CHRG-110shrg50414--208 Secretary Paulson," Well, I was dealing with--very well with the regulatory burdens on my firm, but to look back and say--look at the broader economy, to look at some of the holes in the regulatory system as it relates to other institutions, yes, that is it. Senator Bunning. Mr. Secretary, do you know if large Treasury debt holders such as foreign official investors, Commonwealth Fund, Bank of China, whatever it might be, are going to go along with a massive debt issue? Have you heard from any such investors who are complaining about the close to one trillion or more dollars of debt increase we are looking at between the GSE plan and the new debt to finance the Fed activities? " CHRG-109shrg21981--197 Chairman Shelby," I want to touch on one last thing. Your written testimony Mr. Chairman, notes that the low national savings rate could eventually slow the rise in living standards either by increasing the burden of servicing U.S. foreign debt or by impinging on domestic capital formation. To what extent will the anticipated further increases in interest rates affect this possibility? " fcic_final_report_full--148 The mortgage pipeline also introduced leverage at every step. Most financial institu- tions thrive on leverage—that is, on investing borrowed money. Leverage increases profits in good times, but also increases losses in bad times. The mortgage itself cre- ates leverage—particularly when the loan is of the low down payment, high loan-to- value ratio variety. Mortgage-backed securities and CDOs created further leverage because they were financed with debt. And the CDOs were often purchased as collat- eral by those creating other CDOs with yet another round of debt. Synthetic CDOs consisting of credit default swaps, described below, amplified the leverage. The CDO, backed by securities that were themselves backed by mortgages, created leverage on leverage, as Dan Sparks, mortgage department head at Goldman Sachs, explained to the FCIC.  “People were looking for other forms of leverage. . . . You could either take leverage individually, as an institution, or you could take leverage within the structure,” Citigroup’s Dominguez told the FCIC.  Even the investor that bought the CDOs could use leverage. Structured invest- ment vehicles—a type of commercial paper program that invested mostly in triple-A- rated securities—were leveraged an average of just under -to-: in other words, these SIVs would hold  in assets for every dollar of capital.  The assets would be financed with debt. Hedge funds, which were common purchasers, were also often highly leveraged in the repo market, as we will see. But it would become clear during the crisis that some of the highest leverage was created by companies such as Merrill, Citigroup, and AIG when they retained or purchased the triple-A and super-senior tranches of CDOs with little or no capital backing. Thus, in , when the homeownership rate was peaking, and when new mort- gages were increasingly being driven by serial refinancings, by investors and specula- tors, and by second home purchases, the value of trillions of dollars of securities rested on just two things: the ability of millions of homeowners to make the pay- ments on their subprime and Alt-A mortgages and the stability of the market value of homes whose mortgages were the basis of the securities. Those dangers were under- stood all along by some market participants. “Leverage is inherent in [asset-backed securities] CDOs,” Mark Klipsch, a banker with Orix Capital Markets, an asset man- agement firm, told a Boca Raton conference of securitization bankers in October . While it was good for short-term profits, losses could be large later on. Klipsch said, “We’ll see some problems down the road.”  BEAR STEARNS’S HEDGE FUNDS: “IT FUNCTIONED FINE UP UNTIL ONE DAY IT JUST DIDN ’ T FUNCTION ” Bear Stearns, the smallest of the five large investment banks, started its asset manage- ment business in  when it established Bear Stearns Asset Management (BSAM). fcic_final_report_full--80 Fannie and Freddie grew quickly, too. Fannie’s assets and guaranteed mortgages increased from . trillion in  to . trillion in , or  annually. At Fred- die, they increased from  trillion to . trillion, or  a year.  As they grew, many financial firms added lots of leverage. That meant potentially higher returns for shareholders, and more money for compensation. Increasing leverage also meant less capital to absorb losses. Fannie and Freddie were the most leveraged. The law set the government- sponsored enterprises’ minimum capital requirement at . of assets plus . of the mortgage-backed securities they guaranteed. So they could borrow more than  for each dollar of capital used to guarantee mortgage-backed securities. If they wanted to own the securities, they could borrow  for each dollar of capital. Com- bined, Fannie and Freddie owned or guaranteed . trillion of mortgage-related as- sets at the end of  against just . billion of capital, a ratio of :. From  to , large banks and thrifts generally had  to  in assets for each dollar of capital, for leverage ratios between : and :. For some banks, leverage remained roughly constant. JP Morgan’s reported leverage was between : and :. Wells Fargo’s generally ranged between : and :. Other banks upped their leverage. Bank of America’s rose from : in  to : in . Citigroup’s increased from : to :, then shot up to : by the end of , when Citi brought off-balance sheet assets onto the balance sheet. More than other banks, Citi- group held assets off of its balance sheet, in part to hold down capital requirements. In , even after bringing  billion worth of assets on balance sheet, substantial assets remained off. If those had been included, leverage in  would have been :, or about  higher. In comparison, at Wells Fargo and Bank of America, in- cluding off-balance-sheet assets would have raised the  leverage ratios  and , respectively.  Because investment banks were not subject to the same capital requirements as commercial and retail banks, they were given greater latitude to rely on their internal risk models in determining capital requirements, and they reported higher leverage. At Goldman Sachs, leverage increased from : in  to : in . Morgan Stanley and Lehman increased about  and , respectively, and both reached : by the end of .  Several investment banks artificially lowered leverage ratios by selling assets right before the reporting period and subsequently buying them back. As the investment banks grew, their business models changed. Traditionally, in- vestment banks advised and underwrote equity and debt for corporations, financial institutions, investment funds, governments, and individuals. An increasing amount of the investment banks’ revenues and earnings was generated by trading and invest- ments, including securitization and derivatives activities. At Goldman, revenues from trading and principal investments increased from  of the total in  to  in . At Merrill Lynch, they generated  of revenue in , up from  in . At Lehman, similar activities generated up to  of pretax earnings in , up from  in . At Bear Stearns, they accounted for more than  of pretax earnings in some years after  because of pretax losses in other businesses.  FinancialCrisisInquiry--119 Depository institutions like Citibank were able to parlay their deposits into large levered bets in the derivatives marketplace. In fact, at fiscal year-end 2007, Citigroup was 68- times levered to its tangible common equity, including off balance sheet exposures. Clearly, the composition of these assets is important as well, but I am simply trying to illustrate how levered these companies were at the start of the financial crisis. While AIG’s derivatives book was only 20-times levered to their book equity, $64 billion of these derivatives were related to subprime and subprime credit securities, the majority of which were ultimately worth zero. In some cases, excessive leverage cost the underlying company many years of lost earnings, and in other cases it cost them everything. I’ve put a table labeled “exhibit two” in my presentation. What we’ve done is looked back at the cumulative net income that was lost in financial institutions since the third quarter of 2007. Fannie Mae lost 20 ½ years of its profits in the last 18 months. AIG lost 17 ½ years of its profits in the last 18 months. Freddie Mac lost 11 ½ years of profits in a little bit more than a year. The point I’m trying to make is the ridiculousness of what’s gone on in the leverage that was in the system. The key problem with the system is the leverage and we must regulate that leverage. I’m going to—my third point that I’ll talk about briefly here is Fannie and Freddie. With $5.5 trillion of outstanding debt in mortgaged-backed securities, the quasi-public are now in conservatorship, Fannie and Freddie, have obligations that approach the total amount of government-issued bonds the U.S. currently has outstanding. There are so many things that went wrong or are wrong at these so-called “GSEs” that I don’t even know where to start. First, why are there two for-profit companies with boards, shareholders, charitable foundations, and lobbying arms ever given the implicit backing of the U.S. government? The Chinese won’t buy them anymore because our government won’t give them the explicit backing. The U.S. government cannot give them the explicit backing because the resulting federal debt burden will crash through the congressionally mandated debt ceiling, which was already recently raised to accommodate more deficit spending. CHRG-111shrg50815--5 STATEMENT OF SENATOR AKAKA Senator Akaka. Yes. Thank you very much. I appreciate the Chairman holding this hearing. Too many in our country are burdened by significant credit card debt. Not enough has been done to protect consumers and ensure they are able to properly manage their credit burden. We must do more to educate, protect, and empower consumers. Three Congresses ago, or the 108th Congress, I advocated for enactment of my Credit Card Minimum Payment Warning Act. I developed the legislation with Senators at that time, Senators Sarbanes, Durbin, Schumer, and Leahy. We attempted to attach the bill as an amendment to improve the flawed minimum payment warning in the Bankruptcy Abuse Prevention and Consumer Protection Act. Unfortunately, our amendment was defeated. My legislation, which I will be reintroducing shortly, requires companies to inform consumers how many years and months it will take to repay their entire balance if they make only minimum payments. The total cost of interest and principal if the consumer pays only the minimum payment would also have to be disclosed. These provisions will make individuals much more aware of the true costs of credit card debt. The bill also requires that credit card companies provide useful information so that people can develop strategies to free themselves of credit card debt. Consumers would have to be provided with the amount they need to pay to eliminate their outstanding balance within 36 months. My legislation also addresses the related issue of credit counseling. We must ensure that people who seek help in dealing with complex financial issues, such as debt management, are able to locate the assistance they need. Credit card billing statements should include contact information for reputable credit counseling services. More working families are trying to survive financially and meet their financial obligations. They often seek out help from credit counselors to better manage their debt burdens. It is extremely troubling that unscrupulous credit counselors exploit for their own personal profit individuals who are trying to locate the assistance they need. My legislation establishes quality standards for credit counseling agencies and ensures that consumers would be referred to trustworthy credit counselors. As financial pressures increase for working families, credit counseling becomes even more important. As we work to reform the regulatory structure of financial services, it is essential that we establish credit counseling standards and increase regulatory oversight over this industry. Mr. Chairman, I appreciate your inclusion of this in your bill, of a provision that mirrors the minimum payment warning provisions in my bill. Thank you very much, Mr. Chairman. Senator Johnson. Thank you, Senator Akaka. Senator Menendez, do you have a very brief statement to make? CHRG-109hhrg28024--155 Mr. Moore," Thank you, Mr. Chairman. Mr. Chairman, welcome to the committee. In a speech you gave last March of 2005 before the Virginia Association of Economists, you stated that reducing the Federal budget deficit is still a good idea. You said that reducing the deficit would reduce ``debt obligations that will have to be serviced by taxpayers in the future.'' I have six grandchildren. A lot of us here have children and grandchildren whom I believe would be affected, as you have indicated, by what we do as a country in the future. I believe Congress should be doing what we can to relieve our children and grandchildren of the burdens we are imposing on them today. One way I think we can do that is to address the deficit/debt issue, to reinstate a rule called pay/go. In 2002, the pay/go rule in Congress was allowed to expire. It has not been renewed. In fact, former Chairman Greenspan and a group in Congress called the Blue Dog Coalition, which believes in fiscal responsibility, has advocated reinstatement of pay as you go, pay/go rules, that would require Congress to pay for spending increases and revenue reductions. Should pay/go in your estimation be reinstated? Should it apply to new spending as well as new revenue reductions or tax cuts? " CHRG-111shrg51290--5 STATEMENT OF SENATOR AKAKA Senator Akaka. Thank you very much, Mr. Chairman. I want you to know that I appreciate your conducting this hearing and also appreciate your advocacy on behalf of consumers, Mr. Chairman and Ranking Member, Senator Shelby. I also want to welcome our witnesses this morning to this hearing. Well before the current economic crisis, our financial regulatory system was failing to adequately protect working families, home buyers, individuals from predatory practices and exploitations. Prospective home buyers were steered into mortgage products with risks and costs that they could not afford. Working families were being exploited by high-cost fringe financial service providers, such as payday lenders and check cashers. Low-income taxpayers had their Earned Income Tax Credit benefits unnecessarily diminished by refund anticipation loans. Individuals trying to cope with their debt burdens were pushed into inappropriate debt management plans by disreputable credit counselors. We must increase consumer education so that individuals are able to make better informed decisions. However, although it is essential, education is not enough. We must also restrict predatory policies, ensure that consumers' interests are better represented in the regulatory process, and increase effective oversight of financial services. Mr. Chairman, you mentioned this in your opening statement and I will certainly work with you on these measures. I appreciate the witnesses today and I look forward with all of you to educate, protect, and empower consumers. Thank you very much, Mr. Chairman. " CHRG-111shrg54533--20 Chairman Dodd," Thank you, Senator, very much. Senator Akaka. Senator Akaka. Thank you very much, Mr. Chairman. Mr. Secretary, our current regulatory structure, I feel has failed to adequately protect working families from predatory practices. Working families are exploited by high-cost fringe financial service providers, such as payday lenders and check cashers. Individuals trying to cope with their debt burdens are pushed into inappropriate debt management plans by disreputable credit counselors or harmed by even debt settlement agencies. Mr. Secretary, agencies already have had the responsibilities in these areas, but what will be done to ensure that the Consumer Financial Protection Agency will be able to effectively protect working families? " CHRG-109shrg26643--69 Chairman Bernanke," To the extent that their currency is undervalued, it does, yes. Senator Sarbanes. Yes. In fact, we are becoming more and more dependent. Tennessee Williams has that wonderful line in ``A Streetcar Named Desire'' where Blanche DeBois says dependent upon the kindness of strangers, and there are some who look at the American economy and are increasingly concerned that that is what is happening. I quoted Warren Buffett earlier in my opening statement saying right now the rest of the world owns $3 trillion more of us than we own of them. In my view, it will create political turmoil at some point. Pretty soon, I think there will be a big adjustment. Aren't the Chinese accumulating a leverage over our decisionmaking as a consequence of increasing so substantially these holdings of our Government debt? " CHRG-110shrg38109--14 STATEMENT OF SENATOR ROBERT MENENDEZ Senator Menendez. Thank you, Mr. Chairman. Chairman Bernanke, welcome. It is great to welcome a fellow New Jerseyan back again to the Committee. Today, some people say the economy is solid due to some of the leading economic indicators appearing generally healthy, with unemployment below 5 percent, with moderate economic growth, with inflation stabilized, and I certainly want to commend you for the stewardship you have shown at the Fed in working on this economy. But at the same I also worry about who is benefitting from this economy and who is being left behind. Indeed, there are serious limitations, I think, in judging a situation solely through looking at the big-picture numbers, as this view often hides the details of a situation, and specifically I am talking about the burden being placed on our middle class. So while some in this country might believe that our economy is chugging along quite well because our gross domestic product continues to grow, there seems to be an increasing gap between the average citizen and those at the top of our economic ladder. And the disparity that continues to grow, in my mind, is widening at an alarming rate. When I am back in New Jersey, I hear more and more from New Jerseyans that our current economic policies are not working for them. The middle class continues to shrink, poverty is increasing, the gap between the rich and the poor is growing wider. We have a record-breaking national debt and a record-breaking trade deficit. The personal savings rate is now below zero, which has not happened since the Great Depression. Millions of Americans are seeing their wages stagnant and their pension and health care benefits slashed, while the wealthiest people in the country are doing better than ever. So ultimately my concern is that our economy is not working for the broadest scope of Americans that we would hope. The middle class is shrinking instead of growing, and we seem far more concerned about boosting the incomes of the wealthiest Americans while denying our responsibility to those struggling to make ends meet. I do not think we can sustain that position over the long-term. We are borrowing to pay for tax cuts and the war effort. It is an unfair burden we are placing on our children and grandchildren. So, I look forward to your testimony today and hearing your thoughts on some of these things I have mentioned, some of the other things I hope you will address, like the cooling off of the housing market, what that may mean; energy prices; the consequences of deficit and debt, from large budget deficits to record personal debt. And I understand that in your capacity as Chairman of the Federal Reserve, you are responsible for keeping inflation low and stable while maintaining economic growth, not economic equality. But I do hope either in your opening statement or subsequently in the questions that we will have an opportunity to ask to hear your views about how we get this economy working in a direction that it really helps middle-class families in this country. Thank you, Mr. Chairman. " CHRG-111hhrg63105--67 Mr. Conaway," Thank you, Mr. Chairman. Gentlemen, thanks for being here. Not beating the lack of data dead horse to even further pulverize it, but if you go ahead and move forward without the data, as may be the indication that is here, how quickly will you know you have gotten it wrong? Are there things that you will watch for to say that we have driven speculators off that side of the deal and that burdens on hedgers have increased? I am assuming by burdens, Mr. Gensler, that you mean increased costs of transactions and other things, that you might expound on a burden a little bit. But how quickly will you know that you have done some harm, rather than just trying to ease into this thing without disrupting it and creating--going crazy, as Mr. Chilton said? What are your matrix or your benchmarks to say this one was too far? " CHRG-111hhrg53246--46 Mr. Gensler," It was actually both. The customized product get a lot more publicity obviously because they are so exotic. But it was also the standard. It is the amount of leverage that you can put in the system, how much debt you can put on a very small basic capital. " CHRG-111hhrg74855--343 Mr. Upton," Yes, you know, Mr. Wellinghoff, Chairman Wellinghoff in one of his answers talked about uncertainty creates more risk and clearly I think that is what this 3795 really does. It does need to be maybe a little more than tweaked but it needs to be fixed. There is an old saying if it ain't broke, don't fix it but in fact, I think this would really send us back and the bottom line would be that the extra burden would probably increase rates for most America. I know PJM, I thought stood for Michigan in this thing but that is all right. But it would, the burden would in fact have the potential of increasing rates for all consumers is that--does anyone disagree with that? So and, you know, the electric industry is unified, right? Is there anyone else that is not on the same page, any major organization that is not with your testimony, right? " CHRG-111hhrg53021--289 Mr. Hensarling," Thank you, Mr. Chairman. Mr. Secretary, I am going to paraphrase part of your testimony. You essentially said, I believe, we are here because the Administration inherited an economic mess. I don't necessarily disagree with that assessment. I would say the question is whether or not the Administration's policies are making this mess better or worse. Since the Administration has come to office, clearly you know that unemployment has risen to 9.5 percent, the highest in a quarter century: 2.6 million additional jobs have been lost since the Administration has taken office. The public debt has increased by almost $1 trillion or $7,430 per household. Given that backdrop, I am having to look at this new proposal that you bring before us today. In the Capital Markets Subcommittee last month the 3M Company testified that they projected that they would be looking at $100 million per year on average in additional costs for a mandatory clearing environment. Now, I believe in questions by the gentleman from Kansas, Mr. Moore, I believe you said something along the lines of: It is very difficult to ultimately gauge the cost burden for those who may have to go to a mandatory clearing. " CHRG-111hhrg53021Oth--289 Mr. Hensarling," Thank you, Mr. Chairman. Mr. Secretary, I am going to paraphrase part of your testimony. You essentially said, I believe, we are here because the Administration inherited an economic mess. I don't necessarily disagree with that assessment. I would say the question is whether or not the Administration's policies are making this mess better or worse. Since the Administration has come to office, clearly you know that unemployment has risen to 9.5 percent, the highest in a quarter century: 2.6 million additional jobs have been lost since the Administration has taken office. The public debt has increased by almost $1 trillion or $7,430 per household. Given that backdrop, I am having to look at this new proposal that you bring before us today. In the Capital Markets Subcommittee last month the 3M Company testified that they projected that they would be looking at $100 million per year on average in additional costs for a mandatory clearing environment. Now, I believe in questions by the gentleman from Kansas, Mr. Moore, I believe you said something along the lines of: It is very difficult to ultimately gauge the cost burden for those who may have to go to a mandatory clearing. " CHRG-109hhrg22160--5 Mrs. Maloney," Thank you. It is always a pleasure to welcome Chairman Greenspan. I look very much forward to your testimony on the economy and monetary policy, but I would also like to get your views on some broader issues regarding the sharp turn in economy policy from the late 1990s, when we eliminated the deficit and started to pay down the debt, to now, when once again we see deficits as far as the eye can see and mounting debt. The state of the economy at present deeply disturbs me. This administration has repeatedly set records for debts and deficits. In the 1990s, we were looking toward a budget surplus of $5.6 trillion over 10 years. Now we have a budget deficit of over $400 billion, with no end in sight. We have raised the debt limit three times in this administration, and our debt now stands at well over $7 trillion, an unfortunate record. That means that $26,000 is owed by every man, woman and child in America, the highest it has ever been. Their newest record is an all-time high trade deficit for last year: nearly $618 billion. The debt and deficit policies of this administration place a severe burden on our economy because we are borrowing huge sums from foreign countries. Some of our allies are warning us that they are approaching the limit of their willingness to buy our debt. It has gotten to the point where some European bankers who were in Washington, D.C., last week were asking if the dollar will continue to be the reserve currency of the world. So I want to know, Mr. Greenspan, are you really comfortable with the policies of what I can only call the debt-and-deficit Republicans who are now running our economic policy? Chairman Greenspan, your testimony explains why the Federal Reserve is likely to continue what it calls its measured policy of interest rate increases, but I would hope that you would take a second look at this policy. I am concerned that we are not seeing the kind of robust job growth we would normally see in a strong economy. The Bush administration is proud of its job creation over the past 20 months, but when you break it down, we are only gaining 140,000 jobs per month, barely enough to keep pace with normal growth in the labor force. Most indicators of workers' wages show that they are barely keeping up with inflation, and wages may actually be falling at the lower end of wage distribution. That hardly sounds like an economy that needs to be slowed by interest rate hikes. On the question of debt, I am sure you cannot be happy with what has happened to the federal budget deficit since 2001. And frankly, Mr. Chairman, you had something to do with that, when you gave the green light to the administration's tax policies in 2001. But you have repeatedly said that persistent budget deficits are toxic to the economy and that deficit reduction is one of the best strategies to have for raising national savings and boosting future standards of living. And I completely agree with you on that. That brings me to the administration's proposal for phasing out Social Security by privatizing it. I know you share the President's philosophy about privatized accounts, but you cannot share his budget arithmetic. Experts estimate that the creation of privatized accounts would add upwards of $4 trillion to $5 trillion to our national debt in the first 20 years alone. I believe that you told the Senate yesterday that the privatized accounts proposal would do absolutely nothing to address the solvency of Social Security and would do nothing to boost national savings, yet it adds new problems to our debt. I believe you also said that no one knows how financial markets would respond to all of that debt coming on the market. So I ask mainly what possible benefit could there be to plunging ahead with such a reckless policy when we already have a deficit and debt problem that is out of control? As always, I look forward to your testimony. " CHRG-111hhrg49968--50 Mr. Hensarling," If the Fed will not monetize the debt and if the Congress refuses to deal with the spending curve, which will average about 23 percent of GDP for the next 10 years, that is either going to leave us with a massive tax increase or massive borrowing. But yet, apparently, as we send representatives to China to encourage them to continue to buy our debt, they are shifting to commodities; they are indicating concerns about the level of our debt. Recently, as I believe you know, S&P downgraded UK's debt on May 21st from stable to negative. So what is going to happen if the U.S. loses its AAA rating, or what happens if we have a 60 percent tax increase over the next 10 years to deal with this massive infusion of debt? " CHRG-111hhrg53242--27 Mr. Lowenstein," Thank you, Mr. Chairman, and members of the committee. I appreciate the opportunity to be here this morning and to present our views on the financial regulatory reform issues. The Private Equity Council is a trade association representing 12 of the largest private equity firms in the world. I think members of this committee are well aware of the positive role private equity has played in helping hundreds of American companies grow, create jobs, innovate, and compete in global markets. In the process, over the last 20 years, private equity firms have been among the best, if not the best performing asset class for public and private pension funds, foundations, and university endowments, distributing $1.2 trillion in profits to our investors. In these remarks, I want to make four general points. First, it is important for Congress to enact a new reform regime. Obviously, action which elevates speed over quality is undesirable. But the sooner businesses understand how they will be regulated, the quicker they will be able to organize themselves to carry out their roles in reviving strong capital markets. Private equity firms today have $470 billion in committed capital to invest, and we are looking forward to the opportunity to do that. Second, the Obama Administration articulated three fundamental factors that trigger systemic risk concerns: first, the impact a firm's failure would have on the financial system and the economy; second, the firm's combination of size, leverage, including off balance sheet exposures, and the degree of its reliance on short-term funding; and third, the firm's criticality as a source of credit for households, businesses, and State and local governments, and as a source of liquidity for the financial system. Private equity contains none of these systemic risk factors. Specifically, PE firms have limited or no leverage at the fund level, and thus are not subjected to unsustainable debt or credit or margin calls. PE firms don't rely on short-term funding. Rather, PE investors are patient, and commit their capital for 10 to 12 years or more, with no redemption rights. Private equity does not invest in short-term tradeable securities like derivatives and credit default swaps, and private equity firms are not deeply interconnected with other financial market participants through derivative positions, counterparty exposures, or prime brokerage relationships. And finally, private equity investments are not cross-collateralized, which means that neither investors nor debt holders can force a fund to sell unrelated assets to repay a debt. Third, we support creation of an overall systemic risk regulator who has the ability to obtain information, is capable of acting decisively in a crisis, and possesses the appropriate powers needed to carry out its mission. As to exactly how you carry that out, we are frankly agnostic on that subject. And fourth, regarding private equity and regulation specifically, we generally support the Administration's proposal for private equity firms, venture capital firms, hedge funds, and other private pools of capital to register as investment advisers with the SEC. And we support similar legislation introduced by Representatives Capuano and Castle. To be clear, registration will result in new regulatory oversight for private equity firms. There are considerable administrative and financial burdens associated with being a registered investment adviser. And in fact, these could be especially problematic for smaller firms. So it is important to set the reporting threshold at a level which covers only those firms of sufficient scale to be of potential concern. But despite the potential burdens, we do support strong registration requirements for all private pools of capital because it is clear that such registration can help restore confidence in the financial markets. And in the long run, private equity will benefit when confidence in the system is high. While supporting registration, we believe Congress should direct regulators to be precise in how new regulatory requirements are calibrated so the burdens are tailored to the nature and size of the individual firm and the actual nature and degree of systemic risk it may pose. It is vital that any information provided to the SEC be subjected to strong confidentiality protections so as not to expose highly sensitive information beyond that required to carry out the systemic risk oversight function. We stand ready to work with you, Mr. Chairman, and members of the committee as these issues are resolved through the legislative process. Thanks again. [The prepared statement of Mr. Lowenstein can be found on page 76 of the appendix.] " CHRG-111hhrg56847--185 Mr. Edwards," Okay. As we go forward, would making permanent all of the Bush 2001 and 2003 tax cuts reduce the national debt or increase the national debt? " CHRG-110hhrg34673--224 Mr. Perlmutter," So no alarm bells in the trend of consumer debt, because I guess my perception has been that we have had significant increase to consumer debt really as compared to over the last 10 years, and that there have been some concerns about that. " FinancialCrisisInquiry--295 WALLISON: OK. The—since Goldman was regulated by the SEC, which I think, again, in about 2004, your leverage increased substantially from 2004 until about 2008. Why would leverage increase after you became regulated by the SEC? CHRG-110shrg38109--66 Chairman Dodd," Thank you very much, Senator Bunning. Senator Casey. Senator Casey. Thank you, Mr. Chairman, and the other Chairman in the room, thank you for your time and for your service. I have two general questions, one on debt and one on children. With regard to debt, I was looking at the report that the Federal Reserve Board is submitting in connection with your appearance here today and your testimony. And, in particular, I wanted to direct your attention and the attention of others to the report. I note here that in the section which deals with the Federal Government and expenditures and outlays by the Federal Government, it says, ``Net interest payments increased 23 percent in fiscal year 2006 as interest rates rose and Federal debt continued to grow.'' Then it goes on from there and talks about the outlays for Medicare Part D, Medicare itself up 10.5 percent. It talks about disaster relief, Medicaid spending, and then it gets to the next part of the paragraph. ``Outlays for defense in fiscal year 2006 slowed to their lowest rate of increase since fiscal year 2001, although the rise was still about 6 percent.'' That is the first predicate of my question. It goes on to talk about debt, the Federal debt subject to the statutory limit has increased, now we are at the $8.6 trillion level. I guess with that as a predicate, let me tell you what I think about this. I think that that is unsustainable, and as much as we have talked, as important as it is to talk about the good sound bite, reducing our dependence on foreign oil, I think we need a lot more effort in this Congress and in this town on reducing our dependence on foreign debt. I think it is making us less safe in the fight against terrorism. I think it is making us less safe in terms of our ability to spend money on defense, not to mention our inability to spend money on good investments in the economy, as you talked about, education, training, and the rest. So, I guess my basic question is: In light of that data, and any other data you want to factor into this question, are these numbers sustainable, an $8.6 trillion debt and a 23-percent increase in net interest payments? Is that sustainable over time? " CHRG-111hhrg56847--41 Mr. Bernanke," I am familiar with her study, and I would say that her book with Ken Rogoff on debt crisis and financial crisis is an extraordinary piece of work that includes analyses of, as you say, dozens of crises. On this particular issue, I agree with the general point that as debt increases, interest rates increase. That tends to make investments more costly, tax rates go up. " CHRG-109hhrg28024--159 Mr. Moore," Are you aware of a pending request for an increase in the debt limit? " CHRG-109hhrg28024--294 Mr. Bernanke," Congressman, China is not holding our debt because they want to be nice to us. They're holding it because they value the fact that this debt is being traded in deep, liquid, and safe financial markets, and so their own interest is in holding this debt. And despite occasional rumors of diversification and the like, generally speaking, there's not been, as far as I know, any significant changes in the amount of debt, U.S. debt or U.S. dollar-denominated assets being held by China, and any sharp change really would not be in their interest to undertake. I think that the financial markets are really very deep and liquid for U.S. dollar assets. If you include not only U.S. Government debt, GSE debt, but also highly rated corporate debt, for example, the size of the market for high-rated U.S. dollar credit instruments is perhaps $40 trillion, something along those lines, which means that China is only holding a few percentage points of that debt. So I'm not deeply concerned about this issue. I think that realistic changes in China's portfolio are not going to have major impacts on U.S. asset prices or interest rates. The issue is not so much the change in China's portfolio. The issue really is the fact that we are consuming more than we are producing domestically. That means that foreign debt is increasing, and there may come a period or a time when foreigners are not willing to continue to add to their holdings of U.S. dollar assets, and that will in turn lead to perhaps an uncomfortable adjustment in the current account. " CHRG-109hhrg31539--148 Mr. Paul," Do you see our deficits that we produce--and that you have no control on--as a burden to the Federal Reserve in managing monetary affairs and maintaining interest rates as well as maybe even living with a lower increase in the money supply? " CHRG-109hhrg22160--52 Mrs. Maloney," Especially, Mr. Greenspan, when you said yesterday in the Senate that the increased debt of over $1 trillion in a 10-year period would be too much for the markets to absorb. And so, when we have independent analysis and economists saying that it will be $4 trillion to $5 trillion over 20 years, doesn't that cause a tremendous problem on top of the debt and deficits that we already have, yes or no? " FinancialCrisisInquiry--403 SOLOMON: Well, I’ll take a crack at that. I don’t know quite how to answer that saying, “I’ll take a crack at it.” I think that the taxing of debt and equities is fairly appropriate. And I think credit is what is makes the world go round, and credit is what makes the economy go round. And what we’re trying to do here and what I hope you will reach conclusions on is what is the balance between the capitalist markets and liquidity of the capitalist markets and the need to regulate them. And if there are changes that should be made in the tax code over a long period of time to cause that to be in balance and to not favor one greatly over another, then you—then I would hope you would reach those type of conclusions. But I don’t see that as the number one issue. I see the extension of risky, as both my colleagues here have noted. It’s the extension of bad loans. It’s simply bad loans. There was a testimony today about the role of leveraged loans. I think Mr. Blankfein said it, but Mr. Dimon and all people here who testified this morning were extending loans— covenant-light loans and leverage buyouts. Well, who would think that was a good idea? Was that equity or was that debt? That’s the question. If you don’t have to repay it, if you violate a covenant, is it actually debt even if you have to repay it at the end? Maybe it isn’t. CHRG-109hhrg28024--163 Mr. Moore," It would take us up to eight trillion plus. It was at about $900 billion, the request for the debt increase is supposed to come by February of next year. Is that correct? " CHRG-111hhrg56847--187 Mr. Edwards," So in and of themselves, extending those tax cuts and making them permanent would increase the national debt, is that correct? " CHRG-109shrg21981--117 Chairman Greenspan," Senator, we have the difficult problem that people find U.S. Treasury securities the safest in the world. And it is not as though we are forcing them to go buy our securities, nor do I believe we have any legal mechanism to prevent them from buying them in the open market, which is what they do. So, I am not sure how to address this issue because I am not sure what we can do about it. The notion, however, which came out, I think, a couple of weeks ago, that there was a significant move toward selling off U.S. dollar instruments by foreign central banks, that actually was not accurate. The extent of holdings remains very heavy for dollars as a share of their aggregate holdings. And part of the decline, very small, is the very fact that if you take a portfolio with dollars and, say, euros, and a dollar's price falls relative to the euro, then the value of euros in dollar equivalents rises and that therefore it looks as though the dollar has gone down as a share of total outstanding portfolios, when indeed it has not. That is basically what the case is. But on the broader issue you are raising, I am not sure how to handle that because I am not sure what the longer-term implications are. You are quite correct at the moment, excluding the U.S. Treasury debt held by the Federal Reserve, half of our debt is owned abroad. And I would assume at some point it has consequences, but I cannot tell you what they are. Senator Stabenow. Mr. Chairman, is it not reasonable to assume, though, that every time we are adding national debt, we are adding opportunities for foreign investors to purchase those bonds, so that one way to stop the foreign holdings increasing would be to stop the national debt from increasing? " CHRG-109shrg30354--103 Chairman Bernanke," I think I had a similar question earlier and I mentioned two things. One would be that we would have an inflationary problem which is greater than we now expect. And the other would be energy prices coming from geopolitical concerns or other sources. I think those are two. Obviously you can think of others. Senator Sarbanes has pointed to the housing market and other things. But I think those would be the ones I would point to. Senator Allard. My colleague from Connecticut talked about the debt. We have the public debt and then we have the total debt, which includes transfer funds for Social Security into the debt. If we did not have a deficit today and even, in fact, had a surplus, wouldn't our total debt figures increase because of the transfer from Social Security surpluses into the general fund? Would that not reflect on the total debt figure? And if we are ever really going to accomplish total debt reduction, how are we going to do that without mandatory spending reform? " CHRG-109shrg21981--52 Chairman Greenspan," I think the issue is something which I am still puzzling about in the sense I am trying to get a sense as to whether the markets read this as no change in national savings, and therefore it is not a problem. I do say, as I said previously, that I would be very careful about very large increases in debt, but I do believe that relatively small increases are not something that would concern me. Senator Sarbanes. Do you regard increases of $1 trillion or $2 trillion or $3 trillion as large? " FinancialCrisisInquiry--92 WALLISON: OK. The—since Goldman was regulated by the SEC, which I think, again, in about 2004, your leverage increased substantially from 2004 until about 2008. Why would leverage increase after you became regulated by the SEC? BLANKFEIN: You know, I don’t have—the way we did leverage, the way we looked at leverage under our regulatory regime, it was the notion of adjusted leverage, which was—which didn’t rate every asset the same way. So for example, right now we sit here with a balance sheet of about $880 billion. But about $170 billion of that is cash, but it’s on our balance sheet. So we assign a very low risk to that. And the regulation assigned a low risk. So we had notions of our metric was an adjusted test. The Federal Reserve for bank holding companies has a growth leverage test, which I—which, again, I don’t want to misspeak, but I don’t—I’m not—we never really focused on, and even at this moment, I don’t think is as important as the risk-adjusted leverage test. It is how—what is the— how much capital do you have to have against cash? WALLISON: I fully agree, but—but the leverage tests have been published in the newspapers—not tests, but leverage numbers have been published in the newspapers. People are under the impression that the investment banks became very highly leveraged after the SEC began to regulate them. And I’m trying to get at... BLANKFEIN: I’ll have to get you what our leverage was at each time. But the investment banks, as a gross term, there was comments—and I read some of the materials -- 40-, 60-times leverage. I think the high water mark of our leverage, which we never sat at, I think was in the mid-20s—ever—as a high water mark, for example. WALLISON: CHRG-110shrg50418--66 Mr. Mulally," Mr. Chairman, I think the only thing I would add is I think the most significant risk would be what would happen to the economic development, to the GDP growth, especially with the unemployment and with the debt, because clearly with the interdependence that we have with the supply chain and all of that, they are highly leveraged, also. I think the biggest single risk would be further slowdown in the economic development. " FinancialCrisisInquiry--129 SOLOMON: Well, I’ll take a crack at that. I don’t know quite how to answer that saying, “I’ll take a crack at it.” I think that the taxing of debt and equities is fairly appropriate. And I think credit is what is makes the world go round, and credit is what makes the economy go round. And what we’re trying to do here and what I hope you will reach conclusions on is what is the balance between the capitalist markets and liquidity of the capitalist markets and the need to regulate them. And if there are changes that should be made in the tax code over a long period of time to cause that to be in balance and to not favor one greatly over another, then you—then I would hope you would reach those type of conclusions. But I don’t see that as the number one issue. I see the extension of risky, as both my colleagues here have noted. It’s the extension of bad loans. It’s simply bad loans. There was a testimony today about the role of leveraged loans. I think Mr. Blankfein said it, but Mr. Dimon and all people here who testified this morning were extending loans— covenant-light loans and leverage buyouts. Well, who would think that was a good idea? Was that equity or was that debt? That’s the question. If you don’t have to repay it, if you violate a covenant, is it actually debt even if you have to repay it at the end? Maybe it isn’t. BASS: I’d like to make two observations... VICE CHAIRMAN THOMAS: Just briefly, yes. BASS: Two quick observations on that. The first one is I agree with Mr. Solomon about the tax structure. I think it’s fairly appropriate the way it stands today. I think that when you look at the banking business, there were securities that were considered to be hybrid securities. They weren’t equity. They weren’t debt. Banks could raise hybrid securities in forms designated as trust preferreds. fcic_final_report_full--9 And the leverage was often hidden—in derivatives positions, in off-balance-sheet entities, and through “window dressing” of financial reports available to the investing public. The kings of leverage were Fannie Mae and Freddie Mac, the two behemoth gov- ernment-sponsored enterprises (GSEs). For example, by the end of , Fannie’s and Freddie’s combined leverage ratio, including loans they owned and guaranteed, stood at  to . But financial firms were not alone in the borrowing spree: from  to , na- tional mortgage debt almost doubled, and the amount of mortgage debt per house- hold rose more than  from , to ,, even while wages were essentially stagnant. When the housing downturn hit, heavily indebted financial firms and families alike were walloped. The heavy debt taken on by some financial institutions was exacerbated by the risky assets they were acquiring with that debt. As the mortgage and real estate mar- kets churned out riskier and riskier loans and securities, many financial institutions loaded up on them. By the end of , Lehman had amassed  billion in com- mercial and residential real estate holdings and securities, which was almost twice what it held just two years before, and more than four times its total equity. And again, the risk wasn’t being taken on just by the big financial firms, but by families, too. Nearly one in  mortgage borrowers in  and  took out “option ARM” loans, which meant they could choose to make payments so low that their mortgage balances rose every month. Within the financial system, the dangers of this debt were magnified because transparency was not required or desired. Massive, short-term borrowing, combined with obligations unseen by others in the market, heightened the chances the system could rapidly unravel. In the early part of the th century, we erected a series of pro- tections—the Federal Reserve as a lender of last resort, federal deposit insurance, am- ple regulations—to provide a bulwark against the panics that had regularly plagued America’s banking system in the th century. Yet, over the past -plus years, we permitted the growth of a shadow banking system—opaque and laden with short- term debt—that rivaled the size of the traditional banking system. Key components of the market—for example, the multitrillion-dollar repo lending market, off-bal- ance-sheet entities, and the use of over-the-counter derivatives—were hidden from view, without the protections we had constructed to prevent financial meltdowns. We had a st-century financial system with th-century safeguards. When the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the short-term loans, and the risky assets all came home to roost. What resulted was panic. We had reaped what we had sown. • We conclude the government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets. As part of our charge, it was appropriate to review government actions taken in response to the developing crisis, not just those policies or actions that preceded it, to determine if any of those responses contributed to or exacerbated the crisis. CHRG-111hhrg52261--10 Mr. Loy," Thank you, Chairman Velazquez, Ranking Member Graves, and members of the committee. Thank you for the opportunity to be part of this important discussion today. I would like to begin by talking about risk and the difference between entrepreneurial risk and systemic financial risk. Entrepreneurial risk involves making calculated and informed bets on people and innovation and is critical to building small businesses. Systemic financial risk involves a series of complex financial interdependencies between parties and counterparties operating in the public markets. The venture industry and the small business community are heavily dependent on embracing entrepreneurial risk, but we have virtually no involvement in systemic risk. Let me explain why. The venture capital industry is simple. We invest in privately held small businesses created and run by entrepreneurs. These entrepreneurs grow the business using their own personal funds as well as the capital from ourselves and our outside investors, known as LPs or limited partners. We invest cash in these small businesses to purchase equity, i.e., stock, and we then work closely alongside the entrepreneurs on a weekly basis for 5 to 10 years until the company is sold or goes public. When the company has grown enough so that it can be sold or taken public, the VC exits our investment in the company and the proceeds are distributed back to our investors in our funds. When we are not successful, we lose the money we invested, but that loss does not extend to anyone else beyond our investors. Even when we lose money on investments, it does not happen suddenly or unexpectedly. It takes us several years to lose money and the investors in our funds all understand that time frame and the risk when they sign up. Debt, known as leverage, which contributed to the financial meltdown, is not part of our equation. We work simply with cash and with equity. We do not use debt to make investments or to increase the capacity of the fund. Without debt or derivatives or securitization or swaps or other complex financial instruments, we don't expose any party to losses in excess of their committed capital. In our world, the total potential loss from a million dollar investment is limited to a million dollars. There is no multiplier effect because there are no side bets, unmonitored securities, or derivatives traded, based on our transactions. There are no counterparties tied to our investments. Nor are venture firms interdependent with the world's financial system. We do not trade in the public markets and our investors cannot withdraw capital during the 10-year life of a fund, nor can they publicly trade their partnership interest in the fund. The venture capital industry is also much smaller than most people realize. In 2008, U.S. venture capital funds held approximately $200 billion in aggregate assets and invested just $28 billion into start-up companies. That is less than 0.2 percent of the U.S. gross domestic product. Yet, over 40 years, this model has been a tremendous force in U.S. economic growth, building industries like biotech, semiconductor and software. Now we are increasingly helping to build renewable energy and other green-tech sectors. Companies that were started with venture capital since 1970 today account for 12.1 million jobs and $2.9 trillion in revenues in the U.S. That is nearly 21 percent of the U.S. GDP, but it grew from our investments of less than 0.2 percent of GDP. My main point, therefore, is that harming our industry will prevent a major part of the future American economy from growing out of businesses that are today's small businesses; and that is the risk that you should be concerned about. Now, we do recognize the legitimate need for transparency and we simply ask that you customize the regulatory approach to fit what we do. Today, VCs already provide information to the SEC. That information, submitted on what is called Form D, should already be sufficient to determine the lack of systemic risk from venture capital firms. This filing process could easily be enhanced to include information that would provide greater comfort to our regulators. An enhanced Form D--let's call it Form D-2, could answer questions on our use of leverage, trading positions, and counterparty obligations, allowing regulators to then exempt from additional regulatory burdens firms like ours that don't engage in those activities and, therefore, don't pose systemic risks. In contrast, formally registering as investment advisers under the current act, as the current proposals require, has significant burdens without any additional benefits. And let me be clear, registering as an advisor with the SEC is far from simple, and it is not just filling out a form. The word ""registration"" in that context might sound like registering your vehicle, telling the motor vehicle department what kind of car it is and who you are and where you live. It might conjure up images of things like smog checks and our proposal for the Form D-2 is equivalent to that. But actually the word ""registration"" in the SEC context comes with a lot of other requirements. To continue my analogy with your car, it is equivalent to having to hire a full-time driver, plus a compliance officer who rides in the front seat to make sure that driver is operating the car correctly, plus a mechanic who lives at your house to fix the car and works only on your car, plus providing the government with information about every place you drive. Moving back to the actual world of SEC registration involving examinations, complex programs overseen by a mandatory compliance officer, it will demand significant resources which promise to be costly from both a financial and human resources perspective. My own firm believes it will be one-third of our entire annual budget. Your support has not gone unnoticed by us and we appreciate it. We cannot afford another situation where the unintended consequences of well-intentioned regulation harms small businesses and the economic growth that we drive. We look forward to working with the committee on that goal. " CHRG-111shrg53176--166 RESPONSE TO WRITTEN QUESTIONS OF SENATOR MENENDEZ FROM MARY L. SCHAPIROQ.1. Business Development Companies (BDCs), which are regulated under the Investment Company Act, support more than 10,000 jobs in my home State of New Jersey through their extension of credit and investments in more than 20 small and middle-market companies. I understand that the BDC industry has largely ceased to extend credit due to certain Investment Company Act rules that, in the current market environment, may be having unintended consequences. Does the Commission intend to address this problem, and if so, could the Committee expect to receive a report on the Commission's actions?A.1. Over the past year, the greatest challenges to BDCs have resulted from market conditions rather than regulatory restrictions. The dearth of available credit, with the general decline in the value of financial assets, has severely limited the ability of BDCs to raise new capital to invest in small and middle-market companies. During the year ending on March 31, 2009, the net asset value (``NAV'') of the four largest BDCs declined an average of 32.5 percent. Declines in the market value of the shares of these BDCs were more severe, and shares of all four BDCs trade at significant discounts to NAV. The two largest BDCs are in default under their loan agreements, and their auditors have raised going concern issues. As detailed below, the staff generally believes that the regulatory requirements for BDCs are operating as intended. The staff also generally believes that improvements in the availability of credit and in the market values of assets held by BDCs are far more likely to enable BDCs to raise additional capital, and extend credit to small and middle-market companies, than regulatory relief.The Relevant Regulatory Requirement for BDCs Under the Investment Company Act of 1940 (``Act'') BDCs are a type of closed-end investment company regulated under the Act. The Act's capital structure requirements limit the ability of a BDC to raise additional capital by issuing preferred stock or incurring debt. Specifically, the Act prohibits a BDC from issuing or selling preferred stock or incurring debt (or declaring cash dividends on its common stock or repurchasing its common stock), unless immediately thereafter the BDC has asset coverage of its preferred stock plus debt securities of at least 200 percent. These requirements are more permissive than the Act's requirements for other closed-end investment companies whose debt securities must have asset coverage of at least 300 percent. In addition, a BDC may issue multiple classes of debt securities, but other closed-end investment companies may issue only one class of debt security. The Act's asset coverage requirement for BDCs exists for the protection of both investors in common stock on one hand and investors in debt securities or preferred stock on the other hand. As the percentage of a BDC's capital from preferred stock or debt increases, the risk to the common stockholders also increases. At the same time, the risk also increases that the BDC will lack the resources to pay promised interest or dividends or the principal or liquidation preference to the holders of the debt securities or preferred shares. In this regard, Section 1(b) of the Act states that the national interest is adversely affected ``when investment companies by excessive borrowing and the issuance of excessive amounts of senior securities [i.e., preferred stock or debt securities] increase unduly the speculative character of their junior securities [i.e., common stock]'' or ``fail to protect the preferences and privileges of the holders of their outstanding securities.'' Section 1(b) also states that the Act is to be interpreted ``to mitigate and, so far as is feasible, to eliminate the conditions enumerated in this section which adversely affect the national public interest and the interest of investors.''The Regulatory Requirement Generally Is Operating as Intended The Act does not prohibit a BDC from investing all of its available capital in portfolio companies. If a BDC fully invests its capital, a subsequent decline in the value of those investments that cause asset coverage to dip below 200 percent does not constitute a violation of the Act. (However, as explained above, the Act would prohibit the BDC from taking on additional leverage, declaring cash dividends on its common stock or repurchasing its common stock unless its asset coverage equals at least 200 percent at that time.) The Act's asset coverage requirement does not limit the ability of BDCs to raise capital by issuing additional common stock. In the past, some of the largest BDCs periodically issued shares priced at a premium to NAV. This additional equity capital, in turn, increased the BDCs' borrowing capacity. Under the Act, a BDC may issue additional shares priced at a discount to NAV, provided that the BDC's board makes certain findings and shareholders approve the offering. A number of BDCs have obtained board and shareholder authorization for such offerings. In fact, Prospect Capital Corporation, one of the ten largest BDCs, recently raised over $60 million in a public offering of its common stock priced below NAV. To the extent that BDCs have been interested in exploring relief from the Act's asset coverage requirement, the staff has given this issue serious and careful consideration in numerous meetings with BDC representatives, their accounting firms and their lawyers. The staff continues to engage in a dialogue with BDCs and their representatives about regulatory relief. In general, the staff believes that the Act's restriction on further leverage and payment of cash dividends on common shares or repurchase of common shares when asset coverage is less than 200 percent are generally working as intended. Nevertheless, the staff has provided no-action relief from the asset coverage requirement to the largest BDC so that it, and other BDCs in similar circumstances, could make cash dividend payments to the extent necessary to take advantage of IRS relief made available to certain closed-end investment companies earlier this year. The staff also agreed to permit BDCs to use the shelf registration process for sales of shares priced below NAV. Prospect Capital Corporation used a shelf registration for its recent sale of shares priced below NAV. We hope that this analysis constitutes the report contemplated by this question, but if Senator Menendez or the Committee requires additional information or updates, the staff would be pleased to provide it.Q.2. Does the Commission need any additional authority to address these problems, or are there legislative solutions that are necessary to make certain that credit continues to be made available to small and middle-market companies?A.2. The staff does not believe that additional authority would enhance the ability of BDCs to attract additional capital to invest in small and middle-market companies. If Congress were explicitly to authorize the Commission to suspend or eliminate all of the Act's capital structure requirements applicable to BDCs, the staff doubts that lenders would be more willing to extend credit to BDCs or the capital markets more willing to purchase shares issued by BDCs. ------ CHRG-109shrg21981--99 Chairman Greenspan," We have to change it. The question is how. Senator Schumer. Yes. Well, nobody disputes that we need some change. But it seems to me if the markets have discounted all of this, then it does not do any harm, but it does not do any good, because net savings is not increasing, as you said before. If the market has not discounted a rather large amount of debt being added to the existing debt--obviously, 15 or 20 years ago this would not have been a problem--then we have real trouble. " fcic_final_report_full--187 The OTS approved Countrywide’s application for a thrift charter on March , . LEVERAGED LOANS AND COMMERCIAL REAL ESTATE: “YOU ’VE GOT TO GET UP AND DANCE ” The credit bubble was not confined to the residential mortgage market. The markets for commercial real estate and leveraged loans (typically loans to below-investment- grade companies to aid their business or to finance buyouts) also experienced similar bubble-and-bust dynamics, although the effects were not as large and damaging as in residential real estate. From  to , these other two markets grew tremen- dously, spurred by structured finance products—commercial mortgage–backed se- curities and collateralized loan obligations (CLOs), respectively—which were in many ways similar to residential mortgage-backed securities and CDOs. And just as in the residential mortgage market, underwriting standards loosened, even as the cost of borrowing decreased,  and trading in these securities was bolstered by the development of new credit derivatives products.  