Jon Hixson, and I am director of Federal Government relations at Cargill. I want to thank you for the opportunity to testify today. Cargill is an international provider of food, agricultural, and risk-management products and services. As a merchandiser and processor of commodities, Cargill is an extensive end-user of derivatives on both regulated exchanges and in the OTC markets. Cargill's activity in offering risk-management products and services to commercial customers and producers in the agriculture and energy markets can be highlighted with the following OTC examples: We offer customized hedges to help bakeries manage price volatility of their flour so that their retail prices for baked goods can be as stable as possible for consumers and grocery stores; we issue critical hedges to help regional New England heating oil distributors manage price spikes and volatility on their purchases so that they can offer families stable prices throughout the winter season; and we offer customized hedges to help a restaurant chain maintain stable prices on their chicken so the company can offer consistent prices and value for their retail customers when selling chicken sandwiches. Chairman Frank's discussion draft is a positive step in addressing comprehensive market reforms of the OTC market. While we have some areas of concern, there are many well-supported elements included in this proposal. The discussion draft would improve transparency with dealer registration and audit trails, the proposal would create a regulated trade data repository and has a stronger focus on reducing systemic risk and more rigorous requirements for inter-dealer transactions. The bill also provides flexibility for end-users and traditional hedgers utilizing OTC risk-management products and clearly establishes regulatory authority to ban any swap deemed abusive. Cargill supports these provisions and appreciates the work of the chairman and other members of the committee in developing this discussion draft. The draft bill represents a significant improvement over many other proposals that, in our view, would overly restrict the use of OTC markets for hedging purposes. Our main concerns with the discussion draft relate to two areas of the legislation: first, the application of capital and margin requirements. The discussion draft gives regulators discretion in whether to impose margining requirements in traditional hedging and risk-management transactions. We appreciate this flexibility. However, we are concerned that, given recent regulatory statements and testimony, the imposition of mandatory margining for hedging transactions would still likely occur. This will make it very difficult, if not unlikely, that firms would be able to affordably and efficiently hedge their flour, heating oil, and chicken risks as described earlier. To ensure congressional intent, the legislation could include a list of factors and in a similar style as the provisions within the discussion draft that provide greater guidance on the clearing requirement. In addition, capital requirements should clearly recognize and reflect the risk-management processes utilized by dealers. When Cargill offers tailored risk-management products to our customers like the bakery hedge, we offset a substantial amount of that risk by taking positions on a regulated, centrally cleared exchange, margined for daily mark-to-market exposure. We also use margin agreements with most of our customers. These steps greatly reduce overall risks in the hedging transaction. Regulators should consider such prudent risk-management actions as they analyze and develop appropriate capital requirements to ensure that the charges are based on actual risk of loss. Regulators are also given much discretion in setting margin and capital requirements for non-bank dealers. The provisions often call for requirements as strict or stricter than those a prudential regulator would establish for a systemically significant financial institution. While we are very sensitive to the role played by a non-banking firm in last year's financial crisis, there should be some recognition that the bakery hedge, for example, did not cause systemic risks for the financial system. Excessive requirements on our segment will likely only result in less competition among dealers within the OTC segment. Surrogation of assets is our second area of concern. We are sympathetic to those who lost initial margin money last year and would like to work with others, including members of this committee, to address this issue. However, restrictions around variation margining will have the unintended consequence of curtailing sound business practices that would otherwise minimize the risks of a hedging transaction. We appreciate the opportunity to testify before the committee to offer examples of our use of OTC products in risk management and to highlight our areas of support and concern within the discussion draft. We look forward to working together as this legislation continues to develop. [The prepared statement of Mr. Hixson can be found on page 135 of the appendix.] Ms. Bean. Thank you for your testimony. We are going to proceed to the next witness, Professor Rene Stulz, chair of banking and monetary economics at the Fisher College of Business at Ohio State University. STATEMENT OF RENE M. STULZ, EVERETT D. REESE CHAIR OF BANKING AND MONETARY ECONOMICS, FISHER COLLEGE OF BUSINESS, THE OHIO FOMC20080430meeting--67 65,MR. STOCKTON.," I think that is a fair characterization. You know, one thing that we're struggling with--and I assume you are as well in giving your own views about the uncertainty and the skewness around your forecast--is whether things have changed. Is the skew large enough for us to argue that, in fact, the risks look unbalanced? We thought about that and about the potential upside and downside risks. Clearly, as I indicated, upside risks would be associated with ongoing increases in underlying prices for oil and other commodities that would probably feed through indirectly into core inflation over time. On the downside, we have been struck with how little upward pressure there has been on labor compensation and labor costs. Now, if you pinned me down and said draw a fine line on this, I'd probably say that, given the pattern of the past few years, it would look to me as though there's probably a little more upside risk than downside risk, but I don't see that skewness as being material in the forecast. " CHRG-111shrg56262--24 Mr. Davidson," Addressing the current illiquidity, I would focus sort of on two different areas. One is the area of uncertainty. We still have a tremendous amount of economic uncertainty and regulatory uncertainty, and that just takes some investors out of the market because they need the risks to know a little bit better. And the other area is just the lack of availability of leverage to certain types of instruments. Without leverage, many instruments have to trade at very discounted prices, and so the institutions who hold those now and do have leverage are not willing to transact at the all equity price as opposed to the leveraged price. And I think that is why some of the Government programs, like TALF, have been so effective is because they have reinstituted leverage into these markets. In thinking about the solutions, we have to consider what is the appropriate amount of leverage and make sure that that can be delivered through those markets because that will be an important part of their future success. " FOMC20080805meeting--17 15,MR. BULLARD.," Thank you, Mr. Chairman. I'm just following up here. I mean, as much as I love exhibits 14, 15, and 16--and I have used a lot of them myself when I talk about the economy--it is not really appropriate to look at these as measures of stress. You could just say that these are the equilibrium prices in an economy that is adjusting to a big shock. You could have a completely flat line here that would indicate stress in markets because these prices aren't moving around appropriately to the risks that have developed and opened up. So a lot of the concern around the table has been exactly that, when markets freeze up, you can't do any trade at any price; and for that the volume data would seem to be a much better indicator of the kinds of things that we are worried about. I think that this is conditioning a lot of our thinking about the economy--you look at this picture, and you naturally think it has to go back to 10 basis points before the crisis is over. That probably is not going to happen anytime soon and maybe never. Thanks. " 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? " CHRG-111shrg57322--706 Mr. Viniar," What is the value? And then if we have bought something and we still have it and we want to sell it and we just think our risk is too big, we might have to cut the price and sell it at 80 cents on the dollar and the other purchaser may not think it is a great security, but they may think it is worth more than 80 cents. They may think it is worth 83 cents, which is still not 100 percent, but it is a price at which they want to buy it. Senator Coburn. Could you answer this question for me, and maybe you can't, but I would like for you to try because it concerns a lot of us. How is it that Goldman got 100 percent payback on this collateral dispute with AIG? " FOMC20080805meeting--117 115,MS. PIANALTO.," Thank you, Mr. Chairman. My outlook for economic growth and inflation over the next few years is broadly similar to the one that I held last meeting, although I think that the prospects for both inflation and economic growth in the near term have deteriorated since June. To a close approximation, my outlook ends up looking very similar to the Greenbook's baseline scenario. The most significant change I am making to my outlook is to mark down the prospects for business fixed investment this year and next, based on the reports that I am hearing from the manufacturers in my District. There is an interesting short-term/long-term dynamic taking place in the manufacturing sector. The manufacturing CEOs with whom I have spoken say that over the long term they are very bullish on America. The dollar depreciation, increased transport costs, and rising wages in China all favor more U.S.-based production. A senior executive from Alcoa told me that, in his 35 years of working in the manufacturing sector, he has never seen the fundamentals point so strongly toward the United States as a profitable location for manufacturing. The short term, however, presents a more mixed picture for manufacturers. Although some industries, such as power generation equipment and aerospace, are running flat out and expect to continue doing so, companies in other manufacturing industries have received or expect to receive order cancellations. In particular, the manufacturers that supply the automotive and commercial construction sectors are reporting a worsening outlook. Perhaps the best way to summarize the sentiments that I am hearing from manufacturers is to say that they see a bright future but they see challenging conditions over the next 12 months. We all know that housing markets are extremely weak. Housing prices began their decline earlier in Cleveland than in the rest of the country, and we are now seeing some stability in housing prices. Despite that hopeful glimmer, we have not seen any pickup in home sales. Based on this experience, it seems that we still have a long way to go nationally before we see any pickup in residential construction. In regard to financial markets, my chief concern is that lending is going to be constrained by lenders needing to maintain sound capital ratios in the face of asset write-downs and loan charge-offs. Balance sheet constraints and a declining risk appetite on the part of bankers mean that some worthy borrowers are going to be rationed out of credit markets, further restraining economic activity. Turning to inflation, I anticipate that price pressures will intensify further before we see some relief, just as the Greenbook baseline scenario depicts. Manufacturers are still raising their prices in response to rising prices for raw materials that they purchase. Some companies have had fixed-price contracts in place for five and ten years, and as these contracts mature, the companies are passing on huge price increases to their customers. Consequently, I think that even after a point at which energy and commodity prices flatten out, prices at the wholesale and retail levels are likely to adjust upward for a while longer. I just said that manufacturers are expecting some challenging times ahead. One reason is that many of them are caught between weakening demand conditions and soaring input costs. Sherwin-Williams represents an extreme case, but I think it illustrates the situation pretty starkly. The CEO of Sherwin-Williams told me last week that their business is down more than 20 percent in sales channels both to new construction and to existing homes. They have been in business for 126 years, and the last time this occurred was during the Great Depression. Despite these dismal sales, they are having to raise prices. The CEO told me that the company typically raises prices once a year, but in July they announced their third price increase this year. In the entire history of the company, they have never before had three price increases in one year. So I continue to see the risk to my projection for output as being to the downside for the reasons that we have been discussing for some time--high energy prices, severe financial stress, and a depression in the housing markets. The risk to my inflation outlook is weighted to the upside because I am concerned that inflation could remain elevated for too long, potentially destabilizing inflation expectations. The Greenbook baseline scenario expects the near-term inflation picture to worsen in the second half of this year before improving gradually over the entire forecast period. This pattern is a concern to me. In that environment, I worry that inaction on our part before next year could be seen as complacency on our part. So when I stack up the two risks against one another, I regard them as fairly equal right now. But my outlook is conditioned on a federal funds rate path that begins to increase about a quarter earlier than called for in the Greenbook baseline. I will speak to the relevance of this factor when we discuss monetary policy in the next go-round. Thank you, Mr. Chairman. " FOMC20060328meeting--76 74,MR. STOCKTON.," For my part, the most salient risk that I would note is housing, for a few reasons. One, it’s an asset market as well as a natural investment, and I just don’t know how to forecast those prices. I think that, in our presentation last June, we made pretty clear just what the uncertainties are there. Beyond that, I’m not sure what the effects will be if, in fact, there is a correction either on the construction side or on the price side. There are just so many uncertainties. As we’ve noted in the past, we use a standard wealth effect to calculate the consequences of that. But there could be bigger effects associated with equity extraction. There also could be confidence effects that are difficult to gauge. And so I see big risks on both sides. Obviously, I’d be more worried about the downside risk than the upside risk if we get another couple of years of things going on as they have been going. It means that for a while you’ll have to lean a little harder against the strength in housing, but it also means you’ll be dealing with potentially bigger consequences when the correction in housing markets occurs. So looking at the data, I’m feeling comfortable with our basic forecast—that things are tipping down. But as I indicated, we’re just really not sure what it’s unwinding to—whether it’s unwinding to the sort of benign soft landing that we’re forecasting. We think that forecast is reasonable. There’s nothing in the rate environment or in other factors that makes the forecast look far-fetched to us. On the other hand, one could certainly envision a more painful and bumpier adjustment that will cause bigger problems for the Committee." FOMC20080805meeting--119 117,MR. PLOSSER.," Thank you, Mr. Chairman. Economic conditions in the Third District remain relatively weak, but they are not materially different from what we and our business contacts have been expecting for the past several months. Manufacturing and residential construction sectors continue to show a slow decline. Payroll employment in our three states fell in June, but it is still above the levels of where it was three months ago and so has been performing somewhat better than in the nation as a whole. The pace of retail sales seems to have been softening, and commercial real estate firms indicate that most office and industrial markets have weakened slightly since the spring. My business contacts generally expect weak growth for a while. Manufacturers do expect a rebound during the next six months; but most other sectors, particularly retail sales, anticipate only soft or slightly improving conditions in the near term. Residential real estate is not expected to strengthen appreciably in the second half of the year. Banks expect somewhat sluggish growth in overall lending for the rest of the year, although compared with some regions, banks in our District are in pretty good shape. There are stresses, but they seem to be manageable. Credit, however, is generally available to businesses, and we hear only sporadic information from businesses that they are unable to obtain needed loans. For some time my business contacts have expressed concern about rising energy and commodity and transport prices. Our business outlook survey's prices-paid index rose yet again in July, and it is now at its highest level since March 1980. Although the prices-received index edged down slightly, it remains at a very, very high level relative to historical standards. The BOS's future prices-received index rose to 49.6 percent, which is the highest level it has been since January 1989. This indicates that roughly half the manufacturing firms that responded to our survey expect the prices they receive for their products to be increased over the next six months. To gauge the extent to which manufacturing firms have been able to pass on rising costs to their customers, we asked several special questions about product pricing in our July survey. More than 60 percent of our respondents indicated that, since the beginning of the year, they have been able to raise prices and pass along increased costs to their customers. About 26 percent said this took the form of increases in base prices. Almost half of them had increased base prices. The rest said they have used either surcharges or escalator clauses and, in some cases, combined those with base price increases as well. Surcharges and escalation clauses are not likely to go away anytime soon and may even become more widespread. About 56 percent of our respondents indicated that price escalation clauses and surcharges are likely to be a part of their pricing in the future. Further, since a large number of firms have already built cost increases into their base prices, it is not clear at all that prices will come down quickly, even if oil prices stabilize at a lower level. On the national level, the incoming data since our June meeting have been mixed but largely in line with my expectations for the near-term path of the economy. Real GDP growth for the second quarter came in somewhat weaker than many expected, although I will note that as recently as April many people were expecting negative growth in the second quarter and it is now almost 2 percent. But I think that the strength is a remarkable testament to the ability of this economy to weather shocks from financial market disruptions, a severe housing correction, and surges in energy and commodity prices. Nonfarm payroll employment has fallen an average of 66,000 jobs per month over the last seven months--a weak number to be sure but not nearly as severe as the job losses over the last three recessions, which averaged nearly 180,000 jobs a month. Since our June meeting, we have taken further steps to address fragile financial markets that were manifested by the difficulties surrounding the GSEs and the IndyMac takeover. On balance, my outlook for the economy is little changed, although the financial market developments since our last meeting have marginally increased the uncertainty surrounding my forecast. I do see near-term weak growth for the economy, but I continue to expect an improvement in output and employment growth next year as the economy rebounds closer to trend. Unfortunately, there has been a resurgence in financial market volatility, especially on the part of the banking sector and mortgage markets related to the problems of the GSEs. The liquidity in the interbank and primary dealer markets appears to have improved somewhat relative to the first quarter of this year. I read the conditions in the financial markets and the wide spreads on selected assets as having improved somewhat on net and the spreads we are seeing increasingly reflecting real credit risk as opposed to dysfunctional markets. As I indicated in my questions earlier, we should not use such spreads as the primary criteria for assessing the fragility of the financial markets. Moreover, we must be cautious in using monetary policy or other tools at our disposal as a form of forbearance that delays the necessary adjustments in the pricing of various financial claims. I think we need a high hurdle--that there are real market failures--before we intervene to stem liquidity desires on the part of traders or attempt to influence the price of specific asset classes. To agree with President Bullard's comments, we should begin to deemphasize and destress the importance of systemic risk because I think it is gradually dissipating as firms adjust to the more volatile and risky environment. The current state of the financial markets seems to me to bear some resemblance to the financial headwinds analogy that many people referred to during the early 1990s. Indeed, spreads on many forms of business and consumer loans are behaving now much in the way as they typically behave during recessionary times as credit risks rise. In the early '90s, monetary policy was less accommodative than it is now--at least the funds rate reached a low point of 3 percent from October 1992 to February 1994--and during that time headline PCE inflation ran about 2 to 3 percent. The real funds rate, measured by a one-quarter-ahead forecast of the CPI from the professional forecasters, was minus 0.1 percent over the six quarters from 1993:Q3 to 1994:Q4. Currently, the real funds rate using the same measure of one-quarter-ahead professional forecasters' CPI stands at minus 1.1 percent. The inflation outlook remains a cause of concern. Headline inflation is higher, and there is evidence of modest pass-through to core inflation measures. Inflation compensation on the six-to-ten-year horizon has risen modestly. Inflation compensation at the near term has fallen with recent declines in oil prices, but it remains volatile. The staff has suggested that a portion of the increase in the longer-dated inflation compensation measures may reflect an increase in inflation risk premiums. That is, markets are uncertain about the long-run path of inflation. This is not terribly comforting. It suggests that our credibility may be waning. Despite the recent drop in oil prices, I remain uncomfortable with the longer-term inflation outlook. Indeed, the focus of monetary policy must be on the intermediate to longer term, and we must resist the temptation to act as if our funds rate decisions can manage the outcomes over the very near term. Year-over-year inflation, headline CPI and PCE inflation, have now been consistently above 3 percent since October 1987. Year-over-year core PCE inflation has exceeded 2 percent every month but one since April 2004. That is four years. Businesses are reporting an increased willingness to pass on cost increases. Near term, we might get some moderation in headline inflation, if the recent drop in oil prices holds. This might result in less upward pressure on inflation expectations, at least in the near term. Of course, as has been pointed out, oil prices are notoriously hard to predict, and we may well see a resurgence in oil prices before the year's end; but we don't know. More important, a drop in oil prices will only temporarily mask what I view as the underlying inflationary pressures. Oil prices have clearly exacerbated the recent numbers and may mitigate them in the near term going forward. But my concern is that the real source of intermediate-term to longer-term inflationary pressures comes from our own accommodative policy, whose consequences for inflation will be felt only over time. We are unable to control the rise in oil prices and its consequences for inflation in the short term, but we must hold ourselves accountable for the longer-term consequences of our choices. Should we maintain our accommodative stance for too much longer, my view is that we are likely to see higher trend inflation in the intermediate term and a ratcheting up of inflation expectations. If that scenario unfolds, it will take a much more costly policy action to re-anchor those expectations than the cost of a preemptive move to raise the funds rate in the near term. To be sure, shifting policy to a less accommodative stance will be a difficult decision to make, given the continued volatility in financial markets and the projected near-term weakness in employment and output growth. However, what has been referred to as the tail risk of a very negative growth outcome has decreased since the start of the year, whereas inflation risks have increased. I think the enhancements we have made to our liquidity facilities should be sufficient to address any remaining dysfunctions in the financial markets, but they will not address the credit or solvency issues, nor should we expect them or desire them to do so. The markets will have to do that admittedly heavy lifting. I do not believe that we can wait until employment growth and the financial markets have completely turned around to begin to reverse course. But by our aggressive attention to short-term risk to growth and financial turmoil, we do put at some risk our ability to deliver on our intermediate- and longer-term goals of both price stability and sustainable growth. Thank you, Mr. Chairman. " FinancialCrisisReport--197 Resisting FDIC Advice. During the period 2004-2008, internal FDIC evaluations of Washington Mutual were consistently more negative than those of OTS, at times creating friction between the two agencies. OTS also resisted the FDIC’s advice to subject WaMu to stronger enforcement actions, downgrade its CAMELS rating, and solicit buyers for the bank. As early as 2005, the FDIC examination team expressed concerns about WaMu’s high risk lending strategy, even though the bank’s management expressed confidence that the risks were manageable. In an internal memorandum, for example, the FDIC team identified multiple negative impacts on WaMu’s loan portfolio if housing prices were to stop climbing. The memorandum stated in part: “Washington Mutual Bank’s (WMB) single-family residential (SRF) loan portfolio has embedded risk factors that increase exposure to a widespread decline in housing prices. The overall level of risk is moderate, but increasing. … A general decline in housing prices would adversely impact: a) The SRF loan portfolio; b) The home equity loan portfolio; and c) Mortgage banking revenue. … In January 2005, management developed a higher-risk lending (HRL) strategy and defined company-wide higher-risk loans as … sub prime loans … SFR loans with FICO scores below 620, … consumer loans with FICO scores below 660, and … [the] Long Beach … portfolio. Management intends to expand the HRL definition and layer additional risk characteristics in the future. … Management acknowledges the risks posed by current market conditions and recognizes that a potential decline in housing prices is a distinct possibility. Management believes, however that the impact on WMB would be manageable, since the riskiest segments of production are sold to investors, and that these investors will bear the brunt of a bursting housing bubble.” 752 751 See, e.g., April 16, 2010 Subcommittee Hearing at 61 (testimony of OTS Director Reich: “[F]irst of all, the primary regulator is the primary Federal regulator, and when another regulator enters the premises, when the FDIC enters the premises, confusion develops about who is the primary regulator, who really is calling the shots, and who do we report to, which agency.”) 752 Undated draft memorandum from the WaMu examination team at the FDIC to the FDIC Section Chief for Large Banks, FDIC-EM_00251205-10, Hearing Exhibit 4/16-51a (likely mid-2005). In an interview, when shown the draft memorandum, FDIC Assistant Regional Director George Doerr, who was a member of the WaMu examination team, told the Subcommittee that this type of analysis was prepared for a select group of mortgage lenders, including WaMu, to understand where the mortgage market was headed and how it would affect those insured thrifts. He did not have a copy of the final version of the memorandum, but said the FDIC’s analysis was discussed with OTS. Subcommittee interview of George Doerr (3/30/2010). FOMC20051213meeting--88 86,MR. FERGUSON.," Thank you, Mr. Chairman. The concept of the known unknown came to the national consciousness about a year or two ago, and I sense that it’s very much in this room today. The baseline forecast calls for a very nice, soft landing to potential growth with contained inflation if we just tighten our policy one or two more turns. I’m certainly prepared to accept that forecast for the purpose of today’s meeting, but the uncertainties or the known-unknown factors around it are to me quite obvious. To me the risks are clearly to the upside with respect to growth, but surprisingly may be more balanced with respect to inflation. It is easier to see an upside growth risk than a downside one, in large part because the incoming data have been surprisingly robust, making a slowing just a quarter or two away seem a little bit of a stretch. Much of the waning wealth effect on which the baseline is built is due to a slowing in the housing market. It is true that some of the indicators suggest some moderation there, December 13, 2005 56 of 100 when lined up against the actual strength shown in home sales themselves, both existing and new— and also prices, which have continued to appreciate at a double-digit pace through the third quarter— it is hard to say that the housing market is anything but robust. A second element of the wealth effect that the Greenbook assumes is that the equity price appreciation will be no more than needed to keep the current level of the equity risk premium about stable. But again, it is easy to see some upside potential here. The equity risk premium is now above average. The recent run-up in equity prices, coupled with sustained high levels of productivity growth, an attractive profits outlook, and healthy corporate balance sheets all make it perhaps a little more likely that equity prices will rise rather than fall, and indeed, rise more than expected. If this were to occur, the earnings-price ratio would decline and the equity risk premium would return to the normal range, and in doing so would provide more equity wealth impetus to the economy than perhaps the baseline assumes. Finally, global growth is a surprise to the upside. As Dino indicated, equity prices have shown remarkable strength globally. Monetary policy itself has in many cases been somewhat stimulative and generally financial conditions have been supportive of growth. All of this suggests a bias toward faster global growth due to accommodative financial markets broadly. On inflation, I judge that the risks to the baseline forecast are perhaps a little better balanced. While the upside growth risk would certainly pressure resources with inflationary consequences, that is not the entire story. For one thing, inflation has come in a little softer recently than we had expected. Secondly, energy prices seem to have flattened, and market participants expect them to moderate even further, providing a rapid diminution of the upward momentum to headline inflation. December 13, 2005 57 of 100 pass-through has been relatively low. Finally and importantly, longer-term inflation expectations are moderate. I would also add in this regard something that has not been much discussed here: Labor compensation itself has been on the weaker side, even as resource utilization has tightened. And finally, the productivity growth story, I think, has shown continued robustness. In this regard I’d point out that we talk a great deal about the upward adjustment to the structural productivity growth in the staff forecast, but all they’ve really done is just to maintain what has happened from 2001 to 2004. So maybe we’ve put too much weight on the temporary downward movement as opposed to just recognizing that things haven’t changed very much. So given this view of the risks around the forecast, why do I propose that we accept the baseline for purposes of today’s decision and communication? First, I am mindful that policy works with long and variable lags. While the risks for us are not totally balanced, the greater weight of the evidence, I think, is still for a good outcome, given that we have moved rates up quite considerably. And with inflation expectations still well contained, I think there’s no reason to adjust market perceptions of what we’re likely to do going forward. If those two facts did not adhere, my judgment might be different. Secondly, one would have to say that while the housing sector story is yet to come, there are, as we’ve heard around this table, a large number of anecdotes all pushing primarily in the same direction—supporting, I would think, the baseline. Third, I take some comfort in the fact that the baseline forecast is shared roughly by most outside forecasters. The Greenbook does not seem to be out of the trend. The Blue Chip consensus is that after more than two years of above-trend growth, activity in 2006 is likely to moderate to its trend December 13, 2005 58 of 100 underlie the Blue Chip are not distinguishable dramatically from the Greenbook forecast. President Moskow has already talked about what happened in Chicago at their outlook symposium. Again, the consensus seems quite consistent with our forecast from the staff. And the NABE members we met with in this room not too long ago also expect growth to be in the range of 3.25 to 3.5 in 2006. Finally, I am willing to take the baseline as the basis for policy today because I recognize that our language will convey the proper sense of caution to reflect the risks and leave us with the flexibility to respond to other changes. I will delay any further comment on that, as you have suggested, until the second part of our discussion." CHRG-111hhrg48867--174 Mr. Bartlett," Dr. Price, I would share the one that we have come up with, and this is about our 18th draft: ``Systemic risk is an activity or a practice that crosses financial markets or financial services firms and which, if left unaddressed, would have a significant material and adverse effect on financial services firms, markets, or the U.S. economy.'' " FOMC20061025meeting--83 81,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Our view of the national outlook hasn’t changed much since September. If monetary policy follows the path that’s laid out in the Greenbook, and it’s flat for the next few quarters, then we expect growth to return to a level close to 3 percent in ’07 and for inflation to moderate gradually from current levels. However, we still face the basic tension in the forecast—the combination of relatively high core inflation today and an economy that has slowed significantly below trend—and we still face the same basic questions: Will inflation moderate enough and soon enough to keep inflation expectations reasonably stable at reasonably low levels? Will weakness spread beyond housing and cumulate? Relative to September, we see somewhat less downside risk to growth and somewhat less upside risk to inflation, but as in September, I think inflation risks should remain our predominant concern. Relative to the Greenbook, we expect somewhat faster growth in ’07, but we have a higher estimate of potential. The difference is really mostly about hours and trend labor force growth. We expect more moderation in core PCE and expect it to fall just below 2 percent in ’07, but this difference is mostly the result of different assumptions about persistence. With these exceptions, our basic story about the contour of the expansion is fairly close to the Greenbook, and the implications for monetary policy are similar. The markets do seem relatively positive, a little more optimistic about the near-term outlook. Equity prices, credit spreads, and market interest rates all reflect somewhat less concern about both recession and inflation risks. Some of this, however, is probably the result of the exceptional factors supporting what the markets call liquidity. What is liquidity, and what’s behind it? I don’t know that we have a good answer to that. Most people would cite a combination of the facts that real interest rates are fairly low in much of the world still, that reserve accumulation by the countries that shadow the dollar is still quite large, that a big energy-price windfall is producing demand for financial assets, particularly in dollars, and that there is confidence in the willingness and ability of the central bank, particularly this central bank, to save the world from any significant risk of a recession. I don’t think all of this, therefore, is the result simply of confidence about fundamentals, so we shouldn’t take too much reassurance. But it still is a somewhat more positive constellation of asset prices, of market views about the outlook. Someone wrote this week that the fog over the outlook has lifted. I don’t think that’s quite right. It’s true that the economy still looks pretty good except for housing, and I do think it’s fair to say that core inflation is moderating and that expectations are behaving in ways that should be pretty reassuring to us. But it is too soon to be confident that inflation is going to moderate sufficiently soon enough with the path of monetary policy priced into markets today, and it is too soon to be confident also that the weakness we see in housing, in particular, won’t spread and won’t cumulate. So I think that overall the balance of risks hasn’t changed dramatically, and as in September, I still view the inflation risk as the predominant concern of the Committee." 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. " FinancialCrisisReport--391 Goldman began marketing Hudson 1 securities in October 2006, soliciting clients to buy Hudson securities. It did not fully disclose to potential investors material facts related to Goldman’s investment interests, the source of the CDO’s assets, and their pricing. The Hudson 1 marketing materials stated prominently, for example, that Goldman’s interests were “aligned” with investors, because Goldman was buying a portion of the Hudson 1 equity tranche. 1581 In its marketing materials, Goldman did not mention that it was also shorting all $2 billion of Hudson’s assets – an investment that far outweighed its $6 million equity share and which was directly adverse to the interests of prospective investors. In addition, the marketing materials stated that Hudson 1’s assets were “sourced from the Street” and that it was “not a balance sheet CDO.” 1582 However, $1.2 billion of the Hudson assets had been selected solely to transfer risk from ABX assets in Goldman’s own inventory. Goldman also did not disclose in the materials that it had priced the assets without using any actual third party sales. The absence of arm’s length pricing was significant, because the Hudson CDO was designed to short the ABX Index using single name RMBS securities, and there was a pricing mismatch between the two types of assets. 1583 Goldman not only determined the pricing for the RMBS securities purchased by Hudson 1, but retained the profit from the pricing differential. The marketing materials did not inform investors of Goldman’s role in the pricing, the pricing methodology used, or the gain it afforded to Goldman. In addition, the marketing materials stated Hudson 1 was “not a balance sheet” CDO, without disclosing that Hudson had been designed from its inception to remove substantial risk from Goldman’s balance sheet. The Hudson 1 Offering Circular contained language that may have also misled investors about Goldman’s true investment interest in the CDO. The Offering Circular stated: “[Goldman Sachs International] and/or any of its affiliates may invest and/or deal, for their own respective accounts for which they have investment discretion, in securities or in other interests in the Reference Entities, in obligations of the Reference Entities or in the obligors in respect of any Reference Obligations or Collateral Securities ... , or in credit default swaps ... , total return swaps or other instruments enabling credit and/or other risks to be traded that are linked to one or more Investments.” 1584 This provision seems to inform investors that Goldman “may invest” for its own account in the CDO’s securities, reference obligations, or CDS contracts, while withholding the fact that, by the time the Offering Circular had been drafted, Goldman had already determined to take 100% of the short position in the CDO, an investment which was directly adverse to the interests of Hudson securities investors. 1581 10/2006 Goldman Sachs report, “Hudson Mezzanine Funding, 2006-1, LTD.,” at 4, GS MBS-E-009546963, Hearing Exhibit 4/27-87. 1582 1583 1584 Id. For more information on this pricing mismatch, see the Hudson discussion, below. 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS- E-021821196 at 251 (emphasis added). CHRG-111hhrg58044--28 Mr. Snyder," Good morning. Chairman Gutierrez, Ranking Member Hensarling, Mr. Price, and members of the subcommittee, my name is Dave Snyder, and I am vice president and associate general counsel for the American Insurance Association. In the midst of the financial turmoil and its related chaos, the U.S. property and casualty insurance sector is stable, secure, and strong. There are good reasons for this. We, you and the States never lost sight of our fundamental shared goals, reduce risk where possible, accurately assess and assume the remaining risk, and provide effective coverage to the American people. As a result, auto and homeowner's insurance markets are by every measure financially sound, competitive, and affordable. Claims are being paid daily by solvent companies. The market is very competitive by any measure and insurance is taking less of a bite out of household incomes than in the past. This is good for the economy because this maximized competition forces prices down to the lowest feasible level so people have money to spend on other things. Insurance scoring has played a major role in creating this positive market for all concerned. By empowering more effective risk assessment and pricing, the majority of the population pays less. Insurance is more available and more people can receive reasonably priced coverage, instead of being relegated to the high-risk pools, because insurers have a cost-effective tool to assess and price for risk, giving them the certainty they need to provide coverage to nearly everyone. You have asked us to address certain issues relating to insurance scoring. In summary, it is race and income blind, and has repeatedly been proven to be an accurate predictor of risk, indeed, one of the most accurate. The States have actively regulated it and insurance commissioners have full access to all the information they desire. In response to your request for recommendations, we suggest that all States adopt the National Conference of Insurance Legislators' model law. Second, the States should make sure they capture and analyze all of the credit complaints they can and communicate with insurance companies about them, individually, and any trends. We note, for example, from Director McRaith's testimony, that the rate of complaints under the existing system for credit-based insurance scores is about 1 complaint out of every 1.5 million policies issued or renewed. In addition, we all need to work together more effectively on financial literacy to help the American people understand how insurance scores are used by insurance companies to provide them with coverage. There is one other recommendation we did not emphasize in our written statement, that is to make it more possible to innovate on a pilot basis. For example, to introduce more direct measures of driving performance, such as the ability to assess risk, based not only on mileage, but how, when, and where those miles were driven. One other factor in the strength of the personal lines insurance market is that we have collectively reduced risk. Thanks to your leadership and that of safety groups, the insurance industry, and the States, far fewer Americans are injured and killed on our highways than ever would have been expected. Using fatality rates of 1964, last year alone, we have collectively saved 120,000 lives and prevented millions of injuries. This has created a solid foundation of the healthy auto insurance system we have today. The insurance industry is focused on building safety as never before through advocacy of smoke detector laws and codes requiring sprinklers and disaster resistant buildings, and the eminent opening of a building construction test center with wind turbines powerful enough to test the structural integrity of buildings. We hope to see a pattern of positive change similar to that which we helped bring about in auto safety with your cooperation and assistance. Thank you for inviting me to speak with you today. I would be pleased to answer any questions you may have. [The prepared statement of Mr. Snyder can be found on page 147 of the appendix.] " FOMC20051101meeting--140 138,MR. KOHN.," Thank you, Mr. Chairman. Unlike President Geithner, I view the incoming information over the intermeeting period as having mixed implications for what might be required from us to keep inflation in check. On the one hand, demand and output, as he noted, appear to be continuing to grow at a pace that over time is likely to gradually put added pressure on resources. Apparently, the tightening of monetary policy, the rise in energy prices, and the appreciation of the dollar in the first half of the year were not enough to slow growth to trend in the third quarter. And the September employment report and October data on initial claims suggest that the underlying pace of job creation has been maintained going into the fourth quarter. Moreover, demand over the next few quarters, as many of you pointed out, should be boosted by the ramping up of rebuilding efforts. Still, conditions do seem to be in place for a moderation in growth over the intermediate term. Financial conditions have tightened. Interest rates have moved higher; in response the exchange rate has firmed and stock prices have dropped a little. All of the increase since the last meeting was in real interest rates, and most of the rise didn’t seem to be in response to data, but rather to our own speeches, making it unambiguously restraining. In addition, volatilities have backed up a little and risk spreads have widened just a little since the middle of the summer, suggesting that investors are a bit less confident about the future, even if they’re still too confident. Data and anecdotes on housing markets hint at some moderation, and that began even before the recent rise in rates, perhaps as a consequence of the earlier increases in interest rates as well as the elevated level of house prices relative to incomes. Home equity loans at banks actually fell last month, suggesting that equity extraction is no longer so attractive. But as best we can tell, without a November 1, 2005 66 of 114 slowed, while price increases for condos have moderated very little and remain quite high. All in all, we seem to have reached an inflection point in the housing market, fortunately. And house price increases, working through the wealth channel and as an inducement to construction, should be less of a stimulus to demand in the future, though how much and how fast is a very open question. Higher energy prices could take something off of consumption, even after gasoline prices decline in coming months. Natural gas prices will be elevated through the winter heating season. And the negative results of consumer sentiment surveys—which persisted into October, even as gas prices declined—could be suggesting a more marked response than we’ve seen over the past few years of increases. In the staff forecasts these forces slow the economy to a rate of growth slightly below its potential, even with a slight easing of financial conditions as policy firms less than the market has built in. It’s as good a guess as any and better than any forecast I might make. Given the range of uncertainty, however, the important point for us at this meeting is that growth is likely to slow to closer to the rate of growth of potential, but it’s probably going to take at least a couple more policy firmings. The news on prices and costs has been more favorable for the inflation outlook. Core inflation has been damped, despite substantial increases in energy prices before the hurricanes. Because the increases in the prices of petroleum and petroleum products have been large and sustained, they are more likely to show through to core prices than at any time since 1980. But I’m encouraged by the lack of much response so far this year. And energy prices themselves have eased off much more than expected when we last met. Pass-through effects of past increases in energy prices in the staff forecast are magnified and November 1, 2005 67 of 114 results of the Michigan Survey are cautionary, but long-run forward measures of inflation compensation in the market have risen only modestly, and they do remain well below their levels of last year and the early part of this year. I suspect that household inflation expectations will ease back if gasoline prices retreat, as they are expected to. Business labor costs are probably not putting much upward pressure on prices. The trend in ECI compensation continues to be favorable, including wages and salaries increasing at a 2½ percent rate for several quarters now. The lack of upward pressure is especially noteworthy in the face of huge increases in consumer energy costs, and it seems inconsistent with tightness in labor markets that might begin to escalate costs at prevailing levels of resource utilization. And productivity growth in the third quarter was strong, holding down the rise in unit labor costs. In the Greenbook, compensation and core prices accelerate noticeably over coming quarters. In my view, incoming price and compensation data raise the odds that the pickup could be a bit smaller, with inflation settling at a slightly lower level if output follows the Greenbook path. On attitudes, we’ve had competing anecdotes at this meeting. Most of you—I think the majority of you—seem to suggest that businesses are sensing some increased pricing power. That would, if it’s true, support the staff forecast; but it hasn’t shown through in actual prices paid by consumers as of yet. Because the economy seems to have a good deal of forward momentum at a time when resource utilization is high, and because higher energy prices do threaten to feed through to core prices and inflation expectations, we need to continue firming until we have some better indications that conditions are in place to keep inflation restrained. Underlying trends in output and employment will be obscured by the effects of the hurricanes, including the onset of rebuilding efforts, and this circumstance probably amplifies the already November 1, 2005 68 of 114 neutral federal funds rate, will be in reducing the risk of overshooting. They do provide a rough guide that we’re in the neighborhood, but I don’t think they’re a very precise measurement. In that regard, I myself am not uncomfortable retaining the “accommodative” language until we decide we don’t need to tighten anymore. I’ve defined accommodative for my own purposes as too low [laughter]—too low to accomplish my objectives. I think we can mitigate the risk of overshooting in policy by keeping our eyes on the underlying drivers of resource utilization and demand—such as housing prices and household reaction to energy prices, as well as cost pressures and inflation expectations. And I do think the “measured pace” of tightening has been helpful in this regard as well, in contrast to 1994 and 1995 when tightening picked up at the end and I think the risk of overshooting increased. I’m comfortable with tightening again at this meeting and signaling that we do not think we are finished removing accommodation. But just what we should signal about our expectations for the future will require a fresh look at each meeting, and I support the general sentiment that we need to look at our language very, very carefully going forward. Thank you." CHRG-111hhrg51698--178 Mr. Buis," All right. Thank you, Congressman. That farmer, that soybean farmer in Albert Lea, what this really means to them is their ability to price their product when they can get a decent return out of the marketplace. That doesn't occur after harvest, because you generally have a lot of product coming onto the market. So they look for opportunities at other times during the year, after harvest, on when they are going to deliver that product and get the best price. When they are precluded from the marketplace, like this time, in many cases--my friend, Mr. Damgard, got $7\1/4\ for his corn, but not everyone did--then they have to accept a price after harvest. If you look at all the spring crops this year, in Minnesota and elsewhere, they all collapsed before harvest; and so those producers were put at even a greater risk. I would remind the Committee this is--the original derivative is farmers selling their products after harvest into the future, and that sound financial instrument was taken out of their hands this year. " FOMC20071211meeting--43 41,MR. STOCKTON.," Food is important. In fact, we devote, I would imagine, a surprising amount of resources to it. We have an agricultural economist whose job is to follow those developments and report on them. It is his view—and based on both the futures prices and some of the modeling that we have done—that we will see a deceleration going forward in retail food prices. As you know, futures prices basically are projecting a flattening-out. I assume that is part of what is in Nathan’s forecast as well. We are not trying to outguess the markets in that regard, and the reports that we have received on agricultural production look relatively favorable for the coming year. Now, most of that is a bit of winter wheat at this point and not much more in terms of production, although we have seen some significant rebuilding of both flocks and livestock herds that suggests that we are on the right track in terms of an output response to the higher prices that we have seen in the past year. Markets are tight, and I think there probably is some asymmetry in the risk surrounding the food price forecast, in that it is easier to see some possibility of stock-out problems if there is any shortfall in production over the coming year, than that there would be some massive boom in agricultural production that will depress prices sharply. But I do think—and in the Greenbook Part 2 quite often, especially in the autumn, when we are actually doing a more careful accounting of the harvest—we devote a fair amount of attention to resources to it. We can certainly do even more going forward." CHRG-109shrg30354--89 Chairman Bernanke," Senator, the two interact because if there was just a one-time pass-through and the public were completely convinced that the Fed would keep inflation low and expectations were low and the Fed were perfectly credible, then that inflation would be just a temporary thing and would come back down. So the risk is the interaction of the two. The risk is that inflation will go up because of energy prices, because of greater pass-through, and that will feed into inflation expectations, which then will feed into a round of additional price increases and the like. You really cannot get a permanent increase in inflation unless people increase their inflation expectations. That is why the Fed's credibility is, I think, such a major asset of the United States. Senator Sununu. It seems to me to the extent that you are in the midst of a little bit of a dilemma it is as follows. Right now, inflation is above what has been stated in different ways your target range. We have still got high energy prices. So that would suggest that the absolute level of inflation remains a concern. On the other hand, you have a forecast for moderating growth. You have a slowdown in the housing industry. So while the inflation numbers may push you toward a rate increase, the moderating growth that has been forecast might encourage you to pause or to forgo further rate increases. That is a dilemma. I think we all understand that. To what extent is the fact that you now find yourself in this dilemma the result of a slowness or a delay to action in beginning this cycle of rate increases? " CHRG-110hhrg44903--79 Mr. Hensarling," Thank you, Mr. Chairman. Mr. Geithner, in my opening comments I asked a rhetorical question; now I would like to ask a direct question. And that is, just how will the Federal Reserve think about the balance between price stability, financial stability, consumer protection, full employment, and taxpayer protection? I am curious about how you, as head of at least the New York Fed, would think about this balance. And what would be the risk associated with increasing the charge to the Fed with more responsibilities, particularly at a time when at least many of our constituents, when they look at price stability, might not give you an A-plus? " FOMC20080625meeting--92 90,MR. KOHN.," Thank you, Mr. Chairman. My forecasts for both economic growth and inflation are within the central tendency of the rest of you and a little stronger than the staff's outlook. In fact, my 2008 projections for economic activity for the second half of the year were revised very little from two months ago. Growth turned out to be stronger than I expected in the first half, and that carries some weight going forward; but financial conditions are tighter with higher bond rates and lower equity prices, and of course oil prices are a lot higher and that will damp demand going forward. So I expect slow growth in the second half followed by expansion around, maybe a little above, the rate of growth of potential in '09 and '10, with the same basic story that everybody else has: drags on activity from declining housing activity, decreasing wealth, tight credit conditions, and higher petroleum prices. All of those drags will abate over time, allowing the natural resilience, with slightly accommodative financial conditions, to show through, and I assume a gradual tightening of monetary policy beginning next year. Incoming information on prices and costs has been mixed. Oil and food price increases will raise headline inflation, but core has been stable and has come in a little to the soft side of expectations, and labor costs as yet show no signs of accelerating. Going forward, I see a sharp decline in headline inflation later this year with the assumed leveling-out in oil prices and a gradual decrease in core as economic slack inhibits wage and price increases, offsetting the pass-through from oil prices. Now, that's my central tendency. I consider the odds on that being realized to be even lower than usual, and the usual odds are disappearingly small. It seems to me that the defining characteristics of the current situation are uncertainty and risk. We're facing multiple shocks, many of them unprecedented in size and persistence, in the housing market, financial markets, and commodities. The outlook is full of puzzles, and in my mind anyone who thinks he or she understands what's going on is either a lot smarter than I am or delusional--or both. [Laughter] I class the risks for both output and headline inflation as greater than usual, and let me tell you about some of the things I wrestled with. Financial conditions, are they accommodative? I continue to believe that the 2 percent nominal funds rate is not indicative of a highly accommodative financial condition, given the current state of financial markets. That is, in my view we have limited insurance. Spreads have widened sufficiently over the past 10 months both for long-term and short-term credit, and bank terms and conditions for loans and lines of credit have tightened enough that only a small part of the drop in the fed funds rate is showing through to the cost of capital for median households and firms. The staff's flow of funds estimates show a marked deceleration in the growth of both household and business debt in the first half of this year, from 10 percent for households last year to 3 percent in the first half of the year and from 12 percent for businesses to 7 percent in the first half of the year. A 2 percent fed funds rate will become accommodative as spreads narrow and financial functioning returns more toward normal, and that's one reason I assumed a gradually rising federal funds rate over 2009 and forward. The evidence about improving financial markets over the intermeeting period was decidedly mixed. Some spreads did come in from late April. Investment-grade businesses tapped bond markets in size, but almost all spreads remain unusually wide. We were reminded of the fragility of the evolving situation, especially in the financial sector, with the worries about continuing credit problems resulting in sharp declines in equity prices on financials and an uptick in their CDS spreads, which had narrowed the previous month or two; the downgrading of monolines and investment banks; and the increasing attention to the problems of regional banks. It would be surprising if these were not reflected in even greater caution by banks and other lenders in their lending practices. Also the securitization markets, especially for non-agency mortgages, are not functioning in a way to replace bank intermediation. This is going to be a prolonged process of reintermediation, deleveraging, and building liquidity with an uncertain endpoint. Like the staff, I assume that the conditions return to something approaching normal over the next 18 months, but the risks are skewed toward an even longer recovery period. The second topic is household spending. Households are facing a huge number of adverse shocks: higher oil prices, tighter credit, declining house prices, and rising unemployment. It's not surprising that confidence is at recessionary levels. It is surprising that spending is so resilient. I assumed that the saving rate would rise very gradually once the tax rebate effects wore off, but I think a more abrupt and sizable increase in household saving is a distinct downside risk. What about housing? Some sales measures have shown a few tentative indications of leveling off. I was encouraged by President Lockhart's report from Florida, but I'm also struck by renewed pessimism about housing in the financial markets. Equities of construction firms and builders have declined after stabilizing, actually rising, earlier this year. ABX indexes have turned down, reversing earlier improvements; and perhaps underlying the previous two developments, the Case-Shiller futures indexes remain in steep decline, though today's information was less weak than expected. The view of the financial markets, anyhow, is that the light at the end of the housing tunnel is receding, and declines in expected house prices must be an important reason for the erosion in market confidence in financial intermediaries. In sum, although the incoming data may have reduced the threat of a sharp drop in spending, in my view there remains a very pronounced downward skew around my outlook for modest growth in H2 and a strengthening next year. However, that downward skew around output did not translate into a downward skew around my forecast for headline inflation. In fact, I saw the risks on headline inflation as tilted to the upside, though roughly balanced around the gradual decrease in core. I think the upside risks result from two additional areas of uncertainty. One area is commodity prices, though the trend increases in commodity prices over the past few years can be attributed to rising demands from emerging market economies relative to sluggishly responding supplies. Despite Nathan's best efforts, I really don't think we have much of a clue about the cause of the spike in oil prices this year. It has been especially striking to me over the intermeeting period, when the prices of industrial commodities have been falling on balance. Presumably prices in these markets already incorporate expectations of reasonably strong global growth outside the United States as in the Greenbook. Absent any surprises, futures market quotes ought to be the best guide, but what we don't understand can fool us, especially when so much of the relevant information involves emerging market economies, where data are sparse and of questionable value. Given our experience over the past few years, I think continued increases in commodity prices would seem to be an upside risk. The other area is inflation expectations. I assume that as headline inflation comes down, both short- and long-term inflation expectations, especially in the survey data, will reverse their recent increases based a lot on the kind of information that President Yellen was observing about how the household survey has tended to follow contemporaneous inflation. I'm encouraged by the relatively flat readings on core inflation and labor compensation increases. Higher expectations have not so far become embedded in prices and costs, despite all the talk of passing along cost increases. But headline inflation is going to rise before it falls. Real wages will be further eroded by higher energy costs. Although this is a necessary part of an adjustment to an adverse terms-of- trade shock, it will be resisted. Hence, a further rise in inflation expectations and a stronger determination by households and businesses to act on those expectations will be a risk over coming months. With that further rise in oil prices, it's a bigger risk than it was a couple of months ago. In terms of the long-term projections, Mr. Chairman, I think I'm fine with something like your proposal. Our objective for adding a year was to give the public a better sense of where we're going over the long term. Given the shock to the economy, that's not as informative as it was before. I think we're close to where most people would say their inflation objective was, but not for the growth rate of potential or the NAIRU. I could live with option 3 or President Bullard's alternative to that--to state exactly what our long-term expectations are instead of talking about five to seven years or five to ten years. I don't think we'll gain a lot. I don't think the costs or benefits are very large on either side of this. Our problems now are not that people don't understand where we're going in the end. I think they have a pretty good idea that we want inflation to be a lot lower than it has been. But I think they don't really understand how we're going to get either to full employment or to price stability, given where we're starting. So I think the uncertainty about our objectives is a very small problem relative to the other problems now. But if we can reinforce what those objectives are, it might help a little around the edges. I do worry, as President Lacker said, that what we say about output and employment not be interpreted as goals but rather as a judgment about the state and the structure of the economy. I am hopeful that we could take care of that in what we say about what we're publishing. Thank you, Mr. Chairman. " FOMC20070131meeting--32 30,MR. DUDLEY.,"1 Thank you. In terms of market developments, I would like to focus on three major topics. First is the sharp adjustment in market expectations concerning monetary policy since the last FOMC meeting. Second, I will talk about the persistence of high risk appetites in credit markets, with a focus on what may be the most vulnerable market in the United States—the subprime mortgage sector. Third, I want to discuss the possible factors behind some of the sharp shifts we have seen in commodity prices since the last FOMC meeting, in particular whether these price movements reflect a shift in risk appetite among noncommercial investors or fundamental developments in supply and demand. First, there has been a sharp shift in market expectations with respect to interest rates since the last meeting. At the time of the December meeting, the consensus view among market participants was that the FOMC would begin to lower its federal funds rate target this spring and that this easing process would continue into 2008, with cumulative rate cuts of about 75 basis points. As you can see in chart 1, which looks at the federal funds futures market, and chart 2, which looks at the yield spreads between the March 2008 and the March 2007 Eurodollar futures contracts, expectations have shifted very sharply over the past month. There is now no easing priced in through midyear 2007 and a residual of only about 25 basis points of easing priced in beyond that. This shift in expectations can also be seen across the Treasury yield curve. As chart 3 shows, the Treasury yield curve is now slightly above where it was at the time of October FOMC meeting. Since the December FOMC meeting, there has been a rise of about 35 to 40 basis points in yields from two-year to thirty- year maturities. The shift in expectations is reflected predominately in real interest rates. As can be seen in chart 4, breakeven inflation rates have not changed much since the last FOMC meeting—the decline in breakeven rates that occurred early in the intermeeting period has been reversed more recently, and so we are at or slightly above where we were at the December meeting. This upward shift in real rates appears to reflect a reassessment by market participants not only about the near-term path of short-term rates but also about what level of real short-term rates is likely to prove sustainable over the medium and longer term. The buoyancy of the recent activity data may have caused some market participants to reassess what level of the real federal funds rate is likely to prove “neutral” over the longer term. Regarding the issue of risk appetite, there appears to be no significant change since the last FOMC meeting. Risk appetite remains very strong. Corporate credit spreads remain very tight—especially in the high-yield sector (as shown in chart 5)— and implied volatilities across the broad market categories—equities and interest rates (see chart 6) and foreign exchange rates (see chart 7)—remain unusually low. Moreover, the turbulence in some emerging debt and equity markets experienced 1 Material used by Mr. Dudley is appended to this transcript (appendix 1). early this month was mostly transient and has subsided as well. So things appear calm. But what are the areas of greatest risk? In the United States, the subprime mortgage market appears to be a particularly vulnerable sector. The vulnerability stems from four factors. First, this market is relatively new and untested. Chart 8 shows the overall trend of first residential mortgage originations and the share of these mortgages by type—conforming, jumbo, subprime, and alt-A, which is a quality category that sits above subprime but is not quite as good as conforming. As can be seen in this chart, subprime mortgage originations have climbed in recent years, even as overall originations have fallen. In 2006, subprime mortgages were 24 percent of total originations, up from a share of about 10 percent in 2003. The second factor is that credit standards in this market appear to have loosened in 2006, with the proportion of interest-only loans and low- documentation loans climbing as a share of the total. As a result, there are some signs that strains in this market are increasing. As chart 9 shows, delinquency rates have moved somewhat higher. In contrast, charge-offs remain low, held down by the rapid house price appreciation that we saw in recent years. Most noteworthy, as shown in chart 10, the most recent 2006 vintage of subprime mortgages is showing a much more rapid rise in delinquencies than earlier vintages showed. The third factor is that most outstanding subprime mortgage loans have adjustable rates. There is significant reset risk given the rise in short-term rates in 2005 and the first half of 2006 and the fact that many of these loans started with low “teaser” rates. Fourth, housing prices are under some pressure, and this could contribute to further credit strains. I see some risk of a vicious cycle. If credit spreads in the securitized market spike because loan performance is poor, a sharp downturn in lending could result as the capital market for securitized subprime mortgage products closes. This constriction of credit could put downward pressure on prices and lead to more credit problems among borrowers. The result would be additional credit quality problems, wider credit spreads, and a further contraction of credit. Fortunately, to date the news is still fairly favorable. The strong demand for the credit derivatives obligations created from subprime mortgage products has restrained the rise in credit spreads. As can be seen in chart 11, spreads are still well below the peaks reached in late 2002 and early 2003. Thus, the economics of making such loans and securitizing them into the capital markets still work. But this situation could change very quickly, especially if the labor markets were to become less buoyant and the performance of the underlying loans were to deteriorate, leading to a surge in delinquencies and charge-offs. Let me now turn to the commodity markets. The issue I wish to examine here is whether some of the sharp movements in commodity prices that we have observed since the last FOMC meeting represent shifts in the risk appetite among noncommercial investors who have put funds into commodities as a new asset class versus the contrasting view that these price movements predominantly represent changes in the underlying supply and demand fundamentals. To get a sense of this, let’s look briefly at three commodities that have moved the most and are representative of their classes—copper, corn, and crude oil. As chart 12 shows, the sharp decline in copper prices appears linked to the large rise in copper inventories at the London Metal Exchange. If anything, the price decline appears overdue. For corn, the rise in prices also appears consistent with declining stocks both in the United States and globally (see chart 13) as well as the growing demand anticipated for corn in the production of ethanol. For crude oil, the decline in prices is more difficult to tie back to inventories. Although U.S. inventories remain high relative to the five-year historical average (as shown in chart 14), this situation has persisted for some time without having a big effect on prices. Instead, the shift in oil prices appears to be driven mostly by longer-term forces. This can be seen in two ways. First, as shown in chart 15, the change in oil prices has occurred in both spot and forward prices. The oil curve has shifted downward in mostly a parallel fashion, which also calls into question the role of unseasonably warm weather as the primary driver. If weather were the primary factor, then the decline in prices should have been reflected much more strongly in the spot and very short-end of the oil price curve. Second, as shown in chart 16, OPEC spare production capacity has been increasing and is expected to continue increasing in 2007. This growing safety margin reflects both slower growth in global demand and the expansion of non-OPEC output. The