Historically, leveraged loans had been made by commercial banks; but a market for institutional investors developed and grew in the mid- to late s.  An “agent” bank would originate a package of loans to only one company and then sell or syndi- cate the loans in the package to other banks and large nonbank investors. The pack- age generally included loans with different maturities. Some were short-term lines of credit, which would be syndicated to banks; the rest were longer-term loans syndi- cated to nonbank, institutional investors. Leveraged loan issuance more than dou- bled from  to , but the rapid growth was in the longer-term institutional loans rather than in short-term lending. By , the longer-term leveraged loans rose to  billion, up from  billion in .  Starting in , the longer-term leveraged loans were packaged in CLOs, which were rated according to methodologies similar to those the rating agencies used for CDOs. Like CDOs, CLOs had tranches, underwriters, and collateral managers. The market was less than  billion annually from  to , but then it started grow- ing dramatically. Annual issuance exceeded  billion in  and peaked above  billion in . From  through the third quarter of , more than  of leveraged loans were packaged into CLOs.  As the market for leveraged loans grew, credit became looser and leverage in- creased as well. The deals became larger and costs of borrowing declined. Loans that in  had paid interest of  percentage points over an interbank lending rate were refinanced in early  into loans paying just  percentage points over that same rate. During the peak of the recent leveraged buyout boom, leveraged loans were fre- quently issued with interest-only, “payment-in-kind,” and “covenant-lite” terms.  Payment-in-kind loans allowed borrowers to defer paying interest by issuing new debt to cover accrued interest. Covenant-lite loans exempted borrowers from stan- dard loan covenants that usually require corporate firms to limit their other debts and to maintain minimum levels of cash. Private equity firms, those that specialized in investing directly in companies, found it easier and cheaper to finance their lever- aged buyouts. Just as home prices rose, so too did the prices of the target companies. One of the largest deals ever made involving leveraged loans was announced on April , , by KKR, a private equity firm. KKR said it intended to purchase First Data Corporation, a processor of electronic data including credit and debit card pay- ments, for about  billion. As part of this transaction, KKR would issue  billion in junk bonds and take out another  billion in leveraged loans from a consortium of banks including Citigroup, Deutsche Bank, Goldman Sachs, HSBC Securities, Lehman Brothers, and Merrill Lynch.  CHRG-110hhrg41184--61 Mrs. Maloney," Thank you very much, and welcome, Mr. Bernanke. New problems in the economy are popping up like a not-very-funny version of Whack-a-mole, as Alan Blinder, a former Vice Chair of the Fed, recently observed, and yesterday's news was no exception with their wholesale inflation soaring consumer confidence falling and home foreclosures are spiking and falling sharply. Added to this, many people believe that the next shoe to fall will be credit card debt, which is securitized in a very similar way as the subprime debt. And, as you know, the Fed has a statutory mandate to protect consumers from unfair lending practices. But there is a widespread perception that the Federal Reserve and Congress did not do enough or act quickly enough to correct dangerous and abusive practices in the subprime mortgage market. Many commentators are now saying that credit cards will be the next area of consumer credit where over-burdened borrowers will no longer be able to pay their bills. We see a situation with our constituents where many responsible cardholders, folks who pay their bills on time and do not go over their limit, are sinking further and further into a quicksand of debt, because card companies are raising interest rates any time, any reason, retroactively, and in some cases quite dramatically--30 percent on existing balances--and there are very, I'd say scary, parallels between the subprime mortgage situation and what is now happening with credit cards. In your response to Chairwoman Biggert's question on what the most important thing a consumer needs to know about their credit card you responded, and I quote: ``Consumers need to know their interest rate and how it varies over time.'' You also mentioned that it is important for consumers to know how their interest rate works. I have introduced legislation with Chairman Frank and 62 of our colleagues that would track your proposed changes to Regulation Z to always give consumers 45 days notice before any rate increase. But it would also give consumers the ability to opt out of the new terms by closing their account and paying off their balance at existing terms. Would you agree that this notice and consumer choice would allow consumers to know their interest rate and how it varies over time and how it works? " FinancialCrisisInquiry--576 MAYO: Yes. I would say I mean I have four D’s. One is de- leveraging. We’re seeing consumer loans go down. You’re seeing commercial loans go down. Loan growth is not happening yet. One reason is because I don’t think all the bad assets have been sold. And so until that takes place, we’ve been talking about that for two years, still hasn’t happened yet. De-leveraging. Number two, de-risking. Not just the de-risking of assets, but also the de-risking of liabilities, several trillion dollars of bank bonds that mature over the next three years that’ll have to be refinanced. That’ll be an issue at the same time that some of the government debts have to be refinanced. Number three would be deposit insurance or resolving all the potential failed banks. And then number four, the deposit service charges where a lot of attention on that recently that could hurt earnings down the road. So those are issues. And as far as—yes? CHRG-111hhrg49968--51 Mr. Bernanke," At some point, you have to have a path of spending and taxes that will give you a stabilization of the debt-to-GDP ratio. If you don't, then fear that the debt will continue to rise will make it very difficult to finance it. And, at some point, you will hit a point where you will have to have both very Draconian cuts and very large tax increases, which is not something we want. So, in order to avoid that outcome down the road, we need to begin now to plan how we are going to get the fiscal situation into a better balance in the medium term. " CHRG-110hhrg46594--154 Mr. Nardelli," Well, then, sir, certainly the increase in the balance sheet, the reduction in the debt to equity ration for these banks, they need to let it start flowing. " CHRG-111hhrg49968--43 Mr. Bernanke," Well, Congressman, I am not sure whose CBO projection, I guess, that is. I would say that that picture is concerning not only because of the level but because of the fact that it continues to rise. Sustainability means--there are countries that have 80 percent or 100 percent debt-to-GDP ratios. I am not recommending that. But, clearly, you can't have a debt-to-GDP ratio which continues to rise indefinitely. So it is very important that we have now or very soon a plan to stabilize, at least, the debt-to-GDP ratio so that it doesn't go into a continued increase, which, because of interest payments, would make sort of a vicious circle going forward. " CHRG-111hhrg49968--44 Mr. Hensarling," I have seen one analysis that, clearly, to keep the debt at today's level, 41 percent of GDP, that either, number one, you are going to have to monetize the debt and essentially inflate the money supply 100 percent, or that tax increases across the board in the neighborhood of 60 percent would be necessary to balance the budget in 10 years. Has the Federal Reserve done its own calculations? Does this seem to be an accurate analysis? " FOMC20070816confcall--102 100,MR. DUDLEY.," If I could just add one more point—another issue of a narrower spread is that, as Brian pointed out, you probably increase the number of people, and so there are also some operational issues relating to the staff that the Federal Reserve Banks are managing. If we thought that cutting it in half would lead to a dramatic increase in the number of banks, which is certainly possible, given the fact that we have 8,000 banks and many more depository institutions than that, there is an issue in terms of the operational burden and our capacity to do that, given that this is basically very rarely used in the current environment." CHRG-110hhrg46591--215 Mr. Stiglitz," For instance, on some of these there was the possibility of a debt-for-equity swap so that if you--you know, we bailed out the debt holders, the bond holders, as well as--even when the equity owners took a beating. There were huge amounts of increases in the value of the debt. And I was also concerned at the terms at which the money was being provided. And you can see one piece of evidence that we got--two pieces--three pieces of evidence that we got a very bad deal in the way it was administered by our Secretary of the Treasury is the fact that most of the companies, when it was announced they were going to get an equity injection, their share price went way up. Second, you compare the terms that we got versus the terms that Warren Buffett got, there is absolutely no comparison. Third, you look at the terms that we got versus the terms that the U.K. Government got, there is no comparison. So I was concerned-- " CHRG-110shrg46629--70 Chairman Dodd," Thank you, Senator. Correct me if I am wrong, Mr. Chairman, but the numbers I have used, what I am told is that the average household has revolving debt in excess of $9,000, most of that being credit card debt. Just to make the point that Senator Menendez is talking about, and a negative savings rate. These are very disturbing statistics, if in fact those numbers increase like that. That is just unacceptable, I think. Senator Allard. CHRG-111hhrg51585--152 Mr. Lance," Your testimony indicates that issuance of debt by California, as I understand your testimony, has increased a yield from 4 percent to 6 percent in the last several months. Am I reading your testimony correctly? " FinancialCrisisInquiry--389 BASS: OK. Thank you. Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Kyle Bass. I’m the managing partner of Hayman Advisors in Dallas. And I would like to thank you and the members of the committee for the opportunity to share my views with you today as you consider the causes of the recent crisis as well as certain changes that must take place to avoid or minimize future crises. I believe that I have somewhat of a unique perspective with regard to this crisis, as my firm and I were fortunate enough to have seen parts of it coming. Hayman is a global asset management firm that managed several billion dollars of subprime and Alt-A mortgage positions during the crisis. And we remain an active participant in the marketplace today. While I realize the primary objective of the hearing today is to provide baseline information on the current state of the financial crisis and to discuss the roles that four specific banks or investment banks—Goldman, Morgan Stanley, Bank of America and JPMorgan—have played in the crisis, in my opinion, no single bank or group of large institutions single-handedly caused the crisis. While I will address each participant’s structure and problems independently later in my testimony, the problems with the participants and regulatory structure needs to be considered more holistically in order to prevent future systemic breakdowns and taxpayer harm. January 13, 2010 While there are many factors that led to the crisis, I will address what I believe to be the key factors that contributed to the enormity of the crisis. The first of which is the OTC derivatives marketplace. It was brought up in the prior hearing. But with nearly infinite leverage that it—that it afforded and continues to afford the dealer community, it must be changed. AIG, Bear Stearns and Lehman would not have been able to take on as much leverage as they did had they been required to post initial collateral on day one for the risk positions they were assuming. Asset management firms, including Hayman, have always been required to post initial collateral and maintenance collateral for virtually every derivatives trade we engage in. However, in AIG’s case, not only did they have to post initial collateral—or didn’t have to post initial collateral for these positions, when the positions moved against them, the dealer community forgave the so-called variance margin. The dealer community as well as other supposed AAA rated counterparties were, and some still are, able to transact with one another without sending collateral for the risk they are taking. This so-called initial margin was and still is only charged to counterparties that are deemed to be of lesser credit quality. Imagine if you were a 28-year-old mathematics superstar at AIG Financial Products Group, and you were compensated at the end of each year based upon the profitability of your trading book, which was ultimately based upon the risks you were able to take without posting any money initially. How much risk would you take? Well, the unfortunate answer turned out to be many multiples of the underlying equity of many of the firms in question. In AIG’s case, the risks taken in the company’s derivatives book were more than 20 times the firm’s shareholder equity. For a comprehensive look at those leverage ratios we can move to tables in my presentation later. The U.S. taxpayer is still paying huge bonuses to the members of AIG’s Financial Products Group because they’ve convinced the overseers that they possess some unique skill necessary to unwind these complex positions. In reality there are hundreds of out-of-work derivatives traders that would happily take that job for $100,000 a year instead of the many millions being paid to these supposed experts. January 13, 2010 To solve this OTC derivatives problem—I heard a few of the—of the potential solutions this morning. But I’ll go over the three that I think are absolutely mandatory to fix this problem. One is—is the key issue—is homogeneous minimum collateral requirements. All participants in the derivatives marketplace—do not bar the dealers from this— should be required to post initial capital based upon some formulaic determination of the risk by the appropriate regulatory body. Two, centralized clearing and mandatory price reporting of all standardized CDS, FX and interest rate derivatives—we believe close to 90 percent of these derivatives are standardized. Centralized data repository for all cleared and non-cleared derivatives trades—essentially there must be some place where every single transaction is recorded and monitored. As of today, that still doesn’t exist. It’s hard for me to believe that where we are today that that doesn’t exist. The second thing I’d like to talk about is bank leverage. And this is just the fundamental tenants of the U.S. banking system. Under current regulatory guidelines, banks are deemed to be well- capitalized with 6 percent tier one capital and adequately capitalized with 4 percent tier one capital based upon risk weighted assets. As an aside, the concept of risk weighting in assets should also be reviewed. This in turn means that a well-capitalized bank is leveraged 16 times to its capital, much more to its tangible common equity. And an adequately capitalized bank is—or a minimum capitalized bank—sorry—is 25 times levered to its tier one capital. I don’t know how many prudent individuals or institutions can possibly manage a portfolio of assets that is 25 times levered when we hit a crisis. But—but I surely can’t. Unfortunately, the answer so far has been not many of the other banks have been able to manage these risks either. Of the 170 banks that have failed during the crisis to date, the average loss to the FDIC and the taxpayer is well over 25 percent of their assets. When you think about that, that means they’ve lost more than six times their equity, of the banks that have gone down so far. January 13, 2010 Depository institutions like Citibank were able to parlay their deposits into large levered bets in the derivatives marketplace. In fact, at fiscal year-end 2007, Citigroup was 68- times levered to its tangible common equity, including off balance sheet exposures. Clearly, the composition of these assets is important as well, but I am simply trying to illustrate how levered these companies were at the start of the financial crisis. While AIG’s derivatives book was only 20-times levered to their book equity, $64 billion of these derivatives were related to subprime and subprime credit securities, the majority of which were ultimately worth zero. In some cases, excessive leverage cost the underlying company many years of lost earnings, and in other cases it cost them everything. I’ve put a table labeled “exhibit two” in my presentation. What we’ve done is looked back at the cumulative net income that was lost in financial institutions since the third quarter of 2007. Fannie Mae lost 20 ½ years of its profits in the last 18 months. AIG lost 17 ½ years of its profits in the last 18 months. Freddie Mac lost 11 ½ years of profits in a little bit more than a year. The point I’m trying to make is the ridiculousness of what’s gone on in the leverage that was in the system. The key problem with the system is the leverage and we must regulate that leverage. I’m going to—my third point that I’ll talk about briefly here is Fannie and Freddie. With $5.5 trillion of outstanding debt in mortgaged-backed securities, the quasi-public are now in conservatorship, Fannie and Freddie, have obligations that approach the total amount of government-issued bonds the U.S. currently has outstanding. There are so many things that went wrong or are wrong at these so-called “GSEs” that I don’t even know where to start. First, why are there two for-profit companies with boards, shareholders, charitable foundations, and lobbying arms ever given the implicit backing of the U.S. government? The Chinese won’t buy them anymore because our government won’t give them the explicit backing. The U.S. government cannot give them the explicit backing because the resulting federal debt burden will crash through the congressionally January 13, 2010 mandated debt ceiling, which was already recently raised to accommodate more deficit spending. These organizations have been the single largest political contributors in the world over the past decade, with over $200 million being given to 354 lawmakers in the last 10 years or so. Yes, the United States needs low-cost mortgages, but why should organizations created by Congress have to lobby Congress? Fannie and Freddie used the most leverage of any institution that issued mortgages or held mortgage-backed bonds in the crisis. At one point in 2007, Fannie was over 95-times levered to its statutory minimum capital, with just 18 basis points set aside for loss. That’s right -- 18/100ths of 1 percent set aside for potential loss, with 95 times leverage. They must not be able to put Humpty Dumpty back together again. If they are going to exist going forward, Fannie and Freddie should be 100 percent government-owned and the government should simply issue mortgages to the population of the United States directly since this is essentially what is already happening today, with the added burden of supporting a privately funded, arguably insolvent capital structure. I will conclude my testimony there, and—and leave it to questions. CHRG-109shrg26643--132 FROM BEN S. BERNANKE Chairman Bernanke, you wrote in your macroeconomic textbook about the consequences of budget deficits. The Congressional Budget Office estimates that the deficit for 2006 will be $337 billion--even before including the cost of an anticipated supplemental appropriation for Iraq and Afghanistan expected early this year. The deficits for 2003, 2004, 2005, and 2006 are the four largest deficits in American history. Because of these deficits, the long-term attractiveness of the United States as an investment destination could be hurt as investors worry about our Nation's ability to manage its debts. And the deficits could also cause consumers problems if foreign investors stop buying U.S. assets, forcing interest rates to rise sharply. Finally with the ongoing wars in Iraq and Afghanistan, our budget is going to be under continued pressures in the future. Over time, large deficits and debt will raise interest rates, crowd out private sector investment, and slow long-term economic growth.Q.1. How much importance do you put on paying down the publicly held debt that our Nation currently holds?A.1. I am quite concerned about the intermediate to long-term Federal budget outlook. In particular, the budget is expected to come under severe pressure as impending demographic changes fuel rapid increases in entitlement spending. By holding down the growth of national saving and real capital accumulation, the prospective increase in the budget deficit will place at risk future living standards of our country. As a result, I think it would be very desirable to take concrete steps to lower the prospective path of the deficit. Such actions would boost national saving and ultimately the future prosperity of our country, as our children and grandchildren would inherit a larger capital stock that would support greater productivity and higher income. Moreover, steps should be taken soon to address the long-term budget pressures so that people have adequate time to prepare for whatever changes might occur, especially to entitlement programs. Although the stock of debt held by the public would decline in absolute magnitude only if budget surpluses are run, fiscal actions that result in smaller deficits can slow the growth in the stock of debt held by the public and reduce the Federal debt relative to the size of the economy. The key is not so much the absolute level of Federal debt, but rather that we take deficit-reducing steps to increase national saving and, hence, future living standards. As you know, the pay-as-you-go budget provisions of the 1990's required lawmakers to pay for any increases in entitlement spending or decreases in revenues (that is, tax cuts); such changes had to be offset either by equivalent budget cuts or by revenue increases elsewhere. Since those rules expired in 2002, Congress has strived and did enact a variation on PAYGO that completely exempts taxes from the equation: No tax cuts would require offsetting, and spending increases could only be offset by entitlement cuts elsewhere--never by tax increases. This despite the fact our Federal budgets over the last few years have run recorded deficits. This one-sided PAYGO passed despite the recommendations of people like Federal Reserve Chairman Alan Greenspan, Congressional Budget Office Director Douglas Holtz-Eakin, and Government Accountability Office Comptroller General David Walker, who all strongly and repeatedly urged Congress to adopt full PAYGO rules.Q.2.a. Chairman Bernanke, do you support full PAYGO rules over spending-only ones?A.2.a. As I noted in response to the previous question, I believe reducing the Federal deficit is very important, especially in light of the need to prepare for the retirement of the baby-boom generation. I urge the Congress to proceed on that effort in a timely manner and to pay particular attention to how its decisions on spending and tax programs will affect the U.S. economy over the long-term. However, I also believe that in my role as head of the Federal Reserve, I should not be involved in making specific recommendations about the internal decisionmaking process of the Congress and the structure of its budget procedures.Q.2.b. The Treasury Department recently issued its first 30-year bonds in over 4 years. Do you support this decision to bring back the long bond?A.2.b. The responsibility for Federal debt management, of course, rests with the Treasury Department. However, I do support the Treasury's decision to resume issuance of 30-year bonds. Given the large current and prospective Federal financing needs, it is prudent to distribute the Treasury's borrowing across the yield curve. Moreover, long-term interest rates are currently quite low, apparently reflecting in part strong demand among investors for long-term issues. In these circumstances, it is sensible for the Treasury to accommodate this demand in part by issuing 30-year securities. Last week, when the Treasury issued its first 30-year bond since 2001, there was $28 billion in bids for $14 billion of bonds being offered. This in turn made it cheaper for the Treasury to borrow for 30 years than 6 months.Q.3. Do you have any concern that this will contribute to the creation of a bond market bubble, which has the potential effect of lowering inflation-adjusted interest rates to incredibly low levels?A.3. I do not have any such concerns. I should note that I do not see particular significance to the level of bids relative to the size of the recent auction. I attribute the relatively low level of long-term interest rates generally to several factors, including a tendency in recent years for global saving to exceed the amount of potential capital investments, yielding historically normal rates of return as well as relatively low-term premiums in interest rates to compensate investors for interest rate risk. In the unlikely event that any of these factors tended to push real long-term yields to levels that appeared to be incompatible with our macroeconomic objectives, the Federal Reserve would respond by adjusting the stance of monetary policy appropriately.Q.4. What impacts could this have on our economy?A.4. No significant adverse effects are likely. Last week, the Commerce Department reported that our trade deficit rose 17.5 percent to $725.8 billion in 2005, a new record for the fourth consecutive year. You have stated in the past your belief that what you call a ``global savings glut'' is the main driver behind America's record trade deficit, and that the ability to reduce our trade deficit is largely beyond our control.Q.5. Is there nothing we can do to alleviate the pressure building up in the global financial system?A.5. The emergence of large U.S. trade deficits and corresponding surpluses on the part of our trading partners is, to an important extent, the outcome of market forces. Several factors, including the lingering effects of financial crises in emerging market economies and concerns about the outlook for growth in some industrial economies, have led saving abroad to exceed investment. This excess saving has been attracted to the United States by our favorable investment climate, strong productivity growth, and deep financial markets. Although the U.S. net external debt has been growing as a consequence of these inflows, as a fraction of our Nation's income it remains within international and historical norms. Given the strength and flexibility of our economy, there is every reason to believe that, if changes in the foreign outlook or in the tone of financial markets were to cause a reduction in capital inflows and the trade deficit, economic activity, and employment would stay strong.Q.6. Wouldn't reducing our budget deficit and getting tough on currency manipulators help?A.6. All that said, as our net external debt rises, the cost of servicing that debt increasingly will subtract from U.S. income. Accordingly, it would be helpful to raise our domestic saving and reduce our trade deficit while maintaining an environment conducive to investment and growth. Reducing the budget deficit would release resources for private investment and reduce the future burden of repaying the public debt, although studies indicate a relatively modest effect of budget-cutting on the trade deficit. Pro-growth policies among our trading partners would also contribute to some adjustment of external imbalances. Finally, more flexible exchange rate regimes in some countries would provide greater scope for market forces to reduce our trade deficit, and would be in the interests of the countries implementing these regimes as well. Nevertheless, in the absence of a shift in market perceptions of the relative attractiveness of United States and foreign assets, government policies would likely have only limited effects on the trade balance. Chairman Bernanke, under the fiscal year 2006 Congressional budget resolution and the two related reconciliation bills, Congress has cut Medicaid by $6.9 billion while spending up to $70 billion over the next 5 years to repeal some of the sunsets of President Bush's 2001 and 2003 tax cut packages. According to the Urban-Brookings Tax Policy Center, more than 70 percent of the benefits of those tax breaks have gone to the 20 percent of taxpayers with the highest incomes, and more than 25 percent of the benefits to the top 1 percent. Medicaid's benefits, by contrast, go almost entirely to those at the bottom of the income scale.Q.7. Don't these additional tax breaks (from the fiscal 2006 reconciliation bills), when combined with the Medicaid cuts, amount to a massive redistribution of income from those at the bottom to those at the top?A.7. As I stated in my testimony on the Monetary Policy Report, the Federal Government has an important role to play in boosting national saving as a share of national income over time. Of particular concern to me is the mismatch between taxes and spending in long-term budget projections. This mismatch means that over time either taxes will have to be raised or the spending increases embedded in current laws will need to be scaled back, or some combination of the two. Deciding on the mix of policy actions to be implemented will require the difficult balancing of sometimes conflicting goals regarding the provision of public services, the effects on economic efficiency of increasing taxes, and the distribution of fiscal burdens among various groups. The judgments about how to balance these priorities are ultimately political judgments and not ones that I believe I should address in my role as Chairman of the Federal Reserve. Chairman Bernanke, the 1991 edition of your Macroeconomics textbook contains a policy debate on the minimum wage. At the end of the debate, the textbook concludes: ``Therefore, the total labor income of unskilled workers does increase when the minimum wage rises . . . . Overall, taking these various effects into account, a recent study finds that raising the minimum wage from $3.35 per hour to $4.25 per hour [note: those were the amounts under discussion at that time] could reduce the number of families in poverty by about 6 percent, on balance a reasonably substantial effect.'' The textbook goes on to find: ``Thus, the inflationary effects of an increase in the minimum wage are relatively small . . . As a result, an increase in the minimum wage has negligible effects on aggregate employment and output.'' Your textbook was written in 1991 when the minimum wage was $4.25 an hour. Today, in real terms it is below that level ($4.25 in 1991 would be $5.89 today).Q.8. Do you believe that increasing the minimum wage above its current level of $5.15 an hour--where it has been stuck for over 8 years--would be good economic policy, along the lines that your textbook concluded?A.8. I am reluctant to comment on specific proposals regarding the minimum wage, but I can offer some general comments. In particular, I would note that the minimum wage is a very controversial issue among economists. Clearly, if the minimum wage were raised, then those workers who retain their jobs will benefit from the higher income associated with the higher minimum wage. However, economists have raised two concerns about minimum wages. The first is whether minimum wages have adverse employment effects; that is, do higher wages lower employment of low-skilled workers? The second is whether the minimum wage is as well targeted as it could be; that is, to what extent is the increase benefiting workers other than those from low-income families? My own view is that an increase in the minimum wage probably does lower employment. However, I would note that while this is the consensus view among economists, there is some research indicating that any such disemployment effects could be negligible. In any event, it does seem likely that the employment losses from a modest increase in the minimum wage would be relatively small from a macroeconomic standpoint and thus, at the levels of the minimum wage prevailing in the United States, a modest increase would not have sizable negative effects on aggregate output. The effect of a higher minimum wage on poverty is also a hotly debated topic among economists. However, my reading of the research that has become available over the past 10 years or so is that if there is any reduction in poverty associated with a higher minimum wage, it is likely to be quite small. In this context, one might consider alternative ways of helping low-income workers, such as the Earned Income Tax Credit, which delivers money directly to working families and is thus better targeted toward poverty reduction than is the minimum wage. fcic_final_report_full--97 CREDIT EXPANSION CONTENTS Housing: “A powerful stabilizing force” ...............................................................  Subprime loans: “Buyers will pay a high premium” ............................................  Citigroup: “Invited regulatory scrutiny” ..............................................................  Federal rules: “Intended to curb unfair or abusive lending” ................................  States: “Long-standing position” ..........................................................................  Community-lending pledges: “What we do is reaffirm our intention” ................  Bank capital standards: “Arbitrage” ....................................................................  By the end of , the economy had grown  straight quarters. Federal Reserve Chairman Alan Greenspan argued the financial system had achieved unprecedented resilience. Large financial companies were—or at least to many observers at the time, appeared to be—profitable, diversified, and, executives and regulators agreed, pro- tected from catastrophe by sophisticated new techniques of managing risk. The housing market was also strong. Between  and , prices rose at an an- nual rate of .; over the next five years, the rate would hit ..  Lower interest rates for mortgage borrowers were partly the reason, as was greater access to mort- gage credit for households who had traditionally been left out—including subprime borrowers. Lower interest rates and broader access to credit were available for other types of borrowing, too, such as credit cards and auto loans. Increased access to credit meant a more stable, secure life for those who managed their finances prudently. It meant families could borrow during temporary income drops, pay for unexpected expenses, or buy major appliances and cars. It allowed other families to borrow and spend beyond their means. Most of all, it meant a shot at homeownership, with all its benefits; and for some, an opportunity to speculate in the real estate market. As home prices rose, homeowners with greater equity felt more financially secure and, partly as a result, saved less and less. Many others went one step further, borrow- ing against the equity. The effect was unprecedented debt: between  and , mortgage debt nationally nearly doubled. Household debt rose from  of dispos- able personal income in  to almost  by mid-. More than three-quarters  of this increase was mortgage debt. Part of the increase was from new home pur- chases, part from new debt on older homes. CHRG-109shrg24852--65 Chairman Shelby," Chairman Greenspan, since we are talking about GSE's, how many companies with $12 billion accounting errors--which would be representing a significant portion of the capital of that company--see no increase in debt cost in the market after that? I am referring to Fannie Mae. " CHRG-110hhrg34673--225 Mr. Bernanke," There have been increases in consumer debt. There have been even larger increases in consumer assets, and so our wealth has grown. Our wealth is now at the highest level ever. So, again, for most people there is a reasonable balance between assets and liabilities. Again, there are some pockets of concern, but I don't think that at this point that they have significant implications for the behavior of the overall economy, although we obviously have to watch the individual sectors. " CHRG-110hhrg41184--133 Mr. Royce," And there are several studies, I have seen economists arguing that we could see a 2 percent increase in home loans, because banks would face increased uncertainty of future revenue if loans could be rescinded. And basically, the economists are looking at the prospect of a judge undermining existing contracts as a result of such a law. And that is one of the reasons I think mortgage debt has always been treated differently than other types of debt, it was to encourage lower rates on a less risky investment. And so these lower rates are dependent upon the ability really of the lender to recover collateral, and that would be a heavy price to pay. The last line of questioning that I wanted to pursue with you is one on the estimates that have the deficit rising to $400 billion or more in the coming year. I think a lot of us were concerned about that $152 billion stimulus package. I voted against it because of my concern for what it would do, piling up the deficits. And you know now, we understand that in the Senate, they are working on a second bill, maybe in the $170 billion range without any offsetting spending cuts. And I just ask, are you concerned we may be headed toward the scenario that you described to the Senate Budget Committee when you testified earlier this year? You said at that time you know something to the tune of ``a vicious cycle may develop in which large deficits could lead to rapid growth in debt and interest payments, which in turn adds to subsequent deficits.'' And you said, ``ultimately a big expansion of the nation's debt would spark a fiscal crisis, which could be addressed only by very sharp spending cuts tax increases, or both should such a scenario play out.'' If we didn't have the policy changes here in Congress to do something about those deficits and thus I ask you about the magnitude of the deficits that we are running up with the stimulus package and now a second one being organized in the Senate. Your response please, Mr. Chairman? " CHRG-111hhrg48674--228 Mr. Price," In closing, in the few seconds I have left, you mentioned that the debt-to-GDP ratio has increased about 15 percentage points and that is, ``tolerable in a growing economy.'' In a contracting economy, what level of ratio is tolerable? " CHRG-111shrg55117--106 Mr. Bernanke," If it did not, it would not. If it did not address the cost issue, it would not meet the challenges. Senator Bayh. So, in some ways, the test that is being applied around here, they are looking at health care in isolation rather than as a part of the broader fiscal picture. My concern is that the long-term fiscal policies that we are on now are unsustainable. I know you are concerned about the increasing debt of more than 2 percent per year. Some people would say it really cannot increase more than the annual rate of GDP growth. If you look at this 5-year budget and the likely 5 years after that, in no year will the growth of the debt be really below 3 and in many years it will be substantially beyond that. So as you know, it takes on a multiplier effect. And if we do not come to grips with this, it really is going to get away from us. So if all we did was even pass a health care bill that was deficit neutral, did not make things worse but did not make it better fiscally over the next 10 years, that really does not get to the heart of the problem either, does it? " CHRG-111hhrg51585--11 Mr. Hensarling," Thank you, Mr. Chairman. Bailouts beget bailouts which beget more bailouts. As Members of Congress, we have to ask ourselves the question, how many more bailouts can the taxpayers in future generations bear? Last week an economic plan, a budget was adopted that will triple the national debt in 10 years, more debt in the next 10 years than in the previous 220, leading to a debt burden of $148,926 per household. Now stocks are down. People have lost $11 trillion since the peak in the market, $11 trillion. Pension funds have lost. Charities have lost. Families have lost. Small businesses have lost, and yes, municipalities in State governments have lost as well. The question I have, Mr. Chairman, is, who hasn't lost? And who isn't hurting in this economy? So if everyone who lost money in the market is to bail out everyone else who lost money in the market, are we truly better off? I think not. How about the States and municipalities that lost money in Circuit City? Where is their bailout? How about the Washington State Investment Board that lost millions and millions in WaMu? Where is their bailout? How about the State of North Carolina State Pension Fund? They are down $17 billion. Where is their bailout? And a couple near and dear to my heart, small businesses in the Fifth District of Texas, United Rentals, Mineola Mercantile. They went out of business. Where is their bailout? Once you absolve people of responsibility, you will beget more irresponsible behavior. We will also end up with firms that only invest in the largest firms that are perceived to be too-big-to-fail. This is a bad idea, and I do not believe we should go down this road for taxpayers and for future generations. I yield back the balance of my time. " CHRG-111hhrg48875--206 The Chairman," The gentleman from Texas. Dr. Paul. Thank you, Mr. Chairman. The chairman in his opening statement talked about the problem being excessive leverage, and I certainly agree with that. And others refer to that as pyramiding of debt. And then we run into trouble, and we come up with the idea that regulations will solve this without asking the question: where did all this leveraging come from and how much of it was related to easy money from the Federal Reserve and artificially low interest rates? So I am very skeptical of regulations per se because I don't think that solves the problem. And of course, everybody knows I am a proponent of the free market, and this is not certainly free markets that got us into this trouble, and this certainly won't solve it. But, you know, in other areas we never automatically resort to regulations. When it comes to the press, if we had regulations on the press, we would call it prior restraint and we would be outraged. If we wanted to regulate personal behavior, we would be outraged and call this legislating morality. But when it comes to economics, it seems like we have been conditioned to say, oh, that is okay because that is good economic policy. I accept it in the first two but not in the third, and therefore I challenge the whole system. And it hasn't been that way forever. It has really been that way since the 1930's, about 75 years, that we in the Congress have deferred to the Executive Branch to write regulations, which are essentially laws. And yet the Constitution is very clear. All legislative power shall be vested in the Congress. So we write laws and we transfer this power. So essentially--we have done this for years--we have reneged on our responsibility. We have not met our prerogatives. And therefore, we participate in this. But in your position, you have been trained throughout your life to be a regulator, and that is something I know you can't deal with. But there is one area that I think that you might be able to shed some light on and work toward the rule of law because, you know, traditionally under common law--our system has always assumed that we are innocent until proven guilty. And yet when it comes to regulations, first we allow the Executive Branch to legislate as well as the court. But in the administrative courts, we are assumed to be guilty until proven innocent. You are in charge of the IRS. So this is someplace where, if there were a reasonable respect for the rule of law, that we could change that tone and assume that the taxpayer and the person that is on the receiving end of these regulations could say, hey, at least now the burden of proof is on the government to prove that somebody broke these regulations. And yet look at what we are doing endlessly. And yet I see that as the real culprit in all this because we are assuming the citizen is guilty. Could you comment on that and tell me what you might be able to do in changing the direction? " CHRG-111hhrg48875--207 Secretary Geithner," That was a very thoughtful set of questions. I just want to correct one thing. I have never been a regulator, for better or worse. And I think you are right to say that we have to be very skeptical that regulation can solve all these problems. We have parts of the system which are overwhelmed by regulation, overwhelmed by regulation. It wasn't the absence of regulation that was a problem. It was, despite the presence of regulation, you got huge risks built up. But in banks, because banks by definition take on leverage and transform short-term liabilities into long-term assets for the good of the system as a whole, they are vulnerable to runs. Because they are vulnerable to runs, governments around the world have put in place insurance protections to protect against that risk. Because of the existence of those protections, you have to impose standards on them on leverage to protect against the moral hazard created by the insurance. That is a good economic case for regulation-- Dr. Paul. Excuse me, but I only have a couple of seconds left. But see if you can address the subject of giving more respect to that individual who is accused of a crime. Can't we assume that the government has the burden of proof? " CHRG-109hhrg28024--158 Mr. Bernanke," Doing so increases national saving and reduces the burden on our grandchildren. I'm sorry that I don't feel it is appropriate for me to make recommendations to Congress about their procedures. I do hope Congress will be thinking about the long-term implications of spending and tax programs so that we are looking not just at the very near term, but the very long term implications. I think that is very sensible. I think in my role as head of the central bank, I should not be involved in making specific recommendations about your internal decision making process. " CHRG-111hhrg56766--19 Mr. Paulsen," Thank you, Mr. Chairman, for being here this morning as well. I have two issues of particular concern and hopefully, you will be able to address them. The first is the lack of available credit for the small business community and the fear that if the Fed raises interest rates in the near term, it will further erode credit opportunities for small business and exacerbate that problem. I would like to hear about the potential of the Fed Reserve increasing rates in the near future and ensuring that credit for small businesses is going to be available for job growth. Second, the issue of the explosion of the deficit and the debt, and the warning signals are getting louder that our fiscal situation is putting increasing pressure on our bond rating. I would like your opinion on the long-term impact of not addressing our debt as it relates to our bond rating, but more importantly, the impact it would have on our global competitiveness. Thank you and I do look forward to your testimony. " CHRG-111hhrg49968--18 Mr. Bernanke," Mr. Ryan, I certainly am concerned about that. I think we face a double challenge. One is that we have to restore ourselves to a more balanced fiscal path after addressing the financial and economic crises that we currently are facing. But, in addition, that is complicated by the fact that with the retirement of the baby boom and the increase in medical costs that we are facing rising entitlement costs, which--this is no longer a long-term consideration. This is something that has got to happen in the next 5 or 10 years. So that is extraordinarily challenging. My rough rule of thumb to the Congress would be, given that we have seen this increase in the debt-to-GDP ratio, that we should hope to try to at least stabilize it at the higher level and over time to try to reduce it. But certainly we cannot allow ourselves to be in a situation where the debt continues to rise, that means more and more interest payments, which then swell the deficit, which leads to an unsustainable situation. So it is very, very important that we---- " FinancialCrisisInquiry--122 The financial community changed dramatically in the 1980s. Incorporation and public ownership by security firms enabled them to compete with commercial banks. Innovations like junk bonds, for example, allowed securities firms to lend to non- investment-grade companies. All the firms accelerated the push into global markets, far- flung operations, mathematical modeling, proprietary dealings in debt and equity, and the growing use of leverage and derivatives to hedge risk. As the commission investigates the causes of the 2007-2009 crisis, it is important to remember that market crises occur periodically. To name a few in the last 20 years, the markets have been roiled by Asian, Russian and Mexican crises, the crash of ‘87, the collapse of long-term capital, the 2000 dot-com bubble collapse, and of course, Enron’s bankruptcy. The question before the commission is: What events or actions occurred within the capital markets or the environment which allowed this crisis to become a debacle? First, every legislative and regulatory move in the last 20 years has been towards obliterating the distinctions between providers of financial services and freeing the capital markets. The shining example, of course, is the Gramm-Leach- Bliley Act of 1999, which removed the last vestiges of Glass-Steagall. Second, financial institutions used the more lenient regulatory environment to build scale and extend scope. Citigroup, Bank of America, J.P. Morgan, and Lehman Brothers, for instance, acquired competitors and expanded their operations into new fields. Concentration created institutions too big to fail. Government regulation in terms of oversight and coherence did not keep pace with innovation, leverage and the expanded scope of the banks. Three, access to new capital permitted the banks and security firms to shift the nature of their business away from agency transactions and towards more proprietary trading that took positions in marketable and less liquid securities and assets such as commercial real estate. Combined with greater leverage, earnings volatility increased. FinancialCrisisInquiry--33 And then, as a balance-sheet matter, there was extensive hedging, I assume, because of the significant leverage and maybe the opacity or the risk profile of the assets you held. In the end of the day—and I’m going to press you on this—it seems to me that you survived with extraordinary government assistance. There was $10 billion in TARP funds, $13.9 billion as a counterparty via the AIG bailout. By your own Form 10-K, you said that you issued $28 billion in debt guaranteed by the FDIC, which you could not have done in the market but for that. You were given access to the Fed window and the ability to borrow at next to nothing. You became a bank- holding company over the weekend. You had access to TALF. You benefited from a ban on short selling, which you initially opposed, which Mr. Mack had advocated. And you got relief—some relief from mark-to-market rules even though I understand you were assiduous about marking to market. I guess when you look at the amount of leverage that you had and you do look at your rapid growth, do you really believe that your risk management in the big picture was sufficient to have allowed you to survive but for that government assistance which I laid out? BLANKFEIN: Well, there’s a lot of predicates to that question. The fact of the matter is we were—much leveraged now, so you could take that as a vote that we wish we were less leveraged then. But when you look at the leverage of companies and people are throwing out 30 to 1 or 40 to 1, our high watermark was actually a fraction of that. It was about 20 -- which was kind of small. BLANKFEIN: A lot of that included cash on our balance sheet. I think we did a very good—we had tremendous liquidity through the period. But there were systemic events going on, and we were very nervous. If you are asking me what would have happened but for the considerable government intervention, I would say we were in—it was a more nervous position that we would have wanted in. We never anticipated the government help. We weren’t relying on those mechanisms. CHRG-109shrg24852--37 Chairman Greenspan," It is difficult to judge. It has similar effects of other types of deficits in the Federal system. It clearly is negative, and I think it is a worrisome thing for American taxpayers, needless to say. But it is hard to see at this stage any spillover effects yet on economic forces. As large as the numbers are, relative to a $12 trillion economy obviously they are not yet critical. My main concern is that it ultimately will require U.S. Treasury bonds to fill in the gap, which is another way of saying increasing the deficit and increasing the Federal debt. Senator Bunning. Do you have any comment on this morning's report that the Chinese are moving away from the dollar peg toward a currency basket? " CHRG-109shrg21981--49 Chairman Greenspan," That is correct. Senator Sarbanes. Because I recall 4 years ago you came before us--Senator Dodd alluded to that--and you told us, and I am quoting you now--this was when we were projecting, over a 10-year period, a $5.6-trillion surplus in the Federal budget, a $5.6-trillion surplus projected over 10 years, and now we are projecting a $3.7-trillion deficit. That is a rather staggering turnaround of $9.3 trillion, almost $10 trillion. You told us, then, and that is why I am really concerned here, ``The time has come, in my judgment, to consider a budgetary strategy that is consistent with a preemptive smoothing of the glide path to zero Federal debt or, more realistically, to the level of Federal debt that is an effective, irreducible minimum.'' Now, that was taken I think by all as a view on your part that we were paying down the debt too quickly, and we had to alter the glide path and the payment down of the debt. I remember saying to you at the time you have just taken the lid off the punch bowl because, at that time, of course, we were debating whether to do these extensive tax cuts. They were done. They were done the following year. Even more were done the year after, and now we have managed to transpose our economic outlook from this projection of over $5 trillion in surplus to almost $4 trillion in deficits, which I would take it you would agree constitutes a major setback to the goal of increasing net national savings. " CHRG-110hhrg34673--115 Mr. Hensarling," You spoke earlier about the percentage of debt to GDP by 2030, and you mentioned, I guess, the challenges of trying to, without entitlements, reform the level of spending decreases or tax increases, some combination of the two. I think I heard you say before we are not going to grow our way out of this challenge, is that correct? " CHRG-110hhrg44903--52 Mr. Royce," It has been reported recently that many of the investment banks have scaled back their usage of the primary dealer credit facility that we established in March that was--in fact I think the window has gone unused, the discount window has gone unused for the past 3 weeks by these institutions. What should we make of this pullback? If there isn't this borrowing going on now through the discount window, is this a reflection of the health now of these institutions? Or is this a statement to regulators and lawmakers that these investment banks are not prepared to trade access to the discount window in exchange for the burdens of increased regulation? I was just wondering what your take is on that. " CHRG-110shrg50414--242 Mr. Bernanke," I don't know how they make those decisions. I don't know. But I do know that a weak economy means lower tax revenues. So if it goes either way, there is going to be a fiscal hit. Senator Tester. OK. I understand. So what you are saying is the increase in potential debt would not have an impact on U.S. Treasuries. " fcic_final_report_full--118 As the United States ran a large current account deficit, flows into the country were unprecedented. Over six years from  to , U.S. Treasury debt held by foreign official public entities rose from . trillion to . trillion; as a percentage of U.S. debt held by the public, these holdings increased from . to .. For- eigners also bought securities backed by Fannie and Freddie, which, with their im- plicit government guarantee, seemed nearly as safe as Treasuries. As the Asian financial crisis ended in , foreign holdings of GSE securities held steady at the level of almost  years earlier, about  billion. By —just two years later— foreigners owned  billion in GSE securities; by ,  billion. “You had a huge inflow of liquidity. A very unique kind of situation where poor countries like China were shipping money to advanced countries because their financial systems were so weak that they [were] better off shipping [money] to countries like the United States rather than keeping it in their own countries,” former Fed governor Frederic Mishkin told the FCIC. “The system was awash with liquidity, which helped lower long-term interest rates.”  Foreign investors sought other high-grade debt almost as safe as Treasuries and GSE securities but with a slightly higher return. They found the triple-A assets pour- ing from the Wall Street mortgage securitization machine. As overseas demand drove up prices for securitized debt, it “created an irresistible profit opportunity for the U.S. financial system: to engineer ‘quasi’ safe debt instruments by bundling riskier assets and selling the senior tranches,” Pierre-Olivier Gourinchas, an economist at the Uni- versity of California, Berkeley, told the FCIC.  Paul Krugman, an economist at Princeton University, told the FCIC, “It’s hard to envisage us having had this crisis without considering international monetary capital movements. The U.S. housing bubble was financed by large capital inflows. So were Spanish and Irish and Baltic bubbles. It’s a combination of, in the narrow sense, of a less regulated financial system and a world that was increasingly wide open for big international capital movements.”  It was an ocean of money. MORTGAGES: “A GOOD LOAN ” The refinancing boom was over, but originators still needed mortgages to sell to the Street. They needed new products that, as prices kept rising, could make expensive homes more affordable to still-eager borrowers. The solution was riskier, more ag- gressive, mortgage products that brought higher yields for investors but correspond- ingly greater risks for borrowers. “Holding a subprime loan has become something of a high-stakes wager,” the Center for Responsible Lending warned in .  Subprime mortgages rose from  of mortgage originations in  to  in .  About  of subprime borrowers used hybrid adjustable-rate mortgages (ARMs) such as /s and /s—mortgages whose low “teaser” rate lasts for the first two or three years, and then adjusts periodically thereafter.  Prime borrowers also used more alternative mortgages. The dollar volume of Alt-A securitization rose almost  from  to .  In general, these loans made borrowers’ monthly mortgage payments on ever more expensive homes affordable—at least initially. Pop- ular Alt-A products included interest-only mortgages and payment-option ARMs. Option ARMs let borrowers pick their payment each month, including payments that actually increased the principal—any shortfall on the interest payment was added to the principal, something called negative amortization. If the balance got large enough, the loan would convert to a fixed-rate mortgage, increasing the monthly payment—perhaps dramatically. Option ARMs rose from  of mortgages in  to  in .  FinancialCrisisInquiry--16 The past two years have been unlike anything I’ve seen in my 40 years in financial service. Unprecedented illiquidity and turmoil on Wall Street saw the fall of two leading franchises and the consolidation of others. We saw credit markets seize, the competitive landscape remade, and vast governmental intervention in the financial sector. And the consequences have obviously spread far beyond Wall Street. Millions in America today are struggling to find work. They’ve lost homes. They watched their retirements evaporate their savings. I believe the financial crisis exposed fundamental flaws in our financial system. There is no doubt that we as an industry made mistakes. In retrospect it’s clear that many firms were too highly leveraged. They took on too much risk, and they didn’t have sufficient resources to manage those risks effectively in a rapidly changing environment. The financial crisis also made clear that regulators simply didn’t have the visibility, tools or authority to protect the stability of the financial system as a whole. Let me briefly walk you through what happened from Morgan Stanley’s viewpoint and our response to the crisis. As the commission knows, the entire financial service history was hit by a series of macro shocks that began with the steep decline in U.S. real estate prices in 2007. Morgan Stanley, like many of its peers, experienced significant losses related to the decline in the value of securities and collateralized debt obligations backed by residential mortgage loans. This was a powerful wake-up call for this firm, and we moved quickly and aggressively to adapt our business to the rapidly changing environment. We cut leverage. We strengthened risk management. We raised private capital and dramatically reduced our balance sheet. We increased total average liquidity by 46 percent, and we entered the fall of ‘08 with $170 billion in cash on our balance sheet. Thanks to these prudent steps, we were in a better position than some of our peers to weather the worst financial storm, but we did not do everything right. When Lehman Brothers collapsed in early September of ‘08, it sparked a severe crisis of confidence across global financial markets. Like many of our peers, we experienced a classic run on the bank as the entire investment banking business model came under siege. Morgan Stanley and other financial institutions experienced huge swings and spreads on the credit-default swaps tied to our debt and sharp drops in our share price. This led clearing banks to request that firms post additional collateral causing further depletion of cash resources. FOMC20081216meeting--430 428,MR. DUDLEY.," It is better than the time I found out I had to discuss a Stiglitz paper in grad school about 12 hours ahead of time. That was harder. I read the Stiglitz paper three times, and then I started to understand it. [Laughter] What I thought I would do, if I could, is invert the order and start with the balance sheet issues and then go into the TALF because I think that there is a broader question of our exit from all our liquidity programs. That is a very legitimate issue. You can imagine a circumstance that sometime in the future we still have an inflated balance sheet, and we actually want to raise the federal funds rate target. The question is, Would we be able to do so? The good news, of course, is that a lot of our facilities are going to go away pretty naturally--the swaps, the CPFF, and the TAF. We may have to give it a bit of a nudge, but those programs should downsize pretty automatically. Even after that, we are still going to have on our books a lot more agency debt and a lot more agency mortgage-backed securities. We're going to have loans outstanding that are associated with Bear Stearns and AIG. We are going to have longer-term Treasuries. We have potentially a very large funding obligation to Citigroup, if its losses go through the FDIC and TARP money. Then, of course, the TALF could also still be on our balance sheet, depending on what the terms of those TALF loans are. I am going to come back to that a little later. Generally, I am not worried about our ability to raise the level of interest rates, even if our balance sheet is still inflated at the time, for a number of reasons. First, I think the interest rate on excess reserves does work, just not quite as well as we had hoped. The gap between the interest on excess reserves and the effective funds rate has been running in the 40 to 50 basis point range. That means that, if we were to raise the interest rate on excess reserves, we would raise the whole complex of interest rates, including the effective fed funds rate. The gap is as large as it is because, when balance sheet capacity is scarce, people have to be paid to use their balance sheet to arbitrage that difference. But I think that gap today is pretty stable, and we can expect that, as the balance sheets return to a more normal condition, over time that gap might actually narrow as people say, ""Well, gee, I have more balance sheet capacity to do this arbitrage."" So that would be point number 1. Point number 2 is that we can probably take active steps that reduce the cost of that arbitrage to banks today. We can limit the GSEs in terms of their fed funds sales, and we can also reduce the balance sheet consequence of the arbitrage by potentially removing those purchases from the leverage ratio, giving them a little regulatory relief, which actually makes some sense because there is really no risk to a bank that is buying fed funds from another bank and putting them on deposit with the Fed. There is no interest rate risk overnight. So that is something that we might want to consider. Another thing that I think is important to recognize is that there may be other means of addressing our excess reserves problems. The first point is that interest on excess reserves is probably good enough to do a reasonable, if somewhat sloppy, job in pushing up interest rates. In addition to that, we have other ways of addressing excess reserves in the system. We have the ability to change our monetary policy framework. We had a meeting earlier this year in which we discussed some of the potential places we might want to go. To drain excess reserves, if we decided that was necessary to get better control of the federal funds rate, we could do reverse repos with a broader set of counterparties, like money market mutual funds. We could do that using the agency debt on our balance sheet and using the Treasury debt on our balance sheet, and we could probably do that in size, since the money market funds would be very happy to be our counterparts. Second, we could also change the monetary framework in a more radical way. One can imagine a system by which we set voluntary reserve targets for banks at pretty high levels, where the rate they got if they were above the target dropped off considerably and the rate they got below the target dropped off considerably. So we could basically give the banks incentives to hold the amount of their excess reserves that actually are in the banking system. Third, the Treasury could help us, as it was helping us for a while. The SFP bills actually did work. The problem was that, as the Treasury's borrowing needs skyrocketed, it started to worry about running into the debt limit. What actually happened--it was a political issue--it didn't want to notify the Congress 60 days ahead of time that it might hit the debt limit, and that is really why it started backing away from the SFPs. Now, we could resolve this in a couple of different ways. One, if the debt limit were raised enough, you would have plenty of room. Or you could potentially exempt the SFPs from the debt limit, and you could argue that doing so makes sense because there is debt here and there is cash on the Federal Reserve balance sheet, so no real net debt is created. Last, you could gain legislative authority to issue Fed bills, which I think is actually a little more radical step. But the attractiveness of that, of course, is then we have complete control over our destiny, and you don't have the mushing together of church and state, where we are at least somewhat dependent on the Treasury for managing our monetary policy. So the bottom line for me is that I don't think we should be concerned about the large size of our balance sheet constraining our ability to manage our interest rate policy going forward. That should not be a driver of what we decide about our liquidity facilities. So why is this important? Well, the TALF, just to recap, is a program in which we would basically lend funds against AAA-rated consumer asset-backed securities on a nonrecourse basis to basically anyone--not quite anyone, not foreigners, but pretty much anyone who wants to do it--and we would conduct these transactions through the dealer community. In the TALF program we would be offering three things to investors. First, they would be offered more leverage than they can get today because the haircuts that we would put on the securities would not be the 50 percent type of haircuts that the market is putting in place today. They might be 10 percent, 20 percent, or 30 percent. We are still negotiating, determining that. So investors could get a lot more leverage than they can get today. The second thing that would be offered is protection against tail risk, and that is something that investors very definitely can't get today. Because the loan would be nonrecourse, the investor could lose only the amount of the haircut, and that is really important in a world where prices are very volatile. So that would significantly reduce the mark-to-market risk of investing in the securities from the perspective of investors. Finally, probably the most important thing, we would be providing term funding. People could buy these securities, which are of relatively long duration. It depends on what security you are looking at, but the securities probably range in duration from two years to seven or eight years, if you are looking at student loans. So this facility would not work if the term were very, very short. We have been in the process of going out and talking quite extensively to issuers and investors over the past couple of weeks. The Board staff has been involved. The New York Fed staff has been involved. Basically what we found out is that they like the program. The leverage is not quite as important as we thought. They said they could live with less leverage rather than more leverage. They like the protection against the tail risk. The nonrecourse nature of the loans, of course, is very attractive. But the main thing on which they focused and that they said was most important for the success of the program was the length of the term of the loans. When we went forward with the initial term sheet, we were talking about a one-year term, and the investors have come back quite forcefully and said that a one-year term is not sufficient. The program will not work with a one-year term. Now, maybe they are exaggerating the degree to which it wouldn't work, but it does seem fairly credible that there is no reassurance that one year from now we are going to be completely out of the situation that we are in today. So, certainly, it is completely legitimate to be worried as an investor about the rollover risk one year from now, given that these are assets of longer durations. Where I come out on all of this is that I think we really do need to be attentive to that concern, and we should try to make the term of the TALF loans as long as possible, subject to protecting the Fed, obviously, from credit losses. If we were to make it short term, I think there is a high probability that the program would fail. I think that would be a huge blow to our credibility. Up to now we have done pretty well in wheeling out programs that have done what we said they were going to do. I think this is a particularly important program because of its ability to be expanded in multiple directions. The Treasury is very, very interested in this program as a way of using TARP capital efficiently. So to wheel this out on terms that are too short and that make the program unattractive would be very, very damaging to our credibility. My view is that we should be willing to offer these loans at term. I would favor three years. I think if we do that, this program will be successful. Obviously, if we do that, we are going to have more balances on our books. This program was originally conceived of as about a $200 billion program. That is probably as big as it would get for consumer ABS, but obviously, if we expand it to CMBS and other things, it could be considerably larger than that. So that is sort of where we are. Pat, do you have anything you want to add? " CHRG-111hhrg56766--143 Mr. Sherman," The gentleman from California, Mr. McCarthy, talks about trade agreements and I would agree with him that if we had genuine free trade that might produce jobs, but so far our trade agreements have given us malignantly-unbalanced trade and I don't think that helps our job situation. Chairman Bernanke, I'm going to lay out a few reasons that have been put forward why you might want an easier monetary policy, both short-term and long-term, and get your response. The first of these is that monetary easing short term can help stimulate the economy at zero increase to our national debt and in fact reduces our debt because it reduces our borrowing costs whereas we in Congress are considering fiscal stimulus which, of course, does increase the national debt. The second is that there is a stickiness in cutting certain nominal payments, particularly wages, and so if we had a modest 3, 4, even 5 percent inflation rate, that in effect solves that problem or allows for the solution of that problem without cutting a nominal amount. The third is that your predecessor used to come to Congress and say that the CPI was overstating the inflation rate. So if you're targeting for 2 percent inflation rate as measured by the CPI, you were really targeting for a 1 percent inflation rate, as he thought it ought to be calculated. And then, finally, you have the recent IMF economist report saying that central bankers ought to aim for a higher inflation rate so that in bad times they had more monetary tools. When you start with low interest rate and low inflation and then you try to stimulate the economy, you can't go below zero. So the first question is, are you currently pedal to the metal? I see the statements coming out that talk about increasing the discount rate and those very statements can have a slight effect, more than a slight effect of reducing monetary easing, taking your--the accelerators--I realize a lot of talk about accelerators in the other room here, but easing up on the accelerator a bit and then your discussion here of the clear statement you're not going to monetize the debt also is a little less than absolute pedal to the metal. So short term, are you or should you be pedal to the metal? Longer term, should we be aiming for a somewhat higher inflation rate, given the report of the IMF? " CHRG-111hhrg49968--42 Mr. Hensarling," Thank you, Mr. Chairman. Welcome, Chairman Bernanke. If the staff could put up chart 10, please. Mr. Chairman, as you well know, we are looking at an explosion of debt over the next 10 years. Now, presently, our Federal debt is at 41 percent of GDP. I know this is well-known to you. CBO says that it will increase to 82 percent of GDP in 10 years. In your testimony, you speak of the need to have prompt attention to questions of fiscal sustainability in order to maintain the confidence in our financial markets. So, certainly, the case has been made for short-term Federal intervention in our marketplace. I believe that in testimony by the head of CBO their estimate is that we will reach positive GDP growth in the third quarter of this year and that unemployment will level off, I believe, I think, the second quarter of next year. OMB had a rosier scenario. And today, in your testimony, you speak of an incipient recovery, and I believe you said economic activity should turn up later this year. So my question is, if OMB, CBO, and the Federal Reserve are predicting positive GDP growth, an upturn in economic activity somewhere in the next 6 to 18 months, we have concerns about the fiscal sustainability of these levels of debt. Having our debt go from 41 percent of GDP to 82 percent of GDP in 10 years, tripling the national debt in 10 years, does this meet your definition of prompt attention to questions of fiscal sustainability? " 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-109hhrg23738--109 Mr. Paul," Thank you, Mr. Chairman. If indeed this is your last appearance before our committee, Mr. Greenspan, I would have to say that in the future I am sure I will find these hearings a lot less interesting. [Laughter.] But I do have a couple of parting questions for you. Keynes, when he wrote his general theory, made the point that he had a tremendous faith in central bank credit creation because it would stimulate productivity. But along with this, he also recognized that it would push prices and labor costs up. He saw this as a convenience, not a disadvantage, because he realized that in the corrective phase of the economic business cycle, that wages had to go down, and people would not accept a nominal decrease in wages; but if they were decreased in real terms, it would serve the economic benefit. Likewise, I think this same principle can be applied to our debt. To me, this system that we have today is a convenient way to default on our debt, to liquidate debt through the inflationary scheme. Even you, in the 1960s, described the paper system as a scheme for the confiscation of wealth. And in many ways I think this is exactly what has happened. We have learned to adapt to deficit financing, but in many ways the total debt is not that bad because it goes down in real terms. As bad as it is, in real terms it is not nearly as high. But since we went on a total paper standard in 1971, we have increased our money supply essentially 12-fold. Debt in this country, federal debt, has gone up 19-fold; but that is in nominal dollars, not in real dollars. So my question is this: Is it not true that the paper system that we work with today is actually a scheme to default on our debt? And is it not true that, for this reason, that is a good argument for people not--eventually, at some day--wanting to buy Treasury bills because they will be paid back with cheaper dollars? And indeed in our lifetime we certainly experienced this in the late 1970s, that interest rates had to go up pretty high, and that this paper system serves the interests of big government and deficit financing because it is a sneaky way of paying for deficit financing. At the same time, it hurts the people who are retired and put their money in savings. And aligned with this question, I would like to ask something dealing exactly with gold: If paper money--today it seems to be working rather well, but if the paper system does not work, when will the time come, what will the signs be, that we should reconsider gold? Even in 1981, when you came before the Gold Commission, people were frightened about what was happening, and that was not too many years ago, and you testified that it might not be a bad idea to back our government bonds with gold in order to bring down interest rates. So what are the conditions that might exist for the central bankers of the world to reconsider gold? We do know that they have not given up on gold. They have not gotten rid of their gold. They are holding it there for some reason. So what is the purpose of the gold if it is not with the idea that someday they might need it? They do not hold lead or pork bellies; they hold gold. So what are the conditions that you might anticipate when the world may reconsider gold? " FinancialCrisisInquiry--18 We learned an important lesson from 2008 crisis and have adapted our business to help prevent something like this from happening again. One of the clearest lessons was that many firms simply carried too many leverage. As I mentioned, Morgan Stanley moved aggressively, beginning in ‘07, to reduce leverage cutting it in half from 33 times at the end of ‘07 to 16 times by the third quarter of ‘09. We raised a total of $14 billion in capital from private sources maintaining one of the highest tier one capital ratios. We’ve also taken a number of steps to diversify our revenue and funding sources, including through an expansion of our wealth-management business and extending maturities on our debt. We have made important changes, systemic changes to our business practices, including scaling back proprietary trading. Morgan Stanley also devoted significant resources over the last two years to further strengthen our risk-management policies and procedures. This including naming a new risk officer early in 2008 and adding about a hundred more people to the risk-management process. We have enacted changes to how we pay our employees and ensure that compensation is linked even more closely to performance and does not encourage excessive risk taking. We were the first major U.S. bank to enact a claw-back for a portion of year-end compensation in 2008, one that exceeded TARP requirements. We have since strengthened this provision further so we can claw back compensation for up to three years if investments or trading positions produce subsequent losses. We’ve also enacted a new, multi-year performance plan that makes a portion of senior executives’ year-end compensation contingent on reaching certain three-year performance goals. And we’re increasing a portion of year-end compensation that’s deferred to all employees. Finally, as CEO, I recommended to the board that I receive no bonus in 2009 because of the unprecedented environment in which we are operating and the government’s extraordinary financial support to our industry. This was the third year in a row that I recommended no bonus to my board. CHRG-110hhrg34673--223 Mr. Bernanke," Consumer debt has risen quite a bit. It is rising more slowly recently mostly because home mortgages aren't rising as quickly due to the flattening out of prices and the slower amount of home purchase. Generally speaking, though, as we said in the testimony, households are in reasonable financial shape. Offsetting their debt is an increase in wealth; the stock market is up. House prices over the last few years have gone up a lot, and so many people have a considerable amount of equity in their home. And moreover, the strength of the labor market means that the job availability, incomes, wages are also pretty strong. So for the larger part of the population, finances seem reasonably good relative to historical norms. Now, of course, there are always some people who are having problems, and as I noted in testimony, there are some sectors, notably the subprime lending sector, where we were seeing some distress, and we are watching that very carefully. " CHRG-111hhrg56766--194 Mr. Hensarling," Okay. If we can't grow our way out, you have said repeatedly you do not intend to monetize the debt, although there are a number of people within our economy who think you are already doing that. We will leave that subject to a different time and place. That unfortunately leaves, under my hypothetical, tax increases. I have seen studies that show that if we only try to solve this problem on the tax side, that number one, just over the next 10 years of the President's budget window, we would have to increase income taxes roughly 60 percent. Have you seen similar studies? Has the Fed researched this? " CHRG-109hhrg22160--90 Mr. Greenspan," I am not in favor of tax cuts without the issue of a PAYGO. In other words, I argued a year ago that my support for the tax cuts is in the context of a PAYGO rule. And looking out beyond, say, 2008, the problems we have with the budget deficit are huge. And therefore we need very significant changes to come to grips with those issues. So I am not saying that we have no problems. Our problems, in my judgment---- Ms. Waters. No, I understand that, Mr. Greenspan. But if you are saying that tax cuts are okay as long as you understand PAYGO--you got to pay as you go--then that certainly has not happened with this administration. As a matter of fact, the debt has increased, the borrowing has increased since the tax cuts. So you must be very unhappy. " CHRG-111shrg53822--80 Mr. Wallison," I think what Raghu has said is a very interesting proposal. I have this concern, however. And if we keep our eye on the ball, we are talking about systemic risk. And what is systemic risk? Systemic risk is the risk that when a large financial institution fails, a large bank fails, it has effects on all others throughout the economy, or many others, a contagion, if you will, a cascading of losses. The idea that we would convert debt into equity is good for the bank, but you have to consider what it does to the holders who previously had debt and now have equity; what it does to their balance sheets and what it does to their risk profiles. And what it does, of course, it make them much more risky. So in other words, in a time when we are talking about trying to prevent systemic risk, we are also thinking favorably about an idea that, actually, encourages, increases the possibility of contagion from a failed institution or a failing institution, to institutions that might otherwise be healthy. " CHRG-110shrg46629--69 Chairman Bernanke," But if I have $1,000 appreciation and I take out $500 in debt, I have increased my debt by $500 but I am still, on net, $500 better off than when I started. Now having said all that, let me just say that I agree with you on the issue of consumers needing to build wealth and assets. The Federal Reserve manages the Survey of Consumer Finances, which is the best available source for family asset building, information about family asset holdings. The fact is that the bottom third of our population has almost no savings, maybe less than $500. And I think that is a very serious problem. We need to find ways to make people more cognizant of the need to save, to help them to save, so that they can build wealth and that they will have more security in case they have, for example, an illness or an unemployment spell. So your general point that there are many families that do not have adequate wealth reserve, I think is entirely correct. Senator Menendez. Thank you, Mr. Chairman. " CHRG-111hhrg56766--188 Mr. Bernanke," It is not a single number, because as you mentioned in your question, first of all, it is risk-weighted. It depends on the mix of assets. As you know, we currently have the 8 percent requirement under Basel II. I think we want to, first of all, increase the risk weights so that there is more protection against risky assets, number one. Second, we want to make sure the capital is of higher quality that is more common equity and less subordinated debt instruments, for example. And third-- " fcic_final_report_full--47 Traditional and Shadow Banking Systems The funding available through the shadow banking system grew sharply in the 2000s, exceeding the traditional banking system in the years before the crisis. IN TRILLIONS OF DOLLARS $15 12 9 6 $13.0 Traditional Banking $8.5 Shadow Banking 3 0 1980 1985 1990 1995 2000 2005 2010 NOTE: Shadow banking funding includes commercial paper and other short-term borrowing (bankers acceptances), repo, net securities loaned, liabilities of asset-backed securities issuers, and money market mutual fund assets. SOURCE: Federal Reserve Flow of Funds Report Figure . Figure . shows that during the s the shadow banking system steadily gained ground on the traditional banking sector—and actually surpassed the bank- ing sector for a brief time after . Banks argued that their problems stemmed from the Glass-Steagall Act. Glass- Steagall strictly limited commercial banks’ participation in the securities markets, in part to end the practices of the s, when banks sold highly speculative securities to depositors. In , Congress also imposed new regulatory requirements on banks owned by holding companies, in order to prevent a holding company from endan- gering any of its deposit-taking banks. Bank supervisors monitored banks’ leverage—their assets relative to equity— because excessive leverage endangered a bank. Leverage, used by nearly every finan- cial institution, amplifies returns. For example, if an investor uses  of his own money to purchase a security that increases in value by , he earns . However, if he borrows another  and invests  times as much (,), the same  in- crease in value yields a profit of , double his out-of-pocket investment. If the investment sours, though, leverage magnifies the loss just as much. A decline of  costs the unleveraged investor , leaving him with , but wipes out the leveraged investor’s . An investor buying assets worth  times his capital has a leverage ratio of :, with the numbers representing the total money invested compared to the money the investor has committed to the deal. CHRG-109shrg21981--12 STATEMENT OF SENATOR CHARLES E. SCHUMER Senator Schumer. Thank you very much, Mr. Chairman, and I, too, want to welcome my friend and someone who has been just a superlative Chairman of the Federal Reserve Board. He has a reputation--deserved--as a straight shooter and somebody who is really brilliant on monetary policy and economic policy. And that is why, when he comes here, we all want to ask him a whole lot of questions because we respect his judgment so. My view, Mr. Chairman, is that if we left things to you, and I think the way you have handled monetary policy in the last few years has been excellent. I think the steps where the market has certainty and knows exactly what you are doing is a very good idea, provided the economy continues to move along at this pace--Senator Sarbanes mentioned that it may not--and then, of course, it would have to be reexamined. Down the road, on Pennsylvania Avenue, we tend to mess things up. And I am truly worried about the debt, and particularly the added debt that Social Security could create in terms of the privatization of accounts. I think they are ideologically driven, frankly. I do not think they fall within the rubric of fixing Social Security, of, as I would call it, ``mend it not end it.'' I think, rather, there are a group of people who want to prove that every Government program does not work and, therefore, they have come up with so-called ``privatization.'' That is what they want to do is privatize. Now, they do not want to call it that because the public does not like it, but I think the name has stuck. The junk bond dealers tried to change the name of junk bonds for years, and they are still referred to as junk bonds 10 years later. I know they want them to call them high-yield bonds, but these personal accounts, there is privatization, and private accounts, and they are going to stick. My view, you have been a strong voice for restraining our fiscal policies. We have disagreed on some of the tax cuts, but you have always talked about PAYGO, and you talked as early as 2001, I believe it was--it may have been 2000--of creating a glide path, which reduces the debt to as close to zero as possible. We had that under the Clinton years. We have lost it in the Bush years. My one criticism of your nonmonetary aspects of your policy is that you would speak out strongly, but I will be very interested in your views of privatization and whether the so-called ``gain of privatization,'' having Joe and Jane Smith be able to manage a little bit of their own money in some kind of account, is equal to the huge amount of debt that it would throw on the shoulders of our already burdened Government. We are giving a birth tax to every child born in America now of about $15,000. If we do all the things Senator Reed mentioned, that birth tax will double to $30,000, and I do not think that is good for the newborns. I do not think it is good for the economy, and I am interested in your views and hope you will give us a straightforward answer about the effects of privatization on debt. Thank you, Mr. Chairman. Senator Dole. CHRG-109hhrg23738--5 Mrs. Maloney," Welcome, Mr. Greenspan. As always, it is a pleasure to hear your testimony--all 35 times. You have served, more than any other person, as our country's captain of monetary policy. You have guided us through economic growth, recession, and into globalization. In serving our country, you have often spoken out strongly against positions that you disagree with. So I find it very surprising that you are not strongly criticizing the ballooning deficits this administration has foisted on the American people. The Bush legacy is the largest national debt in history. The Republican Congress and president inherited a surplus, yet they have voted three times to raise the debt ceiling. We now have a record debt of over $7.5 trillion, the largest in history; and this breaks down to each citizen's share being over $26,000. We also have the largest trade deficit in our history, supported by the willingness--at least so far--of foreign investors and governments to keep extending us credit. We have the largest percentage of foreign holders of U.S. debt ever. We keep being told that the administration is going to fix this, but nothing is happening. Just last week the administration announced that the federal budget deficit for this year will not be as large as they were predicting it would be in January. Republicans are taking this as some kind of evidence of a supply-side miracle in which the president's tax cuts are actually creating large increases in revenue. And surely a man of your reputation, or anyone who actually read the OMB Mid-Session Review, is not going to take it as evidence of any real change in the structural budget deficit picture. As analysts at Goldman Sachs and in other places have pointed out, this year's large increase in tax receipts stems from temporary factors that are unlikely to be repeated, including the expiration of the tax cut on business investment. CBO Director Holtz-Eakin, a former Bush administration economist, has made the same point about the temporary nature of the revenue surge, saying that once you go out to 2008 and 2010, things look about the same as they did before we found out about this year's jump in revenues. The administration, in my opinion, is trying to distract us from the long-term budget problems they have created with irresponsible policies. But the American people deserve to know the truth, and surely you, of all people, Mr. Greenspan, should be speaking out about this. You were part of the team that helped the Clinton administration balance the budget, you were part of the team that helped build the surplus, and you know it can be done. The American people are absolutely being skewered with this crushing debt that will affect them and the lives of their children, their grandchildren, their quality of life. I really would hope that today and in the future you will take a stand against spending the American people into a hole that is very difficult to get out of and very painful to get out of, and I wish that you would speak out as strongly on this issue and as forcefully on this issue as you have on others. " CHRG-109shrg24852--53 Chairman Greenspan," Well, the run up in prices has been so significant, and the accumulated equity has been so large, indeed, it has been larger than the debt increase. So that the ratio of equity in homes to debt has been rising in the most recent period. So there is a fairly significant buffer. But there is no question that, if you confronted a situation of declining house turnover and even declining house prices, home equity extraction would be expected to decrease. Senator Allard. Mr. Chairman, I have a few questions, if I may proceed. " Chairman Shelby," [Presiding.] You go ahead, you take your time. Senator Allard. This has to do with the terrorist attacks and the security in our financial industry. Do you believe that the financial services industry is prepared to protect people, processes, and infrastructure against potential disruptions from a terrorist attack, and do you see any further steps that need to be taken if not? " CHRG-111shrg56376--192 Mr. Baily," Well, I think I would defer to my colleagues on the details. The part of it that I think I would like to comment on is the capital requirements. I actually don't like the idea of designating Tier 1 institutions. I don't like the idea of trying to cap the size of institutions. But clearly, we need to do something so that we don't end up bailing out these great big institutions. So having a sort of sliding scale, that the bigger you are or the more interconnected you are or depending on the kind of activity you do, that the capital requirements and potentially the extent of supervision--how often, the nature, the information you have to report, how frequently you have to report it--those kinds of things could increase as an institution becomes larger or more important to the system, and I think that is also a way of taking some of the burden off of the community banks. " CHRG-110hhrg44900--103 Secretary Paulson," I wish I could tell you one thing, but there isn't a silver bullet. If there was, and we knew how to address it right now, we would. And what is going on now as I said earlier, is it's just taking us a good while because there is much more leverage than was--what was once healthier--much more leverage than was perceived to be the case. And it was in the form of financial products. And then many of which were complex. There has been recorded progress made. It hasn't been in a straight line, but the progress I would site has been the risk reduction, the de-leveraging, the things that the Chairman has cited, in terms of increased liquidity and management, funding management by the investment banks, the capital that has been raised, being raised. But I believe part of this of course, is confidence. And having been through periods like this, they always are the worst until they are resolved. And before they are resolved, you wonder how they ever are going to be resolved. But confidence has a way of returning to the markets. And over time there have been many investors, wise investors, that have come in during times of great risk, adversity, and made investments and have made money on those investments. I think one of the key things is going to be when you start to see, and we are seeing some, more of these hard-to-sell assets changing hands and private money coming into the markets. But meanwhile, we have, all of us, some real work to do. " CHRG-111hhrg61852--7 Mr. Meltzer," Thank you Mr. Chairman, and Congressman Bachus. It is a pleasure to be here. I have been coming since the esteemed late Chairman Wright Patman, who hired me to work for the committee back in 1959. So I am an old friend of this committee. The recession has ended, according to the statistical record, but unemployment remains high at between 9 and 10 percent, with long-term unemployment at the highest level since the series began in 1948. Much of the public does not see improvement. Many will not believe that the recession is over until they and others are back at work. Why is this recovery slow and what can be done to increase growth and employment? Let us start with some of the problems. The fiscal stimulus helped very little. It didn't do nothing, but it didn't do much. And the best evidence that it didn't do much is the fact that the Administration is asking for a new fiscal stimulus, and many are urging that we do that. I think that is not what we need to do. Since the Eisenhower Presidency in 1961, the Federal budget has been in deficit almost every year. The deficits have gotten larger and larger, and the reported deficits are dwarfed by the present value of promises for health care and retirement. Uncertainty is the enemy of business investment and expansion, and what we have created is massive uncertainty. Here are some of the questions that businessmen worry about: What tax rate will apply in the future to income from investments made now? What new regulations will be imposed on businesses? How will existing and new regulations for pollution, financial services and health care be implemented, and what will they cost? What will employee health care cost? Will rules governing labor unions be changed to make unionization easier? How much will that add to production costs or increased outsourcing? If employers have no idea about future costs, they are reluctant to hire additional workers. They satisfy increases in demand by asking current employees to work overtime. Our current situation can be improved by reducing uncertainty and stimulating business investment. Here are some suggestions. Let me begin by saying that when Arthur Okun, the chairman of President Lyndon Johnson's Council of Economic Advisers, and a main architect of the Kennedy-Johnson tax program, analyzed the program after he left office, he concluded that the corporate tax cut which was part of the Kennedy-Johnson program was the most effective part of the program. Later work, including recent work, confirmed his conclusions. What can be done? Declare a 3-year moratorium on new regulations, including labor market rules and the new financial restraints, unless each new rule is approved by a supermajority in Congress. Develop and announced a precise, credible program of deficit reduction that specifies planned spending reductions and any tax increases. Eliminate uncertainty about future tax rates and where the tax burden will increase by announcing the program now, a definite program. Announce correct, believable costs of providing health care under the recently approved legislation. Recognize that many States are unable to pay additions to Medicaid. How much more will the government commit to the Medicaid program? How will these costs be paid? Use the remaining unspent funds in the January 2009 stimulus program to reduce the corporate tax rate. Reduce the risk of future inflation by eliminating a gradual program to reduce excess reserves in the banking system. Some economists argue that the risk does not exist. The public doesn't believe them. Some economists actively urge more government spending and larger deficits. They neglect or denigrate concerns about the debt, the interest costs of servicing the debt, and the negative effect that large deficits and growing debt have on decisions to invest. Their arguments ignore the most important development in macroeconomics for the past 40 years: the careful integration of expectations about the future in dynamic economic models. A program that begins to lift uncertainty and reduce debt and deficits has a positive effect on private spending. It reduces uncertainty. Recent efforts in Britain and in the euro area to reduce spending and deficits have been followed by currency appreciation there and other evidence of relief and more favorable expectations, knowing many governments are willing to act against future calamity. Deflation has become a subject of much conversation. Deflation means a sustained decline in a broad-based price index. We do not suffer from deflation. Mention of deflation arouses memories of the Great Depression. That is a mistake. There have been 7 periods of deflation in the 97 years under the Federal Reserve Act. Some were large, 30 percent decline; some were small, 1 or 2 percent decline. Only one, 1929 to 1933, brought the economy close to disaster. Recovery from the others, most recently 1960-1961, looks like any other recovery. We know that the 1929-1933 disaster was caused by inappropriate monetary policy. That policy reduced money growth by 50 percent. By 1933, prices had fallen less than 50 percent, so the expectation was prices will decline further. That is nothing like the situation that we are in now. We have massive excess reserves. The banks that report their forecasts to The Economist magazine do not predict deflation anywhere except in Japan, and there by 0.1 percent. For any of the developed economic countries that they monitor, they expect prices to rise modestly. Their current forecast for the United States in 2011 is 1.5 percent. Congress gave the Federal Reserve a dual mandate. It is inefficient and costly to concentrate on one objective at a time. That is what caused the great inflation of the 1970's. The Federal Reserve should not repeat that mistake as it is now doing. A small increase in interest rates would maintain negative real rates. [The prepared statement of Mr. Meltzer can be found on page 42 of the appendix.] " fcic_final_report_full--167 The CSE program was based on the bank supervision model, but the SEC did not try to do exactly what bank examiners did.  For one thing, unlike supervisors of large banks, the SEC never assigned on-site examiners under the CSE program; by comparison, the OCC alone assigned more than  examiners full-time at Citibank. According to Erik Sirri, the SEC’s former director of trading and markets, the CSE program was intended to focus mainly on liquidity because, unlike a commercial bank, a securities firm traditionally had no access to a lender of last resort.  (Of course, that would change during the crisis.) The investment banks were subject to annual examinations, during which staff reviewed the firms’ systems and records and verified that the firms had instituted control processes. The CSE program was troubled from the start. The SEC conducted an exam for each investment bank when it entered the program. The result of Bear Stearns’s en- trance exam, in , showed several deficiencies. For example, examiners were con- cerned that there were no firmwide VaR limits and that contingency funding plans relied on overly optimistic stress scenarios.  In addition, the SEC was aware of the firm’s concentration of mortgage securities and its high leverage. Nonetheless, the SEC did not ask Bear to change its asset balance, decrease its leverage, or increase its cash liquidity pool—all actions well within its prerogative, according to SEC officials.  Then, because the CSE program was preoccupied with its own staff reor- ganization, Bear did not have its next annual exam, during which the SEC was sup- posed to be on-site. The SEC did meet monthly with all CSE firms, including Bear,  and it did conduct occasional targeted examinations across firms. In , the SEC worried that Bear was too reliant on unsecured commercial paper funding, and Bear reduced its exposure to unsecured commercial paper and increased its reliance on se- cured repo lending.  Unfortunately, tens of billions of dollars of that repo lending was overnight funding that could disappear with no warning. Ironically, in the sec- ond week of March , when the firm went into its four-day death spiral, the SEC was on-site conducting its first CSE exam since Bear’s entrance exam more than two years earlier.  Leverage at the investment banks increased from  to , growth that some critics have blamed on the SEC’s change in the net capital rules. Goldschmid told the FCIC that the increase was owed to “a wild capital time and the firms being irrespon- sible.”  In fact, leverage had been higher at the five investment banks in the late s, then dropped before increasing over the life of the CSE program—a history that suggests that the program was not solely responsible for the changes.  In , Sirri noted that under the CSE program the investment banks’ net capital levels “re- mained relatively stable . . . and, in some cases, increased significantly” over the pro- gram.  Still, Goldschmid, who left the SEC in , argued that the SEC had the power to do more to rein in the investment banks. He insisted, “There was much more than enough moral suasion and kind of practical power that was involved. . . . The SEC has the practical ability to do a lot if it uses its power.”  CHRG-109hhrg28024--95 Mr. Bernanke," If there was broad interest in the Congress in receiving this information, we would look at it. But, again, Congressman, remember, it's a burden on the reporting banks to provide the information, and we are trying to reduce that burden as much as we can. Dr. Paul. But, of course, this has been available to the financial community for a lot of years, and for some people it's very important to measure what you're doing. If the money supply is important, which a lot of people believe it is, and it causes the inflation, this to me seems like we're taking information about the money supply and literally hiding it from the people. And I yield back. " CHRG-109hhrg28024--170 Mr. Bernanke," The deficit is certainly adding to the national debt. The total debt includes a lot of debt which is held by trust funds and the like, so that the so-called debt held by the public is more in the vicinity of $4.5 to $5 trillion. Some of this debt is accounting money held within Government trust funds. " FinancialCrisisInquiry--173 Thank you. CHAIRMAN ANGELIDES: Terrific. I just have a little time left here. They’ll tell me how much. Oh, I don’t believe that. Oh, there you go. They added one minute just because I frowned. I’ll be brief. I just have two questions very quickly. Today to the extent that what do you think are the still persistent biggest risks that exist today in the financial system? Is there still fragility? Very quickly, yes? MAYO: Yes. I would say I mean I have four D’s. One is de- leveraging. We’re seeing consumer loans go down. You’re seeing commercial loans go down. Loan growth is not happening yet. One reason is because I don’t think all the bad assets have been sold. And so until that takes place, we’ve been talking about that for two years, still hasn’t happened yet. De-leveraging. Number two, de-risking. Not just the de-risking of assets, but also the de-risking of liabilities, several trillion dollars of bank bonds that mature over the next three years that’ll have to be refinanced. That’ll be an issue at the same time that some of the government debts have to be refinanced. Number three would be deposit insurance or resolving all the potential failed banks. And then number four, the deposit service charges where a lot of attention on that recently that could hurt earnings down the road. So those are issues. And as far as—yes? CHAIRMAN ANGELIDES: And the first two are pro-cyclical in a sense? I mean, well... The continuing problems that exist. CHRG-110shrg50420--128 Mr. Kepplinger," They were relatively small, and the problem was taken care of with what often speaks very effectively, was money. And that was agreeable to the other participants in this facility because they had made the business judgment that it was better for them to make concessions and retain their debt than it was to go into a bankruptcy. So I can't remember who on the panel referred to carrot, but there needs to be that carrot. There need to be those business judgments. And as Gene suggested before, the board has to have enough specific requirements and conditions that they have leverage to negotiate with, but that they also have enough flexibility to deal with the vagaries, and as Gene also pointed out, the differences between the current financial situations of the players. Senator Bayh. My time has expired, but I think the carrot, absolutely. I was also interested, is there a stick here possibly that could be balanced against the carrot to lead to a decent outcome? I mean, it is sort of---- " CHRG-111shrg61513--85 Mr. Bernanke," Well, the earlier question was about the debt-to-GDP ratio, which was the tipping point. Another way to look at this is what does the trajectory look like? If the trajectory is such that you have an unstable dynamic where interest payments get larger and larger, that in turn increases the deficit, that in turn leads to higher interest payments and it explodes, essentially, then that is a situation where markets will become very concerned. So I think this is as much a political question as an economic question. The question is, can the Congress--and I recognize these are very, very hard problems. I don't want to in any way downplay the difficulty that it is for Congress to address these hard problems. But it would be extraordinarily helpful if there was persuasive evidence that Congress had the political will to achieve over a number of years a stabilization of the debt-to-GDP ratio or of the fiscal trajectory, and that could be done either through whatever mechanisms you choose to undertake or it may be through specific plans, or maybe even through actions that you could take now that would affect expenditures and deficits in the out years. Senator Gregg. But something should be done. " fcic_final_report_full--253 Some members were concerned about the lack of transparency around hedge funds, the consequent lack of market discipline on valuations of hedge fund hold- ings, and the fact that the Federal Reserve could not systematically collect informa- tion from hedge funds because they were outside its jurisdiction. These facts caused members to be concerned about whether they understood the scope of the problem. During the same meeting, FOMC members noted that the size of the credit deriv- atives market, its lack of transparency and activities related to subprime debt could be a gathering cloud in the background of policy. Meanwhile, Bear Stearns executives who supported the High-Grade bailout did not expect to lose money. However, that support was not universal—CEO James Cayne and Earl Hedin, the former senior managing director of Bear Stearns and BSAM, were opposed, because they did not want to increase shareholders’ potential losses.  