improved safety margin may be an important factor behind recent developments in the energy sector. Finally, there were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the December FOMC meeting." FOMC20061025meeting--246 244,MS. DANKER.," I’ll be reading the directive wording and the risk assessment for alternative B from page 29 of the Bluebook: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” Then the risk assessment: “Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”" CHRG-109shrg30354--72 Chairman Bernanke," I think it is the risk that we are considering, and again it is just a risk, that inflation might move up and might force us to be more aggressive, which we do not want to do, because we hope that inflation will stay under control or come down as we expect it to. I think that is a risk. We also have the geopolitical issues. We have seen the latest in the Middle East, for example. Oil prices are a risk and a concern, and we are paying very close attention to that situation as well. Senator Menendez. And last, I had asked you in a written question which you answered about paying down publicly held debt and the importance of that. Now we see where CBO tells us we are headed to $12 trillion worth of debt by 2011. How much importance do you place on paying down that publicly held debt in the context of long-term economic health? " CHRG-111hhrg52397--12 Mr. Price," Thank you, Mr. Chairman, I appreciate it. In a free market, over-the-counter derivatives provide an essential function by allowing companies to customize the way that they address their risks. Many companies have successfully used OTC products to help their consumers save money and to create jobs, including 3M, which is testifying today, as an end user of derivatives. A market-based economy allows institutions to succeed and to fail. And they fail for a number of reasons: The business takes on too much risk; it may be under bad management; or it may have an ineffective business model. Despite the fact that credit default swaps have come under fire lately because of AIG's remarkable over-exposure, when they are used appropriately, they can be a very effective risk management tool. Thus, we need to be extremely cautious and careful as we decide how to appropriately regulate derivatives. In fact, the market has already begun addressing some of the concerns that credit default swaps and OTC derivatives posed. So I look forward to hearing from the witnesses about what they are doing to make OTC and CDS trades more transparent. In the end, however, regulation must not be a one-size-fits-all system. Such a system stifles innovation, raises prices for consumers, punishes entrepreneurs, and destroys jobs. Thank you, Mr. Chairman. " CHRG-111hhrg53021--130 Mr. Scott," Thank you very much, Mr. Chairman. I am over here, Mr. Secretary, over here in the corner. I would like to see if I could squeeze in a couple of questions. First of all, I have a concern that your proposal could very well force non-financial dealers to meet capital requirements in order to provide legitimate managed risk. But, given that these non-financial dealers do not have depositors, unlike large financials, and a low or no systemic risk profile, is it possible that such a requirement could unintentionally create a bank monopoly in the over-the-counter derivatives market? And wouldn't that reduce competition, reduce liquidity, raise prices, and increase systemic risk by consolidating the markets? " CHRG-111hhrg53021Oth--130 Mr. Scott," Thank you very much, Mr. Chairman. I am over here, Mr. Secretary, over here in the corner. I would like to see if I could squeeze in a couple of questions. First of all, I have a concern that your proposal could very well force non-financial dealers to meet capital requirements in order to provide legitimate managed risk. But, given that these non-financial dealers do not have depositors, unlike large financials, and a low or no systemic risk profile, is it possible that such a requirement could unintentionally create a bank monopoly in the over-the-counter derivatives market? And wouldn't that reduce competition, reduce liquidity, raise prices, and increase systemic risk by consolidating the markets? " FOMC20070509meeting--16 14,MS. JOHNSON.," The basic message from the rest of the global economy is that economic conditions are favorable and appear likely to remain so through the end of next year. Although small variations in the basically optimistic outlook are present, real GDP growth in the foreign economies seems poised to continue at an average annual rate of about 3½ percent throughout the forecast period. Inflation risks are present as slack has been reduced in several foreign economies. However, we anticipate that central banks abroad will respond further as needed such that inflation abroad will edge up only slightly through the end of 2008. In this forecast round, the staff had to contend with a move back up in global crude oil prices and further increases in nonfuel commodities prices—shocks common to the whole global economy. In addition, for the U.S. outlook, we needed to take account of the depreciation of approximately 2 percent in the foreign exchange value of the dollar over the intermeeting period, as Dave discussed. We have recently revisited the question of whether we could improve upon the forecast for crude oil prices embedded in market futures prices and have convinced ourselves based on empirical evidence that we cannot. As a result, our projections for future WTI spot oil prices and the average oil import price are shifted up and down over time by fluctuations in spot and futures oil prices. This has been an “up” forecast round. After reaching a peak around August of last year, global oil prices fell through very early this year and then reversed to trend back up, but not smoothly. The upward move of oil prices over the intermeeting period was apparently a response to the surprising degree of continued production restraint from OPEC and heightened concerns about supply from Iran, Iraq, and Nigeria. The strength in global demand for energy, too, no doubt provided support for continued elevated prices. In this forecast we also had to take into account a deviation in the usual price spread between West Texas intermediate and other grades of oil. Reduced refinery activity has led to an unusually large accumulation of crude oil stocks in the Midwest, the delivery area for WTI, and depressed its price relative to that for other grades. When we were finalizing the baseline forecast, spot and futures prices implied an increase to our projection for WTI crude oil in the current quarter of about $4.50 per barrel relative to the projection in the March Greenbook; however, this change understates a bit the upward shift in overall oil prices because of the change in spreads. These considerations led us to revise upward the average oil import price in the Greenbook for the current quarter about $6.50 per barrel. We expect that over the forecast period the relative prices of WTI and other grades will gradually move back toward normal, so our upward revision narrows somewhat in future quarters, particularly by the second half of 2008. The baseline forecast reflects the consequences of these higher oil prices for the U.S. economy and the rest of the world. Turning points in the ups and downs of oil prices have an uncanny way of happening at the time that we are finishing the Greenbooks, and such a turning point might have happened again. Since the Greenbook path was set, crude oil prices have moved back noticeably. If we were concluding our forecast today based on yesterday’s futures prices, we would show an upward revision in the near term of only about half that in the Greenbook. For 2008, our upward shift would be about two-thirds of that in the Greenbook. The effects of this more benign level for oil prices would be slightly positive for real GDP growth both in the United States and abroad. Such a lower projected path for oil prices would also slightly lessen the pressures on headline inflation rates that are a feature of the baseline forecast. Another element in the forecast worth a brief mention is the upward revision to both core import price inflation and core export price inflation for the second quarter, to annual rates of 4.5 percent and 5.5 percent, respectively. Prices for core imports and core exports accelerated in the first quarter as prices for food and industrial supplies, particularly fuels and metals, surged. Metals prices have continued to rise in recent weeks, and the increase, along with the recent depreciation of the dollar, led us to revise up our current-quarter projections. In constructing our forecast for these trade prices, we base our projection of the commodity-price component on market futures prices. Again, we have done recent work to see if a better alternative is available, but we have concluded that none is. Despite rapid increases in prices of various traded commodities over the past few years, the futures markets are implying a path through the end of 2008 that is about flat for an index of nonfuel commodities. In combination with our projection for only modest real dollar depreciation and no major changes in overall inflation rates here and abroad, such an outlook for commodity prices yields a deceleration in both core import prices and core export prices. Our forecast for the increase in these prices in 2008 remains low, at 1.3 percent. Although oil prices have been revised up this time, their projected path flattens in mid-2007. This outlook and the flat projected paths for commodity prices and the dollar imply a waning of the upward push to consumer prices that has resulted from rising oil and commodity prices. Consequently, in the Greenbook forecast, only limited further tightening by some foreign central banks is required to contain inflation. That events in these markets may surprise futures traders and us for yet another year with additional commodity-price increases is a major risk to our outlook for inflation. David and I will be happy to take any questions." FOMC20060328meeting--132 130,MR. STONE.," Thank you, Mr. Chairman, and welcome back. And welcome to the new Governors. First, I’d like to make a couple of comments on the region before I talk about the national economy. The Third District didn’t see a fourth quarter as weak as the national economy, nor is our first quarter as strong. But we’re seeing solid growth, which our indicators tell us will continue at current rates for the foreseeable future. Payroll employment is a particular issue in our District. With the benchmark revisions that were made, our employment growth has been stronger than we originally estimated. Our three-state unemployment rate fell to 4.4 percent in January, and businesses report an increasingly difficult time finding qualified workers. Indeed, more than half the respondents to a special question on our manufacturing survey said that they were having trouble filling openings because of the lack of qualified applicants. That’s an increase from 40 percent when we asked that question two years ago. Firms report the greatest difficulty in finding production workers and computer-savvy employees, but I would go on to point out that one of our directors, who heads a temporary employment agency, has been reporting for the past two years a continuing difficulty in finding workers with even limited skills to deploy. Manufacturing in our area continues to expand at a moderate pace. After a temporary dip in January, the index in our survey has rebounded to the level consistent with last summer, and that level is consistent with moderate expansion in activity. Retail sales in our District are rising only modestly, but retailers tell us that weaknesses in February were weather-related and that they expect a pickup in April. Demand for nonresidential office space in the District is growing, and that’s unusual for our market. The office market absorption rate is rising in the Philadelphia metropolitan area, and the office vacancy rate is declining in both the city and the suburbs. We had some office building in the last couple of years, which is the first office building we’ve had in downtown Philadelphia in a decade. We are seeing a few signs of modest slowdown in housing markets, with permits, home sales, and mortgage lending softening in recent months. Finally, we have received some further welcome news of moderation in price pressures in the District. Our manufacturers’ survey measures of prices received and prices paid have fallen sharply over the past two months. Expectations of future price increases remain subdued, and several respondents told us that, in their view, input price pressures have settled down and that their inflation concerns have subsided. Turning to the national economy, our economic outlook is broadly consistent with the Greenbook baseline. All signs point to a strong rebound of growth this quarter, after the temporary weakness in the fourth quarter. Employment, business spending, and manufacturing remain strong, and consumer spending continues to increase at a solid pace. There are emerging signs that the housing market is beginning to cool off, but no signs of a sharp retrenchment at this point. The economic fundamentals remain solid, and after the rebound this quarter, we expect growth to settle down to a range of 3 percent to 3½ percent, near potential growth. The economy is expected to remain near full employment, with labor markets tight. We expect hourly compensation growth to accelerate somewhat over the forecast period, but not dramatically. Now, in my view, the risks to growth are roughly balanced. A sharper decline in the housing market than that built into our forecast poses some downside risk, but it’s also possible that housing will not turn down as much as or as soon as forecasted. The extent to which we see an improvement or further deterioration in exports is another risk that could go either way. In fact, there appears to be a considerable divergence of views on the path of net exports among private- sector forecasters. In my view, the inflation risks are tilted somewhat to the upside. It’s true that the data on core inflation and inflation expectations and our own recent decline in survey measures of prices paid and received are encouraging. The acceleration of core inflation at the end of 2005 has been reversed in the first months of 2006. So far, firms have had a remarkable ability to absorb cost shocks via new-found productivity gains, and increased global competition has limited their pricing power. Both have helped keep inflation in check. On the other hand, oil prices remain at high levels and continue to be volatile. The ability of firms to maintain low pass-through in the presence of continued higher costs is a question. With inflation running near the top of the range that I consider consistent with price stability and with the economy operating at high levels of resource utilization, there is a risk that strong inflation pressures could emerge. Several times in the past we have seen core inflation quickly rise by a sizable amount when the economy was operating at high levels of resource utilization following periods of accommodative monetary policy, even when oil prices did not rise sharply. So in my view, the inflation risks remain at least moderately on the upside, even though the recent data have been benign. That said, on the whole I think the economy and the economic outlook are very positive. Thank you." CHRG-111hhrg74855--111 Mr. Gensler," Congressman, hedging is a very important part of our economy. We are promoting that in this bill. We are lowering risk to the American public allowing utilities and energy companies to hedge customized risk but those risks that are standard enough, for instance a 2-year risk on natural gas pricing, standard contract, we want to move that onto the clearinghouses to lower risk and very importantly on the transparent trading venues. And if I might note, I don't think the transparency costs end users. If you didn't know what an apple cost when you walked in the store, does it help you if you have to pay an extra nickel or 10 cents for that apple because you don't know what it cost the prior person walking in the store? I don't think so. We bring every securities transaction and every futures transaction to transparent markets. Why shouldn't we do that in natural gas and electricity over-the-counter markets? " CHRG-111hhrg52397--108 Mr. Pickel," Well, primarily because if you want to be able to have a product there for those who do need to hedge a risk, it is important to have a market there where people are willing to take a view on whether the pricing of that is cheap or expensive, so providing that liquidity. Furthermore, you have the traditional bond or loan holder, but you have other individuals, including the dealers who sell the protection to those people who hold the bonds and loans who will also need to manage that risk. So it is a complicated issue of many different types of risks even though the underlying bond and loan may be only held by 10 or 15 percent of the users. Mr. Miller of North Carolina. I probably do not have enough time to ask another question, so I yield back. " FOMC20050322meeting--102 100,MS. PIANALTO.," Thank you, Mr. Chairman. Conditions in the Fourth District have been gradually improving across a broad range of industries this year, and business confidence appears to be strengthening as well. Actually, it feels good to no longer be a Beige Book outlier. [Laughter] As it turns out, I am also not a Greenbook outlier. I find myself in broad agreement with the staff’s baseline projection. I know I should feel comfortable being in such good company, but I view the projection as the result of competing risks. Both the Greenbook and my business contacts are bringing to my attention the positives associated with productivity growth and the negatives associated with price increases. Although the rate of structural productivity growth might slow somewhat over the next few years, in my view the decline in the Greenbook multifactor productivity projections seems a little steep. The productivity growth surprises of the last couple of years may persist a bit longer. Business executives that I talk to tell me that they are still very focused on looking for opportunities to enhance productivity and that their capital investments are designed to achieve that goal. The drive for efficiency has become even more pronounced for those companies that are grappling with large increases in energy prices and in the prices of other raw materials. And, of course, many companies continue to experience large increases in medical care costs, adding to the incentives to wring out labor costs and other costs. The prospect that productivity growth may exceed the Greenbook baseline gives me some optimism about the inflation outlook at a time when the headline inflation numbers keep escalating. Yet the factors driving the price level up do not seem to be going away. Energy prices, as we’ve commented, have ratcheted up again. And, as multiyear contracts with energy suppliers roll off, many companies continue to face increases in the prices they have to pay. The same situation exists, March 22, 2005 37 of 116 and also intermediate products. In addition to these factors, there is also the possibility that past dollar depreciation could show up in the form of higher prices of both imported and domestic products. The anecdotal information that I have been receiving about pricing has taken on a different tone from last year. Last year, retailers like Wal-Mart and Home Depot would not accept price increases from their suppliers. But the dam seems to be showing some cracks. Recently, I heard from the CEO of a global company that supplies the big-box retailers with adhesive products, such as duct tape. He told me that during a recent meeting with Wal-Mart he explained that he was requesting a price increase. He was told that they weren’t accepting any price increases and that they would go to his competitors. Three days later he received a call from Wal-Mart saying that they were going to purchase these supplies from him at the price increases he requested because his competitors had also asked for a price increase. Also, a large manufacturer of capital equipment who supplies the adhesive industries, among others, told me that he can get price increases for his equipment even though his costs are not rising that dramatically. But because the businesses he is supplying are able to pass on price increases, they are willing to take a price increase from him. So it seems that, at least in this industry, it’s more than the adhesives themselves that are beginning to stick. [Laughter] All things considered, I do think that the pricing environment over the next year or so will be very challenging for companies. I see some evidence that price pressures have been building, yet, if businesses are successful in maintaining strong productivity growth, these pressures might be held in check. The Greenbook illustrates the tension between these two factors and, as I said, I can find March 22, 2005 38 of 116 I think our strategy of gradually removing our policy accommodation has convinced the public that we are determined to keep inflation in check over the long term. It will be important for us to earn that same degree of confidence as we go forward and as resources in the economy become more intensely utilized. Although I’m concerned that the possibility of inflation creep over the next year is there, the risks still seem balanced to me as long as we continue to remove our policy accommodation at a measured pace and do so for the foreseeable future. Thank you, Mr. Chairman." CHRG-111shrg57322--193 Mr. Swenson," We bid on--our requirement for our desk is to bid on ABS securities. When clients come to us, we try to give--we give the market value bid or the offer for that security. Senator Coburn. So you are a true market maker. So even if it is the worst possible combination of securities, there is a price at which the risk is worth taking. Is that correct? " CHRG-111hhrg55811--105 Mr. Gensler," The advantages that economists for decades have noticed is that end-users then get the benefit of seeing that price discovery function. If you are a small hospital in any State, and you are thinking about hedging an interest rate risk, you can see what happened even a half an hour earlier on a standard interest rate hedging transaction. " FOMC20060131meeting--110 108,VICE CHAIRMAN GEITHNER.," I’d like the record to show that I think you’re pretty terrific, too. [Laughter] And thinking in terms of probabilities, I think the risk that we decide in the future that you’re even better than we think is higher than the alternative. [Laughter] With that, the economy looks pretty good to us, perhaps a bit better than it did at the last meeting. With the near-term monetary policy path that’s now priced into the markets, we think the economy is likely to grow slightly above trend in ’06 and close to trend in ’07. We expect underlying inflation to follow a path close to current levels before slowing to a rate closer to 1.5 percent for the core PCE sometime out there. Relative to the Greenbook, we’re a little softer on growth in ’06 and a little stronger in ’07, but our inflation outlook is similar. The uncertainty around this forecast still seems considerable, perhaps more than the market has priced in. On the positive side, consumer and business confidence still seems pretty high, with employment growth solid and compensation growth likely to pick up. We think that household income growth is likely to be pretty strong. Investment may be strengthening, and it could surprise us with more strength. The tone of the anecdotal to us seems more positive, less cautious than it has been. And just to cite our Empire survey, the six-month-ahead numbers show a fair amount of optimism. Overall, financial conditions, of course, still seem quite supportive of continued expansion. Global growth has strengthened. And like the staff, the market seems to have looked through the negative surprises in the fourth-quarter numbers and priced in a bit more, rather than less, confidence about the strength of demand growth going forward. On the darker side, we have the familiar concerns about potential adverse shocks, energy supply disruptions, terrorism, et cetera. But even in the absence of these events, we face a fair amount of uncertainty about key elements of the forecast. The prevailing expectation of a gradual moderation in housing prices and a relatively small increase in the saving rate could prove too optimistic. Private investment growth could slow further, productivity growth could disappoint, risk premiums could rise sharply. And, of course, that could happen even in the absence of a major deterioration in the growth or inflation outlook. But this, on balance, still leaves us with what looks like a relatively balanced set of risks around what is still a quite favorable growth forecast. The inflation outlook still merits some concern—I think modest concern—about upside risk. Underlying inflation is still somewhat higher than we would be comfortable with over time. The core indexes are running above levels said to define our preference over time. Other measures of underlying inflation are running above the core rates. The behavior of inflation expectations at longer horizons has been reassuringly stable in the face of the elevated headline numbers, but the levels are still at the higher end of comfort. With the economy near potential, unit labor cost growth should accelerate. And, of course, although profit margins still show ample room to absorb more unit cost increases, their behavior suggests continued pricing power. The strength of global demand, the continued rise in commodity prices, other input costs, and the latest increase in energy prices all suggest a possibility of further upward pressure. With this outlook and this set of risks, we believe some further tightening of monetary policy is necessary with another small move today and a signal that some further tightening is probable. We’re comfortable with how the market’s expectations have evolved over the past few weeks and with the present forecast of perhaps one—maybe slightly more than one—move beyond today. It’s hard, though, to understand why the market attaches so little uncertainty to monetary policy in the second half of the year. And this underscores the fact that one of our communication challenges ahead is to make sure we convey enough uncertainty about our view of the outlook and its implications for monetary policy. In this regard, I want to compliment the recent innovations to the Bluebook presentations and hope that they persist." FOMC20050503meeting--167 165,MS. DANKER.," I’ll be reading from page 28 of the Bluebook the language for alternative B: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the May 3, 2005 102 of 116 the federal funds rate to an average of around 3 percent.” “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" FOMC20060808meeting--8 6,MS. JOHNSON.," From the perspective of the global economy, one of the important revisions in this forecast from last time is the projected path for crude oil prices. We have incorporated into the baseline forecast a path for both West Texas intermediate (WTI) prices and the U.S. oil import price that is more than $5 per barrel higher in the fourth quarter of this year and nearly $7 higher by the fourth quarter of next year than was the case in the June Greenbook. It is still true, however, that the projected path, based as usual on market futures prices at the time the forecast was made final, is quite flat. The sizable jump in oil prices this time reflects the volatility that we have seen in market prices for oil since late June, when the previous Greenbook was being finalized. Spot prices for WTI moved from below $70 per barrel at that time to a recent peak of $77 in mid-July and again yesterday, following BP’s announcement that pipeline repair in Alaska will shut in about 400,000 barrels per day of crude oil. Price fluctuations during the intermeeting period reflected market concerns about the potential effect on supply of ongoing events in the Middle East, some disruptions to production in Nigeria, and a slight reduction in output by Saudi Arabia, as well as an awareness that hurricane season has arrived. No doubt the underlying strength of the global economy is contributing by maintaining overall demand as well. As of close of business yesterday, the futures path for WTI oil prices during the remainder of this year and next year was about $2 per barrel above the Greenbook baseline path. Clearly, further moves in oil prices are a risk to the forecast. Another important element in the foreign outlook is the continued elevated level of nonfuel commodity prices, especially the industrial metals. Metals prices are down from their highs in May, but they are also up from their near-term lows in June. During the intermeeting period, spot prices for copper and zinc rose through mid-July and then partially reversed their recent increases but since have moved up again. On balance, metals prices are modestly higher since the time of the June Greenbook, but prices of other primary commodities are somewhat lower. As a result, our projected path for nonfuel commodity prices in this forecast is very similar to that of last time. The elevated level of these prices means that they will continue to have lagged effects on U.S. import and export price inflation for a time. The flatness of the path going forward means that we anticipate that the implications for import price inflation will abate noticeably in 2007, contributing to a sharp drop in the rate of inflation for core imports. Further fluctuation in the prices for these global commodities is also a risk to our baseline forecast. These developments in global commodity prices, both fuel and nonfuel, along with other data released over the intermeeting period, led us to revise up some our forecast for inflation abroad through mid-2007. We expect that the upward pressures on inflation in the industrial countries will be felt in the near term, particularly this quarter, whereas those in the emerging market economies will be evident later this year and into next. The revisions are small, in part because foreign industrial countries have to date been very successful at containing the inflation consequences of higher crude oil prices and several have tightened monetary policy and in part because emerging market economies have continued to suppress domestic energy prices, delaying their effects in the process. Some monetary policy tightening has also been implemented by a number of Asian central banks. We continue to read the evidence for foreign real GDP growth as indicating a solid pace of expansion, with the possible exception of Canada, where output growth slowed in the second quarter. We have fine-tuned our outlook for expansion abroad a bit—strengthening last quarter and this quarter and lessening the pace just a little next year; but the overall path for foreign real GDP is about the same as in June. Indicators from most of our important trading partners—for example, from Japan, the euro area, and China—suggest considerable momentum in foreign economic expansion at the present time. Global financial markets confirm a generally favorable climate for continued strong growth, and many of the signs of increased risk concerns and heightened volatility from earlier in the year have faded. Over the intermeeting period, stock prices in many of our trading partners have risen. Equity price indexes in emerging market countries, in particular, have rebounded from the lows of mid-June but generally have not returned to the levels reached in early May. Other than in the United Kingdom and Japan, yields on ten-year sovereign bonds have moved down 10 or more basis points in the major foreign industrial countries since your June meeting, and spreads on dollar-denominated emerging market sovereign debt have partially retraced previous increases and are not far above the lows observed in early May, with the exception of spreads for Turkish debt. On balance, the dollar is down just a little over the period. The bottom line is that the staff’s picture of the global economy implies an essentially neutral effect of the external sector on U.S. GDP growth over the forecast period, although one must remember that there are risks on both sides to that picture. The arithmetic contribution of real net exports to GDP growth for the rest of this year and next year is essentially zero—with a small positive contribution over the second half of this year, unusual for us, followed by a small negative contribution in 2007 as a whole. Exports of both goods and services are expected to grow strongly, supported by steady expansion of real GDP growth abroad. The step-down in U.S. real GDP growth should restrain import growth somewhat over the next six quarters. The nominal trade deficit on goods and services is projected to widen about $75 billion from the estimated figure for the second quarter to that for the fourth quarter of 2007. The change in the non-oil nominal trade balance accounts for only one-third of that $75 billion. This change in the overall trade balance is sufficiently small that the projected ratio of the trade deficit to GDP is steady at about 6 percent. Nevertheless, the current account deficit is projected to exceed $1 trillion at the end of 2007, and the ratio of the current account deficit to GDP rises from 6.5 percent to 7 percent next year. A growing net deficit in investment income flows largely explains the further deterioration in the current account balance. That change, in turn, is accounted for by a substantial widening of the deficit on portfolio income that more than offsets a gain in the balance of direct investment income. The financing requirements of our external deficit remain large and will continue to grow as long as the level of the trade balance remains far from zero. David and I will be happy to answer any questions." FOMC20060510meeting--132 130,CHAIRMAN BERNANKE.," At this point I would normally try to summarize the remarks around the table. But since you have all just heard them and since my own views are not terribly different from many who have spoken, I think in the interest of time I will just go ahead and talk briefly on my own behalf about what I see the economy doing, and then we will turn to the policy go-round. First of all, with respect to growth, I think we are following the path laid out by the Greenbook toward greater moderation in the second half. The main difference is that, since our last meeting, the uncertainty around that prospective path has increased. Obviously, the key to this moderation is the housing market, and fundamental analysis would suggest that the combination of high prices and rising interest rates would make affordability a problem and would bring housing starts and housing prices down. So far we are seeing, at worst, an orderly decline in the housing market; but there is still, I think, a lot to be seen as to whether the housing market will decline slowly or more quickly. As I noted last time, some correction in this market is a healthy thing, and our goal should not be to try to prevent that correction but rather to ensure that the correction does not overly influence growth in the rest of the economy. I would also note that there are going to be some offsets to the decline in residential investment. We’ve noted increases in nonresidential construction, which is about half the size, as a share of GDP, of residential construction and, in terms of contribution to GDP, could make up something like a half of the direct impact of a decline in residential spending. We also have gotten a sense that capital spending is relatively strong, and world growth is also strong, which may enhance our exports. So there are some countervailing factors to help cushion the presumed decline in the housing market. But as we talk about the housing market, which is 6 percent of GDP, or nonresidential construction, which is 2.7 percent of GDP, we have to pay very close attention to consumption, which is 70 percent of GDP and which really is the center of the forecast for the rest of the year. The soft landing scenario viewed in the Greenbook requires that consumption grow the rest of the year at something around 3.4 percent, which is roughly what it has been doing in the last year or so on average. I think that is broadly plausible. There are factors on both sides of it. Supporting consumption, obviously, are some increases in compensation likely coming forward both in terms of hourly wages and in terms of hours worked, job availability, and to some extent maybe increases in stock prices. On the negative side, many people have pointed out the effect of rising interest rates and softening in housing prices. Energy is actually a bit of a mixed bag. Energy prices are obviously a negative for consumption in level terms, but we have had a big drag on consumption for the past two years from increasing energy prices, and so if energy prices do stabilize, the drag will actually be less in 2006 than in previous years. So, again, I do think that the slowdown that has been forecast by the Greenbook is plausible, but like a number of people around the table, I would note that so far it is largely a prospective slowdown and that the data have only begun to support that development. On the inflation side, I have somewhat more concern, like a number of people. Core inflation has been remarkably stable, and I do not think it is going to rise very much; but to the extent that there are risks, they are very largely to the upside. And I also have some concerns about the possible emergence of some inflation psychology, which is a very negative thing for our policymaking. The factors that support higher inflation are well known. First, energy and commodity prices. I would point out that, rather than being transitory, they have now undergone a long, sustained increase, which evidently must at some point get into the cost structure of firms. Second, the weakening dollar over the past month or so may be sufficient to add some pressure. Third, the effect of compensation, I understand, is a little ambiguous. There are some factors working in the other direction, including markups and productivity, but clearly the sense around the table is that compensation is beginning to move up somewhat, and the risks there I think are also to the upside. Finally, it is worth noting that, at a technical level, some of the components of the inflation indexes are moving upward—in particular, owners’ equivalent rent. It economically makes sense that, if house prices have risen so much, rents will begin to rise. Since that is a very large share of both the CPI and the PCE core measures, that is going to be an upside risk for us. Now, again, I do not want to overstate the problem. I think that core inflation will remain contained, to use our language, but I am concerned about those risks. Clearly, the markets have seen a strengthening of the economy and increased inflation risk. Despite all of our communication and language, it is summarized by an increase of about 25 basis points in where they think the federal funds rate is going to end up later this year. We have seen and already discussed the increase in inflation compensation and in other measures of inflation expectations. Much of our confidence that the pass-through from energy, from the dollar, and from labor costs to final goods inflation will be low is predicated on the view that inflation expectations are low and well contained. When that premise begins to break down, then all the other elements of the analysis also begin to come under pressure. Finally, as a number of people have noted, although we do not have an official definition of price stability, we are at the upper level of what might plausibly be called the region of price stability, and further increases will be difficult and potentially costly to reverse. So looking forward to the policy discussion, I think we are going to have to take into account the emerging inflation risk. At the same time, there is an awful lot of uncertainty about what is going on in the economy. It is going to be a difficult balancing act to try to maintain as much flexibility as possible so that policy can respond to new data as they arrive. At this point I would like to turn over the floor to Vincent, who will talk about the policy options." CHRG-111shrg52966--33 Mr. Polakoff," Senator, I would say they understood the risk for the period of time that they were operating in, but failed to---- Senator Bunning. In other words, what I am trying to get at, there is a reasonable rate of return on equity that everybody expected at a given point in time. Somehow, that got out of kilter, and instead of being happy with a 7 or 8 percent return on equity, people were leveraging from--and I don't blame anybody, but regulators ought to be looking at the rate of return on equity and not giving permission for these firms to get into mischief, and that is what happened. That is why we are here today asking you these questions. The regulators should have stopped the risk takers taking undue risk with taxpayers' money or with equity that has been invested. Now the taxpayers are paying the price. So go ahead, finish your answer. " FOMC20080805meeting--115 113,MS. YELLEN.," Thank you, Mr. Chairman. Developments during the intermeeting period have heightened my concern about downside risks to economic growth and slightly allayed my concern about upside risks to inflation. Let me begin with growth. The moderate growth rate registered in the second quarter was disappointing, especially because it benefited from the temporary effects of the fiscal stimulus package. Moreover, the pattern of consumer spending during the quarter, with weakness in June, is worrisome. With all the publicity surrounding the rebate checks, households may have put them to work earlier than usual, especially since they were facing significantly higher prices for food and gasoline. This interpretation does not bode well for activity in the current quarter. Assuming no change in the funds rate this year, we have lowered our forecast for real GDP growth for the second half of the year about percentage point, to just � percent, and project a correspondingly higher unemployment rate. Our forecast for weak second-half growth reflects not only the unwinding of fiscal stimulus but also adverse financial sector developments. The credit crunch appears to have intensified since we last met. Evidence of tighter financial conditions abound. Risk spreads and the interest rates charged on a variety of private loans, including mortgages, are up noticeably, and lending standards have tightened further. Credit losses have risen not only on mortgages but also on auto loans, credit cards, and home equity lines of credit. As a consequence, the list of troubled depository institutions is growing longer. IndyMac and First National will not be the last banks in our region to fail. Indeed, the decline in broad stock market indexes is partly a reflection of the market's concerns about the health of the financial sector. Many financial institutions are deleveraging their balance sheets and reducing loan originations. For example, a large bank in my District has begun now in earnest to cancel or cap outstanding home equity loans and lines of credit, despite an ongoing concern about alienating consumers. Tighter credit is affecting demand. Anecdotal reports suggest that the plunge in July car sales partly reflects a tightening of credit standards for auto loans and leases. A large bank reports a substantial drop in demand for mortgage credit in response to the recent rise in mortgage interest rates, and the anecdotal reports that we hear support the Greenbook's negative view of the effect of credit conditions on investment in nonresidential structures. The housing sector is of considerable concern. House prices have continued to fall at a rapid rate, and futures prices suggest a further decline of around 10 percent over the next 12 months. This forecast seems reasonable given the overhang of homes for sale, the recent rise in mortgage rates, and the tightening of credit. Unfortunately, the risk of an adverse feedback loop from tighter credit to higher unemployment, to rising foreclosures, to escalating financial sector losses, to yet tighter credit remains alive and well, in my opinion. Indeed, stress tests conducted by some of the large financial institutions in our District reveal an exceptionally high sensitivity of credit losses to both home-price movements and unemployment. The ""severe financial stress"" simulation in the Greenbook illustrates my concern. It is not my modal forecast, but it certainly seems well within a reasonable range of outcomes. The probability of such a scenario has risen, in my view, since we met in June. One partially mitigating factor that should help to support consumer spending is the drop in the price of oil since our last meeting. But to the extent that the decline in oil prices partly reflects reduced expectations for global growth, the net impetus from stronger domestic spending will be offset by weaker export growth. Continued declines or even stabilization in oil prices will, however, be good for inflation. We have revised down slightly our forecast for core inflation as a consequence. Moreover, the fact that we were not once again surprised on the upside by oil prices has had a small favorable effect on my perception of inflation risks going forward. That said, inflation risks obviously remain. Even with the recent decline, energy prices are well above year-ago levels and are not only pushing up headline inflation but also spilling, to some extent, into core. Higher headline inflation could undermine our credibility and raise inflation expectations. If the public concludes that our implicit inflation objective has drifted up, workers may demand higher compensation, setting off a wage�price dynamic that would be costly to unwind. Fortunately, the reports I hear are consistent with the view that no such dynamic has taken hold. My contacts uniformly report that they see no signs of wage pressures. They note that high unemployment is suppressing wage gains. Growth in our two broad measures of labor compensation are low and stable; and taking productivity growth into account, unit labor costs have risen only modestly. I tend to think of the chain of causation in a wage�price spiral running from wages to prices, but it is certainly possible that the causation also, or instead, runs in the opposite direction. Either way, though, faster wage growth is an inherent part of the process by which underlying inflation drifts up, and at present we see not the slightest inkling of emerging wage pressures. Growth in unit labor costs also remains at exceptionally low levels. I would also note that I have looked for evidence of some increase in the NAIRU due to sectoral reallocation by examining the Beveridge curve, thinking that if there were sectoral reallocation we might see an outward shift in the Beveridge curve. I have detected no evidence of such an outward shift. These facts provide me with some comfort. Moreover, various measures of longer-term inflation expectations suggest that they remain relatively well contained. When we met in June, the Michigan survey of inflation expectations five to ten years ahead had recently jumped a couple tenths of a percentage point. I argued then that the respondents to that survey typically overrespond to contemporaneous headline inflation. Since that meeting, oil prices have come down a bit, and so have the Michigan survey measures. Assuming that the funds rate is raised from 2 percent to 3 percent in 2009, my forecast shows both headline and core PCE inflation falling to about 2 percent in that year. So, in summary, during the intermeeting period, my forecast for economic growth has weakened, and that for inflation has edged down slightly. I consider the risks to our two policy objectives pretty evenly balanced at the present time. " CHRG-111hhrg53246--69 Mr. Gensler," And our mission is to make sure that the markets are fair and orderly and provide the risk management for those hedgers. But through position limits, Congress gave us the authority many years ago to set position limits to protect those markets, so that they are fair and orderly and they represent the price discovery that you are so--so I think we are aligned on that, and it is whether this promotes market integrity along that front. " FOMC20060920meeting--60 58,MS. JOHNSON.," In the international economy, the striking development over the intermeeting period has been the rapid and substantial drop in crude oil prices and in prices for some nonfuel commodities. The spot price of WTI crude reached a recent high of about $77 per barrel on August 7, following news of problems with the BP pipelines at Prudhoe Bay. Since then, it has declined to less than $62 in trading yesterday, decreasing about $15 per barrel. The far futures price is down somewhat less, nearly $10 per barrel, leaving a barrel of WTI crude for delivery in 2012 priced about the same as a barrel of crude in the current spot market. As has been our practice for many years, we have assumed for the Greenbook baseline forecast that oil prices over time will match those contained in the futures price curve that held when we finalized the forecast last week. The timing of our forecast this Greenbook and last and the smoothing from quarterly averaging results in our forecast path for the oil import price shifting a bit less than did the spot price of crude. The downward revision in the oil import price amounts to nearly $12 per barrel in the near term and narrows to somewhat more than $8 per barrel by the end of 2007. Some other commodity markets were remarkably volatile over the intermeeting period as well. The spot prices for gold declined more than $60 per fine ounce since the time of the August FOMC meeting. Many of the industrial metals also moved down sharply in the past week or two, but in some cases these declines merely retraced run-ups earlier in the intermeeting period and resulted in only small net changes. Regarding the implications of the lower oil prices for our forecast, it is helpful to remember that our assumed price for WTI crude in the fourth quarter is near, but still more than $1 per barrel above, the average price that prevailed in the first quarter of this year, when we regarded oil prices as very elevated. In addition, the forecast path for WTI now rises into 2007 and then is about flat at close to $70 per barrel through the end of 2008. It also is relevant for constructing the forecast to ask why oil prices have come down as they have. The new developments that triggered the reaction in market prices seem to be importantly about the risks attached to future supply. Some aspects of geopolitical tensions, such as the conflict in Lebanon and the ongoing dispute with Iran over its nuclear program, seem to have eased. The Atlantic Ocean hurricane season has pleasantly surprised, with fewer storms than previously expected and none so far threatening the Gulf of Mexico. One factor that likely influenced the price reaction to the apparent lessening of risks to supply is the high level of inventories of crude oil at the present time. Current demand and supply plus market expectations of future demand and supply combine to determine spot and future prices plus desired inventories. With inventories already high, news that future supply is less uncertain sharply lowered the price required to clear the spot market and the premium that buyers are willing to pay to ensure future access to oil. Nevertheless, the positive slope to the futures curve over the forecast period suggests that, on balance, market participants are not expecting future supply to be as abundant relative to demand as is the case currently. With respect to the implications for our forecast of foreign growth and inflation, we needed to consider the direct effects of lower energy prices and also to ask whether actual or prospective slowing of global economic activity and, hence, demand for oil and other primary commodities have contributed to the downward shift in these prices. On balance, our outlook for real GDP growth abroad generally remains quite strong. However, we do expect a decrease in the average rate of growth of foreign real GDP from about 4 percent at an annual rate in the second quarter to 3¼ percent in the second half of this year and over the remainder of the forecast period. In both the industrial countries and the emerging-market economies, the pace of real growth was particularly vigorous during the first half of this year and contributed to continued strong demand for oil and other commodities. Monetary policy has been tightened in response to concerns of inflation and overheating in many countries, measures to tighten fiscal policy have been passed in some cases, and officials in China have imposed additional administrative measures to restrain growth. Prospective moderation of the rate of foreign growth was a feature of our forecast in August. Data from Canada and Japan already provide evidence of a lessening in the rate of growth in those countries. However, available data on activity in the euro area, China, and Mexico continue to be buoyant. In putting the pieces of the forecast together, we have concluded that the lower oil prices are consistent with overall foreign growth remaining moderately strong and will help to ensure that it remains so. At the same time, the projected pace of global economic activity is consistent with oil prices remaining quite elevated and rising somewhat into next year. We judged that the implications for foreign growth of the downward revision to the outlook for U.S. real output growth were partly offset by some boost to foreign growth that we otherwise would have incorporated in response to the reduced energy costs, although these factors differ across countries. As a result and given data received since the August forecast, the path for foreign real GDP growth was little revised on balance from that in the previous Greenbook. We have revised down our forecast for headline consumer price inflation abroad a few tenths for the second half of this year and next as a consequence of the lower path for energy prices. We project that in the industrial countries other than Japan inflation will move down somewhat over the forecast period. In contrast, Japanese inflation is expected to edge up but to remain below 1 percent. Some emerging-market economies in Asia still have controls on or subsidies of domestic fuel prices, which delays any pass-through of higher energy prices into domestic inflation. Accordingly, we project that increases in global oil prices earlier this year will push inflation in emerging Asia temporarily above 3 percent during the first half of next year. We look for inflation in Latin America to remain contained near present rates. We see the risks to this forecast in many respects as balanced. We have been surprised on the upside by the strength in foreign real activity during the first half of the year, and strong domestic demand in some regions could push off into the future some of the slowing that we are projecting. Alternatively, foreign activity may be more sensitive to the U.S. slowdown than we currently envisage. We feel especially uncertain with respect to the outlook for oil prices, given market reaction to recent events; the sharp change in prices caught us and the futures market by surprise. Although we are once again assuming that oil prices will follow the path implied by futures prices, we recognize that a much larger move up or down is quite possible. David and I will be happy to answer any questions." 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. FOMC20050202meeting--147 145,MR. HOENIG.," Thank you, Mr. Chairman. For the economy, growth currently remains above trend and, as we all know, is likely to remain above trend several quarters forward. As a result, we are systematically approaching long-run potential GDP for the economy. I expect growth will be near 4 percent this year—above trend. There are obvious reasons for this: monetary policy remains accommodative, consumer spending on goods and housing is strong, and business equipment spending is strong. While fourth-quarter growth was below expectations, final sales to domestic purchasers were at a robust 4.3 percent pace. And I think the labor market continues to improve. Evidence from our District is very much in line with this outlook. Most retailers we contacted said that holiday sales were moderately higher than a year ago, and many said that sales were above their plan. In addition, many ski resorts in our region reported sharp increases in hotel occupancy and a near-record volume of ski visits, many from foreigners. Job growth picked up in December. Hiring announcements since the last FOMC meeting exceeded layoff announcements by a margin of two to one, and a substantial fraction of small and midsized manufacturers said that they plan to increase employment in the coming months. District manufacturing continues to expand at a brisk pace; production, new orders, and employment all rose in December, and firms remained upbeat about future activity. Capital spending plans for 2005 are reported strong. We all know where the price indexes are right now but, looking to the future, I would expect to see further increases in core inflation. With the federal funds rate below the lower bound of most estimates for the neutral rate, I remain alert to the greater or increasing risk of inflation. In addition, there are several other reasons to think that this upside risk may be rising. First of all, as others have said here today, we are hearing more about the return to pricing power. Further, a greater pass- through of higher commodity prices seems to be occurring. The possibility of continued dollar depreciation is strong, as is a greater pass-through of higher import prices. And slowing productivity February 1-2, 2005 101 of 177 Evidence from the District supports these observations. For example, the fraction of businesses reporting labor shortages was 53 percent in January, up significantly from last quarter and last year. As a result, wage pressures in the District have also increased. About 26 percent of the employers contacted in January said that they had to boost wages more than normal as compared to 17 percent last quarter and 11 percent a year ago. In addition, our manufacturing survey showed evidence of greater pricing power. For example, among respondents reporting higher input prices, the share who also reported higher output prices has risen markedly, from 40 percent in the fourth quarter of 2003 to 60 percent in the fourth quarter of 2004, the same as before the recession. Similarly, among those who expect to pay higher input prices going forward, those who also expect to charge higher output prices has risen markedly from 41 to 51 percent. In summary, the outlook for the nation and our region is certainly good. Growth is robust, and we are hearing increasingly that there is a lot of money looking for opportunity. I would submit that the risk of higher inflation, therefore, is now large enough that we should at least be thinking about raising rates more aggressively toward neutral than we have in the past. Thank you." FOMC20080805meeting--104 102,MR. EVANS.," Thank you, Mr. Chairman. Overall there has been little change in the sentiment of my business contacts since our last meeting. Most are still reporting sluggish domestic demand with little evidence of any improvement over the near term. On the price front, everyone continued to cite cost pressures. Manufacturers have long lists of materials cost increases, while retailers note large increases in wholesale prices of imported consumer goods. Everyone discusses how they are planning to continue passing these costs along to customers in second-round effects. Undoubtedly weak market conditions will limit their efforts, but I suspect that many will be successful in raising prices significantly. Turning to the financial situation, to start I should note that I did hear some good reports with regard to liquidity in Chicago financial markets. A contact at the Chicago Mercantile Exchange told us that they conducted extensive liquidity reviews for their largest clearing members, with special scrutiny of firms that had substantial volumes of hard-to-value assets on their books. The clearinghouse was very pleased with the results, finding that these firms had good access to liquidity. Overall, however, my financial conversations this round were relatively downbeat. I did hear some interesting details, though, about the dynamics of the restructuring of credit intermediation. With commercial-mortgage-backed securities markets effectively shut down, a highly rated owner-developer of high-end shopping malls described his increasingly difficult attempts to find funding for his regular flow of balloon payments on mortgage properties. He has gone from restrictive loans from life insurance companies to attempting to put together his own structured-debt securitization. They want to issue bonds backed by the revenues generated from a pool of their high-quality properties and sell them to major fixed-income investment funds. This is one example of what economists like Kashyap and Shin estimate will be a reduction of at least $1 trillion in lending to nonfinancial institutions due to mortgage-related losses at U.S. financial institutions. It is also an example of how firms are trying to find workarounds for the functions that intermediaries used to do for them. But such restructuring must be raising the cost of financing in ways that are not obviously amenable to mitigation through liquidity policies. Turning to the national outlook, the information we have received over the past several weeks has contained many crosscurrents, but overall our forecast for output growth is little changed from our June projections. With regard to prices, I am concerned that inflation risks continue to grow. The most recent news on core prices has not been good. Oil prices may be coming off the boil, but they are still scalding. Prices are still down only to where they were in May. My impression from my contact calls is that the ultimate pass-through to final product prices of earlier increases could take a disconcertingly long period of time. Furthermore, I continue to think that the current funds rate in conjunction with our enhanced lending facilities represents a quite accommodative monetary policy stance, even given the disruptions in financial markets. If the policy path remains as accommodative as futures markets expect, then improvement in inflation will most likely require fortuitous favorable developments in inflation expectations and more restraint from resource slack than we might have otherwise expected. This brings me to three considerations that I would like to highlight as we evaluate the riskmanagement positions underlying our views on appropriate policy and our economic projections. The first factor is that, according to many econometric estimates, the 5� to 6 percent unemployment rate envisioned in the projections would provide only very modest restraint on inflation. In addition, costly reallocation could lead to less resource slack, perhaps temporarily driving the NAIRU above 5 percent. You know, when I talk to my staff, they assure me that there are very good reasons, demographically based, to believe a NAIRU under 5 percent. But I tend to think I've read a few too many papers on policy and policy mistakes where that's exactly the issue--when you think the sustainable unemployment rate is lower than it actually is. So that's a risk, I think. The second factor is that many individuals and businesses see the large relative price changes in oil, food, and commodities as precursors to more-persistent inflation. Whether or not their assessments are analytically correct depends on their expectations of our policy response. A substantive response may be necessary to prevent self-fulfilling price increases and keep inflation under control. Words can take us only so far. The third consideration is the potential diminishing returns through our efforts to mitigate distressed financial market conditions. It is my interpretation that our current accommodative monetary policy and suite of lending facilities are set to mitigate severe downside risks and the systemic risks that you mentioned earlier, Mr. Chairman. This is helpful under the assumption that reducing liquidity strains will assist financial markets to return to normal operations and prevent a permanent impairment of our financial infrastructure. But financial conditions seem unlikely to return to our previous perceptions of normal, at least for some time. Thus, I see a risk that extra accommodation intended to grease the financial wheels could be left in place too long and prove counterproductive for price stability. Indeed, the old perception of ""normal"" likely is not the correct benchmark for us to use in looking for whether we are experiencing structural changes in the intermediation process in which new liquidity providers are playing enhanced roles in the lending process and in which risk standards are changing. So when thinking about market functioning, it would be useful to discuss this within a longer-term framework of what we can feasibly expect from market functioning and what central bank liquidity has the ability to usefully and appropriately influence. Thank you, Mr. Chairman. " FOMC20050322meeting--240 238,MS. SMITH.," I’m reading from page 25 of the Bluebook. The wording would be: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 2¾ percent.” And then B modified is: “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" FOMC20061212meeting--201 199,MS. DANKER.," I’ll be reading the directive and risk assessment from page 23 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” Then: “Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”" FOMC20080625meeting--118 116,MR. EVANS.," Thank you, Mr. Chairman. I'd like to start by saying that I agree with your comments yesterday about how we should proceed with the Committee approach and think very collaboratively about the policies and delicate strategies that we're facing. Although we disagree on a number of the elements of the outlook, I think that bringing everything together is a very important part of this. I have fully endorsed funds rate cuts that we have taken so far in large part as insurance against tail risks to growth. I think that policy last summer was much too restrictive given what we were facing and that, along the way, a lot of these cuts have been motivated by tail risks to growth. The funds rate at 2 percent is pretty ample insurance to my mind--more so given the improvement in the outlook for growth that we've seen as second-quarter growth has been marked up so much and even more so given the inflation risks that we're facing, the risks to inflation expectations, and the potentially very low real interest rates that we might be looking at, depending on the measure. If we had the opportunity to recalibrate things a bit, I probably would prefer something more like a 2� percent fed funds rate to be positioned against the different risks that we're facing, but I understand that we're at 2 percent, and no change seems like the right move for today. I do have a few concerns about the way we're thinking about this, more in the line of risks. One is that, as we take insurance against tail risk, we're positioning the funds rate against an event that we think is not the most likely and is negative compared with where we are. Unless and until that event happens, policy is somewhat accommodative because it hasn't happened, and we're thinking that it is closer to where it ought to be if that should happen. Unless you think that we haven't taken out insurance, then I think that we have more accommodation than we might like. The second concern is whether it is possible to be more precise about what we mean by this tail risk. I mean, it's really a catch-all. Nobody is very comfortable with all of this. What are the markers that we could look at for improvement if we could quantify this somehow? Is it that financial markets should be functioning better? I think surely that is the case. Is there a way that we could describe that? I'm sure we'll disagree on many elements of this. Labor market improvement--we should expect that, if the labor market does better than we were thinking, then that would tend to bolster consumption spending a bit better in the face of all the shocks that we're looking at. So the extent to which the labor market doesn't continue to deteriorate, at least in line with some of the recession scenarios and the tail risk scenarios that we were thinking about, is a potential marker. As we keep pushing out our expectation that the economy is going to weaken--and we've done this a number of times--and if we're looking at the third quarter being revised up--and I agree that we're facing a lot of risks there--but if we start marking that one up, I think that's a marker that we have to be concerned about. Obviously, if oil prices and commodity prices were to decline and free up purchasing power for consumers, that would help out, too. So these are just some of the things that come to mind. Is there a way to think about the details a little better, with a bit less of a SWAG? Another risk relates to financial markets. Here I'm thinking about the really influential work of yours, in 1983, on nonmonetary influences on the Great Depression. A lot of the actions that we have taken are defenses against those types of issues, right? In the 1930s, when the economy was doing very badly and banks were failing--I'm telling this to you, and you've described it to everyone--then the knock-on effect was that the banks weren't there anymore and important resources for evaluating credit were lost, and so it was more expensive and very difficult to do. We have some of that going on now, right? We've moved from the banks making mortgages and holding them to the ""originate to distribute"" model. Those resources have been dispersed, and now that securitization market is closed. I heard that very clearly yesterday. Those important resources aren't there to originate mortgages, so if we get to the point that buyers are willing to purchase these houses, that could be a concern. What happens if there's a true impairment to the financial capital stock, and real resources aren't there anymore to help out with this? We're probably looking at a reallocation of resources from that sector of the financial market either back to banks or to somewhere else. But as we see those resources reallocated and as we think about unemployment being higher, we can talk ourselves into thinking that a lot of slack is in the economy when, in fact, there may not be so much slack. At some point it may be slack, and at other times it won't be, until those resources are reallocated most efficiently. I think this could reduce potential growth rates and have structural elements to it, not just cyclical elements. So there's not a slam-dunk for this. There is just a risk that an element of that is playing out throughout this, and other factors are superimposed on that. But it's something that I worry about. In a robust type of policy development, I think we should be considering things like that. It's just the case that, in the current situation that we're looking at, there might be a limited role for monetary policy to repair real capital stocks. Another concern is that anytime we've engaged in substantial risk-management policies, there has always been difficulty in taking them back. That's part of the delicate strategy that you are referring to, I think. That's how I heard it. So we have to be very careful. There's a lot of art to this clearly, but it would be good if we could offer a few more bright lines about how we'll approach that. Still, I certainly agree. I think we need to seek consensus. It's our role to raise these issues and then come to the best judgment. So I'm quite comfortable with no change today. I'm quite comfortable with the language in alternative B, although in the third paragraph we say, ""However, in light of the continued increases in the prices of energy,"" and I think it would be better if we didn't say ""continued."" I think it's enough to say ""the increases."" In part, I don't know if this is a marker that, if prices level out, we'd still be comfortable with the inflation risk. I think that there will be a lagged effect of all the very large increases that we've seen for oil as they work their way through. If prices just level out, we still have risks to inflation expectations. So I prefer taking that out. Thank you, Mr. Chairman. " 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. " FinancialCrisisInquiry--448 BASS: Sure. First of all, I’ll—in the interest of full disclosure, I was a senior managing director at Bear Stearns for five and-a-half years from 1996 to 2001. So a lot of the people at that firm are very good friends of mine. And a lot of the people that ran the firm are very good friends of mine. In—in September of 2006, I went to Bear Stearns to meet with a guy named Bobby Steinberg, who at the time was their chief risk manager at the firm. He congregated a meeting in a conference room at their headquarters for me with the head of mortgage trading, the head of fixed income trading, the head of mortgage risk, fixed income risk and himself. And I went through my entire presentation as to what I saw building in the housing market where I— where I thought mortgage credit was going to go. And—and—and, you know, a couple points that I’ll make. Someone—someone in this morning’s hearing said did you ever contemplate housing prices ever dropping. They didn’t even have to drop for losses to show up. OK? If housing prices just went flat, they would have lost 9 or 10 percent on these securitizations, which would have wiped out everything up to close to the AAs. So to put it into perspective, I—I went through my presentation with their risk committee and said do you realize that if I’m right—and— and by the way, I’m one data point from Dallas, so I realize that they can discount what I had to say. But the presentation’s fairly compelling. If I’m right, do you realize what’s going to happen to this firm, knowing how—the firm’s position? And he said-- he said, Kyle, you worry about your risk management, and we’ll worry about ours. And that was the last time I spoke with them. Again, it’s—it’s one data point. And with regard to the Federal Reserve, I met one of President Bush’s staffers and—and went through it with him. And he suggested I go talk with the Federal Reserve here in D.C. And I met with one of the Federal Reserve board members and went through my— my presentation again, just a data point from Dallas—meeting at the Federal January 13, 2010 Reserve here in D.C. It’s—it’s not a large data point. However, their answer at the time was—and—and this was—this was also the thought that was—that was homogeneous throughout Wall Street’s analysts—was home prices always track income growth and jobs growth. And they showed me income growth on one chart and jobs growth on another, and said, “We don’t see what you’re talking about because incomes are still growing and jobs are still growing.” And I said, well, you obviously don’t realize where the dog is and where the tail is, and what’s moving what. But again, it was my opinion which, you know, they intended—or they—disregarded. FinancialCrisisReport--525 Goldman senior executives closely followed Hudson’s development and sale. Hudson was discussed, for example, at five different Firmwide Risk Committee meetings attended by senior Goldman executives. 2271 Mortgage Department executives also sent progress reports to the senior executives on Hudson 1. On October 25, 2006, for example, Mr. Sobel sent an email to COO Gary Cohn and CFO David Viniar alerting them to Hudson sales efforts and the pricing of its securities. 