Their fears proved accurate. By July, the two hedge funds had shrunk to al- most nothing: High-Grade Fund was down ; Enhanced Leverage Fund, .  On July , both filed for bankruptcy. Cioffi and Tannin would be criminally charged with fraud in their communications with investors, but they were acquitted of all charges in November . Civil charges brought by the SEC were still pending as of the date of this report. Looking back, Marano told the FCIC, “We caught a lot of flak for allowing the funds to fail, but we had no option.”  In an internal email in June, Bill Jamison of Fed- erated Investors, one of the largest of all mutual fund companies, referred to the Bear Stearns hedge funds as the “canary in the mine shaft” and predicted more market tur- moil.  As the two funds were collapsing, repo lending tightened across the board. Many repo lenders sharpened their focus on the valuation of any collateral with po- tential subprime exposure, and on the relative exposures of different financial institu- tions. They required increased margins on loans to institutions that appeared to be exposed to the mortgage market; they often required Treasury securities as collateral; in many cases, they demanded shorter lending terms.  Clearly, the triple-A-rated mortgage-backed securities and CDOs were not considered the “super-safe” invest- ments in which investors—and some dealers—had only recently believed. CHRG-109hhrg31539--4 The Chairman," The gentleman's time has expired. The Chair now recognizes the gentlelady from Ohio, the subcommittee chairwoman. Ms. Pryce. Thank you, Mr. Chairman. And thank you, Chairman Bernanke, for being with us here today. I was pleased to read in your testimony that you believe that even though the economy is currently in a transition period, that it will continue to expand even under the pressure of increased oil prices, consumer spending, and a slowing housing market. I would like to talk about that just briefly. Studies have shown that housing accounted for more than one-third of economic growth during the previous 5 years. The robust housing market had enabled homeowners to reduce their debt burdens and maintain adequate levels of consumer spending by tapping into the equity of their homes. Unfortunately in research done by the National Association of Home Builders, they show a serious downtrend in housing demand that many believe correlates with the rise in interest rates by the Federal Reserve. As I have said in the past, I am concerned that this house price boom has been driven far more by investors than ever before, and could lead to a series of mortgage failures, and as the Federal Reserve tries to balance rising rates with fluctuations in the markets, I don't need to remind you that your actions have a trickle-down effect to local communities, and losses on housing investments are just one example. A study by the Mortgage Bankers Association puts my own State of Ohio at the very top of the list of foreclosures, and so we are very concerned in the Midwest. Although we would sometimes like to think of our economy as one that stands apart from the rest of the world's sociopolitical issues, the effect of volatility overseas is reaching into our economy more than we might realize. Just yesterday I held a hearing in my subcommittee on currency issues. We had representatives there from the Federal Reserve and the Mint discussing with us the rising cost of the commodities and materials that make up our coins. We heard these commodities are affected by the volatility in the world or through rising demand in other markets, and are also themselves affecting our inflation here in the United States. The more they cost, the more they drive up the cost to make our currency, and the more it drives up costs overall. In your remarks at the Senate yesterday, you touched upon a number of issues concerning citizens, such as rising rates, gas prices, and wage earnings. One of the issues that has been important to me, and a number of other members on this committee, is the ratio of consumer debt to consumer savings in America, and the effects that a slowing economy could have on a more local level. I agree with your statement yesterday that we must be forward-looking in our policy actions, and I would appreciate hearing your thoughts on what Congress can do about low savings rates, especially coupled with rising consumer costs. Some of us, Mrs. Kelly, Mrs. Biggert, Mrs. Maloney, and myself, have worked to bring this issue to a national focus for a number of years, and we mentioned it repeatedly, working with the Administration to highlight increasing financial education in the United States, but much more needs to be done. You also talked about an international savings glut that I believe we have here in America, a credit glut. I believe we can say it is almost a national epidemic. Consumer spending is key to our continued growth, but I believe we also need to send a message that consumer savings is just as important, and I appreciate hearing from you what the Federal Reserve and the rest of us can do to help consumer savings become a priority in this Nation. And I want to thank you once again, Mr. Chairman, for your appearance. I look forward to your testimony, and I yield back. Thank you. " CHRG-110shrg38109--92 Chairman Dodd," Thank you, Senator. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Chairman Bernanke, I want to start where I started off in my opening comments to you. I am very concerned about the economic squeeze that has been put on the middle class, particularly since the turn of the 21st century. Since the beginning of 2001, middle-class families have experienced increased levels of debt, anemic growth in real wages, all the while essential costs for food, housing, and medical services have increased at levels drastically higher than inflation. As a result, the financial security of middle-class households has suffered, and more and more American families are unable to afford life emergencies such as an unexpected health problem or unemployment. Employment opportunities are at their lowest level since the Great Depression. Since the recession ended in November 2001, job growth has averaged a mere eight-tenths of a percent per month, less than a third of the 2.7 percent average growth we experienced in previous recovery periods since World War II. For the first time since the 1950's, job opportunities have actually decreased from a 16-percent growth rate in the 1990's to a 14-percent decrease since March 2001. I look at that and I add to that factor that families seems to me to be living on thin ice. I hear these stories of families in New Jersey that they are only one unexpected illness or lay-off away from sinking into perpetual debt. I think one measure of this economic insecurity is the percentage of middle-class families who have at least 3 months of their salary in savings. The percentage of middle-class families who had 3 or more months salary in savings rose 72 percent from 16.7 percent in 1992 to 28.8 percent in 2001. So middle-class families are becoming more secure year by year. But, unfortunately, in the span of less than 4 years, that percentage dropped by over 36 percent, down to 18.3 percent in 2004. Finally, I noted with interest in your written statement, you said, ``Consumer spending continues to be the mainstay of the current economic expansion.'' That is true, but when you add that reality to anemic growth in wages and sharp increases in the cost of necessities, household debt in America has risen to record levels over the past 5 years. By the third quarter of 2006, outstanding household debt was 130 percent relative to disposable income. That means that the average family is in debt of over $130 for every $100 it has to spend. And, additionally, the average household savings rate has actually been negative for the past seven quarters, averaging about a negative 1 percent rate for 2006. So, I look at all of this, and I say to myself, you know, I have my friends and colleagues who are heralding this great economy. I do not get the sense that people back at home and in other parts of the country feel that good about it. You see it in every poll of the barometer of their feelings. They feel really squeezed and really put upon. And so my question to you is: Aren't these indicators a real cause for concern as it relates to the struggle that the middle-class families in this country are facing? And how do we create an economy that is more inclusive and which the macro benefits end up being achieved by those who are the great center of those who keep this country afloat? " CHRG-111shrg62643--61 Mr. Bernanke," Obviously, it will be partly subjective, yes. Senator Bunning. OK. You know, we are $13 trillion going to $14 trillion in our debt. And if you count agency debt--that is public debt. If you count agency debt, just in Social Security, we are at $1 trillion. So if we add that to the $13 trillion, agency debt plus public, that is $14 trillion already. This year, we are not going to have a $14 trillion GDP, not unless we have an unbelievable recovery in the second half of this year. Isn't that pretty close to where Greece was? " CHRG-111hhrg61852--110 Mr. Meltzer," We have to export or we are going to default on the debt. It is not pay back the debt, it is just pay the interest on the debt. " CHRG-111shrg50815--2 Chairman Dodd," The Committee will come to order. My apologies to our witnesses and my colleagues. Today is the 200th anniversary of Abraham Lincoln's birthday and I took my daughter up to Lincoln's cottage this morning up at the Old Soldier's Home where there was a ceremony this morning to unveil a wonderful statue of Abraham Lincoln and his horse Old Boy that he used to ride every morning for about a quarter of his Presidency from the White House to the Old Soldiers Home where he lived for a quarter of that Presidency and he wrote the Emancipation Proclamation. So I thought I would take my daughter out of school this morning for a bit of history and I am sorry to be a few minutes late getting back here this morning, so apologies to everybody for being a few minutes late for enjoying a moment of history with a 7-year-old. Well, let me begin with some opening comments, if I can. I will turn to Senator Shelby. We are honored to have such a distinguished panel of witnesses with us this morning on an issue that many of my colleagues know has been a source of interest of mine for literally two decades, the issue of reform of the credit card industry. And so this hearing this morning will give us a chance to reengage in that debate and discussion, and I want my colleagues to know at some point, and I say this to my good friend, the former Chairman of the Committee, at some point, I would like to be able to mark up a bill in this area. I know he knows that, but I wanted to say so publicly. So good morning to everyone, and today the Committee meets to look into an issue of vital importance to American consumers, their families, and to the stability of our financial system, and that is the need to reform the practices of our nation's credit card companies and to provide some tough new protections for consumers. In my travels around my State, as I am sure it is true of my colleagues, as well, we frequently hear from constituents about the burden of abusive credit card practices. In fact, the average amount of household credit card debt in my State is over $7,100. Actually, the number is higher, I think, nationally. Non-business bankruptcy filings in the State are increasing. In the second quarter of last year, credit card delinquencies increased in seven of eight counties in my State. Across the country, cardholders are paying $12 billion in penalty fees annually, every year. It is a major problem throughout our nation. At a time when our economy is in crisis and consumers are struggling financially, credit card companies in too many cases are gouging, hiking interest rates on consumers who pay on time and consistently meet the terms of their credit card agreements. They impose penalty interest rates, some as high as 32 percent, and many contain clauses allowing them to change the terms of the agreement, including the interest rate, at any time, for any reason. These practices can leave mountains of debt for families and financial ruin in far too many cases. When I introduced Secretary Geithner earlier this week as he unveiled the framework of the President's plan to stabilize our financial system, I noted then for too long, our leading regulators had failed fully to realize that financial health and security of the consumers is inextricably linked to the success of the American economy. In fact, for too many years, I think people assumed that consumer protection and economic growth were antithetical to each other. Quite the opposite is true. I noted that unless we apply the same urgent focus to helping consumers that we apply to supporting our banks' efforts to restart lending, we will not be able to break the negative cycle of rising foreclosures and declining credit that is damaging our economy. In this hearing, the Committee examines abusive credit card practices that harm consumers and explores some very specific legislative ideas to end them. These kinds of consumer protections must be at the forefront of our efforts to modernize our financial regulatory system. Why is this both important and urgent? Well, today, far too many American families are forced to rely on short-term, high-interest credit card debt to finance their most basic necessities. And as layoffs continue, home values plunge, and home equity lines of credit are cut or canceled, they are increasingly falling behind. This December, the number of credit card payments that were late by 60 days or more went up 16.2 percent from last year. Banks increasingly worried about taking more debt, bad debt, into their balance sheets are monitoring their credit card portfolios very closely, slashing credit lines and increasing fees and interest rates even more for consumers who have held up their end of the bargain. That puts consumers, including many of my constituents and others around the country, in the worst possible position at the worst possible time. For too long, the use of confusing, misleading, and predatory practices have been standard operating procedures for many in the credit card industry. The list of troubling practices that credit card companies are engaged in is lengthy and it is disturbing: Predatory rates, fees, and charges; anytime, any reason interest rate increases and account charges; retroactive interest rate increases; deceptive marketing to young people; shortening the period consumers have to pay their bills with no warning. Even the Federal financial regulators, of whom I have been openly critical for a lack of appropriate oversight throughout this subprime mortgage market crisis, recognize the harm these sinister practices pose not only to credit card customers, but also to our economy. Last May, the Federal Reserve, the Office of Thrift Supervision, and the National Credit Union Administration proposed rules aimed at curbing some of these practices. These rules were a good step and I applaud them, but they are long overdue. But they fell far short of what is actually needed, in my view, to protect American families. Just as we have seen in this housing crisis, when companies lure people into financial arrangements that are deceptive, abusive, and predatory, it only means mountains of debt for families, bankruptcy, and financial ruin for far too many. It also proved catastrophic, of course, for our economy. Today as the Committee examines how best to modernize and reform our outdated and ineffective financial regulatory system, we have a clear message to send to the industry. Your days of bilking American families at the expense of our economy are over. Today, we will discuss proposals to reform abusive credit card practices that drag so many American families deeper and deeper and deeper into debt, including the Credit Card Accountability, Responsibility, and Disclosure Act, which I recently reintroduced. We must protect the rights of financially responsible credit card users so that if a credit card company delayed crediting your payment, you aren't charged for this mistake. We must prevent issuers from changing the terms of a credit card contract before the term is up. And perhaps most importantly, we must protect our young people who are faced with an onslaught of credit card offers, often years before they turn 18, or as soon as they set foot onto a college campus. These practices are wrong and they are unfair. And mark my words, in the coming months, they are going to end. Of course, we must do all we can to encourage consumers to also act responsibly when it comes to using credit cards. But we should demand such responsible behavior when it comes to the companies that issue these cards, as well. The need to reform credit card practice has never been more important. It is not only the right thing to do for families and our consumers, it is the right thing to do for our economy, as well. I have been working on reforms in this area for many, many years and I am determined to move forward on these reforms. With that, let me turn to our former Chairman and Ranking Member, Richard Shelby. CHRG-111shrg50814--93 Mr. Bernanke," We have done quite a bit. Honestly, Senator, I think it is not up to me to make that judgment. That is going to depend on the economy, on the scenarios, and on the amount of margin of safety that the decision is made to address. Ultimately the Treasury and the administration have to make that proposal. Senator Tester. OK. I would sure like your input on that, if that is possible. I mean, we are going to be talking about some--I mean, we have already directed some serious dollars and it is, from everything I am hearing, it is going to require some more. The worst thing that could happen is if we don't get cooperation from Europe, from Asia, we end up pumping a bunch of money in and then all it does is increase the debt. We don't get out of the situation we are in. " CHRG-110hhrg46593--321 Mr. Royce," Thank you. Let me ask a question of our two economists here. Because one of the occurrences that we listen to over and over again in this committee is the Federal Reserve coming up here and also Treasury Secretaries saying that there was a systemic risk to the economy because of the leveraging that was occurring in the system. And, specifically, they were identifying the leveraging, which I guess got up to about 100 to 1 at a point, with the GSEs, with Fannie Mae and Freddie Mac doing what somebody described as arbitraging, but borrowing at one rate and then--I guess they borrowed about $1 billion and then went out into the market and had $1.5 billion in these mortgage-backed securities in the portfolios. And, as they described it, one of the consequences of this was that the financial system worldwide was relying heavily on the mortgage-backed securities and, I guess, also, the debt a lot of the banks were holding as part of their collateral, these instruments from Fannie and Freddie. So maybe one of the things we weren't thinking about at the time was that there was also all of this leveraging going on not just in the institutions themselves--maybe that got up to 100 to 1--but also, because it was collateral for loans, there was this additional leveraging that was leveraged into the system. And then, along the way, there was a little bit of nudging from Congress to Fannie and Freddie, in terms of the type of loans that they should be purchasing, the goals that they should have. And so, as a consequence, Alt-A loans, you know, and subprime loans, I mean, this was a place then that those who were writing those loans could get Fannie and Freddie to purchase them, as they got near the end of the year especially and needed to make that target. And so, as they ended up buying those back into their portfolio, and that being 10 percent of the portfolio, the argument that I have seen is that 50 percent of their losses at one point were these Alt-A loans and subprime loans that they had repurchased. And so one of the questions was: We have tried creating a charter, we have tried giving direction to a quasi-governmental entity or a private entity, however we want to define Fannie and Freddie, but might it be wiser, going forward, for us to just let market principles play out, rather than take a scheme like securitization through Fannie and Freddie and then disallow or prevent the regulator--in this case, OFHEO, because OFHEO testified here maybe a month ago or so, the Director of OFHEO. He said, if they had gotten the legislation that they wanted, which would have allowed them to regulate for systemic risk, they could have deleveraged the situation, forced more capital. And they felt that even as, you know, 16 months from today, if they could have gotten that authority, they could have deleveraged this problem and made it a lot less of a crisis for at least the GSEs. And that might have staved off--they said it would have staved off the GSE problem. Be that as it may--that is their opinion--I had carried legislation in 2005 that the Federal Reserve had asked for to try to give them the ability to regulate for systemic risk in this way. But that is the question I wanted to ask you gentlemen. Do you think, going forward, that perhaps we should back off of the portfolio arrangement there that we have, or the leveraging arrangement, and look at simply market principles maybe, in terms of the way that Fannie and Freddie would conduct itself in the future? Because I can see, going out 4 years, 5 years from now as we get this thing resolved, that same dynamic occurring again as long as we have that-- " CHRG-111hhrg55811--31 The Chairman," Yes, so burden of proof should be on those to show you that they can't be. " CHRG-111hhrg55811--399 Mr. Holmes," Well, if we weren't carved out as a nonmajor swap participant and we had to clear all of our transactions and post initial and variation margin or collateral, we would have to curtail significantly our hedging activities because--in my testimony, I indicated that our credit operation, which executes the majority of our derivatives, is prohibited from posting collateral under its indentures. And that prohibition will last as long as the debt is outstanding for up to 10 years. So we would have to curtail our hedging activity and that would increase the volatility that we experience and ultimately the price of our goods that we sell internationally, as well as the cost of our financing for our customers both domestically and internationally. " CHRG-109hhrg31539--6 Mrs. Maloney," Thank you, Mr. Chairman. And welcome, Chairman Bernanke. All eyes are on you and the other members of the Federal Open Market Committee as we reach a critical point in monetary policy. While the U.S. economy was going through its most protracted jobs slump since the 1930's, the Federal Reserve acted appropriately and kept interest rates very low. And when the economy began to respond, the Federal Reserve told us they were raising interest rates gradually to restore them to a level consistent with stable noninflationary growth. But that process, 17 increases in short-term interest rates, began 2 years ago, and people are naturally wondering when is it going to stop. Ordinary American families should be wondering the most because they are the ones who have been left behind in whatever economic recovery we have seen. Regrettably, the gap between the haves and the have-nots continues to widen. GDP growth has been satisfactory, although not as strong as in the average postwar business cycle recovery, and productivity has been very strong. But as Ranking Member Frank has pointed out, what have ordinary American workers gotten in return for their hard work? Paychecks that have not kept up with inflation, much less with their increased productivity. And now rising interest rates and a slowing economy may choke off the economic recovery before most Americans have even had a chance to benefit. It is a challenging time for monetary policy because our fiscal policy is such a mess. The President's tax cuts were poorly designed to produce job-creating stimulus in the short run while adding to the budget deficit in the long run. The fiscal discipline built up in the 1990's has been squandered. Let us remember that President Bush inherited a budget surplus of $5.6 trillion over 5 years, but now we are back to a legacy of deficits and debt. We have record budget deficits and record debt, over $8 trillion, and a record trade deficit, the largest in history, $800 billion. Due to the debt, each American owes over $28,000. We are borrowing large amounts from the rest of the world and have had to raise our national debt limit four different times already during this current Administration. The fiscal discipline of the 1990's allowed the Federal Reserve to pursue a monetary policy that encouraged investment and growth. The challenge is greater now because the Federal Reserve will have to fight the excesses of fiscal policy which have drained our national savings and turned us into a massive international debtor. Chairman Bernanke, I look forward to your testimony and to exploring with you the challenges you face as you try to keep the economy growing and inflationary pressures contained so that ordinary Americans can begin to see their standard of living grow once again. Thank you. " CHRG-111hhrg53244--169 Mr. Bernanke," I think the ability to float large amounts in the short to medium term depends on the credibility of a longer-term plan that brings the deficits down. If the markets don't think that you are on a sustainable path, then they will bring forward in time their concern about future deficits. So it is important to have, as I said before, a medium-term sustainability plan. I must say one thing about health care costs, which is that is the most important determinant right now of our long-run fiscal situation. And even under the status quo, we have a very serious problem, and so, we do need to address that problem in some way. Because, given the aging of our population, the increases in medical costs are going to be a huge burden on our fiscal balance. " FinancialCrisisInquiry--22 The final crisis and perhaps the most daunting is that we have a severe economic recession going on. While some would say that the financial crisis caused the recession, the experts will analyze that for the coming years to establish the exact causal relationship. But one thing is clear. The U.S. economic growth in the first decade of this century was funded in part by home price appreciation and the ability of homeowners to access the equity in their homes to use for spending. In addition, home mortgage and home equity financing helped drive residential construction activities, which contributed to the economic expansion. The history of past economic cycles and this cycle shows that an economic expansion built on excessive debt or leverage will end in a recession, no matter what triggers it. And this one surely did. This crisis has taught us some very valuable lessons. And let me highlight a few of those that are in my written testimony. First, this credit starts and ends with sound underwriting, a clear assessment of the borrower’s ability to repay the loan. Rating agencies or credit bureaus are no substitute for diligent and independent risk analysis. Second, capital is important. And the leverage of investment banks and other market participants was untenable. While the leverage requirements for a bank holding company may have been better, banks and others should, and undoubtedly will, hold more capital going forward. Third, liquidity is the key. Liquidity allows an institution to meet marginal calls, fund redemptions or pay depositors without having to sell illiquid assets at discounts, which could lead to further losses. And fourth, current accounting rules need to be reviewed. Current rules require banks to reduce reserves against loan losses in good times and build them in bad times. In addition, mark-to-market accounting can become disjointed when there’s no real market for many products. CHRG-111hhrg56766--113 Mr. Manzullo," Thank you. Congratulations on your re-election, Mr. Chairman. You got reappointed, but you had to get elected, just like we do. It was a vote count. Chairman Bernanke, the FDIC reported yesterday that bank lending in 2009 fell by 7.5 percent or $587 billion, $587 billion, and the Wall Street Journal, its headline today said it was epic, the decline. There's a chart behind. Why is bank lending falling so dramatically? It has fallen, I believe, because we're forced to hold greater capital reserves, given the rising default rates on commercial real estate. Up on the committee room TV now is a chart from the most recent Congressional Oversight Panel report which shows the value of delinquencies on CRE loans has increased 700 percent since the first quarter of 2007. You'll notice from the chart behind you, Mr. Chairman, that if the trend continues, the rate of CRE loans will soon be literally off that chart. The dramatic increase in delinquencies to me is really approaching a tsunami, threatening our local communities and banking system. It's estimated to peak between 2011-2012 with over $300 billion in CRE debt expected to mature each year. As you know, the CRE market is huge. It's $3.5 trillion of the total debt. It's about $1.7 trillion held by banks and thrifts. Much of this debt is held by community banks across the country that have survived the first part of the tsunami, the mortgage default crisis, but now are being threatened by this one. The FDIC yesterday informed us that they're adding 450 banks to the Troubled Bank List, more than doubling the number from the start of 2009. Many are small lending institutions that have invested in their communities for decades. Chairman Bernanke, I just held a hearing January 21st on the epidemic of bank failures focusing on the failure and seizure of a great Chicago community institution, Park National Bank. I would rather not have more hearings in the coming year on the autopsies of what have been rather good banks. I want to focus on how we can help these good banks and how we're getting back to lending. So how much do you think of the coming tsunami of these loans, $1.7 trillion held by our local banks, loan defaults are going to harm our communities and local banks, and what have you done about it and what future plans do you intend to make about it? " CHRG-110hhrg34673--118 Mr. Bernanke," Well, the projection would be that in 2030 the entitlement programs would be about 15 percent of GDP, which means that the entitlement programs and interest on the debt together would be something about our total budget today. So increases would have to be related to how much additional spending you would have. If you want to keep nonentitlement spending constant, you would have to raise tax rates approximately 6 or 7 percentage points of GDP, from about 18 percent now to about 25 percent of GDP, with no other changes in order to retain about the same deficit. " 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-111hhrg53244--10 The Chairman," The gentleman from Texas. There are 2 minutes remaining on the Republican side. We will make it 2\1/2\ minutes. Dr. Paul. Thank you, Mr. Chairman. Good morning, Chairman Bernanke. The Federal Reserve, in collaboration with the giant banks, has created the greatest financial crisis the world has ever seen. The foolish notion that unlimited amounts of money and credit created out of thin air can provide sustained economic growth has delivered this crisis to us. Instead of economic growth and stable prices, it has given us a system of government and finance that now threatens the world's financial and political institutions. Real unemployment is now 20 percent, and there has not been any economic growth since the onset of the crisis in the year 2000, according to nongovernment statistics. Pyramiding debt and credit expansion over the past 38 years has come to an abrupt end, as predicted by free market economists. Pursuing the same policy of excessive spending, debt expansion, and monetary inflation can only compound the problems and prevent the required corrections. Doubling the money supply didn't work. Quadrupling it won't work either. The problem with debt must be addressed. Expanding debt when it was a principal cause of the crisis is foolhardy. Excessive government and private debt is a consequence of loose Federal Reserve monetary policy. Once a debt crisis hits, the solution must be paying it off or liquidating it. We are doing neither. Net U.S. debt is now 372 percent of GDP, and in the crisis of the 1930's, it peaked at 301 percent. Household debt services require 14 percent of disposable income, at an historic high. Between 2000 and 2007, credit debt expanded 5 times as fast as GDP. With no restraint on spending, and revenues dropping due to the weak economy, raising taxes will be poison to the economy. Buying up the bad debt of privileged institutions and dumping worthless assets on the American people is morally wrong and economically futile. Monetizing government debt, as the Fed is currently doing, is destined to do great harm. In the past 12 months, the national debt has risen over $2 trillion. Future entitlement obligations are now reaching $100 trillion. U.S. foreign indebtedness is $6 trillion. Foreign purchase of U.S. securities in May were $7.4 billion, down from a monthly peak of $95 billion in 2006. The fact that the Fed had to buy $38 billion worth of government securities last week indicates that it will continue its complicity with Congress to monetize the rapidly expanding deficit. The policy is used to pay for the socialization of America and for the maintenance of an unwise American foreign policy and to make up for the diminished appetite of foreigners for our debt. Since the attack on the dollar will continue, I would suggest that the problems we have faced so far are nothing compared to what it will be like when the world not only rejects our debt but our dollar as well. That is when we will witness political turmoil, which will be to no one's benefit. " CHRG-109shrg26643--90 Chairman Shelby," Senator Schumer for your first round. Senator Schumer. Thank you, Mr. Chairman, and I thank you, Chairman Bernanke--that has a nice ring to it. I am glad you are here. I thought your confirmation process was both a tribute to you and a model of how we should do other confirmations, particularly on other Committees on which I might serve or do serve, with a lot of consultation, bipartisanship, et cetera. I have a bunch of questions. The first relate to the overall global situation of the United States and as it relates to China. You said yesterday that we need to increase national savings as one of the ways to deal with our big trade deficit with the rest of the world and China. Yet, the budget we passed 2 weeks ago increased the debt we have further and there is a push to put new tax cuts in that. Now, I am not asking you to opine on tax cuts. I know you do not want to do that. I do want to ask you does it make sense, from a global perspective, for us to continue to increase this deficit, whether it is by tax cuts or increased savings? Does that not weaken the position of the United States in trying to accomplish many of our other international economic goals? " FOMC20080625meeting--253 251,MR. PARKINSON.," I have in front of me data from Bank of New York, which facilitates about two-thirds of the repos. At Bank of New York, 18 percent of the collateral is debt that's settled through DTC--so that would be non-government, non-agency debt--and another 6 percent is equity. So about 25 percent is non-OMO things. The biggest chunk by far is agency MBS. Of course, I think in extremis Bear was having trouble financing even agency debt, importantly given the illiquidity that had developed in even the agency debt markets at that time, which was the critical thing that made investors no longer willing to provide financing for that kind of collateral with a shaky counterparty. " FinancialCrisisInquiry--120 These organizations have been the single largest political contributors in the world over the past decade, with over $200 million being given to 354 lawmakers in the last 10 years or so. Yes, the United States needs low-cost mortgages, but why should organizations created by Congress have to lobby Congress? Fannie and Freddie used the most leverage of any institution that issued mortgages or held mortgage-backed bonds in the crisis. At one point in 2007, Fannie was over 95-times levered to its statutory minimum capital, with just 18 basis points set aside for loss. That’s right -- 18/100ths of 1 percent set aside for potential loss, with 95 times leverage. They must not be able to put Humpty Dumpty back together again. If they are going to exist going forward, Fannie and Freddie should be 100 percent government-owned and the government should simply issue mortgages to the population of the United States directly since this is essentially what is already happening today, with the added burden of supporting a privately funded, arguably insolvent capital structure. I will conclude my testimony there, and—and leave it to questions. CHAIRMAN ANGELIDES: Thank you very much, Mr. Bass. Mr. Solomon? SOLOMON: Thank you, Chairman—Vice Chairman Angelides and Vice Chairman Thomas and members of the commission. Thank you for asking me to appear before the commission. Before I begin, I want to commend the leadership of the House and the Senate for creating this bipartisan commission to examine the causes of the current financial and economic crisis in the United States. When I entered Wall Street in the early 1960s, security firms and commercial banks had not changed much since the 1930s. Stock ownership was not widespread. Pension funds and endowments did not invest broadly. CHRG-110hhrg34673--104 The Chairman," We are going to convene a minute early, but the next person on our list here is from Kansas, Mr. Moore. Would someone please close the doors--thank you--and Mr. Chairman, we appreciate, again, your giving us all this time. The gentleman from Kansas is recognized for 5 minutes. Mr. Moore of Kansas. Thank you. Mr. Chairman, thank you and welcome to the committee, and I appreciate your coming here and taking our questions. I want to follow up on kind of an area at least that the gentleman from Texas asked you about, and that was our debt as a Nation and what that is going to do to future generations in our country. I have seven grandchildren, and I am very concerned that we are accumulating a debt in this country that presently stands at $8.7 trillion. I understand it has gone up approximately $3 trillion in the past 6 years, and I was at the White House about 6 weeks ago, and I had a chance to talk with the President. I said, Mr. President, I am not pointing a finger at your Administration, and saying it is your fault, because this goes back 25 years, 30 years, but through a process of borrowing and accumulating debt, interest on our national debt now stands at $8.7 trillion, and as I think Mr. Paul pointed out, over 40 percent of our debt is held by foreign nations. Should we, as a Nation, be concerned about that much debt? Should we, as a Nation, be concerned about the fact that more than 40 percent of our debt is held by foreign nations? If for any reason, whatever reason, foreign nations decide to sell off our debt, what impact, if any, would that have on interest rates in our country? " CHRG-109hhrg28024--21 Mr. Frank," Thank you, Mr. Chairman. I'll start my time and give credit where credit is due. As this colloquy about the 30-year bond has occurred, when President Bush came to office, there was some concern, and Mr. Greenspan had it, about how the Federal Government would deal with this problem with surpluses and a disappearing debt, and the Bush Administration certainly solved that problem. No one has to worry any more, thanks to our recent fiscal policy about the possibility of surplus and not enough debt. So I did want to acknowledge that accomplishment. On the question that I began with, Mr. Bernanke, I wonder, Mr. Greenspan did on several occasions lament the increasing inequality that was happening in America. Again, I want to stress inequality is a good thing in a capitalist economy. The economy doesn't work without it. But it can become excessive in ways that I think don't, are not necessarily for efficiency and can cause other kinds of problems. Do you feel his concern about inequality, both in the abstract and in terms of how we've been in the last few years? " CHRG-109hhrg28024--293 Mr. Cleaver," I am extremely concerned about the debt, as I think many of my colleagues have expressed, with China, Japan, and the U.K. holding $1.3 trillion of that debt. What impact on the U.S. economy would take place if China made the decision that they would invest internally or in Europe rather than the U.S.? If they called in their debt, what happens to the U.S. economy? The Chinese hold like $255 billion of our debt. What happens if they call it in? " CHRG-110hhrg38392--82 Mr. Hinojosa," I agree with you because, in my district, I have seen that we give out about 7,500 checks a year as subsidies, and 10 percent of the biggest farms in our district receive 80 percent of the total amount of money given by the Federal Government. So I agree with you. The second question refers to Mexico and to the fact that it is the United States' second leading trade partner. This is especially visible on the border in my congressional district in south Texas. The communities along the Mexico-U.S. border have faced great burdens on their infrastructure due to such trade growth. Do you support an increase in resources for the NADBank to support local projects such as wastewater treatment facilities, roadways, and bridges to address this regional challenge? " CHRG-111hhrg48875--86 Secretary Geithner," We are a nation of 8,000 to 9,000 banks. We're a much stronger country because of the hundreds and thousands of smaller institutions that operate in our communities across the country. This is--they were not, mostly not part of the problem. They're going to be part of the solution going forward. It's very important they have access to capital on the same terms the large institutions do, and we're moving very, very quickly since we came into office to try to make sure that we're accelerating the procedures at the Treasury to make sure they can have access to capital. Now in our proposal, as you saw, we want to hold the large institutions to stronger, tougher, more rigorous standards, tougher constraints on leverage. That will help counteract this risk that we have further consolidation over time to leave the system more risky. But you're absolutely right to underscore the importance of effective antitrust enforcement, and we have significant--we have these caps now on the scale of share of deposits that any single institution can have across the United States. We want to keep those in place, because we want to have a system that still relies on not just a few large institutions, but hundreds and thousands of smaller institutions across the country. And, again, if you look at what's happening across the country, they're bearing a lot of the burden for filling the gap left by those institutions that have to pull back now and get smaller because they took too many risks. " CHRG-111hhrg54867--11 Secretary Geithner," Thank you, Mr. Chairman, Ranking Member Bachus, members of the committee. It is a pleasure to be back before you today and to talk about how best to reform the system. I am pleased to hear the enthusiasm for reform across both sides of the aisle. And, of course, we all recognize the task we face is how to do it right and how to get it right. Our objective, of course, is to provide stronger protection for consumers and investors, to create a more stable financial system, and to reduce the risk that taxpayers have to pay for the consequences of future financial crises. We have outlined a broad set of proposals for achieving these. We provided detailed and extensive legislative language. We welcome the time and effort you have already put into considering these proposals and the suggestions you have made, many of you individually and collectively, have made to improve them. As the President likes to say, we don't have a monopoly of wisdom on these things. Our test is, what is going to work? That is our test. What will work? What will create a more stable system, better protections, with less risk to the taxpayer? I want to focus my remarks briefly on what I think are the two key challenges before us at the center of any debate on reform. The first is about how you achieve the right balance between consumer protection and choice and competition. And the other is how to deal with the moral-hazard risk people refer to as ``too-big-to-fail.'' So, first, on the consumer challenge, our system of rules and enforcement failed to protect consumers and investors. The failures were extensive and costly. They caused enormous damage not just to those who were the direct victims of predatory practice, fraud, and deception, but to millions of others who lost their jobs and their homes or their savings in the wake of the crisis. And to fix this--and I will just say it simply--we need to have strong minimum national standards for protection. They need to apply not just to banks but to institutions that compete with banks in the business of providing credit. They need to be enforced effectively, consistently, and fairly. And there need to be consequences for firms that engage in unfair, ineffective practices, consequences that are strong enough to deter that behavior. We believe we cannot achieve that within our current framework of diffused authority with the responsibility divided among a complex mix of different supervisors and authorities who have different missions and many other priorities. We think it requires fundamental overhaul so that consumers can understand the risks of the products they are sold and have reasonable choices, and institutions have to live with some commonsense rules about financial credit. Of course, the challenge is to do this without limiting consumer choice, without stifling competition that is necessary for innovation, and without creating undue burden and cost on the system. Our proposal tries to achieve this balance by consolidating the fragmented, scattered authorities that are now spread across the Federal Government and State government. And it is designed to save institutions that are so important to our communities--credit unions, community banks, other institutions that provide credit--from making that untenable choice between losing revenue, losing market share, or stooping to match the competitive practices that less responsible competitors engage in, competitors that had no oversight, that were allowed to engage in systematic predatory practices without restraint. Now, some have suggested that, to ensure no increase in regulatory burden, we should separate rule-writing authority from enforcement. But our judgment is this is a recipe for bad rules that are weakly enforced--a weaker agency. So we think we need one entity with a clear mission, the authority to write rules and enforce them. Now, just briefly on this deeply important, consequential question of moral hazard and ``too-big-to-fail,'' no financial system can function effectively if institutions are allowed to operate with the expectation they are going to be protected from losses. And we can't have a system in which taxpayers are called on to absorb the costs of failure. We can't achieve this with simple declarations of intent to let future financial crises burn themselves out. We need to build a system that is strong enough to allow firms to fail without the risk of substantial collateral damage to the economy or to the taxpayer. And this requires that we have the tools and authority to unwind, dismantle, restructure, or close large institutions that are at the risk of failure without the taxpayers assuming the burden. It requires that banks pay for the costs incurred by the government in acting to contain the damage caused by bank failures. And this requires higher capital standards, tougher constraints on leverage across-the-board, with more rigorous standards applied to those who are the largest, most complicated, posing the biggest risks to the system. Now, this package of measures is central to reform. You can't do each of these and expect it to work. You have to take a broad, comprehensive approach. And the central objective, again, is to make the system strong enough so we can allow failure to happen in a way that doesn't cause enormous collateral damage to the economy and to the taxpayer. As the President said last week, taxpayers shouldered the burden of the bailout, and they are still bearing the burden of the fallout in lost jobs, lost homes, and lost opportunities. We look forward to working with this committee to help create a more stable system. We can't let the momentum for reform fade as the memory of the crisis recedes. Thank you, Mr. Chairman. [The prepared statement of Secretary Geithner can be found on page 54 of the appendix.] " CHRG-111hhrg53244--62 Mr. Bernanke," Well, the purpose of our limited program was to address private credit markets, Congressman. When we complete the $300 billion program that we announced, we will have less treasuries on our balance sheet than we did 2 years ago, because we sold off a lot of treasuries in order to make room for these other things we were doing. Secondly, after we complete that $300 billion, our share of outstanding treasuries will be at one of the lowest points in the post-war period. So we are not taking a significant portion of U.S. Treasuries. And we are not actively intervening or actively trying to make it easier for the government to issue debt. Dr. Paul. So you are saying, if you buy $300 billion worth of U.S. Government debt, that is not inflationary. The true definition of ``inflation'' is when you increase the money supply. And the immediate consequence is it sends out false, bad information to the marketplace. So whether it is when the bubble is being formed or afterwards, all you are doing is inflating constantly. You have doubled the money supply; interest rates are artificial. People make mistakes. So it seems to me that you are in the midst of massive inflation. But I guess you have a different definition. When you double the money supply, that is not inflation itself? Or are you looking at only prices? " CHRG-110hhrg44903--152 Mr. Geithner," Just two quick things. The Federal Reserve cannot bear the sole responsibility for responding to the kind of challenges that the United States is going through. I think that the Fed has an important role but I think as the Congress has recognized, the Administration has recognized and it is truly in all financial crises. You need a set of policy measures to be responsive to these challenges. And monetary policy cannot bear the sole burden of responding to those challenges. We have been very careful to make that line there. On the broad question about scope of authority, what I want to underscore again is how important it is not to give us broader responsibility without authority, that we cannot compensate for--without basic authority. If you gave us more responsibility, that would probably come with a broader increase in moral hazard, with less capacity to mitigate that risk. And getting that balance right is very important. " CHRG-110hhrg46595--39 Mr. Price," Thank you, Mr. Chairman. Over the past year, we have seen an unprecedented level of government intervention into the market, and there seems to have been enough time and enough pain to pose this question, how is it working? One does not have to be an expert to judge the efficacy of recent government bailouts. Congress is appropriately in the position of asking some very difficult questions. One that must be addressed is whether or not the congressionally-backed taxpayer safety net that has been cast far and wide has only served to prolong and deepen our current financial downturn while at the same time burdening an unconceivable and enormous debt on our children, our grandchildren, and now, yes, even our great grandchildren. We are in real danger of politicizing our entire economy. And there is historic risk in that, for it has always been the absence of politics in the greater economy that has allowed more success for more people than any nation in the history of mankind. In a political economy, Washington is the judge. Washington picks the winners and losers. Washington decides what products and services we need. We all want the American auto industry to survive and to thrive. My sense is that the concessions necessary by all of the involved stakeholders to ensure a robust American automobile industry will require a legally expedited restructuring process. And I would ask our guests what is it specifically that prevents you from supporting this more tried and true, and dare I say American solution? " CHRG-111hhrg63105--39 Mr. Gensler," I am sure. I don't think that the Commodity Exchange Act or Congress has said that the CFTC is an agency to regulate prices. What we have as our mission is to ensure fair and orderly markets, that the price discovery function is transparent, and that there is an integrity of the markets, and that the position limit regime that has been in place since the 1930s is to ensure that there is a diversity of points of view. It doesn't limit hedgers, it limits the number of contracts a speculator can hold, and speculators and hedgers, importantly, must meet in a marketplace, but that there may be burdens that come from excessive speculation. I will use an extreme case: If somebody had half a market, for instance, and then they were to liquidate that position it would be a burden on the market. Maybe if it is only ten percent of the market, to liquidate that market, it would be a burden. So, over the decades what we did is we put in place limits in the agricultural markets. There were limits through the exchanges in the metals and energy markets in the 1980s and 1990s. In fact energy markets had limits all the way through the summer of 2001, for these all-months-combined. And it was to prevent, prospectively as much as anything, the burdens that may come from large positions and the concentration of those positions in a marketplace. " CHRG-109shrg24852--98 Chairman Shelby," I will get Senator Bennett first. I think he has a question. Senator Bennett. Yes, one quick additional issue that I would like to raise with you again just to get this on the record. As we grapple with the Social Security problem, and I am trying to craft a solution that deals with the solvency challenge, I think the political situation says that the personal accounts will be a fight we will have at some future point. I think there are good enough idea that they will stay around and I think eventually the Congress will adopt them. But in this Congress, there does not seem to be an appetite to do that and the solvency issue is still very much with us. So, I have tried to craft a bill to deal with that, as my colleagues know. But in this process, I come back to an issue that you have commented on in the past and I would like to get a fresh response from you so that I am not guilty of using outdated information. This has to do with the professional consensus among economists which says that the CPI overstates changes in the cost of living, and the Bureau of Labor Statistics in 2002, perhaps in response to that consensus, began publishing a new index called the Chain CPI. I had a little trouble understanding what that meant. But it takes into account the fact that consumers will make substitutions in their purchases. If the price of X goes so high, they will switch to Y, and so their standard of living presumably has not changed that much, but the cost of living is better measured by the chain CPI. My staff on the Joint Economic Committee has come up with information that the implications of using the chain CPI as opposed to the CPI are huge. Over 10 years, the Boskin Commission says, quoting CBO, that if CPI overstated the cost of living by 1.1 percent per year, the standard programs that we have in place would increase the national debt by a trillion dollars over a 10-year period. And Congress may want, as a matter of policy, to say let's increase the national debt by a trillion dollars in order to increase these programs by more than the cost of living, but at least the stated position of Congress in the current law is that we simply want to have the actual cost of living taken care of. Another side of it is that CPI is tied to the taxation bracket, which means that people get a massive tax cut over time with respect to the issue of bracket creep. Bracket creep is dampened by using the CPI. So you get less revenues and more expenditures by doing this, which means that the trillion-dollar number may be exacerbated by the impact on the tax side. I do not think they took the tax side into consideration when they looked at the expenditure side. Could you comment on all of this and where you think we as policymakers should go on this issue? " fcic_final_report_full--328 Even after both Fannie and Freddie became public companies owned by share- holders, they had continued to possess an asset that is hard to quantify: the implicit full faith and credit of the U.S. government. The government worried that it could not let the . trillion GSEs fail, because they were the only source of liquidity in the mortgage market and because their failure would cause losses to owners of their debt and their guaranteed mortgage securities. Uncle Sam had rescued GSEs before. It bailed out Fannie when double-digit inflation wrecked its balance sheet in the early s, and it came through in the mid-s for another GSE in duress, the Farm Credit System. In the mid-s, even a GSE-type organization, the Financing Cor- poration, was given a helping hand. As the market grappled with the fundamental question of whether Fannie and Freddie would be backed by the government, the yield on the GSEs’ long-term bonds rose. The difference between the rate that the GSEs paid on their debt and rates on Treasuries—a premium that reflects investors’ assessment of risk—widened in  to one-half a percentage point. That was low compared with the same figure for other publicly traded companies, but high for the ultra-safe GSEs. By June , the spread had risen  over the  level; by September , just before regulators parachuted in, the spread had nearly doubled from its  level to just under , making it more difficult and costly for the GSEs to fund their operations. On the other hand, the prices of Fannie Mae mortgage–backed securities actually increased slightly over this time period, while the prices of private-label mortgage–backed securities dra- matically declined. For example, the price of the FNCI index—an index of Fannie mortgage–backed securities with an average coupon of —increased from  in January  to  on September , , two days prior to the conservatorship. As another example, the price of the FNCI index—Fannie securities with an average coupon of —increased from  to  during the same time period. In July and August , Fannie suffered a liquidity squeeze, because it was un- able to borrow against its own securities to raise sufficient cash in the repo market. Its stock price dove to less than  a share. Fannie asked the Fed for help.  A senior adviser in the Federal Reserve Board’s Division of Banking Supervision and Regula- tion gave the FCIC a bleak account of the situation at the two GSEs and noted that “liquidity was just becoming so essential, so the Federal Reserve agreed to help pro- vide it.”  On July , the Federal Reserve Board in Washington authorized the New York Fed to extend emergency loans to the GSEs “should such lending prove necessary . . . to promote the availability of home mortgage credit during a period of stress in fi- nancial markets.”  Fannie and Freddie would never tap the Fed for that funding.  Also on July , Treasury laid out a three-part legislative plan to strengthen the GSEs by temporarily increasing their lines of credit with the Treasury, authorizing Treasury to inject capital into the GSEs, and replacing OFHEO with the new Federal Housing Finance Agency (FHFA), with the power to place the GSEs into receiver- ship. Paulson told the Senate that regulators needed “a bazooka” at their disposal. “You are not likely to take it out,” Paulson told legislators. “I just say that by having something that is unspecified, it will increase confidence. And by increasing confi- dence it will greatly reduce the likelihood it will ever be used.”  Fannie’s Mudd and Freddie’s Syron praised the plan.  CHRG-110hhrg46593--345 Mrs. Biggert," Thank you, Mr. Chairman. Mr. Blinder, you talked about, in your statement, that there had been zero purchases of the two asset classes, and it has just been capital injections into the banks. And you say, ``Were I a Member of Congress, I would be pretty unhappy about this turn of events. In fact, as a taxpayer shouldering his share of the $700 billion burden, I am unhappy.'' But there is still--and I don't know if you were here for the prior panels--well, one of them was a plan for the insurance, which was actually in the bill. What do you think of the insurance plan? Is this something that we should look at? Which would then--you know, the actual financial institutions would carry the burden for paying for the premiums. " CHRG-111shrg57319--477 Mr. Killinger," Well, in hindsight, you look at the position we were in and we made a decision to overnight, instantly, give Wall Street banks access to becoming bank holding companies and access to the Federal Reserve for liquidity. We very quickly passed the various legislation that increased the FDIC insurance limit to $250,000 and had the FDIC guarantee bank debt. That would have been huge for Washington Mutual. They injected the TARP money across the board. There were many banks, particularly Wall Street banks, that liquidity was a major issue for them and they were saved by this. Senator Kaufman. What was your relationship with the regulators before this? Did you have a good relationship with the regulators? " CHRG-110shrg50416--169 Chairman Dodd," Well, thank you. Let me just end on that note. As you point out, Mr. Lockhart, a lot of our problems was the private secondary market here that contributed significantly to bad lending practices. Clearly, we need to change this notion. But as I understand it, the only country in the world that has provided a 30-year fixed-rate mortgage was the United States. I do not know of any example around the world. And to attribute all of the problems, in fact, as you point out, in the absence of the liquidity provided today by this, we would be in a very, very difficult, far more difficult situation than we are in. Now, clearly, we are going to change. We are going forward. What replaces this? That will be a debate. There are various ideas on how to do it. But one of the things I take exception to is the notion somehow that it has been a bad idea to take relatively poor people and make it possible for them to get into homeownership. We have greatly benefited as a country, what it has meant to a family, a neighborhood, what it has meant to our economy. And as long as you have got good, strong, underwriting standards that demand accountability by that borrower in the process, it has worked. And I hope we do not retreat from that. It has been a great wealth creator for many millions of people in this country over the years, and providing the means by which we do it. Now, there are a variety of means by which you can do it, but one of my fears will be, as we see here, the assumption somehow because there is a Government-sponsored enterprise of one kind, whether it is a utility idea, as Secretary Paulson has suggested, or others, clearly the present model does not work. And that has to change without any question whatsoever. And there is a legitimate debate about whether or not--which side you replace it with. But I just want to point out that we would not be in the mess we are in today were it not for the fact that there was an improper or lack of regulation in that private secondary market as well. So I want to be careful before people jump to that option without some serious considerations as well as the way we are headed. This has been a very worthwhile hearing, and we thank you. We are going to come back again and again, obviously, on this, and some of the issues involving foreclosure we want to continue to raise with you as well. But I am very grateful to all of you, and I appreciate the work that you are doing. The Committee will stand adjourned. [Whereupon, at 1:10 p.m., the hearing was adjourned.] [Prepared statements and responses to written questions supplied for the record follow:][GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM SHEILA C. BAIRQ.1. Please provide the legal justification for establishing the Temporary Liquidity Guarantee Program under the systemic risk exception in the Federal Deposit Insurance Act.A.1. The legal authority for establishing the Temporary Liquidity Guarantee Program (TLGP) is set forth in 12 U.S.C. 1823(c)(4)(G). Based on information regarding the unprecedented disruption in credit markets and the resulting effects on the ability of banks to fund themselves and the likelihood that the FDIC's compliance with the least-cost requirements of the Federal Deposit Insurance Act (12 U.S.C. 1823(c)(4)(A) and (E)) would have serious adverse effects on economic conditions or financial stability by increasing market uncertainty, the Board of Directors of the FDIC and the Board of Directors of the Federal Reserve System made written recommendations to the Secretary of the Treasury that the FDIC's creation of the TLGP program to guarantee bank depositors and senior unsecured creditors against loss under certain described circumstances would avoid or mitigate such effects. After consultation with the President, as required by the statute, the Secretary of the Treasury made the systemic risk determination that provided the FDIC with the authority to implement the TLGP.Q.2. According to press reports, the emergency actions taken by the FDIC to guarantee unsecured senior debt issued by FDIC-insured depository institutions has had the unintended consequence of driving up the costs of borrowing for Fannie Mae, Freddie Mac and the Federal Home Loan Banks (FHLBs). Was this taken into account as a possible consequence as you formulated this course of action?A.2. As noted in the press, the spread of debt issued by Government-sponsored enterprises (GSEs), including Fannie Mae, Freddie Mac and Federal Home Loan Banks (FHLBs), over Treasuries increased considerably in October and November although the overall cost of funding declined. According to Merrill Lynch data on U.S. bond yields, the spread between AAA-rated agency debt and Treasuries increased by nearly 40 basis points between September and November 2008. We believe these developments primarily reflect broad financial market uncertainty and a generally unfavorable market sentiment towards financial firms. In fact, the spread of debt guaranteed by the FDIC under the Temporary Liquidity Guarantee Program over Treasuries is larger than the spread on GSE debt. Financial firms, including those with a AAA-rating, saw their borrowing costs increase sharply, both in absolute terms and relative to Treasury yields, during the same two months, even as the Federal Reserve continued to lower the federal funds target rate. Merrill Lynch data show that the effective yield on AAA-rated corporate debt issued by financial firms increased by 140 basis points between September and October, before declining somewhat in November. Lower-rated corporate debt experienced even more significant increases over the same period of time. The primary purpose of the FDIC's Temporary Liquidity Guarantee Program is to provide liquidity in the inter-bank lending market and promote stability in the long-term funding market where liquidity has been lacking during much of the past year. While the FDIC's action was focused primarily on helping to restore a stable funding source for banks and thrifts, we believe that such liquidity can, in turn, help promote lending to consumers and small businesses, which would have a considerable benefit to the U.S. economy, in general, and financial firms, including mortgage lenders and GSEs. Nevertheless, partly to mitigate any potential effect of the FDIC guarantee on funding costs for GSEs, the federal banking agencies have agreed to assign a 20 percent risk weight to debt guaranteed by the FDIC (rather than the zero risk weighting that is assigned to debt guaranteed by a U.S. Government agency that is an instrumentality of the U.S. Government and whose obligations are fully and explicitly guaranteed as to the timely repayment of principal and interest by the full faith and credit of the U.S. Government).Q.3. The FFIEC has proposed a rule that would lower the capital risk weighting that banks assign to Fannie Mae and Freddie Mac debt from 20 to 10 percent, but does not change the treatment for FHLB debt. Has any consideration been given to giving the same treatment to FHLB debt? Will FDIC-guaranteed unsecured bank debt have a comparable risk weight?A.3. On September 6, 2008, the Treasury and Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship, administered by the FHFA. The next day, September 7, 2008, the Treasury announced the establishment of the Government Enterprise Credit Facility and entered into senior preferred stock purchase agreements (the Agreements) with Fannie Mae and Freddie Mac. These Agreements are intended to ensure that Fannie Mae and Freddie Mac maintain a positive net worth and effectively support investors that hold debt and mortgage-backed securities issued or guaranteed by these entities. On October 27, 2008, the Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, and Office of Thrift Supervision (together, the Agencies) published in the Federal Register a Notice of Proposed Rulemaking that would permit a banking organization to reduce to 10 percent from 20 percent the risk weight assigned to claims on, and the portions of claims guaranteed by, Fannie Mae and Freddie Mac (the NPR).\1\ As proposed, the NPR would permit a banking organization to hold less capital against debt issued or guaranteed by Fannie and Freddie. The preferential risk weight would be available for the duration of the Treasury's Agreements.--------------------------------------------------------------------------- \1\73 Fed. Reg. 63656.--------------------------------------------------------------------------- The NPR requested comment on the proposed regulatory capital treatment for debt issued or guaranteed by Fannie Mae and Freddie Mac and whether the Agencies should extend this capital treatment to debt issued or guaranteed by other government-sponsored entities (GSEs), such as the Federal Home Loan Banks (FHLBanks). The comment period for the NPR closed on November 26, 2008, and the Agencies received more than 200 public comments. Most of the commenters support lowering the risk weight for debt issued or guaranteed by the FHLBanks to narrow the credit spread between Fannie Mae and Freddie Mac debt and FHLBank debt. TheAgencies are reviewing the comments and determining whether a 10 percent risk weight is appropriate for a banking organization's exposure to a GSE. On November 26, 2008, the FDIC published in the Federal Register a final rule implementing the Temporary Liquidity Guarantee Program.\2\ Under the Temporary Liquidity Guarantee Program, the FDIC will guarantee the payment of certain newly issued senior unsecured debt issued by banking organizations and other ``eligible'' entities. Consistent with the existing regulatory capital treatment for FDIC-insured deposits, the Agencies will assign a 20 percent risk weight to debt guaranteed by the FDIC.--------------------------------------------------------------------------- \2\ 73 Fed. Reg. 72244.Q.4. I commend you for aggressively pursuing loan modifications of the IndyMac loans that the FDIC now services. Please elaborate on the following three points that you make in your testimony that I want to explore further:Q.4.a. You state that you have established a program to systematically modify troubled loans that IndyMac serviced. Please give us more details about this approach and how it differs from modifying loans on a case-by-case basis. Is there really such a thing as a systematic approach to loan modification, or do you have to touch every loan as you would on a case-by-case basis?A.4.a. The FDIC's loan modification program at IndyMac provides a streamlined and systematic approach to implementing affordable and sustainable loan modifications. By establishing clear guidelines for loan modifications determined by an affordability metric based on mortgage debt-to-gross income, the loan modification program allows servicers to apply the model to thousands of mortgages quickly, while defining for each loan how to achieve the targeted DTI. By using a waterfall of three basic loan modification tools--interest rate reductions, term or amortization extensions, and principal deferment--it is relatively simple to run thousands of loans through a computerized analysis of the necessary combination of tools needed to achieve an affordable and sustainable payment. A standardized net present value analysis, also computerized, allows IndyMac to ensure that its modifications provide a better value to the FDIC or investors in securitized or purchased loans. All IndyMac modifications are based on verified income information from third party sources such as the Internal Revenue Service or employers. This is very different from the loan-by-loan approach used by most servicers, which seeks to gather detailed financial information from borrowers--usually based on verbal statements--and get the highest possible monthly payment while leaving the borrower with a set amount of `disposable income.' While this approach may appear to offer a more customized approach, it has often meant that servicers relied on stated income and stated expenses to achieve a short-term solution that continued to place the borrower in a precarious and unsustainable payment. The difficulty with this approach is demonstrated by the high redefault rates reported by some servicers. The FDIC Loan Modification Program at IndyMac achieves an affordable payment through a three step waterfall process: Interest Rate Reduction: Cap the interest rate at the Freddie Mac Weekly Survey Rate for the balance of the loan term and, if needed to reach the DTI target, reduce the interest rate incrementally to as low as 3 percent and re-amortize the principal balance over the remaining amortization term. The interest rate charged will not be greater than the current Freddie Mac Weekly Survey Rate at the time of modification. The reduced rate remains in effect for at least 5 years. If the target debt-to-income ratio has not been achieved, proceed to the next step. Extended Amortization Term: For loans with original terms of 30 years or less, re-amortize the principal balance at the reduced interest rate (3 percent floor) over an extended amortization term of 40 years from the original first payment date. If the target debt-to-income ratio has not been achieved, proceed to the next step. Partial Principal Forbearance: Defer a portion of the principal balance for amortization purposes, and amortize over a 40-year period at the reduced interest rate (3 percent floor). The remaining principal balance remains as a zero interest, zero payment portion of the loan. The repayment of the deferred principal will be due when the loan is paid in full. Of the loan modification offers made at IndyMac thus far, 73 percent required rate reduction only, 21 percent required rate reduction and term extension, and 6 percent required rate reduction, term extension, and principal forbearance.Q.4.b. Your testimony says that modifications are only offered where they are profitable to IndyMac or investors in securitized or whole loans. Are you finding that most modifications are profitable, and if so, please explain how you determine that they are more profitable than foreclosures?A.4.b. Yes. While there are always some proportion of delinquent mortgages where a modification will not provide the best alternative to preserve value for the mortgage, many mortgages can be modified successfully while gaining the best value compared to foreclosure. One illustration of this fact is the net present value comparisons between the modified mortgage and foreclosure for the more than 8,500 completed modifications at IndyMac. To date, on average, the net present value of completed modifications at IndyMac has exceeded the net present value of foreclosure by $49,918 for total savings compared to foreclosure of more than $423 million. As conservator, the FDIC has a responsibility to maximize the value of the loans owned or serviced by IndyMac Federal. Like any other servicer, IndyMac Federal must comply with itscontractual duties in servicing loans owned by investors. Consistent with these duties, we have implemented a loan modification program to convert as many of these distressed loans as possible into performing loans that are affordable and sustainable over the long term. This action is based on the FDIC's experience in applying workout procedures for troubled loans in a failed bank scenario, something the FDIC has been doing since the 1980s. Our experience has been that performing loans yield greater returns than non-performing loans. The FDIC's Loan Modification Program at IndyMac is primarily based on four principles: (1) Affordable and sustainable modifications generally provide better value than foreclosure to lenders and investors, and to the IndyMac conservatorship and the FDIC's Deposit Insurance Fund. Modifications that exceed the net present value of foreclosure generally are consistent with servicing agreements and protect the interests of investors in securitized mortgages. (2) Sustainable loan modifications must be affordable for the life of the loan. As a result, the Loan Modification Program is based on a first lien mortgage debt-to-gross income ratio ranging from 38 percent to 31 percent. The modifications use a combination of interest rate reductions, term extensions, and principal deferment to achieve affordable payments. The interest rate on the modified mortgages is capped at a prime conforming loan rate reported by the Freddie Mac Weekly Survey. The interest rate can be reduced to as low as 3 percent for five years in order to achieve an affordable payment followed by gradual interest rate increases of 1 percent per year until the Freddie Mac Weekly Survey rate is reached. (3) All modifications should be based on verified income information, not stated income. This is essential to establish affordability. (4) A streamlined and systematic modification process is essential to address the volume of delinquent mortgages in today's market. The FDIC, along with many mortgage servicers, has adopted a more streamlined process focused on modifying troubled mortgages based on a simple debt-to-income ratio since it is easy to apply and avoids costly and unnecessary foreclosures for many more borrowers. The Program results in a positive outcome for investors and borrowers as investor loss is minimized and the borrower receives a sustainable long-term modification solution. The Program requires full income documentation in order to minimize redefault and ensure the affordability standard is uniformly implemented. The gross monthly income for all borrowers who have signed the mortgage note must be supported by either the prior year's tax returns or recent pay stubs.Q.4.c. You state that securitization agreements typically provide servicers with sufficient flexibility to apply the modification approach you are taking for the IndyMac loans. Given this flexibility, why are so few loan modifications being made?A.4.c. While the securitization agreements do typically provide servicers with sufficient flexibility, many servicers have been reluctant to adopt the streamlined modification protocols necessary to stem the rate of unnecessary foreclosures due to concerns about challenges from investors, a tendency to continue prior practices of focusing on loan-by-loan customized modifications, and by staffing limitations. At IndyMac, of the more than 45,000 mortgages that were potentially eligible for modification, IndyMac has mailed modification offers to more than 32,000 borrowers. Some proportion of the remainder do not pass the NPV test and others must be addressed through more customized approaches. So far, IndyMac has completed income verification on more than 8,500 modifications and thousands more have been accepted and are being processed and verified. As the FDIC has proven at IndyMac, streamlined modification protocols can have a major impact in increasing the rates of sustainable modifications. However, even there, challenges in contacting borrowers and in getting acceptance of the modification offers can inhibit the effectiveness of modification efforts. These are challenges that we have sought to address by working closely with HUD-approved, non-profit homeownership counseling agencies, such as those affiliated with NeighborWorks. In addition, we have sought to reach out to local community leaders and provide cooperative efforts to contact borrowers at risk of foreclosure. These efforts, which many servicers are starting to pursue, should be a focus of efforts by all servicers going forward. In addition, servicers' concerns over challenges from investors makes adoption of a national program to provide incentives from federal funds a critical part of the strategy to achieve the scale of modifications necessary to address our housing crisis. To address conflicting economic incentives and fears of re-default risk, the FDIC has proposed that the government offer an administrative fee to servicers who systematically modify troubled loans and provide loss sharing to investors to cover losses associated with any redefaults. These financial incentives should make servicers and investors far more willing to modify loans. This proposal addresses the biggest disincentive to modify troubled mortgages--the potential for greater losses if a modified loan redefaults and foreclosure is necessary some months in the future in a declining housing market. As a result, the FDIC proposal is designed to cover a portion of the losses that could result if the modified mortgage redefaults. This will provide practical protection to servicers by allowing easier proof for the value of the modification and eliminate investors' primary objection to streamlined modifications. We have estimated the costs of this program to be about $25 billion. To protect taxpayers and assure meaningful loan modifications, the program would require that servicers truly reduce unaffordable loan payments to an affordable level and verify current income, and that borrowers make several timely payments on their modified loans before those loans would qualify for coverage. This proposal is derived from loss sharing arrangements the FDIC has long used to maximize recoveries when we sell troubled loans. We believe this or some similar program of financial incentives is necessary to achieve loan modifications on a national scale to halt the rising tide of foreclosures and the resulting economic problems.Q.5. Each agency represented at the hearing has aggressively used the tools at their disposal in dealing with the crisis. However, sometimes the use of those tools has led to unintended consequences. For instance, when the Treasury Department guaranteed money market funds, it led to a concern on deposit insurance and bank accounts. When the FDIC guaranteed bank debt, it had an effect on GSE borrowing costs, which in turn directly affects mortgage rates. Acknowledging that there is often a need to act quickly in these circumstances, please explain what steps and processes you have employed to inform other agencies about significant actions you undertake to ensure that there are not serious adverse unintended consequences and that your actions are working in concert with theirs.A.5. The FDIC's Temporary Liquidity Guarantee Program was created during intensive discussions between the FDIC, the Department of the Treasury and the Federal Reserve over the Columbus Day weekend (October 11-13) and announced on October 14. Over the next several weeks, the FDIC adopted an Interim Rule, an Amended Interim Rule and a Final Rule. The FDIC's Interim Final Rule adopted on October 23 specifically requested comments on the Temporary Liquidity Guarantee Program and the FDIC received over 750 comments, including comments from other government agencies. During this process, the FDIC had frequent discussions with the Treasury, the Federal Reserve, the Office of the Comptroller of the Currency and the Office of Thrift Supervision about various aspects of the program and its potential consequences. With regard to concerns that the actions by the FDIC to guarantee bank debt had an effect on GSE borrowing costs, as discussed above, the spread of debt issued by Government-sponsored enterprises (GSEs), including Fannie Mae, Freddie Mac, and Federal Home Loan Banks (FHLBs), over Treasuries increased considerably in October and November although the overall cost of funding declined. According to Merrill Lynch data on U.S. bond yields, the spread between AAA-rated agency debt and Treasuries increased by nearly 40 basis points between September and November 2008. We believe these developments primarily reflect broad financial market uncertainty and a generally unfavorable market sentiment towards financial firms. In fact, the spread of debt guaranteed by the FDIC under the Temporary Liquidity Guarantee Program over Treasuries is larger than the spread on GSE debt. Financial firms, including those with a AAA-rating, saw their borrowing costs increase sharply, both in absolute terms and relative to Treasury yields, during the same two months, even as the Federal Reserve continued to lower the federal funds target rate. Merrill Lynch data show that the effective yield on AAA-rated corporate debt issued by financial firms increased by 140 basis points between September and October, before declining somewhat in November. Lower-rated corporate debt experienced even more significant increases over the same period of time. The primary purpose of the FDIC's Temporary Liquidity Guarantee Program is to provide liquidity in the inter-bank lending market and promote stability in the long-term funding market where liquidity has been lacking during much of the past year. While the FDIC's action was focused primarily on helping to restore a stable funding source for banks and thrifts, we believe that such liquidity can, in turn, help promote lending to consumers and small businesses, which would have a considerable benefit to the U.S. economy, in general, and financial firms, including mortgage lenders and GSEs. Nevertheless, partly to mitigate any potential effect of the FDIC guarantee on funding costs for GSEs, the federal banking agencies have agreed to assign a 20 percent risk weight to debt guaranteed by the FDIC (rather than the zero risk weighting that is assigned to debt guaranteed by a U.S. Government agency that is an instrumentality of the U.S. Government and whose obligations are fully and explicitly guaranteed as to the timely repayment of principal and interest by the full faith and credit of the U.S. Government). ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI FROM SHEILA C. BAIRQ.1. I was happy to note in your testimony that you discussed the need to stop unnecessary foreclosures. You mentioned the FDIC's work as conservator of IndyMac and your participation in the Hope for Homeownership program as recent examples of your effort. Does the FDIC plan to develop a new program to extend loan modifications to a broader pool of mortgages than those held by IndyMac? How would such a program work and what would its impact be on mortgage investors? Where would the FDIC derive authority for such a program?A.1. In mid-November, the FDIC announced a new proposal for loan modifications that is similar to the program we developed at IndyMac. Both target borrowers who are 60 days or more past due, and both seek to apply a consistent standard for affordable first-lien mortgage payment. The new FDIC proposal has a 31 percent debt-to-income ratio, whereas IndyMac modifications are designed to achieve a 38 percent debt-to-income ratio, but can go as low as 31 percent. The FDIC's proposal is designed to promote wider adoption of systematic loan modifications by servicers through the use of payment incentives and loss-sharing agreements, and thus reach more troubled borrowers. Specifically, to encourage participation, funds from the Troubled Asset Relief Program (TARP) would be used to pay servicers $1,000 to cover expenses for each loan modified according to the required standards. In addition, TARP funds would be used to provide guarantees against the losses that lenders and investors could experience if a modified loan should subsequently redefault. The guarantee would be paid only if the modification met all prescribed elements of the loan modification program, if the borrower made at least 3 monthly payments under the modified loan, and if the lender or servicer met the other elements of the program. The impact of this new proposal will be less costly than the lengthy and costly alternative of foreclosure, where direct costs can total between 20 and 40 percent of a property's market value. We expect about half of the projected 4.4 million problem loans between now and year-end 2009 can be modified. Assuming a redefault rate of 33 percent, this plan could reduce the number of foreclosures during this period by some 1.5 million at a projected program cost of $24.4 billion. We believe that Section 109 of the EESA provides authority for this proposal. Section 109 provides that ``the Secretary may use loan guarantees and credit enhancements to facilitate loan modifications to prevent avoidable foreclosures.''Q.2. Has the FDIC given any further consideration to the FDIC's own Home Ownership Preservation Loan program? I believe this program is a good way to avoid foreclosures and severe mortgage modifications at the same time. If this program is no longer being considered, why?A.2. When the FDIC proposed the Home Ownership Preservation (HOP) Loan program in May 2008, we noted that congressional action would be required to authorize the Treasury Department to make HOP loans. We believe that the HOP Loan program could be an important tool for avoiding unnecessary foreclosures in combination with other tools. As the housing market and home prices have continued to decline, we have suggested the loss guarantee approach discussed above as a way of streamlining and increasing the scale of loan modifications. ------ CHRG-111hhrg49968--92 Mr. Bernanke," Well, in reference to my specific comment about boosting household income, the ``make work pay'' tax cuts and the UI insurance and other transfer payments, Social Security, veterans payment will of course go to your constituents like anyone else in the country. So they will get extra income. As I mentioned also in my testimony, how much of that they will spend and how much they will use to pay down debt or to squirrel away is an open question. But we saw already just this week, we have seen an increase in personal income, and a lot of that is coming from government support. " CHRG-111hhrg51698--105 Mr. Conaway," We would like, if there is anybody else out there that has any comments about how they would actually comply with that, and if that is such a stifling burden, we may adjust it. Thank you, Mr. Chairman, I yield back. " CHRG-111hhrg55811--150 Mr. Hu," We differ slightly from Chairman Gensler as to the mandatory exchange trading as distinguished from the clearinghouse arrangements. We believe that clearinghouse arrangements will get you a lot of the transparency and other benefits associated with the two. And in terms of the burdens on end-users, we believe that the enhanced transparency and the standardization of a lot of these swaps that the end-users will be relying on may in some ways reduce costs, in some circumstances, for end-users. Mr. Moore of Kansas. Thank you. And, Mr. Hu, something to remember as we consider derivatives regulation is that we are not legislating in a vacuum, and this is part of a broader regulatory reform package. I believe there are some items related to municipal swaps that should clearly remain under the jurisdiction of the SEC in order to be covered by the increased protections for many securities and advisors that are coming out of the SEC and other parts of regulatory reform. But what are your thoughts on the unique nature of municipal finance that often require their contracts to be more customized? " CHRG-109hhrg31539--43 The Chairman," Without objection, so ordered. The gentlelady from Ohio. Ms. Pryce. Thank you, Mr. Chairman, and you, Mr. Chairman, for your testimony. We have--many of us on this committee have worked very hard on legislation to reform the Committee on Foreign Investment in the United States, the CFIUS process. Yesterday The Wall Street Journal quoted economist Lawrence Kotlikoff's recent study which said that foreign investment helps offset the low savings rate in the United States and has helped to raise the average wage of American workers by increasing productivity. The savings rate in America continues to be terribly low, as I said in my opening statement. Can you discuss your thoughts on if certain pieces of this legislation does become law, and it looks like we in the House will be maybe dealing with that as early as next week, will it make that harder for foreign companies to invest in the United States? Do you believe it will be detrimental to our economy, especially the savings rate debt--rate/credit debt ratio facing Americans? And are you familiar enough with the House and Senate versions of the legislation to be able to comment on either one of them? " CHRG-109shrg30354--73 Chairman Bernanke," Senator, I think it is really important to think about the long-run. And what we are facing going forward is an aging population, increasing costs of medical care, and the costs for our entitlement programs that are going to be rising very seriously. So, I think the strongest case for trying to pay down some debt sooner is to try and provide some buffer or some savings that will help us meet those challenges as we go forward. I think that the most serious long-term issue for our budget, is these growing transfer programs. Senator Menendez. Thank you, Mr. Chairman. " CHRG-111hhrg61852--39 Mr. Meltzer," Yes. I listed in my testimony about five things that you can do. I say quite explicitly that I don't expect you are going to do them. But let me say, as I agree with Mr. Mishel, uncertainty is always there, but there are different degrees. And right now, it is enormous. Businessmen do not have an idea of what it is going to cost them to hire another worker. That is why they don't hire another worker. So you could do a lot without doing anything fiscally or monetarily by simply saying, we are going to end all new regulations for the next 3 to 5 years unless Congress, by a supermajority, decides it is absolutely essential for the country. That would remove a great burden hanging over people, because they don't know what health care is going to cost, they don't know what financial services are going to cost, they don't know what cap-and-trade is going to do or if there is going to be cap-and-trade. If you are sitting there trying to decide on an investment, and you are sitting on all this cash, you are not concerned about the things that they are talking about. You are not concerned about what is going to happen the next quarter. That investment is going to have to pay off over 3 to 5 more years. That is what you are worried about. What is it going to be like? You don't know. If you don't know, the sensible thing to do is wait. Put your money in government bonds, earn 3 percent, and wait to see how it settles down. So what you could do that would be helpful would be announce a program of dealing with the deficit. Remove that uncertainty. Tell them what tax rates are you going to be facing 5 or 10 years from now, because you are not going to solve the deficit problem in a year or a week or a day; it is going to take years. Therefore, tell people what the environment is you are going to be working in, and that will help them a great deal to decide what is feasible and what isn't. That begins to work against the deficit, but it doesn't do draconian measures immediately. Add to that a reduction in corporate tax rates. Tell businessmen, look, we are going to make it profitable, more profitable for you to invest. This country has an enormous international debt. To service that debt, it has to export. In order to export, it has to invest. So let us get started making investments. " FinancialServicesCommittee--12 Frequently, when we have extreme market volatility, the cry goes out, somewhere quick, ‘‘Let’s shoot the computers.’’ I have never really agreed with that particular position, although I do have an open mind that perhaps some reprogramming may be in order. Specifically, I do believe that we at least need to look and examine the desirability of having stock-specific circuit breakers across all of our markets, and certainly, there is an open question on the impact of canceling trades. How many folks ended up with unintended short positions while arguably adding needed liquidity in a sinking market? But at the end of the day, I think we should tread very, very carefully in this space. Improved technology, rule MNS, have brought great benefits to trading: more competitive markets; cheap- er trades; and really a democratization of investment opportunities. But more importantly, I believe that we need to look beyond simply the mechanics of the panic and look to its likely underlying cause, that being the international debt crisis that is first manifesting itself in Greece. A number of media outlets have spoken to this. We had a CBS–AP report, ‘‘Greek Debt, Trader Error Eyed in Market Selloff,’’ on May 6th: ‘‘Traders were not comforted by the fact that Greece seemed to be working towards a resolution of its debt problems. Instead, they focused on the possibility that other European countries would also run into trouble.’’ Wall Street Journal: ‘‘Many traders worried about the economic situation in Europe. The Dow had already been moving lower as television screens displayed scenes of rioting on Greek streets.’’ Fox Business quoted a managing director of Nye Capital Part- ners: ‘‘The tone and tenor of the global debt crisis has taken over the market. Everything else has taken a back seat.’’ So there is an open question among many in our investing public whether or not we are on the road to becoming Greece ourselves, given that the deficit has increased tenfold in just 2 years, and the President has put forth a budget that will triple the national debt in 10 years. There is fear that Greece is the preview of coming at- tractions to the United States, and no matter how many well-de- signed exits you have, no matter how many well-trained ushers you have, no matter how well-designed your exit plan, if people in the theater sense that something is smoldering, you cannot ultimately remove the conditions of panic. Thank you, Mr. Chairman. I yield back. Chairman K ANJORSKI . Thank you, Mr. Hensarling. We will now hear from the gentleman from Georgia, Mr. Scott, for 1 minute. Mr. S COTT . Thank you, Mr. Chairman. I think what we have here is a clear example of how we as a society have become more the servants of the machine that was created to serve us. Our tech- nology has now far surpassed our human ability to keep up with it. I think we have to move with caution, to make sure we get the right causes of this problem, to understand that our foremost obli- gation at this point is to make sure we have investor confidence, that the American people have confidence in our system. CHRG-111hhrg53021Oth--145 Secretary Geithner," Well, again, this was a--it took us a long time to get into this. You know, as a nation, we just were living way beyond our means for a long period of time. People took on way too much debt. And it will take some time to work through that. But we are making progress. You have already seen a very substantial increase in private savings. As I said, that is a healthy, necessary process. Our current account deficit, which approached seven percent of GDP only 2 years ago, is now under three percent of GDP. We are starting to see this country get back to a point where we are going to have a stronger foundation for sustainable growth, going forward, but it is going to take some time. " CHRG-111hhrg53021--145 Secretary Geithner," Well, again, this was a--it took us a long time to get into this. You know, as a nation, we just were living way beyond our means for a long period of time. People took on way too much debt. And it will take some time to work through that. But we are making progress. You have already seen a very substantial increase in private savings. As I said, that is a healthy, necessary process. Our current account deficit, which approached seven percent of GDP only 2 years ago, is now under three percent of GDP. We are starting to see this country get back to a point where we are going to have a stronger foundation for sustainable growth, going forward, but it is going to take some time. " CHRG-111hhrg58044--375 Chairman Gutierrez," I thank you. Ms. Kilroy, you are recognized for 5 minutes. Ms. Kilroy. Thank you, Mr. Chairman. Thank you to the panelists. Ms. Fortney, you stated that you believed that medical debt is predictive in determining an individual's credit worth? Ms. Fortney. I believe I said medical debt collection information. It is my understanding that is the information that is used in credit scoring, as witnesses testified at the last hearing. Ms. Kilroy. Witnesses when they testified at the last hearing--I ask unanimous consent to enter into the record a May 3rd letter from VantageScore to me. You believe it is appropriate that we consider medical debt differently depending on where the information is coming from? Is that what you are telling us? Ms. Fortney. No. What I am saying is in credit scoring systems, as I recall, I think it was the witness from Fair Isaac that testified, in a credit scoring system, the credit scoring models they have developed, they used collection information including medical debt collection information in the development of those models because that information has been found to be predictive in the models that are predicting credit risk. Ms. Kilroy. You disagree with VantageScore which stated categorically that, ``We do not believe medical debt will contribute to predictive performance?'' Ms. Fortney. I have not seen that letter. I would like to see it before I comment on it. Ms. Kilroy. Would you agree or disagree with the statement? Ms. Fortney. What is that statement again? Ms. Kilroy. Do you agree or disagree that medical debt will contribute to predictive performance? Ms. Fortney. What I understand and what I have said is we are talking about collection information. That statement refers to medical debt alone without discussing whether that medical debt information is limited to collection information. Ms. Kilroy. Mr. Rukavina, you talked about the confusion and inconsistency in medical debt reporting. You have taken a look, as I understand, at some medical debt studies. Have you seen when taking a look at or talking to either lenders or others an impact that medical debt, including paid medical debt, may have on a person's ability to obtain, say, a home loan? " CHRG-111hhrg54869--22 Mr. Volcker," In terms of the resolution authority, which would give extraordinary authority to whatever agency is designated to control the institution, I do not think it is desirable to provide in that same arrangement authority to lend money or to provide money because that will encourage the ``too-big-to-fail'' kind of syndrome. So if you give it strong enough authority to control the institution and to manage such things as forcing, negotiating or forcing, whatever word you want use, let us say a conversion of debt into equity, hopefully you would avoid the need for injecting money and the stockholder would lose, the creditor might lose, and the creditor should be concerned about whether he is going to lose. Now, I would also say--I guess I didn't mention in this preliminary statement--that if the overseer, for instance, identified an institution or several institutions as being so large and so extended as to present a real risk, there would be some residual authority to place capital requirements on that institution, leverage requirements, maybe liquidity requirements. But that doesn't involve government money. " CHRG-110hhrg38392--139 Mr. Murphy," I certainly appreciate your thoughts on that. I share your view that we can get very similar, if not better, outcomes for less money spent within the system. The last related question is in regard to global competitiveness in relation to the costs being borne by American businesses on health care costs versus competitors in other countries who simply aren't required to bear the burden of providing health care for their employees. Do you, as you look at the future outlook of American competitiveness, worry about the burden that American businesses have to bear regarding health care costs? " CHRG-111hhrg54867--22 Secretary Geithner," We are deeply worried about that risk. And you are absolutely right, as is the chairman, to point out the risk in any regime that creates the expectation that the government will be there if you screw things up. But let me just make clear what is important. It is very important that these institutions that matter, whose future could threaten the economy as a whole, are subject to higher constraints on leverage in the future, more conservative cushions of capital and liquidity so that they can absorb losses they face when they make big mistakes. So what we are trying to do is to make it clear that, if you have this particular source of threat to the system, we are going to hold you and subject you to more conservative constraints on risk-taking. Now, you can't do that without identifying who those institutions are. But you have to do it in a way that doesn't, as you said, create an expectation that the government will be in there if they fail. But that is why you can't just do it with tighter capital requirements. You have to give them the tools for the government to intervene to save them, but to act in a way that allows them to be dismantled and restructured and--I won't use the chairman's language--again, without the taxpayers assuming that burden. That is the central imperative for reform. And you are all right when you say that the key thing we have to do is not reinforce any expectation that the government is going to step in and protect people from losses in the future. Our job, though, is to make sure the system is less vulnerable to the collateral damage that can be caused when people make big mistakes. " CHRG-109hhrg22160--50 Mrs. Maloney," That is true, but the point is in 2042, the entire system is not bankrupt. But I would like to get back to your statements in the Senate yesterday where you pointed out that the President's plan does nothing to solve the solvency challenge of Social Security and it does nothing to improve national savings and it creates new debt that will have trouble being absorbed by the markets. So, in other words, the President's plan doesn't address the real problems and it creates new ones. The cost for transition has been estimated to be $4 trillion to $5 trillion over 20 years, and this is on top of the deficit and debt that we now have and do not seem to be able to control. We have the highest debt ever, over $7 trillion; the highest deficit ever, over $400 billion; the highest trade debt ever, over $600 billion. And my question is, wouldn't you say that for the immediate future, the deficit is more of a problem with our economy than Social Security is, particularly since we do not even have to touch it, the trust fund, or the principal until 2018? " CHRG-110hhrg41184--92 Mr. Meeks," But let me also ask you this. The United States has been heavily financed by foreign purchases of our debt, including China, and there has been a concern that they will begin to sell our debt to other nations because of the falling dollar and the concerns about our growing budget deficits. Will the decrease in short-term interest rates counterbalance other reasons for the weakening dollar, enough to maintain demand for our debt? And if that happens, what kind of damage does it do to our exports? And I would throw into that because of this whole debate currently going on about sovereign wealth funds--and some say that these sovereign wealth funds are bailing out a lot of our American companies--so is the use of sovereign wealth funds good or bad? " CHRG-111hhrg48868--361 The Chairman," One other issue before I get to--well, two others. You are optimistic in here about paying down the Federal Reserve debt. You don't mention the debt to the Treasury. Is that next after the Federal Reserve debt? " CHRG-111hhrg49968--123 Mr. Bernanke," My understanding again is that about half of the effect will be in 2010, is my understanding of the timing of the stimulus package. But there are other factors at work as well. I mean, as confidence returns, private sector activity ought to increase, low-interest rates will stimulate demand. The rest of the world is strengthening. There are a lot of other factors that would provide support for growth outside the fiscal package. That being said, again, there are a lot of issues to be resolved, such as excessive leverage, for example, that are likely to be headwinds as the economy tries to get back to a sustainable growth path. " CHRG-111shrg56376--209 Mr. Ludwig," Well, Senator Corker, I couldn't agree with you more that resolving the largest institutions is a critical issue and I am not in favor of propping them up. That is, if we don't resolve them, we basically create two problems. One is we have public utilities if we don't have an ability to resolve them. And we also disadvantage the community and regional institutions. Rather, this whole structure ought to be one that creates sufficient stability and focuses in a professional way on proper supervision so as to minimize burden and increase the ability of all these institutions to support the economy of the United States. And where one of these institutions is not doing its job correctly and it gets into problems, we have to have a private sector component here--this is really a private sector activity--where it fails, and we have to have the ability to fail it without creating a systemic crisis. If we don't have that, I think we also have the danger that these largest institutions end up controlling the economy and the Governmental mechanism, not vice-versa. " fcic_final_report_full--447 The role of Fannie Mae and Freddie Mac in causing the crisis The government-sponsored enterprises Fannie Mae and Freddie Mac were elements of the crisis in several ways: • They were part of the securitization process that lowered mortgage credit quality standards. • As large financial institutions whose failures risked contagion, they were massive and multidimensional cases of the too big to fail problem. Policymakers were un- willing to let them fail because: – Financial institutions around the world bore significant counterparty risk to them through holdings of GSE debt; – Certain funding markets depended on the value of their debt; and – Ongoing mortgage market operation depended on their continued existence. • They were by far the most expensive institutional failures to the taxpayer and are an ongoing cost. There is vigorous debate about how big a role these two firms played in securitiza- tion relative to “private label” securitizers. There is also vigorous debate about why these two firms got involved in this problem. We think both questions are less impor- tant than the multiple points of contact Fannie Mae and Freddie Mac had with the fi- nancial system. These two firms were guarantors and securitizers, financial institutions holding enormous portfolios of housing-related assets, and the issuers of debt that was treated like government debt by the financial system. Fannie Mae and Freddie Mac did not by themselves cause the crisis, but they contributed significantly in a number of ways. THE SYSTEM FREEZING Following the shock and panic, financial intermediation operated with escalating frictions. Some funding markets collapsed entirely. Others experienced a rapid blowout in spreads following the shock and stabilized slowly as the panic subsided and the government stepped in to backstop markets and firms. We highlight three funding markets here: • Interbank lending. Lending dynamics changed quickly in the federal funds market where banks loan excess reserves to one another overnight. Even large banks were unable to get overnight loans, compounding an increasingly re- stricted ability to raise short-term funds elsewhere. • Repo. By September , repo rates increased substantially, and haircuts bal- looned. Nontraditional mortgages were no longer acceptable collateral. • Commercial paper. The failure of Lehman and the Reserve Primary Fund breaking the buck sparked a run on prime money market mutual funds. Money market mutual funds withdrew from investing in the commercial paper mar- ket, leading to a rapid increase in funding costs for financial and nonfinancial firms that relied on commercial paper. CHRG-111hhrg56766--136 Mr. Bernanke," Well, first, let me say that we're not going to be monetizing the debt, but I think everyone understands the basic arithmetic here, that if deficits go on at 3, 4, and 5 percent of GDP and that picture, if you extend it beyond 2020, would probably get worse because entitlement spending, aging society and so on, that you'll get increasing interest payments and it will spiral out of control and the CBO will give you the same results. Again, it's very easy for me to say this because I don't have to grapple with these difficult problems, but it is very, very important for Congress and the Administration to come to some kind of program, some kind of plan that will credibly show how the United States Government is going to bring itself back to a sustainable position. " CHRG-111shrg57709--103 Mr. Wolin," Well, I would say, Senator, and I think those are all extremely important questions, I agree with Senator Shelby that size by itself is not the only thing. But we do believe that it is an important element of risk and that there is a meaningful correlation in general between size and risk, and it is part of what we are trying to constrain, not the only thing to be sure. I think on competitiveness U.S. banks are already relatively smaller than an awful lot of financial institutions in Europe and elsewhere in the world, and I think they compete awfully well as it stands. So I do not think that is liable to be a competitive problem. As I think Chairman Dodd said, at the end of the day, the most important thing for the competitiveness of our financial system is that it is safe and sound, and that people will see it as safe and sound. And that will, I think, be an awfully important thing going forward to make sure that we do maintain the strong competitive position of the U.S. financial services industry. So I think those are all considerations that we have for those questions. Senator Warner. But I think capital requirements, leverage restrictions, convertible debt requirements, funeral plans may also be other tools we could use---- " FinancialCrisisInquiry--62 In the consumer area—and there are other people here who have consumer businesses— clearly, all that’s been written about origination and Jamie referred to stated income without tests, and I’m sure he can pick up that cudgel and talk about on the consumer side. On the more corporate side, I would say it had to do with leverage and it had to do with terms, covenants, conditions. The markets got more competitive. There was a sense that the world had a lot of liquidity. And so the commodity of money got less scarce and people paid less attention to it. BLANKFEIN: And as a consequence, people were lending to support transactions, which is a business that we’re very familiar with, that had more multiples of debt for the equity and the conditions that applied—the covenants, the maintenance, the things that allowed a lender to intervene in the company became more and more lax, and so you could intervene less. So that lack of rigor on the—on the transactional side I think had its counterpart in the consumer side and in the commercial lending side, which others here are more familiar with. HOLTZ-EAKIN: Were you aware of this at the time? Did you see the standards going down? And if so, how did you highlight this in your risk management? BLANKFEIN: In all honesty, we did—we did know. You cannot miss the fact that the covenants are getting a little lighter and that the leverage is getting bigger. With the benefit of hindsight, I wish I weren’t in the position of having to explain it. But at the time, I know we all rationalized the way a lot of people—other people—have rationalized. “Gosh, the world is getting wealthier. Technology has done things. Things are more efficient. Interest—there’s no inflation. Things belong low. These businesses are going to do well.” And I think we talked—much of the world did—talked yourself into a—into