2272 During discussions over the best price at which to market the CDO’s equity tranche, a senior executive emailed Peter Ostrem and others: “keep in mind the overall objective - this is not about one trade - having said that, I agree that [the proposed price] may be too low.” 2273 On October 26, 2006, Mr. Jha, a Goldman risk officer, circulated a Mortgage Department Risk Report to a number of Goldman executives, including CEO Lloyd Blankfein and COO Gary Cohn, noting in the forwarding email: “Risk reduction [in the Mortgage Department] is primarily due to pricing of $2bn Hudson Mez synthetic CDO.” 2274 Selling Hudson. Once the Hudson CDO was ready for sale, the Goldman sales force had difficulty selling Hudson securities to investors due to its reliance on BBB and BBB- rated subprime RMBS securities. Allied Irish Bank (AIB), for example, apparently referred to the Hudson securities as “junk.” 2275 One Goldman employee emailed the CDO team and asked: “[D]o we have anything talking about how great the BBB sector of RMBS is at this point in time ... a common response I am hearing on both Hudson & HGS1 is a concern about the housing market and BBB in particular? We need to arm sales with a bit more.” 2276 2271 Firmwide Risk Committee meetings were often chaired by David Viniar and frequently attended by Lloyd Blankfein and Gary Cohn. See 9/20/2006 Firmwide Risk Committee Minutes, GS MBS 0000004472; 9/27/2006 Firmwide Risk Committee Minutes, GS MBS 0000004474; 10/4/2006 Firmwide Risk Committee Minutes, GS MBS 0000004476; 10/11/2006 Firmwide Risk Committee Minutes, GS MBS 0000004478; 11/1/2010 Firmwide Risk Committee Minutes, GS MBS 0000004484. See also 10/11/2006 email from Arbind Jha to Joshua Birnbaum, GS MBS-E-012695030 ( “Sobel this morning in the firmwide risk committee mentioned that we have circled up the junior and some of the equity tranches ”). 2272 2273 2274 10/25/2006 email from Jonathan Sobel to David Viniar and Gary Cohn, GS MBS-E-009757821. 10/12/2006 email from Thomas Cornacchia to Peter Ostrem and others, GS MBS-E-0000066413. 10/26/2006 email from Arbind Jha, “MarketRisk: Mortgage Risk Report (cob 10/25/2006),” GS MBS-E- 0000056041, Hearing Exhibit 4/27-89. That same day, October 26, 2006, Mr. Swenson also described the risk transfer to Goldman executive Bill McMahon when updating him on the trading desk ’s ABX position: “In addition to $2bb of risk that was placed into the CDO , we have sold to retail since 4pm yesterday $2bb of BBB- risk.” 10/26/2006 email from Michael Swenson to Bill McMahon, others, GS MBS-E-0000054856. 2275 10/11/2006 Goldman internal email, “FW : Hudson Mezz, ” GS MBS-E-017502610, Hearing Exhibit 4/27-170c. (A Goldman employee asked a sales associate: “what specifically did AIB say was ‘junk ’ about the hudson mezz deal? ” The employee then forwarded the email to M r. Herrick saying: “You may want to ask [the sales associate] about this when she ’s there tomorrow and Friday. ... She said ‘AIB are too smart to buy this kind of junk.’”). 2276 10/19/2006 email from Mitchell Resnick to Jonathan Egol, Darryl Herrick, and David Rosenblum, GS MBS-E- 009557391. “HGS1 ” refers to Abacus HGS1, a CDO 2 where Goldman, as in Hudson 1, held 100% of the short interest. CHRG-109shrg30354--55 Chairman Bernanke," Senator, I agree that there is more of a problem in the product markets than in the labor markets. In the product markets they are sufficiently tight that firms are developing pricing power and they are passing on their energy and materials costs. It still is an inflation problem because if inflation rises, it is still going to have the same adverse affects. It is going to get into expectations. I am not saying that is going to happen. Our forecast is for inflation to decline over time. But it is a risk. And nevertheless, if it is coming from product markets more than labor markets, it is still a risk to inflation. Senator Sarbanes. Thank you, Mr. Chairman. " FOMC20050630meeting--9 7,MR. LEHNERT.," As Josh noted, everyone’s talking about house prices; but they also seem to be talking a great deal about mortgages. The popular consensus appears to be that homebuyers, especially in hot housing markets, now make token down payments and can just scrape into their homes by resorting to interest-only mortgages; in this view, borrowers and lenders alike are vulnerable to any fall in house prices. In my prepared remarks I will address each of these issues. An obvious measure of the vulnerability of a borrower to a decline in his house price is the ratio of the current mortgage balance to the current value of his home; this ratio is known as the current loan-to-value, or LTV, ratio. The top panel of your first exhibit compares the distribution of the estimated current LTV as of September 2003 (the black bars) with the distribution as of March 2005 (the red bars). June 29-30, 2005 8 of 234 The middle left panel uses the same data to concentrate on the most leveraged borrowers. For a given drop in nominal house prices (the horizontal axis), the vertical axis gives the percent of borrowers who would have negative equity. As before, the black line reflects data from September 2003 while the red line reflects the most recent data. As shown by the red line, following a house-price drop of 10 percent, an estimated 4 percent of borrowers would have negative equity, while a drop of 20 percent would leave about 18 percent of borrowers in negative territory. The middle right panel summarizes average LTVs at origination for homes purchased in 2004, by state, relative to price appreciation in that state over the previous four years. States with lower-than-average appreciation, such as Utah, Texas, and Oklahoma, are at the left, while states with faster-than-average appreciation, such as California, Massachusetts, and New York are at the right. As shown, LTV at origination in 2004 was actually lower in states with more appreciation. Thus, homebuyers in California and other high-appreciation states made larger down payments relative to the price of their house than homebuyers in low-appreciation states such as Oklahoma. Increasing home equity, mainly driven by rising house prices, has supported mortgage credit quality in recent quarters. The bottom left panel plots delinquency rates for loans held on banks’ books (the black line) as well as for the broader MBA [Mortgage Bankers Association] measure (the red line). Both have fallen significantly in recent years. The bottom right panel summarizes the vulnerability of borrowers to house- price shocks. The average LTV on mortgages has declined over the past 18 months, and most households currently have substantial equity in their homes. In the past few years, borrowers have benefited from rapidly rising house prices, which have kept mortgage delinquencies at extremely low levels. However, an estimated 4 percent of borrowers are highly leveraged and could lose all of their home equity if house prices were to fall 10 percent. As I noted earlier, recent anecdotal reports have highlighted a second potential risk lurking within mortgage markets—the sudden popularity of interest-only mortgages. These are the subject of your next exhibit. June 29-30, 2005 9 of 234 Turning to the data, line 1 of the top left panel shows that the dollar value of RMBS pools has nearly doubled over the past two years. Moreover, as shown in line 2, RMBS pools backed by interest-only, or IO, mortgages have increased almost sixfold, and now amount to nearly $300 billion. However, total home mortgage debt, line 3, has also increased over the past two years. As shown in the memo line, interest-only RMBS pools now account for 3.6 percent of all home mortgage debt, up from less than 1 percent two years ago, but still a small share of all mortgages. As their name implies, interest-only mortgages do not require the borrower to make principal payments, at least during an initial period. Borrowers willing to use IO mortgages could qualify for a larger mortgage and thus be able to buy a more expensive house. The top right panel gives some idea of the relationship between price appreciation and the popularity of IO mortgages. The vertical axis shows the fraction of IO mortgages used to purchase houses, by state, in 2004. Again, I should emphasize that the IO shares are calculated within the RMBS world, and so are probably overstated. The horizontal axis gives state-level house-price appreciation from 1999 through 2003. As you can see, IO mortgages are somewhat more popular in states that saw more appreciation, although, as seen in the inset box, the correlation is not particularly strong. While the principal value of an IO loan doesn’t decline, if the initial down payment is large enough, the borrower may have a substantial equity cushion against price shocks. The middle panel reports the LTV at origination for IO loans made over the past three years. As shown, most IO mortgages had LTVs below 80 percent, although the trend over time has been away from the very lowest LTVs. That said, lenders have continued to make relatively few IO loans with LTVs above 80 percent. Those higher LTV loans now account for about 15 percent of all outstanding IOs. Finally, anecdotes often emphasize that IO loans are extended to borrowers with lower credit quality. The bottom panel shows the distribution of credit quality, measured by FICO scores, among IO borrowers. As a rough approximation, most lenders define prime quality borrowers as those with FICO scores of 660 or above. The leftmost set of bars thus represents subprime borrowers. As shown, between 8 and 10 percent of IO loans have been extended to these borrowers. Moving to the right, the next two sets of bars show that the great majority of IO borrowers had solid credit scores between 660 and 779. As shown by the rightmost set of bars, about 10 percent of IO borrowers had credit scores above 780. On the whole, therefore, the credit quality of borrowers using interest-only loans does not appear particularly risky. June 29-30, 2005 10 of 234 exclusively hold or guarantee conforming mortgages with fixed rates. Private mortgage insurers, line 2, insure the component of mortgage principal that exceeds 80 percent of the property’s value and so are effectively exposed to the credit risk associated with high-LTV loans. RMBS pools (line 3), as well as banks and thrifts (line 4), hold a wide variety of different mortgage types, including traditional fixed- rate mortgages as well as variable-rate and junior liens. The top right panel emphasizes that the housing GSEs hold very little credit risk. As shown on line 1, the average LTV at origination of GSE-guaranteed mortgages was 70 percent; based on regional house-price appreciation, the estimated current LTV of these mortgages (line 2) has fallen to 57 percent. The average credit score of the underlying borrowers (line 3) is also solidly in the “prime” category. Obviously, these average values mask some variation in the borrower population, which no doubt contains some higher-risk borrowers. However, as shown on line 4, 19 percent of the mortgages guaranteed by the GSEs carry some form of credit enhancement. If one of these mortgages defaults, the GSE receives a payment from the insurer, usually a private mortgage insurance, or PMI, company. The middle left panel examines the health of the PMI industry. As shown by the black line (left axis), the ratio of total insured mortgages to capital, the risk- capital ratio, has declined steadily over the past 10 years, indicating that PMI companies have historically high capital on hand relative to the risks they insure. The red line (right axis) shows net underwriting income—that is, income from premiums less losses and expenses, relative to capital. After suffering large losses in the late 1980s, PMI companies have consistently recorded positive underwriting income. In sum, PMI companies appear to have built up a historically large cushion to absorb the losses that might be associated with a widespread drop in real estate values. The middle right panel analyzes the risks posed to investors in RMBS pools. These pools contain some of the riskier outstanding mortgages. However, they are structured so that investors can choose their risk exposure. Further, RMBS pools are exceptionally transparent, so investors have extensive information on each mortgage in the pool. In principle, investors should have understood, and appropriately priced, the risks inherent in these mortgages. In practice, however, investors price these mortgages using loss models, which are estimated using relatively little data from major house-price declines. June 29-30, 2005 11 of 234 account for more than 40 percent of assets. Residential mortgage credit risk is more concentrated at these institutions than at the institutions in the lower quartiles. The panel to the right shows the average size and capital-to-asset ratio of institutions in each of the quartiles. Reading down the first column, which gives average institution size, one can see that smaller institutions are concentrated in the first two quartiles, which have relatively little mortgage exposure. Reading down the second column, which gives average tier 1 capital ratios, institutions in all quartiles are extremely well capitalized. Thus, institutions with large amounts of mortgage credit risk on their portfolios are well positioned to handle severe losses. To sum up, neither borrowers nor lenders appear particularly shaky. Indeed, the evidence points in the opposite direction: borrowers have large equity cushions, interest-only mortgages are not an especially sinister development, and financial institutions are quite healthy. Nonetheless, even the most sanguine analyst quails when contemplating a historically unprecedented drop in nationwide nominal house prices. Such a drop will obviously hurt both borrowers and lenders and will also no doubt expose weaknesses that will only be obvious in hindsight. Thus, perhaps it would be best simply to venture the judgment that the national mortgage system might bend, but will likely not break, in the face of a large drop in house prices. That concludes my prepared remarks." FOMC20060629meeting--116 114,CHAIRMAN BERNANKE.," Thank you. If I could try your patience for a few more minutes at the end of a long afternoon, I’d like to summarize what I’ve heard today and then just add a few comments of my own. While I’m doing that, Brian, would you distribute table 1? Table 1 in the Bluebook shows the three alternative suggestions for the statement. Since the Bluebook, we have received some suggestions, and we’ve done some wordsmithing—we’ve actually responded to a few things we heard today. The general tone of the three statements is the same, but we wanted you to see where it was today, so that you could think about it overnight and so that it would help you for your discussion tomorrow. That’s going to be coming around. Let me just briefly summarize what I heard. Certainly, a central theme of the speakers today was the increase of uncertainty and risk in the environment. It’s getting more and more difficult to forecast, and there are certainly risks both to the upside and to the downside. The central tendencies with respect to output seem to be that output is slowing to something close to potential. Some felt growth would be stronger than the Greenbook suggested; others, like the Greenbook, thought it would be falling somewhat below potential. A few people saw downside risks from previous tightening. There was some disagreement on the extent to which financial conditions are supportive of the economy, and some disagreement on consumption, although there was a view that lower-income consumers were going to do worse than higher-income consumers. Housing is certainly slowing. Some took the view that it was slowing more or less as expected, whereas some thought the slowing was somewhat worse than expected—certainly that’s a source of downside risk. The view of the labor market is that it remains reasonably healthy, that it’s difficult to find skilled workers, but there are still few signs of wage pressures in the economy. The business-sector evaluations were much more upbeat, with ongoing expansion, good sentiment, and capital investment. Finally, there seems to be considerable unease about recent inflation developments. Everyone considered these recent developments to be unwelcome. Some felt that the recent increase in inflation might be temporary. Others saw it as more persistent. But there certainly was a sense that it’s a risk to the economy. Let me add just a few thoughts about the situation. The situation is, I think, exceptionally complicated because at least three different things are going on. First of all, there’s a cyclical transition from a period of above-trend growth to what we would hope would be a period of trend growth, the normal soft-landing problem. Second, we essentially have a supply shock. It’s not exactly a supply shock because it has complicated elements to it, but oil prices and commodity prices are rising significantly, and that is creating a worsened tradeoff. Third, we are having a housing cycle that has a certain autonomous component to it because it’s like any other asset-price correction taking place on its own schedule, so to speak, and it is interacting with the other two forces. So given these three things occurring at the same time, the situation is obviously very complicated. Now, the ideal situation would be for us to move to a steady, sustainable pace without inflation. Right now, the biggest risk to that steady pace seems to be the pickup that we’ve seen recently in inflation. The main point I want to make about inflation—many points have already been made—is that it really is quite broad-based. I think there are good reasons to downweight, to some extent, owners’ equivalent rent. It is arguably a cost of living; however, the effects of monetary policy on this kind of cost of living are somewhat ambiguous. So we could get ourselves into a bad situation if we focus on it too much. But having said that, if you slice, say, core PCE in any other way—if you look, for example, at core PCE prices excluding OER, at core goods, at core PCE services excluding OER, at market-based core PCE less OER, at any of these ways of slicing inflation—you get a similar pattern in terms of the three-month, six-month, and twelve-month averages, which suggests a broad-based acceleration and one that I think we should be concerned about. We should also note that the three-month total PCE inflation rate is 5.2, which is significant because it influences inflation expectations overall. Now, a concern that we all have—and many people expressed—is that we don’t fully understand why this sudden acceleration is taking place. Some of the possibilities are, first, the supply-shock increases of energy prices; second, the tight product markets; and third, changes in inflation psychology, perhaps related to headline inflation. I guess I would just raise the possibility that these three things are interacting. Perhaps with tighter product markets it’s easier to pass through your energy costs or your commodity costs. That pass-through interacts with higher inflation psychology, and there’s maybe a vicious cycle there. The thing we should be concerned about is whether those higher prices then lead to higher wage pressures in an inverse kind of spiral. So I do have concerns about inflation, although I don’t want to exaggerate. I think we’re still looking at numbers that are historically not extremely high. The other big issue is the housing cycle. I’m going to give us a bit of perspective. It is a good thing that housing is cooling. If we could wave a magic wand and reinstate 2005, we wouldn’t want to do that because the market has to come back to equilibrium. The level of activity now is about a third bigger than it was in during the boom in the late 1990s. The housing construction industry is large, bigger than historically normal, and a controlled decline in housing obviously is helpful to us at this stage in bringing us to a soft landing in the economy. But as people have pointed out, the cooling is an asset-price correction. Like any other asset-price correction, it’s very hard to forecast, and consequently it is an important risk and one that should lead us to be cautious in our policy decisions, as we’ll talk about tomorrow. Another potential nonlinearity is in financial markets, as we’ve seen recently. We don’t have a good understanding of how changes in interest rates are affecting risk reduction and positions in financial markets right now. Just a bit of commentary on consumption: A lot of our uncertainty—I guess you’d call it model uncertainty—is the question about how a decline in housing prices will affect consumer spending. The range of views is wide, some arguing that, because of equity withdrawal and so on, the effect would be very large. I don’t know the answer to that question, obviously, but I think there are some positive factors that will support consumption going forward. To name a few, the job market remains good, unemployment insurance claims are low, unemployment is low, and I suspect that wages and incomes will start to rise sometime soon. Consumer confidence is not that bad. Gasoline prices are likely to come down. In part, they are reflecting high ethanol prices, which will come down over time. We’ve seen before that consumer confidence can be very sensitive to gasoline prices. Balance sheets remain reasonably healthy. Even if housing prices flatten out, people have accumulated a lot of equity, and the implication of that is that they can smooth their consumption through rough times, if necessary, by drawing on that equity. Finally, Kevin and Randy, I think, gave different sides of the surge in tax collections, but on the whole it is probably a positive sign. It probably suggests there is more economic activity than we are capturing. So let me just conclude by reiterating that we find ourselves in an extraordinarily complicated situation because we have these different themes—the cyclical turning point, the supply shock, and the housing cycle. The implication is that, whatever we do, we’re going to have to be very deliberate and careful; but I think we cannot ignore the inflation side of this equation. Any other comments? Well, thank you again for your patience in a long afternoon. I’m glad this is a two-day meeting. [Laughter] Everyone should have table 1; I don’t expect significant changes before tomorrow. I’ll see you tonight at the British Embassy, and we will reconvene tomorrow morning at 9:00. [Meeting recessed] June 29, 2006—Morning Session" CHRG-111hhrg53234--37 Mr. Adler," Thank you, Mr. Chairman. Mr. Vice Chairman, you a moment ago articulated Congress' mandate to the Federal Reserve with respect to maximum employment and to price stability. To what extent, if any, do you think additional responsibility as a systemic risk regulator would in any way distract the Federal Reserve from its 1977 congressional mission? " FOMC20080625meeting--129 127,MS. YELLEN.," Thank you, Mr. Chairman. I favor alternative B with the proposed wording. Given the forecast and the risks around it, our next move on the funds rate is likely to be up, and the question is when. Assuming that the data on growth and inflation come in roughly as I and the Greenbook expect, I would envision beginning to remove policy accommodation toward the end of this year, similar to the assumption in the Greenbook. As I mentioned, I'm not very confident that the outlook for growth and employment has improved as much as the Greenbook assumes. I'm concerned that households and firms are in a python squeeze of an intensifying credit crunch and a continuing decline in housing wealth as well as pressures from surging food and energy prices. I think the economy has shown resilience so far, and that's reassuring, but I don't think it's assured for the future. The aggressive policy actions that we have put in place since January are actually working to cushion the blow, and that's part of the reason that we haven't seen a greater unraveling so far. I mentioned yesterday that, with respect to inflation, the behavior of both core inflation and wages thus far makes me optimistic that headline inflation will come down if commodity prices finally level off. But I think there's no doubt that the risks with respect to inflation are not symmetrical at this point, and they have definitely increased. I still see inflation expectations as reasonably well anchored, but there's no doubt that a wage�price spiral could develop, and dealing with it would be a very difficult and very painful problem for the Committee. So while I feel that we are essentially credible now, I wouldn't want to take absolutely for granted that this is something that we can count on going forward. At this point, the federal funds rate remains well below the recommendations of most versions of the Taylor rule. I have viewed this as appropriate, not largely as insurance against downside risk but simply in refection of the unusually severe pressures from collapsing wealth and tight credit and financial constraints. But it does seem to me to be appropriate going forward to at least take out some insurance against the development of a wage�price spiral mentality, and that could take the form of gradually removing that discrepancy from what, for example, a Taylor rule recommends. But before we begin to do that, it does seem to me that we should wait to get a somewhat clearer picture of where the real side is going. " FOMC20070807meeting--89 87,MR. ROSENGREN.," The Boston staff forecast is broadly consistent with the Greenbook forecast, with export-led growth being significantly offset by weakness in residential investment, resulting in a gradual increase in the unemployment rate and core PCE inflation settling around 2 percent. The Boston staff forecast is somewhat more optimistic on residential investment but also has somewhat higher potential than the Greenbook forecast. My own view is that residential investment is likely to be as weak as in the Greenbook forecast but that potential may be closer to Boston’s estimate. Taken together, weak residential investment and somewhat stronger productivity, along with the possibility that construction employment will be more depressed going forward, may result in more of an upward drift in unemployment, helping to reduce some of the concerns with labor market pressures on inflation. However, given the similarities in the forecasts, well within standard errors, at this time it is probably more important to highlight the risks to the forecast. It is notable that the rather benign outlook of the forecasters is in marked contrast to the angst I hear when talking to asset and hedge fund managers in Boston. The angst is new and reflects heightened concerns with the financial ramifications stemming from subprime mortgages. Recent developments in residential markets are of potential concern. They have been raised by many around the table. Over the past several years, large homebuilders have been able to increase their market share. Given the use of subcontractors and with little obvious economies of scale, the primary advantage of large homebuilders would seem to be access to external finance, which allows them to purchase large tracts of land. When housing and land prices were rising, particularly in fast growing areas of the country, this access provided a significant advantage over the small builders that could not tie up significant resources in land. However, what provided a competitive advantage in the first half of this decade now places a significant strain on large homebuilders. A large investment in land whose price is falling is aggravating the problem these builders have with unsold inventory and depressed prices for new homes. Not surprisingly, the largest homebuilders, which account for nearly a quarter of homes sold, have equity prices trading lower than at any time in the past year, and recent earnings announcements have highlighted significant write-downs in land values. The low equity prices of homebuilders seem broadly consistent with residential investment remaining quite weak well into 2008. Financial market disruptions are likely to be a further impediment to the housing market and potentially provide a channel for problems to extend beyond residential investment. A number of financial instruments, such as the 2/28 and 3/27 mortgages that were widely used last year, are no longer readily available. Furthermore, the originate-to-distribute model has been disrupted by the heightened uncertainty surrounding CDOs and CLOs that we heard about earlier this morning. There seem to be two significant developments. First, the liquidity of these instruments has declined, making valuation assessment difficult. As lenders have made margin calls, forced liquidation of collateral in illiquid markets has further depressed the market. While of concern, I would hope that this is only a short-run effect. The second development of concern is that many investors have been relying on rating agencies to evaluate credit risk but the underlying credit risk is relatively opaque and the correlations between tranches may not have been fully appreciated. If investors have lost confidence in the rating agencies to accurately assess credit risk for structured products, the market could be impeded until confidence is restored. Since similar structures are used for financial instruments besides mortgages, getting secondary market financing for a broader range of financing needs could be difficult, and external financing for some borrowers could be affected. This has been reflected in the widening spreads for riskier corporate bonds, where the spreads have widened from unusually low levels and are still relatively narrow compared with earlier periods of significant financial disruption. While recent problems are not compelling enough for me to have a significant disagreement with the forecast presented in the Greenbook, the risks surrounding that forecast on the downside have increased. I remain concerned that higher oil prices, a falling dollar, and tight labor markets pose upward risks to the forecast of inflation, but recent events have significantly raised my estimate of the risk of a slower economy than I would have predicted a few weeks ago." FOMC20080805meeting--130 128,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Like the Greenbook, our modal forecast shows weaker real activity and slightly higher core inflation over the forecast period. Downside risks to growth remain substantial, in my view, and have probably increased relative to what we thought in June. Risks on the inflation front remain weighted to the upside, perhaps somewhat less than in June, but this is hard to know with confidence. The adverse growth risks are worse for several reasons. The labor market and labor income are weakening more quickly than expected. Although there were some tentative signs of stabilization of housing demand in the spring, demand seems to have fallen further since. Credit conditions are tighter and are expected to be tighter longer, and this seems likely to produce a further deterioration in overall demand--note, of course, the reduction in credit for autos, the rise in mortgage rates, and the more conservative lending standards for consumer and corporate credit. Growth outside the United States seems likely to slow further. Of course, fundamental to this dynamic, as has been true for 12 months, each shift in perceptions that the bottom in overall economic growth is further away produces additional stress for financial institutions and markets, adding to the intensity of prospective financial headwinds and to concerns about downside risks to growth. Now, the adverse tail on the inflation front remains significant. Many measures of underlying inflation suggest a broad-based, if limited to date, acceleration in the rate of underlying inflation. Market- and survey-based measures of long-term expectations are high. Surveys suggest that firms are able to pass on some part of the acceleration in energy and materials costs. On the more positive side, energy, commodity, and materials prices have declined significantly, principally it seems because of expectations of slower growth in global demand. Growth is moderating significantly around the world, and it's going to have to moderate further in the most populous parts of the world as central banks there get monetary policy tighter. The growth of unit labor costs has been and is expected to be very moderate here. Profit margins still show plenty of room to absorb cost increases, and as David reminded us, you can have a relatively benign outlook for the path of core inflation without margins narrowing very dramatically. Inflation expectations have not deteriorated meaningfully here, even with the flatter expected path of monetary policy in the United States. Of course, it's very important that inflation expectations and pricing power moderate from current levels. If some of the downside risks to growth materialize, this will happen, and inflation risks will moderate. If, however, the economy continues to prove to be resilient to these downside risks, then we will face higher inflation. On balance, the rate of growth in underlying inflation suggests that growth in demand in the United States will have to be below potential for a longer period of time if inflation expectations are to come down sufficiently. This means that we will have to tighten monetary policy relatively soon compared with our previous behavior in recoveries--perhaps before we see the actual bottom in house prices and the actual peak in unemployment. However, at this point, the risks to real growth remain critical. In my view, we need to have more confidence that we have substantially reduced the risks of a much sharper, more protracted decline in growth before we begin to tighten. I think it is unlikely that we will be able or will need to move before early next year. Short-term market expectations for monetary policy in the United States seem about right at present. I don't see a strong case for trying to alter those expectations in either direction at this point. To try to pull forward the expected tightening would risk adding to the downside risk to growth and magnifying the risk of a much more severe financial crisis. On the other hand, if we avoid some of these downside risks to growth, then policy will need to tighten more quickly, perhaps, than the expected path now priced in the markets. The evolution of monetary policy expectations and of inflation expectations since May illustrates how uncertain the markets are about what path of policy will be appropriate. But the pattern of changes in both of these measures of expectations suggests that the markets believe we will get this balance right--that we will do enough soon enough to keep underlying inflation expectations from eroding materially. Thank you. " FOMC20060131meeting--116 114,MR. KOHN.," Thank you, Mr. Chairman. The projections I submitted for this meeting reflected expectations of an economy that probably is operating in level terms somewhere in the neighborhood of its long-run, sustainable potential and will continue to do so over the next two years with growth broadly in line with the growth of potential and inflation basically stable. My forecasts for 2006 are very close to those I submitted last January and June. That’s partly a product of innate stubbornness. [Laughter] But it also reflects the fact that 2005 came in largely as expected—after allowance for hurricanes and an energy shock last year that elevated core inflation and damped growth somewhat compared with our forecasts last January. This is encouraging in that it suggests that we are not looking at major unexplained and unanticipated forces acting on the economy. At this point, our focus appropriately is on keeping inflation contained. I see several reasons for optimism in this regard. One is the performance of core consumer prices and price measures, which continue to suggest that the pass-through of higher energy prices will be limited. Core inflation was roughly stable last year. It picked up a bit in the fourth quarter, but that was from unusually low readings in the third quarter. Declining consumer inflation expectations in the most recent Michigan survey, along with the failure of market-based inflation compensation readings to respond significantly to the substantial run-up in oil prices and higher core readings over the intermeeting period, just reinforce my assessment that any pass-through should be small and limited in duration. As we noted at the last meeting, perhaps the greater threat to sustained good inflation performance comes from possible increases in pressures on resources. The critical question is whether growth in output close to trend is a reasonable expectation with only modest further policy firming, given the low level of long-term rates, reduced drag from energy prices, and a boost from rebuilding. I thought it was a reasonable expectation, for a number of reasons. First, after smoothing through the fluctuations caused by auto incentives and hurricanes, private domestic final demand already showed signs of moderation last year. Growth in private domestic final sales slowed from 4¼ percent in the first half of the year to 3 percent in the second half of the year, with every element—consumption, business fixed investment, residential housing investment— moderating. The staff estimates that about 0.3 of this was due to hurricane effects, but that still leaves underlying private demand slowing to an annual rate of about 3¼ or 3½ percent. This moderation did not reflect the full effects of our policy tightening, especially on the housing market. Even well-anticipated increases in the short-term rates seem to be having a significant effect on housing markets, which have become more dependent on adjustable rate mortgages to maintain affordability. We are just beginning to see the anticipated slowdown in this sector. With growth in consumption and sales constrained by a leveling-out of housing wealth, businesses are unlikely to see the need to step up the pace at which they are adding to their capital stock. As a consequence, investment growth could slow, at least slightly, over the next few years, reflecting reduced impetus from the accelerator. Finally, although foreign economies are strengthening some, foreign investment and consumption remain subdued relative to income. And given our continuing outsized appetite for imports, net exports are unlikely to be putting added impetus to demands on domestic production. I think there are several upside and downside risks around this picture of growth near potential, as a number of you pointed out. I agree that the housing market is the most likely source of a shortfall in demand. I don’t think we can have much confidence about how the dynamics of this market will play out now that it has begun to soften. My suspicion is that, as little bubbles in the froth are popped, the risks are tilted more toward quite a sharp cooling off than toward a very gradual ebbing of price increases and building activity. On the other side, it seems to me global demand would be a major upside risk to growth and to price stability. The extraordinarily rapid rise in commodity prices and upward movement in global equity prices may indicate a very fundamental turnaround in foreign demand and attitudes beyond just a stepwise strengthening of growth. For now, these remain risks that we’ll need to monitor. In making my forecast, I assumed we would tighten at this meeting, and likely at the next as well, to gain greater assurance that inflation will remain contained over time, consistent with my forecast of a 1¾ percent increase in core prices in 2007. However, I do see action in March as dependent on the readings we get in coming months. There is, as usual, considerable uncertainty about the precise nature and magnitude of the risk to the outlook, but we’re dealing with an economic picture that overall is remarkably good and expected to remain that way for the foreseeable future. Reflecting on this situation, among many, many aspects of the past, I end my remarks as I began them: Thank you, Mr. Chairman." 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. " FOMC20070509meeting--186 184,MS. DANKER.," I’ll be reading the directive and the risk assessment from page 23 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” The risk assessment: “In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”" FOMC20080625meeting--125 123,MR. HOENIG.," Thank you, Mr. Chairman. Recognizing, as I do, where we're coming from and its dangers, I think more-recent data suggest that the downside risks to growth have diminished, and in my judgment the current stance of policy is much more accommodative than necessary to address these risks. I continue to believe that the two most recent policy actions of this Committee were more than sufficient, and we really need to think about reversing them sooner rather than later. Inflation risks have risen, and we have seen erosion in longer-term inflation expectations. As I noted in my previous remarks on the outlook, if we do not begin to remove policy accommodation soon, I think we risk having to tighten policy more aggressively in the future to reestablish our credibility. A couple of things. It struck me in looking at some of the major economies besides the United States--the European Union, Japan, and China--if you look at the real interest rates, they're low. I mean, they are 1 percent or less or negative. So this is a lot of stimulus coming into the world economy. And to make my point again, I don't think you can have a sustained recovery with a sustained inflationary environment, which we're in danger of encountering if we continue on this path. Over the past several weeks, markets have significantly altered their expected funds rate path to remove policy accommodation, and therefore, I don't know that doing something today would be that big a surprise. The current funds rate path built into the market rates is closer to what I believe is desirable to maintain price stability over the long run, but I would prefer moving somewhat faster--3 percent by the end of this year and perhaps 4� percent by the end of '09. Thus, in my view, we should begin the process of removing monetary policy accommodation by increasing the fed funds rate target by 25 basis points at this meeting. I think this action would perhaps be somewhat unexpected, and I recognize that there is some risk that markets would react by moving the funds rate path up more dramatically than some might desire. However, taking this action would move us beyond merely talking about inflationary risk and would help us contain inflation expectations by reaffirming our commitment to maintaining price stability. I think it would quickly have a positive effect on the economy as these expectations begin to shift. Now, assuming that's not the majority view today, I would then encourage us to set the stage in our language for stronger actions coming in the future. That is an important issue especially, as you mentioned yesterday, in terms of remarks that we might make following this meeting, in speeches and so forth. Finally, let me just say that I think policy is currently accommodative, perhaps very accommodative. The insurance policy taken out earlier this year to guard against the tail risk of spillovers of the financial distress to activity is less necessary, perhaps far less necessary, and it is potentially even harmful to the efforts of maintaining price stability. Therefore, I encourage action sooner rather than later. Thank you. " FinancialCrisisInquiry--272 HENNESSEY: Just—just 15 seconds. There is a significant difference between an increase in the perception that your firm will fail and whether or not a put option exists. They may both be the case. It may be the case that your spreads increased significantly after Lehman failed, but there might still be— investors still might be pricing in the risk the possibility that the government would step in and rescue your firm. Thank you. FOMC20081007confcall--28 26,MR. FISHER.," Mr. Chairman, I just want to add to Nathan's discussion but join it with the credit road. I spent this afternoon with the National Retail Federation. These are CEOs of Home Depot to JCPenney's to Ann Taylor, et cetera. One thing that I've been concerned about has been Chinese pressures in terms of their selling prices. As you know, these were being elevated--for example, in women's wear, 8 percent across the board. What is interesting is that, in the past two weeks, it has completely changed. They will deal only with those they consider to be creditworthy buyers, and they've now negotiated that price all the way back to last year's levels, as long as you are creditworthy. If you're not creditworthy in their opinion, they won't sell to you, period. So these two things are beginning to join, and I think this adds to the points that Nathan made. It's not just a matter of slack. It's a matter of unwillingness to deal with certain opposite parties--a counterparty risk of its own kind, so to speak--and it at least mitigates the concern I've had about the pass-through risk that we've talked about quite a bit. Thank you, Mr. Chairman. " FOMC20050630meeting--378 376,MS. BIES.," Thank you, Mr. Chairman. I thought I’d focus my remarks today on the topic we discussed yesterday—the housing markets. And then I’d like to talk a little bit about some of the liquidity issues in housing markets and relate that to monetary policy. Let me start by saying that overall I agree that there is not a major risk of significant problems in the housing markets. But there is momentum building in the housing area that is raising some issues about which I am not as sanguine as many of the staff who gave the presentations yesterday. But I want to compliment the staff from both the Board and the Reserve Banks. I thought they did a fantastic job in pulling all of the information together While inflation overall is apparently well contained, I, too, am generally concerned about the continued ratcheting up of our expectations. The one thing that stands out is how much housing prices have jumped relative to overall price levels. We know that the average price for new homes in May was up 8 percent from a year ago. Existing home prices were up 10.2 percent, as was said yesterday. But inventories remain relatively lean, even though the supply has risen by about half a month since the beginning of the year. When I look at the jump in housing prices, I’m trying to see if consumers are saying, “We have good, strong income growth and we’re able to afford more.” Or are they seeing these price increases and trying to jump in while they still can afford a house, before home prices get totally out of their range? Are they viewing real estate as an alternative for investment purposes, after being stung in the stock market drop of a few years ago? Really, all of these factors may be at the heart of the strong demand for housing. But I also think that the financing markets are sending different signals in these areas. I know Mark is going to talk about some of the specifics but I want to discuss some of the macro June 29-30, 2005 149 of 234 customers going to banks to refinance and take advantage of low, long-term fixed interest rates. So most of the mortgage originations in the 2001-2002 period were predominantly fixed-rate loans or they were ARMs that had fairly long fixed-rate periods before becoming adjustable. What is striking is how this has been changing in the last 12 months. ARMs of all types have jumped from about 16 percent of originations in 2001 to about one-fourth in 2002 and 2003, to over half of mortgage originations last year. This is happening in a period when short rates are rising and long rates are flat to down. If bankers are really working to the benefit of their customers, why aren’t they locking in long rates in this environment? It is also the case, when we look at the mix of products, that more of the mortgages are subprime products. Subprime originations have climbed to over 18 percent of total originations. In terms of where these mortgages are being parked—whether they are on the books of banks and other financial institutions or are being securitized—about two-thirds of originations continue to be securitized. So the use of the markets is about the same. But the types of mortgages being securitized are changing. Again, these are predominantly ARMs, and more of them tend to be option ARMs—the higher-risk kinds of structures. As we saw in the information presented about the real estate mortgage pools that are being created, the risk profile in those pools is changing. Interest-only mortgages were basically nonexistent in those pools two years ago; they are now running over 3.6 percent of them. Whereas a lot of these IO mortgages had very conservative loan-to-value ratios—under 80 percent—more and more of them now have loan-to-value ratios in excess of 80 percent. And about 9 percent of the IOs in these pools are going to subprime borrowers—that is, the riskiest customers. Yet those loans require interest-only payments, no amortization. Two weeks ago S&P required additional June 29-30, 2005 150 of 234 HELOCs are being used more for purchase money down payments. People no longer have to save to make a down payment. And when we look at HELOCs in general, for the last three years they’ve grown at a compound rate of over 30 percent a year. As would any supervisor, when I see a product growing 30 percent a year for three years, I tend to get a little nervous about the concentration risk. Where is the liquidity coming from for these? Again, a big chunk of it is going to the securitization markets. I think one of the challenges we have as bank supervisors is that, to the extent the banks are originating these loans with the intent to sell them to the market, they’re looking to the market for the credit definitions. We know from our QIS-4 [Quantitative Impact Study 4] results, looking at the Basel II exercise, that we had a huge disparity in the results on loss expectations on home equity loans and other mortgage products. A lot of these are new types of products. The confidence intervals around the expected defaults, I think, are a lot wider for them than for those that have traditional structures. We also know that there’s a lot of correlation risk that could happen here. If the housing price bubble does break in a market where employment is dropping, people could be leaving an area and we could have more defaults. In addition, we know that the dropping of home prices, in and of itself, tends to create more defaults, especially with negligible equity in these properties. Also, to the extent that people default and the banks have more properties to foreclose, there are neighborhood effects, with losses getting bigger when the defaults do occur. So, what I am concerned about from a liquidity perspective, since these are being securitized and moving into the markets—and there is plenty of appetite in the market to take these products— is the lack of discipline relative to previous periods. In the ancient days, when mortgage loans stayed on the books of financial institutions, liquidity limitations forced them to choose the higher June 29-30, 2005 151 of 234 understands the structure of these loans any better than some of us do in terms of pricing the risk, as evidenced by the S&P move two weeks ago. So, again, I’m not overly concerned. Especially with the record profits and capital in banks, I think there’s a huge cushion. But the implications of this for housing wealth and for investors who take the ultimate risk in these securities could create some problems in terms of the way economic growth proceeds going forward. And it’s something that I think was appropriate to spend the time talking about today." CHRG-110shrg50409--24 Mr. Bernanke," Well, first, of course, I would like to revise and extend my remarks from March of 2007. The issue was that the subprime crisis triggered a much broader retreat from credit and risk taking, which has affected not just subprime lending but a wide variety of credit instruments. And that is why it has become a much bigger element in the situation than, frankly, I anticipated at that time. The housing market is still under considerable stress and construction is still declining. I do believe that we will start to see stabilization in the construction of new homes sometime later this year or the beginning of next year, and that will be a benefit because the slowing construction pattern has been subtracting about 1 percentage point from the growth of the GDP going back now for some time. So that will be a benefit. House prices may continue to fall longer than that because of the large inventories of unsold homes that we still face. And then I would have to say that there is uncertainty about exactly what the equilibrium level that house prices will reach is. Unfortunately, it is that uncertainty, which is generating a lot of the stress and risk aversion we are seeing in financial markets. It is for that reason--the need to find a footing, to find stability in the housing market--that I do think that action by this Congress to support the housing market through strengthening the GSEs and FHA and so on is of vital importance. Senator Menendez. Let me talk about the other major driver, then, of what is happening to our economy, and that is the whole question of energy prices and oil. You know, I appreciate in your answer to the Chairman and in your testimony, because we have had testimony before the Congress by all executives who say that the difference between supply and demand over the last 2 years would largely lead us to a concern that, in fact, speculation may have driven the price of oil up an additional $50 a barrel. You have the view that that may not be the most significant thing in prices, but you do take the view that useful steps can be taken to improve the transparency and functioning of future markets. Are you ready to say to the Committee today what some of those useful steps are? Or are you still depending upon that Committee that you are meeting with to look at that? Because we do not have a lot of time here. " FOMC20080805meeting--79 77,MR. WILCOX.," I would just augment Bill's comment with two other observations. There's plenty of probability mass out in the tail. I think it actually is two-sided risk. We illustrated one side of that risk in our ""severe financial stress"" scenario. The other point I would make is that our projection for national house-price declines of 12 percent cumulative in 2008 and 2009 makes plenty of room for a very much more severe decline in Florida, California, and other highly stressed areas, and we have attempted to take that regional diversity into account. It's a rough exercise, to be sure, but we're not oblivious to the fact that some areas are doing much worse than the average. That is the nature of averages. " fcic_final_report_full--428 II. Housing bubble. Beginning in the late s and accelerating in the s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for home- owners and investors. III. Nontraditional mortgages. Tightening credit spreads, overly optimistic as- sumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to in- crease the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mort- gages and to make prudent financial decisions. These factors further ampli- fied the housing bubble. IV. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies er- roneously rated mortgage-backed securities and their derivatives as safe in- vestments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages. V. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enor- mous concentrations of highly correlated housing risk. Some did this know- ingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions. VI. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liq- uidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were in- sufficiently transparent about their housing risk, creating uncertainty in mar- kets that made it difficult for some to access additional capital and liquidity when needed. FOMC20060131meeting--99 97,MR. HOENIG.," Mr. Chairman, in thinking about the status of the U.S. economy and the appropriate funds rate target at this meeting, I would start by suggesting that, in my judgment at least, the current funds rate is probably within the neutral range. Therefore, we should be mindful of not going too far, especially when it would appear that growth is slowing to trend. The most compelling reason for considering the move now is the continued drift upward in core inflation, but even in this case, I think we need to be especially aware of the past increases in the funds rate. We have yet to see their full effects on inflation. The fourth-quarter growth was surprising; but at this point, as others have said, it does not yet alter our long-term outlook. Like the staff, however, I revised upward my 2006 forecast ¼ percentage point and now expect that growth will be about 3¾ percent in 2006, about ½ percentage point above trend, and will return to trend in 2007. Turning to the inflation outlook, I expect core CPI inflation to be about 2½ percent this year, as higher energy prices are passed through to higher overall and core inflation. However, it is reasonable to expect that the increase will be temporary, as others have said, with core inflation likely to fall back to 2¼ percent in 2007. The reasons for this pattern have a familiar ring. Greater-than-trend growth reflects the lagged effects of past monetary accommodation and generally supportive financial conditions, whereas the prospective slowing growth reflects the removal of monetary accommodation and, in this instance, higher energy prices. Evidence from our District is consistent with an outlook of strong but slowing growth as well. Manufacturing production and new orders rose solidly. Expectations for future production remained high, and expectations for future orders actually surged. Hiring plans also rose strongly in December and January. However, for the District as a whole, hiring announcements were only slightly greater than layoff announcements. Finally, housing showed signs of leveling off, and consumer spending was solid, though not spectacular, during the holiday season. In fact, a number of our contacts said their holiday sales were below plan. Just quickly in the farm sector, there are concerns being voiced for 2006 following a generally good year in 2005, and they were mostly that drought may be reemerging in the District. Wage pressures in the District remain mostly subdued, and increases in raw material costs actually slowed somewhat. However, manufacturers continued to raise output prices in response to past increases in input costs, and a substantial number said they were raising wages more than normal for certain types of workers in short supply. Reports of retail prices said that increases were down somewhat from the last meeting but still higher than they were just last summer. Let me turn just briefly to the risks. I would submit that inflation risks are on the upside and output risks have become more on the downside recently, not exactly the kinds of risk that are friendly from a policy perspective. The outlook for core inflation is 2¼ to 2½ percent. This is higher than I would prefer. Moreover, the potential for even higher energy prices makes core inflation more likely to be higher rather than lower over the next several months. But at the same time, the risks to output are on the downside. First, forward momentum has certainly diminished. For example, real GDP grew about 2.6 percent during the last half of 2005, decidedly below trend. In addition, while the fourth-quarter slowdown was probably temporary, it could also be signaling a more fundamental slowdown. Finally, a possible increase in the term premium poses downside risks to growth. You know the term premium is far below the historical average. If the decline reverses faster than expected, both would be significantly weaker as shown by the Greenbook alternative scenario. As I see things then falling out, the choices are obviously difficult, but I think that the inflation risk for the time-being is the greater risk, and therefore I would be inclined to move at this meeting. But we should have the odds no greater than 50-50 that more upward changes are likely in the fed funds rate at the next meeting. And finally, Mr. Chairman, although I have not served as long with you as some others around this table, I have served among the longest with you, and I would like you to know it has been a real privilege." FinancialCrisisReport--523 By using the phrase, “sourced from the Street,” Goldman may have misled investors into thinking that the referenced assets had been purchased from several broker-dealers and obtained at arms-length prices, rather than simply taken directly from Goldman’s inventory and priced by its own personnel. Moreover, this phrase also appears to hide the fact that Goldman had an adverse interest to investors and was seeking to transfer unwanted risk from its own inventory to the clients it was soliciting. By claiming it was “not a Balance Sheet CDO,” Goldman may have misled investors into believing that Goldman had little interest in the performance of the referenced assets in Hudson, rather than having selected the assets to offset risks on its own books. In addition to the Hudson marketing booklet, in December 2006, Goldman issued an Offering Circular which it distributed to potential investors. 2263 The Offering Circular contained the statement that no independent third party had reviewed the prices at which the CDS contracts were sold to Hudson 1. 2264 In addition to lacking third party verification, no external counterparty had participated in any aspect of the CDS contracts – all of the CDS contracts had been produced, signed, and priced internally by two Goldman trading desks which exercised complete control over the Hudson CDO. Internally, while Hudson 1 was being constructed, Goldman personnel acknowledged that they were using a novel pricing approach. 2265 At one point, Mr. Swenson sent an email to Mr. Birnbaum, raising questions about how they could explain some of the pricing decisions. Mr. Swenson wrote that he was: “concerned that the levels we put on the abx cdo for single-a and triple-bs do not compare favorably with the single-a off of a abx 1 + abx 2 trade,” telling Mr. Birnbaum “[w]e need a goo[d] story as to why we think the risk is different.” 2266 The prices that Goldman established for the CDS contracts that Hudson “bought” affected the value of the CDO and the Hudson 1 securities Goldman sold to investors, but the Offering Circular failed to disclose the extent to which Goldman had single-handedly controlled the pricing of 100% of the CDO’s assets. Perhaps the most serious omission from the marketing booklet and other offering materials was Goldman’s failure to disclose the fact that it would be the sole short party in the entire $2 billion CDO. The Goldman materials told investors that an affiliate, Goldman Sachs International (GSI), would be the “credit protection buyer” or initial short party for the Hudson 1 CDO. 2267 It was 2263 2264 2265 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196. Id. at 021821241. See, e.g., 9/19/2006 email from Michael Swenson to Thomas Cornacchia and Joshua Birnbaum, GS MBS-E- 012684557 ( “we are going to price an innovative full capital structure $1+bb CDO deal with 60% of the risk in ABX (no one has done this before).”); 9/21/2006 email from Darryl Herrick to Deeb Salem, Michael Swenson, Joshua Birnbaum, Peter Ostrem, and Edwin Chin, GS MBS-E-012685645. 2266 2267 9/27/2006 email from Michael Swenson to Joshua Birnbaum, GS MBS-E-012689798. 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196, at 021821229. This disclosure related to the master credit default swap, where Goldman Sachs International served as the credit protection buyer facing the Hudson Mezzanine 2006-1, Ltd., the legal entity that issued the Hudson 1 securities. See 12/1/2006 ISDA Master Agreement, GS MBS-E-021822056. In this role, Goldman was serving as an intermediary, and was protecting the CDO from credit risk by placing the Goldman Sachs name on the transaction and assuring investors that a single credit-worthy entity would be making all required payments to the Hudson 1 trust. Having one common practice for underwriters to act as the initial short party in a CDO, acting as an intermediary between the CDO vehicle and broker-dealers offering competitive bids in order to short the assets referenced in the CDO. 2268 The disclosure provided by Goldman contained boiler plate language suggesting that would be the role played by GSI in the Hudson transaction. Goldman never disclosed that it had provided all of Hudson’s assets internally, GSI was not acting as an intermediary, and GSI would not be passing on any portion of the short interest in Hudson to any other party, but would be keeping 100% of the short position. The Hudson disclosures failed to state that, rather than serving as an intermediary, Goldman was making a proprietary investment in the CDO which placed it in a direct, adverse position to the investors to whom it was selling the Hudson securities. CHRG-111shrg54589--87 Mr. Whalen," I think it is an effective practical question. The chief purpose of regulation should be to focus on things like suitability and the customer-focused issues. Obviously, systems and controls, risk management, all that are very important within a dealer, there is no question. But as I was saying before, there are certain classes of instruments that you really cannot risk manage. You were talking before about an airline that wants to put together a complex, customized swap for fuel. There is no problem with that. Everybody knows what the price of fuel is today. And you do the work, you calculate the optionality in the complex structure, and you can figure out what it is worth. The trouble comes if you look at the subprime complex structured asset market of a couple years ago, that we had everybody in agreement, much like playing Liar's Poker. The model became the definition of value for this class of instruments. But one day a number of people on the buy side started to question that assumption of ``mark-to-model.'' They started backing away from these securities. So did the dealers. So at some point--it is hard to say when--the consensus about value for that class of asset broke down. And that is where we are today. The buy-side customer still does not want to know about securities that have no visible cash market basis and effectively rely upon ``mark-to-model'' for price discovery. So I question really how effective risk management can be in those cases where we do not have a completely separate, independent reference point for value such as a liquid, cash market. " CHRG-111hhrg51698--108 Mr. Damgard," Well, I would say speculation has been demonized to the point where people think speculation is the same thing as manipulation. We speculate all the time by buying stocks, selling stocks. The people that are using futures markets historically, Mr. Congressman, have been institutional users that know precisely what the risks are, and they use those markets for price protection. We have seen those markets expand every year for the last 20 years with one exception, and it is really a credit to this Committee and the education that has gone on that has gotten more and more people involved in these markets that are used primarily by people that are managing risk. Now, without speculators, they wouldn't be able to do that, and the spreads would widen. So speculation is---- " FOMC20070321meeting--59 57,MR. STOCKTON.," That’s possible. We have not taken that view. Overall housing construction had some unexplained strength over the past year, not from a bottom-up demographic addition but just in terms of what we would have expected given the growth in employment, income, and wealth. Admittedly, the evidence is still very tentative, but we think we see some signs of demand stabilizing around current levels so that, in our starts forecast, we’ll be able to drive the months’ supply of homes back down relative to the low level that it had actually been running from the mid-1990s to the middle of the housing boom. So I don’t think we’re seeing an excess supply of homes that people just won’t want at current prices, or roughly current prices, but that is a considerable risk. Adding up household formations and demolitions—there’s a lot of uncertainty about that, and there’s a lot of cyclical sensitivity as well to the overall household formation rates. So whether the housing stock outran the long-run determinants is kind of hard to nail down. We see that as a risk, but it’s not incorporated in this forecast. If that were the case, there could be a bigger drag on housing activity than we’re anticipating." FOMC20070509meeting--82 80,MR. KOHN.," So here is my reasoning. I thought that the average includes lots of episodes of more or less steady growth in steady state and then other episodes of cyclical adjustments. In my mind, we were in the middle of a kind of mini-cycle, which was an adjustment from greater-than-sustainable growth to growth that we hope is sustainable. We’ve seen that the adjustment had already created some inventory overhangs and some changes in capital spending plans. So I thought that, because we’re not at a steady state, things might be a little more uncertain than usual. But I compensated for that by narrowing my confidence bands in ’08 and ’09 [laughter] when I think we’ll be close to a kind of a steady state. On the skews part, like President Geithner, I had downside skews on output. It wasn’t so much housing because I think that, with the adjustment to demand or activity that’s in the staff forecast and my own adjustment to prices, the risks around that are approximately balanced. Nor was it a spreading of problems in the subprime market to other credit markets; I think we’ve seen enough since the subprime problems started to be pretty sure that the risk is no more than the normal kind. Rather, the risk I saw was from concerns about the financial position and the psychology of the household sector and the interaction of those with housing. So it was a spillover in some sense from housing to consumption. The financial obligations ratio is very high. Households, as President Geithner noted, are highly leveraged. One of the surprises to me in the development of subprime markets was apparently how many borrowers and lenders were counting on the future appreciation in houses just to support the debt service, to say nothing of the consumption that must be going on at the same time. I suspect that this is more widespread than just the subprime market. How many households were expecting price appreciation to continue more as it did before rather than to slow down or even for prices to decline (as I think they will), it’s hard to say. But I suspect there are a lot of these households, and I think we could get some feedback there. The staff has the saving rate actually declining in the second and third quarters, and there might be some technical reasons for that. Even to get modest consumption growth, we see a very gradual uptrend in the saving rate over time. That might be the most likely outcome, but it did suggest to me that there is at least some fatter tail on the possibility that households, seeing what’s happening in the housing market and to their financial obligations, will draw back more quickly from spending. When President Geithner and I were in Basel, the most popular question to us was whether capital spending would really pick up again. A number of central bankers doubted that that could happen as long as consumption wasn’t growing more rapidly. But I’m comfortable with the capital spending pattern so long as the consumption pattern looks something like the pattern in the Greenbook and like the one that I have as my most likely outcome. More generally, as you pointed out at one point last fall, Mr. Chairman, I think we’re in a very unusual situation of below-potential growth for an extended period—a situation that is pretty much unprecedented without breaking out one way or another. Some nonlinearity is going to come up and bite us here, and, as I see it, the nonlinearity is most likely in the household sector. Now, if income proceeds along the expected path, it seems to me that there are upside risks to inflation moving down to 2 percent and staying there in our forecast. I think that overall we’re facing a more difficult inflation environment than we have for the past ten years or so: the high level of resource utilization; rising import prices from the decline in the dollar and the high level of demand relative to potential supply globally, including in the emerging-market economies—one thing we heard in Basel was that increasing numbers of these economies are having trouble sterilizing their reserve accumulation and are running into inflation pressures from that happening—higher prices for energy, food, and other commodities; higher headline inflation; and possibly even slower trend productivity growth. I didn’t see a downside skew to any of these things. But, as I thought about the whole picture with all these things seeming to tilt a bit on one side and their interaction, it seemed to me that there was some upside risk to the possibility that inflation expectations would rise rather than stay where they are as assumed in my most likely outcome. Now, for policy purposes, I would weight the upside risk to inflation more than the downside risk to growth, but we’ll get to that later in the day. Thank you, Mr. Chairman." 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-110shrg50369--89 Mr. Bernanke," Senator, we have to keep balancing those things. As I said, our current view is that inflation will moderate this year as oil and food prices do not rise as much this year as they did last year. We are also watching very carefully to make sure that higher oil and food prices do not feed into other costs and into other prices or that inflation expectations do not become unanchored. If those developments began to happen, that would certainly force us to pay very serious attention. At the moment, I think the greater risks are to the downside--that is, to growth and to the financial markets; but, again, we are always vigilant on all of our objectives and are always trying to balance those risks against each other. Senator Bunning. You read the Wall Street Journal. I am very sure of that. Today, in the Wall Street Journal, ``Report on profits a bright spot in the gloom. The Dow Jones Industrial Average has gained 6 percentage points since the first day of the year.'' In the Standard & Poor's index, 462 corporations have reported their earnings for the fourth quarter; 62 percent of those that have reported topped their earnings estimates--62 percent. If you drop out financials, carve out financials, which were 12 percent lower, the gloom and doom that I have heard here today is not gloom and doom. Are you going to tell me that these same corporations that reported--and we had a really low growth rate in the fourth quarter--are going to be worse in the first quarter? Or are we also going to have the same kind of reporting in the first quarter of 2008 that this profit report on the Standard & Poor's and the Dow is not as accurate in the first quarter as it was in the fourth? " CHRG-111shrg61651--73 Chairman Dodd," Thank you, Jack. Senator Merkley. Senator Merkley. Thank you very much, Mr. Chair, and thank you all for testifying today on these issues that are so important to our future economic health. Mr. Reed, you noted the question as to why do we rescue Long-Term Capital Management, and you noted that it stood alone, and I think you said, but there is an instinct in the system to save a major player. I want to turn back to that example to pursue that a little bit further. This was at the end of the 1990s and there were a lot of investments by major financial houses in Russian derivatives. If I recall right, Long-Term Capital Management, had it gone under, it would have been selling at fire sale prices. Many of these investments, which I believe we also had a number of large financial houses deeply invested in, including, I believe, Goldman and JPMorgan both had positions that were at risk, and so these other entities came together to help bail out Long-Term Capital Management to avoid at that point interconnections that were driven by market considerations. That is, one piece of the interconnectedness, if one firm fails and has to sell at fire sale prices, it drives down everybody else's asset portfolios. That is another form of interconnectedness or risk in the system. So could those of you who were involved in this or who have studied it share just a little bit more about the lessons to be learned from that setting, that form of risk, how that can be addressed? And it also certainly came up in mortgage-backed securities, the potential for them to be sold, and so forth. " fcic_final_report_full--226 THE BUST CONTENTS Delinquencies: “The turn of the housing market” .............................................  