a place of complacency, which we should not have gotten ourselves into and which, of course, after these events, will not happen again in my lifetime, as far as I’m concerned. CHRG-110shrg38109--109 Chairman Bernanke," I do not know the number for revolving debt specifically. The incidence of debt issues varies quite a bit across the population. For a good bit of the population, particularly those of higher incomes, there has been asset accumulation which offsets the debt. " CHRG-109hhrg28024--192 Mr. Bernanke," When Congress passes a spending act or a tax act, that has implications for the amount of debt. Arithmetically, that has implications for the amount of debt the Government is going to take on. And therefore, I think that the debt ceiling doesn't really provide much additional value. The Congress ought to be contemplating the effects of its spending and tax actions on the debt and the deficit as it goes along, with each determination, both in the short run and in the long run. " CHRG-111hhrg61852--29 Mr. Bachus," Stop borrowing and spending. During the Great Depression, the ratio of household debt to disposable personal income was in the 30 to 40 percent range. Currently, that ratio is above 120 percent. So, that is quite a difference. People have much more debt today, 3 or 4 times as much debt as they did then. So one of the reasons that they may not be borrowing money is because they simply can't afford to pay any more debt. Would you agree? " CHRG-111shrg62643--150 Mr. Bernanke," From the debt perspective, yes. Senator Menendez. From the debt perspective. " FOMC20060328meeting--155 153,MR. OLSON.," Thank you, Mr. Chairman. In preparation for today’s meeting, I talked with the CEOs of three banks—one major money center, one major East Coast regional bank, and one major West Coast—that pretty well have the markets covered. There have been times when those conversations have either been directionally or substantively at odds with, or maybe ahead of, our Greenbook and our preparation data, but not this time. The conversations pretty well corroborated or were consistent with both the Greenbook and our flow of funds data. They all reported that, into ’06, consumer loans remain strong with good prospects for growth. Asset quality remains very good, above levels that historical experience would suggest they could maintain. Interestingly, we had that message a year ago, that asset quality was better than what they thought they could maintain through their normal credit review process, and that situation continues. Commercial lending continues to be solid for both large and small borrowers, but the utilization of credit lines still remains at about 50 percent. So it means that we are moving up from a very soft commercial loan market and may, in fact, be consistent with what President Poole suggested. This comes back to a question that President Hoenig raised yesterday. The markets are much more concerned with event risk than with inflation risk—which is to say, issues like major energy disruptions, terrorism activity, or even weather-related activity. This means that risk avoidance tends to be, to a significant extent, related to geography or market segment. Two particular areas struck my contacts and, therefore, me as being unusual and worthy of comment. One of them relates to a significant change in the market for initial public offerings, and this particularly came from the West Coast. The expectations for start-ups, particularly tech start- ups, are much more stringent on the West Coast. A couple of years ago, a very good idea could generate a significant IPO experience, but now a good idea plus five years of solid cash-flow experience might result in half the level of an IPO that they would have had fairly recently. The venture capital side of the business notices that very significant change. A start-up today is much more likely to end up being an acquisition candidate than an IPO, and the reason for that may be varied. Part of the reason might be caution, but a lot of it is being attributed to the additional regulatory burden, particularly the Sarbanes–Oxley regulatory burden. In the money center, the liquidity in the market is provided significantly by the institutional investors, and the activity on the loan side is to a great extent in structured credit. The collateralized loan obligations and the collateralized debt obligations are providing a lot of that activity. One significant change that is sort of consistent with the IPO experience is that, in many cases, internationally active businesses are more apt to go offshore for either debt or equity and do it as a private placement rather than do it in the United States. Also, the banks that are active internationally can follow the flow either through a direct transaction or through some sort of a collateralized arrangement that can provide the financing, so an international customer has a distinct advantage in doing business with an international bank. An overall reflection on the economy: Consumer activity remains strong, but flattening of real estate equities will certainly restrain the wealth effect on consumption to some extent. In the so-called bubble markets, we are clearly seeing prices drop. In the mortgage business, the purchase mortgages are very active, but refinancings are almost entirely eliminated. There is a significant disparity between U.S. and offshore markets in terms of regulatory reporting requirements, and that is becoming increasingly apparent and has become a factor in both credit and equity issuance. Notably there is a significant absence of concern expressed about inflationary pressure: None of the three CEOs expressed concern that they are feeling the effect of inflation. Thank you." CHRG-111hhrg48873--358 Mr. Capuano," Then why is it that on your Web site? You say, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets. What am I--is this not right, or am I reading it wrong? " FinancialCrisisInquiry--229 ROSEN: The good news is it’s a smaller dollar amount. But it’s a big dollar amount. GEORGIOU: It’s—less than—it’s about $1 trillion isn’t... ROSEN: The loss number is going to be somewhere between $500 and $700 billion out of $3.5 trillion debt component. GEORGIOU: Right. ROSEN: So it’s a much smaller number. We have something called a mend and extend happening now where they are mending and extending loans. But the same bubble that happened in residential happened somewhat in commercial. Big value increase and now a 40 percent value decline. So there’s a—a lingering issue that’s going to be there. I—it - it doesn’t all hit at once. The good news is it’s stretched out over the next five years. So I think we’re OK. It’s not good. It—but I think the residential losses going forward for the next year and a half are going to be bigger still, than the commercial over five years. GEORGIOU: Except that the commercial loans are bigger—each one is bigger. And so they—they— some of them pose a bigger risk to—to... ROSEN: Some institutions. CHRG-111hhrg61852--79 Mr. Meltzer," It won't do anything good, for sure. But let me just say where I disagree with Mr. Koo. He talks about the Japanese case. I am sure he knows a lot about the Japanese case. But American corporations have billions of dollars of cash on their balance sheet. They are not suffering from debt deflation. They pay back their debts, many of them, and they are holding on to cash. " FOMC20071211meeting--115 113,MR. KROSZNER.," Thank you. At the last meeting I expected a somewhat rougher patch, particularly in housing, than the last Greenbook scenario—a sort of slow-burn scenario, or something that Dave made reference to. But over just the past three weeks or so, the heat of that fire has become a lot greater than I had expected in terms of the burn that I’m seeing in the financial markets as well as in the real markets, particularly with respect to consumption, as many people have mentioned, and then more broadly just the reclosing of markets that had opened up. I described some of the markets and the turmoil, saying that things were in sort of a brittle circumstance. Unfortunately, I think in certain parts we’re starting to see some cracks show. I want to focus on thinking about banks’ balance sheets and how that addresses some of the issues that we’ve talked about. For commercial and industrial lending, as many people said, there still seems to be reasonable robustness in the investment-grade corporate sector. Those guys haven’t yet seen a lot of pressures in terms of increased cost of funding—not a reduced cost of funding but also not an increased cost of funding—just a slight increase in terms; but it’s no problem for them to deal with those kinds of terms. They have the markets open to them both for long-term debt issuance and for intermediate-term debt issuance. They have bank funding that is available. Most of the banks, the large banks as well as smaller banks, are suggesting that, although they may be tightening standards somewhat, there is still a reasonable amount of credit demand and that most boards and executives are saying “continue to make those loans.” Firms’ balance sheets are still quite strong. Firms have built up a lot of cash or liquid assets on their balance sheets over the past few years of profitability, so that part hasn’t seen that much of a challenge. Some of the increases that we’ve seen and measured on the books of banks in terms of their C&I portfolios are the taking on board of some leveraged loans on which they had made commitments a number of months ago; those commitments are now being drawn down, and so they’re increasing their portfolios. So some of the increase in C&I lending is really just commitments that have come in earlier. The leveraged-lending market, which had opened up for syndication, has quite affirmatively closed once again. That’s clearly a negative development. With respect to SIVs, asset-backed commercial paper conduits, it seems that many of the banks are going it alone without waiting for the M-LEC. Virtually all major banks have announced programs for bringing asset-backed commercial paper or SIVs onto their balance sheets. So this is still orderly, but it’s beginning to show some stress on the balance sheets with the leveraged lending and all of the SIVs coming on board, and this underscores the importance that a number of people mentioned about capital-raising efforts and ensuring that capital will be available, not just above the regulatory minimums but enough to make the market certifiers, the rating agencies, and others continue to feel comfortable. A number of people have also mentioned that the flattening, and in some cases the downturn, in commercial real estate and the tightening of terms are of particular concern at the midsized and smaller banks. As you know, we had issued some guidelines a little more than a year ago on commercial real estate concentration and concerns about that because we had looked back to what happened during the savings and loan crisis and saw that we were starting to get banks into the same levels of concentration that we had seen back then that were associated with troubles. Although we had a lot of negative pushback at that time, I think that was not an unreasonable thing to do, but there are still a lot of challenges at those institutions. Consumer lending is probably the area in which I’ve seen the greatest change, and it has raised my concerns the most. I’ll hold off on mortgages for a moment. First, I talked with a very large provider of credit cards and other consumer products, HELOCs, mortgages, et cetera, who said that, since the report that I received just before the last FOMC meeting, when things were reasonably stable, they had seen significant deterioration. As some people have said, even though it has gone up sharply, the numbers are still reasonable, but it’s the delta that concerns me, the very sharp deterioration that they’re seeing. They’re seeing this nationwide. The sharpest deterioration is, as a number of people have said, in the areas that have seen the greatest housing-price stress— California, Nevada, and Florida—but it’s not limited to those. I won’t go through all the details of what they told me on delinquency rates on different types of products, but nationwide they are seeing doubling, tripling, or quadrupling in those areas, and this is over a period of just six to eight weeks. So that’s really quite significant and concerns me in combination with some of the lower numbers that we’re seeing with respect to consumption. Also, one of the phrases that they use is that they’re now seeing “contagion in their book.” So it’s not just in one particular area but through a series of consumer products, and it’s not just for subprime borrowers. They noted that one-third of the charge-offs had a credit score of over 700 at the origination of the mortgage. So it’s far beyond just the subprime area. Obviously, as a number of people have said, the mortgage markets have really not reopened. There had been some hope around the last meeting that the jumbo market would reopen. We’re seeing no evidence of that. The subprime market is not really open. The ABX indexes and other indexes are suggesting that markets are anticipating extremely high loss rates, even beyond what Bill was suggesting with the 15 percent loss. Now, I don’t know whether those are reflecting just loss rates or whether other issues with respect to a lack of liquidity in the markets, or hedging that is going on, but still it’s a concern. As I mentioned last time, the Case-Shiller S&P index, although extremely thinly traded when you go out a year or two, is still suggesting potentially a 20 percent decline on average in the ten cities that they look at. So nothing has improved there, and given the tightness in the markets, given that we know that there will be more resets coming, given the continuing pressures, there’s probably going to be a lot more downside potential for housing prices, and that, of course, could again feed into lower consumer spending. So that’s the concern on the real side. The concern on the financial side is that, obviously, all these things put a lot of pressure on bank balance sheets. Gathering capital is very important, but basically what we’re seeing is a very, very slow revival of the markets, and I agree with many of the others who have said that it’s going to take a while. A lot more information, model building, and hiring of people who can analyze these things will be needed. Something that was disheartening to me is that the Mortgage Bankers Association said that they hope by early next year to be able to provide sufficient information to the market so that people can really assess on a loan-by-loan basis what’s in their CDOs, and that’s a real concern. The information is simply not out there. So it’s not just confidence or concerns. People are now looking carefully and saying, “I just don’t have the information to be able to make an assessment.” That’s, of course, on top of the macroeconomic risk and uncertainty about housing prices in general. So I do think it’s going to take a while for these markets to revive. As the Vice Chairman—actually both Vice Chairmen—and others mentioned, if you look into the forward markets for the OIS spread and other things, this is going to persist. This is not just an end-of-the- year problem. People are looking to the banks for re-intermediation and for taking a lot of things on the balance sheets. That’s going to continue to put a lot of pressure on the capital that they have, and I think there will be continuing uncertainty for both U.S. institutions and international institutions that things have to keep coming on their books and they won’t be able to get other things off their books. So that is a real challenge going forward. Just a moment on inflation. I certainly am heartened, as many other people have said, that as expectations about our policy moves have changed, we haven’t seen a significant uptick in inflation expectations, although by some survey measures we have seen some upticks. But real inflationary pressures are out there, and each incremental step we take with respect to policy easing potentially has higher and higher costs with respect to inflation. There are no free lunches here, but we do have to be mindful of the downside risk, particularly with respect to the banking and the financial system. Thank you." CHRG-109hhrg31539--238 Mr. Garrett," Thank you, Mr. Chairman. And thank you, Mr. Chairman, as well. And one of the first comments at the very beginning of the day from the other side of the aisle, that all the credit can be given to you for the rise in the stock market yesterday based on your testimony--I think we are about halfway through the trading day. I have not seen whether or not there has been an inflection one way or the other based on testimony today. But there was an article in, I think, The Washington Post about a month ago where economists from some investment firm made some sort of comments saying that, well, the chairman is selected by the President, confirmed by the Senate; his real bosses are really in Wall Street. I just wonder how you take that sort of comment or criticism. And then following that, though, a more serious note, and that is the point of the discussion that we have had so far on wages here. You touched part of this with regard to the unemployment rate. My question is two-part. One, what are the impediments, if any, that are holding down a significant or any real increase in wages? As I say, you touched upon the aspect of the unemployment rate being basically at historic lows for the period of time. On the other side of it, what are the impediments on the other side, or what could be pressures that we could use to, if we wanted to, to see a raise of wages? Is there something Congress has done in the past or is there something Congress should be doing in the future in this area? We know that, just a couple of years ago, in light of the economic doldrums that we were in, this Congress passed an economic growth package and--all the markets were going down; we passed the economic growth package, and you had the charts, you would see all the charts were going up in the other direction in a positive direction because of that. We passed tax cuts in this Congress which basically shifted the tax burden. There was a progressive tax cut, basically shifted the tax burdens so those who were making at the higher end of the income range are now paying a bigger, a larger percentage, a larger portion of the pie of the entire tax burden than they did before. So is there anything that we have done in the past that has been a negative impact, if you will, if that is the correct term, as far as the wage growth or lack of wage growth? And conversely, is there something we haven't done because we have heard from several members already with regard to the minimum wage, and we haven't moved on that in maybe over a half dozen years but maybe just comment what impact that would have anyway just considering the size of the population that is currently at the minimum wage and whether that would have any significant impact overall on wage growth? " CHRG-110shrg38109--108 Chairman Dodd," Someone mentioned to me the other day as well that, of course, the consumer debt issues are staggering, and at least the revolving debt, a good part of which is probably credit card debt, on the average is around $9,300 per individual. Does that number ring true with you? " CHRG-109hhrg23738--6 The Chairman," The gentlelady's time has expired. The gentlelady from Ohio, Judge Pryce? Ms. Pryce. Thank you, Chairman Oxley. Welcome, Chairman Greenspan. Thank you for taking time to discuss with us your insightful thoughts on monetary policy and the state of our economy. I am pleased to read in your testimony that you believe overall the economy remains steady. Many financial analysts have credited the strong, vibrant housing market as a vital segment of the health of our economy. Recent studies have found that housing accounted for more than one-third of economic growth during the previous 5 years. Many observers, including yourself, have noted that mortgage refinancing provided crucial support to the economy during the past recession, enabled homeowners to reduce their debt burdens and maintain adequate levels of consumer spending by tapping into the equity of their homes. I for one took great advantage of that. Despite these latest gains in home ownership, I am concerned about the recent surge in home prices in many metropolitan areas. In most countries, the recent surge in home prices has gone hand in hand with a much larger jump in household debt than in previous booms. Not only are new buyers taking out bigger mortgages, but existing owners have increased their mortgages to turn capital gains into cash that they can spend. So I hope to hear your views on the current status of this country's housing market and whether a nationwide bubble exists, also what effect a measured rise in inflation will have on the housing market. As we have seen in the Australian economy, they experienced a surge and were able to slowly raise rates and control real estate speculation, keeping that economy healthy after the market peaked. So I look forward to talking more about that with you. Shifting gears, I would also like to know--and I will ask later--whether you feel the recent string of data security breaches has affected consumer confidence in our payment systems. As you know, Mr. Chairman, I, along with many of my colleagues on both sides of the aisle here, are working hard on some legislation that will provide uniform national standards for consumer protection and data breach notification, and we would appreciate any insights you care to share. Data security breaches are something that all of us are concerned with, as we see more and more instances of breaches in the headlines every day. I am pleased to be working with many members, Congressman Castle and LaTourette, Moore, Hooley, even Mr. Frank, on these important issues. And we appreciate the leadership of Chairman Oxley and Chairman Baucus as well. But under Gramm-Leach-Bliley, financial services firms already have an obligation to keep consumer information secure and confidential, and we need to extend those safeguards to information brokers and others. When a breach occurs that could lead to financial fraud or misuse of sensitive financial identity information, customers have the right to be informed about the breach and what steps they should take to protect themselves. I believe there should be one federal standard for data security and for notification. Disparate standards that vary from state to state are an administrative nightmare and make compliance very difficult. Varying standards can cause consumer confusion, and customers should be assured that when their information is breached, they receive the same notification no matter where they live. So, thank you, Mr. Chairman, for your appearance today. I look forward to your testimony. And thank you, Chairman Oxley. I yield back. " CHRG-110hhrg44901--22 Mr. Bernanke," Well, you want to take the right actions. Let me say a word about GSEs. The GSEs are adequately capitalized. They are in no danger of failing. However, the weakness in market confidence is having real effects as their stock prices fall. It is difficult for them to raise capital. If their debt spreads widen, it will increase the borrowing costs. As I said yesterday, I think the housing market is really the central element of this crisis, and anything we can do to strengthen the housing market or to strengthen mortgage finance would be beneficial. Therefore, I do think this is one area where Congress needs to think hard about how to restore confidence in the GSEs to make sure that they can carry out the function of supporting the mortgage market, which, right now, except for the FHA-Ginny Mae combination, they are the entire securitization market for mortgages. I think that is an area particularly where action is needed and justified. " CHRG-109shrg21981--116 Chairman Shelby," Senator Stabenow. Senator Stabenow. Thank you, Mr. Chairman. And welcome again, thank you for your service and for your being with us today. I want to follow up on Senator Dole's questions on manufacturing. I share her concerns. Michigan has had the same type of, certainly, challenges as it relates to manufacturing. But I first want to thank you for some insights in your statement that you expand upon in your written statement more than you are able to do as you spoke today, as it relates to education. Because I think this is critically important, and I appreciate your wisdom of your comments here and I think they are comments that we should take very, very seriously. You talk about, ``The failure of society to enhance the skills of a significant segment of our workforce has left a disproportionate share with less skills. The effect is a widening wage gap between the skilled and the less-skilled.'' And then you go on to talk about ``In a democratic society, such a stark bifurcation of wealth and income trends among large segments of the population can fuel resentment and political polarization,'' which I believe is happening today. And I share your concern about the concentration of wealth and, really, what I view as splitting of the middle class in this country due to a host of issues. But I think it is important to emphasize that you said that strengthening elementary and secondary schooling in the United States, especially in the core disciplines of math, science, and written and verbal communications, is one crucial element in avoiding such outcomes. I would not expect you to comment on this, but I would just say for my colleagues, putting my budget hat on, this is of deep concern to me when I see that one-third of what has been proposed in the President's budget in terms of cuts are in education. And I think that goes right to the heart of what you speak about here. I would not necessarily expect you to comment on the President's budget, but I think we should be listening to you because we have huge wage and skill gaps that will affect us for decades to come and we need to be investing in skills and education. Turning to a different subject, in terms of our debt, and this actually goes back to my concerns on manufacturing, but it relates indirectly to manufacturing when we look at our dependency on in-flows of foreign capital to finance economic activity. And then I would argue on the other hand our difficulty in enforcing trade agreements against those who own so much of our foreign debt. I think this is going to be making it more and more difficult for us. I would welcome your thoughts on that. But when we look at the fact that--and I just have a small chart, but in the last 4 years, foreign holdings of U.S. Treasury debt has gone from basically a trillion to $1.85 trillion, and about half of that is owned by China and Japan. People would be shocked to know who else owns our foreign debt, as we are talking about financing private accounts through Social Security or other privatization efforts or anything else that we are doing for that matter--the war or anything else. That South Korea, Taiwan, Germany, Hong Kong, OPEC, Switzerland--we have a lot of foreign entities that hold portions of our debt right now. And I am wondering at what point, particularly when we are looking at $2 trillion, or we are hearing now that 20 years down the road, two decades, potentially $5 trillion in new debt added if in fact privatization in some part goes into effect, of Social Security, at what point do you believe that we should be concerned that our foreign financing of our national debt is becoming too great? " fcic_final_report_full--435 TURNING BAD MORTGAGES INTO TOXIC FINANCIAL ASSETS The mortgage securitization process turned mortgages into mortgage-backed securi- ties through the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, as well as Countrywide and other “private label” competitors. The securitiza- tion process allows capital to flow from investors to homebuyers. Without it, mort- gage lending would be limited to banks and other portfolio lenders, supported by traditional funding sources such as deposits. Securitization allows homeowners ac- cess to enormous amounts of additional funding and thereby makes homeownership more affordable. It also can diversify housing risk among different types of lenders. If everything else is working properly, these are good things. Everything else was not working properly. Some focus their criticism on the form of these financial instruments. For exam- ple, financial instruments called collateralized debt obligations (CDOs) were engi- neered from different bundled payment streams from mortgage-backed securities. Some argue that the conversion of a bundle of simple mortgages to a mortgage- backed security, and then to a collateralized debt obligation, was a problem. They ar- gue that complex financial derivatives caused the crisis. We conclude that the details of this engineering are incidental to understanding the essential causes of the crisis. If the system works properly, reconfiguring streams of mortgage payments has little ef- fect. The total amount of risk in a mortgage is unchanged if the pieces are put to- gether in a different way. Unfortunately, the system did not work as it should have. There were several flaws in the securitization and collateralization process that made things worse. • Fannie Mae and Freddie Mac, as well as Countrywide and other private label competitors, all lowered the credit quality standards of the mortgages they se- curitized.  A mortgage-backed security was therefore “worse” during the crisis than in preceding years because the underlying mortgages were generally of poorer quality. This turned a bad mortgage into a worse security. • Mortgage originators took advantage of these lower credit quality securitization standards and the easy flow of credit to relax the underwriting discipline in the loans they issued. As long as they could resell a mortgage to the secondary mar- ket, they didn’t care about its quality. • The increasing complexity of housing-related assets and the many steps be- tween the borrower and final investor increased the importance of credit rating agencies and made independent risk assessment by investors more difficult. In this respect, complexity did contribute to the problem, but the other problems listed here are more important. • Credit rating agencies assigned overly optimistic ratings to the CDOs built from mortgage-backed securities.  By erroneously rating these bundles of mortgage-backed security payments too highly, the credit rating agencies sub- stantially contributed to the creation of toxic financial assets. • Borrowers, originators, securitizers, rating agencies, and the ultimate buyers of the securities into which the risky mortgages were packaged all failed to exer- cise prudence and perform due diligence in their respective transactions. In particular, CDO buyers who were, in theory, sophisticated investors relied too heavily on credit ratings. • Many financial institutions chose to make highly concentrated bets on housing prices. While in some cases they did that with whole loans, they were able to more easily and efficiently do so with CDOs and derivative securities. • Regulatory capital standards, both domestically and internationally, gave pref- erential treatment to highly rated debt, further empowering the rating agencies and increasing the desirability of mortgage-backed structured products. • There is a way that housing bets can be magnified using a form of derivative. A synthetic CDO is a security whose payments mimic that of a CDO that contains real mortgages. This is a “side bet” that allows you to assume the same risk as if you held pieces of actual mortgages. To the extent that investors and financial institutions wanted to increase their bets on housing, they were able to use syn- thetic CDOs. The risks in these synthetic CDOs, however, are zero-sum, since for every investor making a bet that housing performance will fall there must be other investors with equal-sized bets in the opposite direction. CHRG-109shrg30354--12 STATEMENT OF SENATOR ROBERT MENENDEZ Senator Menendez. Thank you, Mr. Chairman. Welcome, Chairman Bernanke. Let me say, recently we learned that the anticipated deficit for the fiscal year 2006 is down from what had been projected and for that we should all be happy. However, we are still talking about a deficit of $296 billion. And though that is better than the original estimated deficit of $423 billion, which some considered was an inflated estimate in the first instance, it is a far cry from the $600 billion budget surplus for 2006 that was predicted by the White House back in 2001. Now that discussion certainly belies the $10 trillion to $12 trillion debt that the Congressional Budget Office tells us we are headed to by 2011. So while some in this country believe that are our economy is chugging along quite well because our gross domestic product continues to grow, there seems to be an increasing gap between the average citizen and those at the top of our economic ladder. The disparity between the haves and have-nots seems to be widening at an alarming rate. When I am back in New Jersey, I hear more and more from New Jerseyians that they are working harder and longer just to try to keep their heads above water, whether it is because of higher costs for college, soaring health care costs, increasing energy prices, gas prices, stagnant and flat wages, or pensions being underfunded and in some cases totally abandoned, there is a huge disconnect between growth in our GDP and the situation that the average American finds themselves and their families in. So the question is, who is this economy working for? I look forward to your testimony today and to hearing your thoughts on some of those items I have just mentioned and other challenges we face as a Nation, such as the cooling off of the housing market and what that may mean, rising energy prices, consequences of deficit and debt, record trade deficits, real wages remaining flat, negative household and national savings, a variety of global influences and how these factors affect the dynamic of the modern global economy that we have. Those are the challenges I hear from average New Jerseyians and Americans that they are currently facing and that you have before you. So as we wish you well in the stewardship of the economy, we look forward to hearing your testimony and hopefully reflecting upon some of those items. If not, I will pursue it in my questions. Thank you, Mr. Chairman. " CHRG-109shrg30354--97 Chairman Bernanke," That is what I was saying, that it is in our interest to keep our debt attractive both because the capital markets are deep and liquid and because our economy is strong. I do not really see a good alternative right now. I think that the great majority of the international reserves are held in U.S. dollars and I think that will continue to be the case. However, from a current account perspective, if we look forward 5 or 10 years at the rate we are going, there will be increasing reluctance of foreigners to hold U.S. assets. And that will have effects on our economy and we need to address that. Senator Dodd. Mr. Chairman, I will come back to the savings rate and the consumer debt issue, which is a concern of mine as well. And I want to just quickly raise this issue about the job creation issue, because it seems to me based on indications--this did not happen, by the way, in the last 4 or 5 years. There has been a trend, as you pointed out, over the last 20 or 30 years where we are seeing job growth occurring at the very low level of the lower-income levels and at the upper-income levels. It is in that middle range, that middle-income earner that Senator Menendez talked about, and Senator Reed addressed, where we see not just a skill gap. But it seems to be hollowing out of job opportunities in that area. And that troubles me very deeply, with that sense of being a low-income earner and the sense of upper mobility, moving into those middle-income jobs. And they just seem to be disappearing at an incredible rate. I heard you say you had not really examined the outsourcing issue of jobs. I wish you would. It would be interesting to come back and give us some report on how you look at that issue of that. If I am correct, is there a hollowing out occurring here? And if so, how troubling is that to the Federal Reserve? " FOMC20080318meeting--5 3,VICE CHAIRMAN GEITHNER.," May I say just one thing, Mr. Chairman? I want to point out that not only has Bill, along with a whole range of people in New York and on the Board staff, been working 24 hours a day for about five days, not only did he write a terrific statement for the FOMC just now, despite all of those other preoccupations, but he sat with his wife through major surgery on Thursday and Friday and with her as she recovered. Just a remarkable, terrific performance. I compliment him and just note that the burden he has been carrying is considerable even in comparison with the burden of so many others. " CHRG-110hhrg34673--105 Mr. Bernanke," The Federal debt that I am most concerned about is sort of the implicit debt, the debt associated with our promises to future retirees for Social Security and Medicare. If we were to stop here in some sense, it would not be quite so bad. The amount of government debt held by the public currently is about 37 percent of the GDP, which is fairly normal across industrial countries, lower than some in fact, but the situation is going to get a lot worse as we have retirements of the baby boomers and so on and medical care costs go up. According to the Congressional Budget Office, in the immediate scenario, by 2030, the debt, instead of being 37 percent of GDP, will be 100 percent of GDP, and the deficit will be 9 percent of GDP instead of being a little under 2 percent as it is this year. So, if we allow things to continue, the debt interest cycle will continue to build up, and we will hurt our fiscal position to the detriment of our children and grandchildren. On the issue of holding the treasury debt, the reason that foreign countries hold our debt is, for the most part, because they find it beneficial to themselves to have ownership of this very safe, liquid, and convenient form of assets, and I find it unlikely that anywhere in the foreseeable future there will be a major sell-off of any kind. If there were to be some sell-off, there would probably be some short-term effects, but-- Mr. Moore of Kansas. What kind of short-term effects, Mr. Chairman? " fcic_final_report_full--188 As late as July , Citigroup and others were still increasing their leveraged loan business.  Citigroup CEO Charles Prince then said of the business, “When the mu- sic stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Prince later explained to the FCIC, “At that point in time, because interest rates had been so low for so long, the private equity firms were driving very hard bargains with the banks. And at that point in time the banks individually had no credibility to stop participating in this lending business. It was not credible for one institution to unilaterally back away from this leveraged lending business. It was in that context that I suggested that all of us, we were all regulated entities, that the regulators had an interest in tightening up lending standards in the leveraged lending area.”  The CLO market would seize up in the summer of  during the financial cri- sis, just as the much-larger mortgage-related CDO market seized. At the time this would be roughly  billion in outstanding commitments for new loans; as de- mand in the secondary market dried up, these loans ended up on the banks’ balance sheets.  Commercial real estate—multifamily apartment buildings, office buildings, ho- tels, retail establishments, and industrial properties—went through a bubble similar to that in the housing market. Investment banks created commercial mortgage– backed securities and even CDOs out of commercial real estate loans, just as they did with residential mortgages. And, just as houses appreciated from  on, so too did commercial real estate values. Office prices rose by nearly  between  and  in the central business districts of the  markets for which data are available. The increase was  in Phoenix,  in Tampa,  in Manhattan, and  in Los Angeles.  Issuance of commercial mortgage–backed securities rose from  billion in  to  billion in , reaching  billion in . When securitization markets contracted, issuance fell to  billion in  and  billion in . When about one-fourth of commercial real estate mortgages were securitized in , securitizers issued  billion of commercial mortgage CDOs, a number that again dropped pre- cipitously in .  CHRG-111hhrg54869--45 Mr. Meeks," Thank you, Mr. Chairman. Good to see you Mr. Volcker. We have been debating something within my office. I am going to make a quick statement and then just ask you if, in fact, you can give me your opinion on it; that we when we consider the issue of ``too-big-to-fail'' and moral hazard, we are basically trying to get firms and their investors to internalize the cost of negative externalities that they may present to the system as a whole. In other words, we want the capital costs and the capital structure and the appetite for the risk to reflect all the costs of the institution, both internally and externally. And I think Larry Summers, when he was speaking before this committee earlier, said that if a firm is too big to resolve in an orderly manner, it is undoubtedly too big to run in a professional manner. In other words, if the senior management of a financial institution cannot present a plan that will convince the public and its regulators that it can disentangle and wind down its operations in an orderly manner, there is no reason to believe that this same management team can run the institution on a daily basis, because they themselves don't fully understand their own company. And for this reason, I believe that a properly structured, comprehensive resolution authority is, in fact, the most critical pillar to managing the moral hazard of the ``too-big-to-fail'' and systemic risk going forward. And the reason for that is different than what has been commonly discussed. It seems to me that the strength of the resolution authority is that it makes debt capital markets work in concert with regulators, and debt presents multiples of equity on financial institutions' balance sheet and debt holders have the power of covenants to manage what they perceive as risk or threats to their privileges as debt holders. With effective, credible resolution authority, bondholders will know that they can no longer rely on the government as an informal insurance policy on their debt. It is this expectation in the past that has allowed firms to become ``too-big-to-fail'' as debt markets and every incentive to provide nearly unlimited financing to the largest institutions, knowing that the larger it got, the more likely it was that the investment would be backed by the government in case of institution failure. So I think that is the crucial area we are looking at, and I would like just to get an idea of what you think in that regard, because I think that is absolutely key as we move forward with reform, with regulation reform in this particular instance. I would love to get your opinion on that. " CHRG-111shrg54675--98 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM ED TEMPLETONQ.1. Some have suggested that the Federal Reserve Board's unfair and deceptive practices (UDAP) authority is very broad and could be used to successfully protect consumers. The problem is that this authority has not been used in a material fashion prior to the credit card rule. Rather than bifurcating consumer protection from safety and soundness, should Congress consider ways to improve UDAP authority? If so, what options do you recommend?A.1. We have concerns about bifurcating consumer protection from safety and soundness as has been proposed with the new Consumer Financial Protection Agency (CFPA). We believe consumer protection can be enhanced in the current system by strengthening UDAP authority and creating consumer protection offices at the functional regulators. One way UDAP could be improved would be to give the FTC more efficient rulemaking authority over nonfederal entities, as their process is currently inefficient and hampers their rulemaking. We would support a CFPA that would have authority over nonregulated institutions that operate in the financial services marketplace, including supplanting the FTC on these matters. However, we do not believe such an agency should have authority over regulated federally insured depository institutions and would oppose extending that authority to Federal credit unions. Giving the CFPA such authority to regulate, examine and supervise credit unions that already are regulated by the NCUA would add an additional regulatory burden and cost to credit unions. Additionally, it could lead to situations where institutions regulated by one agency for safety and soundness find their guidance in conflict with their regulator for consumer issues. Such a conflict and burden will surely increase compliance costs to credit unions, leading to diminished services to their members. Recognizing that more should be done to help consumers, we would propose that, rather than extending the CFPA to Federal depository institutions, each functional regulator of Federal depository institutions have a new or strengthened office on consumer affairs established. We are pleased that NCUA Chairman Michael Fryzel has proposed such an office for NCUA. This is particularly important to credit unions, as they are regulated and structured differently than others in financial services, and we believe that it is important that any regulator examining credit unions should understand their unique nature. We believe that such approach would strengthen consumer protection while not adding unnecessary regulatory burdens on our Nation's financial institutions. ------ CHRG-111shrg54789--79 Mr. Barr," Thank you, Senator. Our judgment is that the new agency will have the ability to set high standard across the financial services marketplace, including for mortgages, that we will continue to see innovation in the mortgage sector, but that if firms want to offer products that are difficult for consumers to understand, there will be a higher burden on them to explain those products and services. And I think that we have seen the consequences of a system in which there is inadequate supervision of those kinds of practices. So I do think we are going to see a rebalancing, if you will, where it is a much lighter regulatory burden even than we have today with respect to straightforward products. So you can do things like combine the Truth in Lending Form and the Real Estate Settlement Practices Form into one simple Mortgage Disclosure Form everybody can use. That is easy under the new approach, very hard under the current approach. It is a way of reducing regulatory burden for banks, improving disclosure for consumers. We can see a lot of that happening in this space with the new agency. Senator Johnson. My time is up. " fcic_final_report_full--189 Leveraged loans and the commercial real estate sector came together on July , , when the Blackstone Group announced its plan to buy Hilton—a hotel chain with , properties—for  billion, a  premium over the share price. A year later, one author described this deal as “the apogee of the early-millennial megabuy- out frenzy, where cheap and readily available credit, coupled with a relentless one-up- manship, spurred private equity firms to buy out companies at often absurd overvaluations, saddle them with massive debt, and then pay themselves hefty fees for the trouble.”  Twenty billion dollars in financing came from the top five invest- ment banks and large commercial banks such as Bank of America and Deutsche Bank.  Bear Stearns was increasingly active in these markets. While Bear topped the  market in residential securitizations, it ranked in the bottom half in commercial se- curitizations.  But it was racing to catch up, and in a  presentation boasted: “In , we firmly established Bear Stearns as a global presence in commercial real es- tate finance.” The firm’s commercial real estate mortgage originations more than dou- bled between  and .  And then the market came crashing to a halt. Although the commercial real estate mortgage market was much smaller than the residential real estate market—in , commercial real estate debt was less than  trillion, compared to  trillion for res- idential mortgages  —it declined even more steeply. From its peak, commercial real estate fell roughly  in value, and prices have remained close to their lows. Losses on commercial real estate would be an issue across Wall Street, particularly for Lehman and Bear. And potentially for the taxpayer. When the Federal Reserve would assume  billion of Bear’s illiquid assets in , that would include roughly  bil- lion in loans from the unsold portion of the Hilton financing package.  And the commercial real estate market would continue to decline long after the housing mar- ket had begun to stabilize. LEHMAN: FROM “MOVING ” TO “STORAGE ” Even as the market was nearing its peak, Lehman took on more risk. On October , , when commercial real estate already made up . of its as- sets, Lehman Brothers acquired a major stake in Archstone Smith, a publicly traded real estate investment trust, for . billion. Archstone owned more than , apartments, including units still under construction, in over  communities in the United States. It was the bank’s largest commercial real estate investment.  Lehman initially projected that Archstone would generate more than . billion in profits over  years—projections based on optimistic assumptions, given the state of the market at that point. Both Lehman and Archstone were highly leveraged: Archstone had little cushion if its rent receipts should go down, and Lehman had lit- tle cushion if investments such as Archstone should lose value.  Although the firm had proclaimed that “Risk Management is at the very core of Lehman’s business model,” the Executive Committee simply left its risk officer, Madelyn Antoncic, out of the loop when it made this investment.  CHRG-111hhrg48868--975 Mr. Liddy," We have an aggressive plan to do that. We are going to sell some assets. That will help us in repayment. We are going to give some assets to the Federal Reserve. These are very well-performing, good value life insurance companies. We will give them to the Federal Reserve in exchange for lowering some of the debt. We will take some of the insurance policies that we have and do what is called a monetization, give that cash flow to the Federal Reserve or the Treasury. We will take our insurance business, our property casualty business, and sell a minority interest in it, and perhaps eventually increase that minority interest. We will take the proceeds from that and give it back to the Federal Government. Ms. Kaptur. How long will it take and how much money will the taxpayers lose? " CHRG-111hhrg67816--114 Mr. Leibowitz," Look, it is a fair question but I think in these times of, you know, where we have seen so much harm to consumers by deceptive acts and practices, you might want to--given that we are an agency that has a track record for being aggressive but balanced, you might want to err on the side of giving us more authority. Believe me, in the 1960's and 70's Congress was always able to pare us back when they thought we were going a little bit too far. But, again, you know, in areas like debt collection, in-house debt collection where we have seen problems including in the Bear Stearns case and debt negotiation, those would be areas not covered by the Omnibus where we think we could do---- " fcic_final_report_full--149 Asset management brought in steady fee income, allowed banks to offer new prod- ucts to customers and required little capital. BSAM played a prominent role in the CDO business as both a CDO manager and a hedge fund that invested in mortgage-backed securities and CDOs. At BSAM, by the end of  Ralph Cioffi was managing  CDOs with . billion in assets and  hedge funds with  billion in assets.  Although Bear Stearns owned BSAM, Bear’s management exercised little supervision over its business.  The eventual fail- ure of Cioffi’s two large mortgage-focused hedge funds would be an important event in , early in the financial crisis. In , Cioffi launched his first fund at BSAM, the High-Grade Structured Credit Strategies Fund, and in  he added the High-Grade Structured Credit Strategies Enhanced Leverage Fund. The funds purchased mostly mortgage-backed securities or CDOs, and used leverage to enhance their returns. The target was for  of assets to be rated either AAA or AA. As Cioffi told the FCIC, “The thesis be- hind the fund was that the structured credit markets offered yield over and above what their ratings suggested they should offer.”  Cioffi targeted a leverage ratio of  to  for the first High-Grade fund. For Enhanced Leverage, Cioffi upped the ante, touting the Enhanced Leverage fund as “a levered version of the [High Grade] fund” that targeted leverage of  to .  At the end of , the High-Grade fund contained . billion in assets (using . billion of his hedge fund investors’ money and . billion in borrowed money). The Enhanced Leverage Fund had . billion (using . billion from investors and . billion in borrowed money).  BSAM financed these asset purchases by borrowing in the repo markets, which was typical for hedge funds. A survey conducted by the FCIC identified at least  billion of repo borrowing as of June  by the approximately  hedge funds that responded. The respondents invested at least  billion in mortgage-backed securi- ties or CDOs as of June .  The ability to borrow using the AAA and AA tranches of CDOs as repo collateral facilitated demand for those securities. But repo borrowing carried risks: it created significant leverage and it had to be renewed frequently. For example, an investor buying a stock on margin—meaning with borrowed money—might have to put up  cents on the dollar, with the other  cents loaned by his or her stockbroker, for a leverage ratio of  to . A home- owner buying a house might make a  down payment and take out a mortgage for the rest, a leverage ratio of  to . By contrast, repo lending allowed an investor to buy a security for much less out of pocket—in the case of a Treasury security, an investor may have to put in only ., borrowing . from a securities firm ( to ). In the case of a mortgage-backed security, an investor might pay  ( to ).  