Rating downgrades: “Never before” ...................................................................  CDOs: “Climbing the wall of subprime worry” .................................................  Legal remedies: “On the basis of the information” .............................................  Losses: “Who owns residential credit risk?” ......................................................  What happens when a bubble bursts? In early , it became obvious that home prices were falling in regions that had once boomed, that mortgage originators were floundering, and that more and more families, especially those with subprime and Alt-A loans, would be unable to make their mortgage payments. What was not immediately clear was how the housing crisis would affect the fi- nancial system that had helped inflate the bubble. Were all those mortgage-backed securities and collateralized debt obligations ticking time bombs on the balance sheets of the world’s largest financial institutions? “The concerns were just that if people . . . couldn’t value the assets, then that created . . . questions about the solvency of the firms,” William C. Dudley, now president of the Federal Reserve Bank of New York, told the FCIC.  In theory, securitization, over-the-counter derivatives and the many byways of the shadow banking system were supposed to distribute risk efficiently among investors. The theory would prove to be wrong. Much of the risk from mortgage-backed securi- ties had actually been taken by a small group of systemically important companies with outsized holdings of, or exposure to, the super-senior and triple-A tranches of CDOs. These companies would ultimately bear great losses, even though those in- vestments were supposed to be super-safe. As  went on, increasing mortgage delinquencies and defaults compelled the ratings agencies to downgrade first mortgage-backed securities, then CDOs. Alarmed investors sent prices plummeting. Hedge funds faced with margin calls from their repo lenders were forced to sell at distressed prices; many would shut down. Banks wrote down the value of their holdings by tens of billions of dollars.  CHRG-111hhrg52397--292 Mr. Duffy," Well, I think Mr. Sprecher said it correctly, you have to look at a lot of these dealers, there are 12 large ones in the United States, of which they have operations throughout the world, and they can pass their book from one place to another so the book truly just travels along through the time zones. And that is a concern because they cannot operate outside the United States. Our concern with that aspect is if you take that market off of the United States, that hurts the regulated U.S. futures exchanges because we are really the price discovery mechanism for a lot of the look-alike's that trade over-the-counter, so that is the price that they are looking to use for their risk management needs. So if we have less liquidity in the over-the-counter trading on our exchange, it is going to hurt the whole food chain. So it is a concern. So when we look at--I will go back to maybe your other question about why we cannot take some of these trades in our clearinghouse, they are so customized in nature where a dealer may be out looking for the other side of a trade for not 6 milliseconds, like we trade at the CME Group, he may be out and be looking for 6 hours for the other side of his one particular trade for his one particular client. That is why it is very difficult. So we cannot bring those into our clearinghouse and assume the risk associated with those transactions at CME Group because we just do not have all the information we have on a standardized futures contract. But I guess that is a long way of saying is we are concerned about the liquidity, which is the direct result that the futures exchanges get from the over-the-counter market. The last panel made a statement, they said that the OTC market is roughly several times larger than a regulated exchange model. It is 5 times larger. It is much larger than a regulated exchange model, so they work together. And the pricing comes from the exchange model. " FinancialCrisisInquiry--142 CHAIRMAN ANGELIDES: Yield a couple of minutes more? BASS: Sure. First of all, I’ll—in the interest of full disclosure, I was a senior managing director at Bear Stearns for five and-a-half years from 1996 to 2001. So a lot of the people at that firm are very good friends of mine. And a lot of the people that ran the firm are very good friends of mine. In—in September of 2006, I went to Bear Stearns to meet with a guy named Bobby Steinberg, who at the time was their chief risk manager at the firm. He congregated a meeting in a conference room at their headquarters for me with the head of mortgage trading, the head of fixed income trading, the head of mortgage risk, fixed income risk and himself. And I went through my entire presentation as to what I saw building in the housing market where I— where I thought mortgage credit was going to go. And—and—and, you know, a couple points that I’ll make. Someone—someone in this morning’s hearing said did you ever contemplate housing prices ever dropping. They didn’t even have to drop for losses to show up. OK? If housing prices just went flat, they would have lost 9 or 10 percent on these securitizations, which would have wiped out everything up to close to the AAs. So to put it into perspective, I—I went through my presentation with their risk committee and said do you realize that if I’m right—and— and by the way, I’m one data point from Dallas, so I realize that they can discount what I had to say. But the presentation’s fairly compelling. If I’m right, do you realize what’s going to happen to this firm, knowing how—the firm’s position? And he said-- he said, Kyle, you worry about your risk management, and we’ll worry about ours. And that was the last time I spoke with them. Again, it’s—it’s one data point. And with regard to the Federal Reserve, I met one of President Bush’s staffers and—and went through it with him. And he suggested I go talk with the Federal Reserve here in D.C. And I met with one of the Federal Reserve board members and went through my— my presentation again, just a data point from Dallas—meeting at the Federal FOMC20080625meeting--47 45,MR. WASCHER.," No, I agree with you. I think our models have been surprised by the low rates of compensation growth. One way to think about it is that in the past we might have seen higher headline inflation passed through more quickly to compensation growth--as in the '70s, when those wage�price spirals were really led by prices, but then wages contributed by following. So far we haven't seen any sign that higher headline inflation has been putting upward pressure on compensation costs. I think there's a risk. We obviously included the simulation because we think there's a risk that could happen in the future, but to date we have not seen evidence that that's been the case. There are a number of reasons to think that things now might be different than they used to be. For example, just a structural reason, unions are less powerful than they used to be; a much smaller share of the work force is unionized. In the 1970s there were all sorts of automatic cost-ofliving adjustment clauses. Even when there weren't, there were big catch-ups for past inflation. Another structural reason might be that the minimum wage was higher in the 1970s, and it is lower in real terms now. I think more generally this fits in with the general notion that inflation expectations are less responsive to immediate shocks in headline inflation than perhaps they used to be. " CHRG-111shrg51303--99 Mr. Kohn," Well, I think we have done some of that, Senator, not to the same---- Senator Menendez. Some of it? I mean, how can you keep coming back and asking for monies in which you cannot quantify for us the systemic risk and the assets here? You are asking for an open-ended check, and gentlemen, you are not going to get that, even from those of us who have supported this overall effort, forgetting about AIG for the moment. You are not going to get that. You have got to quantify this risk. You have to tell us what is the level of the systemic risk. You have to give us a stress test analysis, as best as can be created, for us to quantify and figure out where we are going from here. But that doesn't seem to be the case right now. I am also concerned--you can't give me what they are asking for. I am also concerned of what is happening in the property casualty insurance market here as a result of the government actions that we are taking with AIG. What steps--and I know that there is a GAO report underway, an inquiry underway to assess the impact of all of the aspects of the financial rescue package for AIG and the United States insurance marketplace, and it seems to me that because we are giving them all this money, they keep pricing their products in ways that would not be sustainable for any other insurance company in the marketplace and therefore becomes anti-competitive with the rest of the industry. What steps are being taken to ensure that AIG's property casualty business is not being weakened, because at the end of the day, we may be the owners of it, and shouldn't there be an independent actuarial evaluation of their reserving and pricing practices here? Does anybody want to step up to the plate and answer that question? " CHRG-110shrg50369--30 Mr. Bernanke," Senator, we are facing a situation where we have simultaneously a slowdown in the economy, stress in the financial markets, and inflation pressure coming from these commodity prices abroad. And each of those things represents a challenge. We have to make our policy in trying to balance those different risks in a way that will get the best possible outcome for the American economy. Senator Shelby. Would you be trying to avoid stagflation, as some people call it? " CHRG-111hhrg51698--543 The Chairman," Could you pull the microphone a little closer? " Mr. Rosen,"--including reform that will relate to OTC derivatives. Measures are needed to improve regulatory transparency particularly to ensure appropriate capital oversight of professional intermediaries and OTC derivatives whose activities, as we have seen, can have systemic consequences. We look forward to working with this Committee and Congress on broad regulatory reform to address these issues. However, we are deeply concerned that the draft bill could have profound, albeit unintended, adverse consequences not merely for American markets, but for many mainstream American companies. This would contribute to the forces that are driving the current credit crisis. SIFMA's testimony describes the extraordinary extent to which mainstream American companies depend on CDS and other OTC derivatives to manage their risks and obtain access to financing. Direct and indirect limitations on access to these products will increase the risks to which these companies are subject, and in turn increase the risks of loss to which they are subject, the volatility of their earnings, their cost of funds, and thereby reduce their share prices and impair their competitiveness. A number of provisions in the draft bill raise these concerns. The proposed prohibition on purchasing so-called naked CDS protection would essentially eliminate the corporate CDS market. We can think of no traded product that is subject to a restriction of this kind, yet every financial product can be equally used for hedging or to express a positive or negative market view. It is precisely the interaction of these market views that is the essence of price discovery and efficient markets. As a result of this, CDS would become extremely expensive and illiquid in the sense of financial guarantee insurance or a product whose limitations the credit default swap market was specifically developed to address. American companies, including companies in the agricultural sector, would have reduced access to financing, and available financing costs would increase. Bank revenues from lending activity would also be reduced, placing further pressure on the financial strength of the banking sector, which currently depends heavily on public funds. Mandating the clearing of all OTC derivatives with a narrow exception for contracts that are both highly illiquid and highly customized is understandable but impractical, and we think unnecessary. Not all OTC derivatives can be cleared. As this Committee has heard, clearinghouses must be able to obtain reliable current pricing and historical data in order to calculate the appropriate collateral requirements and to model the clearinghouse risk. Also, not all companies have the operational infrastructure to participate. But rather than mandating clearing, we believe it would be far more effective for a prudential supervisor to have authority over all systemically significant market participants, including the authority to require clearing where it is appropriate and/or impose capital charges for the incremental risks represented by uncleared positions. We think this would be an important element in any comprehensive regulatory reform. With regard to carbon offsets, we believe it is clear that off-exchange markets compliment exchange markets. They serve as incubators for developing products, and they enable derivatives to be tailored to companies' risk management needs. Prohibiting them in the case of environmental derivatives will, in our view, only impede the development of a market that is a national priority. Provisions of the bill would impose indirect and potentially direct position limits on OTC derivatives. In our view, off-exchange physical positions have a far greater ability to influence commodity pricing and disrupt markets than purely notional financially settled contracts. In the absence of a perceived need to impose limits on the size of OTC physical positions, we don't see the justification for limits on notional exposures. The restrictive definition of bona fide hedging in the proposed bill would effectively impose a de facto position limit on OTC derivatives that are hedged on futures exchanges. However, the proposed position limit exception for swap dealers does not reflect the way in which companies manage their risk, or the manner in which swap dealers intermediate client risk. The result could be to curtail corporate access to OTC derivatives even for highly desirable risk management purposes. The draft bill also does not recognize that many index and other strategies are not speculative in nature, and would curtail the use of important strategies that are effectively market-neutral and stabilizing, and preclude fiduciaries from protecting retirees and others investing for retirement from protecting their retirement income from erosion due to high rates of inflation. Commercial interests are inherently directionally biased market participants and have the greatest capacity to influence prices and markets. All or virtually all the CFTC energy manipulation cases brought over the last 5 years have involved commercial energy traders. By decreasing the prevalence of directionally neutral participants and increasing the relative dominance of commercial interests, SIFMA is concerned that the draft bill would make the U.S. futures markets far more susceptible than they are today to manipulation. At a minimum, it will increase spreads and the cost of hedging for commercial interests. [The prepared statement of Mr. Rosen follows:] Prepared Statement of Edward J. Rosen, J.D., Partner, Cleary Gottlieb Steen & Hamilton LLP, New York, NY; on Behalf of Securities Industry and Financial Markets AssociationIntroduction Chairman Peterson, Ranking Member Lucas, and Members of the Committee: My name is Edward Rosen \1\ and I am appearing today on behalf of the Securities Industry and Financial Markets Association (SIFMA).\2\ We thank you for the invitation to testify today on the Committee's draft legislation, entitled ``Derivatives Markets Transparency and Accountability Act of 2009''.\3\ My testimony today reflects the views of SIFMA member firms active in both the listed and over-the-counter (OTC) derivatives markets in the United States and abroad.--------------------------------------------------------------------------- \1\ Mr. Rosen is a partner in the law firm Cleary Gottlieb Steen & Hamilton LLP, testifying on behalf of and representing the views of SIFMA and not those of Cleary Gottlieb Steen & Hamilton LLP. \2\ SIFMA brings together the shared interests of more than 650 securities firms, banks and asset managers locally and globally through offices in New York, Washington, D.C. and London. Its associated firm, the Asia Securities Industry and Financial Markets Association, is based in Hong Kong. SIFMA's mission is to champion policies and practices that benefit investors and issuers, expand and perfect global capital markets and foster the development of new products and services. Fundamental to achieving this mission is earning, inspiring and upholding the public's trust in the industry and the markets. (More information about SIFMA is available at http://www.sifma.org). \3\ Draft dated January 28, 2009 (1:08 p.m.).---------------------------------------------------------------------------Overview Preservation of the integrity of U.S. markets must be a paramount concern for the public sector and the private sector alike. SIFMA thus appreciates the Committee's current attention to this objective and commends the Committee for the ongoing leadership role that it has played over many years in sponsoring measures necessary to ensure the integrity of U.S. derivatives markets. SIFMA wholeheartedly endorses a number of the central themes that underpin the draft bill. Specifically, we agree that: Regulatory Transparency. Effective regulatory oversight of commodity markets requires appropriate regulatory transparency that ensures timely CFTC access to relevant position information; OTC Clearing. The clearance of OTC derivatives can and, we think, will play an important role in mitigating operational and counterparty risks for large segments of the OTC derivatives markets and, where appropriate, should be given a high priority by supervisors and the private sector; Speculative Limits. Limits on the size of speculative positions can play an important role in preserving orderly markets; and Global, Linked Markets. Listed derivatives, OTC derivatives and physical commodity markets are global and inextricably linked. We commend the draft bill's focus on these themes. Nonetheless, SIFMA and its members are deeply concerned by a number of provisions in the draft bill. We believe these provisions do not represent the most effective solutions to current market issues. Instead, we believe these provisions would have profound adverse consequences not merely for OTC and listed derivatives markets, but also for mainstream American companies. Specifically, key provisions in the draft bill would: Prohibit the purchase of uncovered CDS protection; Require the clearing of all OTC derivatives, subject to limited exceptions; Authorize the imposition of position limits for OTC derivatives; Prohibit off-exchange trading in futures on carbon credits and emission allowances; and Eliminate position limit exemptions for risk management strategies. We believe these provisions would: Deepen the current crisis by fundamentally undermining both the efficacy and availability of listed and OTC derivatives as risk management tools for large and small American businesses, thereby increasing costs, risks and earnings volatility for such companies throughout the economy; the draft bill's CDS- related provisions in particular would significantly and adversely impact access to, and the cost of, financing for American companies, which could lead to continued job losses; Increase (and not decrease) the susceptibility of commodity markets to manipulation and disorderly trading and enhance the ability of commercial traders with a vested interest in commodity prices to influence such prices; Impede successful development of cap and trade programs by prohibiting non-exchange derivatives on carbon offsets and emission allowances; Preclude pensioners, retirees and those saving for retirement from protecting the real dollar value of their retirement income against erosion from the effects of commodity price inflation through the use of commodity derivatives; and Drive the development outside the United States of markets in energy and other core commodities and financial products that are key to the U.S. economy, with the result that, while these markets would have the ability to inform or drive U.S. prices for the affected commodities and products, the U.S. Congress would have no ability to influence these markets. We believe the potential consequences of these provisions run directly counter to the Committee's own well-intentioned objectives. They also run counter to the efforts of Congress and the supervisory community to address the credit crisis and, if enacted, would almost certainly exacerbate the crisis. SIFMA understands that there is a need for regulatory reform and that such reform will need to address issues such as regulatory transparency and prudential oversight with respect to OTC derivatives. However, SIFMA strongly believes that any statutory changes in the regulation of OTC derivatives, particularly changes that would have such far-reaching consequences as those proposed in the draft bill, should only be undertaken in the context of broader regulatory reform and should focus on decreasing risk and improving transparency and efficiency in the OTC derivatives markets, while maintaining the significant benefits these markets currently provide for mainstream American companies and institutional investors. It is estimated that more than 90% of the 500 largest companies in the world use OTC derivatives.\4\ An even greater percentage (94%) of the American companies in this group use OTC derivatives. More than half of medium-sized American companies are estimated by Greenwich Associates to use OTC derivatives.\5\ These companies rely on access to OTC derivatives for important risk management purposes (some of which may, but many of which will not, fall within the draft bill's proposed definition of bona fide hedging).--------------------------------------------------------------------------- \4\ International Swaps and Derivatives Association, Inc., 2003 Derivatives Usage Survey, http://www.isda.org/statistics/. \5\ Greenwich Associates, http://www.greenwich.com.--------------------------------------------------------------------------- Mainstream American companies in every sector of the U.S. economy, including within the agricultural sector, depend on access to efficiently priced financing in order to make capital investments, purchase inventory and equipment, hire employees and otherwise fund their businesses. The availability of a robust corporate CDS market is essential if lenders are to meet the demand for these borrowings and to be in a position to do so on an efficiently-priced basis. CDS and other OTC derivatives thus not only play an important market function, they also play a critical role in enabling ordinary companies, outside the financial sector, to manage the risks of their businesses and to obtain the financing necessary to expand, and in many cases to sustain, their businesses. And, as the statistics cited above indicate, significantly more than half of the U.S. economy would be directly and adversely affected by the inability of professional intermediaries to make these products available and to utilize them themselves. Against this background and, particularly in the context of the current crisis, it is all the more important that Congress adopt legislative initiatives that preserve the benefits of these products, and access to these products, while carefully targeting those measures that are appropriate to protect the public interest. Our comments with respect to specific provisions of the draft bill are summarized in the following section.Section-by-Section CommentsProhibition of ``Naked'' CDS (Section 16) Section 16 of the draft bill would prohibit the purchase of CDS protection by any person who does not have direct exposure to financial loss should the referenced credit events occur. Very simply, the proposed prohibition would effectively eliminate the corporate CDS market. Although CDS are a relatively recent financial innovation, they have quickly become the most important tool available to banks and institutional investors, such as pension funds, for managing the credit risks arising from commercial loans and corporate bond investments. CDS, which are typically fully collateralized, are the only liquid financial instruments that enable a company exposed to a third party's default risk to manage that credit risk in an efficiently priced market. As such, CDS enable lenders to hedge the credit risks inherent in corporate financing that are essential to economic growth, and, in turn, reduce the cost of funds for borrowers. CDS also free up additional credit capacity, which enables banks to expand credit facilities available to their corporate clients. In addition, CDS provide important benefits for other market participants as well. For example, asset managers and other institutional investors use CDS as a liquid instrument through which to obtain credit exposure to particular companies and to adjust their credit exposures quickly and at a lower cost than alternative investment instruments. In addition, many market participants use CDS pricing to provide a more accurate valuation of credit risk than would otherwise be possible by looking solely to less liquid cash markets. No traded product is subject to a restriction similar to the one proposed to be imposed on CDS by the draft bill. This is not surprising given that the proposal would strictly limit CDS to hedging transactions and would significantly restrict the involvement of professional intermediaries and investors in these products. As a policy matter, the purchase of uncovered CDS protection is no different than buying or selling futures, options, stocks or bonds because the relevant product is perceived to be undervalued or overvalued by the market. These investment activities are critical to liquidity, reduced execution costs and efficient price discovery in these markets and all involve legitimate and, indeed, desirable investment activities. Absent the participation of intermediaries and non-hedgers, CDS would cease to trade in a market, and they would become extremely illiquid and costly--both to enter into and to terminate.\6\ As a direct result, lenders and investors would be left with far more limited and more expensive alternatives for managing the credit risks arising from their lending and investment activities. In turn, American companies, including those in the agricultural sector, would have significantly reduced access to financing, and the financing that would be available would be more costly. Bank revenues from lending activity would also be reduced, placing further pressure on the financial strength of the banking sector.--------------------------------------------------------------------------- \6\ The proposed requirement could also subject CDS to regulation as a form of financial guarantee insurance, thereby subjecting providers of protection to the additional burdens and inefficiencies of regulation by insurance supervisors in each of the 50 states.--------------------------------------------------------------------------- The impact of these effects on the credit crisis, and efforts to reverse the credit crisis, are plain. The OTC derivatives markets in general, and the corporate CDS market in particular, have performed extremely well and have remained liquid throughout the current market turmoil, providing important benefits not only for financial market participants but also for large numbers of mainstream American companies. The corporate CDS market in particular has provided a critical price discovery function for the credit markets, which have otherwise become extraordinarily illiquid during the crisis and, as a result, provide extremely little credit market price discovery apart from corporate CDS. Measures that would interfere with this function would be highly undesirable and would further exacerbate the credit crisis. The segment of the CDS market in which extremely significant losses have been incurred involved the writing of CDS protection on mortgage-related asset-backed securities; in many ways, a very different product than corporate CDS. The market for CDS on asset-backed securities is also a relatively small segment of the overall CDS market; generally less than 2% of the aggregate CDS market.\7\ Losses in this segment led, in part, to the rescue of the AIG insurance conglomerate and the failure or near failure of many monoline financial guarantee insurers subject to oversight by state insurance supervisors. The losses incurred through these products did not result, however, from flaws in the products; in fact, the products transferred the risk of the referenced asset-backed securities as intended by the parties. These losses were directly related to the unexpectedly large losses in the subprime mortgage sector and the leveraging of these exposures through highly structured securities, such as mortgage-related collateralized debt obligations (CDOs--not to be confused with CDS). A number of capital market participants incurred significant losses in the subprime mortgage-related CDS and CDO market.--------------------------------------------------------------------------- \6\ DTCC Deriv/SERV Trade Information Warehouse Reports (data as of the week ending January 23, 2009), http://www.dtcc.com/products/derivserv/data/index.php.--------------------------------------------------------------------------- Although some CDS market participants have incurred large losses in connection with corporate CDS, for example, in the case of CDS referencing financial institutions such as Lehman Brothers, the corporate CDS market nonetheless functioned well as a result of effective bilateral mark-to-market collateral arrangements. The private sector's initiative to establish a clearinghouse for CDS will further reinforce the salutary and stabilizing effects of appropriate bilateral collateral arrangements. The measures proposed in the draft bill would do little to address the regulatory issues actually presented by the failures and near failures resulting from these events; and we see nothing in the events of the recent past that would justify a response in the form of the effective elimination of corporate CDS.Mandatory Clearing of OTC Derivatives (Section 13) Section 13 of the draft bill would require the clearing of all OTC derivatives, subject to a very limited exemptive process in the case of products that are infrequently transacted, highly customized, do not serve a price discovery function and are entered into by parties able to demonstrate their financial integrity. The clearing of OTC derivatives transactions has the potential to provide many important benefits, including the mitigation of operational and counterparty risks and facilitation of regulatory oversight, and should be encouraged where appropriate. However, section 13 of the draft bill would mandate that all OTC derivative contracts must be cleared, including not only CDS but also other OTC derivatives such as interest rate and currency swaps, the markets for which are also significant and have performed well throughout the current credit crisis, with an extremely narrow exception for certain infrequently traded and highly customized contracts. Such a clearing requirement is unworkable as a practical matter and would adversely affect mainstream American companies and reinforce conditions contributing to the current credit crisis. As a threshold matter, not all OTC derivatives contracts are suitable for clearing or can be cleared without presenting unacceptable risk management challenges for a clearinghouse, and not all market participants can participate in a clearing system. In order to mitigate its counterparty risk, a clearinghouse must determine the aggregate risk to which it is exposed as a result of its clearing activities and must collect mark-to-market margin, in cash or liquid securities such as U.S. Treasury securities, every day from each of its members with respect to such members' positions in the clearinghouse. In order to do this, the clearinghouse must be able to model the risks associated with the products it clears and must be able to determine the amount of the market-to-market margin it is to pay or collect each day, a process that requires access to price data. The administrative and financing demands of participating in a clearinghouse on members are significant, and as a practical matter, mainstream American companies that are end users would not participate because they do not have the personnel, operational infrastructure and expertise, nor the cash and securities on hand, to do so. As evidence of this, although exchange-traded interest rate and currency futures are widely available, mainstream American companies are negligible users of such products. Reliable risk modeling requires statistically robust historical price data sets for each cleared product. Reliable mark-to-market margining, in turn, requires (1) products that are both completely standardized and sufficiently liquid (one or the other of these characteristics is not sufficient) and (2) ready access to reliable price sources. Even where these conditions are present, existing clearinghouses must have developed an approved risk modeling approach in order for market participants to clear their positions without subjecting themselves or the clearinghouse to inappropriate market and counterparty risks. Against this background, it is clear that a regulatory model that requires market participants to obtain a prior exemption based on highly subjective criteria before they transact would be utterly unworkable, would inject unnecessary legal uncertainty (potentially subjecting transactions to after-the-fact legal challenges), would interfere with the execution of risk management transactions and would impede new product development. Further, as noted above, limitations on the availability of CDS would directly and adversely affect American companies. While measures to promote standardization can afford risk-reducing benefits, there are many circumstances in which customized solutions will be more appropriate. For example, standardization of products effectively precludes the application of hedge accounting by American companies, as standardization vitiates the ability to structure customized hedges that comply with the requirements of Financial Accounting Standard 133. Without hedge accounting, American companies who do choose to use derivatives would experience significant volatility in their reported earnings, for reasons altogether unrelated to their core businesses. The potential for such volatility in reported earnings would result in less hedging and more risks being borne by companies who are ill-equipped to manage them. Moreover, the proposed provision is unnecessary and exemplifies the pitfalls of addressing the regulation of OTC derivatives outside of an appropriate comprehensive regulatory framework. As a practical matter, the major OTC derivatives intermediaries (at least in financial derivatives) are subject to supervision by Federal regulators, including the Office of the Comptroller of the Currency and the Board of Governors of the Federal Reserve System, as national banks, Federal Reserve System member banks or members of bank (or financial) holding company groups. These supervisors have plenary authority to identify those circumstances in which clearing is appropriate and to require such clearing and/or impose capital charges that address any incremental risks that are associated with transactions not so cleared. Indeed, the industry has been working with the Federal Reserve since 2005 on various voluntary initiatives to reduce risk and improve the infrastructure of the CDS market, including the development of a CDS clearinghouse. We believe a model under which these issues are addressed by a direct prudential supervisor of all systemically significant participants in the OTC derivatives markets is a far more effective approach than, and one that would avoid the significant pitfalls of, a more rigid statutory mandate such as the one included in the draft bill.Imposition of Position Limits on OTC Derivatives (Section 11) Section 11 of the draft bill would authorize the CFTC to impose position limits on ``speculative'' OTC transactions that are fungible with exchange-traded futures. The potential limitation on the scope of permitted OTC derivatives exposures as contemplated by section 11 of the draft bill would have potentially profound ramifications. The potentially adverse implications of such limits for mainstream American companies are significantly exacerbated by the draft bill's proposed categorization of risk management transactions as ``speculative.'' (See the immediately following discussion of section 6 of the draft bill.) The CFTC and the futures exchanges have been able to ensure orderly futures markets through, among other measures, limitations on speculative futures positions without having to limit, for example, off-exchange positions in fungible (i.e., deliverable) physical commodities. It is plain that large physical positions on either side of the market have a far greater potential to disrupt futures markets than do purely notional, financially-settled OTC derivatives. In the absence of such limitations on physical positions, or any perceived need for such limitations, we question the need to impose such limits on purely notional, financially-settled OTC derivatives positions. As noted above, any such proposal for direct and restrictive regulation of OTC derivatives would, in any event, be more appropriately considered in the context of broader regulatory reform.Elimination of Risk Management Exemption (Section 6) Section 6 of the draft bill would limit the availability of position limit exemptions for risk management positions other than those held by commercial entities directly engaged in a physical merchandising chain under a highly restrictive definition of bona fide hedging. The policy rationale for position limit exemptions has historically been based on the inference that a trader who is directionally neutral with respect to the price of a commodity underlying its futures position lacks the motivation to engage in abusive price manipulation. Thus, hedging, arbitrage and spread trading were early examples of cases in which such exemptions were available. As portfolio theory evolved, and financial futures and OTC derivatives became prevalent, a variety of risk management strategies became the basis for similar exemptions. The draft bill would reject this policy rationale and would arbitrarily subject broad ranges of financial hedging and risk management activity to the limitations applicable to truly speculative positions. SIFMA believes that these limitations would have a profound adverse impact on futures and OTC derivatives markets, on retirees and investors, and on companies seeking to manage the commercial and financial risks to which they are subject. These adverse effects are all the more troubling in light of the absence of any rigorous analysis of empirical data indicating that the involvement of noncommercial entities in the futures markets has caused the recent volatility in energy and other commodity prices. Indeed, the only rigorous analysis to date of relevant empirical data by the CFTC has reached precisely the opposite conclusion.Swap dealers and mainstream American companies. Section 6 of the draft bill would severely restrict the ability of swap dealers to provide customized OTC derivatives hedges to commercial end users and corporations. In most cases, swap dealers use a portfolio approach under which they manage price risk using combinations of physical transactions, OTC financially-settled transactions and exchange-traded futures. Thus, when entering into an OTC swap transaction with a counterparty, the dealer does not necessarily hedge that specific transaction with a specific offsetting transaction in the U.S. futures markets or the OTC derivatives markets. Rather than hedge the price risk created by a specific OTC transaction, the dealer might use the U.S. futures markets or the OTC derivatives markets to hedge the net exposure created by multiple transactions conducted contemporaneously or even at another point in time. Known as ``warehousing risk'', a dealer may also enter into numerous or long-dated OTC transactions with a client that is seeking to hedge its price risk. At the time of entering into the transactions, it may not be prudent or possible for the dealer to enter into offsetting transactions in the futures markets or with other OTC dealers. Thus, in warehousing risk, the dealer assumes the price risk from its client and manages it in its trading book using the portfolio approach described above. By requiring that dealers, in order to qualify for the hedge exemption from speculative position limits, be able to demonstrate that any given position in the futures or OTC derivatives markets (hedged by futures) serves as a hedge against a specific OTC transaction with a counterparty that is itself hedging price risk, the draft bill would prohibit useful and risk-reducing hedging, which clearly runs counter to the public policy goals of the draft bill, and would significantly limit dealers' ability to effectively intermediate the risks of their end user and corporate clients which, in turn, would likely significantly reduce liquidity in the futures and OTC derivatives markets, increase hedging costs and leave the markets far more susceptible than they are today to undue influence by commercial interests that have a stake in directional price movements. It would also increase hedging costs for mainstream American companies, leaving them more susceptible to price risk and less competitive.Index strategies. The draft bill's proposed speculative position limit provisions would limit futures trading that is not, in fact, speculative and that does not have a market impact analogous to speculative trading, and, in turn, could potentially interfere with commodity price formation to the detriment of the markets. As an example, pension plans and other investment vehicles hold portfolios whose ``real dollar'' value is eroded by inflation. Investment of a targeted allocation of the portfolio in a broad-based commodity index can effectively ``hedge'' that risk financially. Such a strategy, like ``bona fide'' physical hedging, is undertaken for risk management and risk reduction purposes, is passive in nature (i.e., positions are bought in accordance with the index algorithm and asset allocations and are generally held, not actively traded) and is not speculative in purpose or effect. The strategy does not base trading decisions on expectations as to whether prices will go up or down--the strategy is generally indifferent as to whether prices go up or down. The strategy generally leads to trading in the opposite direction of speculators, offsetting their impact: when commodity index levels rise, portfolio allocations to index strategies are reduced (resulting in selling), when commodity index prices fall, allocations to index strategies are increased (resulting in buying). Over the long term, the strategy acts as a stabilizing influence for commodity prices. These trends were found by the CFTC in its recent study to be consistent with its analysis of relevant trading data. On the other hand, we are unaware of a rigorous analysis of empirical trading data that supports the correlations that have been alleged between index trading and increasing commodity prices. In addition, investing on a formulaic basis in a broad-based commodity index would be the least effective means of ``manipulating'' the market for an individual commodity.Increased susceptibility to manipulation. By restricting the hedge exemption to commercial entities, the draft bill would, in effect, significantly increase the relative market share of these entities and simultaneously reduce liquidity, by reducing the sizes of positions of traders employing risk management strategies that are truly market neutral. Any proposed legislation on this topic must take into account three basic facts. First, although a commercial user's futures position may be offset by a physical position, commercial entities are almost never price neutral. Second, the category of market participant that is best positioned to influence market prices are commercial users controlling large physical positions. Third, significantly increasing the relevant market share of commercial entities increases the ability of such traders to influence prices. As a result, SIFMA believes that the draft bill would make the U.S. futures markets far more susceptible than they currently are to price manipulation by commercial traders with directional biases. Indeed, nearly all of the CFTC energy manipulation cases that have been brought over the last 5 years have been brought against traders at firms that would be considered commercial entities under the draft bill.Carbon Offset Credits and Emission Allowances (Section 14) Section 14 would establish an exchange monopoly for the trading of futures on carbon offset credit and emission allowances and criminalize off-exchange trading in such products. The most successful, liquid and efficient markets are those in which trading is permitted both on-exchange and off-exchange. Indeed, exchange markets are generally enhanced by the success of related off-exchange markets. Off-exchange trading is also essential for a number of reasons. Off-exchange markets serve as the incubators through which trading terms are able to coalesce around agreed market conventions that promote liquidity and efficiency. This process facilitates the evolution of standardized and liquid products that can be effectively exchange traded. Off-exchange trading also enables derivatives to be tailored to the risk management needs and circumstances of individual companies. Off-exchange trading also facilitates the cost-effective execution of large wholesale transactions for which an exchange environment can be inefficient. Finally, the proposed prohibition would eliminate the fundamental salutary market benefits of inter-market competition--a cornerstone of efficient markets and American capitalism. As a result, we believe the proposed prohibition would impair market efficiency and impede innovation and the successful development of these products. As a direct consequence of these effects, the proposed provisions would, in our view, undermine rather than promote the important national policy objective of encouraging the development of successful and efficient trading markets in these important products.OTC Reporting Requirements (Section 5) Section 5 of the draft bill would require the CFTC to impose detailed reporting requirements with respect to OTC derivatives. We note that the CFTC currently has the authority to ascertain information regarding the OTC derivatives positions of large traders holding reportable positions in related futures contracts. SIFMA urges the Committee to avoid the creation of an ongoing detailed reporting regime applicable to OTC derivatives generally, as such a regime has the potential to result in large amounts of, but disproportionately little useful, information, imposing significant costs and burdens on the resources of the private sector and the CFTC alike. SIFMA would not, however, be opposed to a carefully tailored reporting regime (similar to that currently employed by the CFTC) under which the CFTC may require firms to provide upon request targeted information regarding large positions in OTC derivatives that are fungible with exchange-traded futures contracts (or significant price discovery contracts) that are under review by the CFTC as part of its market surveillance function or in connection with any investigation.Reporting Entity Classification (Section 4) Section 4 of the draft bill addresses the classification and disaggregation of large position data and would require disaggregation and reporting of positions of swap dealers and index traders. SIFMA supports the classification of position data into categories that promote the market surveillance function of the CFTC. The distinction between market participants who have directionally biased positions and those that are directionally neutral is a key one in this context. On the other hand, since swap dealers and index traders may fall into either of these categories, it is not clear that the proposed disaggregation would promote the CFTC's surveillance function.Foreign Boards of Trade (Section 3) Section 3 of the draft bill would require the CFTC to impose specific rule mandates on foreign boards of trade. Recognizing that our markets are global and inextricably linked, international coordination and harmonization are important objectives. However, these objectives can be better accomplished without the prescriptive imposition of U.S. rules on foreign markets. In addition to potentially curtailing U.S. access to foreign markets, any such approach would likely be regarded as imperious and may well invite retaliatory measures that could compromise the ability of U.S. exchanges to compete for international business--currently an important growth segment of U.S. exchange markets.Conclusion OTC derivatives markets play a key role in the functioning of the American economy by helping companies, lenders and investors to manage risk and arrange financing. With the limited exception noted above involving the writing of CDS protection on mortgage-related asset-backed securities by AIG and monoline financial guarantee insurers, the OTC markets have performed well and remained liquid throughout the current market turmoil, providing important benefits for a large number and wide range of companies. It must be recognized that the consequences of many of the proposed provisions in the draft bill would not fall solely or even most heavily on the professional intermediaries participating in these markets. Instead, the consequences of these provisions would, if enacted, harm very large numbers of mainstream American companies whose financial strength is critical to the welfare and recovery of our national economy. As noted above, many American companies use OTC derivatives to hedge their cost of borrowing or the operating risks of their businesses. Many of those who do business overseas use OTC derivatives to hedge their foreign exchange exposures. Many companies also hedge their commodity and other price exposures. For many companies, the availability of efficiently priced access to financing and other products depends on access by their counterparties to OTC derivatives such as CDS and interest rate and currency swaps. By limiting or eliminating access to basic risk management tools that American companies routinely use in the day-to-day management of their businesses, the draft bill could have a potentially profound negative impact on these companies and our nation's economic recovery. Recognizing the importance of OTC derivatives, we continue to support efforts to address the risks and further improve the transparency and efficiency of the OTC derivatives markets. Similarly, recognizing the importance of efficient and orderly exchange markets we continue to support tailored measures to improve the efficiency and integrity of listed futures markets. We look forward to working with this Committee, Congress and regulators on initiatives designed to improve oversight of OTC derivatives, while maintaining the significant benefits the OTC derivatives markets currently provide, and to promote orderly and efficient exchange markets. The Chairman [presiding.] Thank you very much, Mr. Rosen. " FinancialCrisisReport--60 On September 8, 2008, Washington Mutual signed a public Memorandum of Understanding that it had negotiated with OTS and the FDIC to address the problems affecting the bank. Longtime CEO Kerry Killinger was forced to leave the bank, accepting a $15 million severance payment. 137 Allen Fishman was appointed his replacement. On September 15, 2008, Lehman Brothers declared bankruptcy. Three days later, on September 18, OTS and the FDIC lowered Washington Mutual’s rating to a “4,” indicating that a bank failure was a possibility. The credit rating agencies also downgraded the credit ratings of the bank and its parent holding company. Over the span of eight days starting on September 15, nearly $17 billion in deposits left the bank. At that time, the Deposit Insurance Fund contained about $45 billion, an amount which could have been exhausted by the failure of a $300 billion institution like Washington Mutual. As the financial crisis worsened each day, regulatory concerns about the bank’s liquidity and viability intensified. Because of its liquidity problems and poor quality assets, OTS and the FDIC decided to close the bank. Unable to wait for a Friday, the day on which most banks are closed, the agencies acted on a Thursday, September 25, 2008, which was also the 119 th anniversary of WaMu’s founding. That day, OTS seized Washington Mutual Bank, placed it into receivership, and appointed the FDIC as the receiver. The FDIC facilitated its immediate sale to JPMorgan Chase for $1.9 billion. The sale eliminated the need to draw upon the Deposit Insurance Fund. WaMu’s parent, Washington Mutual, Inc., declared bankruptcy soon after. C. High Risk Lending Strategy In 2004, Washington Mutual ramped up high risk home loan originations to borrowers that had not traditionally qualified for them. The following year, Washington Mutual adopted a high risk strategy to issue high risk mortgages, and then mitigate some of that risk by selling or securitizing many of the loans. When housing prices stopped climbing in late 2006, a large number of those risky loans began incurring extraordinary rates of delinquency as did the securities that relied on those loans for cash flow. In 2007, the problems with WaMu’s High Risk Lending Strategy worsened, as delinquencies increased, the securitization market dried up, and the bank was unable to find buyers for its high risk loans or related securities. The formal initiation of WaMu’s High Risk Lending Strategy can be dated to January 2005, when a specific proposal was presented to the WaMu Board of Directors for approval. 138 WaMu adopted this strategy because its executives calculated that high risk home loans were more profitable than low risk loans, not only because the bank could charge borrowers higher interest rates and fees, but also because higher risk loans received higher prices when securitized and sold to investors. They garnered higher prices because, due to their higher risk, the securities paid a higher coupon rate than other comparably rated securities. 137 “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1h. 138 See 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” submitted to Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a. FinancialCrisisReport--116 Mr. Cathcart told the Subcommittee that this change created further separation between him and his risk managers, and compromised the independence of risk management. 409 He testified at the Subcommittee hearing: Mr. Cathcart: The chairman adopted a policy of what he called double reporting, and in the case of the Chief Risk Officers, although it was my preference to have them reporting directly to me, I shared that reporting relationship with the heads of the businesses so that clearly any of the Chief Risk Officers reporting to me had a direct line to management apart from me. Senator Coburn: And was that a negative or a positive in terms to the ultimate outcome in your view? Mr. Cathcart: It depended very much on the business unit and on the individual who was put in that double situation. I would say that in the case of home loans, it was not satisfactory because the Chief Risk Officer of that business favored the reporting relationship to the business rather than to risk. 410 The subordination of risk management to sales was apparent at WaMu in many other ways as well. Tony Meola, the head of home loans sales, reported directly to David Schneider. He had direct access to Mr. Schneider and often pushed for more lenient lending standards. According to Ms. Feltgen, the sales people always wanted more lenient standards and more mortgage products, and Mr. Meola advocated for them. 411 One example was the 80/20 loan, which consisted of a package of two loans issued together, an 80% LTV first lien and a 20% LTV second lien, for a total CLTV of 100%. Ms. Feltgen said she was nervous about the product, as a 100% CLTV was obviously very risky. WaMu’s automatic underwriting system was not set up to accept such loans, but Mr. Meola wanted permission to “side step” the systems issue. 412 Mr. Schneider approved the product, and Ms. Feltgen ultimately signed off on it. She told the Subcommittee that it was a high risk 409 Id. 410 April 13, 2010 Subcommittee Hearing at 34. 411 Subcommittee Interview of Cheryl Feltgen (2/6/2010). 412 See 2/2006 WaMu internal email chain, “FW: 80/20,” JPM_WM03960778. product, but was priced accordingly, and that it might have been successful if housing prices had not declined. 413 FOMC20060510meeting--53 51,MR. STOCKTON.," Thank you, Mr. Chairman. I am told that counselors are taught to begin by acknowledging the validity of the fears and anxieties of those whom they are counseling. The strategy then is to deconstruct and examine in greater detail the specific sources of heightened anxiety in order to gain better perspective on the problems at hand. Being a naturally anxious person, I have had moments in the past six weeks when I felt the need to engage in a little “self help” therapy by employing this strategy on myself. So this morning, I thought that I would report the results of my efforts to identify and analyze some of the developments over the intermeeting period that could have made one more uneasy about the outlook for activity and inflation. I’ll admit that there have been a few reasons to be concerned. The growth in real GDP in the first quarter was very strong—even stronger than we had expected in the March Greenbook. And most components of spending surprised us to the upside. Moreover, hard evidence of the anticipated second-quarter slowdown is still sparse. Meanwhile, inflation concerns have been mounting. Oil prices are up another $10 per barrel, and the prices of non-oil commodities are soaring amid signs that the global economy is strengthening. The dollar seems to be sinking on good news and bad. The incoming data on core consumer prices have exceeded our expectations a bit. And measures of expected inflation have moved higher. Clearly, there is plenty to keep one up at night. At other times, I have awoken with the fear that recent developments could provoke us into a familiar trap of overshooting on policy. If policy were to lean against strength in activity and inflation pressure that was largely seen in the rear-view mirror, the risk of tightening too much and for too long would be amplified. In that regard, the evidence has continued to accumulate that housing markets are softening, and last Friday’s employment report at least hinted at some slowing in labor demand. Tightening significantly further when the economy already may have begun to decelerate risks an unwelcome cyclical downturn in the economy. Given our poor track record in predicting recessions, one should not take lightly the risk of overshooting the mark. I’m not embarrassed to admit that I’ve harbored both fears—that of falling behind the curve and that of overshooting—often on the same day and sometimes even in the same conversation with my colleagues. [Laughter] But in the end, I have come to the view that, while you are almost certainly somewhat behind or somewhat ahead of the curve, there are some good reasons to think that you are not too far from the curve. So just how strong is the economy at present, and will it maintain that strength going forward? As you know, we had been expecting a big bump-up in the growth of output in the first quarter, in part as activity rebounded from hurricane-depressed levels. And we surely got it. We are now estimating that the growth of real GDP in the first quarter was 5¼ percent, about ½ percentage point faster than projected in the March Greenbook. That said, it is important not to exaggerate the extent to which that surprise signals greater underlying momentum in the economy. About half of our miss in the first quarter reflected higher-than-expected federal spending. While I’ll admit that “higher-than-expected federal spending” might seem to be an oxymoron, we view the first-quarter miss as largely one of timing, related in part to FEMA outlays. We are expecting the level of federal spending to drop back in the current quarter. Inventory investment outside the motor vehicle sector, after being very subdued in the second half of last year, also has surprised us to the upside of late. Although it is presently providing a lift to activity, we would not expect inventory investment to be a source of ongoing impetus to production. Of course, these were not our only surprises. Household and business spending, too, have come in above our expectations, and we read domestic demand as having somewhat greater momentum than we had earlier thought. As a consequence, we revised up our projection for second-quarter growth in real GDP to 3¾ percent—similar to the above-trend pace that we experienced over the past year. Had everything else remained as it was in March, this greater strength in near-term activity would have led us to mark up our forecast for the remainder of the year as well. But there have been some powerful countervailing forces with which we have had to contend. The steep rise in the price of crude oil has continued to siphon purchasing power from the household sector. The bill for imported oil is now expected to be about $50 billion per year higher than in our March projection. Moreover, gasoline prices have increased even more than oil prices, reflecting a tight inventory situation that has resulted from some refinery shutdowns and from the higher costs associated with the switch in blends of reformulated gasoline. Because the spending propensities of oil company shareholders are likely lower than those of gasoline consumers, the transfer of income between these two groups also is likely to subtract some from consumer spending. In the very near term, we have households dipping into saving to meet their higher energy bills, but we think that some adjustment to overall spending plans probably is under way and that more will be required in coming quarters. Besides the restraining effects of higher oil prices, the recent increase in long-term interest rates is expected to weigh on activity over the remainder of the projection period. To be sure, some of that increase reflects higher expected inflation. But real long-term rates have increased as well, in part as term premiums have widened a bit. Mortgage rates and corporate bond rates are expected to run about 20 to 30 basis points above the levels that in our previous projection we had assumed would prevail. Obviously, those increases have been too recent to have yet affected demand; but we expect that, by the second half of the year, higher rates will be leaving an imprint on housing activity and business investment. As you know from reading the Greenbook, the stronger underlying momentum in the economy is eventually more than offset by the greater drag from higher energy prices and interest rates, leaving the level of output a touch weaker by the end of 2007 than forecast in March. What about inflation concerns? There can be little doubt that price pressures have intensified somewhat over the intermeeting period. As I noted earlier, crude oil prices have risen about $10 per barrel, and participants in futures markets expect those higher prices to persist. Other commodity prices have been soaring as well, especially prices for industrial metals. These increases can be expected to add a bit to core inflation in coming months. Another troubling development in the inflation picture has been the increase in most measures of inflation compensation and inflation expectations. TIPS measures of inflation compensation have increased between 15 and 20 basis points over the intermeeting period. At the same time, the Michigan survey measure of median year-ahead inflation expectations increased to 3.3 percent, and the median measure of inflation expectations five to ten years ahead edged up to 3.1 percent; both are about ¼ percentage point higher than in March. Still, these developments should be placed in perspective. None of these measures has breached the range that has been maintained over the past few years. And there have been several episodes during that period when expectations moved up as much as or more than they have in the past six weeks, only to reverse course on softer news about the economy or inflation. So for now, it is difficult to gauge the extent to which there has been any meaningful deterioration in inflation expectations. Moreover, we have scant evidence that higher price inflation or higher inflation expectations have become embedded in labor costs. As you know, the employment cost index (ECI) rose at an annual rate of just 2½ percent in the first three months of the year, more than 1½ percentage points less than we had projected. In contrast, we currently estimate that compensation per hour in the nonfarm business sector increased at a 5¾ percent annual rate in the first quarter, about 1½ percentage points more than we had projected. Nonetheless, despite their divergent movements last quarter, both measures actually decelerated over the past year. To be sure, because labor compensation tends to lag prices in the overall inflation process, this observation should provide only limited solace. But I do think the incoming information on labor costs makes it more difficult to argue that you have fallen far behind the curve. We continue to expect the growth of hourly labor compensation to pick up going forward in response to tight labor markets, the increases in labor productivity that have occurred in recent years, and the lagged effects of higher price inflation. Nevertheless, with price markups at very high levels, the projected acceleration in hourly labor compensation is expected to result chiefly in some narrowing of profit margins rather than in an increase in price inflation. What about the price data themselves? Both the core consumer price index (CPI) and core personal consumption expenditure (PCE) prices rose 0.3 percent in March, exceeding our expectations. Some of the surprise in both measures was attributable to higher-than- expected increases in apparel prices that may have more to do with imperfectly anticipated seasonal patterns than underlying trends and to a step-up in medical prices related to increased Medicare reimbursements. As a consequence, we attach only a small signal to this upside surprise. All told, the developments over the past six weeksCanother jump in oil prices, some deterioration of inflation expectations, and a slightly higher reading on core inflationCled us to mark up our projection of core consumer price inflation, but just by 0.1 percent in both 2006 and 2007. The pattern of projected inflation remains the same. As higher prices for oil and other commodities are passed through into the prices of final goods and services, core PCE inflation is projected to move up to a 2¼ percent pace this year. With those prices expected to flatten out next year and with the pass-through of the earlier run-ups largely complete, we expect core PCE inflation to ease back down to a 2 percent pace in 2007. Finally, what about the concern that we could be in the process of overshooting the mark on policy tightening? Because policy operates with a lag and because we are so poor at predicting turning points, this risk seems especially relevant after a period of substantial tightening. But given the strength that appears evident in both domestic and foreign economies, my guess is that the expansion is not so fragile that some modest overshoot on policy would result in a cyclical downturn in activity. Moreover, if our baseline assessment of the economy is close to the mark, a higher path for the funds rate might not even be deemed an overshooting. As we noted in a simulation in the Bluebook, greater policy tightening than is built into the baseline might be desired if your objective is to achieve a more rapid and pronounced decline in core price inflation. So, in the end, while we could see a heap of worries in a variety of different directions, we interpreted recent developments as warranting only small changes in our forecast. That forecast remains one in which activity slows to a more sustainable pace and inflation fluctuates around recent levels. Still, I don’t want to be seen as offering false reassurances. Much could happen to change the outlook. My own concerns about potential outcomes that could take us far from the staff baseline projection are centered mainly on asset markets. Asset markets are impressive information-processing machines that, for the most part, deliver very efficient outcomes. But those markets are also subject, from time to time, to abrupt shifts in confidence and psychology that are difficult for forecasters to predict and difficult for policymakers to influence. I see risks on both sides of the ledger here. One of the risks associated with overshooting is that, at some point, higher interest rates could trigger a sharp contraction in house prices and real estate activity. Given the long lags with which we receive reliable information on house prices, such developments might take some time to recognize and thus might prove harder to counteract than implied by our alternative scenarios. Of course, undershooting on policy also presents risks for asset markets. If policy were to trigger a substantial fall in the dollar, inflation pressures and your efforts to deal with those pressures could create some significant challenges for monetary policy and for the economy. Karen will have more to say on the prospects for the dollar in her presentation." FOMC20080109confcall--26 24,MS. YELLEN.," Thank you, Mr. Chairman. I agree with both the concerns that you expressed and the analysis that you offered. Based on the data we now have in hand, I support a 50 basis point reduction in the federal funds rate in the near future. I think a very good case can be made for moving down 25 basis points today, and it would be my preference. According to what Bill Dudley said, markets apparently do attach some probability to a move of that magnitude before the January meeting. I could also support a 50 basis point move today, but I am concerned that it might be taken as a sign of panic by the Committee and somehow wrongly indicate that we have inside information showing that things are even worse than markets already think or, alternatively, be seen as an overreaction to the employment report. But if we don't move today, I do think we need to take decisive action in January, and I hope you will give a strong signal that we will do so in your speech. I agree with the staff's assessment that the outlook for economic growth has weakened since December, and I also see the downside risks to the forecast as having increased since then. We have revised down our 2008 forecast also because of the sharp increase in energy prices and the deterioration we have seen in financial conditions just since December. It is good that conditions in money markets have improved somewhat, but equity prices have fallen very substantially--I guess around 6 percent since our last meeting. Credit spreads are up, and borrowing rates for many borrowers are higher in spite of a decline in Treasury yields. I also find the labor market developments worrisome. I try not to put too much weight on any single monthly observation, but I find it entirely believable and consistent with everything else we are seeing that we have entered, at best, a period of slow employment growth. It is something that we have been expecting all along. It helps to resolve some of the puzzles we have been discussing about why labor markets have been so strong relative to goods markets. It is true that consumer spending has been amazingly robust so far, but I find it unimaginable that it can continue when slow growth in disposable income is added to everything else that is weighing on households, particularly rising energy prices, accelerating declines in house prices, and falling stock prices. It seems to me that, with the stagnant or contracting labor market, the odds of a recession--and, as you argued, a potentially very nasty one--have risen. I am also very worried about the possibility of a credit crunch if higher job losses begins to make lenders pull back credit. It is true that on the inflation front the recent news hasn't been particularly good. It certainly is true that there are upside risks. But I do take comfort from the fact that inflation compensation has remained well behaved and that we already have slack in the labor market and more seems likely to develop. I support a significant rate cut not only because of the downgrade to the economic forecast since December but also because I think the stance of policy even now with the actions we have taken--I agree with you--is still within the neutral range. Given current prospects and the asymmetric nature of the risks, particularly the high tail risk associated with the credit crunch, I believe that policy should be clearly accommodative. So having revised down my forecast, I would support a significant funds rate cut as a way to catch up with where policy should be. " CHRG-110hhrg44903--80 Mr. Geithner," I think you are raising exactly the right question. I think that it is very important that we are not given responsibilities for which we do not have authority, and it is very important we are not given responsibilities which would conflict fundamentally with the basic obligations that the Congress gave us in the Federal Reserve Act. It is important, though, to recognize that all central banks in any serious economy are given a set of mandates that require a balance between price stability and some mix of sustainable long-term growth objectives. That mix differs. But also financial stability. And in any central bank, the basic lender of last resort instruments that are given to prevent liquidity problems from becoming solvency problems along with some broader financial stability are inherent to the functions of modern central banks. It is very important, though, to recognize that those instruments' responsibilities come with and have implications for moral hazard; and, therefore, it is very important they be complemented by a set of constraints on risk-taking and a framework for dealing with problems that can help limit and offset that moral hazard risk. But that basic framework of responsibilities, from price stability to financial stability, are integral to what all central banks live with every day, and those objectives do not need to conflict. " CHRG-111shrg57319--597 Mr. Killinger," I don't think there is any question. You heard this morning about the layering--we can call it the layering of risk, where the loan-to-value ratios might have increased, where there was more of a prevalence of putting second mortgages on top of firsts at origination, less documentation of some new products in some cases, and very thin pricing because there was so much money kind of chasing, wanting to make those loans. Senator Levin. You say thin---- " CHRG-111hhrg74855--77 Mr. Markey," Chairman Wellinghoff, much