With this amount of leverage, a  change in the value of that mortgage-backed security can double the investor’s money—or lose all of the initial investment. Another inherent fallacy in the structure was the assumption that the underlying collateral could be sold easily. But when it came to selling them in times of distress, private-label mortgage-backed securities would prove to be very different from U.S. Treasuries. CHRG-109shrg30354--94 Chairman Shelby," Senator Dodd. Senator Dodd. Thank you, Mr. Chairman. And thank you, Mr. Chairman, for your presence here today. I want to raise three quick issues if I can with you. I think all three of them could normally consume significant more time than will be allotted to me here to talk about him. And I realize we are here today to talk about monetary policy, but obviously fiscal policy has a direct bearing on monetary policy. I am concerned, along with I presume many of my colleagues, about the rising level of our debt. I recall only a few years ago having a hearing in this Committee with your predecessor on which we actually had a hearing about what the effects would be about eliminating the national debt. Here we find yourselves today, 5 years later, with $8.4 trillion in debt, $2.6 trillion of it occurred in the last 4 or 5 years. In fact, more debt accumulated, I gather, in this period of time than all of our previous administrations combined, and the implications of that. It has been reported that our Vice President allegedly commented that deficits just do not matter. I am quoting him here, that is what I am told he said. I disagree with that. I would like to know how you feel about this. I want to raise with you, in the conjunction of this rising level of debt, and the accumulation of it, the implications about how much of it is being held offshore. I noted when you consider some of the problems we are wrestling with today, whether it is the presence of a--the possibility of a presence of a growing weapons of mass distraction on the Korean Peninsula and obviously the problems we are facing as we speak here in the Middle East, the issue of immigration and the policy on our southern border. I note that of the 10 top holders of our national debt are China at some $326 billion, oil exporters of $103 billion, Korea at $69 billion, Hong Kong at $51 billion. And coming in at number 10 is Mexico at $43 billion. My experience has been that when you are trying to lecture your banker, it can be dangerous in a sense. And I wonder if you are as worried, as many of us are, about this trend and whether or not we should be more concerned about this growing problem, a trillion dollars of it now or more of our debt being held offshore, and what the implications could be here, and what these implications mean in terms of the monetary policy for the country. " CHRG-111hhrg53242--9 Mr. Royce," Thank you, Chairman Kanjorski. Much of the blame for the recent economic turmoil has centered on the belief that a lack of regulation was the root cause of the excessive risks and residual effects that followed, whereas there was a great deal of regulation in the banking sector. It was our most regulated sector. I think that Congressman Richard Baker was the first to really point out at great length the enormous overleveraging that was occurring in Fannie Mae and Freddie Mac, as did the Federal Reserve, and the systemic risk they posed to the system. But I think it is worth noting that while hedge funds and private pools of capital have experienced significant losses, they have not asked for or received any direct government bailouts in an era where the government has become savior of all things failed. The losses borne by hedge funds and their investors did not pose a threat to our capital markets or the financial system. A major reason why this was the case was because of the general lack of leverage within the hedge fund sector. Thus far it appears counterparty risk management, which places the responsibility for monitoring risk on the private market participants who have the incentives and capacity to monitor the risks taken by hedge funds, has held up well. Considering so many of our major heavily regulated financial institutions acted recklessly, drove up their leverage ratios to unstable levels, suffered significant losses on failed investments, and then came to the American taxpayers for assistance, the performance of these private pools of capital over that same period is reassuring. I must also note my concern with adding additional responsibilities to the SEC given their recent handling of the Bernie Madoff incident and what looks like a similar misstep in the handling of Allen Stanford's firm. The few hearings on the Madoff Ponzi scheme revealed an overlawyered, overly bureaucratic SEC. As former SEC Commissioner Paul Atkins recently noted, if hedge funds and private equity firms are forced to register with the SEC, the burden to the agency's examiners would be enormous. I think it would be wise to first address the problems within the SEC, and then discuss adding new responsibilities onto the agency. I would like to thank the panel of witnesses for coming here today, Mr. Chairman. Thank you. " FOMC20070628meeting--36 34,MS. LIANG.," The next four exhibits focus on financial conditions in the corporate and household sectors. As shown by the black line in the top left panel of exhibit 6, operating earnings per share for S&P 500 firms for the second quarter are currently forecasted by analysts to be up about 5 percent from a year ago, a deceleration from the 9 percent pace in the first quarter. However, in view of the sparseness of earnings warnings thus far, we expect second-quarter earnings to top analysts’ forecasts by a few percentage points. As noted to the right, for the year as a whole, analysts are forecasting 8 percent growth in earnings per share (EPS), not very different from the Blue Chip Consensus and the staff’s forecast. For 2008, however, analysts appear to anticipate that EPS growth will pick up to 11 percent, whereas we project that profits will flatten as margins get squeezed by rising unit labor costs. Even adjusting for a typical bias in analysts’ views, our outlook is a little more guarded. The middle panels use analysts’ forecasts to assess equity valuations. As shown by the blue line in the left panel, the trend-forward earnings-to-price ratio for S&P 500 firms has stayed near its level of the past several years, and the gap between it and the real Treasury perpetuity yield—the equity premium shown by the shaded area—narrowed a touch in the past few months as yields rose. But the premium remains close to its average of the past twenty years, suggesting perhaps that investors still are mindful of the risks of investing in equities. However, this caution seems to be less the case for smaller stocks. As shown to the right, a simple metric of valuation—the forward price- earnings ratio—shows that valuations of smaller companies, the red line, are on the high side of their range of the past two decades. Relative to valuations of larger firms, shown by the blue line, small-cap valuations also appear on the high side. As shown by the red line in the bottom left panel, risk spreads for high-yield bonds have fallen on net in recent quarters and currently stand near record lows. To assess the risk premium on high-yield bonds, we subtract from this spread the compensation for expected losses from defaults that would be required by risk-neutral investors. As shown by the black line, expected losses have been low for the past few years, and the risk premium, the gray shaded area, is narrow at about 120 basis points. Low risk spreads and risk premiums may be supported by the exceptional quality of corporate balance sheets. As shown to the right, the ratio of debt to assets for publicly traded speculative-grade firms, the red line, is just off its twenty-year low. The ratio for investment-grade firms, the black line, continues to edge down. Exhibit 7 examines corporate leverage. Some analysts have expressed concern that low risk spreads are encouraging firms to ramp up debt, which will lead to a sharp deterioration in corporate credit quality in the future. As shown by the green bars in the top left panel, share repurchases have risen sharply since 2003, far outpacing the rise in dividend payments, the blue bars. Cash-financed acquisitions, including leveraged buyouts (LBOs), the yellow bars, have also risen. The table to the right characterizes the effects of large repurchases on leverage in 2005 and 2006. Firms with large repurchases, defined as more than 5 percent of assets, had earnings that equaled 9 percent of assets, row 1, higher than earnings of 6 percent at firms with limited or no repurchases. Row 2 shows that high-repurchase firms boosted their debt ratios 2 percentage points, in contrast to the decrease of 1 percentage point at other firms. Even so, the increase raised the debt ratio to only 22 percent at large-repurchase firms, below the average for other firms. Thus, repurchases to date do not suggest material damage to credit quality and would seem likely to do so going forward only if firms were pressured to continue to pay out cash despite weaker profits. LBOs tend to involve much more debt than share repurchases, as firms typically have debt-to-asset ratios of more than 65 percent right after an LBO. As shown in the middle left panel, the issuance of speculative-grade bonds for mergers and acquisitions, including LBOs, the dark portion of the bars, has risen notably, and originations of speculative-grade loans for M&A, shown to the right, have shot up. The sharp rise in loans reflects in part greater demand, particularly for collateralized loan obligations (CLOs), by institutional investors, who are estimated to have purchased more than half of these loans last year. One reason for the greater demand could be the relatively attractive risk-return tradeoff of loans relative to bonds, illustrated in the bottom left panel. Returns on leveraged loans in recent years, the black line, are only modestly lower than returns on high-yield bonds, the red line, but are significantly less volatile. Thus, as noted in the inset box, Sharpe ratios— defined as mean excess returns to standard deviation—are higher for loans than for bonds. We expect that institutional investors will continue to pursue loans until expected returns decline, perhaps through tighter spreads or lower recovery rates on loans. Financial data generally are not available for firms taken private; views of examiners and rating agencies can be used to gauge the effect of LBOs on credit quality. As shown by the black line in the right panel, the most current, and still preliminary, reading on the share of syndicated loans outstanding that were adversely rated shows almost no change from the previous year and remains low. For corporate bonds, the share rated B minus and below, the red line, stayed in its recent range at the end of the first quarter. Although these measures provide a bit of comfort, it may take some years to fully assess whether the operating efficiencies attained through LBOs will be sufficient to cover the higher debt obligations. Exhibit 8 focuses on household financial conditions. As shown in the top left panel, the ratio of net worth to income is estimated to be up on net through the current quarter, largely on stock market gains. While we expect this ratio to decline in coming quarters as house prices flatten and stock prices advance more slowly, it remains high by historical standards. Moving to the right panel, delinquency rates on consumer loans at banks, auto loans at finance companies, and most mortgages have edged up in recent months but do not suggest signs of stress. Overall, most households appear to be in good financial shape. However, there are strains among some subprime mortgage borrowers. As can be seen in the middle left panel, delinquency rates on subprime adjustable-rate mortgages, the solid red line, have climbed sharply and in April moved up again, while those on other mortgages have remained low. As shown to the right, early-payment delinquency rates—at least three missed payments within six months of origination—on adjustable-rate loans rose further in April, though they remain modest for prime and near-prime types, the blue line. As shown in the bottom left panel, we estimate that new foreclosures were started at an annual rate of 1.3 million in the first quarter. Subprime mortgages, the red bars, accounted for more than half of the starts. As noted to the right, foreclosure starts in states with high unemployment, like Ohio, Michigan, and Indiana, continued at a high rate but were little changed from the fourth quarter. The sharpest increases were in four states— California, Florida, Nevada, and Arizona—accounting for more than the nationwide increase, as house prices in those states decelerated. To predict foreclosure starts, we have developed a model of national rates that regresses state-level rates on house price growth, unemployment, the share of loans that are subprime, interest rates, and other variables. This model predicts that foreclosures will continue to rise and reach a bit more than 1.4 million for 2007 as a whole and 1.5 million in 2008, under the Greenbook assumption that national house prices will be roughly flat this year and next. There is unusual uncertainty right now about a forecast given the unprecedented reach of the subprime market in recent years. Some sources of that uncertainty are discussed in exhibit 9. The top four panels present information on interest rate resets on subprime adjustable-rate mortgages, based on a very recently acquired dataset of more than 2 million 2/28 and 3/27 loans that were outstanding as of March of this year. As shown in the top left panel, we estimate that as of the end of the first half of this year, 36 percent of the loans have already had their first interest rate reset. Another 25 percent will face their first reset in the second half of this year, and 21 percent will do so in the first half of 2008. Characteristics of interest rate resets for this snapshot of mortgages are noted in the right panel. The data indicate that, for mortgages close to their first reset date, the initial rate averages about 7.35 percent. Most contracts specified the “fully indexed” rate as the six- month LIBOR plus a margin, which averages 6 percent, and most had caps on the size of each adjustment. The diagram at the middle left presents a progression of interest rates that borrowers about to reset likely will face, based on mortgages that were reset in the past year. As shown by the red line (a slightly stylized version of the actual data, the gray line), the jump in the rate at the first reset date is sizable, almost 2½ percentage points, resulting in a new rate of 9¾ percent. The first reset rate almost never jumps to the fully indexed rate, the blue horizontal line, because of the various caps on increases. But rates are subsequently reset every six months, and as shown on the second reset date, the rate rises another 1 percentage point. Our data suggest that a borrower would not reach the fully indexed rate in the original mortgage until twenty-four months after the first reset (not shown). As noted to the right, however, many borrowers historically have refinanced their mortgages before the first reset date or shortly thereafter. In our sample, 25 percent of mortgages had one reset, and only 12 percent had a second reset. The expected resets in coming months highlight a risk to the outlook for subprime credit quality. Fewer borrowers currently have the ability to refinance because of less home equity accumulation, higher interest rates, and tighter credit conditions. However, many lenders are working with borrowers to modify their loans. In addition, our most recent data indicate that, while credit conditions have tightened, financing remains available. As shown in the bottom left panel, spreads on new subprime MBS issues have eased from their peaks in April, although they have moved up in recent weeks, triggered by concerns related to losses at Bear Stearns’s hedge funds. Subprime mortgage originations, the full height of the bars in the right panel, while down substantially from record highs in late 2005, are not inconsiderable. Moreover, funds appear to have been available both for refinancings, the blue bars, and for home purchases, the green bars. My colleague Mike Leahy will continue." FOMC20080130meeting--129 127,MS. LIANG.," The loans could be packaged in securities. This is debt. It includes all debt. Now, whether it is repackaged into an MBS, it would be there. It wouldn't be if it got in a CDO or something. " FOMC20060510meeting--171 169,MR. WARSH.," Thank you, Mr. Chairman. I support alternative B and would like to echo Governor Kroszner with respect to the reference to inflation expectations remaining contained. In light of where the market’s expectations are, for better or for worse going into today and June, the omission of that language would be a very loud omission. I think that alternative likely would not be expected or generate the kind of balanced reaction that we are trying to achieve. The other emphasis that we have in section 4 addresses what I think is the balance of the discussion that we had today. I also like in alternative B the reference to the current state of the economy in the first line of part 2, where we say that it has been quite strong so far this year. This wording provides some credibility to some of the data that the markets are perhaps not as focused on as they should be. So on balance, I do support alternative B as written and would make only a couple of points. As we approach our last move, or potentially our last move, with respect to this tightening cycle, it does strike me that the burden of persuasion, if not the burden of proof, rests with us to change course. I do not think that there is any evidence to this point that we ought to stop or even suggest to the market that a pause is in some way imminent. We have all largely agreed that the risks of policy error here have increased, and that is why a lot of consistency between the alternative B language and our March FOMC language is perfectly appropriate. As the Vice Chairman referenced in the earlier round, we are trying to express to the markets our view of uncertainty so that they do not take what we say as a guarantee of future results but look at the data in real time as we look at the data rather than look directly just at us. The balance that has been struck in section 4 does that very well. Should we get to a pause at some point over the course of the next several meetings, it needs to be preceded by vigilance, which I do see reflected in section 4. I would conclude only that it is better to leave interest rate expectations higher at this moment until we see some real signs of inflation falling more into that zone of comfort, which President Yellen and others referenced. Thank you." CHRG-111shrg50815--112 Mr. Levitin," There is another significant difference between credit card and mortgage securitization. Mortgage securitization, a typical securitization deal, the originator sells off the loans and has no further interest in them. That is not, as Mr. Clayton points out, that is not what happens with credit cards. The card issuer retains essentially the residual interest. Every month, if after--if the cards generate enough income to pay off all the mortgage-backed security bonds, anything left over goes to the card issuer. That is called the excess spread. What this means is that the card issuer holds all the upside, but it has sold off most of the downside to investors. This gives card issuers an incentive to apply more late fees and over-limit fees because that will result in some people defaulting on the debt entirely, but others, it will result in them paying more. This increases volatility. For credit card securitization, the more volatile the accounts are, that all accrues to the benefit of the issuer, and the downside of the volatility goes to the investors. " CHRG-109hhrg28024--56 Mr. Bernanke," Congressman, I think that in my role as chairman of the Federal Reserve, it is appropriate for me to talk about long-term Government spending, taxes, and deficits. I think that bears on economic stability and financial stability, and I will speak out on those issues. I am concerned about the prospective path of deficits. I believe that it does reduce national savings, and, therefore, imperils to some extent the future prosperity of our country, and increases the burden that will be faced by our children and grandchildren. Of particular concern to me is that in the very near term, the demographic changes in our economy are going to lead to increasing promises, increasing entitlement payments associated with the large programs of Social Security, Medicare, and the Federal contribution to Medicaid. Indeed, according to the best estimates we have, the share of GDP going to those three programs will go from about 8 percent today to about 16 percent when my children, who are now in college, are contemplating retirement. If that were in fact to happen, given that total revenues are now about 18 percent of GDP, that would suggest that either we would have to eliminate all other Government spending, raise taxes considerably, or else take some action to bring entitlement spending under control. I'm not saying which of these things. I'm just pointing out that the implications of these obligations are quite draconian in the long run. We need to be addressing those long-term issues soon. We need to give people the time to prepare for whatever changes might occur in entitlement programs. And, therefore, I think that we do need to think about fiscal deficits and their implications for our national saving and our long-run ability to meet our obligations to our citizens. " FinancialCrisisReport--28 Borrowers were able to pay for the increasingly expensive homes, in part, because of the exotic, high risk loans and lax loan underwriting practices that allowed them to buy more house than they could really afford. C. Credit Ratings and Structured Finance Despite the increasing use of high risk loans to support mortgage related securities, mortgage related securities continued to receive AAA and other investment grade ratings from the credit rating agencies, indicating they were judged to be safe investments. Those credit ratings gave a sense of security to investors and enabled investors like pension funds, insurance companies, university endowments, and municipalities, which were often required to hold safe investments, to continue to purchase mortgage related securities. Credit Ratings Generally. A credit rating is an assessment of the likelihood that a particular financial instrument, such as a corporate bond or mortgage backed security, may default or incur losses. 37 A high credit rating indicates that a debt instrument is expected to be repaid and so qualifies as a safe investment. CHRG-111hhrg63105--41 Mr. Gensler," There are two components in the Act. There is manipulation, or if I can broaden that a little bit, corners and squeezes. But, Congress also said, not only in the 1930s but I think also in the Dodd-Frank Act, has reconfirmed that we shall set position limits to do something that is not just limited to protect against manipulation; it is also to diminish or prevent any burdens that may come from excessive speculation. So they are not identical. And any burdens that may come from excessive speculation may be actually far before somebody corners or squeezes or manipulates a market. Manipulation also includes intent. So I am just trying to highlight. And it is part of our challenge that they overlap, but they are somewhat distinct. " CHRG-110shrg50414--207 Secretary Paulson," I was dealing with all of the best regulators. So I guess what I said is that you have got to see it up close and personal and then step back and look at it and think about it and say, how does this make sense, and that was my statement, yes, sir. Senator Bunning. In other words, you didn't know or somebody in your firm other than you was dealing with the regulatory burdens that were placed on your firm? " CHRG-111hhrg53244--170 Mr. Royce," Well, on that very subject, here is what the head of the CBO said about that. He said, ``As a result of those deficits, Federal debt held by the public is going to soar from 41 percent of GDP to 60 percent at the end of the fiscal year 2010. This higher debt results in permanently higher spending to pay interest on that debt. Federal interest payments already amount to more than 1 percent of GDP. Unless current law changes, that share will rise to 2.5 percent by 2020.'' And he says, ``The Federal budget is on an unsustainable path because Federal debt is going to continue to grow much faster than the economy over the long run, and large budget deficits would reduce national saving, leading to more borrowing from abroad and less domestic investment, which, in turn, would depress economic growth in the United States. Over time, accumulating debt would cause substantial harm to the economy.'' ``Substantial harm.'' Do you agree with the CBO's estimate on that subject of accumulating that amount of debt? " CHRG-111hhrg56766--107 Mr. Bernanke," Well, as I said earlier, the projections of 4 to 7 percent deficits from 2013 to 2020 and increasing after that, I think everyone would agree, including the President, that is not sustainable and that we need to address those numbers and get them down in the out-years. Mr. McCarthy of California. I heard you say that, and I'm trying to say here as a Member of Congress looking at a budget today, hearing your words that you have told us time and time again and every economist says it, that you cannot sustain this, watching our national debt of GDP go up almost to the highest level outside of World War II, especially at the end of this decade to be 77 percent. What do we do today? Your quote earlier said, ``would help the current recovery if we were able to sustain that.'' So looking at the current budget, does it give us the change needed in any shape or form? " FinancialCrisisInquiry--406 BASS: Two quick observations on that. The first one is I agree with Mr. Solomon about the tax structure. I think it’s fairly appropriate the way it stands today. I think that when you look at the banking business, there were securities that were considered to be hybrid securities. They weren’t equity. They weren’t debt. Banks could raise hybrid securities in forms designated as trust preferreds. January 13, 2010 They got to raise that money, and yet it didn’t impact their total indebtedness. So it was this—it wasn’t equity, it wasn’t debt security. I think what you’re asking is should we draw lines. And I think we should absolutely draw lines between equity, preferred stock, subordinated debt, and senior debt. There should be bright lines in the cap structure of U.S. companies and not all these crazy hybrid securities where no one knows where to put into the cap structure. And I guess since I’m being brief, I wanted to add one more point that I didn’t get to make in my testimony with regard to the cap structure and the debt and the equity of these companies. When the taxpayer money comes in—and this is a separate debate. But when taxpayer money comes in to a company—I realize that Treasury was dealing with pitches as they were thrown and that this was very much ala carte model of dealing with the financial crisis because we didn’t prepare for it. But going forward, I think what has to be done from the commission’s perspective is to determine a methodology for which taxpayer money is to possibly be infused in companies. It needs to be last in and first out. It needs to be senior to the bank debt. The fact that we’re buying equity with taxpayer money is an abomination to the taxpayer. So that’s a little bit different spin on debt and equity, but that’s where those loans need to go. CHRG-111shrg62643--149 Mr. Bernanke," Everything else being equal, raising the debt is a negative. Senator Menendez. So raising the debt is a negative. And if I do that in a way in which I don't offset that, that would be a negative, would it not be? " FinancialCrisisInquiry--113 Cause Three: too many eggs in one basket. Look at data for loan growth last decade and look at the fastest area of loan growth. First, mortgages; second, mortgages; construction loans, commercial real estate, multi-family real estate. One element in common: real estate. Cause Four: high balance sheet leverage. Shortly before the crisis, the U.S. banking industry had the highest leverage in 25 years. And then take a look at the securities industry. In the ‘80’s, 20 time levered, in the ‘90’s, 30 times levered. And right before the crisis, almost 40 times levered. Cause Five: more exotic products. Some of these were so exotic that I don’t think the directors, the CEOs, and in some cases, even the auditors fully understood the risks. And I think of this like cheap sangria. A lot of cheap ingredients are bad—or bad sangria, I should say. A lot of cheap ingredients repackaged to sell at a premium. It might taste good for a while, but then you get headaches later and you have no idea what’s really inside. Cause Six: consumers went along. There’s some personal responsibility here. Consumer debt-to-GDP is at the highest level in history. Japan didn’t have that. We didn’t have that during the Great Depression. There is a false illusion of prosperity through this additional borrowing. It’s no secret that everybody from kids to pets to dead people got loan solicitations, but a lot of people took these loans voluntarily. Cause Seven: accountants. The SEC, in 1998 made some rules or some decisions that encouraged banks to take less reserves for their problem assets. And look what happened next. Reserves to loans at U.S. banks declined from 1.8 percent down to 1.2 percent right before the crisis. That was a wrong move. It should change now. And the bank regulators should be back in control in helping us set reserves for problem loans. That was not a close call for many of us in the industry. CHRG-110hhrg34673--41 The Chairman," Without objection. The gentleman from Texas, Mr. Paul. Dr. Paul. Thank you, Mr. Chairman. I would like to pursue the issue of the current account deficit. It seems like almost all economists express concern, some worry about it, but I can't find anybody who tells us that we should totally ignore it. And we do now borrow approximately $800 billion every year. We have a foreign debt of several trillions of dollars, and to me it represents an imbalance which is the consequence of the monetary system and presents a potential problem for us. Likewise, I see that potential problem in the number of derivatives out there. There is one figure that says there are $236 trillion of derivatives, and it seems like very few people understand exactly what that means, and it certainly is so huge and diverse. I don't even think the Congress that we have that is always anxious to regulate everything has offered a scheme for regulating derivatives because, quite frankly, I don't think they are capable of doing that. Foreigners now own 43 percent of our debt, approximately twice as much as the Fed has been required to borrow. And one of the questions I have is how much pressure would it put on you if--I guess in even a theoretical sense, what if they didn't buy any of our debt, and all of a sudden you had to deal with that problem? Right now, there is a sign that maybe they are buying less. We have heard rumors and innuendos in the media and hints from China that, yes, they are not going to be buying as much, and yet there hasn't been really a crisis. There has been no panic, and we know there is self-interest on their part to maintain the dollar because they hold so many. But in many ways I think we get a free ride. We get to export our dollars. We don't have to monetize them here. We get to export our inflation, but it potentially has a problem for us if all of a sudden they buy less, and these dollars come home or these dollars go into goods and services. Also the other concern that I have that I would like you to address is the subject of the revaluation of the yuan. I understand you and Secretary Paulson went over to China to put pressure--at least the media presented it that way--put pressure on them to increase the value of the yuan and decrease the value of the dollar in relationship, which in reality, it seems to me, would put pressure on our interest rates and push our interest rates up and raise our prices. And some people have reported that couldn't possibly be our policy where we would deliberately want to do that. And then again, it would put more pressure on--I know it is an artificial arrangement right now. But in some ways what the Chinese have done is they have revived the old Bretton Woods standard of fixing their currency to our dollar, and some people look longingly to the Bretton Woods days where we worked with fixed exchange rates. Of course, there were different conditions then. But if you would, if you would address both what our position is with the Chinese yuan as well as what happens if they significantly--if the foreigners, especially Japan and China, start to buy a lot fewer dollars and how that would affect your policy. " CHRG-109shrg21981--34 Chairman Greenspan," We have to really ask ourselves what the problem we are trying to solve is. The problem essentially is that we have an unprecedented potential increase in the number of people leaving the workforce and going into retirement over the next 25 years. Indeed, those age 65 and over will increase according to the Bureau of Census by more than 30 million, and that is an inexorable move as we all age and retire. The problem that creates is that unless productivity growth increases significantly, the per capita GDP must significantly slow. That means either the retirees or active workers, say, in the year 2030, must experience a significant slow-down in their standard of living. And my concern is that we are putting forward, in a number of different programs, commitments to be fulfilled in the year 2030, for which the real resources are not being made available. And the way real resources are made available in such a context is for savings to be put aside to be invested in capital assets, and those capital assets, by increasing relative to the labor force, tend to create increased output per hour. The correlation for that is very close. So that unless we develop the savings to invest or significantly increase our borrowing from abroad, we are not going to be able to create the capital assets, to create the amount of goods that are required. Our problem, with respect to retirement, has got nothing to do with finance. It has to do with real assets, real physical resources, and goods and services that people consume. What the test in this context of our individual financial systems should be is do they or do they not create savings to create the capital assets or put it another way, are they fully funded or not? For example, Social Security, as a pay-as-you-go system worked remarkably well for 50, 60, 70 years, largely because a pay-as-you-go system works if population is growing sufficiently quickly and longevity is growing only modestly. Now, we have had, in recent years, some slowing down in population growth, but a remarkable increase in life expectancy after age 65. That has created a very major problem for a pay-as-you-go system. And the reason, essentially, is, by its nature, in the purest form, pay-as-you-go creates no savings. It merely transfers from taxpayers, in any particular period, to beneficiaries. Now, to be sure, there are some savings involved in the OASI fund in the sense of we have built up a trust fund, which is now approximately $1.5 trillion, but a fully funded OASI would require more than $10 trillion. So we are very far short, and we have very great difficulty in fully funding the existing system, and that is the reason why I think we have the problems that we are running into. Not to take too much more time, let me just say very specifically, in response to your question, there are basically two models that we are confronting. One is the pay-as-you-go model which, if we can fully fund it, will work, but it has shown very considerable difficulty in doing that. The other is the forced savings model which, in the current context privatization, is not increasing savings because you are switching from Federal Government savings to a forced savings account. But as a general model, it has in it the seeds of developing full funding by its very nature, and therefore I have always supported moves to full funding in the context of a private account, and I will respond in more detail in response to a number of questions that I am sure you and your colleagues have. The issue with respect to the financing the transition is a difficult one to answer because there are things we do not know. There are two things which we do not know which are important, and if we knew them, we could answer it very explicitly. First, we do not know the extent to which the financial markets at this stage, specifically, those trading in long-term bonds, are discounting the $10-trillion contingent liability that we have. Actually, it is more than $10 trillion now. It was $10 trillion a while back. If, indeed, the financial markets do not discount that $10-trillion-plus, and say it is just as much of a debt as the $4-odd-trillion that is a debt to the public, then, one would say, well, if you wanted to go to a private system, you could go fully to a private system without any response in interest rates because, obviously, you are not changing the liabilities that are involved. You are just merely switching assets to the private sector. But we do not know that. And if we were to go forward in a large way, and we were wrong, it would be creating more difficulties than I would imagine. So, if you are going to move to private accounts, which I approve of, I think you have to do it in a cautious, gradual way and recognize that there is yet another problem involved, which is this: Unlike almost all of the other programs with which we deal, moving to a forced savings account technically does not materially affect net national savings. It merely moves savings from the Government account to a private account. One can argue at the margin as to whether or not that induces some change in personal behavior, but it is at the margin. So the question really is if it does not affect national savings, it should not affect the supply and demand for funds, but, again, we do not know how the markets respond to that. It is one thing to say it as an economist. It is another thing to say how the market is responding. All in all, I am glad that if we are going to move in that direction, we are going to move slowly and test the waters because I think it is a good thing to do over the longer-run and, eventually, because the pay-as-you-go system, in my judgment, is going to be very difficult to manage, we are going to need an alternative. " CHRG-111hhrg48874--12 OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Ms. Duke. Thank you, Mr. Chairman. Chairman Frank, Ranking Member Bachus, and members of the committee, I am pleased to be here today to discuss several issues related to the state of the banking system. As you are all well aware, the Federal Reserve is taking significant steps to improve financial market conditions and has worked with the Treasury and other bank and thrift supervisors to address issues at U.S. banking organizations. We remain attentive to the need for banks to remain in sound financial condition, while at the same time to continue lending prudently to creditworthy borrowers. Indeed, the shutdown of most securitization markets and the evaporation of many types of non-bank credit make it that much important right now for the U.S. banking system to be able to carry out the credit intermediation function. Recent data confirm severe strains on parts of the U.S. banking system. During 2008, profitability measures at U.S. commercial banks and bank holding companies deteriorated dramatically. Indeed, commercial banks posted a substantial, aggregate loss for the fourth quarter of 2008, the first time this has happened since the late 1980's. This loss in large part reflected write-downs on trading assets, high goodwill impairment charges, and, most significantly, increased loan loss provisions. With respect to overall credit conditions, past experience has shown that borrowing by households and nonfinancial businesses has tended to slow during economic downturns. However, in the current case, the slow down in private sector debt growth during the past year has been much more pronounced than in previous downturns, not just for high mortgage debt, but also consumer debt and debt of the business sector. In terms of direct lending by banks, Federal Reserve data show that total bank loans and leases increased modestly in 2008 below the higher pace of growth seen in both 2006 and 2007. Additionally, the Federal Reserve Senior Loan Officer Opinion Survey on Banking Practices has shown that banks have been tightening lending standards over the past 18 months. The most recent survey data also show the demand for loans for businesses and households continue to weaken on balance. Despite the numerous changes to the financial landscape during the past half-century, such as the large increase in the flow of credit coming from non-bank sources, banks remain vital financial intermediaries. In addition to direct lending, banks supply credit indirectly by providing back-up liquidity and credit support to other financial institutions and conduits that also intermediate credit flows. In terms of direct bank lending, much of the increase last year likely reflected households and businesses drawing down existing lines of credit rather than extensions of loans to new customers. Some of these draw-downs by households and businesses were precipitated by the freeze-up of the securitization markets. The Federal Reserve has responded forcefully to the financial and economic crisis on many fronts. In addition to monetary policy easing, the Federal Reserve has initiated a number of lending programs to revive financial markets and to help banks play their important role as financial intermediaries. Among these initiatives are the purchase of large amounts of agency debt and mortgage-backed securities; plans to purchase long-term Treasury securities; other efforts including the Term Asset-backed Securities Loan Facility known as TALF to facilitate the extension of credit to households and small businesses; and, the Federal Reserve's planned involvement in the Treasury's Public-Private Partnership Investment Program, announced on Monday. The Federal Reserve has also been active on the supervisory front to bring about improvements in banks' risk-management practices. Liquidity and capital have been given special attention. That said, we do realize that there must be an appropriate balance between our supervisory actions and the promotion of credit availability to assist in the economic recovery. The Federal Reserve has long-standing policies and procedures in place to help maintain such a balance. We have also reiterated this message of balance in recent interagency statements. We have directed our examiners to be mindful of the procyclical effects of excessive credit tightening and to encourage banks to make economically viable loans, provided that such lending is based on realistic asset valuations and a balanced assessment of borrowers' repayment capacities. The U.S. banking industry is facing serious challenges. The Federal Reserve, working with other banking agencies, has acted and will continue to act to ensure that the banking system remains safe and sound and is able to meet the credit needs of our economy. The challenge for regulators and other authorities is to support prudent bank intermediation that helps restore the health of the financial system and the economy as a whole. As we have communicated, we want banks to deploy capital and liquidity to make credit available, but in a responsible way that avoids past mistakes and does not create new ones. Accordingly, we thank the committee for holding this hearing to help clarify the U.S. banking agencies' message that both safety and soundness and credit availability are important in the current environment. I look forward to your questions. [The prepared statement of Governor Duke can be found on page 82 of the appendix.] " CHRG-110shrg38109--131 Chairman Bernanke," Well, it is closely related because if we do not take some measures to address how we are going to deal with the fiscal implications of an aging society, the debt and deficits are going to grow, interest payments on those debt and deficits are going to grow, and we will be in an unsustainable fiscal situation. So the fiscal picture is closely linked to the underlying demographic changes that are going on. Senator Tester. I have had a tough time struggling with, because quite frankly tax load is something I am very concerned about, too, as I think everybody on this Committee is. But the debt load concerns me, too, very much. Could you rank them as what could be the most severe impediment? Is it the debt load or is it tax policy that is flawed? " fcic_final_report_full--503 Most of what was going on here was under the radar, even for specialists in the housing finance field, but not everyone missed it. In a paper published in 2001, 94 financial analyst Josh Rosner recognized the deterioration in mortgage standards although he did not recognize how many loans were subject to this problem: Over the past decade Fannie Mae and Freddie Mac have reduced required down payments on loans that they purchase in the secondary market. Those requirements have declined from 10% to 5% to 3% and in the past few months Fannie Mae announced that it would follow Freddie Mac’s recent move into the 0% down payment mortgage market. Although they are buying low down payment loans, those loans must be insured with ‘private mortgage insurance’ (PMI). On homes with PMI, even the closing costs can now be borrowed through unsecured loans, gifts or subsidies. This means that not only can the buyer put zero dollars down to purchase a new house but also that the mortgage can finance the closing costs…. [I]t appears a large portion of the housing sector’s growth in the 1990’s came from the easing of the credit underwriting process ….The virtuous cycle of increasing homeownership due to greater leverage has the potential to become a vicious cycle of lower home prices due to an accelerating rate of foreclosures. 95 [emphasis supplied] The last increase in the AH goals occurred in 2004, when HUD raised the LMI goal to 52 percent for 2005, 53 percent for 2006, 55 percent for 2007 and 56 percent for 2008. Again, the percentage increases in the special affordable category outstripped the general LMI goal, putting added pressure on Fannie and Freddie to acquire additional risky NTMs. This category increased from 20 percent to 27 percent over the period. In the release that accompanied the increases, HUD declared: Millions of Americans with less than perfect credit or who cannot meet some of the tougher underwriting requirements of the prime market for reasons such as inadequate income documentation, limited downpayment or cash reserves, or the desire to take more cash out in a refinancing than conventional loans allow, rely on subprime lenders for access to mortgage financing. If the GSEs reach deeper into the subprime market , more borrowers will benefit from the advantages that greater stability and standardization create. 96 [emphasis supplied] Fannie did indeed reach deeper into the subprime market, confirming in a March 2003 presentation to HUD, “Higher goals force us deeper into FHA and subprime.” 97 According to HUD data, as a result of the AH goals Fannie Mae’s acquisitions of goal-qualifying loans (which were primarily subprime and Alt-A) increased (i) for very low income borrowers from 5.2 percent of their acquisitions in 1993 to 12.2 percent in 2007; (ii) for special affordable borrowers from 6.4 percent in 1993 to 15.2 percent in 2007; and (iii) for less than median income borrowers (which includes the other two categories) from 29.2 percent in 1993 to 41.5 percent in 2007. 98 94 Josh Rosner, “Housing in the New Millennium: A Home Without Equity is Just a Rental With Debt,” June, 2001, p.7, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162456. 95 96 97 98 Id., p.29. http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf , p.63601. Fannie Mae, “The HUD Housing Goals”, March 2003. HUD, Offi ce of Policy Development and Research, Profiles of GSE Mortgage Purchases, 1992-2000, 2001-2004, and 2005-2007. 499 CHRG-111shrg62643--147 Mr. Bernanke," Right. I think that the fact that we have a 10-percent GDP deficit this year is completely understandable given what we have been through. Senator Menendez. So we are looking at debt and deficits now, and I agree we need to tackle that. So adding another $680 billion to the debt, is that a good idea? " CHRG-111shrg50814--113 Mr. Bernanke," We will start with the capital. If it turns out that the bank, because of good economic outcomes or because they are able to sell assets, doesn't need all the capital we gave them, then they can pay it back eventually. Senator Warner. I know my time is up. Can I ask one more quick question, though? I was happy to see yesterday your Web site and some of your comments this morning about more transparency, but one of the things, Dr. Elmendorf was in recently and did a pretty good outline of all of the various initiatives that have been started, and we realize you are fighting multiple fires on multiple fronts, but my count was there are eight new initiatives that the Fed has started since last fall. You have made investments or potential investments in four separate institutions, as some of my colleagues mentioned, increased the balance sheet by about a trillion dollars with the potential of going up to $4 trillion. Some of these are clearly purchasing of normal Treasury securities, but there is a whole series of new areas where you are taking on assets, AIG in particular and others, where the role of the Fed seems to be evolving into not only monetary policy and regulatory oversight, but more and more a holder of debt or equities in a series of institutions. Do you have the capabilities inside the institution to play this role, and looking back on the Bear Stearns when it looked like we had to bring in what at that point, now in retrospect $29 billion looks like a fairly minor challenge, but now with this potential of a trillion dollars added to your balance sheet, the potential of going to $4 trillion, how do you have the capabilities to manage all these assets inside the Fed? " CHRG-110shrg38109--126 Chairman Bernanke," Again, I think the best way to be competitive is to make sure that the regulatory structure has a minimal costs as needed to justify the benefits that are seen to be obtained from those regulations. Senator Crapo. One of the common themes that we are seeing in terms of the movement of business away from the United States to London and other capital markets is just that, the regulatory burdens and the regulatory regime that we impose here in the United States. I do not think anybody would say that we should simply take down our regulatory position, because we do have one of the strongest markets in the world. But the question is, are we over-regulating. I want to go specifically to an issue that you and I have talked about many times before, and that is the regulation of energy derivatives. As you know, we have faced proposals in Congress and the Senate now for the last 4 or 5 years to increase the regulatory climate around the handling of energy derivatives. There has yet been another bill introduced just yesterday or day I think, to do the same thing, so we are back into the same issue. You have expressed a position on this in the past. I have in front of me the last letter that was put out by the President's Working Group, of which you are a member. The last paragraph of that letter says, ``several times in recent years the PWG has been asked for its views on various legislative proposals to expand regulation of energy derivatives. Most recently, in testimony before the Senate Banking Committee on September 8, 2005 representatives of the PWG agencies reaffirmed the position of the PWG that additional regulation of energy derivatives is not warranted.'' Is that still the position of the PWG, and is it still your position that we do not need to further increase the regulatory regime surrounding energy derivatives? " CHRG-111hhrg54867--234 The Chairman," The gentleman from Kansas. Mr. Moore of Kansas. Thank you, Mr. Chairman. Mr. Secretary, how do we end ``too-big-to-fail?'' I don't know if you have seen the recent proposal by Chairman Tom Hoenig from the Kansas City Federal Reserve. The proposal on resolution authority lays out explicit rules of how a large financial institution like Lehman Brothers or AIG could be resolved so that debt holders, shareholders, and management would be accountable and responsible before taxpayers step in. If you haven't seen the proposal, I would be happy to get you a copy, and would appreciate your comments in writing. Others suggest we require the largest financial firms to undergo a regular stress test that would have aggregate information publicly released even in good times. I know some have argued the list of these firms should remain confidential, but doesn't the market already know who these firms are based on the last round of stress tests? How do we create the right incentives for firms to maintain reasonable leverage ratios and strongly discourage ``too-big-to-fail?'' " CHRG-111shrg51395--36 Mr. Doe," Chairman Dodd, Senator Shelby, and Committee Members, is a distinct pleasure that I come before you today to share my perspective on the municipal bond market. My firm, Municipal Market Advisors, has served for the past 15 years as the leading independent research and data provider to the industry. In addition, from 2003 to 2005, I served as a public member of the Municipal Securities Rulemaking Board, the self-regulatory organization of the industry established by Congress in 1975. There are nearly 65,000 borrowers in the municipal market that are predominantly States and local governments. Recent figures identify an estimated $2.7 trillion in outstanding municipal debt. This is debt that aids our communities in meeting budgets and financing society's essential needs, whether it is building a hospital, constructing a school, ensuring clean drinking water, or sustaining the safety of America's infrastructure. A distinctive characteristic of the municipal market is that many of those who borrow funds--rural counties and small towns--are only infrequently engaged in the capital markets. As a result, there are many issuers of debt who are inexperienced when entering a transaction and are unable to monitor deals that may involve movement of interest rates of the value of derivative products. According to The Bond Buyer, the industry's trade newspaper, annual municipal bond issuance was $29 billion in 1975; whereas, in 2007, issuance peaked at $430 billion. In the past 10 years, derivatives have proliferated as a standard liability management tool for many local governments. However, because derivatives are not regulated, it is exceptionally difficult, if not impossible, to identify the degree of systemic as well as specific risk to small towns and counties who have engaged in complex swaps and derivative transactions. Municipal issuers themselves sought to reduce borrowing costs in recent years by selling bonds with a floating rate of interest, such as auction rate securities. Because States and local governments do not themselves have revenues that vary greatly with interest rates, these issuers employed interest rate swaps to hedge their risk. Issuers use the instruments to transform their floating risk for a fixed-rate obligation. A key factor in the growth of the leverage and derivative structures was the prolific use of bond insurance. Municipal issuers are rated along a conservative rating scale, resulting in much lower ratings for school districts and States than for private sector financial and insurance companies. So although most States and local governments represent very little default risk to the investor, the penal ratings scale encouraged the use of insurance for both cash and derivatives in order to distribute products to investors and facilitate issuer borrowing. So instead of requiring more accurate ratings, the municipal industry chose to use bond insurance to enhance the issuer's lower credit rating to that of the higher insurance company's rating. The last 18 months have exposed the risks of this choice when insurance company downgrades, and auction rate security failures, forced numerous leveraged investors to unwind massive amounts of debt into an illiquid secondary market. The consequence was that issuers of new debt were forced to pay extremely high interest rates and investors were confused by volatile evaluations of their investments. The 34-year era of the municipal industry's self-regulation must come to an end. Today, the market would be in a much better place if: First, the regulator were independent of the financial institutions that create the products and facilitate issuers' borrowing. Municipal departments represent a relatively small contribution to a firm's revenue, and this inhibits MSRB board members from seeking regulatory innovation. Second, if the regulator were integrated into the national regime of regulation. Since the crisis began, we have discovered a limited market knowledge here in D.C., in the Federal Reserve, Treasury, Congress, and the SEC. I might add that when the crisis began to emerge in August 2007, we were immediately contacted by the New York Federal Reserve and the Federal Reserve itself, and are quite impressed in the last 18 months with their vigilance and interest in this sector. So integration, we believe, would speed market recovery by the shared information. Third, the regulator's reach and authority needs to be extended to all financial tools and participants of the municipal transaction. This meant ratings agencies, insurers, evaluators, and investment and legal advisors for both the cash and swaps transactions. This need has become more apparent as we uncover the damaged issuers, and States such as Alabama, Tennessee, and Pennsylvania are suffering relative to interest rate swaps. Fourth, if the regulator were charged with more aggressively monitoring market data with consumers' interests in mind. When I think of consumers, I think of both investors and the issuers. In 2008, there were specific instances of meaningful transactions and price irregularities that should have prompted regulatory investigation to protect consumers. The good news is that this new era of regulatory oversight can be funded by the MSRB's annual revenue in 2008 of $20-plus million, collected from the bond transactions themselves, and can be staffed by the current MSRB policy and administrative infrastructure. I should be clear. The innovations of derivatives and swaps have a useful application and have been beneficial for those for which they are appropriate. However, it is also important that these instruments become transparent and regulated with the same care as the corresponding municipal cash market. It is critical to get this right. There is simply too much at stake. Thank you for having me here today, and I look forward to participating in the questions of the session. " FOMC20081216meeting--189 187,MR. LOCKHART.," Question for Nathan. In an earlier meeting, if I recall correctly, there was mention of the European banks' exposure to emerging-market sovereign debt--a concern about the trend lines in that sovereign debt. Are you tracking that in any sense? My concern is that there could be another full-blown debt crisis of some kind coming. It is not covered in these charts, but do you have a sense of default risk on the part of emerging-market sovereigns? " fcic_final_report_full--71 Indeed, the regulators, including the Fed, would fail to identify excessive risks and unsound practices building up in nonbank subsidiaries of financial holding compa- nies such as Citigroup and Wachovia.  The convergence of banks and securities firms also undermined the supportive relationship between banking and securities markets that Fed Chairman Greenspan had considered a source of stability. He compared it to a “spare tire”: if large commer- cial banks ran into trouble, their large customers could borrow from investment banks and others in the capital markets; if those markets froze, banks could lend us- ing their deposits. After , securitized mortgage lending provided another source of credit to home buyers and other borrowers that softened a steep decline in lending by thrifts and banks. The system’s resilience following the crisis in Asian financial markets in the late s further proved his point, Greenspan said.  The new regime encouraged growth and consolidation within and across bank- ing, securities, and insurance. The bank-centered financial holding companies such as Citigroup, JP Morgan, and Bank of America could compete directly with the “big five” investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—in securitization, stock and bond underwriting, loan syndication, and trading in over-the-counter (OTC) derivatives. The biggest bank holding companies became major players in investment banking. The strategies of the largest commercial banks and their holding companies came to more closely re- semble the strategies of investment banks. Each had advantages: commercial banks enjoyed greater access to insured deposits, and the investment banks enjoyed less regulation. Both prospered from the late s until the outbreak of the financial cri- sis in . However, Greenspan’s “spare tire” that had helped make the system less vulnerable would be gone when the financial crisis emerged—all the wheels of the system would be spinning on the same axle. LONG TERM CAPITAL MANAGEMENT: “THAT ’S WHAT HISTORY HAD PROVED TO THEM ” In August , Russia defaulted on part of its national debt, panicking markets. Rus- sia announced it would restructure its debt and postpone some payments. In the af- termath, investors dumped higher-risk securities, including those having nothing to do with Russia, and fled to the safety of U.S. Treasury bills and FDIC-insured de- posits. In response, the Federal Reserve cut short-term interest rates three times in seven weeks.  With the commercial paper market in turmoil, it was up to the com- mercial banks to take up the slack by lending to corporations that could not roll over their short-term paper. Banks loaned  billion in September and October of —about . times the usual amount  —and helped prevent a serious disruption from becoming much worse. The economy avoided a slump. Not so for Long-Term Capital Management, a large U.S. hedge fund. LTCM had devastating losses on its  billion portfolio of high-risk debt securities, including the junk bonds and emerging market debt that investors were dumping.  To buy these securities, the firm had borrowed  for every  of investors’ equity;  lenders included Merrill Lynch, JP Morgan, Morgan Stanley, Lehman Brothers, Goldman Sachs, and Chase Manhattan. The previous four years, LTCM’s leveraging strategy had produced magnificent returns: ., ., ., and ., while the S&P  yielded an average .  