of your testimony focuses on the potential for the bill approved by the House Ag Committee to harm RTO markets and mechanisms used in those markets to ensure just and reasonable prices such as Financial Transmission Rights or Forward Capacity Markets but isn't there also a risk that this bill could also limit your ability to approve these or other mechanisms in a non-RTO market as well? " FOMC20080130meeting--190 188,MR. ROSENGREN.," Thank you, Mr. Chairman. The contours of our forecast are broadly in line with the Greenbook: Growth well below potential for the first half of this year results in additional slack in labor markets with a consequent reduction in the core rate of inflation over time. Our forecast returns to full employment by 2010 only if we reduce interest rates more than they are in the Greenbook. Thus, our baseline forecast assumes that we reduce rates 50 basis points at this meeting followed by additional easing in 2008, which eventually results in core inflation below 2 percent and the unemployment rate settling at our estimate of the NAIRU, somewhat below 5 percent. But even with this easing, there are significant downside risks to this forecast. Historically, increases in unemployment in excess of 0.6 percent and forecasts of two or more quarters of real GDP growth below 2 percent have almost always been followed by a recession. In fact, a variety of probit models looking at the probability of recession in 2008 indicate an uncomfortably high probability of recession, in most cases above 50 percent. Several factors make me concerned that the outlook could be worse than our baseline forecast. First, we have consistently underestimated weakness in residential investment. While our forecast assumes a gradual decline in real estate prices, it does not have a substantial feedback between rising unemployment rates causing further downward pressure on real estate prices and the health of financial institutions. Were we to reach a tipping point of higher unemployment, higher home foreclosures, increased financial duress, and falling housing prices, we would likely have to ease far more than if we were to act preemptively to insure against this risk. Second, our weak consumption is driven by negative wealth effects induced by weakness in equity markets and modest declines in real estate prices. However, the heightened discussion of a potential recession could easily result in a larger pullback by consumers. This would be consistent with the behavior of rates on credit default swaps of major retailers, which have risen significantly since the middle of December. Third, banks are seeing increasing problems with credit card debt. Capital One, one of the few concentrated credit card lenders, has had their credit default swap rate rise from less than 100 basis points to more than 400 basis points as investors have become increasingly concerned about the retail sector. While liquidity concerns have abated, credit risk for financial institutions has grown. Rates on credit default swaps for our largest banks have been rising since December, despite the announcement of additional equity investments. In addition, the greatest concern I hear raised by the financial community in Boston is a risk posed by the monoline guarantors. The movement in equity prices last week as a result of highly speculative statements on resolving the monoline problem indicates a sensitivity of the markets to significant further deterioration in the financial position of the monolines. Fourth, our model does not capture potential credit crunch problems, although supplementary empirical analysis conducted by the Boston staff suggests that such problems pose additional downside risks to our outlook. Bank balance sheets continue to expand as banks act in their traditional role of providing liquidity during economic slowdowns. While the balance sheet constraints are likely to be most acute at our largest institutions, further deterioration in real estate markets is likely to crimp smaller and midsize banks that have significant real estate exposures. Given my concerns that we could soon be or may already be in a recession, I believe the risks around our forecast of core inflation settling below 2 percent are well balanced. Inflation rates have fallen in previous recessions, and I expect that historical regularity to be maintained if growth is as slow as I expect. Thank you, Mr. Chairman. " CHRG-110hhrg34673--12 Mr. Bernanke," Mr. Chairman, first of all, policy is going to respond to new information. We are going to be continually reassessing our outlook and responding appropriately as we see the economy evolving. Policy also has to respond to risks. There are risks in both directions. On the real side, I talked about housing as a downside risk, but there is also some upside risk. We have seen very strong consumer spending numbers. We have seen some strong income growth which suggests that the economy may be stronger than we think. It is possible. And in a sense, aggregate spending may exceed our capacity and put pressure on product markets, and that would be a concern. The other issue is on inflation. We have had a period where inflation has been above where we would like to see it as far as consistency with price stability is concerned. In order for this expansion to continue in a sustainable way, inflation needs to be well-controlled. If inflation becomes higher for some reason, then the Federal Reserve would have to respond to that by raising interest rates. That would not contribute to the continued-- " FOMC20071031meeting--77 75,MR. KOHN.," Thank you, Mr. Chairman. In broad outline, the situation is evolving as we anticipated in our last meeting. Spending outside of housing has been well maintained. The housing market is very weak. Financial markets have been returning more toward normal functioning, banks have tightened credit terms and standards, and core inflation has remained low. I think it is the nuances around each of these that complicate our decision at this meeting. As Dave Stockton and others pointed out, spending outside housing has been a bit stronger than expected. Paths of consumption and investment, along with employment, seem to be moderating going into the fourth quarter, but gradually. Importantly, the data for September haven’t been especially weak, and these could have potentially been affected by the financial tightening, increased uncertainty, and reduced consumer confidence that followed the events of August. With growth in the third quarter likely to be at or above 3 percent and no material change in the output gap for several quarters now, it does appear that the real funds rate of 3 percent plus that persisted since mid-2006, while quite high relative to historical averages, was not far from the equilibrium real rate at that time, given the low level of long-term rates, the ready availability of credit at historically low spreads, and the high level of wealth relative to income through this period. It seems somewhere between difficult and impossible to calibrate the effects on aggregate demand of the rise in long-term rates last spring, the tightening of credit conditions of the past few months, and the expected decline in housing prices. The staff has judged 50 basis points of easing—we did that at the last meeting—to be enough to keep the economy near its potential in the context of the relatively solid incoming data. That doesn’t seem unreasonable, though it does leave the fed funds rate at the higher end of its historical range. Nonetheless, I see a couple of reasons for important downside risks to such a growth forecast. First, though the housing market was roughly in line with staff forecasts, builders have made only a little progress in reducing inventory overhangs. Moreover, reports suggest that downward price pressures are increasing—for example, the constant quality new home index declined in the past two quarters. Market expectations for the Case-Shiller index revised down, suggesting that the drop in house prices could be steeper than the moderate drop assumed in the staff forecast. Substantial decreases in house prices would at some point revive the demand for housing. At the same time, that decline threatens greater spillovers from wealth effects on consumption and from tighter credit conditions as lenders react to threats to their capital from declining collateral values. Second, although financial markets are improving in many respects, the trajectory is gradual, uneven, and subject to reversal. We saw this just in the past couple of weeks, when adverse housing data, downgrades of highly rated mortgages and senior tranches, and earnings warnings caused some risk spreads to widen out. The secondary markets for nonconforming mortgages are still quite disrupted. Clearly, uncertainty about the pricing of many of the assets in question, about the amount of credit that will get put back to the bank balance sheets, and about the size and location of the losses that have to be taken continue to make lenders very skittish. In this environment, I wouldn’t be at all surprised to see a further tightening of credit availability at banks in the coming months. The developments in housing and financial markets are also likely to weigh on business spending plans, as we saw hinted at in the capital spending revisions that some of the Reserve Banks reported, and for households as evidenced by the low confidence surveys. These downside risks are strong enough that I think they will persist even if we ease slightly tomorrow. Besides the influences I already cited, my judgment in this regard takes account of market expectations. The markets’ implied r* has been below the staff’s and, I think, the Committee’s implied r* for some time now, but the gap seems to have widened considerably. In an environment of increased uncertainty about the outlook, such disparities perhaps aren’t surprising, and we can’t substitute market participants’ judgment for our own, but I did take a little signal from the extent of the pessimism about aggregate demand that I inferred from the interest rate path in the market relative to the staff’s path in the Greenbook. I don’t think r* is quite as low as President Yellen was suggesting—it is perhaps in the 2 to 2½ range since term premiums are still low; and even with house prices declining, the wealth-to-income ratios are still pretty high, and the dollar has been falling. But I did assume a slight easing of monetary policy sometime in the fourth quarter in my projection. I also projected low, stable core and ultimately total inflation, but I do see some upside risks around this outcome if the economy follows its most likely path. It is still producing at a high level of resource utilization, and some measures of compensation and labor costs have been rising. Core CPI inflation on three-month and six-month bases has accelerated even if the acceleration hasn’t shown through to the PCE measures. Increases in energy and commodity prices, along with recent declines of the dollar, are also a risk factor—less from their direct effects on prices, which are likely to be small, but more because they could suggest a potential for a more inflationary psychology that could feed through to expectations. Our decision tomorrow will involve weighing these risks, the extent of the relative risk to our dual objectives, and the potential costs of missing in either direction in the context of the market conditions and expectations built into markets. Thank you, Mr. Chairman." CHRG-111hhrg52397--149 Mr. Price," So a decrease in potential business viability? Mr. Don Thompson. It is generally being exposed to a risk that is not its core business. 3M is a great example. They make all these little things in the book and they do a great job, and we all use them. Their specialty is not forecasting interest rates or forecasting the exchange rate of the U.S. dollar versus the Thai bhat. They would prefer to hedge those risks away and focus on their core business, which is the attitude of many of our corporate clients. However, if they have to post liquid securities or cash to a clearinghouse or if they have to suffer income statement volatility because their hedges have to be on an exchange and thus do not qualify for FAS 133 hedge accounting, they face a difficult choice: Do I pay the increased cost? Do I suffer the increase income statement volatility and go ahead and hedge the risk anyway or do I not hedge the risk and hope it works out for the best? I am sure some companies will pay the increased cost. I am sure some companies will say, ``No, we will leave the risk open.'' I think in neither case is that good for American business. " FOMC20060629meeting--122 120,MR. LACKER.," As I said yesterday, although the outlook for real growth is noticeably softer than it was at the last meeting, it doesn’t seem to me clearly inconsistent with growth around trend going forward. I see the risk of slowing the economy overly much in the near term by increasing real rates as relatively low. The way I look at the evidence, real short-term interest rates are still somewhat low by historical standards. If you compare the periods of extended growth, such as the late 1990s, it looks as though they come in between 3 and 5 percent and center near 4 percent or so, although I know there are many ways to measure them. Right now it appears that, by the same sort of measurement, the real funds rate is between 2½ and 3 percent. So I still sense that the real rate is low by historical standards for a period of economic expansion like the one we seem to be in now. My sense is that we may need to raise rates beyond today because it seems clear to me that we’re not pleased with recent inflation or the inflation outlook. The rate of inflation has been substantially higher over the past few months than we would like, and I think the level of inflation expectations is too high as well, although I recognize some of the subtleties involved in gauging inflation expectations accurately. Moreover, inflation expectations appear to be unnecessarily fluctuating; we’ve been on something of a rollercoaster ride for the past few months. Inflation expectations rose when the public wasn’t sure how we would respond to the oil-price shocks, just as they did after Katrina, and inflation expectations came down as they did last October and November only after we communicated our intentions. These ups and downs really serve no useful purpose in my view. Last night at dinner, Rachel Lomax made a relevant remark about the extent to which their regime anchors inflation expectations and causes firms to adjust to oil-price increases, not by passing through but by cutting wages and costs elsewhere. I think that’s a relevant example here. To say that some inflation currently is a consequence of oil-price increases is incomplete, as we all know, because the extent to which oil-price increases pass through to overall inflation is entirely a consequence of the policy reaction function that is either in place or is viewed as being in place by the public. Now, I’m not going to claim that this is the end of the world. This isn’t the 1970s. I think the credibility of our commitment to not let inflation rise to 10 percent is very secure. But we ought to be able to improve upon a policy regime and an accompanying equilibrium in which expectations for ten-year-ahead inflation fluctuate as much as they have over the past several months. So I agree with Governor Kohn that we ought to raise rates at this meeting. We ought to leave open the option in our statements that we could raise rates again. I think it’s very important to use today’s statement to clarify our intentions regarding inflation; otherwise we’re likely to be in for more rollercoaster rides in the months and quarters ahead. I have two concrete recommendations about the statement. First, note that on June 1 the Chairman characterized recent inflation readings as “unwelcome”—a very important word that harkens back to the word the Committee used in 2003 to communicate a lower bound on the range of inflation rates the Committee considered consistent with price stability. We should use that word again today in our statement to communicate that we do not view current inflation readings as consistent with price stability. I’m afraid that failing to do so would be a glaring omission and would unnecessarily perpetuate ambiguity about our intentions. My second recommendation about the statement has to do with the assessment of risk, the first sentence in alternative B, row 4, that reads, “Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain.” Placing anticipation of an aggregate demand slowdown front and center in our assessment of inflation dynamics seems odd to me in light of all of the talk around this table over the recent years about how flat the relationship is between aggregate demand and inflation. Moreover, even with the sentence that follows it in that paragraph, it seems to imply that we’re willing to simply wait for a moderation of inflation rather than take sufficient action ourselves. Given the Greenbook’s forecast, it asks a relatively modest output gap to do a whole lot of work. It also—but this is a sort of broader doctrinal issue—risks leaving the impression that our methodology for controlling inflation is to manipulate aggregate demand, and I’m not sure that’s entirely accurate. The assessment-of-risk sentence in alternative C would be much more appropriate than the first sentence in alternative B. It states clearly what we would like to see happen with inflation: “In order to foster price stability and a sustainable economic growth, the Committee seeks a medium-term decline in core inflation from its recent elevated levels.” My sense is that this is something that everyone around the table wants—a medium-term decline in core inflation; if that’s the case, we ought to state it clearly to the public. These two changes would send a much clearer message about our focus on inflation risks. Thank you, Mr. Chairman." FOMC20080430meeting--71 69,MR. SHEETS.," It is, quite frankly, pretty tough to get a straight and compelling answer out of the OPEC folks about how they think about the oil markets. A number of us have sat in international meetings and listened to various explanations. In fact, at one recent meeting in Basel, the representative from Saudi Arabia indicated that OPEC was not prepared to supply any more oil to the market because the market was already well supplied at the equilibrium price. It is really quite frustrating. Now, what they say in these meetings is that their analysis of supply-and-demand fundamentals would suggest a price of $70 a barrel, $80 a barrel, or something like that. Then they blame the residual on speculators and so on, and we spend a fair amount of time looking for such speculative effects in these oil prices, and we wouldn't want to rule anything out. I mean, from what we've seen, there may be an explanation out there that eludes us, but there are a number of things that we would expect to see if it were speculation--for instance, run-ups in inventories--that we don't see. We have also looked at the behavior of noncommercial traders, and it does not seem as though the noncommercial traders are actually predicting prices. Quite the opposite--they seem to be chasing the price, which is quite different from what we would have expected. Most recently, in a statement just this week, OPEC's president linked the run-up in oil prices to the depreciation of the dollar and indicated that, for every 1 percent decline in the dollar, oil prices would rise $4.00 a barrel, which strikes us as being just absolutely extraordinary. We can see 1 percent on the dollar moving oil prices 1 percent, but to get a coefficient beyond that just seems--I don't want to say ""economically impossible,"" but I'd like to see the model that generates it. Now, about how they actually talk about oil prices behind closed doors, I don't have any additional insight to provide other than what I've heard them say in some of these international meetings. Certainly in our analysis we try to think through the outlook for demand from countries like China and India. In fact, quite regularly we do a full-blown supply-and-demand balance exercise in which we say, ""Here is the price. What kind of supply-and-demand fundamentals would be necessary to deliver that price?"" We use the IEA, the EIA, and others as input, but we actually do our own separate analyses. We try to think very granularly about the demand from these emerging market countries and the implications that that has on the price. As to the last part of your question, I think certainly it's true, at least until recently, that there was a sense on the part of OPEC that, if they allowed the price to stay too high for too long, there would be a significant supply response that would end up driving the price back down. Now, the fact that they seem quite comfortable to live with the price of $115 or $120 a barrel suggests to me that maybe they have come to the conclusion that there is just more demand out there and, in some sense, they are going to ride the wave of this increasing demand in some of these emerging market economies. That said, the prices have risen a lot. They're up 75 percent or 80 percent over the past year. A year ago I'm sure that that's not what my predecessor was forecasting, and it's hard for me to imagine that we're going to see oil at $200 a barrel. Nevertheless, given the income and price elasticities of this thing, our view is that 1 percent greater global demand that's not met by supply could very well push prices up at least 10 percent. It isn't going to take a whole lot of surprise on global demand to have a significant impact on prices. As I said, I think that OPEC is aware of that and is willing to run the risk that there may be at some point a large supply response that could put significant downward pressure on the price of oil. " CHRG-111shrg56262--95 PREPARED STATEMENT OF ANDREW DAVIDSON President, Andrew Davidson and Company October 7, 2009 Mr. Chairman and Members of the Subcommittee, I appreciate the opportunity to testify before you today about securitization. My expertise is primarily in the securitization of residential mortgages and my comments will be primarily directed toward those markets. Securitization has been a force for both good and bad in our economy. A well functioning securitization market expands the availability of credit for economic activity and home ownership. It allows banks and other financial institutions to access capital and reduces risk. On the other hand a poorly functioning securitization market may lead to misallocation of capital and exacerbate risk. \1\--------------------------------------------------------------------------- \1\ Portions of this statement are derived from ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- Before delving into a discussion of the current crisis, I would like to distinguish three types of capital markets activities that are often discussed together: Securitization, Structuring, and Derivatives. \2\--------------------------------------------------------------------------- \2\ See, Andrew Davidson, Anthony Sanders, Lan-Ling Wolff, and Anne Ching, ``Securitization'', 2003, for a detailed discussion of securitization and valuation of securitized products.--------------------------------------------------------------------------- Securitization is the process of converting individual loans into securities that can be freely transferred. Securitization serves to separate origination and investment functions. Without securitization investors would need to go through a very complex process of transferring the ownership of individual loans. The agency mortgage-backed securities (MBS) from Ginnie Mae, Fannie Mae, and Freddie Mac are one of the most successful financial innovations. However, as the last years have taught us, the so-called, ``originate to sell'' model, especially as reflected in private-label (nonagency) MBS, has serious shortcomings. Structuring is the process of segmenting the cash flows of one set of financial instruments into several bonds which are often called tranches. The collateralized mortgage obligation or CMO is a classic example of structuring. The CMO transforms mortgage cash flows into a variety of bonds that appeal to investors from short-term stable bonds, to long-term investments. Private label MBS use a second form of structuring to allocate credit risk. A typical structure uses subordination, or over-collateralization, to create bonds with different degrees of credit risk. The collateralized debt obligation or CDO is a third form of structuring. In this case, bonds, rather than loans, are the underlying collateral for the CDO bonds which are segmented by credit risk. Structuring allows for the expansion of the investor base for mortgage cash flows, by tailoring the bonds characteristics to investor requirements. Unfortunately, structuring has also been used to design bonds that obfuscate risk and return. Derivatives, or indexed contracts, are used to transfer risk from one party to another. Derivatives are a zero sum game in that one investor's gain is another's loss. While typically people think of swaps markets and futures markets when they mention derivatives, the TBA (to be announced) market for agency pass-through mortgages is a large successful derivative market. The TBA market allows for trading in pass-through MBS without the need to specify which pool of mortgages will be delivered. More recently a large market in mortgage credit risk has developed. The instruments in this market are credit default swaps (CDS) and ABX, an over-the-counter index based on subprime mortgage CDS. Derivatives allow for risk transfer and can be powerful vehicles for risk management. On the other hand, derivatives may lead to the creation of more risk in the economy as derivate volume may exceed the underlying asset by substantial orders of magnitude. For any of these products to be economically useful they should address one or more of the underlying investment risks of mortgages: funding, interest rate risk, prepayment risk, credit risk, and liquidity. More than anything else mortgages represent the funding of home purchases. The twelve trillion of mortgages represents funding for the residential real estate of the country. Interest rate risk arises due to the fixed coupon on mortgages. For adjustable rate mortgages it arises from the caps, floors and other coupon limitations present in residential mortgage products. Interest rate risk is compounded by prepayment risk. Prepayment risk reflects both a systematic component that arises from the option to refinance (creating the option features of MBS) as well as the additional uncertainty created by the difficulty in accurately forecasting the behavior of borrowers. Credit risk represents the possibility that borrowers will be unable or unwilling to make their contractual payments. Credit risk reflects the borrower's financial situation, the terms of the loan and the value of the home. Credit risk has systematic components related to the performance of the economy, idiosyncratic risks related to individual borrowers and operational risks related to underwriting and monitoring. Finally, liquidity represents the ability to transfer the funding obligation and/or the risks of the mortgages. In addition to the financial characteristics of these financial tools, they all have tax, regulatory and accounting features that affect their viability. In some cases tax, regulatory and accounting outcomes rather than financial benefit are the primary purpose of a transaction. In developing policy alternatives each of these activities: securitization, structuring and derivatives, pose distinct but interrelated challenges.Role of Securitization in the Current Financial Crisis The current economic crisis represents a combination of many factors and blame can be laid far and wide. Additional analysis may be required to truly assess the causes of the crisis. Nevertheless I believe that securitization contributed to the crisis in two important ways. It contributed to the excessive rise in home prices and it created instability once the crisis began. First, the process of securitization as implemented during the period leading up to the crisis allowed a decline in underwriting standards and excessive leverage in home ownership. The excess lending likely contributed to the rapid rise in home prices leading up to the crisis. In addition to the well documented growth in subprime and Alt-A lending, we find that the quality of loans declined during the period from 2003 to 2005, even after adjusting for loan to value ratios, FICO scores, documentation type, home prices and other factors reflected in data available to investors. The results of our analysis are shown in Figure 1. It shows that the rate of delinquency for loans originated in 2006 is more than 50 percent higher than loans originated in 2003. The implication is that the quality of underwriting declined significantly during this period, and this decline was not reflected in the data provided to investors. As such it could reflect fraud, misrepresentations and lower standard for verifying borrower and collateral data. The net impact of this is that borrowers were granted credit at greater leverage and at lower cost than in prior years.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In concrete terms, the securitization market during 2005 and 2006 was pricing mortgage loans to an expected lifetime loss of about 5 percent. Our view is that even if home prices had remained stable, these losses would have been 10 percent or more. Given the structure of many of these loans, with a 2-year initial coupon and an expected payoff by the borrower at reset, the rate on the loans should have been 200 or 300 basis points higher. That is, initial coupons should have been over 10 percent rather than near 8 percent. Our analysis further indicates that this lower cost of credit inflated home prices. The combination of relaxed underwriting standards and affordability products, such as option-arms, effectively lowered the required payment on mortgages. The lower payment served to increase the price of homes that borrowers could afford. Figure 2 shows the rapid rise in the perceived price that borrowers could afford in the Los Angeles area due to these reduced payment requirements. Actual home prices then followed this pattern. Generally we find that securitization of subprime loans and other affordability products such as option arms were more prevalent in the areas with high amounts of home price appreciation during 2003 to 2006. To be clear, not all of the affordability loans were driven by securitization, as many of the option arms remained on the balance sheet of lending institutions.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Figure 3 provides an indication of the magnitude of home price increases that may have resulted from these products on a national basis. Based on our home price model, we estimate that home prices may have risen by 15 percent at the national level due to lower effective interest rates. In the chart, the gap between the solid blue line and the dashed blue line reflects the impact of easy credit on home prices.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] On the flip side, we believe that the shutting down of these markets and the reduced availability of mortgage credit contributed to the sharp decline in home prices we have seen since 2006 as shown in Figure 4. Without an increase in effective mortgage rates, home prices might have sustained their inflated values as shown by the dashed blue line. \3\--------------------------------------------------------------------------- \3\ See, http://www.ad-co.com/newsletters/2009/Jun2009/Valuation_Jun09.pdf for more details.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Thus the reduced focus on underwriting quality lead to an unsustainable level of excess leverage and reduced borrowing costs which helped to inflate home prices. When these ``affordability'' products were no longer sustainable in the market, they contributed to the deflation of the housing bubble. The way securitization was implemented during this period fostered high home prices through poor underwriting, and the end of that era may have led to the sharp decline in home prices and the sharp decline in home prices helped to spread the financial crisis beyond the subprime market. The second way that securitization contributed to the current economic crisis is through the obfuscation of risk. For many structures in the securitization market: especially collateralized debt obligations, structured investment vehicles and other resecuritizations, there is and was insufficient information for investors to formulate an independent judgment of the risks and value of the investment. As markets began to decline in late 2007, investors in all of these instruments and investors in the institutions that held or issued these instruments were unable to assess the level of risk they bore. This lack of information quickly became a lack of confidence and led to a massive deleveraging of our financial system. This deleveraging further depressed the value of these complex securities and led to real declines in economic value as the economy entered a severe recession. In addition, regulators lacked the ability to assess the level of risk in regulated entities, perhaps delaying corrective action or other steps that could have reduced risk levels earlier.Limitations of Securitization Revealed To understand how the current market structure could lead to undisciplined lending and obfuscation of risk it is useful to look at a simplified schematic of the market. \4\--------------------------------------------------------------------------- \4\ Adapted from ``Six Degrees of Separation'', August 2007, by Andrew Davidson http://www.securitization.net/pdf/content/ADC_SixDegrees_1Aug07.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In the simplest terms, what went wrong in the subprime mortgage in particular and the securitization market in general is that the people responsible for making loans had too little financial interest in the performance of those loans and the people with financial interest in the loans had too little involvement in the how the loans were made. The secondary market for nonagency mortgages, including subprime mortgages, has many participants and a great separation of the origination process from the investment process. Each participant has a specialized role. Specialization serves the market well, as it allows each function to be performed efficiently. Specialization, however also means that risk creation and risk taking are separated. In simplified form the process can be described as involving: A borrower--who wants a loan for home purchase or refinance A broker--who works with the borrower and lenders to arrange a loan A mortgage banker--who funds the loan and then sells the loan An aggregator--(often a broker-dealer) who buys loans and then packages the loans into a securitization, whose bonds are sold to investors. A CDO manager--who buys a portfolio of mortgage-backed securities and issues debt An investor--who buys the CDO debt Two additional participants are also involved: A servicer--who keeps the loan documents and collects the payments from the borrower A rating agency--that places a rating on the mortgage securities and on the CDO debt This chart is obviously a simplification of a more complex process. For example, CDOs were not the only purchasers of risk in the subprime market. They were however a dominant player, with some estimating that they bought about 70 percent of the lower rated classes of subprime mortgage securitizations. What is clear even from this simplified process is that contact between the provider of risk capital and the borrower was very attenuated. A central problem with the securitization market, especially for subprime loans was that no one was the gate keeper, shutting the door on uneconomic loans. The ultimate CDO bond investor placed his trust in the first loss investor, the rating agencies, and the CDO manager, and in each case that trust was misplaced. Ideally mortgage transactions are generally structured so that someone close to the origination process would take the first slice of credit risk and thus insure that loans were originated properly. In the subprime market, however it was possible to originate loans and sell them at such a high price, that even if the mortgage banker or aggregator retained a first loss piece (or residual) the transaction could be profitable even if the loans did not perform well. Furthermore, the terms of the residuals were set so that the owner of the residual might receive a substantial portion of their cash flows before the full extent of losses were known. Rating agencies set criteria to establish credit enhancement levels that ultimately led to ratings on bonds. The rating agencies generally rely on historical statistical analysis to set ratings. The rating agencies also depend on numeric descriptions of loans like loan-to-value ratios and debt-to-income ratios to make their determinations. Rating agencies usually do not review loans files or ``re-underwrite'' loans. Rating agencies also do not share in the economic costs of loan defaults. The rating agencies methodology allowed for the inclusion of loans of dubious quality into subprime and Alt-A mortgage pools, including low documentation loans for borrowers with poor payment histories, without the offsetting requirement of high down payments. To help assure investors of the reliability of information about the risks of purchased loans, the mortgage market has developed the practice of requiring ``representations and warranties'' on purchased loans. These reps and warrants as they are called, are designed to insure that the loans sold meet the guidelines of the purchasers. This is because mortgage market participants have long recognized that there is substantial risk in acquiring loans originated by someone else. An essential component in having valuable reps and warrants is that the provider of those promises has sufficient capital to back up their obligations to repurchase loans subsequently determined to be inconsistent with the reps and warrants. A financial guarantee from an insolvent provider has no value. Representations and warranties are the glue that holds the process together; if the glue is weak the system can collapse. The rating agencies also established criteria for Collateralized Debt Obligations that allowed CDO managers to produce very highly leveraged portfolios of subprime mortgage securities. The basic mechanism for this was a model that predicted the performance of subprime mortgage pools were not likely to be highly correlated. That is defaults in one pool were not likely to occur at the same time as defaults in another pool. This assumption was at best optimistic and most likely just wrong. In the CDO market the rating agencies have a unique position. In most of their other ratings business, a company or a transaction exists or is likely to occur and the rating agency reviews that company or transaction and establishes ratings. In the CDO market, the criteria of the rating agency determine whether or not the transaction will occur. A CDO is like a financial institution. It buys assets and issues debt. If the rating agency establishes criteria that allow the institution to borrow money at a low enough rate or at high enough leverage, then the CDO can purchase assets more competitively than other financial institutions. If the CDO has a higher cost of debt or lower leverage, then it will be at a disadvantage to other buyers and will not be brought into existence. If the CDO is created, the rating agency is compensated for its ratings. If the CDO is not created, there is no compensation. My view is that there are very few institutions that can remain objective given such a compensation scheme. CDO bond investors also relied upon the CDO manager to guide them in the dangerous waters of mortgage investing. Here again investors were not well served by the compensation scheme. In many cases CDO managers receive fees that are independent of the performance of the deals they manage. While CDO managers sometimes keep an equity interest in the transactions they manage, the deals are often structured in such a way that that the deal can return the initial equity investment even if some of the bonds have losses. Moreover, many of the CDOs were managed by start-up firms with little or no capital. Nevertheless, much of the responsibility should rest with the investors. CDO bond investors were not blind to the additional risks posed by CDO investing. CDOs generally provided higher yields than similarly rated bonds, and it is an extremely naive, and to my mind, rare, investor who thinks they get higher returns without incremental risk. It is not unusual, however, for investors not to realize the magnitude of additional risk they bear for a modest incremental return. Ultimately it is investors who will bear the losses, and investors must bear the bulk of the burden in evaluating their investments. There were clear warning signs for several years as to the problems and risk of investing in subprime mortgages. Nevertheless, investors continued to participate in this sector as the risks grew and reward decreased. As expressed herein, the primary problem facing securitization is a failure of industrial organization. The key risk allocators in the market, the CDO managers, were too far from the origination process and, at best, they believed the originators and the rating agencies were responsible for limiting risk. At the origination end, without the discipline of a skeptical buyer, abuses grew. The buyer was not sufficiently concerned with the process of loan origination and the broker was not subject to sufficient constraints.Current Conditions of the Mortgage-backed Securities Market More than 2 years after the announcement of the collapse of the Bear Stearns High Grade Structured Credit Enhanced Leverage Fund the mortgage market remains in a distressed state. Little of the mortgage market is functioning without the direct involvement of the U.S. Government, and access to financing for mortgage originators and investors is still limited. Fortunately there are the beginning signs of stabilization of home prices, but rising unemployment threatens the recovery. In the secondary market for mortgage-backed securities there has been considerable recovery in price in some sectors, but overall demand is being propped up by large purchases of MBS by the Federal Reserve Bank. In addition, we find that many of our clients are primarily focused on accounting and regulatory concerns related to legacy positions, and less effort is focused on the economic analysis of current and future opportunities. That situation may be changing as over the past few months we have seen some firms begin to focus on longer term goals.The Effectiveness of Government Action I have not performed an independent analysis of the effectiveness of Government actions, so by comments are limited to my impressions. Government involvement has been beneficial in a number of significant respects. Without Government involvement in Fannie Mae, Freddie Mac, and FHA lending programs, virtually all mortgage lending could have stalled. What lending would have existed would have been for only the absolute highest quality borrowers and at restrictive rates. In addition Government programs to provide liquidity have also been beneficial to the market as private lending was reduced to extremely low levels. Government and Federal Reserve purchases of MBS have kept mortgage rates low. This has probably helped to bolster home prices. On the other hand the start/stop nature of the buying programs under TARP and PPIP has probably been a net negative for the market. Market participants have held back on investments in anticipation of Government programs that either did not materialize or were substantially smaller in scope than expected. Furthermore Government efforts to influence loan modifications, while beneficial for some home owners, and possibly even investors, have created confusion and distrust. Investors are more reluctant to commit capital when the rules are uncertain. In my opinion there has been excessive focus on loan modifications as a solution to the current crisis. Loan modifications make sense for a certain portion of borrowers whose income has been temporarily disrupted or have sufficient income to support a modestly reduce loan amount and the willingness to make those payments. However for many borrowers, loan modifications cannot produce sustainable outcomes. In addition, loan modifications must deal with the complexities of multiple liens and complex ownership structures of mortgage loans. Short sales, short payoffs, and relocation assistance for borrowers are other alternatives that should be given greater weight in policy development. The extensive Government involvement in the mortgage market has likely produced significant positive benefits to the economy. However unwinding the Government role will be quite complex and could be disruptive to the recovery. Government programs need to be reduced and legislative and regulatory uncertainties need to be addressed to attract private capital back into these markets.Legislative and Regulatory Recommendations I believe that the problems in the securitization market were essentially due to a failure of industrial organization. Solutions should address these industrial organization failures. While some may seek to limit the risks in the economy, I believe a better solution is to make sure the risks are borne by parties who have the capacity to manage the risks or the capital to bear those risks. In practical terms, this means that ultimately bond investors, as the creators of leverage, must be responsible for limiting leverage to economically sustainable levels that do not create excessive risk to their stakeholders. Moreover, lenders should not allow equity investors to have tremendous upside with little exposure to downside risk. Equity investors who have sufficient capital at risk are more likely to act prudently. Consequently, all the information needed to assess and manage risks must be adequately disclosed and investors should have assurances that the information they rely upon is accurate and timely. Likewise when the Government acts as a guarantor, whether explicitly or implicitly, it must insure that it is not encouraging excessive risk taking and must have access to critical information on the risks borne by regulated entities. In this light, I would like to comment on the Administration proposals on Securitization in the white paper: ``Financial Regulatory Reform: A New Foundation.'' \5\ Recommendations 1 and 2 cover similar ground:--------------------------------------------------------------------------- \5\ http://www.financialstability.gov/docs/regs/FinalReport_web.pdf pp. 44-46. 1. Federal banking agencies should promulgate regulations that require originators or sponsors to retain an economic interest in a material portion of the credit risk of securitized credit --------------------------------------------------------------------------- exposures. The Federal banking agencies should promulgate regulations that require loan originators or sponsors to retain 5 percent of the credit risk of securitized exposures. 2. Regulators should promulgate additional regulations to align compensation of market participants with longer term performance of the underlying loans. Sponsors of securitizations should be required to provide assurances to investors, in the form of strong, standardized representations and warranties, regarding the risk associated with the origination and underwriting practices for the securitized loans underlying ABS. Clearly excessive leverage and lack of economic discipline was at the heart of the problems with securitization. As described above the market failed to adequately protect investors from weakened underwriting standards. Additional capital requirements certainly should be part of the solution. However, such requirements need to be constructed carefully. Too little capital and it will not have any effect; too much and it will inhibit lending and lead to higher mortgage costs. The current recommendation for retention of 5 percent of the credit risk does not seem to strike that balance appropriately. When a loan is originated there are several kinds of credit related risks that are created. In addition to systematic risks related to future events such as changes in home prices and idiosyncratic risks such as changes in the income of the borrower, there are also operational risks related to the quality of the underwriting and servicing. An example of an underwriting risk is whether or not the borrower's income and current value of their home were verified appropriately. Originators are well positioned to reduce the operational risks associated with underwriting and fight fraud, but they may be less well positioned to bear the long term systematic and idiosyncratic risks associated with mortgage lending. Investors are well positioned to bear systemic risks and diversify idiosyncratic risks, but are not able to assess the risks of poor underwriting and servicing. The securitization process should ensure that there is sufficient motivation and capital for originators to manage and bear the risks of underwriting and sufficient information made available to investors to assess the risks they take on. The current form of representations and warranties is flawed in that it does not provide a direct obligation from the originator to the investor. Instead representations and warranties pass through a chain of ownership and are often limited by ``knowledge'' and capital. In addition current remedies are tied to damages and in a rising home price market calculated damages may be limited. Thus a period of rising home prices can mask declining credit quality and rising violations of representations and warranties. Therefore, incentives and penalties should be established to limit unacceptable behavior such as fraud, misrepresentations, predatory lending. If the goal is to prevent fraud, abuse and misrepresentations rather than to limit risk transfer then there needs to be a better system to enforce the rights of borrowers and investors than simply requiring a originators to retain a set percentage of credit risk. I have proposed \6\ a ``securitization certificate'' which would travel with the loan and would be accompanied by appropriate assurances of financial responsibility. The certificate would replace representations and warranties, which travel through the chain of buyers and sellers and are often unenforced or weakened by the successive loan transfers. The certificate could also serve to protect borrowers from fraudulent origination practices in the place of assignee liability. Furthermore the certificate should be structured so that there are penalties for violations regardless of whether or not the investor or the borrower has experienced financial loss. The record of violations of these origination responsibilities should publically available.--------------------------------------------------------------------------- \6\ http://www.ad-co.com/newsletters/2008/Feb2008/Credit_Feb08.pdf and ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- I have constructed a simple model of monitoring fraudulent loans. \7\ Some preliminary results are shown in Table 1. These simulations show the impact of increasing the required capital for a seller and of instituting a fine for fraudulent loans beyond the losses incurred. These results show that under the model assumptions, without a fine for fraud, sellers benefit from originating fraudulent loans. The best results are obtained when the seller faces fines for fraud and has sufficient capital to pay those fines. The table below shows the profitability of the seller and buyer for various levels of fraudulent loans. In the example below, the profits of the seller increase from .75 with no fraudulent loans to .77 with 10 percent fraudulent loans, even when the originator retains 5 percent capital against 5 percent of the credit risk. On the other hand, the sellers profit falls from .75 to .44 with 10 percent fraudulent loans even though the retained capital is only 1 percent, but there is a penalty for fraudulent loans. Thus the use of appropriate incentives can reduce capital costs, while increasing loan quality.--------------------------------------------------------------------------- \7\ The IMF has produced a similar analysis and reached similar conclusions. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/chap2.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Under this analysis the Treasury proposals would not have a direct effect on fraud. In fact, there is substantial risk the recommended approach of requiring minimum capital requirements for originators to bear credit risk would lead to either higher mortgage rates or increased risk taking. A better solution is to create new mechanisms to monitor and enforce the representations and warranties of originators. With adequate disclosure of risks and a workable mechanism for enforcing quality controls the securitization market can more effectively price and manage risk. Recommendation 3 addresses the information available to investors: 3. The SEC should continue its efforts to increase the transparency and standardization of securitization markets and be given clear authority to require robust reporting by issuers of asset backed securities (ABS). Increased transparency and standardization of securitization markets would likely to better functioning markets. In this area, Treasury charges the SEC and ``industry'' with these goals. I believe there needs to be consideration of a variety of institutional structures to achieve these goals. Standardization of the market can come from many sources. Possible candidates include the SEC, the American Securitization Forum, the Rating Agencies and the GSEs, Fannie Mae and Freddie Mac. I believe the best institutions to standardize a market are those which have an economic interest in standardization and disclosure. Of all of these entities the GSEs have the best record of standardizing the market; this was especially true before their retained portfolios grew to dominate their income. (As I will discuss below, reform of the GSEs is essential for restoring securitization.) I believe a revived Fannie Mae and Freddie Mac, limited primarily to securitization, structured as member-owned cooperatives, could be an important force for standardization and disclosure. While the other candidates could achieve this goal they each face significant obstacles. The SEC operates primarily through regulation and therefore may not be able to adapt to changing markets. While the ASF has made substantial strides in this direction, the ASF lacks enforcement power for its recommendations and has conflicting constituencies. The rating agencies have not shown the will or the power to force standardization, and such a role may be incompatible with their stated independence. Recommendations 4 and 5 address the role of rating agencies in securitization. 4. The SEC should continue its efforts to strengthen the regulation of credit rating agencies, including measures to require that firms have robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise promote the integrity of the ratings process. 5. Regulators should reduce their use of credit ratings in regulations and supervisory practices, wherever possible. In general I believe that the conflicts of interest facing rating agencies and their rating criteria were well known and easily discovered prior to the financial crisis. Thus I do not believe that greater regulatory authority over rating agencies will offer substantial benefits. In fact, increasing competition in ratings or altering the compensation structure of rating agencies may not serve to increase the accuracy of ratings, since most users of ratings issuers as well as investors are generally motivated to seek higher ratings. (Only if the regulatory reliance on rating agencies is reduced will these structural changes be effective.) To the extent there is reliance on rating agencies in the determination of the capital requirement for financial institutions, a safety and soundness regulators for financial institutions, such the FFIEC or its successor, should have regulatory authority over the rating agencies. Rather than focus on better regulation, I support the second aspect of Treasury's recommendations on rating agencies (recommendation 5) and believe it would be better for safety and soundness regulators to reduce their reliance on ratings and allow the rating agencies to continue their role of providing credit opinions that can be used to supplement credit analysis performed by investors. To reduce reliance on ratings, regulators, and others will need alternative measures of credit and other risks. I believe that the appropriate alternative to ratings is analytical measures of risk. Analytical measures can be adopted, refined, and reviewed by regulators. In addition regulators should insist that regulated entities have sufficient internal capacity to assess the credit and other risks of their investments. In this way regulators would have greater focus on model assumptions and model validation and reduced dependence on the judgment of rating agencies. The use of quantitative risk measures also requires that investors and regulators have access to sufficient information about investments to perform the necessary computations. Opaque investments that depend entirely upon rating agency opinions would be clearly identified. Quantitative measures can also be used to address the concerns raised in the report about concentrations of risk and differentiate structured products and direct corporate obligations. I recently filed a letter with the National Association of Insurance Commissioners on the American Council of Life Insurers' proposal to use an expected loss measure as an alternative to ratings for nonagency MBS in determining risk based capital. Here I would like to present some of the key points in that letter: An analytical measure may be defined as a number, or a value, that is computed based on characteristics of a specific bond, its collateral and a variety of economic factors both historical and prospective. One such analytical measure is the probability of default and another measure is the expected loss of that bond. While an analytical measure is a numeric value that is the result of computations, it should be noted that there may still be some judgmental factors that go into its production. In contrast, a rating is a letter grade, or other scale, assigned to a bond by a rating agency. While ratings have various attributes, generally having both objective and subjective inputs, there is not a particular mathematical definition of a rating. Analytical measures may be useful for use by regulators because they have several characteristics not present in ratings. 1. An analytical measure can be designed for a specific purpose. Specific analytical measures can be designed with particular policy or risk management goals in mind. Ratings may reflect a variety of considerations. For example, there is some uncertainty as to whether ratings represent the first dollar of loss or the expected loss, or how expected loss is reflected in ratings. 2. Analytical measures can be updated at any frequency. Ratings are updated only when the rating agencies believe there has been sufficient change to justify an upgrade, downgrade or watch. Analytical measures can be computed any time new information is available and will show the drift in credit quality even if a bond remains within the same rating range. 3. Analytical measures can take into account price or other investor specific information. Ratings are computed for a bond and generally reflect the risk of nonpayment of contractual cash flows. However, the risk to a particular investor of owning a bond will at least partially depend on the price that the bond is carried in the portfolio or the composition of the portfolio. 4. Regulators may contract directly with vendors to produce analytical results and may choose the timing of the calculations. On the other hand, ratings are generally purchased by the issuer at the time of issuance. Not only may this introduce conflicts of interest, but it also creates a greater focus on initial ratings than on surveillance and updating of ratings. In addition, once a regulator allows the use of a particular rating agency it has no further involvement in the ratings process. 5. Analytical measures based on fundamental data may also be advantageous over purely market-based measures. As market conditions evolve values of bonds may change. These changes reflect economic fundamentals, but may also reflect supply/ demand dynamics, liquidity and risk preferences. Measures fully dependent on market prices may create excessive volatility in regulatory measures, especially for companies with the ability to hold bonds to maturity. Even if regulators use analytical measures of risk, ratings from rating agencies as independent opinions would still be valuable to investors and regulators due to the multifaceted nature of ratings and rating agency analysis can be used to validate the approaches and assumptions used to compute particular analytical measures. Additional measures beyond the credit risk of individual securities such as stress tests, market value sensitivity and measures of illiquidity may also be appropriate in the regulatory structure. The use of analytical measures rather than ratings does not eliminate the potential for mistakes. In general, any rigid system can be gamed as financial innovation can often stay ahead of regulation. To reduce this problem regulation should be based on principles and evolve with the market. Regulators should always seek to build an a margin of safety as there is always a risk that the theory underlying the regulatory regime falls short and that some participants will find mechanisms to take advantage of the regulatory structure. Finally, as discussed by the Administration in the white paper, the future of securitization for mortgages requires the resolution of the status of Fannie/Freddie and role of FHA/GNMA. As stated above, I believe that continuation of Fannie Mae and Freddie Mac as member owned cooperatives would serve to establish standards, and provide a vehicle for the delivery of Government guarantees if so desired. The TBA, or to be announced, market has been an important component in the success of the fixed rate mortgage market in the United States. Careful consideration should be given to the desirability of fixed rate mortgages and the mechanisms for maintaining that market in discussions of the future of the GSEs. ______ CHRG-111hhrg48867--173 Mr. Price," Thank you, Mr. Chairman. I want to thank the panelists, as well, for their testimony today and their forbearance with the questions and the time. I think it is important to remember that our Nation has provided the greatest amount of freedom and opportunity and success for more people than any nation in the history of mankind. And I think it is incumbent upon us to appreciate that we haven't done that by virtue of excessive regulation. It would seem that it would be important for us, as Members of Congress, to attempt to define what has allowed that success--if you define that as success--what has allowed that success to occur and attempt to embrace those fundamental principles. Everybody has talked about systemic risk, but I don't know that we have a definition of it. Anybody care to give me a definition of systemic risk? " CHRG-111shrg61651--75 Mr. Reed," There was a tremendous amount of leverage. Senator Merkley. ----101 or something like that. Senator Reed. Yes, it was tremendous leverage, and what we should have learned was that there wasn't enough capital to absorb the risks that were in the system, and therefore, when the risks manifest themselves, the human reaction is, let us gang together and we will see if we can take this together. Well, we had a situation there that was a one-institution version of what later happened to all of us and where basically the taxpayer had to step in because there wasn't enough capital in the private sector to cover the risks that were manifesting themselves in this crisis we have gone through. And so my question about Long-Term Capital was there was the anatomy of the problem that we are today wrestling with. It was alone that sat there. It was tremendously interconnected. As you say, it had counterparty lines. It had all sorts of assets which conceivably would have been liquidated at very distressed prices and so forth, which would have impacted the market. And yet as a system, we sort of ganged together, papered it over, and went on having learned nothing. " fcic_final_report_full--274 Prince and Rubin appeared to believe up until the fall of  that any downside risk in the CDO business was minuscule. “I don’t think anybody focused on the CDOs. This was one business in a vast enterprise, and until the trouble developed, it wasn’t one that had any particular profile,” Rubin—in Prince’s words, a “very important member of [the] board”  —told the FCIC. “You know, Tom Maheras was in charge of trading. Tom was an extremely well regarded trading figure on the street. . . . And this is what traders do, they handle these kinds of problems.”  Maheras, the co-head of Citigroup’s investment bank, told the FCIC that he spent “a small fraction of ” of his time thinking about or dealing with the CDO business.  Citigroup’s risk management function was simply not very concerned about hous- ing market risks. According to Prince, Bushnell and others told him, in effect, “‘Gosh, housing prices would have to go down  nationwide for us to have, not a problem with [mortgage-backed securities] CDOs, but for us to have problems,’ and that has never happened since the Depression.”  Housing prices would be down much less than  when Citigroup began having problems because of write-downs and the liquidity puts it had written. By June , national house prices had fallen ., and about  of subprime adjustable-rate mortgages were delinquent. Yet Citigroup still did not expect that the liquidity puts could be triggered, and it remained unconcerned about the value of its retained super-senior tranches of CDOs. On June , , Citigroup made a presenta- tion to the SEC about subprime exposure in its CDO business. The presentation noted that Citigroup did not factor two positions into this exposure: . billion in super- senior tranches and . billion in liquidity puts. The presentation explained that the liquidity puts were not a concern: “The risk of default is extremely unlikely . . . [and] certain market events must also occur for us to be required to fund. Therefore, we view these positions to be even less risky than the Super Senior Book.”  Just a few weeks later, the July  failure of the two Bear Stearns hedge funds spelled trouble. Commercial paper written against three Citigroup-underwritten CDOs for which Bear Stearns Asset Management was the asset manager and on which Citigroup had issued liquidity puts began losing value, and their interest rates began rising. The liquidity puts would be triggered if interest rates on the asset- backed commercial paper rose above a certain level. FOMC20080430meeting--320 318,MR. LACKER.," Presumably, the rate we pay would be viewed as a risk-free rate. Presumably, any market rate would be priced relative to that to include a credit premium in the usual way. If any other dynamics are anticipated by the staff, it would be useful to know that. But the usual presumption we have is that observed market rates would have our rate plus a credit premium booked into it, or transaction costs, or whatever. I'd just make that comment. " FOMC20080430meeting--204 202,VICE CHAIRMAN GEITHNER.," I don't think the canary is wheezing. Look, I think there are lots of good arguments on both sides of this. I think all the good ones have been made. The markets have been giving us a pretty good test against the concern, which I think we all share, that if we move today we risk some significant erosion of our inflation credibility or inflation expectations feeding through the dollar into a commodity price spiral. We have had a pretty good test of it. Over the past several weeks, there has been a very substantial shift in expectations for the path of the fed funds rate, which embody substantial expectations around a near-term cut and very little beyond that and some modest retracing as we go forward. Expectations have come down despite what has happened to oil prices. Inflation has come down. The dollar is stronger on net over that period. This is pretty good validation that the path that is represented in alternative B does not come with excessive risk that we will be eroding our credibility. We can't know for sure. It's good to be worried about that risk, but the protection against that risk is fairly good. What strikes me about this discussion is the extent of the gap in this Committee in how we think about the way to measure the stance of monetary policy. What we could do is use a seminar and a bit of history on this. It would be nice to run monetary policy back over the past four decades to see, if it had been set with a basic policy regime in which we looked only at the real fed funds rate deflated by headline inflation today, what the outcomes would have been for the economy at that time. That's essentially what you guys are saying. It seems to me that you are basically saying that equilibrium doesn't vary and that deflating the nominal fed funds rate with some mix of headline and core today is the best way to judge the stance of policy. But I think it's worth having a little exercise in it. It is hard to look back. " FOMC20070509meeting--75 73,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Our outlook has changed very little. As in March, we see the expansion continuing, with growth moving back up to potential—we see potential around 3 percent—later this year. This view rests on the familiar expectations: Housing stabilizes relatively soon without a major drop in prices; investment spending strengthens somewhat as the temporary factors holding it down recede and positive fundamentals reassert themselves; consumption moderates a bit but continues to be supported by strong income growth; the saving rate moves up but only modestly and slowly; and external demand remains strong. We still expect inflation to moderate gradually to a rate just below 2 percent for the core PCE by the end of ’08. We view the recent numbers as somewhat reassuring. Recent data in general have provided a bit more comfort for this scenario. On balance, the downside risks to growth have diminished a bit. The risk that inflation will fail to moderate sufficiently, however, remains significant and material. But in general, the overall outlook, in our view, hasn’t changed that much. Now, our forecast assumes that we hold the fed funds rate where it is for a while. Our expected path is above the market’s but below the Greenbook’s. We’re below the Greenbook because, although our expected forecast is really similar, we attach somewhat greater weight to alternative scenarios that suggest slower growth. The recent growth numbers have been, on balance, encouraging, and the markets are a bit more confident about the outlook than they were. But I still think the downside risks to growth are significant. Housing could still surprise on the downside, and we could see a deeper, more protracted contraction in activity and, of course, broadly based more-substantial declines in prices. Consumption could be weaker for this reason or because the saving rate rises for other reasons, such as pessimism about long-run income growth. The household sector is substantially more leveraged than it was, and it has less of a cushion to absorb shocks and, therefore, presents some risk of amplifying rather than mitigating broader weakness in the economy. Although a bit better than it was in March, the investment outlook is still a bit tenuous, and it seems unlikely to be a substantial source of strength if broader weakness in demand in the rest of the economy materializes. The most rapidly growing parts of the world are growing well above potential and face rising inflation and substantial asset-price inflation, and I think the authorities there are generally starting tentatively to tighten policy more significantly. On the inflation front, we still face substantial uncertainty about what is happening to underlying trends and how they will evolve. The broader inflation environment is, if anything, less benign than it has been over the past three quarters, with inflation accelerating a little outside the United States, energy and commodity prices continuing to show signs of rapid demand growth, the dollar potentially weakening further, compensation here firming a bit, and productivity growth probably staying a bit below what we thought was trend. In this context, with inflation still running about 2 percent, inflation expectations could drift up. Continuing on the risks for a bit, I still think we live with a significant risk of a sharp deterioration in financial markets. Credit spreads, other risk premiums, low levels of implied volatility, and the strength of asset prices in many parts of the world—all imply a level of confidence in ongoing, stable growth and low inflation that seems a bit implausible. In addition, the low level of long forward rates seems hard to reconcile with the strength of demand growth outside the United States, suggesting that much of the world is likely to need to move further toward tighter monetary policy. As financial conditions exert more restraint on demand growth globally, we could see a rapid unwinding of this long period of very benign assessment of fundamental risks. We, of course, face some risk of policy actions here in the form of trade or investment protection. This risk, against the backdrop of some uncertainty about the strength of productivity growth going forward, might make the rest of the world less comfortable financing our still-large external balance on the favorable terms that have prevailed thus far. On the longer-term outlook for potential in the United States, we are sticking with our forecast of 3 percent, but we have altered the mix a bit, just as the Greenbook has in some sense; however, we feel a little less comfortable with our basic view about potential. We lowered our productivity growth assumption a bit, to 2.25 for the nonfarm business sector, and raised our estimate of trend hours a bit. If potential is lower than we’re assuming, then we are less likely to see the moderation of inflation that we currently expect, but we would expect a lower path for output growth as well. At this stage, however, in view of the strength in income growth that we’ve seen, earning expectations, and other measures, we’re reluctant to embrace a more negative view about growth in potential. On balance, in view of these risks, I favor staying where we are for a while. I don’t think there is a very strong case for tightening policy or for inducing a significant rise in market expectations about the path of the fed funds rate going forward, nor do I think now that we’re at risk of being too tight. So, in general, I think the best choice for us is to continue to lean against the expectation that we will move to reduce rates soon. Thank you." FOMC20060328meeting--268 266,MS. DANKER.," I will read the directive wording from page 25 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 4¾ percent.” And now the risk assessment from the statement that was just handed out: “The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.” Chairman Bernanke Yes Vice Chairman Geithner Yes Governor Bies Yes President Guynn Yes Governor Kohn Yes Governor Kroszner Yes President Lacker Yes Governor Olson Yes President Pianalto Yes Governor Warsh Yes President Yellen Yes" CHRG-111shrg52619--113 Mr. Dugan," People were watching. I think what drove that initially--my own personal view on this--is that most of those loans were sold into the secondary market. They were not loans held on the books of the institutions that originated them. And so for someone to sell it and get rid of the risk, it did not look like it was something that was presenting the same kind of risk to the institution. And if you go back and look at the time when house prices were rising and there were not high default rates on it, people were making the argument that these things are a good thing and provide more loans to more people. It made our examiners uncomfortable. We eventually, I think too late, came around to the view that it was a practice that should not occur, and that is exactly why I was talking earlier, if we could do one thing--two things that we should have done as an underwriting standard earlier is, one, the low-documentation loans and the other is the decline in downpayments. " FOMC20050202meeting--154 152,MR. KOHN.," Thank you, Mr. Chairman. My forecast for economic activity in 2005 and 2006, like the rest of yours, was for growth a little faster than the trend rate of growth in potential. That reflects my judgment that the forces that had been holding back the economy in recent years have largely dissipated, allowing the effect of relatively stimulative financial conditions to continue to show through and raising the level of production relative to potential. My projection for growth in 2005 and 2006 is in line with the rate of growth in 2004. Yet energy prices, whose rise must have damped growth to some degree in 2004, are expected to be flat or somewhat lower. In addition, financial conditions have eased since the middle of the year, with bond rates and the exchange rate lower and stock prices a little higher. So, as I thought about my projection, the logical question seemed to be whether we were on the verge of a much stronger pace of economic growth. Although that’s a possibility, I see several factors that should keep growth to a moderate pace. Monetary policy and fiscal policy are at the top of the list. On the fiscal side, the partial-expensing provisions probably brought forward some capital expenditures from 2005 to 2004. For monetary policy, I assumed a continued gradual withdrawal of monetary stimulus along the lines built into the staff’s forecast or the market’s. That should lead to rising real intermediate- February 1-2, 2005 106 of 177 investment spending directly, take something off the increase in house and equity prices—holding down gains in wealth—and support the dollar. Of course, that hasn’t been the experience over the last six months or so, as President Lacker just pointed out. But longer-term real rates have fallen to such a low level that I find it difficult to believe they won’t rise from here, provided moderate growth is sustained. Indeed, I see an important downside risk to the forecast from the possibility of a sizable jump in longer-term real interest rates, which could have a pretty serious effect on house prices and consumption if it results from an unwinding of special factors or from a revision of unreasonably low expectations rather than from an unexpectedly faster pace of economic activity. Until those rates ratchet higher, however, their low level, along with the basically sideways movement of equity prices since late last year, would seem to suggest that caution among savers and spenders has not dissipated entirely. At the very least, the behavior of bond yields and stock prices seems inconsistent to me with a new more ebullient attitude that would presage boom-like conditions. In addition, the behavior of the trade deficit is likely to be damping the growth of demand on U.S. resources for a while. The staff forecast, which has net exports making a modest net negative contribution on average over the next two years, is itself premised on a pickup in foreign demand—a pickup we don’t yet see in the data. This suggests to me another source of downside risk. Over the long haul, as people become more reluctant to send us growing proportions of their savings, the deficit will have to fall. That will put considerable pressure on productive capacity in the United States, but it’s not at all clear when that will begin to happen. Finally, in making my forecast of real growth, I took account of my serial forecast errors. I’ve been overpredicting growth since I got on the Committee, so I used a sophisticated algorithm to compensate for this propensity: I decided what I really wanted to forecast and I took a little off! February 1-2, 2005 107 of 177 My projection for core PCE inflation for 2005 and 2006 that goes with this path of output is slightly higher than the staff forecast. I gave some weight to the market-based core PCE numbers, which have been running higher than the total core PCE, but that forecast remains below 2 percent, and it is stable at that level. For inflation, the question I wrestled with was: Why not further increases this year after the acceleration of 2004? In that regard, the recent data from the last part of 2004 have been supportive, I think, of a stable inflation forecast. With these data, every broad index of core inflation—from GDP prices to the CPI to PCE—grew less rapidly in the second half of last year than in the first— and significantly less rapidly, by at least ½ percentage point. This pattern is not consistent with accelerating prices. It reinforces the hypothesis that a good portion of the pickup in core inflation in the first half of 2004 was attributable to special factors: a reversal of the unexplainable undershoot in inflation in 2003 and the pass-through of higher energy, commodity, and other import prices from late 2003 and early 2004. At least in terms of energy prices—not imports, which are a big question mark—I think these upward pressures should not be a factor in 2005. In labor markets, increases in measures of compensation also slowed from the first half of the year to the second. Now, this is particularly noteworthy in that one might have expected the previous run-up in energy prices and the strength in productivity increases in recent years to put upward pressure on compensation gains. As a consequence, I think I’m a little less concerned than some others of you that slack has already been absorbed. I can only explain the recent pace of compensation data if appreciable slack is persisting in labor markets to balance these other upside pressures. In this environment, continued intense competitive conditions are likely to limit labor cost increases and the ability or willingness of firms to pass through shorter-term increases in unit labor costs into prices and thus risk market share. Finally, inflation came in lower in the second half of 2004 than I had expected. My projection was at the low end of our collective central tendency, so most of you were a little higher February 1-2, 2005 108 of 177 decline in the unemployment rate. But energy and import prices rose more than I had anticipated. Consequently, I also wondered whether at midyear I had given enough weight to the factors restraining inflation—slack, elevated markups, and stable inflation expectations. To be sure, slack should be diminishing, businesses will try to resist any squeeze on markups, and the economy may be closer to potential than it appears right now. If the dollar declines substantially, import prices will increase, reducing foreign competitive pressure. Or if trend productivity slows more than projected, firms could be more insistent and more successful in passing through costs than is consistent with keeping inflation in check. Still, for now, I think low, stable inflation is the most likely outcome for the next few years, provided policy continues gradually to firm, as slack slowly diminishes and output grows at a moderate pace. As for the balance of risks, I’ve always thought that that phrase applies primarily, or first and foremost, to the most likely path for inflation and output relative to our objectives at the assumed path for policy. And, in that context, the risks still seem to me to be balanced. The fact that I found myself asking these particular questions about the outlook suggests, perhaps, a slight skew to the distribution around these modal outcomes. But I think we should await further developments to assess whether those skews will become large enough to influence the central tendencies, the balance of risks, and the path on which we remove policy accommodation, or whether, as the market and the staff expect, we actually will need to slow the pace of tightening in the future. Thank you, Mr. Chairman." FOMC20061025meeting--98 96,CHAIRMAN BERNANKE.," Thank you. Let me summarize what I heard, and then I would like to make a few comments of my own. There were several themes around the table. Many people noted the bimodal economy. Housing is still quite weak, although a number of people noted that they thought the lower tail had been trimmed somewhat. Autos are undergoing inventory adjustment, and some people noted slowing in a few other sectors. However, the general view was that spillovers from housing to the rest of the economy had not yet occurred. Most people noted that the labor market is quite healthy, with widespread shortages of labor, particularly of skilled workers. It was further noted that consumption spending would be supported by the job market, by income growth, and by the fall in energy prices. Overall, the assessments of growth, as I heard them, were that it would be moderate going forward, either around potential or perhaps slightly below potential, and some saw a bit of upside risk to that projection. With respect to inflation, costs of raw materials and energy are rising more slowly or are declining, and headline inflation has fallen with energy costs. Some felt that core inflation would moderate gradually, but others were less confident about that. The behavior of rents and the behavior of productivity are two important unknowns going forward, and wage growth probably presents the biggest upside risk to inflation. Most members expressed concerns that the high level of inflation could raise inflation expectations and undermine Fed credibility. So the general view, which I think essentially everyone shares, was that the upside risks to inflation exceed the downside risks to growth at this juncture. I hope that summary was okay; let me just make a few comments of my own. As a number of people noted, the intermeeting data were actually fairly limited. The employment report did indicate a fairly strong labor market. There is still, to my mind, some disconnect between the anecdotes and the data; in particular, the wage data do not yet reflect what I’m hearing around the table about wage premiums. For example, average hourly earnings actually grew more slowly in the third quarter than in the second quarter. I think the ECI next week will be a very important check for our anecdotes. On the positive side, as Kevin and others noted, the tone was generally stronger in financial markets. The stock market is up. I note the ten-year real rate was up about 15 basis points since the last meeting, which I take to be a positive indication of growth. Oil prices continue to decline, which obviously is good for both growth and inflation. I thought you might be interested in thinking about the quantity effects of the decline in oil prices. We’ve had a decline in oil prices of about $15, which back-of-the-envelope calculations or FRB/US analysis can tell us should add about 0.45 percent to the level of real consumption or about 0.35 percent to the level of real GDP. Dave Reifschneider was very helpful in finding those numbers. That’s a change to the level, so the oil price declines could add 0.3 to 0.4 percentage point to growth, say, over the next six quarters. Another way to look at that is to think about the relationship between oil prices and house prices. A rule of thumb that might be useful is that a $3 decline in oil prices offsets approximately a 1 percentage point decline in house prices in terms of overall consumption effects. So oil price declines are essentially the negative equivalent of a 5 percent decline in house prices. An interesting question that we may have to address at some point is, what is the policy implication of oil price declines? I think it’s clear that oil price declines will lower both total and core inflation, but will also increase growth. Therefore, our policy response to the lower oil prices could depend on our preferences about growth versus inflation and also our assessments of the risks to both of those variables. On the housing correction, I agree that there is perhaps some reduction in the lower tail. But it’s important to point out that, even if we see some stabilization in starts and permits, a lot of inventory is still out there, and there’s going to be an inventory correction process that could be quite significant. The current months’ supply of homes for sale is greater than 6 now, excluding cancellations; the number over the past eight years has been very stable around 4, although before 1997 it was higher and more variable, which is a source of uncertainty. To get a sense of the magnitudes of the potential housing correction, I asked Josh Gallin to do the following simple simulation. Single-family housing sales were about 1.0 million at an annual rate in July, about 1.05 million in August. So I asked Josh to consider a case in which sales flatten out at the level of 1.1 million and continue at that level indefinitely; in addition, homebuilders respond to three-fourths of the increase in sales by extra building and allow the other fourth to go into reducing inventory. When you do that calculation, you find that you actually work off the inventory. By the end of 2008, the months’ supply is down to 4.1. Part of that decrease occurs because the sales level is higher, and so the denominator is bigger as well. Thus that particular scenario is a sensible one in terms of getting the inventories down. However, the effects on GDP, because the correction is still significant, are not trivial, but they are also not that large. The effect of this scenario on GDP growth from the fourth quarter of this year to the second quarter of next year is about 0.2 on growth and about 0.1 in the third and fourth quarters. So a very substantial part of the housing correction is still in place because of the need to work off inventories over the next few quarters. Those are a few comments on the real side. I think that some of the tail risk has been reduced. I agree with the Greenbook that growth should be slow, at least through the first quarter of next year, because of housing corrections, but consumption will probably pick up and lead to a stronger growth path after that. Let me say a few words about inflation. I think I need to push back a little on the view that there has been no improvement in core inflation or total inflation. In fact, inflation is very slow to respond to its determinants, and the fact that we actually have seen some improvement in some sense is a positive surprise, not a negative surprise. The attention that’s paid to the twelve-month lagging inflation measure is a problem in this context, because we had four months of 0.3 percent readings from March to June, and they’re going to stay in that twelve- month lagging measure until next March. I can predict with great confidence that next March through next June the twelve-month lagging inflation measure will decline. So I think it’s more useful, President Lacker, to look, a bit at least, at the higher-frequency measures to see what the trend of movement is. Although, like President Lacker and others, I’m not happy with the level, I think the direction is actually very good. For example, the core CPI three-month went from 3.79 in May to 2.75 in September, so it’s a decline of 104 basis points. The core PCE three- month inflation measure went from 2.95 in May to 2.20 in September, using the staff estimate for the core PCE deflator for September. So it’s certainly moving in the right direction. The other comment I would make about this subject is that we must keep in mind how much is tied to the owners’ equivalent rent component. I would say, in fact, that once you exclude that, if you do, just for comparison, that 2006 is roughly equivalent to 2005 in terms of core PCE inflation. To look at the high frequency numbers, excluding OER, which I’m doing now for illustrative purposes, core CPI fell from 3.01 in May to 2.23 in September, and core PCE inflation fell from 2.52 in May to 1.93 in September at an annual rate. This is saying that a significant part of the speedup and now the decline in the rate is related to this owners’ equivalent rent phenomenon—not all of it, but a significant part. It’s important to know that because, as we’ve discussed around the table, the OER may have its own dynamic. It may respond in different ways to monetary policy than some other components do. It is an imputed price, which people do not actually observe, and so it may have a different effect on expectations than, say, gasoline prices or other easily observed prices. The other important aspect of the OER is that, to the extent that it is a major source of the inflation problem, it makes clear that inflation probably has not been a wage-push problem so far because owners’ equivalent rent is obviously the cost of buildings, not the cost of labor. So if you look at inflation over the past few months, there has been slow improvement, and so far I don’t think that we have seen a great deal of feedthrough of wage pressures into inflation. I’ve looked through all the various categories of goods and services whose prices have increased, and I can find no particular relationship to labor market factors. Another comment along this line: It’s also true that inflation of even 2.20 percent, which was the core PCE three-month inflation rate in September, is too high in the long run. I agree it should be lower than that. We do have to ask ourselves, given that inflation has been high and that, as people pointed out, it has been high for a number of years now, how quickly we should bring it down. Most optimal monetary policy models will suggest that a slow reduction is what you would try to achieve if you start off far away from the target and if the real economy is relatively weak. Now, the question arises whether we are going in the right direction. I think so far we are, but I would certainly agree that we have to ensure that we continue to go in the right direction. The Greenbook forecast is predicated on a constant federal funds rate from the current level; actually the rate declines in 2008. But what it leaves out is the notion that we are gathering information and trying to resolve uncertainty, depending on how things develop. Obviously, policy can respond in one direction or another and could, if inflation does not continue to decline, be more aggressive to achieve that. I felt I needed to talk a bit about the fact that we do have some improvement in inflation, and so the situation cannot really be said to be deteriorating. Having said all of that, now let me come back and agree with what I’ve heard, which is that, although we have not yet seen much wage-push inflation, clearly the risk is there. Anecdotally, and to some extent statistically, we have very tight labor markets. It is surprising how little wage push there has been so far, and if labor markets continue to stay at this level of tightness, then one would expect that you would get an inflation effect that would be uncomfortably persistent. That is a real concern, which I share with everyone around the table. If the Phillips curve language doesn’t appeal to you, another way of thinking about it is that, if the labor market stays this tight, which means that growth is at potential or better, then the real interest rate that is consistent with that growth rate needs to be higher than it is now. I agree with that point as well. So my bottom line is that I do agree that inflation is the greater risk, certainly. I think that the downside risk from output has been slightly reduced. I also think the upside risk to inflation has been slightly reduced. Thus we’re not in all that different a position than we were at our last meeting. We can discuss the implications of that tomorrow. I think I’ll stop there. Yes, President Poole." FOMC20080625meeting--160 158,MR. KROSZNER.," Thank you very much. Obviously, as we have all discussed, we are facing enormous challenges from the continuing strength in prices and price changes in energy and raw materials. Now, some of those are relative price changes that we don't have the tools to address directly. Recently, we have seen wheat come down as Australia has been able to replant, and it seems that things are going to come back. Corn has gone up, as we heard from a number of people around the table, because of the challenges there. We don't have the tools to address that directly, but obviously, when so many of these commodity prices and energy prices are going up, that leads to concerns about where both headline inflation and core inflation are going. So we definitely do have to be very mindful of that. I think the type of approach that we are taking in alternative B is a reasonable one. Given the challenges that we are facing right now with the fragility in the financial markets--the continuing smoldering of those embers, with still chances that they could reignite and cause us a great deal of difficulty--it seems sensible to me to be roughly where we are now in terms of policy but to be signaling that we understand that challenges are coming from various sources that could lead to inflation pressures and that we need to be ready to offset those. In terms of how accommodative monetary policy is, I think actually it would be worthwhile--and maybe at the end of this I might pose a question to Brian--to look at LIBOR� OIS spreads and how much they typically go up during recessionary periods. I know that other risk spreads typically go up, but my understanding is that those typically don't go up as much. Since so many contracts are based off the one-month and three-month LIBOR, that 75 basis points suggests that at least now we might want to take that into account in thinking about where monetary policy stands relative to other times when we would have had a funds rate at roughly this level. In terms of the language, I share Governor Warsh's view on the use or lack of use of the word ""considerable."" I think President Stern's suggestion--this is always a very dangerous and difficult game--would actually push the markets further than they are because I agree that broadly the path that they are seeing in the future is a reasonable one for them to see. This language would roughly keep it there. Taking out the acknowledgement of downside risks to growth remaining would make me concerned because (1) I certainly see those as still being there and (2) I think that would push the markets further to think that this is a signal that next time we are going to do it, and I don't think we are quite there yet. Thank you, Mr. Chairman. " FOMC20080430meeting--104 102,MR. HOENIG.," Thank you, Mr. Chairman. Economic activity continues to be slow in the Tenth District with a soft tone in our residential and nonresidential construction and certainly in our retail sales. Mitigating this weakness, however, to some extent is continued strength in energy and agriculture exports and, to a lesser degree, manufacturing. With regard to exports, one interesting development is a shortage of shipping containers domestically and internationally that is limiting the volume of exports of both our agricultural and some of our manufacturing products. On balance though, the District activity continues to be stronger than the national economy, and this is reflected in better employment growth and firm labor markets in many parts of our region. In my recent discussions with directors at our Bank and in our Branches and the Economic Advisory Council members, several themes have been prominent. Concern about inflation has escalated to the highest level I've been involved with in the last decade. Businesses across the board are experiencing the largest input cost pressures in recent memory for them. Many businesses have not been able to absorb these cost pressures and have raised prices to both retail and business customers, and generally speaking, businesses are finding much less resistance to price increases than in the past. Businesses also report that suppliers are increasingly reluctant to make contractual price quotes very far in the future. We have also been monitoring the effects of credit availability on business capital spending in our area. Although businesses report some tightening of credit conditions, credit costs and availability are not the primary factors behind reduced capital spending plans. Bank loans have actually continued to grow. Instead, businesses cite uncertainty about the economic outlook as the main impediment to investment. They are in a wait-and-see mode. So spending is being held back not for financial reasons but just caution. Indeed, they suggest that uncertainty about whether monetary policy will be eased further is a factor currently inhibiting their capital spending plans. They want to see when we're done. Turning to the broader economic output and the national economy, I have revised down my growth estimate for the first half of 2008 but have had few changes to my longer-term outlook. Compared with the Greenbook, I see somewhat stronger growth this year and somewhat weaker growth next year. Weaker growth in the first half of this year is coming largely from the effects of higher energy prices on consumer and business spending coupled with the continued weakness in residential construction. I would say that the effect of high energy prices is now about as large as or even larger than the contraction in residential construction, and I think that the energy outlook constitutes a main downside risk to growth in the period ahead. In contrast--and contrary to the Greenbook and the views of some--I think that energy and housing perhaps now more than credit problems are holding back economic growth. Certainly credit conditions have continued to tighten as reflected in the April Senior Loan Officer Opinion Survey, and markets for many asset-backed securities, of course, have shut down. But the availability of credit for good business and household borrowers does not appear to have really been restricted that much. They are pricing more wisely for risk, and that is probably a positive. Consequently, the downside economic risks from a pronounced credit contraction appear to have diminished considerably over the past few months. I want to turn to inflation. In my view, the inflation outlook has worsened considerably. For the first time in many years, we are seeing significant inflation pressure from goods prices, especially imported goods prices. Moreover, the recent moderation in monthly inflation numbers is coming mainly from some softness in service prices, which in my opinion, is unlikely to continue. More optimistic views of inflation, including those in the Greenbook, rely heavily on economic slack and a turnaround in food and energy prices to improve the outlook. I am skeptical on both counts. I do not think that there will be as much slack generated in the current slowdown as does the Greenbook, and there is evidence that the effects of output and employment gaps on inflation have fallen, well, actually more than a little over the past two decades. Furthermore, I have not seen any indication that elevated energy and food price inflation is likely to dissipate soon, as many of these pressures are reflective of international economic developments that we have talked about here, including the weakness in the dollar. I believe that we are entering a dangerous period, if I can use that word, in which inflation expectations are beginning to move higher and inflation psychology is becoming more prominent in business decisions. In this regard, I also do not take much comfort from favorable readings of labor costs as wages tend to follow prices in my experience. In these circumstances, I am concerned that maintaining a highly accommodative policy stance for an extended period would greatly increase the likelihood that inflation exceeds our long-run objectives. Thank you. " FinancialCrisisReport--51 At the same time that WaMu was implementing its High Risk Lending Strategy, WaMu and Long Beach engaged in a host of shoddy lending practices that contributed to a mortgage time bomb. Those practices included qualifying high risk borrowers for larger loans than they could afford; steering borrowers to higher risk loans; accepting loan applications without verifying the borrower’s income; using loans with teaser rates that could lead to payment shock when higher interest rates took effect later on; promoting negatively amortizing loans in which many borrowers increased rather than paid down their debt; and authorizing loans with multiple layers of risk. In addition, WaMu and Long Beach failed to enforce compliance with their lending standards; allowed excessive loan error and exception rates; exercised weak oversight over the third party mortgage brokers who supplied half or more of their loans; and tolerated the issuance of loans with fraudulent or erroneous borrower information. They also designed compensation incentives that rewarded loan personnel for issuing a large volume of higher risk loans, valuing speed and volume over loan quality. WaMu’s combination of high risk loans, shoddy lending practices, and weak oversight produced hundreds of billions of dollars of poor quality loans that incurred early payment defaults, high rates of delinquency, and fraud. Long Beach mortgages experienced some of the highest rates of foreclosure in the industry and their securitizations were among the worst performing. Senior WaMu executives described Long Beach as “terrible” and “a mess,” with default rates that were “ugly.” WaMu’s high risk lending operation was also problem-plagued. WaMu management knew of evidence of deficient lending practices, as seen in internal emails, audit reports, and reviews. Internal reviews of WaMu’s loan centers, for example, described “extensive fraud” from employees “willfully” circumventing bank policy. An internal review found controls to stop fraudulent loans from being sold to investors were “ineffective.” On at least one occasion, senior managers knowingly sold delinquency-prone loans to investors. Aside from Long Beach, WaMu’s President Steve Rotella described WaMu’s prime home loan business as the “worst managed business” he had seen in his career. Documents obtained by the Subcommittee reveal that WaMu launched its High Risk Lending Strategy primarily because higher risk loans and mortgage backed securities could be sold for higher prices on Wall Street. They garnered higher prices, because higher risk meant they paid a higher coupon rate than other comparably rated securities, and investors paid a higher price to buy them. Selling or securitizing the loans also removed them from WaMu’s books and appeared to insulate the bank from risk. From 2004 to 2008, WaMu originated a huge number of poor quality mortgages, most of which were then resold to investment banks and other investors hungry for mortgage backed securities. For a period of time, demand for these securities was so great that WaMu formed its own securitization arm on Wall Street. Over a period of five years, WaMu and Long Beach churned out a steady stream of high risk, poor quality loans and mortgage backed securities that later defaulted at record rates. Once a prudent regional mortgage lender, Washington Mutual tried – and ultimately failed – to use the profits from poor quality loans as a stepping stone to becoming a major Wall Street player. FinancialCrisisReport--6 Documents obtained by the Subcommittee reveal that WaMu launched its high risk lending strategy primarily because higher risk loans and mortgage backed securities could be sold for higher prices on Wall Street. They garnered higher prices because higher risk meant the securities paid a higher coupon rate than other comparably rated securities, and investors paid a higher price to buy them. Selling or securitizing the loans also removed them from WaMu’s books and appeared to insulate the bank from risk. The Subcommittee investigation indicates that unacceptable lending and securitization practices were not restricted to Washington Mutual, but were present at a host of financial institutions that originated, sold, and securitized billions of dollars in high risk, poor quality home loans that inundated U.S. financial markets. Many of the resulting securities ultimately plummeted in value, leaving banks and investors with huge losses that helped send the economy into a downward spiral. These lenders were not the victims of the financial crisis; the high risk loans they issued were the fuel that ignited the financial crisis. (2) Regulatory Failure: Case Study of the Office of Thrift Supervision The next chapter focuses on the failure of the Office of Thrift Supervision (OTS) to stop the unsafe and unsound practices that led to the demise of Washington Mutual, one of the nation’s largest banks. Over a five year period from 2004 to 2008, OTS identified over 500 serious deficiencies at WaMu, yet failed to take action to force the bank to improve its lending operations and even impeded oversight by the bank’s backup regulator, the FDIC. Washington Mutual Bank was the largest thrift under the supervision of OTS and was among the eight largest financial institutions insured by the FDIC. Until 2006, WaMu was a profitable bank, but in 2007, many of its high risk home loans began experiencing increased rates of delinquency, default, and loss. After the market for subprime mortgage backed securities collapsed in July 2007, Washington Mutual was unable to sell or securitize its subprime loans and its loan portfolio fell in value. In September 2007, WaMu’s stock price plummeted against the backdrop of its losses and a worsening financial crisis. From 2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity crisis, followed by the bank’s closure. OTS records show that, during the five years prior to WaMu’s collapse, OTS examiners repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, asset quality, and appraisal practices, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but never did. OTS failed to respond with meaningful enforcement action, such as by downgrading WaMu’s rating for safety and soundness, requiring a public plan with deadlines for corrective actions, or imposing civil fines for inaction. To the contrary, until shortly before the thrift’s failure in 2008, OTS continually rated WaMu as financially sound. The agency’s failure to restrain WaMu’s unsafe lending practices stemmed in part from an OTS regulatory culture that viewed its thrifts as “constituents,” relied on bank management to correct identified problems with minimal regulatory intervention, and expressed reluctance to interfere with even unsound lending and securitization practices. OTS displayed an unusual amount of deference to WaMu’s management, choosing to rely on the bank to police itself in its use of safe and sound practices. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems would be corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results. FOMC20070807meeting--63 61,MS. PIANALTO.," Thank you, Mr. Chairman. The reports that I am hearing from business leaders in the Fourth District lead me to conclude that the pace of economic activity hasn’t changed a great deal since our last meeting. However, the uncertainties surrounding the business climate seem to have risen measurably. The troubled housing sector is still weighing on the region, as it is nationally. I now have little doubt that this theme is going to recur throughout the balance of the year and perhaps well beyond. My view of the housing sector conforms closely to the way housing is depicted in the Greenbook baseline, but I have had many conversations in the past few weeks with anxious industry insiders, who believe that housing markets are likely to worsen substantially over the balance of the year with the possibility of significant spillovers to other sectors of the economy. The stories they tell me sound a lot like the greater housing correction scenarios that are depicted in the Greenbook. Indeed, casualties in the mortgage markets are rising, and I am hearing more and more that the fallout from housing is affecting deals in other sectors of the economy. For example, I talked with a CEO who runs a large national real estate development company. He told me that some of his projects are being held up by his investment banker’s inability to price deals and to bring them to market. Where the deals can be priced, risk spreads have widened across a range of issuers and financial instruments. This CEO’s comments are very much in line with the points that Bill Dudley made in his report earlier this morning. Because of these uncertainties in financial markets, some of my contacts confirm that they have been reevaluating their capital formation plans. They are trimming their projections of some of the projects that they are going to put on the books, and that led me to trim my projection for business fixed investment accordingly. Even with this adjustment, however, I am concerned that the pattern of business investment that I have incorporated into my GDP projections for this meeting may still be somewhat optimistic. This is a risk to the outlook that was not on my radar screen at our last meeting. The June retail price measures gave us more evidence that the inflation trend may be coming down. Inflation moderated in the second quarter, as measured by the median CPI and the 16-percent trimmed mean that we produce at the Cleveland Fed. I am not yet persuaded that this progress will be sustained, but the patterns in the June data were promising. My projection for inflation in the outyears of the forecast are actually a little more favorable than what is in the Greenbook baseline, primarily because I still expect a bit more potential GDP growth than the Greenbook envisions. So I am feeling more comfortable about the inflation risks than I have felt for a while but less comfortable about the real-side risks. My overall risk assessment is moving closer into balance. Nevertheless, I still think that inflation is the predominant risk we face today. Thank you, Mr. Chairman." CHRG-111shrg51303--91 Mr. Kohn," So if, in fact, there are no credit losses on them and they pay off at par in the end, the taxpayer will realize the gain on that, because we paid market price for them when we bought them from the counterparties, who already had margins. So if they go up in value, five-sixths of that increase will belong to the taxpayers. Senator Corker. I have a hard time understanding the systemic risk issue then. The company was bankrupt. It could not meet its obligations. So, in our wisdom, we decided to fund all of this--this insurance product was drawn up so they had to put up collateral every time the value went down. If we had not funded that, there still was no systemic risk that I understand. If we would have had long on insurance, like most of Buffett's companies and others are, if we were long on insurance instead of this crazy mechanism that AIG had come up with, there still were no losses. So if we had just said we are not going to fund these, we will stand behind these as the Federal Government, but we are not going to fund the collateral in the interim, what would have been the systemic risk? " CHRG-111hhrg55811--7 Mr. Lucas," Thank you, Mr. Chairman. Thank you for holding this hearing. I think the discussion draft the committee has before it today is an interesting next step in our review of the overall counterderivatives market. Since the Administration's proposal on this issue was published on August 11th, the end-user community has been constantly knocking on my door. As ranking member of the House Agriculture Committee, I listened to the testimony of the end-user community, the exchanges and the traders, when they appeared in front of that committee on September 17th. The common theme to the testimony was that the Administration's proposal overreached and would treat many bona fide hedgers as systematically risky financial institutions. Are there problems in the derivatives markets? Yes. What we cannot do is overreach or overregulate. If we do, the impact will be felt far beyond Wall Street and reach Main Street. It will cost jobs, economic development, and ultimately increase the prices consumers pay for energy, food, and manufactured goods. I am anxious to hear from our second panel today if this draft allows effective legitimate domestic risk management better than the Administration's proposal. And I am equally anxious to hear if our regulators still want to regulate everybody to avoid regulatory arbitrage or if they recognize the concerns that we shared when they appeared in front of the House Agriculture Committee that their approach will make risk management too expensive and increase prices and volatility. Mr. Chairman, we need to improve the safety and soundness of our financial regulation, but we cannot do it at the expense of economic development, increased prices, and job losses. Thank you, Mr. Chairman. " CHRG-111hhrg53246--143 Mr. Gensler," I think that bringing derivatives onto centralized clearing and exchanges will actually be an enormous benefit to the market. I think it will promote transparency and efficiency, and end users will get the benefit of seeing those prices, where right now they can't. And I think it will lower risk. So, though I might not have understood the question, but I don't see it as a disruption, I see it as an enormous benefit to markets. " CHRG-111hhrg51698--349 Mr. Neugebauer," Mr. Taylor, I know that I heard from a number of my producers when we had the anomalies in the cotton market, and everybody was scrambling as they wanted to certainly find a way to sell at the prices the commodity contracts moved to. Since then, things have seemed to have stabilized some. Can you kind of give me a quick snapshot? Currently, are the markets behaving in a more normal way and are producers able to cover or put in place the risk management that they need to do? " 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. FOMC20080318meeting--51 49,MR. ROSENGREN.," Thank you, Mr. Chairman. Since our last meeting, the economic data have continued to indicate a very weak economy and that, in all likelihood, we have entered a recession. Like the Greenbook, my outlook is particularly influenced by indications of significantly weaker labor markets and a housing market that is as yet showing no signs of reaching bottom. Private payroll employment fell 101,000 in February, and the sum of the downward revisions in December and January was about the same magnitude. Not only have we had three months of declining private payroll employment, but also the decline has been widespread across most industries. The Blue Chip economic forecast, the Greenbook forecast, and our own forecast have the unemployment rate peaking somewhere between 5� and 6 percent. While most analysts are in the process of downgrading their forecasts from skirting to actually having a mild recession, the risk of a more severe downturn is uncomfortably high. A major determinant of the severity of a downturn will be the housing market. Because recent developments in the housing market are so different from most postwar history, I remain very concerned that the effects of substantial declines in housing prices will be difficult to capture in statistical models based on historical data. The Case-Shiller index indicates that housing prices fell approximately 10 percent in 2007, and a decline of similar magnitude this year would mean that many homes purchased in the past several years are in a negative equity position. Elevated foreclosures and large inventories of unsold properties are providing abundant opportunities to purchase homes at heavily discounted prices financed at low interest rates by historical standards. But widespread concerns that prices will continue to fall have resulted in many prospective buyers deferring purchase decisions. To date, the housing market has been quite weak, despite relatively low unemployment rates. But if our forecasts are right, job losses this year are likely to exert a significant further drag on housing prices as rising unemployment rates force additional home sales or foreclosures. Falling housing prices are likely to have a collateral impact on consumption. Perhaps reflecting this risk, the credit default swap rates on retailers have been rising, and we are increasingly hearing of retailers that are closing stores or postponing expansions. Retailers, like consumers, are aware that high oil prices, increasing job losses, and losses of wealth in the stock and housing markets are not likely to be conducive to robust consumption. Exacerbating the negative economic news is the continued deterioration in financial markets. Credit spreads have widened significantly over the past six weeks, with many spreads more than 50 basis points higher than at the last meeting. Hedge fund and money managers that I talk to are acutely aware of the counterparty risk and are very carefully managing their collateral. Most firms with excess collateral are in the process of managing that position down. The deleveraging that is going on has reduced the willingness of banks and other financial intermediaries to finance their positions. In addition, as concerns with liquidity rise, we are once again seeing renewed pressure on the asset-backed commercial paper market. The rise in credit default swaps for companies like Washington Mutual and Lehman Brothers indicates increased concerns for the solvency of other large financial institutions with large exposures to mortgages. The potential for a further episode of financial market dysfunction and for runs on additional financial firms is significant. My primary concern at this time is that we could suffer a severe recession. Falling collateral values and impaired financial institutions can significantly exacerbate economic downturns. Some indicators of inflation are higher than we want, but during previous recessions, commodity prices and inflation rates fell. Given my forecast for the economic outlook, I expect substantial excess capacity to significantly reduce inflationary pressures going forward, and I see little evidence that higher commodity prices are causing upward pressures on wages and salaries. " FOMC20080805meeting--138 136,MR. MISHKIN.," Well, I get one more chance in the policy round. That is the one I am going to really go for. I am sure that people are waiting for it. [Laughter] My modal forecast has not changed appreciably. Clearly, I am very concerned about the headwinds as a result of the difficulty in recapitalizing financial institutions, which Governor Warsh talked a lot about. As a result, I think that we are going to have subpotential growth for quite a period of time. However, the bigger concern is that I see downside risks as having risen substantially. So let me first talk about the things that are the less worrisome downside risks. I think there are increased downside risks just on the real side of the economy. In particular, the consumer has been very resilient, but I am not as sure that that will be true in the future. We just saw terrible auto sales. It could be just one month, and it could bounce back up. But it could be a precursor to much bigger problems, which would not be completely surprising given some of the other things going on with housing prices and credit restrictions. That is one downside risk. The second is that European growth may have shifted down, and so the kind of problems that we are experiencing here perhaps are being experienced there, particularly in terms of lower housing prices in some parts of the euro zone. That could mean less demand for our exports, and it would be another negative for economic activity. The third is that we have actually seen a backup in mortgage rates, and that can have a direct effect on housing demand. It is pretty grim when you look at what is going on in terms of housing starts, but it could get worse. It can't go below zero, but it could get worse. So if that were all there was, I would say that there may be a little increase in downside risk, but it wouldn't frighten me. But I really am very worried about the potential downside risks in the financial sector. I have to disagree very strenuously with the view that, because you have been in a ""financial stress"" situation for a period of time, there is no potential for systemic risk. In fact, I would argue that the opposite can be the case. Just as a reminder, remember that in the Great Depression, when--I can't use the expression because it would be in the transcripts, but you know what I'm thinking--something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock. In this particular environment, we have to think about where we started. We were very lucky that this financial disruption occurred when bank balance sheets actually were in very good shape initially. You know, thank our lucky stars that it happened at that point. We are now a year into this. Bank balance sheets do not look very good, for all the reasons that we have been discussing. In fact, they look pretty grim. We have had some failures, and we are concerned about other failures. So we have a very different environment. In that situation, if a shoe drops--and we have had big shoes dropping; we had Bear Stearns, we had the GSEs, and we had smaller cases like IndyMac--and if financial systems are in a very weakened state, really bad things could happen. I think that there really is a serious danger here. In particular, we could have a dynamic through a decline in demand for housing because of the backup in mortgage rates or other reasons lowering housing prices and that spilling over into the financial system in terms of raising credit spreads, which then lowers demand, and we could get a nasty, vicious spiral. It is exactly one of these adverse feedback loops that we are all concerned about. So this is not off the table, and it very much worries me. I will talk about the implications of that for policy later. On the inflation front, although I definitely see upside risks, I think they may have diminished just a smidgen. There is a question about how large those upside risks are. In terms of my thinking about what drives the inflation process, it is expectations about future output gaps and expectations about inflation over a long period, not a short-term period. I see absolutely no evidence that, in the last couple of months, we have had deterioration in long-term inflation expectations. If anything, they have gotten a little better since March. If you look at the numbers--and Bill had it in his picture--basically there was some ratcheting up when the crisis first hit. I would argue a lot of that had to do with inflation risk, because there really was increasing inflation risk. There has been a slight movement up--maybe a tenth, maybe you could say two-tenths--in expectations when you look at forecasters. I am very skeptical of consumer surveys because, exactly what behavioral economics tells us, there is framing. If headline inflation is high, short-term inflation expectations go up, which should happen, but long-term inflation expectations also go up. When headline goes down, then they will come down. There was a nice little article from the San Francisco Fed in one of those little letter deals on exactly this issue, which came up with exactly this conclusion. I recommend that you read it; and the good news is that it takes only four minutes to read because the articles are meant to be very short. So I really do not see that there has been deterioration, and--I think that this is very important--it is why I stressed the issue of the analytic framework for thinking about the inflation process and what monetary policy can do. We can't control relative prices, but we can do something about long-run inflation expectations and expectations about future output gaps. So I haven't seen a problem lately that there has been deterioration in long-run expectations. What about output gaps? Well, if anything, they look as though they are expected to widen maybe a smidgen, not that much. We don't have any indication to expect that we will be overshooting in terms of having output greater than potential. Again, that should not be raising inflation. It should, if anything, maybe lower it a bit. Finally, of course, oil prices are lower. I don't think that means that they will stay low because the volatility is huge; but at least the fear that they are going to keep on going up and up and up--so it would not be a one-shot change but would be put into long-run inflation--has, I think, diminished somewhat. So where do I stand in terms of the upside risk? There still is upside risk because having high headline inflation does have the potential to spill over into inflation expectations. All of us have that concern. But I want to emphasize very strongly that it has not happened yet; I think that is very important. I also think it is very important to monitor this. One concern that members of the Committee have is that we wouldn't react fast enough because we have sometimes been inertial in the past. That is a serious concern. But I think there is a strong argument that, when you have very big downside risks to economic activity, you want to deal with inflation expectations when they actually indicate that there is some problem. And I just do not see that at this juncture. Thank you very much. " FOMC20070918meeting--122 120,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. In my view, the balance of risks has changed significantly over the past several weeks. Although outside of housing we don’t see much evidence nationally of a significant softening of growth, growth is likely to be somewhat softer than we had expected, and the downside risks to that lower path have increased substantially. I think inflation risks have diminished somewhat, but we have to remain attentive to the familiar sources of continued upward pressure. Financial conditions have tightened since the August meeting, even with the increase in the amount of easing priced into markets, and despite the moderation in the LIBOR term spread to fed funds over the past few days, conditions in credit and funding markets remain very fragile. Even under relatively optimistic assumptions about how these developments in markets will unfold, the process of adjustment will take some time to work through the financial system, and very protracted impairment to market functioning would raise, of course, the possibility of even more-adverse outcomes on the real side of the economy. These changes, in my view, justify a reduction in the fed funds rate at this meeting. Monetary policy has an important role to play in reducing the width of the adverse tail of the range of potential outcomes for real activity. By reducing the probability of an extremely bad outcome on the real side, monetary policy can help mitigate some of the coordination problems that are hampering financial market functioning and delaying the necessary repricing of risk that needs to take place, particularly in markets for term funding, the interbank market, and for mortgage-related products. The difficult and consequential judgment we face is about the appropriate size of the monetary policy response to these changes in risks to the outlook. I believe the arguments work in favor of doing more now rather than less. Policy needs to provide a convincing degree of insurance against a more adverse outcome. Of course, there are risks of erring on the side of doing too much now, and let me just address three of those risks. First, a large move could add to concerns about the downside risks to growth and about financial fragility rather than mitigating those concerns. My view, however, is that doing too little now would risk exacerbating uncertainty about the macroeconomic outlook, and a gradualist, tentative response would be more disconcerting than encouraging. The risk of underdoing it now is that we will ultimately be forced to do more. A second risk is that a large move now could add to uncertainty about future inflation outcomes. This is true. However, I think various measures of changes to the inflation outlook suggest that risks to inflation have moderated a bit, and the markets are displaying a fair amount of confidence in both our will and our ability to keep future inflation stable at reasonably low levels. Acting in a way that suggests that we believe our credibility is more fragile would be more disconcerting than encouraging to the markets. The third risk is that a large move could reinforce concerns that we are adding to the moral hazard in the financial system. This is, I think, an inevitable, necessary consequence of acting to provide insurance against an extremely negative outcome, but it’s not a good argument against doing what we think is justified by the balance of risks to the outlook. In this context, it is important to be careful in the way we talk publicly about moral hazard regarding this balance. In our financial system there is a substantial amount of leverage in institutions and vehicles that are subject to very acute liquidity risk, and part of what you are now seeing in Europe, in the United Kingdom in particular, are the effects on confidence of finding the wrong balance, frankly, between concerns about moral hazard and the appropriate role of the central bank in situations like this. I think the framework that the Chairman laid out in Jackson Hole explains exactly the right balance between what we cannot or should not try to do and what is important to do with monetary policy. The process of adjustment and deleveraging that is under way in markets, in asset prices and risk premiums, is necessary, and we should not direct policy at interrupting or arresting that process or at insulating investors or institutions from the consequences of the decisions that got us to this point. Our objective should be to help facilitate that process but to do so in a way that reduces the chance that it will cause too much damage to the functioning of the core of the financial system and to confidence, because of the consequence of such a scenario for the real economy. To get through this process, bank balance sheets need to expand substantially, and we’re fortunate that they can expand and are now expanding very substantially. A range of nonbank financial institutions and financing vehicles will have to be unwound and restructured. Asset prices and risk premiums may have to move further as more deleveraging takes place and assets are liquidated. Some of the inevitable increase in macroeconomic uncertainty is priced into expectations. Investors will have to get more comfortable that they can make judgments about how to value mortgage-related and other asset-backed securities, despite the loss of faith in ratings. The process of differentiation among strong and weak institutions, conduits, financing vehicles, et cetera, also has to continue. But as many of you said, this process could take quite some time, and it will leave us with the risk of a fair amount of fragility in markets in the interim. Let me end just by reminding you of what I’ll call the “Bernanke Doctrine of Credibility” that the Chairman laid out at one of our previous meetings. Credibility for a central banker is not just about the confidence that we instill in markets that we will act to keep inflation stable and low. It is also a function of our capacity to demonstrate that we have a sufficient feel for the evolution of the economy and about confidence and that we will meet those inflation objectives without excessive cost to real activity and confidence. Part of that credibility is a feel for what is happening in markets and a capacity to look forward and anticipate the potential implications that those developments may have for the outlook. Thank you." FOMC20070918meeting--320 318,MR. PLOSSER.," Thank you, Mr. Chairman. Actually, I do have some sympathy for this proposal. I think it is very creative. But there are a lot more people around this table who know a lot more details about this market, how it works, and how treasurers work than I do, and I will certainly defer to their judgment. But I have a couple of points that I’d like to make. President Hoenig made the point that really gives me a little pause as I absorb this. What I’m really worried about is the law of unintended consequences, and I don’t know what they are right now. Many of you around the table have raised some possibilities that this could exacerbate. I think President Poole’s suggestion about creating a tension between large and small banks about who has access to this could prove to be a problem. I also agree that it might be unusual, but it would be troubling if, in fact, we ended up lending money in this facility going below the targeted funds rate, which would be maybe unlikely but would complicate our lives in other dimensions as well. I also worry a bit as I look at the market—and this probably has more generally to do with provisions of liquidity—that part of the problem here is price discovery. Who has the risk? Where are the risks, how much are they, and how do we price them? I worry a bit, too, about the degree to which providing liquidity shuts down or slows down the price-discovery process, which is something that we really want to get done. I don’t know how to answer that question, but it’s one that I just sort of struggle with in trying to think about whether we are hampering the process of price discovery, by slowing it down and making it easier for people, or are we moving it along at a faster rate. I don’t know the answer to that. The last point, I think, is more of a policy question. Again, President Hoenig, I think, made it. If we view this as a temporary tool, which I think is fine, it is important that we lay out in our own minds under what circumstances in the future we would decide whether or not to implement this tool and how we decide. What criteria do we have? We need something a little more objective than just whenever we want to. I worry a bit that by failing to do so we will abandon some expectations about how the market will react to this and when they might expect us to use it or not. Do I know what the consequences of that will be? I don’t know. I’m struggling with those kinds of questions, so having a little more time to think through some of these things would be very helpful. Those are my comments. Thank you." FOMC20080805meeting--13 11,MR. DUDLEY.," I think it is a fair point that we shouldn't assume that ""normal"" is returning to the LIBOR�OIS spreads that applied before August 2007, so we have to look at a broader set of indicators. For example, I think that it would be worthwhile looking at the spread between jumbo mortgage rates and conforming mortgage rates as evidence of the degree of the shadow price of balance sheet capacity. I think that, once financial institutions either raise sufficient capital or stop taking loan-loss provisions or writing down assets so that they have enough capacity to expand their balance sheets, we will be getting to the end of this process. Another thing I would say to add to the answer I gave earlier to President Evans is that the trajectory of housing in all of this is going to be hugely important. One thing that may signal the next phase, maybe the beginning of the end, is when people really do get a sign that the housing sector is starting to bottom, probably first in activity and then in price. Once that happens, the huge risk premium embedded in some of these mortgage-related assets will then collapse. That means that the mark-to-market losses in a lot of institutions will start to fall. So I think that is going to be a very, very important metric once housing starts to really bottom and people get some visibility about how much home prices will go down. You know, when the argument is about whether home prices are going to go down 15 percent or 20 percent, that will be a very different argument from the argument now, which is whether home prices are going to go down 15 percent or 30 percent. " FOMC20050202meeting--76 74,MR. GRAMLICH.," I’m going to get to meatier things! [Laughter] Is it desirable to have an anchor? I think it is, and I think Bill Poole gave the reason—that we actually have more flexibility to move against unemployment if we have a well-understood anchor. On the other side, I’m gratified that nobody is really in favor of a full, formal inflation targeting routine, such as was described in the document by the International Finance Division. The system is not broken. We have somehow or other managed to convey that the Committee cares a lot about low inflation, and many of us in our talks have even used the word “anchor.” There may be some incremental steps we could take, but I agree with what Mike just said—that since it is not broken, we should be very, very careful. Mr. Chairman, you raised the question of asset prices, and I notice that nobody has commented on that, so let me. It strikes me that asset prices are a fundamentally different breed of cat here. Asset prices—stock prices, exchange rates, even housing prices—I see as part of the monetary transmission mechanism. We should, as we say, take them into account in making our forecasts and doing our analysis of the economy, but I think we have to leave them out of the index. If we go to targeting some index or another, I don’t want that index to include anything about asset prices. I think that’s a fundamentally different notion. The staff, I think, gave us good information. As for me, I favor a core index on the grounds of the numbers shown here. If we have an index and want to keep it in a zone, I’d like to have that February 1-2, 2005 46 of 177 out of the zone. And to me, it’s almost self-evident that we would want to use consumer prices and the rate of inflation. On the question of what is our target, everybody seems to be for 1 percent on the bottom, and that’s fine. I am, too; there’s little disagreement about that. But I think some of you are being a little too hawkish on the top side. There’s an old experiment that I learned about in graduate school from Richard Ruggles, who used to be a professor at Yale: Offer somebody $10,000 and the choice of ordering from a catalog of all goods and services made this year or five years ago, and take a poll on which option they vote for. Try it. You all give talks to Chambers of Commerce and so forth. I’ve been doing it for years, and people will consistently vote for the current menu. Obviously, this experiment has to be done at a much higher level of scientific rigor. But I think in the utility sense, even core PCE rates as high as 3 percent may be more or less consistent with price stability, given the great difficulty we have in dealing with technological change in price indexes. On the range or point issue, I think Janet raises a good point about the point, and this is the way I take her point. [Laughter] Let’s say the point is 2 percent, and the inflation rate goes from 2.4 to 2.5 to 2.6 to 2.7 percent. That won’t be a huge issue and we might not have to explain that. But I have to come back to the fact that when I think about inflation, I actually do think in terms of ranges. I’m prepared to believe that inflation will fluctuate within a zone, and I’m not going to worry in that range. So I’m a little more comfortable with setting a range or zone than I am a point. It will require occasional explanation when inflation gets out of the zone, but I think that we ought to be prepared to do that. If it does get out of the zone, we ought to be able—thinking among ourselves—to say why that is. So, I guess I don’t find that too costly. In terms of how we do this, I would definitely take a low-key approach. I think we’d want to be clear that this is part of a broader agenda. We have our dual mandate, and we feel that if we make it clear what our inflationary anchor is, we can actually fight unemployment better. This wouldn’t February 1-2, 2005 47 of 177 step as we could possibly imagine. I actually liked the paragraph that Ben wrote, so something like that might be a good start. Should we consult with Congress? Yes, we would have to consult with Congress. And there is a risk in consulting with Congress because their first question is going to be, “Well, are you going to set a range for unemployment?” The staff dealt with that issue in their document and found that doing so actually risks making fundamental macroeconomic mistakes. So, I would not want to be forced to set a range for unemployment—and we would face that risk. At the same time, if we’re going to do something like this, I think we do have to tell Congress about it. But open up the Federal Reserve Act? No way. Thank you." FOMC20071031meeting--83 81,MR. MISHKIN.," Thank you, Mr. Chairman. My forecast is actually quite similar to the Greenbook forecast. In terms of inflation, I see a little faster movement back to 2 percent, where I think inflation expectations are grounded, but the difference is very minor. I do think the risks are quite balanced around that. In terms of economic growth, I am fairly comfortable with the Greenbook forecast, maybe a smidgen less sanguine in the next two quarters but really not very different. However, in terms of the issue of potential downside risk, I do think that, given the policy path that the Greenbook assessed, there are substantial downside risks and they come from several sources. One source is that the financial market disruptions have led to some tightening of lending standards. I think that could have some potential effect on business investment. The housing market is pretty grim. We still have a big inventory overhang, and there is a question about whether that large inventory overhang is going to lead to even fewer housing starts than the Greenbook has forecasted. Furthermore, it has raised the issue about house prices, which have spillovers into household spending. The spreads for commercial real estate are still very high, and so there is a question about whether commercial real estate will be as strong as it has been. That is a bit worrisome as well. Consumer confidence has not deteriorated too much, but it has been on a path of deterioration. So, again, I worry a little about what the consumer might do. In general, I worry more about these downside risks, given the policy path of keeping the federal funds rate constant. What about the financial markets and their disruptions? Well, I think that there are two elements to the disruption in these big, widening credit spreads. One is the valuation risk: All of a sudden people realized that they didn’t know as much about what kind of assets were in portfolios and how complicated the structures were in terms of those assets. Clearly, the solution to that problem is price discovery. We see that happening, but it is going to be very slow. So that problem, in terms of the credit markets, will take a fair amount of time to resolve. The second element is what I call macro risk, which is the concern about a downward spiral: The problems in the credit markets will lead to a weakening of the economy, which then makes price discovery harder to do, which means that you have wider credit spreads, which then make things worse. Of course, that’s the issue with the tail risk that all of us have been talking about. I think the policy change that we did in September clearly had a big impact. It did exactly what we wanted it to do. It is almost a textbook case in doing what we wanted it to do—it took out a lot of the macro risk. It didn’t take out the valuation risk, which is getting better but very slowly over time. So looking at this issue and thinking about going forward in terms of the credit markets, I am a little worried that credit markets are still quite skittish. That has several elements. One is the danger that macro risk could come back. So there is a question about shoes dropping. There is an issue about what we might do at this meeting, and then there are issues about what might actually happen that people don’t know about. One thing that is sort of surprising is that, when you look at what is happening in credit spreads, they seem pretty reasonable in their steady but very slow improvement. But then, you sense some discomfort—in particular, the reaction to the Treasury superconduit has not been very positive. If it worked, it would actually reveal information because it would look like the way that the old clearinghouses used to work, when they would combine assets. Randy knows all about this because he studied this stuff. You pool your assets, then you monitor each other, and then you actually create information that makes the markets work better. I think that is what the Treasury was trying to get at. But the skepticism in the markets is such that they think this could be used to hide information about assets and that other shoes may be dropping in this regard. This does not give me a lot of confidence, and so I worry very much at this juncture, which I think is a critical one, that a policy move could have an effect of sending the credit markets in a bad direction. That is something we have to take into account tomorrow. Thank you." FOMC20050322meeting--126 124,MR. FERGUSON.," Thank you, Mr. Chairman. At the last meeting, I described the economy as being in what I called a mid-cycle sweet spot, so the obvious question is: What has happened since then? I would say that, in general, my headline is bifurcated. One is, “so far so good;” and two is, “there are a number of caveats”. Let’s first look at the “so far so good” part of the headline. As all of you have already pointed out, the economy seems to be gaining momentum. Households continue to be in good shape. The saving rate is, unfortunately, low, but that is supporting consumption. Households are also being supported by an increase in compensation per hour that continues to look quite robust. As the Greenbook has pointed out, there seems to be no pothole on the investment side, so the business fixed investment component is also kicking in. Nevertheless, as a number of you have already indicated, some concerns have arisen recently on the inflation front. But I think we should also recognize that long-term inflation expectations continue to be well anchored. And importantly, while a number of costs have gone up, unit labor costs themselves continue to be, if anything, quite moderate. All of this suggests to me—though I will point out some caveats—that the incoming data are not flashing a signal that we are clearly behind the curve. So what are the caveats that seem to be important? Both of them deal with some uncertainties regarding the supply side of the economy. First, we have a question about what is going on in the labor markets. As all of you know, several meetings ago, and then at the AEA [American Economic Association], I put forth some relatively rudimentary analysis that suggested that some of the decline we’ve seen in labor force participation rates may not turn around very quickly. The staff has done some much more sophisticated analysis and has come to a not too March 22, 2005 62 of 116 increase in labor hours that can go into overall potential GDP. The staff has done that, and I support that conclusion. The second uncertainty with respect to the supply side has to do with productivity growth. This, I think, will be an ongoing question for us for some time to come. I recognize—as do others, including President Yellen—and applaud the fact that there appear to be many positive signs with respect to productivity growth. We had a discussion in this room, for example, in a meeting with the SIA, suggesting that Moore’s Law continues to be in shape, which is obviously a very positive thing. And we have seen some upside surprises in income and productivity growth, which, again, is a very positive development. Having said all of that, the staff takes into consideration the net debt financing of financial firms and the financing gap information, both of which show that firms have a great deal of room left to invest; the staff views those as positive signs that there is some potential upside to productivity. I would say that we should at least be a little cautious in that assessment because those developments may involve some negative signs. So I think there’s a little question mark on the capital deepening component of productivity increases. At this stage, I’m generally willing to support the consensus that has emerged around the table, and in the Greenbook forecast, that productivity probably is in good shape. But we need to monitor that. Another caveat has to do with this issue of energy prices. I, along with Governor Bernanke, realize that energy prices play a relatively small part in inflation in the U.S. economy, particularly against the backdrop of well-contained unit labor costs. However, like others, I recognize that the increases in oil prices seem to have had a dramatic impact on market psychology and may be the thing that could undermine the relatively well-contained inflation expectations that have been March 22, 2005 63 of 116 dynamics are such that not only are oil prices likely to be in a higher range, as indicated by the far- dated futures, but also that the surprises are more likely to be skewed to the upside. In my view, the recent increases in oil prices reflect some real concerns that world supply will not be able to keep pace with demand growth, as a few of you have already said. In particular, I think the cushion of spare production capacity has narrowed significantly. In preparation for this meeting, I asked the staff to do an options-derived probability density function of WTI prices. I don’t have the results to hand out, but when one looks at the December 2005 function, there is a particularly large skew to the right-hand side. I think this is telling us that there are significant market concerns that prices could surge in the event of supply disruptions. These concerns have pushed up both futures prices—which to me can be interpreted as a mean expectation for future spot prices—and also spot prices today, reflecting, I think, some heightened precautionary motives for holding inventories. So there is a real risk that with very low short-run price elasticity of demand, a supply shock could lead to very big moves in price and potentially unhinge the inflation expectations that we have benefited from. So I think that is another caveat to worry about. Finally, President Geithner has raised a few times the question of whether or not the predictability of our language has been the source of a reduction in either implied volatilities or spreads over Treasuries. I had the staff do some basic historical charts to look at this issue. We first introduced in the Chairman’s congressional testimony in 2003 the notion that we’d keep rates low for a considerable period, and that showed up in our press statement for the first time in August 2003. Since then, obviously, we’ve gone through other terms such as “patience,” “measured pace,” et cetera. All of that I think has played to some degree in the reduction of implied volatilities and March 22, 2005 64 of 116 implied volatilities and in the spreads over Treasuries, both started to decline many, many months before our original focus on using the kind of language we’ve been using. So while I don’t necessarily disagree that there are carry trades and that some real risks have emerged, in my view we should not take too much of the blame for that upon ourselves. I think a number of market dynamics have driven that, along with predictability and transparency at the Fed. That leads me to the final point: What does all this mean for monetary policy? First, I would say, at bottom, that I find the baseline outlook to be credible and reasonable. But it is surrounded by a range of risks that I believe, as do others, are primarily on the upside. Against that background, it seems prudent to continue to execute our pre-announced strategy. The economy is growing well and needs less and less stimulus; therefore, continuing to remove our accommodative policy at a measured pace seems to me reasonable. Second, given the stage of the cycle, the skew in the general risk assessment that I outlined, and the need to manage market expectations, I think we should use our statement to signal our awareness that inflation pressures may have picked up. The incoming data are indicative of that. If we are wrong on the upside risks, both we and the market will adjust. On the other hand, if we fail to reflect the existence of these upside risks, we could easily be perceived as being behind the curve, with negative consequences in terms of inflation dynamics and, potentially, our own credibility. Finally, I think the statement, as drafted in the last meeting, clearly links the concept of a measured removal of accommodation with a general sense of the incoming data. And I believe that gives us the kind of flexibility that we need. Therefore, I’m not terribly supportive of removing the “measured pace” concept at this stage. I think we have sufficient flexibility using that phrase, when March 22, 2005 65 of 116 how things were evolving. So I would caution against making that kind of change in the statement today. Thank you, Mr. Chairman." CHRG-111hhrg53245--78 Mr. Kanjorski," I agree with you, but I wanted to perhaps attack part of your premise there. I recall very clearly in 2005, the Chairman of the Federal Reserve was testifying before this committee. I specifically asked him a question, whether or not there was a real estate bubble in his opinion, and he said he thought there was, and that the price of real estate was ever increasing, but it was perfectly manageable and it did not constitute a risk to the system. If he in fact were the gatherer of that information and the analyzer of that information, we would have missed the opportunity to have found systemic risk. What is your answer to Mr. Greenspan's lack of perceiving that difficulty? Ms. Rivlin. I think he was just wrong. He said that himself. He did not see this one. I think we have learned a lot about bubbles. One thing we have learned is that interest rates is not a perfect tool for controlling them, which is why I would give them more leverage control as well. " FOMC20060328meeting--84 82,MR. MOSKOW.," Okay. Well, most of my contacts this time were upbeat about current conditions. Though the Midwest continues to underperform the rest of the nation, the U.S. economy seems to remain on solid footing. So we tried to assess whether the strength in January and February was just a transitory bounceback from the fourth quarter or whether it represents some persistent forward momentum. And while a few contacts expressed concerns about higher energy prices and softening housing markets—as we were just discussing—most pointed to an economy with substantial staying power. A bit of good news is that the Chicago purchasing managers’ index, which will be released on Friday, will show a significant increase—from 54.9 to 60.4. The persistent momentum in the economy appears to be creating some pressure on resources. One example is the airline industry. Business and leisure travel are at very high levels, with strong bookings for the past few months. Load factors are at near-record highs, in part reflecting a reduced capacity in the industry. There continue to be more reports of fare increases, and surprisingly the increases are now being led by the low-cost carriers. We’re hearing about tightening labor markets. Manufacturers continue to have difficulty finding skilled workers. In the temporary-help area, Manpower—headquartered in our District— said that wage growth is accelerating nationally. Three months ago wages were basically flat on a year-over-year basis. Now they’re expecting increases of 4 to 5 percent in the second quarter of this year. Kelly Services, also headquartered in our District, reported steady nationwide increases in the 3 percent to 4 percent range. But both companies noted that labor markets were still nowhere near as tight as they were in the late ’90s. Speaking of labor markets, to update the GM–Delphi–UAW saga, Rick Wagoner, General Motors’ CEO, thinks that the GM buyout plan will take the heat off the poor Delphi–UAW relations, lessening the chance of a strike there. He expects a significant number of GM and Delphi workers to sign up for the plan. This will allow them to reduce the size of their workforce more quickly. One aspect of this agreement that parties are not publicizing widely, for obvious reasons, is that GM and Delphi should have more flexibility in hiring temporary workers and outsourcing in the future. The temporary workers will have lower wages, and they won’t have the full GM benefit package. Turning to the outlook, I feel that the near-term risks to the forecast have changed somewhat since our last meeting. On the growth front, I had previously thought that high energy prices and sticker shock from heating bills might damp spending substantially. And on the price front, I was concerned that pass-through of higher energy prices and other costs could boost core inflation and feed through to inflation expectations. Neither risk has materialized so far. Private domestic demand appears to be growing at a solid pace. The recent price news has been favorable, and inflation expectations have moved little. So what are the risks now? I do not see many immediate downside risks to growth; to the contrary, I personally think that the risk may have tilted to the upside. It’s true that housing appears to be moderating, but the softening seems to be happening much as we expected it to. In contrast, consumption growth continues to be quite strong. This may be a signal that households are more confident about their permanent income prospects, perhaps because of healthy labor markets and the strong underlying productivity growth. If so, then we could be in for some continued robust consumer spending. In addition, growth abroad has improved. Notably, Japan and Europe are showing some life. Thus, we could see more demand emanating from abroad. So in the short term, growth will likely exceed potential. But given a funds rate path like that in the Greenbook, which I would characterize as a touch restrictive, my outlook and the Greenbook’s get growth back to potential by 2007. Despite the recent good readings on inflation, the current strength of the economy is showing through in our simple indicator-based forecasts of inflation. We run about two dozen forecasting models that encompass common statistical indicators of future inflation. These are not structural models. They are simple regression forecasting models that use only current data, and they have no explicit conditioning assumptions regarding future policy, oil prices, or other such factors. And this contrasts with a more structural methodology like the FRB/US model. Nearly all of these indicator models predict some uptick in core inflation over the next two years—not a big one but to something a bit above 2 percent in 2007. Looking ahead, these projections would probably move down with a further string of good news about prices and more-balanced prospects for resource utilization. Nonetheless, given the models’ forecasts and the fact that we currently are operating with very little resource slack in the economy, I see a risk that inflationary pressures will be somewhat greater than what is currently built into the Greenbook." FOMC20050630meeting--352 350,MR. MOSKOW.," Thank you, Mr. Chairman. In recent weeks we’ve heard a wide variety of views about business conditions in the Seventh District. Most sectors have good news as well as some bad news but, overall, conditions are positive and seem consistent with an economy growing near trend. Evidently, accommodative policy is offsetting the drags from energy and the international sector. Within manufacturing, heavy equipment producers continue to report strong sales growth. For example, all 21 of Caterpillar’s business units are above plan. This year some of their product lines have sold out for 2006, and they have begun taking orders for 2007. In contrast, one of our directors who is the CEO of a large diversified manufacturing company reports a surprisingly sharp slowdown in orders, although he concedes that business had been growing at an unsustainably high rate. The Chicago Purchasing Managers’ Index, which will be released today, edged down from 54.1 in May to 53.6 in June. In retail, apparel sales are generally strong and mall traffic seems good, but a retailer in home furnishings reported a marked slowdown in sales during the past six to eight weeks. In motor vehicles, GM noted strong sales in response to its new marketing program. GM and Ford both continue to forecast light vehicle sales of about 16.8 million units in 2005—the consensus forecast from our recent auto outlook symposium had similar numbers for 2005—and they expect sales to remain near this pace in 2006. Labor markets continue to improve. Temporary-help firms report that growth is moderate, not spectacular. They say demand is soft for low-skilled workers, but it is stronger for professional, technical, and clerical workers. And average temp wage and benefit increases have held steady in June 29-30, 2005 110 of 234 The news on the price front is similar to what we’ve seen in the last few meetings, with increases for plastics, rubber, and heavy machinery—and, of course, energy. Integrated steel producers are burdened by high coke and iron ore prices. In contrast, steel scrap prices have fallen 35 percent from their peak in November of last year, which reduced the costs for the mini mills. Turning to the national outlook, since our last meeting we’ve learned that the soft patch was temporary, as many of us expected. Furthermore, the core inflation numbers improved but energy prices moved up even further, as we’ve just been discussing. Looking forward, our outlook is very similar to the forecast in the Greenbook, with growth slowing in the current quarter but picking up somewhat in the second half of the year. On balance, we project that GDP will increase at a rate near 3½ percent both this year and next. The story underlying this forecast is a familiar one. Accommodative monetary policy and the trend in underlying productivity appear sufficient to offset the current drag from higher energy prices. On the inflation front, we don’t see broad-based resource constraints pushing up prices. The pass-through of cost pressures to consumer prices has been modest. In fact, Mr. Chairman, after you left our board meeting two weeks ago, my directors gave me a hard time regarding the suggestion that businesses had any pricing power at all. In addition, inflation expectations remain contained, even with the most recent increase in energy prices. So we see core PCE price inflation peaking at 2 percent this year and edging off a touch next year. Of course, we should not be too sanguine. It would be unfortunate if underlying core inflation drifted above 2 percent, and there is some risk of that happening. Resource slack has narrowed, as Dave Wilcox pointed out earlier. And given our uncertainty as to the true level of potential output, we may already have closed most meaningful resource gaps. With oil prices June 29-30, 2005 111 of 234 could happen if we are perceived to be improperly monetizing the higher oil prices. Therefore, it will be important for us to continue to remove policy accommodation in order to contain inflationary pressures and inflationary expectations. So at this meeting, we should increase rates by 25 basis points. For the remainder of 2005, we may need to increase rates more than currently expected by the futures markets. I agree with the view expressed by some people during the chart show: Risk management suggests that a path with higher interest rates would be a better course for our policy than the one outlined in the futures market. And given the risks to the inflation outlook, a flat federal funds rate of 3¾ percent throughout 2006, as the markets expect, is simply too low." FOMC20060629meeting--109 107,MR. KOHN.," Thank you, Mr. Chairman. Incoming data have tended to confirm to a degree both the downside risks to growth and the upside risks to core inflation that we’ve been talking about at recent meetings. Higher inflation interacting with policymaker comments on the inflation situation triggered higher expected real interest rates and more uncertainty about the longer-term future. That in turn further tightened financial conditions, leading to more markdown of growth prospects. Notably, the worry about added inflation pressures has not been confined to the United States, given strong growth abroad, high energy and commodity prices, and a sense that output is close to potential. Widespread policy tightening and greater uncertainty have led to increased caution on the part of investors and tighter global financial conditions. The incoming data certainly have influenced my projections—I expect less growth and more inflation than I did a few months ago. I’m also even less confident, if that’s possible, than I was given these surprises. The key question in my mind is whether the conditions are in place or soon will be in place—that is, after tomorrow—to keep core inflation at considerably lower levels than it has been so far this year. I think they are, and in this regard I’m a touch more optimistic than the staff. I have slightly lower inflation for 2007 with the same policy assumption. Most important, I don’t believe that the extra inflation we’ve had results from the economy producing beyond its long-run potential. We obviously can’t be very confident about this. The decline in the unemployment rate to noticeably below 5 percent occurred only at the beginning of this year, but the behavior of compensation last year and this year suggests to me that the NAIRU is more likely to be under than to be over 5 percent. Perhaps better job- matching through Internet search, declining real minimum wages, and lingering worker insecurity, after the only-moderate increase in employment early in this expansion, have lowered the NAIRU a touch. We should expect compensation growth to pick up as in the staff forecast, but the implications of this pickup for inflation are unclear, given elevated profit margins and what is likely to be a competitive business environment. I do think relative price adjustments are playing an important role in what we’ve been seeing. I suspect I have been implicitly underestimating the effect of higher energy prices on both output and inflation. Before this year, the effect of rising energy prices on inflation was offset by slack in the economy, and the effect on activity was offset by easing monetary policy that was put in place to counter that slack. With both slack and easing policy disappearing, the effects of higher energy prices are showing through in both output and inflation. Another adverse price shock seems to be coming from the housing market, where the previous run-up in prices and the higher interest rates are weakening prospects for home price appreciation. This weakening, in turn, is both reducing activity and raising actual and imputed owners’ equivalent rents. The longer-term inflation effects of both these relative price changes will depend on their persistence and their propagation into other prices. In this regard, President Poole, I see us as perhaps accommodating the first-round effects of the increase in prices but making sure they don’t propagate beyond that, rather than having a price-level target that would bring us back down to the old price level. With regard to persistence, petroleum prices have leveled out since April, and futures markets don’t suggest further increases. It’s difficult to get much of a fix on future rent increases, as prices and rents realign to higher interest rates and lower expected capital gains. In the past, most of that realignment has come through prices; but we don’t have many observations, and the required adjustment appears much larger this time. There are two keys to preventing the relative price changes from becoming embedded in broader and more persistent inflation: low inflation expectations and a competitive business environment. If energy prices do flatten out, headline inflation will come down, and I think that will help to contain the inflation expectations of households and businesses and bring down core inflation. The propagation of higher rates of increase in rents, should they persist, to other prices I found much harder to analyze. After all, homeowners are, in effect, paying themselves higher imputed prices, and it’s not clear that they would change their behavior in labor markets to expect higher wages as a result. Moreover, with respect to owners’ equivalent rent, I think our usual financial market measures of inflation expectations may not be reliable indicators of behavioral shifts. Expected persistent increases in owners’ equivalent rent will boost expected CPI showing up in TIPS spreads but not necessarily affecting other pricing decisions. A persistence of elevated rent increases will put a premium on viewing their implications for future inflation rather than on simply reacting to the incoming data. The competitive environment will depend largely on the degree of resource utilization. In this regard, the negative effects of the oil and housing market developments on activity, along with the tightening in financial conditions, suggest that activity could well run at least a little below the rate of growth of potential for the next several quarters. That will help to limit longer-run inflation pressures. In a sense, the forces that seem to be pushing up inflation are also contributing to the conditions that should hold it in check. In sum, recent inflation data have been an unpleasant surprise, but the source of the price increases—that is, price shocks, not overshooting—and the economic conditions coming into place should imply a softening of core inflation over the next 1½ years. This outcome is based on the assumption that the relative price increases don’t become more broadly embedded in other prices and second-round effects. We’ll talk tomorrow about how policy might contribute to reducing the odds of that possibility. Thank you, Mr. Chairman." FOMC20071031meeting--175 173,MR. ROSENGREN.," Thank you, Mr. Chairman. I, too, find myself torn between alternative A and alternative B and have been anguishing over them much of the last week figuring out where I come out. The economic outcome detailed in both Boston’s and the Board’s forecasts with no change in interest rates seems reasonable. The evidence since the last meeting indicates that there may have been more strength in the real economy than we expected in the third quarter; and financial markets have been recovering, but they are certainly not back to normal. The risks are clearly on the downside, and our forecast expects a weak fourth quarter. So certainly an argument for alternative B is to cut when it is clearer that the fourth quarter will be weak or we have data of more-significant collateral damage from the housing sector. The argument for alternative A would seem to be that we should take out more insurance against the downside risks. The costs for such action are not great; and given the downside risk, some additional insurance is not unreasonable. However, we have discussed the modal forecast at some length, but our rigor around the tail is quite limited, making it difficult to determine how often and how much insurance should be taken out against downside risk. Thus, I prefer to wait until there are more data that the economy is weakening, which I think is likely to happen. Just to comment on the assessment of risks—when I look at the uncertainty in terms of GDP growth, I think of the histograms. That’s quite stark. If the major concern we have is downside pressure on prices of housing, which is my concern—that housing prices continue to decline and housing gets much worse—I think 25 basis points is probably a small premium to pay. But I doubt that I would change where I would put the weighting even with a 25 basis point cut. I think the housing scenario that is detailed in the Greenbook will still be there whether or not we cut the 25 basis points, and my guess is that between now and December we’ll have more confirmation that it is a concern. Whatever we do in terms of the language, we need it to be consistent and accurate, and I am a little worried about the language in alternative A being consistent and accurate with what we are going to portray in our uncertainty of risks if we show those histograms. So if we’re showing the histograms, regardless of whether or not we have a 25 basis point cut, I think the alternative B language is more consistent with at least what we put down. Unless people think that, with the 25 basis point cut, there is a big shift in the uncertainty and the risks to GDP growth, I do worry about how that will play out in the market and what kind of a tension there will be." 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." FOMC20080130meeting--199 197,MR. KOHN.," I thought we needed some insurance, and I also assumed some fiscal stimulus as in the Greenbook. I still see, despite these policy responses, risks around my outlook for activity as skewed to the downside, and it's because of the potential further increases in required compensation for risk and tightening standards for extending credit and the feedback on demand. Although inflation has been running higher than expected of late, and that is troubling, I expect it to ease back even with my more accommodative policy. The combination we've seen of slower income growth and higher inflation suggests elements of a supply shock, and that's obviously coming from the energy sector and its spillover into food. It is true, as President Fisher pointed out, that some of those increases in food and energy prices are coming from demand from emerging-market economies, but to the extent that such demand is putting upward pressure on our prices and it's not really sucking exports from the United States at any great rate, I think that it acts more like a supply shock on the U.S. economy than a demand shock. Energy and other commodity prices should level off in an environment of slower global growth, and they've started to do that. They have at least showed signs of leveling off recently. Greater slack in resource utilization and product markets should discipline increases in costs and prices. At least some of the reports about airlines suggest that they have tried to pass through fuel surcharges and have been unable to do so, and I think that's an encouraging sign from the inflation perspective. Any easing of inflation pressure does require that inflation expectations not begin to ratchet higher. I agree with everyone else. I'm persuaded that the balance of evidence is that they have not, despite the rise in five-yearforward inflation compensation and despite the persistently higher rate of increases of total headline than of core inflation. But this is something we will need to monitor very carefully. I interviewed Paul Volcker yesterday afternoon for our oral history project. The discussion with him reminded me again of the high cost of reversing a rise in inflation once higher inflation expectations become entrenched. Thank you, Mr. Chairman. " FinancialCrisisInquiry--109 BLANKFEIN: I think nobody—looking what happened and the most horrible thing of this crisis, what has happened to consumers, to individuals, in the mortgage market, in other things have taken on debt as a consequence of behavior. And the confluence of behavior and the recession I would say no one would argue that there shouldn’t be more protection and safeguards and regulation of that interaction between finance and the consumer. CHAIRMAN ANGELIDES: All right. There’s one minute left. And the only final question I have is for you, Mr. Dimon. How do you control—correct the asymmetry in compensation? Let me just say it simply. I was in the private sector half my life. I was in a business where you put real equity at risk and if you lost you lost. You bet big, you could also lose big. There’s an asymmetry here where in the financial services industry it seems that it’s almost like you’re at a Black Jack table in which you never really get wiped out. At the end of the day the worst you can do is walk out with what you had. On the other hand, if you hit big you can hit big. It seems to always tilt towards making the biggest bet possible because there’s no consequence for the biggest bets. How do you correct that? DIMON: Well, there’s a consequence that you could lose your job. You could lose your reputation. But I do think that you raise an issue. The first way to correct it is that you actually risk adjust it, actually look at the capital being deployed and you make an evaluation. Did they do the right things for the right reason, for the client, et cetera? So you are constantly trying to evaluate are you doing the right things on trading debts. But it is a little one- sided that way. And the more senior the people become, the more stock they own in the company. So they are responsible for the well being of the whole company and they will pay a price if our company pays a price. I think that’s generally—you’ve seen that a lot of the companies that went belly-up their people did pay a price. CHRG-111hhrg74855--177 Mr. Gensler," I think, Congressman, commercial hedgers have raised two concerns. One is could they enter into commercially needed but particular tailored transactions that aren't standard and the answer is an unambiguous yes but that is a legitimate question they have raised. Some members of the Senate or the House might feel differently but the administration says yes. Two is on the standard contracts they have raised the question is how is credit priced in there? Will they have to post collateral if it is lowering risk to a clearinghouse? " FinancialCrisisInquiry--56 That’s the change. CHAIRMAN ANGELIDES: All right. Thank you very much. All right. Let’s go—thank you. Mr. Holtz-Eakin? HOLTZ-EAKIN: I want to pick up on that and ask a question a little more broadly of the whole panel. Each of you, in your testimony, talked about problems of managing risk and excessive risk. Mr. Blankfein talked about under pricing of risk that led to massive leverage across wide swaths of the economy. A discussion from Mr. Dimon about compensation practices and misjudgments about aggressive underwriting standards. Mr. Mack talks about not having sufficient resources to manage those risks. And so each of the institutions you represent are publicly traded. They have audit committees. They have boards. They have internal auditors. And so my question is what is it about this traditional structure that failed us? Why is it that the risks that you have identified weren’t uncovered in the moment? And what specifically has each of you done, in addition to what you’ve discussed, to change your risk management practices since the crisis? We’ll just start with Mr. Blankfein. BLANKFEIN: I think if I had to say one thing in specific—and a lot of—we focus a lot, a lot of efforts and always have on risk management and our senior risk managers rise to the highest levels, including our named executive -- one of our named executive officers is our risk manager. So it’s the highest level of the firm. I’d say the one thing that we constantly learn from every crisis—‘98, tech, this one, of course, which is a different level—is the need for more stress tests. Very often in our business, we go through the analytical process of what could go wrong versus what is the probability of that going wrong. And, therefore, tend to discount the consequences too much. FOMC20051101meeting--113 111,MR. MOSKOW.," In our contact calls for this round, energy prices were a pervasive concern. So far they’ve had a limited effect on consumer spending, but our contacts worry that high heating bills will take a bigger bite out of sales in the coming months. In contrast, we’re seeing the impact on costs right now. Nearly every contact reported pressures from higher energy prices. There are many examples, but here’s one that seemed a bit more surprising than others. A large specialty November 1, 2005 29 of 114 which is a petroleum derivative. He said that in 30 years in the furniture business, this is the first time that the stuffing cost more than the fabric or the frame. [Laughter] Labor markets are also starting to generate cost pressures. For example, both Manpower and Kelly report signs of tighter labor markets. These contacts say that many firms, after having been very cautious about hiring, now feel they have pushed productivity growth as far as it can go and, accordingly, finally feel they need to hire more permanent employees, particularly in office jobs. Our contacts see this as a further sign that firms are more confident about demand. One of the staffing services firms said that they are paying higher wages and also spending more on recruiting and retention bonuses. And several of our directors report that they’re budgeting larger salary increases for 2006, in the range of one-half to a full percentage point higher than this year. The consensus among our contacts was that only a portion of these higher costs has been passed through to prices, at least so far. Several reported that labor costs are mostly eating into margins, which is what we’ve been expecting. But more price increases may be coming. A home goods retailer noted that they had set their current list prices last spring. When they decide how to price their products for next year, they’ll take into account the fuel cost outlook at that time. There has been no let-up in the auto industry’s woes. Our contacts say that higher oil prices seem to have frozen consumers, and showroom traffic is down. There have been some interesting developments with regard to labor costs in the auto industry. GM’s recent renegotiation of its health care liabilities, if ratified, would be the UAW’s [United Auto Workers] first major mid-contract give-back in history. Ford and DaimlerChrysler will be demanding similar concessions. Indeed, it might be that the Delphi bankruptcy has helped the industry at least get the ball rolling on some November 1, 2005 30 of 114 a clear possibility of a strike at Delphi that could seriously disrupt the auto industry, particularly General Motors. For the national outlook, the last six weeks of data have confirmed that the dislocations from Katrina and Rita have had a limited impact on aggregate economic activity. Outside the areas affected by the hurricanes, labor markets are improving at a pace similar to earlier in the year. And I’m getting favorable impressions of business sentiment from my contacts, which is a good sign for hiring and capital spending. However, there is a risk that the recent sluggishness in consumer expenditures and low levels of confidence may be foreshadowing a period of somewhat softer growth in consumption. Households have further run down savings to maintain spending in the face of higher energy prices, and it’s very difficult to gauge how this might influence consumption going forward. With regard to inflation, the readings on core prices in the last quarter were good. Given all that I’ve heard in recent weeks, though, it seems likely that past increases in energy and material costs will soon begin to show through more clearly in prices downstream, as is forecast in the Greenbook. Furthermore, labor markets have tightened. As I noted, many of my business contacts are planning for larger increases in wages and benefits next year. They can only absorb these higher costs in margins for so long. Finally, there’s a chance that increases in costs and prices will result in a meaningful rise in longer-run inflation expectations, which would be a risk to the longer-run Greenbook forecast. All of these risks add up to increasing the funds rate by 25 basis points again today. Looking ahead, I think we should continue tightening. At least we are comfortably in the middle of a neutral range, and there’s a possibility we’re going to have to go further. There’s a good deal of uncertainty November 1, 2005 31 of 114 Bluebook suggests that a 4 percent nominal funds rate might be the midpoint of the range, but I’m personally skeptical that the rate is that low. This is going to be an important issue for us to consider going forward. I’m glad that we at least started the discussion earlier today, and I hope we’ll continue it later in the meeting." FOMC20051213meeting--71 69,MS. YELLEN.," Thank you, Mr. Chairman. Incoming data since our last meeting have been quite encouraging. Economic growth over the next few quarters should be boosted by rebuilding and the full return of energy production in the Gulf. As rebuilding winds down and the lagged effects of monetary policy tightening take hold, it seems plausible that growth will slow toward potential, keeping unemployment around the current level of 5 percent, the scenario envisioned in the Greenbook. The economy’s remarkable resilience in the face of devastating hurricanes and three years of rising energy prices suggest that the expansion has gained footing and no longer needs support from December 13, 2005 35 of 100 whether policy might actually need to move to a restrictive stance in order to forestall inflationary pressures. I will therefore focus my attention on the factors affecting the inflation outlook. To do that, we need to look first at the here and now and remind ourselves that recent readings on core prices have consistently come in at or below expectations. There are no signs of acceleration. In fact, core PCE [personal consumption expenditures] price inflation has slowed over the past year; the most recent reading of 1.8 percent over the past twelve months is down 0.3 from the preceding year. And the downward inflation trend has continued through this year, with core PCE inflation running at only 1.6 percent over the past six months, which is about the middle of my preferred range. Of course, even though recent core inflation data look pretty darn good, there may be forces at work that could undermine price stability. In my remaining remarks, I’d like to comment on some factors that could push inflation higher and consider their likely effects in the current situation. The first risk to price stability is that, contrary to the Greenbook forecast, growth may not actually subside toward potential. So labor and product markets could tighten further, pushing unemployment below NAIRU, which current estimates place around 5 percent. This possibility is illustrated in the stronger aggregate demand scenario in the Greenbook. That simulation shows that monetary policy would, of course, need to tighten. But the inflation consequences would be modest, given a reactive Taylor rule monetary policy response. So to deal with this risk, it seems to me that policy need not be preemptive. A sustained slowdown in productivity growth would pose a more challenging dilemma for policy and the inflation outlook. Fortunately, however, productivity growth over the past year has not slowed. Quite the contrary, it has been surprisingly robust. Output per hour in the nonfarm business December 13, 2005 36 of 100 productivity growth of around 2¾ percent. As I discussed at our meeting a year ago, I think there are compelling reasons why productivity growth may well remain elevated for some time, having to do with the gradual diffusion of new technologies and workplace practices throughout the economy. Therefore, I concur with the staff’s conclusion that the accumulated evidence indicates that structural productivity growth is around 3 percent and with the corresponding upward revision in the outlook for actual productivity. Given the sluggish adjustment of wages to changes in productivity, the stronger path of productivity reduces the rate of growth of unit labor costs, putting downward pressure on inflation. So productivity trends suggest a tempering of inflationary pressures, not an intensification. Energy prices also pose a potential threat to inflation. But as I argued a few meetings back, the empirical evidence does not support significant pass-through of energy prices into core inflation. I won’t repeat those arguments today but simply note, once again, that core PCE inflation has actually moderated, despite a nearly 30 percent increase in energy prices over the past year, on top of a 15 percent rise in the previous year. Moreover, energy prices on the whole have come down sharply of late, and, therefore, the risk of significant pass-through to core inflation has moderated as well. In addition, it appears that the Fed’s credibility has held up well this year, despite the supply shocks associated with higher energy prices and hurricanes. Survey measures of longer-run inflation expectations are about where they stood before the storms. Longer-run inflation expectations based on Treasury securities have come down about ¼ percentage point since the last FOMC meeting and are now below levels of a year ago. Finally, it’s possible that wage growth could accelerate, putting upward pressure on the growth of unit labor costs and inflation. And, indeed, the Greenbook forecast projects exactly such an acceleration, reflecting lagged pass-through of earlier increases in both energy prices and productivity December 13, 2005 37 of 100 employment cost index, will increase 4.2 percent in 2006, following a 3 percent gain this year. It projects an even larger—1.7 percentage point—acceleration in compensation per hour in the nonfarm business sector. To gauge the likelihood of such an acceleration in compensation, my staff examined the pass- through of energy prices and productivity into wages. They used forecasting models in which wage inflation is determined by lagged wage inflation, price inflation, productivity growth, and the unemployment rate. Now, it turns out that when the sample period used in the analysis includes the 1970s, our empirical work finds clear evidence of pass-through from energy prices into compensation. But when the sample begins in the 1980s, pass-through effects from energy prices to compensation are dramatically weaker or insignificant. This result is consistent with the finding I reported previously. There is no real evidence that energy prices pass through to core consumer inflation since the early 1980s. With respect to the pass-through of productivity growth into compensation, our staff finds evidence of only very gradual pass-through regardless of the sample period. Going forward, our models predict significantly less increase in compensation growth than the Greenbook over the 2006­ 2007 forecast horizon. We conclude from this empirical work that an increase in inflation due to a sharp acceleration in compensation growth is, at most, an upside risk to inflation and not the most probable outcome. I opened my remarks by noting that a key issue facing us over the next few meetings is whether policy needs to move to a restrictive stance in order to forestall inflationary pressures. While we must obviously remain vigilant and respond to developments that threaten price stability, the evidence that we have at this time, in my opinion, points to relatively low and stable inflation going December 13, 2005 38 of 100 tightening takes hold and the economy reaches a turning point. Therefore, it’s important that we keep the lags of monetary policy actions in mind in our deliberations and not go too far." CHRG-111hhrg51698--63 Mr. Gooch," They are the members, but, that you definitely require their cooperation. But you also require global cooperation, because these instruments are also traded throughout Europe. So you can't have a clearing mechanism that considers that all of the transactions are only in the U.S. Additionally, of course, there are highly illiquid instruments that just dump themselves for clearing, and that the financial system benefits from the willingness of investors to put capital at risk that provides liquid markets. I am a free marketeer myself, so I believe that it is important to have free liquid markets. If you create price controls, you create shortages. This price control, which is what it would amount to be, would be creating a shortage of credit. You know, blaming the CDS is like shooting the messenger, because the CDS were the instruments that were certainly used in the financial markets, but there was no ultimate failure in the CDS market. The CDS markets performed perfectly. What is failing is the mortgages and the lending that was done to persons that shouldn't have been borrowing. And to that extent we have a sort of global responsibility for having just enjoyed living beyond our means and having a massive global credit bubble, and that credit bubble also drove oil prices to $140. I mean, until it burst, investors overseas that would be concerning themselves with the future needs of the growing economy in countries like China, buying up oil reserves, was what partly was driving the price of oil. So it is not the credit derivatives that are at fault, it is the entire free, cheap credit in the system that was the problem. " FinancialCrisisInquiry--7 One contributing factor to the attractiveness of the housing market was public policy’s active support of the expansion of homeownership, recognizing the societal benefits. For our industry, it is important to reflect on some of the lessons learned and mistakes made over the course of the crisis. At the top of my list are the rationalizations that we made to justify that the downward pricing of risk was different. While we recognize that credit standards were loosening, we rationalized the reasons with arguments such as: the emerging markets were growing more rapidly, the risk mitigants were better, there was more than enough liquidity in the system. A systemic lack of skepticism was equally true with respect to credit ratings. Rather than undertake their own analysis, too many financial institutions relied on the rating agencies to do the central work of risk analysis. Another failure of risk management concerned the fact that risk models, particularly those predicated on historical data, were too often allowed to substitute for judgment. Next, size mattered. Whether you owned $5 billion or $50 billion of supposedly no-risk super-senior debt in a CDO, the likelihood of loss rate would appear to be the same. But the consequences of a miscalculation were obviously much bigger if you had a $50 billion exposure. Third, risk monitoring failed to capture the risk inherent in off-balance sheet activities such as structured investment vehicles, or SIVs. It seems clear now that financial institutions with large off-balance sheet exposure didn’t appreciate the full magnitude of the economic risks they were exposed to. Equally worrying, their counter parties were unaware of the full extent of those vehicles and therefore, could not accurately assess the risk of doing business. CHRG-109hhrg28024--11 Mr. Bernanke," Mr. Chairman and members of the committee, I am pleased to be here today to present the Federal Reserve's monetary policy report to the Congress. I look forward to working closely with the members of this committee on issues of monetary policy, as well as on matters regarding the other responsibilities with which the Congress has charged the Federal Reserve system. The U.S. economy performed impressively in 2005. Real gross domestic product increased a bit more than three percent, building on a sustained expansion that gained traction in the middle of 2003. Payroll employment rose two million in 2005, and the unemployment rate fell below five percent. Productivity continued to advance briskly. The economy achieved these gains despite some significant obstacles. Energy prices rose substantially yet again, in response to increasing global demand, hurricane-related disruptions to production, and concerns about the adequacy and reliability of supply. The gulf coast region suffered through severe hurricanes that inflicted a terrible loss of life, destroyed homes, personal property, businesses and infrastructure on a massive scale, and displaced more than a million people. The storms also damaged facilities and disrupted production in many industries, with substantial effects on the energy and petrochemical sectors and on the region's ports. Full recovery in the affected areas is likely to be slow. The hurricanes left an imprint on aggregate economic activity as well, seen in part in the marked deceleration of real GDP in the fourth quarter. However, the most recent evidence, including indicators of production, the flow of new orders to businesses, weekly data on initial claims for unemployment insurance, and the payroll employment and retail sales figures for January suggests that the economic expansion remains on track. Inflation pressures increased in 2005. Steeply-rising energy prices pushed up overall inflation, raised business costs, and squeezed household budgets. Nevertheless, the increase in prices for personal consumption expenditures, excluding food and energy, at just below two percent, remained moderate, and longer-term inflation expectations appeared to have been contained. With the economy expanding at a solid pace, resource utilization rising, cost pressures increasing, and short-term interest rates still relatively low, the Federal Open Market Committee over the course of 2005 continued the process of removing monetary policy accommodation, raising the Federal funds rate two percentage points in eight increments of 25 basis points each. At its meeting on January 31st of this year, the FOMC raised the Federal funds rate another one quarter percentage point, bringing its level to four and a half percent. At that meeting, monetary policymakers also discussed the economic outlook for the next 2 years. The central tendency of the forecasts of members of the Board of Governors and the presidents of Federal Reserve Banks is for real GDP to increase about three and a half percent in 2006 and three percent to three and a half percent in 2007. The civilian unemployment rate is expected to finish both 2006 and 2007 at a level of between four and three quarters percent and five percent. Inflation, as measured by the price index for personal consumption expenditures excluding food and energy, is predicted to be about two percent this year and one and three quarters percent to two percent next year. While considerable uncertainty surrounds any economic forecast extending nearly 2 years, I am comfortable with these projections. In the announcement following the January 31st meeting, the Federal Reserve pointed to risks that could add to inflation pressures. Among those risks is the possibility that to an extent greater than we now anticipate, higher energy prices may pass through into the prices of non-energy goods and services or have a persistent effect on inflation expectations. Another factor bearing on the inflation outlook is that the economy now appears to be operating at a relatively high level of resource utilization. Gauging the economy's sustainable potential is difficult, and the Federal Reserve will keep a close eye on all of the relevant evidence and be flexible in making those judgments. Nevertheless, the risk exists that with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately, in the absence of countervailing monetary policy action, to further upward pressure on inflation. In these circumstances, the FOMC judged that some further firming of monetary policy may be necessary, an assessment with which I concur. Not only the risks to the economy concern inflation. For example, a number of indicators point to a slowing in the housing market. Some cooling of the housing market is to be expected and would not be inconsistent with continued solid growth of overall economic activity. However, given the substantial gains in house prices and the high levels of home construction activity over the past several years, prices and construction could decelerate more rapidly than currently seems likely. Slower growth in home equity in turn might lead households to boost their saving and trim their spending relative to current income by more than is now anticipated. The possibility of significant further increases in energy prices represents an additional risk to the economy. Besides affecting inflation, such increases might also hurt consumer confidence and thereby reduce spending on non-energy goods and services. Although the outlook contains significant uncertainties, it is clear that substantial progress has been made in removing monetary policy accommodation. As a consequence, in coming quarters, the FOMC will have to make ongoing provisional judgments about the risks to both inflation and growth, and monetary policy actions will be increasingly dependent on incoming data. As I noted, core inflation has been moderate, despite sharp increases in energy prices. A key factor in this regard has been confidence on the part of the public and investors in the prospects for price stability. Maintaining expectations of low and stable inflation is an essential element in the Federal Reserve's effort to promote price stability. Thus far, the news has been good. Measures of longer-term inflation expectations have responded only a little to the larger fluctuations in energy prices that we have experienced, and for the most part they were low and stable last year. Inflation prospects are important, not just because price stability is in itself desirable and part of the Federal Reserve's mandate from the Congress, but also because price stability is essential for strong and stable growth of output and employment. Stable prices promote long-term economic growth by allowing households and firms to make economic decisions and undertake productive activities with fewer concerns about large or unanticipated changes in the price level and their attendant financial consequences. Experience shows that low and stable inflation and inflation expectations are also associated with greater short-term stability of output and employment, perhaps in part because they give the central bank greater latitude to counter transitory disturbances to the economy. Similarly, the attainment of the statutory goal of moderate long-term interest rates requires price stability because only then are the inflation premiums that investors demand for holding long-term instruments kept to a minimum. In sum, achieving price stability is not only important in itself; it is also central to attaining the Federal Reserve's other mandated objectives of maximum sustainable employment and moderate long-term interest rates. As always, however, translating the Federal Reserve's general economic objectives into operational decisions about the stance of monetary policy poses many challenges. Over the past few decades, policymakers have learned that no single economic or financial indicator, or even a small set of such indicators, can provide reliable guidance for the setting of monetary policy. Rather, the Federal Reserve, together with all modern central banks, has found that the successful conduct of monetary policy requires painstaking examination of a broad range of economic and financial data, careful consideration of the implications of those data for the likely path of the economy and inflation, and prudent judgment regarding the effects of alternative courses of policy action on prospects for achieving our macroeconomic objectives. In that process, economic models can provide valuable guidance to policymakers, and over the years, substantial progress has been made in developing formal models and forecasting techniques. But any model is by necessity a simplification of the real world, and sufficient data are seldom available to measure even the basic relationships with precision. Monetary policymakers must therefore strike a difficult balance, conducting rigorous analysis informed by sound, economic theory and empirical methods, while keeping an open mind about the many factors, including myriad global influences at play in a dynamic, modern economy like that of the United States. Amid significant uncertainty, we must formulate a view of the most likely course of the economy under a given policy approach, while giving due weight to the potential risks and associated costs to the economy should those judgments turn out to be wrong. During the nearly 3 years that I previously spent as a member of the Board of Governors and of the Federal Open Market Committee, the approach to policy that I just outlined was standard operating procedure under the highly successful leadership of Chairman Greenspan. As I indicated to the Congress during my confirmation hearing, my intention is to maintain continuity with this and the other practices of the Federal Reserve in the Greenspan era. I believe that with this approach, the Federal Reserve will continue to contribute to the sound performance of the U.S. economy in the years to come. Thank you, and I'd be happy to take your questions. [The prepared statement of Hon. Ben. S. Bernanke can be found on page 65 in the appendix.:] " FinancialCrisisReport--241 Risk Factors in Insurance Fees. Under a new FDIC deposit insurance pricing system that takes effect in 2011, large depository institutions with higher risk activities will be required to pay higher fees into the Deposit Insurance Fund. 948 This new assessment system is designed to “better capture risk at the time large institutions assume the risk, to better differentiate among institutions for risk and take a more forward-looking view of risk, [and] to better take into account the losses that the FDIC may incur if such an insured depository institution fails.” 949 It is the product of both past FDIC revisions and changes to the insurance fund assessment system made by the Dodd-Frank Act. 950 It is intended to impose higher assessments on large banks “with high-risk asset concentrations, less stable balance sheet liquidity, or potentially higher loss severity in the event of failure,” and impose those higher assessments when the banks “assume these risks rather than when conditions deteriorate.” 951 Under this new system, banks with higher risk activities will be assessed higher fees, not only to safeguard the insurance fund and allocate insurance costs more fairly, but also to help discourage high risk activities. Financial Stability Oversight Council. The Dodd-Frank Act has also established a new intra-governmental council, the Financial Stability Oversight Council (FSOC), to identify systemic risks and respond to emerging threats to the stability of the U.S. financial system. 952 The council is comprised of ten existing regulators in the financial services sector, including the Chairman of the Federal Reserve Board of Governors, the Chairman of the FDIC, and the Comptroller of the Currency, and is chaired by the Secretary of the Treasury. This Council is intended to ensure that U.S. financial regulators consider the safety and soundness of not only individual financial institutions, but also of U.S. financial markets and systems as a whole. (2) Recommendations To further strengthen oversight of financial institutions to reduce risk, protect U.S. financial markets and the economy, and safeguard the Deposit Insurance Fund, this Report makes the following recommendations. 1. Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC) should complete the dismantling of the Office of Thrift Supervision (OTS), despite attempts by some OTS officials to preserve the agency’s identity and influence within the OCC. 2. Strengthen Enforcement. Federal banking regulators should conduct a review of their major financial institutions to identify those with ongoing, serious deficiencies, and review their enforcement approach to those institutions to eliminate any policy of deference to bank management, inflated CAMELS ratings, or use of short term profits to excuse high risk activities. 948 See 2/7/2011 FDIC Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing, RIN 3064. 949 Id. 950 See Sections 331, 332 and 334 of the Dodd-Frank Act. 951 2/7/2011 FDIC press release, “FDIC Approves Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing,” http://www.fdic.gov/news/news/press/2011/pr11028.html. 952 See Title I, Subtitle A, of the Dodd-Frank Act establishing the Financial Stability Oversight Council, including Section 112(a) which provides its purposes and duties. 3. Strengthen CAMELS Ratings. Federal banking regulators should undertake a comprehensive review of the CAMELS ratings system to produce ratings that signal whether an institution is expected to operate in a safe and sound manner over a specified period of time, asset quality ratings that reflect embedded risks rather than short term profits, management ratings that reflect any ongoing failure to correct identified deficiencies, and composite ratings that discourage systemic risks. 4. Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council should undertake a study to identify high risk lending practices at financial institutions, and evaluate the nature and significance of the impacts that these practices may have on U.S. financial systems as a whole. FOMC20080916meeting--130 128,MS. PIANALTO.," Thank you, Mr. Chairman. The recent financial market news is shaking people's confidence dramatically. But even before recent events, the evidence was already pointing to more effects of the financial crisis on the real economy than I had built into my projection at our last meeting. The reports from my District contacts and the incoming data caused me to revise down my near-term output projection even before the latest round of financial market troubles. The improvement in net exports that was reflected in the second-quarter GDP growth has not encouraged manufacturers in my District to revise up their export projections. They are still holding firmly to the opinion that the global economy is slowing and that export growth will slow with it for several quarters. Of course, manufacturers are concerned about weakness spreading further within their domestic customer base. The ongoing turmoil in financial markets continues to affect businesses in my District. Some of the banks in my District are finding it very, very difficult to attract new capital and to manage their way out of trouble. I am hearing that credit is harder to come by for many borrowers who in the recent past would not have thought twice about their creditworthiness. Last week I met with a business contact with a very long and successful track record of buying and operating private companies. He reported that he had reached a deal with a bank to finance a project at a 7 percent interest rate with the loan amortized over a fifteen-year term. On the morning of the close just three days later, the bank faxed him the paperwork, which reflected a 12 percent interest rate on a nonamortizing loan with a 10-year term. So the deal obviously is not going forward. One of my directors, who heads a very large regional banking organization, reported at our board meeting last week that many banks are shedding assets and that in some cases they are walking away from longstanding customer relationships in order to do so. He said that investors are very skeptical about putting new equity into banking deals and that those who have done so in the past vow not to be burned twice, let alone a third time. Of course, inflation remains an important issue as well. My contacts, as Dave mentioned in his report, are not so confident that a broad array of intermediate and retail prices are actually going to move back down as a result of the recent decline in energy and other commodity prices. Several of my contacts report that major suppliers are trying to maintain their prices despite the decline in raw material costs just to make up for a long period of absorbing price increases. Nevertheless, most of my contacts agree that the commodity price environment has stabilized considerably, making me more confident that core inflation will gradually slow over the next couple of years. At our last meeting, my forecast was broadly consistent with the Greenbook baseline. Today my forecasts for output and prices are broadly similar to the Greenbook's for 2009 and 2010, although I am expecting more weakness in economic activity in the second half of this year than the Greenbook is forecasting. My contacts in the manufacturing sector have persuaded me that exports are going to be weaker in the short term than I had previously thought, and I have also revised down my consumption path on the basis of the credit constraints on households. Although I am more encouraged about the recent decline in energy and commodity prices, I would like to see further evidence of price stability in these markets and also continued stability in inflation expectations for a while longer before I reduce the upside risk that I place on my inflation outlook. However, a growing risk to my outlook is that the short-term weakness that I have now built into my outlook extends further out into the forecast period. I worry that my outlook doesn't fully capture all of the many ways in which financial forces at work in the economy are actually going to restrain spending. On Friday, I was convinced that the best course of action was to keep an even keel in these rough seas--to be flexible, of course, but to look beyond the latest wave crashing over the bow. Only six weeks ago, inflation risks were on the verge of being unacceptable, and today the troubles of Wall Street are the focus. I was sure that we were going to be in for many more surprises; I just didn't know when and from where they would be coming. So I supported not only keeping our policy unchanged but also keeping our language changes to a minimum even if that language missed some nuances of the outlook. Given the events of the weekend, I still think it is appropriate for us to keep our policy rate unchanged. I would like more time to assess how the recent events are going to affect the real economy. I have a small preference for the assessment-of-risk language under alternative A. I think it captures my concern that the downside risks have intensified. However, I can support some of the comments and changes to highlight the financial market strains that were made by President Lockhart and President Stern. So I can support the language under alternative B with some additional comments about the financial strains that we are facing. Thank you, Mr. Chairman. " CHRG-109shrg26643--30 Chairman Bernanke," Thank you. Mr. Chairman and Members of the Committee, I am pleased to be here today to present the Federal Reserve's Monetary Policy Report to the Congress. I look forward to working closely with the Members of this Committee on issues of monetary policy as well as on matters regarding the other responsibilities with which the Congress has charged the Federal Reserve System. The U.S. economy performed impressively in 2005. Real gross domestic product increased a bit more than 3 percent, building on the sustained expansion that gained traction in the middle of 2003. Payroll employment rose two million in 2005 and the unemployment rate fell below 5 percent. Productivity continued to advance briskly. The economy achieved these gains despite some significant obstacles. Energy prices rose substantially yet again in response to the increasing global demand, hurricane-related disruptions to production, and concerns about the adequacy and reliability of supply. The Gulf Coast region suffered through severe hurricanes that inflicted a terrible loss of life, destroyed homes, personal property, businesses and infrastructure on a massive scale, and displaced more than a million people. The storms also damaged facilities and disrupted production in many industries with substantial effects on the energy and petrochemical sectors and on the region's ports. Full recovery in the affected areas is likely to be slow. The hurricanes left an imprint on aggregate economic activity as well, seen in part in the marked deceleration of real GDP in the fourth quarter. However, the most recent evidence, including indicators of production, the flow of new orders to businesses, weekly data on initial claims for unemployment insurance, and the payroll employment and retail sales figures for January, suggest that the economic expansion remains on track. Inflation pressures increased in 2005. Steeply rising energy prices pushed up overall inflation, raised business costs, and squeezed household budgets. Nevertheless, the increase in prices for personal consumption expenditures excluding food and energy, at just below 2 percent, remained moderate, and longer-term inflation expectations appear to have been contained. With the economy expanding at a solid pace, resource utilization rising, cost pressures increasing, and short-term interest rates still relatively low, the Federal Open Market Committee over the course of 2005 continued the process of removing monetary policy accommodation, raising the Federal funds rate 2 percentage points in eight increments of 25 basis points each. At its meeting on January 31 of this year, the FOMC raised the Federal funds rate another one-quarter percentage point, bringing its level to 4\1/2\ percent. At that meeting, monetary policymakers also discussed the economic outlook for the next 2 years. The central tendency of the forecast of Members of the Board of Governors and the Presidents of the Federal Reserve Banks is for real GDP to increase about 3\1/2\ percent in 2006 and 3 percent to 3\1/2\ percent in 2007. The civilian unemployment rate is expected to finish both 2006 and 2007 at a level between 4\3/4\ percent and 5 percent. Inflation, as measured by the price index for personal consumption expenditures excluding food and energy, is predicted to be about 2 percent this year and 1\3/4\ percent to 2 percent next year. While considerable uncertainty surrounds any economic forecast extending nearly 2 years, I am comfortable with these projections. In the announcement following the January 31 meeting, the Federal Reserve pointed to risks that could add to inflation pressures. Among those risks is the possibility that to a greater extent than we now anticipate, higher energy prices may pass through into the prices of nonenergy goods and services or have a persistent effect on inflation expectations. Another factor bearing on the inflation outlook is that the economy appears now to be operating at a relatively high level of resource utilization. Gauging the economy's sustainable potential is difficult and the Federal Reserve will keep a close eye on all the relevant evidence and be flexible in making those judgments. Nevertheless, the risk exists that with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action--to further upward pressure on inflation. In these circumstances, the FOMC judged that some further firming of monetary policy may be necessary, an assessment with which I concur. Not all of the risks to the economy concern inflation. For example, a number of indicators point to a slowing in the housing market. Some cooling of the housing market is to be expected and would not be inconsistent with continued solid growth of overall economic activity. However, given the substantial gains in house prices, and the high levels of home construction activity over the past several years, prices and construction could decelerate more rapidly than currently seems likely. Slower growth in home equity, in turn, might lead households to boost their saving and trim their spending relative to current income by more than is now anticipated. The possibility of significant further increases in energy prices represents an additional risk to the economy. Besides affecting inflation, such increases might also hurt consumer confidence and thereby reduce spending on nonenergy goods and services. Although the outlook contains significant uncertainties, it is clear substantial progress has been made in removing monetary policy accommodation. As a consequence, in coming quarters, the FOMC will have to make ongoing, provisional judgments about the risks to both inflation and growth, and monetary actions will be increasingly dependent on incoming data. As I noted, core inflation has been moderate despite sharp increases in energy prices. A key factor in this regard has been confidence on the part of public and investors in the prospects for price stability. Maintaining expectations of low and stable inflation is an essential element in the Federal Reserve's effort to promote price stability, and thus far the news has been good. Measures of longer-term inflation expectations have responded only a little to larger fluctuations in energy prices that we have experienced, and for the most part they were low and stable last year. Inflation prospects are important, not just because price stability is in itself desirable and part of the Federal Reserve's mandate from the Congress, but also because price stability is essential for strong and stable growth of output and employment. Stable prices promote long-term economic growth by allowing households and firms to make economic decisions and undertake productive activities with fewer concerns about large or unanticipated changes in the price level and their attendant financial consequences. Experience shows that low and stable inflation and inflation expectations are also associated with greater short-term stability and output and employment, perhaps in part because they give the central bank greater latitude to counter transitory disturbances to the economy. Similarly, the attainment of the statutory goal of moderate long-term interest rates requires price stability, because only then are the inflation premiums that investors demand for holding long-term instruments kept to a minimum. In sum, achieving price stability is not only important in itself; but it is also central to attaining the Federal Reserve's other mandated objectives of maximum sustainable employment and moderate long-term interest rates. As always, however, translating the Federal Reserve's general economic objectives into operational decisions about the stance of monetary policy poses many challenges. Over the past few decades, policymakers have learned that no single economic or financial indicator or even a small set of such indicators can provide reliable guidance for the setting of monetary policy. Rather, the Federal Reserve, together with all modern central banks, has found that the successful conduct of monetary policy requires painstaking examination of a broad range of economic and financial data, careful consideration of the implications of those data for the likely path of the economy and inflation, and prudent judgment regarding the effects of alternative courses of policy action on the prospects for achieving our macroeconomic objectives. In that process, economic models can provide valuable guidance to policymakers and over the years substantial progress has been made in developing formal models and forecasting techniques. But any model is by necessity a simplification of the real world and sufficient data are seldom available to measure even the basic relationships with precision. Monetary policymakers must therefore strike a difficult balance, conducting rigorous analysis informed by sound economic theory and empirical methods while keeping an open mind about the many factors including myriad global influences at play in a dynamic modern economy like that of the United States. Amid significant uncertainty, we must formulate a view of the most likely course of the economy under a given policy approach while giving due weight the potential risks and associated costs to the economy should those judgments turn out to be wrong. During the 3 years that I previously spent as a Member of the Board of Governors of the Federal Open Market Committee, the approach to policy that I have just outlined was standard operating procedure under the highly successful leadership of Chairman Greenspan. As I indicated to the Congress during my confirmation hearing, my intention is to maintain continuity with this and the other practices of the Federal Reserve in the Greenspan era. I believe that with this approach, the Federal Reserve will continue to contribute to the sound performance of the U.S. economy in the years to come. Thank you, Mr. Chairman. " CHRG-111hhrg52397--230 Mr. Duffy," Thank you, Chairman Kanjorski, for this opportunity to present our views on effective regulation of the OTC derivatives market. Treasury Secretary Geithner's May 9, 2009, letter to Senator Harry Reid outlined the Administration's plan for regulatory reform of the financial services sector. His plan proposed increased regulation of credit default swaps and other OTC derivatives. This committee posed seven questions for our consideration this morning. We agree with many of Secretary Geithner's proposals. For example, we support position reporting for OTC derivatives and agree that enhanced price transparency across the entire market is essential to quantify and control risk. We believe, however, that the measure chosen to achieve these ends should be fine-tuned to avoid adverse consequences for U.S. markets. We are concerned that legislation mandating the clearing of all OTC transactions could well induce certain market participants to transfer this business offshore, resulting in significant loss of U.S. futures business. By reducing liquidity on U.S. exchanges, this would undermine the Congress' attempt to establish greater transparency, price discovery, and risk management of U.S. markets. We applaud the Administration's efforts to enhance transparency, stability, integrity, efficiency, and fairness in all markets, but we believe that with slight modifications to the proposal outlined by Secretary Geithner, and the inclusion of a few additional measures would complement the Administration's efforts. We have responded to your specific questions at length in our written testimony. Let me offer a brief summary of our responses: First, we agree with the informed consensus that the financial crisis was attributable in part to the lack of regulation in the over-the-counter market, which was not subject to appropriate disclosure and risk management techniques. Second, clearing should be offered to the OTC market in a form that makes a compelling alternative to the current model. Central counterparty clearing offers a well-tested method to monitor and collateralize risk on a current basis, reducing systemic risk and enhancing fairness for all participants. Third, we are not in favor of government-mandated clearing even though we are strong proponents of the benefits of central counterparty clearing. Central counterparty clearing serves as an effective means to collect and provide timely information to regulators. It also reduces systemic risk imposed on the financial system by unregulated, bilateral OTC transactions. Nevertheless, rather than compel clearing of all OTC transactions, we believe appropriate incentives should be put in place. The incentives could be in the form of reporting and capital charges for uncleared OTC positions and reduce capital charges for cleared OTC positions. We believe they would contribute both to the transparency and the reduction of systemic risks. Fourth, obviously, we are strong proponents of the benefits of exchange trading of derivatives, but we are also realists on the issue of whether exchanges can generate sufficient liquidity to make exchange trading efficient and economical for our customers. We are concerned that government-mandated exchange trading will be a massive waste of resources and capital. Fifth, in our view, electronic trading offers many benefits. It levels the playing field. It enhances price transparency and liquidity. It speeds execution and strengthens processing and eliminates any classes of errors of unmatched trades. Overall, it is an enormous benefit to the market and to our customers. Electronic trading when coupled with our intelligent audit and compliance programs allows us to better monitor our markets for fraud and manipulation. It also gives us the tools to effectively prosecute anyone foolish enough to engage in misconduct in a forum with a perfect audit trail and a highly skilled enforcement staff. Sixth, we believe that there is an appropriate balance between price discovery and liquidity that is effectively controlled by the current procedures to police excessive speculation. Regulated future markets and the CFTC have the means and the will to limit speculation that distorts prices or the movement of commodities in interstate commerce. Seventh, we operate trading systems in a clearinghouse in which every bid and offer, as well as every completed transaction, is instantaneously documented. In addition, those records are preserved for an extended period of time. We hope that our views on regulating the OTC market will be given significant weight based on our record and experience, and I look forward to answering your questions. Thank you, sir. [The prepared statement of Mr. Duffy can be found on page 132 of the appendix.] " FOMC20080625meeting--67 65,MR. HOENIG.," Mr. Chairman, I will begin my remarks this afternoon with a brief update on the conditions in our District. Overall, District economic activity continues to expand moderately, with strengthened energy, agriculture, and export manufacturing more than offsetting the softness in our housing, retail sales, and other types of manufacturing activity. District labor markets continue to perform reasonably well. While job growth has slowed over the past few months, unemployment remains very low, and many sectors continue to have difficulty finding workers, especially skilled ones. Evidence on wage pressures is mixed. Although wage pressures have moderated somewhat in our Beige Book survey, some recent labor union contracts have built in rising profiles for hourly wage increases over the term of the contract. Rising energy and commodity input prices are continuing to negatively affect our District economic activity. Reports from businesses suggest that higher energy and food prices are being quickly passed on to the customer now. However, businesses are having mixed success in passing on other cost increases, resulting in some severe erosion in margins and profitability in some of the firms. To illustrate some of the cost�price dynamics, I would like to take just a minute and relate the recent experience of one of our Branch directors, who operates a multi-line manufacturing firm. I mention this because I am hearing it more and more. In addition to rising fuel prices, his business has seen a doubling in steel costs since January, with July quotes on steel tubing up an additional 25 percent. In response, his company recently announced a price increase of 16 to 18 percent across a range of products. Competitors immediately matched or exceeded his price increases. Notably, he made these price increases despite a decline in new orders in May. He also noted that import prices from China that he has seen have risen 28 percent this year and that ocean freight prices have risen about 20 percent. As a result, customers who previously bought Chinese products are now purchasing U.S.-manufactured goods. It is interesting--I talked with some of the folks at Union Pacific, and their shipments into the Midwest have dropped slightly, but their shipments out have increased about 3 to 4 percent. So that is what is going on in the region. More broadly, turning to the national economy, I have revised up my growth estimate for the first half of 2008, but it has made little change in my longer-run outlook. Compared with the Greenbook, I see somewhat stronger growth in the second half of this year and somewhat weaker growth next year and in 2010. Most of the difference from the Greenbook in 2009 and 2010 comes from the policy path assumptions. I assume that policy accommodation is removed at a more rapid pace than does the Greenbook. Recent economic data suggest that, although downside risks to growth remain, they have diminished. I continue to judge that the potential spillover effects from the financial distress have understandably been overestimated in this Committee's recent decisions and in Greenbook forecasts in recent months. In my view, the greater risks to the outlook come from rising energy and commodity prices and less from the financial distress as we go forward. In my view, current policy accommodation is greater than needed to address these risks. As I indicated at the last meeting, I believe that the upside risks to inflation have increased considerably over the past several months. Like the Greenbook, I expect both overall and core PCE inflation to move higher in the second half of this year. If this happens and we maintain the current level of the funds rate, I believe we are likely to see further erosion in inflation expectations, which will undermine our credibility with financial markets and the public. In this event, I judge we will greatly increase the likelihood that we will need to raise rates more aggressively, taking rates above neutral, in order to achieve our longer-run inflation objectives; and that is of significant concern to me, Mr. Chairman. Turning to the issue of long-term projections, let me comment that I have felt somewhat constrained by the current three-year horizon for our quarterly projections. Of the options presented by the subcommittee, I am most comfortable with providing estimates of the values for total inflation, output growth, and unemployment at which the economy is likely to converge. I am not sure, however, how we want to label these estimates, if they are included in the table. I understand that putting these estimates out might be interpreted as a move closer to inflation targeting, but I think that this is a bridge we are ready to cross since we adopted the enhanced projections process. The other options seem less desirable. Given the resources required, by my staff at least, I doubt that we could provide a meaningful forecast at a four-year or five-year horizon, and I am not sure how projections for average values over a period of five to ten years ahead would be interpreted by the public. In my view, appropriate policy should be expected to return the economy to its long-run equilibrium over a three-to-five-year period, with the length of the period depending on the nature of the shock. Setting out a five-to-ten-year horizon could be construed as a weakening in our commitment to achieve our mandate in a timely manner. Thank you. " CHRG-111hhrg53234--15 Mr. Kohn," I think there are minimal possibilities. I think some people have asked whether, if we see a systemic risk from the individual institution, that would affect our monetary policy deliberations. But in my view, I think there really is a congruence between the stability of the financial system and monetary policy. We can achieve our objectives of maximum employment and stable prices much more readily in a stable financial system. So I just don't see important instances in which there would be conflicts. " FOMC20070918meeting--167 165,MS. DANKER.," I’ll be reading the directive from page 35 of the Bluebook, and the assessment of risks from the table distributed today. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with reducing the federal funds rate to an average of around 4¾ percent.” Then: “Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”" FOMC20070807meeting--98 96,MR. KOHN.," Thank you, Mr. Chairman. Building on what the Vice Chairman just said, I have been listening in on that Morning Call. I’ve found it very useful, and it’s certainly an opportunity to ask questions if you have them. My forecast for the most likely outcome for output over the next few years is close to that of the staff—growth a little below potential for a few quarters, held down by the housing correction, and the unemployment rate rising a little further. Although some recent data for housing, consumption, and capital spending have been a bit to the soft side, we need to view those data against the background of a lower path for potential GDP and recall the tendency we’ve seen over the past several quarters for short runs of data that are a little hotter or a little cooler than we expected. I think this is sort of what it feels like when the economy is running at about 2 percent. I see a number of reasons to think that moderate growth remains the most likely outcome going forward. First, as President Stern has stressed from time to time, is the natural resilience of the economy, its tendency to grow near potential unless something is pushing it one way or another. If anything, this resilience has probably increased over the past couple of decades, reflecting more- flexible labor and product markets. Second, global growth remains strong, supporting the growth of exports. I don’t think this growth should be undermined by the fact that some unknown quantity of losses in the U.S. mortgage market is being absorbed by investors overseas, and the recent declines in the dollar will reinforce the effects of good foreign demand for U.S. goods and services. Third, the most likely factor to throw the economy off its potential is the financial markets. My most likely forecast assumed that the credit markets would begin to settle down over coming weeks with some, but limited, net tightening of conditions. I’ll return to the subject in a bit, but my outlook in this regard does rest fundamentally on the very strong financial condition of the nonfinancial business sector and commercial banks and my expectation that most households accounting for the vast bulk of consumer spending will not find credit availability newly constrained. Finally, a resumption of growth in consumption should be supported by moderate growth in jobs and household income as the rebound in productivity is limited by the slower path for trend productivity and as income shares shift a little toward labor. I also assumed that households would not face a repeat of the rise in gasoline prices that has taken something out of recent consumption demand. Then moderate growth in consumption along with good export markets should, in turn, support business investment spending. I expect this path for output to be associated with core inflation remaining in the neighborhood of 2 percent. If energy prices follow the path in futures markets, total inflation would come down to 2 percent as well. Basically I don’t see anything in my central tendency forecast for the economy that would push inflation very much one way or another. The economy produces around its long-run potential. My NAIRU was 4¾ percent. Inflation expectations as best we can judge are anchored at something like 2 percent PCE inflation. I’m encouraged that the most recent data on prices have tended to confirm that core inflation remains fairly low. Most measures of compensation also do not show a marked acceleration that might be associated with producing appreciably beyond the economy’s sustainable level of production. Risks around my inflation forecast remain to the upside, provided that output follows my most likely path. Utilization is tight. The recent run-up in energy prices could still feed through to expectations. The damped increase in productivity growth implies greater pressure on business costs and margins. Historically, nominal wages have tended to respond more sluggishly to changes in trend productivity than do prices, and this could be especially the circumstance when workers have seen real incomes held down by higher energy prices and business profit margins have been high. At the same time, like many around this table, I think that the downside risks around the forecast of moderate growth and production going forward have increased. For some time I thought that the risk of a shortfall from our central tendency outweighed the risk of an overshoot, mainly centered on housing and consumption. But the financial developments of the last intermeeting period have appreciably increased those risks. As many have remarked, and Bill said so nicely, problems have spread from the subprime sector to a good part of the mortgage market more generally, including a severe restriction on securitization of nonconforming mortgages. Some business credit has been affected. Spread are widening across a broad array of instruments and ratings. This has occurred in an atmosphere of greatly increased volatility and uncertainty, partly related to the questions about the pricing of complex structured credits that weren’t well understood and compounded by a loss of confidence in the rating agencies. The uncertainty is also a reflection of the perception that activity and prices in the housing market have not yet shown any signs of beginning to stabilize. I agree that we need to keep our focus on the effects of these developments and the financial markets on the economy, not on the distribution of wealth in the financial sector. The relationship of financial markets to real activity is multifaceted, not easily modeled with interest rates and stock prices, especially when markets are reconsidering risk. Tightening nonprice terms of lending, the reduced availability of credit, and simply the pervasive sense of uncertainty about the price of assets and cash flows can also affect spending. In such an environment, it wouldn’t be surprising if businesses and households postponed capital investments. I agree that this reassessment is a fundamentally healthy but somewhat messy correction to more-sustainable term and risk premiums. The most likely outcome is that it will be limited in duration and effect, and that’s what I assume for my forecast. Well-capitalized banks and opportunistic investors will come in and fill the gap, restoring credit flows to nonfinancial businesses and to the vast majority of households that can service their debts. In the end, credit conditions will be tighter than they were a little while ago, for the most part justifiably so, and the effect on output will probably not be very large. To be sure, the latest episode comes on top of a rise in term premiums over the May to June intermeeting period. As a consequence, financial conditions have tightened noticeably in the past few months, even abstracting from market disruptions of the last week. The federal funds rate has been as high as it has been in part to offset the accommodative effects of low volatility and tight term and credit premiums. I think that, even in the relatively benign adjustment scenario, we’ll need to look at whether that rate is still sufficiently supportive of economic activity. But in the circumstances—that is, the benign adjustment—that reassessment can await further information about aggregate demand and further assurance that inflation will remain low. I assumed an easing of policy in 2008 and 2009 in my projections to take account of this. But we can’t know how the market situation will evolve. I also believe that there’s a non-negligible chance of a prolonged and very messy adjustment period that would feed back substantially on confidence, wealth, and spending. With the rating agencies discredited and markets vulnerable to adverse news on the economy, the period of unusual uncertainty could be prolonged. The greatest risk is in the household sector, where uncertainty about valuations of mortgages could continue to feed back on credit availability, housing demand, and prices in a self-reinforcing cycle. Moreover, as lenders and borrowers revise assumptions about house prices even further, credit from home equity lines of credit and mortgage refinancings will become even less available and more expensive, putting to the test the hypothesis that I have been working under—that the feedback from housing on consumption can be approximated by a wealth effect, not something more serious working through housing equity withdrawal. As I noted, I don’t think this is the most likely outcome, but this tail of distribution is a lot fatter than it was only a month or so ago. Thank you, Mr. Chairman." FOMC20050920meeting--98 96,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. The balance of evidence since our last meeting still supports, in our view, a reasonably positive outlook for output and inflation. If we look through, as we should, the transitory effects of Katrina and the reconstruction, and if we factor in what the futures market tells us about the expected magnitude and duration of the rise in energy prices, we still see an economy growing slightly above trend with core inflation following a path somewhat, but not substantially, above our preferred range. The fundamentals still seem favorable to continued expansion with solid productivity growth, strong corporate balance sheets, reasonable growth in household income, and favorable financial conditions. And on the strength of this view, with real interest rates still quite low, we believe that we need to continue to tighten monetary policy at this meeting and beyond. At the September 20, 2005 73 of 117 Now, of course, the degree and balance of uncertainty has changed. We face a higher degree of overall uncertainty. It will be harder to assess over the next few quarters the underlying pace of demand growth. The rise of energy prices pre-Katrina—some of which remains even as the initial effects of the hurricane on expectations have washed out of energy markets, except for natural gas—creates some risk of a larger shock to confidence and behavior than seems to have been evident over the last two years. Damage from future hurricanes to energy and product output may prove harder to bridge through the release of international product reserves. Our capacity to discern the underlying rate of inflation is also somewhat diminished, perhaps less because of the effect of energy prices than the difficulty of sorting out what is actually happening to productivity growth and unit labor costs. Apart from reducing overall confidence around the forecasts, the balance of risks has probably shifted, too—shifted toward a somewhat higher probability of slower growth relative to the path of potential output and toward a greater risk of a larger and more persistent rise in core inflation. If the former risk materialized, the latter might be mitigated. These are risks across the spectrum of scenarios, rather than the most probable combination. But to acknowledge the change in uncertainty is not to suggest that it would be appropriate for us to stop or to push down the expected path of the nominal fed funds rate until we can better assess what we do not know now. The net effect of the changes to the outlook, on balance, probably does not alter the desirable path of the nominal fed funds rate relative to what we thought in mid-August. With the real rate still rather low, my inclination would be to continue to weight the upside risk to inflation as greater than the prospective risk of a significant September 20, 2005 74 of 117 growth is still only prospective. This implies that the slope of the expected fed funds rate should remain materially positive, even if we move today. And I think we would be better off after this meeting if the markets raised the expected path a bit than if the path were to fall from its pre- meeting trajectory. I think we probably know a little less today than we did in August about how far we are going to have to move, even if the economy appears to be following the path of our forecast. If we move today, all we know is that we’re 25 basis points higher than we were. The fact that we are that much closer to some point we can’t measure is a less valuable observation. We may even know less today about where equilibrium lies and whether that range has moved. And, of course, we still face some probability that we’ll have to move past it, or past what in retrospect we thought was equilibrium. Most of the hard questions we face look pretty much like they did at the last meeting. How strong and durable can we expect the expansion to be in the face of less optimism about future housing price gains or other factors that could cause household saving to rise and consumption to grow more slowly? Will this dramatic rise in energy prices over the past two years cause more substantial damage to business and consumer confidence? Will the world’s private savers continue to be willing to acquire claims on the United States at the higher rate implied by our current account forecast, and to do so on such favorable terms? Will business margins start to erode in a way that will portend slower investment and employment growth? Will the U.S. political system be able to make a credible effort in the near term to improve our medium-term fiscal position and sustain our relatively open trade policy? And, if not, do we risk September 20, 2005 75 of 117 These are all factors that could hurt future growth, but that doesn’t mean that monetary policy should be more accommodative than would otherwise make sense in anticipation of those negative effects or should try to preempt them. Rather, these familiar imbalances and concerns make the cost of any erosion in our credibility greater. Thank you." FinancialCrisisInquiry--21 We have seen, in our view, four crises unfold: a mortgage crisis, a capital markets crisis, a global credit crisis, and a severe global recession. The mortgage crisis originated with the dramatic expansion in the availability of mortgage credit through subprime lending and aggressive mortgage terms even in prime products. This led to a greater debt burden for consumers. Lenders, prompted by lower interest rates, rapidly rising home prices, and large amounts of capital available, made credit available to borrowers who could not previously qualify for a mortgage or extended more credit to a borrower who could or perhaps should—would not be able to handle. The national policy to expand American homeownership was also popular and created tailwinds. No one involved in the housing system—lenders, rating agencies, investors, insurers, consumers, regulators, and policy makers, foresaw a dramatic and rapid depreciation of home prices. When the nation did experience this rapid depreciation in home prices, the first that had been experienced since the Great Depression, many of these loans became very unfavorable and the option of refinancing disappeared leading to defaults. The second crisis came in investment banks in the capital markets area. Investment banks not only had underwritten mortgages, but they had retained significant amounts of the risk by holding interest and providing backup liquidity for mortgage-related securities they had sold. Investment banks created products based on these mortgage assets. The risk of these assets spread. This happened when a monoline insurer guaranteed the mortgages or a structured investment vehicle brought the mortgage securities and having the money- market funds to purchase that commercial paper from those vehicles. Third, the stress of the financial crisis began to spread beyond the investment banks and mortgages to other fixed income products and to more market participants. This destabilized the financial institutions and non-financial institutions that had little to do with the U.S. or the mortgage market. This contagion was, in fact, global. Without government intervention to restore liquidity to capital markets, the risk of global economic collapse was very real. CHRG-111hhrg51698--490 Mr. Concannon," Absolutely. Today the OTC derivatives market is a phone-based market. The only difference of NASDAQ when it was formed and the equities market at the time was that it had centralized clearing. It allowed us to form a market around this centralized clearing and bring pricing transparency to an otherwise inefficient market. OTC derivatives today, given the bilateral nature of the product, the product is actually priced based on your creditworthiness. That doesn't exist in things that are centrally cleared. We standardize creditworthiness through a clearinghouse and a system of margin, standardized margin, and collateral collection. So, just like any equity owner can buy a share of Microsoft and they are not judged on their status and their financial well-being, they don't pay a different price. And that can be delivered in the over-the-counter derivatives market. I think it is important, though, that we take steps. Clearing first is an important concept here because of the nature of the market today. It is a highly complex market. And it can continue to be a phone-based market, but we can eliminate a lot of the counterparty risk by just introducing mandated clearing. " FOMC20050322meeting--95 93,MR. MOSKOW.," Thank you, Mr. Chairman. Activity continues to firm in the Seventh District. In general, my contacts are more upbeat than they were a couple of months ago, and there is much more confidence that the expansion is on a solid, self-sustaining footing. And we’re hearing more news about price increases and price pressures. Nevertheless, activity has not yet heated up to the point that there is broad-based pressure on capacity. The positive news is fairly widespread. Demand continues to be robust for heavy trucks and for equipment used in construction, agriculture, and oil and gas industries. Our contacts in retail trade, including shopping mall operators, and in consumer advertising also tell us that business is good The news on hiring, however, is more subdued. Notably, the two major temporary-help firms headquartered in our District reported that their growth has slowed since our last meeting. Also, there is an important downside risk for our District’s economy: The well-publicized woes of General Motors and Ford could develop into an even larger drag than we have seen to date. It’s not clear how the auto market will evolve in 2005. Year-to-date sales have been weak, as automakers appear to be testing the market with lower incentives. Still, the Big Three have not yet backed off their earlier projections that light vehicle sales will run about 16¾ million units this year. They are hoping that sales will increase as the year proceeds, similar to the pattern in 2004 after they raised incentives. But based on our conversations, it is unclear whether the automakers will be willing to March 22, 2005 26 of 116 Given the increasing momentum in the District economy, we took a hard look at resource constraints and price pressures. Heavy vehicle production continues to be constrained by shortages of engines, axles, and especially tires. And Caterpillar expects production to be straining capacity at least through 2005. On the price front, the environment has clearly changed. For example, the head of a large bank told me that, for the first time in many years, suppliers are telling customers to buy now or pay higher prices in 30 days. Manufacturers’ long-term contracts for materials are running out, and several report paying premiums in order to ensure supply and keep production running at full tilt. As more of these long-term contracts expire, cost pressures and pass-through could intensify. Even auto suppliers are digging in their heels and resisting further price reductions. In contrast, the steel price picture looks better, as you mentioned earlier. As one contact noted, this is perhaps due in part to increased production in China. Also, on the international scene, a major retailer told us that his European suppliers recently boosted prices between 8 and 12 percent after holding the line last year. In response, the retailer shifted some business to suppliers in the Far East. Turning to the national economy, it’s clear that growth is on firm, self-sustaining ground. So our focus should shift more to assessing inflationary pressures, and there are indications that inflation risks may have increased. Recent price data and, as I just mentioned, comments from our business contacts, do have a firmer tone. Oil prices continue to surprise us on the upside, the declining dollar is showing through to higher import prices, TIPS measures of inflation compensation have moved up, and resource slack could be smaller than we thought. In particular, work done by our Bank’s economists—and by the Board staff, as Dave discussed—suggests that March 22, 2005 27 of 116 These developments have increased our inflation forecast, but quantifying the extent of the inflation risk is difficult. When we run our models using data back to the 1960s, the models forecast higher PCE inflation—nearly 2 percent this year and next year. But the economy has changed a lot, particularly starting in the early 1980s. When we limit the data to the last 20 years, the uptick is diminished. Furthermore, I do not get the impression that a 1970s-type inflationary mentality is creeping into my contacts’ decisionmaking processes. So, on balance, taking everything into consideration, I think we can continue our pattern of measured rate increases, and I don’t think we need major changes in the wording of our statement at this meeting. Futures markets expect us to move the funds rate to 3¾ percent by year-end. But if a more aggressive tightening is warranted, we could easily get to 4¼ percent just by increasing the funds rate 25 basis points at each meeting. This would be perfectly consistent with our “measured pace” language. But we may need to move more aggressively after this meeting; some warning clouds have clearly developed. We often say we need to be data-dependent. I think it’s particularly important now. We’ll get two months of price data before our May meeting and, of course, a lot of other data. And we’ll want to look carefully at those data in assessing our next steps." FOMC20050322meeting--164 162,VICE CHAIRMAN GEITHNER.," I think there’s a disadvantage in validating the market’s current expectations so explicitly. There are two ways to think about framing our policy assumption or giving a signal. One is to say, “with policy unchanged, et cetera.” The other is to say, “taking the expected path now priced in the markets, we think X.” That’s an approach a number of central banks have taken. To me it doesn’t make sense to make that significant a change in our basic signal at this time; I think there’s a lot of risk in a validation that explicit. In my view, there’s actually a lot of virtue in the combination of these changes to the statement, because they condition and qualify “measured” without taking that word out. So it’s a move in the direction of giving us more flexibility without claiming we think there’s been any abrupt change in the balance of risks. As Vincent said, we can fall back on making explicit what has been implicit—which is that the risks have been balanced only if we commit to do the right thing. If you don’t believe we’re going to do the right thing, …" FOMC20080916meeting--151 149,MR. KOHN.," Thank you, Mr. Chairman. I think that, even before the recent intensification of financial market turmoil, there were trends becoming increasingly evident over the summer, since late June, that suggested that the economy was on a substantially slower path than it had been before. Resource utilization was falling appreciably, and the expected downward path of inflation in the future had much better odds of occurring. Indeed, I think that the expected weakness in the economy and the financial markets are interacting. We have one of these feedback loops in play. There has been a lot of concern not only in the United States but in other countries as well, as I heard in Basel last weekend, about a spillover--that the problems were not confined to the mortgage markets but were spilling into the loan books of the banks. That was related to the weakening in economic activity and was tightening up credit conditions, which would, in turn, further weaken economic activity. So this feedback loop was at work certainly in the United States and was beginning to be felt a little more in other countries as well. Since late June we have come to know a couple of things a little better. One is that consumption is not immune to soft labor markets, increases in energy prices, declining housing wealth, and tighter borrowing conditions. Even if we can't parse out the effects of each of these factors, consumption has weakened substantially. We have had three months in a row of declines in the retail control component and very weak auto sales. Although recent declines in oil prices will support disposable incomes and consumption, I think the other sources of restraint on households-- declining house prices and tighter credit conditions--are more likely to intensify than to abate in coming quarters. Another thing we know is that businesses have not gotten ahead of their need to shed labor, and they continue to trim staff in response to actual and expected weakness in demand. The decline in employment shows no signs of abating. Initial claims are running more than 50,000 higher than they were at the end of June, and they have remained elevated past the time that the introduction of the temporary extended benefits should have been felt. The unemployment rate is already � percentage point higher than anyone around this table predicted for the end of the year. The household survey, along with national income statistics, could be signaling greater softness in activity and higher output gaps than is evident in the GDP and spending data. Another thing we have learned, as Nathan emphasized, is that foreign economies have not decoupled from the United States, and their prospects have been revised down substantially. They're absorbing the effects of weaker U.S. domestic demand on their exports, and growing risk aversion in financial markets is spreading abroad. The latter, the growing risk aversion, is beginning to have, as Chris Cumming was noting, effects on a number of emerging-market economies, where capital inflows show signs of abating or even reversing; and indicators of financial stress have risen as a consequence of all this. Because of the stronger dollar, we will be able to rely less on exports going forward than we did before. We never expected a rapid return to more normal financial market functioning, but the adjustment in the financial sector now looks to be more severe and to take longer than we thought before. Financial firms need to bolster profits to offset losses and track capital. They need to delever by reducing debt relative to equity. They need to consolidate, and above all, they need to protect themselves against the possibility of a run. All of this implies a prolonged period of very cautious lending and a high cost of capital for borrowers relative to benchmark interest rates. If the current severe financial situation persists, I think the flight to safety and liquidity could dry up credit to a broad array of all but the very safest borrowers and reduce asset prices with feedbacks on spending, and that feedback loop could intensify if these market conditions pertain. I think that's a substantial downside risk to the growth outlook. Not all news affecting spending has been negative. Capital goods orders have held up. The decline in interest rates and commodity prices that respond to the markdown in global growth will help support domestic demand, and actions to stabilize the GSEs are helping the mortgage market. Activity is more likely to stagnate than to decline. But I think that we can be more certain than we were, say, at the end of June that the economy will move substantially away from our high employment objective over the next several quarters and that the downside risks to that are larger. On the inflation side, incoming data have been disappointing, a little worse than anticipated, perhaps suggesting greater pass-through. The rise in import prices at the beginning of the third quarter was higher than anticipated. But we've also learned over the last couple of months that oil and other commodity prices can go down as well as up. The drop in retail energy prices helped to reverse much of the run-up in inflation expectations at the household level and reduced inflation compensation in financial markets at least over the next five years. Weaker economies, along with lower commodity prices, are expected to reduce inflation in our trading partners, and that along with the dollar should lower import price inflation. The broadest measures of labor compensation available through the second quarter continue to suggest no upward pressure on the pace of increases in nominal labor costs. Despite elevated headline inflation, surprisingly good growth of productivity is holding down unit labor costs. Taking all of this together, I think that, despite the incoming inflation data, we can have greater confidence in our forecast that inflation will decline late this year and run much lower in the next few years than in the past year or so, though the risks to that still lie on the upside until we actually see the decline in headline inflation persist. On policy, Mr. Chairman, I support alternative B, keeping the funds rate at 2 percent. I think that, at least for now, is consistent with lower inflation and a slow return to full employment in the future over time. We need to assess the effects of the financial turmoil. If asset price declines accelerate and the tightening of financial conditions is large and likely to be sustained, I would be open at some point in the future to a lowering of interest rates. Thank you, Mr. Chairman. " FOMC20060808meeting--70 68,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Growth has moderated, but the economy still seems, to us at least, likely to grow at a reasonably good pace over the forecast period, somewhere in the vicinity of 3 percent. We expect core inflation to moderate gradually from current levels, declining to around 2 percent in ’07. This forecast assumes that monetary policy follows a path fairly close to what’s in the market and in the Greenbook. The key difference between our view of the outlook and that of the Greenbook forecast is in the strength of demand growth relative to potential next year. We have reduced a bit our estimate of potential and also of actual growth, but we still expect the economy to expand at a rate close to potential. This is a very favorable forecast, and we have to recognize, of course, that the economy is going through a set of extremely complicated transitions, including a large, adverse, sustained relative price shock of uncertain duration and a substantial adjustment in asset prices that is now concentrated in housing. Our capacity to anticipate the evolution of these forces and to assess their effect on growth and inflation is, of course, very limited. The forces that now appear to be working on the economy still present the unpleasant combination of upside risk to inflation and downside risk to growth; but for the moment we believe that the former, the possibility that our forecast is too optimistic on inflation, remains the predominant risk. I have a few points on the growth outlook. The economy has clearly slowed, and the composition of growth within the United States and here relative to the rest of the world has changed. These changes were inevitable, and if they continue to occur smoothly, they seem desirable and necessary. As a share of aggregate demand within the United States, residential investment had to contract and consumption had to slow. And U.S. domestic demand had to slow relative to domestic demand growth in the rest of the world. The key issue we face is judging whether we have significantly more weakness ahead of us than we are now expecting. In our view, most signs at present point to fundamentally healthy economic conditions. The survey-based measures of confidence are holding up okay. Real household income growth seems likely to be good going forward. Businesses have the resources and the motivation to sustain fairly strong rates of investment growth. Structural productivity growth, even post- revision, still seems strong. Inventory levels remain relatively thin, and the tentativeness that characterized much of the expansion in terms of investment and hiring should be a source of some comfort. Global demand is still quite strong, of course, and together these forces will offset part, but not all, of the weakness coming from the adjustment in housing and consumption growth. The principal risk to this outlook for growth lies in the possibility that households will slow consumption more sharply because of rising energy costs, higher interest rates, greater pessimism about future income gains, or the effect of the housing adjustment on perceived wealth. Financial markets are showing a little more concern about future growth, but not a lot. This concern is most evident in the greater inversion in the yield curve that has emerged at the one-year to two-year horizon. I think you can see in the market some moderation of exuberance in credit markets, but just a little. Overall, the markets seem to reflect a reasonably favorable view of future growth prospects. On the inflation side, as I said, we expect core inflation to moderate, not quickly and not dramatically but by enough and soon enough to bring core PCE inflation down to just below 2 percent over the next 18 months. The issue we face is not so much about the acceleration in core inflation that occurred in late 2003 and 2004. After that acceleration, core inflation was sort of trendless, in the vicinity of 2 percent for much of the two-year period, until the past six months, when we saw this uptick. The real problem we face is assessing the extent to which the very recent acceleration in core inflation reflects transitory factors, such as the indirect effects of energy prices, and the extent to which it may reflect pressures from higher resource utilization and other things less benign and less transitory. Energy pass-through, of course, seems part of it, but probably not all of it. Shelter doesn’t account for all of it either. This judgment is critical for us, and we need to be careful that we’re not assuming away the more uncomfortable explanation, such as a broader inflationary impulse or a rise in pricing power that could reflect increasing acceptance of higher inflation. How confident can we be that the pressures that have induced this rise in core inflation will moderate sufficiently to bring down the rate of increase in core PCE prices to the vicinity of 2 percent or below? Reasonably confident, I think. With the economy growing at or slightly below trend, with growth of unit labor costs peaking and decelerating a bit as the Greenbook forecast anticipates, with inflation expectations moderating at short horizons and pretty stable at longer-run horizons, with energy prices flattening out, and with the dollar falling only a little, this forecast seems reasonable. But note the number of assumptions and conditions this forecast depends on. Also, the expected path for inflation implies only a very gradual moderation and a period of sustained inflation above what is presumed to be consistent with this central bank’s long-term preferences. The risks of this forecast, as I said, still seem to lie on the upside. It may be some time before we can be confident that the forces are in place to produce the necessary moderation. More generally, however, we face the very difficult consequential challenge of trying to figure out the longer-term consequences of having been in an exceptionally long period of exceptionally low real interest rates—both real short rates and forward rates—that were induced by monetary authorities here and around the world. Real short rates now look as though they were perhaps lower relative to the estimates of equilibrium even than we thought. Perhaps more remarkable was the low level of forward real rates during much of our tightening phase. These financial conditions may have produced more inflation momentum than we thought, and this may be the case even though there is some reassurance in the stability of long-term expectations. Those expectations are substantially below the peak in ’04 at the long horizon. However, the rise in asset prices and residential investment and the leverage caused by this long period of very expansionary monetary policy may lead to a process of adjustment in asset prices that could be more sustained and more damaging in terms of confidence and of demand than we expect. This risk is greater if we end up allowing more inflation than our forecast anticipates, for the required monetary policy response could induce an even sharper adjustment in risk premiums and asset prices. This possibility argues for a lot of humility in judging the appropriateness of the present stance of monetary policy and what will be appropriate over time, and it argues mostly for having as much flexibility as we can going forward, emphasizing that the inflation risks remain the predominant concern of the Committee. Thank you." FOMC20060629meeting--113 111,MR. WARSH.," Thank you, Mr. Chairman. In terms of my overall comments, I consider my views really in the center of gravity, as the Vice Chairman described it, of the speakers around the table and probably, again, quite a bit more optimistic in terms of GDP growth and perhaps also more concerned about inflation risks than the Greenbook. When I look at the strength of the fundamentals of the economy, including strong and accelerating profits, low unemployment, highly accessible capital markets, and remarkably strong balance sheets both for consumers and businesses, I find it hard to reconcile those with some of the pessimism coming not just from the Greenbook but also from some economists that the markets follow. The two trends and the two sets of data seem to be going in very different directions. Regarding the data that have come in since our last FOMC meeting, some time has been spent here on a few of the negative surprises, so I want to highlight a few of the positive bits of news. Federal tax receipts in May were up 26 percent from May a year ago. For the past twelve months, as we’ve talked about before, total tax receipts into the government went up 12.9 percent. Core retail sales rose 0.4 percent in May, up about 6.9 percent year over year if we exclude some of the more volatile items. According to surveys and anecdotes, the manufacturing base continues to be remarkably robust, both in terms of growth and in terms of jobs. I’d also note that durable goods orders, though not incredibly robust over the past month, represent growth of about 10 percent over the past three months if we exclude aircraft and look only at nondefense capital goods. So all in all, I think that the data suggest a more positive trend. What I’d like to do is spend a little time talking about how the markets have reacted to this news and build on a couple of the points that Dino made at the outset. First, a lot of pundits have described the “new volatility” in the marketplace, and I think that Dino made a very compelling case that the volatility has really not been nearly as severe as the commentators suggest. Volatility has in some ways been a euphemism for the fact that the markets have been down, and those are obviously quite different things. [Laughter] I think another bit of conventional wisdom is influencing decisionmakers, both in Washington and in business, and it is probably important to correct. That idea is that somehow the Fed has been the cause of this market volatility. I think that is largely incorrect. When I look at what has happened, I think that the markets are focused more and more on core economic fundamentals. We have changed in the perspective of the markets, which used to think some months and quarters ago that bad news meant good news and now they think that bad news is actually bad news. The bad news previously meant that we weren’t going to be moving rates higher. Again, I think the markets, not the commentators, have a better understanding that they really need to be focusing on economic fundamentals. When I look at the economic fundamentals, one of the data points that I look to is the state of corporate profit growth at this point in the cycle. Over the past twelve months, it was 13.6 percent, and if we look at bottom-up analyst forward estimates for the S&P 500 or for the Russell, it appears that those analyst estimates are actually accelerating. As a former banker, I will admit to some bias in these numbers, but they’ve been tracking reasonably well. The forward estimates are that corporate profits should be up something like 16 percent. So one of the things that we can do over the next several meetings is see how actual results track against those expectations, and my bet is that there will not be as much disappointment in those numbers as the top-down macroeconomic views would suggest. Diving down into some of the individual markets, I suggest that they’re telling us different things about the state of the economy and the state of inflation prospects. First, the equity markets have been off on the order of 7 or 8 percent, and many people, myself included, would have thought that that would have significantly affected CEO confidence, that it would have changed some perspectives about where they are in the capital expenditure cycle. I think that probably has happened in the IPO market. The IPO market has gotten slower and more selective, and issues that can come to market now have been at the top end of what’s in the pipeline. If we look more broadly, however, beyond what’s going on in the equity markets, if we look at the cap-ex market, capital expenditures appear to be above plan generally from the discussions I’ve had with folks who are on boards of different companies. One CEO called before coming out with a survey of CEO expectations for growth in capital expenditures, and he exclaimed, “What are you guys seeing that we’re not?” In some way he was checking to try to understand what the reason was for concern when his company surveys continue to be quite positive. The only caution I have is that, if you look across a breadth of CEO surveys on growth, the survey numbers have, in fact, come down from, let’s say, April to June. But, again, my sense of the matter is that CEOs are scratching their own heads at this very moment that we’re having a discussion about the economy in transition. The messages that come from the Fed and from other policymakers over the next month, including in the Chairman’s monetary policy testimony, will be very important to set the tone, because CEOs are not sure whether to continue to hit the accelerator or whether this might be a time in their own businesses for a pause in capital expenditures. I have a few comments on a couple of other markets. Normally in a time like this, when the equity markets are off 7, 8, or 9 percent, the merger and acquisition markets, which I view as a pretty good proxy for CEO confidence, would stop. In fact, that hasn’t happened: M&A pipelines are more robust than ever. The unthinkable deals are being printed and being published. Pipelines are terrifically strong, and CEOs are ready in some ways to “bet the company” on the strength of their convictions—another reason that I have confidence that business growth could well be in excess of the Greenbook estimates. Let me make two or three other comments. First, in terms of inflation, as I look at the commodity markets and at the TIPS markets, I’m most comforted not so much by relative moves, because those TIPS markets are certainly not perfect in describing inflation expectations, but by the responsiveness of those markets to remarks that have come from folks around this table. That is, if we think about what our authority is in influencing inflation expectations, the very real-time changes in the TIPS markets give me comfort that at this point in the cycle we will be able, with proper and appropriate policies that we’ll discuss tomorrow, to change those inflation expectations rather dramatically. So I think that’s a reasonably comforting idea. Finally, the fixed-income markets and high-yield markets certainly have moved higher in terms of spreads but, again, not a lot by historical perspectives. Under normal market conditions or more-pessimistic market conditions than we have now, that move, even a small relative move, would have slowed down those pipelines. Instead, liquidity is plentiful. A couple of anecdotes that we heard before describe the situation: 25 or 30 basis points in the high-yield markets are not changing activity. They’re not changing the interest of investment banks and issuers in coming to market as quickly as they can. So in terms of market functioning, apart from price, those markets are working exceptionally well. What would be a reason for pessimism, and what would be a reason to think that the volatility that has been discussed over the past several weeks might turn into real volatility? One thing that I look to with some degree of concern is the prices that are being paid and the leverage that’s being put on companies that could change the liquidity in those markets very quickly. I wouldn’t be surprised to find—over the forecast period for sure and maybe even over 2006—a “club” deal in which many private equity partners group together in a highly leveraged situation to buy a very large public company and take it private and, after the course of due diligence and of that acquisition, the deal closes and they find that they missed the first coupon. That is, the leverage that is being put on these companies, for all the reasons we have discussed around this table, is relatively remarkable. Those leverage ratios used to sound like purchase prices, and they’re expecting meaningful cost savings that can come out of these businesses six and nine months out. I suppose I’m concerned that, as these deals come together, there might be a negative surprise that affects the company so that the first coupon would be impossible or difficult to meet. In that circumstance, all the optimism that I’ve described in terms of these debt markets could dissipate rather markedly. So I don’t want to suggest a degree of optimism that isn’t borne out by the facts. That’s something we need to continue to stay attuned to. Thank you, Mr. Chairman." FinancialCrisisReport--92 WaMu did, at times, exercise oversight of its third party brokers. A 2006 credit review of its subprime loans, for example, showed that Long Beach – which by then reported to the WaMu Home Loans Division – had terminated relationships with ten brokers in 2006, primarily because their loans had experienced high rates of first payment defaults requiring Long Beach to repurchase them at significant expense. 292 But terminating those ten brokers was not enough to cure the many problems with the third party loans WaMu acquired. The report also noted that, in 2006, apparently for the first time, Long Beach had introduced “collateral and broker risk” into its underwriting process. 293 WaMu closed down its wholesale and subprime channels in 2007, and its Alt A and subprime securitization conduits in 2008. (b) Risk Layering During the five-year period reviewed by the Subcommittee, from 2004 to 2008, WaMu issued many loans with multiple higher risk features, a practice known as “risk layering.” At the April 13 Subcommittee hearing, Mr. Vanasek, its Chief Risk Officer from 2004 to 2005, testified about the dangers of this practice: “It was the layering of risk brought about by these incremental changes that so altered the underlying credit quality of mortgage lending which became painfully evident once housing prices peaked and began to decline. Some may characterize the events that took place as a ‘perfect storm,’ but I would describe it as an inevitable consequence of consistently adding risk to the portfolio in a period of inflated housing price appreciation.” 294 Stated Income Loans. One common risk layering practice at WaMu was to allow borrowers to “state” the amount of their annual income in their loan applications without any direct documentation or verification by the bank. Data compiled by the Treasury and the FDIC IG report showed that, by the end of 2007, 50% of WaMu’s subprime loans, 73% of its Option ARMs, and 90% of its home equity loans were stated income loans. 295 The bank’s acceptance of unverified income information came on top of its use of loans with other high risk features, such 291 Id. at 58615. 292 12/2006 “Home Loans – SubPrime Quarterly Credit Risk Review,” JPM_WM04107374, Hearing Exhibit 4/13- 14. 293 Id. at JPM_WM04107375. 294 April 13, 2010 Subcommittee Hearing at 16. 295 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. as borrowers with low credit scores or the use of low initial teaser interest rates followed by much higher rates. FOMC20080625meeting--71 69,MR. FISHER.," Mr. Chairman, you are going to get a contrapuntal tune here. That is the beauty of this table and the different perspectives around it. I am going to take a different approach today than I have in the past. I am going to talk a bit about the Eleventh District first, which I don't often do. The reason for that is, because of its nature and size, because of its being the leading exporting state in the country now, and because of its job creation, it is in a slightly different position--or significantly different position, depending on which District it is compared with--from the rest of the country. Our job growth through March is running about 3.8 percent. Unemployment in April was 4.1 percent, despite a sizable influx of immigrants, which we see from new license plate registrations from California and particularly from Florida as well as from people still coming across the border. Sales of existing homes rose in May, while inventories and prices held steady. Apartment demand is robust, and rents in the major cities, such as Dallas and Houston, are rising. The real export growth of Texas was 7.2 percent in April after 3.9 percent in the first quarter. That is telling you that our chemicals are now being priced aggressively but also that everything else is being priced aggressively worldwide. That's a significant export sector for us. Importantly, on the price front, the Dallas Fed's own Texas manufacturing outlook survey and the regional CPI data indicate continuing price increases and substantial evidence of passthrough to higher final goods prices. Thirty-nine percent of the respondents report the ability to realize higher prices of finished goods currently; another 45 percent expect to be able to realize higher prices in the next six months. Despite these strong numbers, our soundings and our instinct project a slowdown in the future. We have been projecting a slowdown--we haven't seen it. Discretionary income has been bolstered by employment, but squeezed by rising food and energy prices and credit constriction. So we are looking for the District to slow and yet to continue to outperform relatively speaking. I would like to devote the rest of my comments to the U.S. economy and to the global economy, particularly to the contrapuntal insights I have gained from my soundings. First, on the global economy, Nathan, our own research at our little globalization institute in Dallas indicates that the projections of real economic growth of most of the advanced countries are being revised downward whereas expected inflation is being revised upward. For the major emerging market economies, growth realization, at least as it appears in their forecasts, for the most part holds up, but inflation expectations are being steadily revised upward. In other words, the two types of economies share on the inflation front, whereas there is disparity and a little cacophony as far as growth is concerned. We are working on it, but we have yet to develop a reliable measure of global slack. JPMorgan, with whom we have been working, has a slack index that purports to be global. But as you pointed out, Nathan, it excludes China. Minor oversight. It also excludes India. One would think that the growing slack in the advanced countries would be mitigating price pressures. Yet those countries with numerical price objectives or inflation targets--from Mexico to Turkey to New Zealand to the European Central Bank to the Brits--are now contending with inflation in excess of their target or comfort range. I was thinking the other day of Mervyn King's comment that, once they had to write to the Chancellor of the Exchequer, it would lead to a lot of letter-writing. It took 15 years for the first letter to be written after inflation targeting was embraced. Of course, two years ago this was resurrected, and now they seem to be doing so with a great deal more frequency. Now there is a risk of acquiring writer's cramp. I would say that, if we were under the same strictures as the Bank of England, we might be subject to the same concerns. In our last meeting, I posited that something persistent and pernicious was occurring on the inflation front. Mr. Chairman, the one thing that is even clearer now--particularly after my soundings, which I'll report in just a second--than it was in May is that inflationary pressures, inflation expectations, and anticipatory behavioral responses among consumers and businesses have intensified, whereas our confidence about economic growth has improved. I don't believe that we are out of the woods yet on the risk of a credit-induced slowdown, though I believe our liquidity initiatives are a proper and good palliative, as you know. But if Robert Frost will forgive me, the woods are not lovely, and they are indeed deep and dark on the price front. Although the tail risk of economic recession has diminished, I think it still exists; certainly the anemia--just to use another word that you referred to--does. But the risk of inflation, in my view, has assumed greater depth and breadth since we last met. Stated differently, I don't believe that inflation expectations are presently well anchored, here or elsewhere. I believe they are being--just to kill the sea analogy, Don--torn from their moorings and are at risk of going adrift. Now, I took a different approach this time with the 30-odd interlocutors with whom I discussed the outlook. I simply asked them one question: What is different in this cycle from what you have seen before? Most of these people have been in business for 30 years plus. Here are some sample testimonials as to what they are seeing. The CEO of Fluor, which has a $38 billion backlog currently, said, ""When I started here in 1974, we put inflation contingencies into every contract. In the 1990s, that had not only gone away, but we were confident we could negotiate cost down to below what we were bidding. Now it is just the opposite."" The CFO of Frito-Lay, which just pushed through a 9 percent price increase (which, parenthetically, WalMart accommodated at 7 percent), said, ""Most of our executives are in their late 30s or early-tomid 40s. They have never seen these kinds of numbers. This is reminiscent of the aftershock to Nixon's wage and price controls, and we are currently having to hold seminars to teach management how to manage inflation."" From the CEO of Wal-Mart USA: ""We see increased""--and this is his word--""pervasive price pressures. I am telling you that we have an economy where the real people are being trampled by inflation, and for the first time in memory, we are getting noise from employees about the cost of living."" Wal-Mart raised the pay of 60 percent of their associates between single and double digits in the last quarter, and my contact said, ""We are now contemplating a series of measures such as providing discounts to employees to counter considerable employee angst about the cost of living."" From the CEO of KimberlyClarke, who just notified the retailers of a 7 percent price increase to come in August after the 7 percent they pushed through in February, in addition to which they are going to add a shipping surcharge: ""Customers are no longer asking if, but when, we will increase prices, so they can move in anticipation."" I can give you other testimonials, Mr. Chairman. One of my favorites, by the way, has to do with a very small operation, a three-store dry cleaning operation, Faulkner's Fine Dry Cleaning in Dallas. They approached me the other day to say that they would have to increase the price of cleaning our shirts because the price of 18-inch white hangers, which are steel-based, has increased 65 percent. They showed me the circular that had been sent around by the fabric cleaning supply company that is the last remaining manufacturer of hangers in the United States. All of that manufacturing has gone to China. The circular that they are sending their customers, the cleaners, says ""What should cleaners do? Raise your prices. You're worth it."" Then--and this strikes at the heart of every son of every Australian--Budweiser, which raised its prices 3� percent in February, according to our local distributor, plans to raise 3� percent again in September. And the Bud distributor in North Texas, who has had that distributorship for 43 years, said that never before in his lifetime had he seen two price increases in one year. Finally, the CEO of JCPenney's just returned from an around-the-world buying trip. After 11 years of apparel price deflation, Chinese manufacturers are seeking 8 to 9 percent price increases in '09, 11 to 12 percent for footwear, and for small kitchen appliances in the mid-20s. The CFO of the company told me that they are running at minimum staffing levels. If anybody begins to break the wage barrier, then, ""Katie, bar the door!"" So, Mr. Chairman, I would say that currently our patient--the economy--is indeed a sick puppy. Some of its vital organs--geographic regions such as the one I am fortunate to live in, or a strong export sector of the United States, or entrepreneurs and business leaders who have learned to wring unanticipated efficiency and profits out of globalization or from within cyberspace--are very strong. Yet others--states like California and Florida, the housing sector, and overall consumer confidence--are bleeding, if not hemorrhaging. This is not to mention the still precarious state, despite the very good report that Bill gave, of our financial system as it recovers, I hope with our help, from years of its recklessness and excess. I think we have, like loyal practitioners and with the equivalent of the Hippocratic oath, done the job that we are expected to do in terms of resuscitating the victim. That is the good news. The real bad news is that our patient appears to be acquiring a staph infection in this hospital that we have created, and that staph infection is inflation. I believe inflation is upon us. I believe expectations are discounting more inflation. Very importantly--and this is tough to get from the models--I believe that behavioral changes are beginning to manifest themselves. Now, some would argue that this infection is temporary and may well go away. Others will argue that it will be stayed by strong rhetoric. Still others say that it will require--I don't know if it's an antibiotic or an antidote--further tightening, lest the infection spread and counteract the good that we have done with our liquidity facilities and by previous policy decisions. That seems to me to be the problem that we will have to deal with at this meeting, and I look forward to hearing my other colleagues' opinions. Thank you, Mr. Chairman. " FOMC20080430meeting--273 271,MR. EVANS.," My primary comment in all of this is related to what President Stern, I think, said. The way the objectives are worded here is ""enhanced monetary policy implementation,"" and the memo is worded more like, ""How do we get our federal funds rate target effectively?"" or something like that. But there is really no discussion that I could find about the transmission of our policy actions to the economy and to inflation. Under our current regime, we think, quite confidently, that the short-term federal funds rate prices short-term risk-free assets along the yield curve all the way up to the Treasuries and then corporates are priced off all of that. I associate that with Marvin Goodfriend, who taught me that quite some time ago. It's not money; it's not liquidity; it's not the reserves per se. It would be nice if, for each alternative, there were some discussion that we are preserving our understanding of the policy transmission mechanism or that we are enhancing it or whatever. President Lacker mentioned the Bank of England--maybe we could set the policy rate as they do. The question is, What will the markets do in terms of actively arbitraging something that helps price these securities? This may not be an issue for many of these systems, but until there's some kind of analysis, I'm not so sure. It's not just averaging over the maintenance period, and I think that analysis would be useful. " FOMC20080318meeting--98 96,MR. FISHER.," Just very quickly, I said that the liquidity situation we're in diminishes the efficacy of fed funds policy; I'm not saying it's not a worthwhile tool. Second, I was fully supportive until we got to 3.5. Then we went from 3.5 to 3 percent. Everything we wanted to go one way then went the opposite way. So I just made the observation that it didn't seem to be effective. Third, I think I spent even more time in Japan than President Geithner, who is an expert on Japan, and you cannot compare the two economies. They are geared totally differently, with totally different efficiency. I'd be happy to debate that at a later point. I think it's a very poor analogy. Now, having said that, I respect the enormous macroeconomic downside risk that we have--and I have one of the most pessimistic forecasts--but there's a price to be paid for what we're doing unless it is efficient, and that price is reflected in inflation expectations. That's my point, Mr. Chairman. " FinancialCrisisReport--22 These practices were used to qualify borrowers for larger loans than they could have otherwise obtained. When borrowers took out larger loans, the mortgage broker typically profited from higher fees and commissions; the lender profited from higher fees and a better price for the loan on the secondary market; and Wall Street firms profited from a larger revenue stream to support bigger pools of mortgage backed securities. The securitization of higher risk loans led to increased profits, but also injected greater risks into U.S. mortgage markets. Some U.S. lenders, like Washington Mutual and Countrywide, made wholesale shifts in their loan programs, reducing their sale of low risk, 30-year, fixed rate mortgages and increasing their sale of higher risk loans. 21 Because higher risk loans required borrowers to pay higher fees and a higher rate of interest, they produced greater initial profits for lenders than lower risk loans. In addition, Wall Street firms were willing to pay more for the higher risk loans, because once securitized, the AAA securities relying on those loans typically paid investors a higher rate of return than other AAA investments, due to the higher risk involved. As a result, investors were willing to pay more, and mortgaged backed securities relying on higher risk loans typically fetched a better price than those relying on lower risk loans. Lenders also incurred little risk from issuing the higher risk loans, since they quickly sold the loans and kept the risk off their books. After 2000, the number of high risk loans increased rapidly, from about $125 billion in dollar value or 12% of all U.S. loan originations in 2000, to about $1 trillion in dollar value or 34% of all loan originations in 2006. 22 Altogether from 2000 to 2007, U.S. lenders originated about 14.5 million high risk loans. 23 The majority of those loans, 59%, were used to refinance 21 See, e.g., “Shift to Higher Margin Products,” chart from Washington Mutual Board of Directors meeting, at JPM_WM00690894, Hearing Exhibit 4/13-3 (featuring discussion of the larger “gain on sale” produced by higher risk home loans); “WaMu Product Originations and Purchases By Percentage - 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i (showing how higher risk loans grew from about 19% to about 55% of WaMu’s loan originations); SEC v. Mozilo , Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 17-19 (alleging that higher risk loans doubled at Countrywide, increasing from about 31% to about 64% of its loan originations). 22 8/2010 “Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data Sources,” Government Accountability Office (GAO), Report No. GAO-10-805 at 1. These figures include subprime loans, Alt A, and option payment loans, but not home equity loans, which means the totals for high risk loans are understated. 23 Id. at 5. an existing loan, rather than buy a new home. 24 In addition, according to research performed by FOMC20080805meeting--149 147,MS. YELLEN.," Thank you, Mr. Chairman. I favor alternative A--no change in the funds rate and a balanced assessment of risks designed to leave market expectations concerning the path of the funds rate roughly unchanged. Oops, I made a mistake, there is no A. [Laughter] So I propose to create it by changing the wording of the first sentence of alternative B, paragraph 4, to read, ""Both downside risks to growth and upside risks to inflation are of significant concern to the Committee."" As it is currently worded, B(4) downplays the downside risks to growth, which have intensified since our last meeting as the credit crunch has worsened and emphasizes inflation risks, which have moderated slightly as oil prices have fallen. The assessment of risks in alternative B, as it stands, is unbalanced and--as Brian just pointed out and the Bluebook does also--is more hawkish than the primary dealer