CHRG-111shrg62643--229 RESPONSES TO WRITTEN QUESTIONS OF SENATOR DEMINT FROM BEN S. BERNANKEQ.1. In the past months, the European Central Bank has spent billions of dollars to purchase sovereign debt from overleveraged EU countries, in essence bailing out these countries by supporting their ability to continue to finance further debt rather than impose needed budgetary discipline. Prior to this program, the ECB, through liquidity facilities, was accepting sovereign debt collateral from European banks. Here at home in the U.S., some States and municipalities have similarly overleveraged themselves and failed to make the difficult decisions necessary to get their finances in order--the clearest example being the States of Illinois and California. Being concerned that the Federal Reserve could choose to pursue a similar course, is it your opinion that the Fed has the authority: a. To accept municipal debt as collateral from commercial or investment banks? b. To create a special lending facility for private-sector purchases of municipal bonds, similar to what the Fed did in 2009 for commercial real estate securitizations? c. To guarantee or directly purchase municipal bonds in the secondary market, similar to the purchase program for the more than $1 trillion of mortgage-backed securities now on the Fed's balance sheet? d. To lend directly to overleveraged States or municipalities?A.1. Answer not received by time of publication.Q.2. If your answer to any of Question Number 1's subparts is yes, please explain, for each and with specific references, from where this authority is derived?A.2. Answer not received by time of publication.Q.3. Would you ever support any of the following courses of action for the Federal Reserve: a. To accept municipal debt as collateral from commercial or investment banks? b. To create a special lending facility for private-sector purchases of municipal bonds, similar to what the Fed did in 2009 for commercial real estate securitizations? c. To guarantee or directly purchase municipal bonds in the secondary market, similar to the purchase program for the more than $1 trillion of mortgage-backed securities now on the Fed's balance sheet? d. To lend directly to overleveraged States or municipalities?A.3. Answer not received by time of publication.Q.4. If your answer to any of Question Number 3's subparts is yes, please explain your rationale for each.A.4. Answer not received by time of publication. ------ CHRG-109hhrg23738--113 Mr. Greenspan," Well, I think there is an issue here which has to do with what type of data and what type of burdens you put on institutions in collecting the data, because it is not a costless operation. Ms. Lee. Sure. " CHRG-111shrg52619--95 Chairman Dodd," It will be included. Senator Menendez. Mr. Chairman, I look forward to asking some questions specifically, but I want to turn first to Chairman Bair. I cannot pass up the opportunity, first to compliment you on a whole host of things you are doing on foreclosure mitigation and what not. I think you were ahead of the curve when others were not and really applaud you for that. But I do have a concern. I have heard from scores of community banks who are saying, you know, we understand the need to rebuild the Federal Deposit Insurance Fund, but I understand when they say to me, look, we are not the ones who drove this situation. We have to compete against entities that are receiving TARP funds. We are not. And in some cases, we are looking at anywhere between 50 and 100 percent of profit. Isn't there--I know that--I understand you are statutorily prohibited from discriminating large versus small, but in this once--and so I understand this is supposedly a one-time assessment. Wouldn't it be appropriate for us to give you the authority to vary this in a way that doesn't have a tremendous effect on the one entity, it seems to me, that is actually out there lending in the marketplace as best as they can? Ms. Bair. Well, a couple of things. We have signaled strongly that if Congress will move with raising our borrowing authority, we feel that that will give us a little more breathing room. Senator Menendez. With what? I am sorry, I didn't hear. Ms. Bair. If Congress raises our borrowing authority--Chairman Dodd and Senator Crapo have introduced a bill to do just that--if that can be done relatively soon, then we think we would have some flexibility to reduce the special assessment. Right now, we have built in a good cushion above what our loss projections would suggest would take us to zero because we think the borrowing authority does need to be raised. It has been at $30 billion since 1991. So we do think that needs to happen. But if it does get raised, we feel we could reduce our cushion a bit. Also, the FDIC Board just approved a phase-out of our TLGP, what we call our TLGP Debt Guarantee Program. We are raising the cost of that program through surcharges which we will put into the Deposit Insurance Fund. This could also reduce the need for the special assessment and so we will be monitoring that very closely. We have also asked for comment about whether we should change the assessment base for the special assessment. Right now, we use domestic deposits. If you used all bank assets, that would shift the burden to some of the larger institutions, because they rely less on deposits than the smaller institutions. So we are gathering comment on that right now. We will probably make a final decision in late May. Increasing the borrowing authority plus we expect to get some significant revenue through this surcharge we have just imposed on our TLGP--most of the larger banks are the beneficiaries of that Debt Guarantee program--we think that will help a lot. Senator Menendez. Well, I look forward, Mr. Chairman, to working with you to try to make this happen, because these community banks are the ones that are actually out there still lending in communities at a time in which we generally don't see much credit available. But this is a huge blow to them and however we can--I will submit my own comments for the regulatory process, but however we can lighten the load, I think will be incredibly important. Mr. Dugan, I want to pursue a couple of things with you. You recently said in a letter to the Congressional Oversight Panel, essentially defending your agency. Included in that letter is a chart of the ten worst, the lenders with the higher subprime and Alternate A foreclosure rates. Now, I see that three of them on this list have been originating entities under your supervision--Wells Fargo, Countrywide, and First Franklin. Can you tell us what your supervision of these entities told you during 2005 to 2007 about their practices? " CHRG-111hhrg48674--164 Mr. Capuano," I thought he already was. Mr. Meeks has suggested some assistance for cities and towns, and I think, a year ago, most people would have thought that the Fed wouldn't be involved with loaning billions of dollars to unregulated investment banks, mutual funds, or getting into credit card debt, auto debt, student debt. I don't think anybody would have really thought you would be doing that now. You found a way to do that. Find a way to help the cities and towns and the States, maybe through insuring their bonds, if you can't actually take the bonds. I understand what the law says, but I also have absolute and total faith in your ability to go around any law that is clear and unequivocal. " CHRG-111hhrg48868--655 Mr. Liddy," I have not read it, so I can't comment on it. Mr. Miller of North Carolina. You said in your testimony, and I agree with this, that when you owe somebody money, you pay that money back. The United States Government and the American people don't owe anyone for the debts of AIG. It is not our debt. Do you agree with that? " Mr. Liddy," I'm not sure I understand, Mr. Miller. AIG owes the government-- Mr. Miller of North Carolina. Right. " Mr. Liddy," --the American people $80 billion-- Mr. Miller of North Carolina. Yes. But what you owe your counterparties, that is not a debt of the United States Government. " FOMC20071211meeting--18 16,MR. DUDLEY.," Well, I guess I would say two things. I think you are absolutely right that the sovereign wealth funds are of significant size and are growing rapidly. But I think that you really have to distinguish between the equity side and the debt side of things. The commitments that you are seeing from the sovereign wealth funds seem to be equity investments, and they are equity investments that have occurred only after share prices fell very sharply. If you look at debt spreads in the United States, debt spreads in Europe, and debt spreads throughout the world, they have widened. So it doesn’t look as though the sovereign wealth fund money is providing much help for that sector. It would be surprising if it were big enough, given the constraints on bank balance sheets globally, that they could come in and fill the gaps. So I think, on the equity side, the sovereign wealth funds are pretty important. They are providing some floor on equity prices, but only after the equity prices of some of these financial firms have gone down very significantly in value." CHRG-111hhrg48868--366 Mr. Liddy," The order in which we would do things is, first, the Federal Reserve debt, and then the TARP dollars. " CHRG-111hhrg49968--54 Mr. Scott," Thank you, Mr. Chairman. The gentleman from Texas just showed a chart that showed how bad things have happened since 2000. What he didn't show is how we got there. This chart shows that when the Clinton administration came into office we made some tough choices and ran up a surplus that was to be surpluses, as far as the eye could see, kind of locked into the budget. In 2001, that is when the budget deficit exploded. The next chart shows the fact that, had nothing happened after 2001, we had a $5.6 trillion 10-year surplus. Because, as the gentleman from Texas has shown, that has gone into additional deficit. In fact, his chart, if you will think back to the chart that he showed, only showed less than a $4 trillion debt held by the public. We had enough continuous surplus to pay off the entire national debt. In fact, it was projected to have been paid off by last year, all of the debt held by the public, if we hadn't messed up the budget. So I think the entire budget process should be shown, not just what happened starting in 2001. We had things under control; we were able to pay off the entire national debt. But the wrong choices were made in 2001, and we went directly into the ditch. One of the first things we have to do, of course, is to get the economy back in order. And I noticed, on page 6 of your testimony, you showed that the stimulus package may only create 1 million to 3.5 million jobs. Is that correct? " CHRG-111hhrg48873--360 Mr. Capuano," Okay. But it is a collateralized debt somehow backed by a toxic asset. " CHRG-111hhrg54872--226 Mr. Calhoun," I will be very quick. I think the bill is right in giving enforcement and supervisory, even for banks, to the CFPA, but to require careful coordination and to especially make sure for community banks that it does not create a regulatory burden. Ms. Bean. Thank you. I yield back. " CHRG-109shrg26643--64 Chairman Bernanke," It depends really on which type of investor is more sensitive to changes in yields. Central banks have actually been less sensitive to changes in yields than private sector investors. So, I cannot say a priori which situation would be one of more concern. I think it is really not so much the portfolio situation; it is the fact that we are accumulating foreign debt over time, year by year. We can do that because foreigners are willing to finance that debt, but I do not think that we can continue to finance the current account deficit at 6 or 7 percent of GDP indefinitely, and it is desirable for us to bring down that ratio over a period of time. Senator Sarbanes. Now it is your view, I take it, that they are doing this because these are attractive investments; is that right? " CHRG-111hhrg56847--42 Mr. Hensarling," I am sorry, since time is limited. Specifically gross debt to GDP of 90 percent where essentially we are at that tipping point now, do you believe that the U.S. is at a tipping point with respect to its debt? " CHRG-111hhrg52261--23 Mr. Robinson," Chairwoman Velazquez, Ranking Member Graves, and members of the committee, thank you for the opportunity to testify. I am J. Douglas Robinson, Chairman and Chief Executive Officer of the Utica National Insurance Group, a group led by two mutual insurers headquartered near Utica, New York. Utica National provides coverages primarily for individual and commercial risks with an emphasis on specialized markets, including public and private schools, religious institutions, small contractors, and printers. My company markets its products through approximately 1,200 independent agents and brokers. Our 2008 direct written premiums were more than $632 million. I am testifying today on behalf of the Property Casualty Insurers Association of America, which represents more than 1,000 U.S. insurers. We commend President Obama and Congress for working to ensure that the financial crisis we experienced last fall is never repeated. Achieving this goal requires a focus on fixing what went wrong with Wall Street without imposing substantial new one-size-fits-all regulatory burdens on Main Street, small businesses, and activities that are not highly leveraged nor systemically risky. My company insures small businesses like bakeries, child care centers, auto service centers, and funeral homes. These Main Street businesses should not bear the burden of an economic crisis they did not create. Home, auto, and commercial insurers did not cause the financial crisis, are not systemically risky and have strong and effective solvency and consumer protection regulation at the State level. We are predominantly a Main Street, not a Wall Street, industry with less concentration and more small business competition than other sectors. Property casualty insurers have not asked for government handouts. Our industry is stable and continues to provide critical services to local economies and communities. However, small insurers are concerned about being subject to administration proposals intended to address risky Wall Street banks and securities firms, but that apply broadly to the entire financial industry. Specifically, we are concerned about the following: The proposed Consumer Financial Protection Agency does not adequately exclude insurance from its scope. An exclusion should be added for credit, title, and mortgage insurance, which are generally provided by and to relatively small businesses. Protection should be added for insurance payment plans which are already well regulated by State insurance departments. The proposed new Office of National Insurance is given too much subpoena and preemption power without adequate due process or limits on its scope and its ability to enter into international insurance agreements. It also needs a definition of ""small insurer"" to prevent excessive reporting requirements. Systemic risk regulation needs to be modified to reduce government backing of large firms at the competitive expense of small financial providers. Leveraged Wall Street behemoths must not be made bigger through government bailouts and consolidation. Government shouldn't forget or harm Main Street in addressing systemic risk regulation. Resolution costs of systemically risky firms should be paid for by firms with the greatest systemic risk. Bank regulators should not be allowed to resolve systemic risk failures by reaching into the assets of small insurance affiliates whose losses would then be charged to other innocent small competitors through State guaranty funds. Finally, congressionally proposed repeal of the McCarran-Ferguson Act would significantly reduce insurance competition, primarily harming smaller insurers that would not otherwise have access to loss data and uniform policy forms necessary to compete effectively, and that would ultimately harm consumers. The cost of new regulations almost always disproportionately affects small business who can least afford the necessary legal and compliance requirements. The property casualty industry is healthy and competitive and the current system of regulating the industry at the State level is working well. Should the Congress fail to address the issues we have identified, the consequences on consumers and the economy could be quite harsh, imposing an especially large burden on small insurers and small businesses. Thank you. " CHRG-111shrg50815--50 Chairman Dodd," I appreciate that very much, Senator. We always appreciate that point. It is a worthwhile one. This is an ongoing issue. I just say regarding young people and unsolicited mail, I have a 3-year-old that got a credit card the other day and they wanted to thank her for her wonderful performance as a consumer. She is a delightful consumer, I want you to know that, but the idea that she warrants a credit card at the age of three is troubling, needless to say. And the idea of having some ability to demonstrate you can pay or some cosponsorship, I think these are basic things that one would require. Let me stop there. Senator Johnson? Senator Johnson. Mr. Plunkett, the new Fed rules prohibit banks from increasing interest rates on credit card debt that a consumer has already accrued, increase the amount of time consumers have to make payments, change how a consumer's balance is computed each billing cycle, ensure that consumer payments go first to balances with the highest interest rates, and crack down on credit cards with low credit limits and APs. What other areas would you like to see improvements regarding consumer protections for credit cards? " CHRG-111hhrg56847--40 Mr. Hensarling," Thank you, Mr. Chairman. Good morning, Chairman Bernanke. As you well know, Chairman Spratt, Ranking Member Ryan and myself serve on the President's Fiscal Responsibility Commission. You testified at our first meeting. At our second meeting, we received testimony from Dr. Carmen Reinhart at the University of Maryland, who presented, I believe, the most exhaustive study of debt crises that I am aware of, covering 44 nations over 200 years. She has come across with the conclusion to her study that when nations have a debt-to-GDP ratio of 90 percent that they will actually lose economic growth. Her study says, I believe the mean was 1 percentage point. So if your economic growth is averaging 3 percent, it would fall by a third to 2 percent. I think her study also showed that in the U.S., that in our Nation's history we actually have received negative economic growth at those points where debt to GDP has reached 90 percent. By a back of the envelope calculation, gross debt in the U.S. to GDP is now 89 percent. I know debt held by the public, I believe, is closer to 60 percent. My question is are you familiar with the professor's study? Are you familiar with her conclusions? Do you agree or disagree? " CHRG-110hhrg46595--465 Mr. Altman," Under the law, you are not permitted to issue new debt and take precedent over existing debts that have been collateralized with assets behind it. So that is protected. General Motors has put forward a plan that they say they have unencumbered assets-- " fcic_final_report_full--54 Before , Fannie Mae generally held the mortgages it purchased, profiting from the difference—or spread—between its cost of funds and the interest paid on these mortgages. The  and  laws gave Ginnie, Fannie, and Freddie another option: securitization. Ginnie was the first to securitize mortgages, in . A lender would assemble a pool of mortgages and issue securities backed by the mortgage pool. Those securities would be sold to investors, with Ginnie guaranteeing timely payment of principal and interest. Ginnie charged a fee to issuers for this guarantee. In , Freddie got into the business of buying mortgages, pooling them, and then selling mortgage-backed securities. Freddie collected fees from lenders for guaran- teeing timely payment of principal and interest. In , after a spike in interest rates caused large losses on Fannie’s portfolio of mortgages, Fannie followed. During the s and s, the conventional mortgage market expanded, the GSEs grew in im- portance, and the market share of the FHA and VA declined. Fannie and Freddie had dual missions, both public and private: support the mort- gage market and maximize returns for shareholders. They did not originate mort- gages; they purchased them—from banks, thrifts, and mortgage companies—and either held them in their portfolios or securitized and guaranteed them. Congress granted both enterprises special privileges, such as exemptions from state and local taxes and a . billion line of credit each from the Treasury. The Federal Reserve provided services such as electronically clearing payments for GSE debt and securi- ties as if they were Treasury bonds. So Fannie and Freddie could borrow at rates al- most as low as the Treasury paid. Federal laws allowed banks, thrifts, and investment funds to invest in GSE securities with relatively favorable capital requirements and without limits. By contrast, laws and regulations strictly limited the amount of loans banks could make to a single borrower and restricted their investments in the debt obligations of other firms. In addition, unlike banks and thrifts, the GSEs were re- quired to hold very little capital to protect against losses: only . to back their guarantees of mortgage-backed securities and . to back the mortgages in their portfolios. This compared to bank and thrift capital requirements of at least  of mortgages assets under capital standards. Such privileges led investors and creditors to believe that the government implicitly guaranteed the GSEs’ mortgage-backed se- curities and debt and that GSE securities were therefore almost as safe as Treasury bills. As a result, investors accepted very low returns on GSE-guaranteed mortgage- backed securities and GSE debt obligations. Mortgages are long-term assets often funded by short-term borrowings. For example, thrifts generally used customer deposits to fund their mortgages. Fannie bought its mortgage portfolio by borrowing short- and medium-term. In , when the Fed increased short-term interest rates to quell inflation, Fannie, like the thrifts, found that its cost of funding rose while income from mortgages did not. By the s, the Department of Housing and Urban Development (HUD) estimated Fannie had a negative net worth of  billion.  Freddie emerged unscathed be- cause unlike Fannie then, its primary business was guaranteeing mortgage-backed securities, not holding mortgages in its portfolio. In guaranteeing mortgage- backed securities, Freddie Mac avoided taking the interest rate risk that hit Fannie’s portfolio. CHRG-111shrg51303--63 Mr. Kohn," I think a major effort in the new terms, first of all, the Treasury put some contingent capital in. They made capital available to help protect the company and stabilize the company, which the company will draw on over time as it needs it. Second, the Federal Reserve restructured its debt to really facilitate this process of breaking apart pieces of the company and taking them public or finding buyers--getting them in a condition that they might be more attractive to outside sources of capital to others who might be interested in buying these pieces of AIG, which would then help to repay the debt and earn a return for the taxpayers. So we did that in part by transferring some of our debt to a preferred interest in two major insurance companies operating outside the U.S., to a trust that owns those. We did that in part by taking security for some of our debt as to the cash-flows on life insurance policies, securitization of life insurance policies, gradually helping the company prepare itself for getting down to its core businesses, selling the other businesses so it could return the cash. Senator Johnson. As Congress considers regulatory modernization, is there a need for Federal insurance regulation? " CHRG-111hhrg49968--17 Mr. Ryan," Thank you, Chairman. Good to see you again, Mr. Chairman. Let's talk about our deficit and debt. The CBO, their re-estimate of the President's budget shows record deficits of 5.4 percent of GDP in 2019 and debt rising to 82.4 percent of GDP. Meanwhile, Medicare and Social Security will have already begun their pathway of permanent deficits. Are you concerned about these levels of deficits and debt? And is this a sustainable and prudent fiscal policy course? " CHRG-111hhrg56847--3 Mr. Ryan," Thank you, Mr. Chairman. And thank you for opening this hearing. I too want to start off by welcoming our newest member, Congressman Charles Djou of Hawaii. We look forward to working with you to tackle our fiscal and economic challenges. And it is exciting to see you and your family here and being sworn into Congress. And we are really looking forward to working with you. Welcome to the Nation's capital. And welcome to you, Chairman Bernanke. It is appropriate you are coming here before our committee today to talk about the state of the economy because the health of the U.S. and global economy is increasingly intertwined with the budget and our fiscal issues that we deal with here in this committee. Over the past few months we have watched as a sovereign debt crisis in Europe has boiled into a real troubling problem. We are seeing that the continent's economic recovery is being threatened and we see even global financial stability in general is being threatened. In some ways, we are seeing a replay of a similar dynamic which impaired global financial markets in 2008. The fear then was the systemic exposure to bad mortgage-related assets, but the fear now is driven by exposure to sovereign credit and the possibility of a debt-induced economic slump. Ominously, interbank lending rates, like LIBOR, are on the rise and credit spreads have widened as investors have become much more risk averse. Volatility is up and the stock market is down. What we are watching in real-time is the rough justice of the marketplace and the severe economic turmoil that can be inflicted on profligate countries mired in debt. At the moment, the U.S. is at the periphery of the European debt crisis and has even reaped some short-term benefits like lower long-term interest rates as a result of the renewed global flight to safety. But Americans are left to wonder. Could we one day find ourselves at the epicenter of such a crisis? Could a European style debt crisis one day happen right here in the United States? The answer is undoubtedly yes. And the sad truth is that inaction by policymakers to change our fiscal course is hastening this day of reckoning. A brief look at the budget numbers shows that our current fiscal situation and its trajectory going forward is very dire. The budget deficit this year stands at $1.5 trillion, or just over 10 percent of GDP. Under the President's budget, the budget we are living under right now, the CBO tells us that the level of U.S. debt will triple by the end of the decade, meaning that in just a few short years, the U.S. is poised to join that group of troubled countries whose public debt absorbs a large and growing share of their economic output. A fiscal crisis in the U.S. is no longer an economic hypothetical but a clear and present risk to our economy, to society's most vulnerable citizens, and America's standing in the world. As the example of Greece has shown, market forces and investor sentiment do not offer countries the luxury of time and delayed promises to get their fiscal house in order. Empty rhetoric is no substitute for results. Foreigners now own roughly half of the U.S. publicly held debt and their willingness to fund our borrowing at record low interest rates will not continue forever. The size of our current and future funding needs makes us quite vulnerable to a shift in market sentiment and higher than expected interest rates. The reemergence of the bond vigilantes and exposure to the rough justice of the marketplace would certainly make our bad fiscal situation even worse. The main point here is the need for policymakers to reassure credit markets that the U.S. is engaged in charting a clear course back to sustainable deficit and debt levels soon. It is clear to me that this means reining in government spending, not simply ramping up taxes. In particular, we need to reform our entitlement programs, which threaten to grow themselves right into extinction, collapse our safety net, overwhelm the entire Federal budget and sink the economy in the process. The budding sovereign debt problems in other parts of the world provide us with a great cautionary tale that it is always best to take action to shore up budget deficits before market forces demand it. So what has this Congress and administration done to respond? Two new entitlement programs and no budget. The majority's failure to even offer a budget and its commitment to continue spending money we don't have, creating brand new entitlements and plunging our Nation deeper into debt tells me, and tells the bond markets more importantly, that Washington still doesn't recognize the severity of our fiscal and economic challenges. I look forward to your testimony today, Chairman Bernanke, and remain hopeful that policymakers will heed your warnings and chart a sustainable course to avert the next crisis. Thank you. " CHRG-111hhrg49968--177 Mr. Bernanke," The Fed is involved very unwillingly because there is no good system for addressing the failure of a major financial institution. Ms. Kaptur. How much more of our rising debt is being provided by foreign creditors now as our debt rises? Can you provide that for the record? " CHRG-110hhrg46591--341 Mr. Garrett," I thank the chairman and I thank you all here for your testimony. One of the things, obviously, that has led to the macro issue, the credit problem issue they are currently experiencing as indicated earlier, is the problems in the mortgage sector. I thought I would take a moment to discuss an alternative to our current mortgage securitization process, and I think one of your members mentioned it before, just very briefly, and that is covered bonds. Covered bonds, as you know, have been used effectively in Europe for centuries and recently were introduced in the United States. Basically, they are debt instruments created from high-quality assets and they are held--and this important--on the bank's balance sheet and secured by a pool, and that is why it is called a covered pool of mortgages. And so in contrast to mortgage securitization where loans are made and then sold off to investors, a covered bond is a debt instrument issued by the lending institutions to the investors. And this debt is then backed or covered by that pool of typically high-rated AAA mortgages, and they then act as the collateral for the investor in the case of a bank failure. This structure keeps the mortgages on a lending institution's balance sheet. And that also provides for greater accountability, if you will, as to the high underwriting standards. And they have the potential to aid and return liquidity to the mortgage marketplace we are in today through improved underwriting and accountability. I will just say as an aside, I dropped in a bill, H.R. 6659, the Equal Treatment of Covered Bonds Act of 2008, and this legislation will clear up some of the ambiguities in the current law and codify several existing parameters of the market. It enshrines in the investment tool the law that will provide greater certainty, stability, and permanency for covered bonds. In addition, the spreads would be narrower, which will encourage more institutions to enter into the covered bond marketplace. And it is a goal to provide an environment through its legislation in which the market would be able to flourish, as it used to be, and produce increased liquidity. So legislation covered bonds provide for a greater sense of legal security than ones through regulations. And so, Mr. Ryan, I will throw that out to you. I know SIFMA announced at the end of July, in the summer, that it was creating a U.S. covered bonds traders committee, possible investors that would support the growth of covered bonds market in the United States and play an active role in fostering and strengthening this market. I know that there have been a lot of other things going on as far as other proposals and recommendations that you have been talking on. But I would ask you, first of all, how is the committee going, what do you see for the future? And then I have another couple of questions. " CHRG-111shrg55117--112 Mr. Bernanke," That is true. Senator Bayh. ----the circumstances that they face today. So in some senses, we are trying to accomplish a humanitarian thing here, which is right, and make systemic reform, but reconcile that with the budget situation that we face and the need to not add burdens to the economy at a time when, as you pointed out in your testimony, it is burdened enough. I just want to conclude by thanking you. I really appreciate your emphasis on the importance of fiscal policy. Your comments today reflected your op-ed piece in the Wall Street Journal. The hardest decision in this town over the next couple of years is going to be how do you go about altering the very accommodative policies that we are now pursuing, both monetarily and fiscally. It is going to take the wisdom of Solomon. I wish you the best with that, but I think we have got a good man in a position to do that. " CHRG-111hhrg56776--104 Mr. Royce," I concur on the points you have made on that publicly. Getting back to the question of the extent that we are dependent upon the carry trade to finance our debt, do you think there is an element of truth to that point? " FOMC20081216meeting--442 440,MR. LACKER.," When I think about leverage and the demand for a given security, if I, as an investor, am going to make a leveraged purchase, then whoever is giving me a loan to make that is also taking a risk position in the security. So the demand that leveraged investors make is really a joint demand by them and the lenders. Everything you have said sounds as if demand is low. Am I missing something here? " CHRG-111hhrg56766--65 Mr. Neugebauer," I also heard you say you are now going back internally and looking within your organization as to what are the things we missed, what should we have been looking at, and moving forward. I think one of the questions--I hear almost all of your former colleagues keep using the word ``capital,'' and I truly believe if you want to regulate the financial entities, capital is the primary way to do that. Looking forward, what is going to be the appropriate leverage level that we should allow our large financial institutions to have so they will have a shock absorber moving forward? Some of these entities were leveraged, 30, 40, big numbers. As the Federal Reserve Chairman, primary regulator for many of these entities, what is the appropriate leverage? " FinancialCrisisInquiry--296 BLANKFEIN: You know, I don’t have—the way we did leverage, the way we looked at leverage under our regulatory regime, it was the notion of adjusted leverage, which was—which didn’t rate every asset the same way. So for example, right now we sit here with a balance sheet of about $880 billion. But about $170 billion of that is cash, but it’s on our balance sheet. So we assign a very low risk to that. And the regulation assigned a low risk. So we had notions of our metric was an adjusted test. The Federal Reserve for bank holding companies has a growth leverage test, which I—which, again, I don’t want to misspeak, but I don’t—I’m not—we never really focused on, and even at this moment, I don’t think is as important as the risk-adjusted leverage test. It is how—what is the— how much capital do you have to have against cash? FOMC20070509meeting--3 1,MR. DUDLEY.,"1 Thank you, Mr. Chairman. I’ll be referring to the handout with the blue on the front. The market turbulence that began in earnest on February 27 is now a distant memory. Risk appetites have recovered, volatility in the fixed income and equity markets has declined, and the U.S. equity market has climbed to a new high. Exhibits 1, 2, and 3 show the correlation matrices for the daily price and yield movements in the fixed income, equity, and currency markets. The blue-shaded boxes indicate correlations with an absolute value greater than 0.5. As shown in exhibit 1, until February 27, the correlations across most of these asset pairs were low. However, beginning on February 27 through mid to late March, correlations rose sharply as risk-reduction efforts dominated financial markets. This shift can be seen in exhibit 2, where all but one of the boxes are shaded blue. Since the March FOMC meeting, calm has returned, with asset-price movements again becoming mostly uncorrelated. The matrix shown in exhibit 3, which shows the correlations since the March FOMC meeting, looks similar to exhibit 1. As I mentioned in my briefing at the March meeting, although the turmoil in the markets was related mostly to risk-reduction efforts, in certain areas—the subprime mortgage market is the best example—the deterioration in performance was related mostly to fundamental developments. As can be seen in exhibits 4 and 5, which plot delinquencies and losses for the notorious 2006 subprime vintage, the deterioration in performance has continued apace. Exhibit 4 shows that delinquencies of more than sixty days for the 2006 vintage are even higher than those for the 2001 vintage. This is noteworthy because in 2001 the U.S. economy experienced a mild recession and payroll employment was declining. Even more noteworthy is the trend of losses for the 2006 vintage. As shown in exhibit 5, losses for the 2006 vintage are running at about triple the rate of the 2001 vintage. This poor loss experience appears due both to deterioration in underwriting standards and to less-favorable underlying conditions—for example, the softening trend of home prices in many local markets. The fundamental deterioration in the subprime mortgage sector can also be seen in other measures of performance. For example, exhibit 6 illustrates the behavior of BBB-rated spreads for the ABX, CDS, and cash markets. The ABX represents an index of twenty credit default swaps on twenty BBB-rated asset-backed securities, and the BBB cash index represents the yield spread on the BBB-rated tranches of the asset-backed securities. Thus, the ABX index references, via the credit default swap market, the underlying asset-backed securities market. As can be seen in this exhibit, although all three spreads have recovered somewhat over the past few weeks, spreads 1 Material used by Mr. Dudley is appended to this transcript (appendix 1). remain much wider than earlier in the year. Also, note that ABX spreads remain considerably wider than the CDS and cash spreads that they reference. This situation underscores the illiquidity of the ABX market and may partially reflect the lack of a natural constituency of investors who might wish to take the long side of this index, especially when the subprime market is under stress. The problems in subprime mortgages have spilled over into the collateralized debt obligation (CDO) market. As you may recall, many CDOs have a substantial proportion of their assets in lower- rated subprime asset-backed security tranches. After widening sharply in late February, the yield spreads on mezzanine structured-finance CDOs have shown no recovery. In fact, as shown in exhibit 7, the spreads on these CDOs have continued to widen. At the last FOMC meeting, I argued that the selloff in the equity market that began in late February had at least one fundamental component—the reduction in earnings expectations for 2007. Yet the equity market has recovered quite strongly. I think that this can be explained by three factors. First, earnings in the first quarter were stronger than expected. The Board staff estimates that first-quarter earnings for the S&P 500 will have increased about 9 percent on a year-over-year basis. Second, perhaps as a result, earnings expectations have stabilized. As shown in exhibit 8, the median bottom-up equity analyst forecast for S&P 500 earnings growth in 2007 has stopped falling and remains above 6 percent. Third, buyout and buyback activity continues unabated. Exhibit 9 shows the flow of funds data on net equity issuance. As can be seen, the outstanding supply of U.S. equities is shrinking rapidly, in contrast to the increase in net supply that occurred over the 2000-04 period. Buyouts and buybacks may also be a factor explaining the recent behavior of corporate credit spreads. As shown in exhibit 10, high-yield and emerging-market debt spreads have mostly recovered since the late February widening. However, investment-grade debt spreads remain wider than in early 2007. Investment-grade debt performance may be lagging because investors fear that the credit quality of this debt will be undermined as buyouts and buybacks result in increased leverage. Turning now to the currency markets, an emerging story is the weakness of the U.S. dollar. As shown in exhibit 11, the dollar has fallen about 3 percent against the euro since the start of the year and is virtually flat against the yen over this period. The weakness against the euro appears to reflect mostly changing interest rate expectations. Exhibit 12 plots the spread between the June 2008 Eurodollar contract and the euribor contract. As can be seen in this exhibit, the expected interest rate differential has fallen about 40 basis points this year. As this has occurred, the euro has strengthened. To date, the dollar’s weakness has not been of much concern to market participants. The decline has been gradual, and investors perceive that global imbalances are unwinding smoothly. Nevertheless, the subprime debacle points to another source of risk for the dollar. In recent years, the net acquisition of dollar- denominated financial assets by foreign investors has shifted to private flows from public flows and to corporate bonds, including asset-backed securities and CDO obligations, from Treasury and agency debt. This shift is shown in exhibit 13. My worry here is that the problems in the subprime and alt-A mortgage market could ultimately affect foreign investors’ appetites for U.S. asset-backed securities and CDOs. For example, a particularly poor performance of lower-rated ABS and CDO tranches, coupled with the widespread corporate rating downgrades that might be associated with such poor performance, could cause foreign investors to lose confidence in investing in dollar-denominated debt. In terms of U.S. interest rate expectations, investors expect no near-term change in policy. However, market participants continue to expect significant easing late this year and in 2008. Interest rate expectations for the remainder of 2007 are back where they were at the time of the January FOMC meeting. Looking at the federal funds rate futures market in exhibit 14, we can see that only about one 25 basis point rate cut is expected in 2007. In contrast, expectations for 2008 more closely resemble expectations at the time of the December and March FOMC meetings, not the January meeting. As can be seen in exhibit 15, which plots Eurodollar futures contract yields, investors expect substantial monetary policy easing in 2008. Why this delayed pattern of easing? There are three potential explanations. First, as I have noted before, futures market yields reflect the mean, not the modal, forecast. To the extent that investors perceive a moderate risk of significant economic weakness that could lead to pronounced monetary policy easing, then the yields in the futures market could be well below the modal forecasts of investors. Second, some investors may disagree with the FOMC about the outlook. In this case, they might anticipate that it will take time for the FOMC to come around to their way of thinking—leading to rate cuts that occur only later. Third, some investors may anticipate that inflation will moderate. As this happens, the FOMC might gradually reduce its nominal federal funds rate target following lower inflation—essentially keeping the real federal funds rate constant. Finally, the survey of the primary dealers shows little change in interest rate expectations since the last FOMC meeting. Exhibits 16 and 17 compare dealer expectations with market expectations before the March FOMC meeting and before this meeting. The horizontal bold lines represent market expectations. The blue circles represent the different dealer forecasts, and the size of a circle represents how many dealers have that forecast. The green circles represent the average dealer forecast for each period. The average of the primary dealer forecasts is consistent with only slightly more than 25 basis points of easing through the end of this year— not much different from what is priced into the federal funds futures market. As can be seen, the dispersion of the dealer forecasts over the next few quarters has narrowed a bit. However, considerable disagreement remains about whether short-term rates will be higher or lower a year ahead. Also, the average of the dealer forecasts for 2008 remains considerably above market expectations. This presumably reflects mainly the “downside risks” notion, which should cause the modal forecasts of dealers to be higher than the mean expectations represented by futures prices. I’ll be happy to take any questions. I will need approval for domestic operations; there were no foreign operations. Also, I circulated a memo asking you to vote to approve renewal of the swap lines to Canada and Mexico." FOMC20070509meeting--84 82,MR. WARSH.," Thank you, Mr. Chairman. My own views on the economy haven’t changed much since we last met and aren’t terribly at odds with the Greenbook. I’d highlight a couple of reasons for concern, a couple of areas in which the misses could be severe. I share the views expressed by many around the table, most recently by Governor Kohn, on the inflation front. I remain quite concerned about inflation prospects, and I’m keeping a wary eye on inflation expectations, particularly if there were to be acceleration in the trends on commodity prices or the foreign exchange value of the dollar. My sense is that the markets haven’t fully taken into account what that could be, and we could find the markets more preoccupied with an inflation scare than they appear to be at this moment. So I think that, during the balance of ’07, the inflation risks tend to be more significant than the growth risks, and I would expect to see sequential increases in GDP, as in the Greenbook, as we go through the next several quarters. The big point of what that is predicated on is really the continued accommodation in the credit markets and the capital markets, as several people have noted. I was thinking about my projections and, as we look to ’08 and ’09, the bigger risks there tend to be more policy oriented as we head into the next election, and they may well have some effect on the capital markets. So as I think about the second half of ’08 and the first half of ’09 and what the likely GDP implications would be, I can’t help but think that changes or perceived changes in tax policy and trade policy could be the biggest drivers to the capital markets and, as a result, have the biggest effects on the macroeconomy. So there are huge risks, as I look beyond ’07, in terms of where GDP might come out; but as a central case, the Greenbook formulation looks roughly in accord with my own. Let me spend a moment on consumption. My view is broadly consistent with what others have said earlier today. I spoke in the past week with one credit card company whose customer base is similar to the average aggregate customer base in the United States. They have about one-fifth of all credit card spending, and they reported to me their April results, which might provide us with some clues about PCE growth and credit quality. Card spending for April, from their perspective, was consistent with moderate deceleration in real consumption. They ended up in April with nominal year-over-year growth of about 4 percent in non-auto retail sales, which is a slowdown from the fourth quarter of ’06 and a slowdown from January, but it is up a bit from February and March, when they were getting quite despondent and were worrying a bit about their projections for the next three quarters. They think their April numbers look okay, quite consistent with the moderate deceleration that many folks here have talked about. They believe that they have hit the floor on that, but time will tell. What they have not been able to do, at least up to the time of my discussions with them, is to break out retail purchases outside fuel to find out whether less strength is there than the 4 percent top-line number would suggest. I suspect that would be the case. How all this fits into market expectations we’ll know over the next couple of days. This strikes me as an average, okay number that may be a touch better than market expectations, but it shouldn’t give us a whole lot of comfort if we’re trying to suggest that there is a robust recovery on consumption and PCE. Credit quality remains very strong across consumer credit and the company’s mortgage products. I would note that they don’t have much subprime in their portfolio—what is subprime has fallen to that level rather than having begun there when they issued the credit. Payment rates, use of credit lines, delinquencies, charge- offs—all are at very positive levels with little indication of more-serious weakening of consumer demand. So, again, I think the prospects outlined by the Greenbook in terms of PCE look broadly consistent with the April numbers. Let me turn now to the capital markets and the credit markets and speak about three or four observations that may be a bit more newsworthy than when we last met six weeks ago. First, I will talk a little about the dearth of defaults in corporate loans, then spend a couple of moments on private equity, building on Bill Dudley’s discussion at the outset on the correlation among asset classes, and finally spend a moment on the shakeout in the mortgage markets. The predicate for this is something that we all know, and several people have spoken about earlier today. As corporate America has become more cautious, Wall Street has become more aggressive to satisfy investors’ appetites for risk. So we’re seeing risk aversion in one category on Main Street and real risk-seeking behavior on Wall Street. Financial risk-taking remains high and may well have even increased since we last met. If you’ll look at the MOVE options index measuring one-month volatility on Treasuries, it’s the lowest it has been in about nine years, since the index came into being, and it suggests President Minehan’s point that all the forces of liquidity and froth that might be in the market are probably more present today than any of us could have imagined given the tumult in the markets in late February. At the same time, nonfinancial corporate risk-taking continues to be more subdued than objective measures would suggest it should be. There is reason to hope that the cap-ex data will come around to where many of us expected it to be already, but some determination still needs to be done on that. So we hear, and some of us even say, that these capital markets appear priced to perfection, that credit markets are as strong as ever, and that liquidity is plentiful. I would add my concern to the implausibility of that notion, which President Geithner and others spoke about. The reason for central bankers to worry is, of course, that these narrower spreads provide less of a shock absorber for unforeseen events. Let me now go through the points that I mentioned at the outset and describe their implications for the decisions we make. First is the dearth of defaults on corporate loans. Historically low year-ahead default rates were referenced in the Greenbook, and they should give us comfort, at least in theory. I share the Greenbook view that corporate defaults should increase as profits level out and leverage increases to more normal levels. But fewer defaults are even possible in this financing environment, and that makes me a little less sanguine about those data. If we think about covenant packages on corporate loans, both originated on Wall Street and originated at community banks—I think President Yellen spoke at a previous meeting about covenant-lite deals—it is incredibly hard to get defaults in the context of these loans, never mind event-of-default notices and everything else that would find its way into the indentures. As a result, we have seen a recent spate of financings with covenant packages that are increasingly issuer-friendly, without triggers that would otherwise cause defaults: no debt payment schedules, never mind even the need to make interest payments, with the ability to turn those into sort of pay-in-kind notes. All of that, it strikes me, should make us nervous if business fundamentals shift abruptly and investors are left with little opportunity to gain access to their capital or to be in a position to force companies to restructure their operations. As a result I am less sanguine about these low default data that we continue to receive from Wall Street. A second point is the state of private equity in the capital markets. What I note builds on the recent history that we’ve seen: massive fund-raisings; larger LBOs; increasing leverage; in the past twelve months, we’ve seen the so-called club deal phenomenon; the growth of equity bridges, which I and others have talked about; and when we last met, we discussed the interest many of these firms have for rushing into the capital markets by finding permanent capital. The newest development is the growth of syndication in the equity placement in these LBO markets. The same way that we have syndicated debt markets that have matured incredibly over the past six to ten years, on the equity side there are huge investments that are presently being considered and potentially being made. So one LBO sponsor might fund a certain portion of the equity check on an LBO and then line up, through an equity syndicate manager at a traditional investment bank or a commercial bank, the ability to sell down the rest of that equity through an infrastructure and distribution system that is being built. I doubt that we will see that syndication market five years from now as deep and as large as the debt markets. But I do think that it shows us that new liquidity continues to come even to the private placement 144(a) markets alongside the growth in the public capital markets. That liquidity could well improve tradability. To the extent that these syndications are new, they show us that liquidity is plentiful; but they also show us that many of these new mechanisms have not been stress-tested. The other implication of this boom in private equity is that it has raised the floor on equity prices. My sense is that there is a private equity put that may well have replaced what used to be thought of as a Federal Reserve put on the floor of equity prices, and that equity put appears to be larger than it has ever been. Thus we have seen increased total leverage through these structured products; credit markets, as I’ve mentioned, are more robust; and there is a question of stress testing, which is still to be determined. Another point on the capital markets relates to what Bill said about the correlation among asset classes. CEOs, CFOs, and chief risk officers of large financial firms have found quite troubling the greater correlation among asset classes than most of their internal models had suggested. As they looked at their dashboards in the weeks after the tumult that we saw last February, they grew increasingly uncomfortable about whether they had accurately measured what their firms’ downside risks are. Certainly it’s encouraging, as Bill showed us, that there appears to be less correlation over recent weeks. That’s a lesson being learned and relearned and tested and retested in these institutions. That they may be heeding the wakeup call is good news, but time will tell whether it will be enough to catch up before problems arise in the market. My final point concerns the consequences of a shakeout in the mortgage markets. My sense is that, after the fallout in subprime, the market is becoming more consolidated with larger, more-sophisticated lenders that can more quickly provide more markets that satisfy customers’ newest wants. The success in these markets of investment banks and hedge funds will go to those with scale, with strong distribution systems, and with control over their servicing businesses, so that they are effectively able to engineer workouts and avoid the need to foreclose. I think that over the balance of this year we will hear more news from small and medium-sized commercial banks that feel as though their market share is being taken away during this tumult, and that is something that we need to continue to observe. With that, Mr. Chairman, I’ll save the rest of my comments for the next round." CHRG-111hhrg52406--43 Mr. Pollock," Thank you, Mr. Chairman, Ranking Member Bachus, and members of the committee. I have both experienced and studied many cycles of financial bubbles and busts, including the political reactions which inevitably follow, and this forms my perspective on today's questions. I think we can all agree that the Consumer Financial Protection Agency, as proposed, would be a highly intrusive, large, very expensive bureaucracy with broad, rather undefined and potentially arbitrary powers, which would impose large costs on consumer financial services while, as Mr. Yingling just said, also imposing requirements which would be highly likely to conflict with those of other regulatory agencies. We differ on whether we like this idea or not. When it comes to so-called plain vanilla products for all providers and intermediaries, a vast jurisdiction apparently unrelated to any charter in definitions, the proposed agency would be able to dictate part of the business across this wide jurisdiction. This strikes me as an amazing assertion. A more sensible proposal would be to define certain financial products as plain vanilla and require disclosure that this is or is not a plain vanilla financial product suitable for an unsophisticated customer. This idea, which strikes me as reasonable, would not require a new agency. For financial institutions, the CFPA would be an additional parallel regulatory system, representing a major burden, a potentially punitive approach and significant, undefinable regulatory risk. This is quite at odds with the intense desire of the United States Government to attract additional capital into the banking system. Discussions that I have read about the formation of this agency make me think a lot of those that preceded the Sarbanes-Oxley Act. I see Mr. Oxley smiling down at me up there. That was the first major regulatory overreaction of the 21st Century, and the Sarbanes-Oxley Act has proved highly successful at generating costs and bureaucracy while apparently having no influence at impeding the build-up of risk, as we see from the result. It created and still creates disproportionate burdens on small and venture businesses, and I believe we would see a similar pattern for the CFPA. Professor Warren and Mr. Yingling both mentioned the special role of community financial institutions, and I think in any kind of body of this kind, should it be created, it would be reasonable to exempt community financial institutions. The Administration's proposal, in my view, emphasizes one extremely good idea--ensuring clear, simple, straightforward, informative disclosures. In congressional testimony in the spring of 2007, while sitting at this table, I proposed a one-page mortgage form so borrowers could easily focus on what they really need to know. It remains my opinion that something like that would be a huge improvement in the way the American mortgage system works. By far the most important reason for good disclosures is for borrowers to be able to decide for themselves whether they can afford the debt service commitments they are making. In my view, that is much more important than choosing among products. The key is: Can you afford the commitments you are making? In the ideal case, the borrowers would be able to complete the one-page form on their own. In this context, it seems remarkable to me that the idea of building personal responsibility on the part of consumers seems to be missing from the Administration's proposal, which seems to me to be a major failure. The Administration's White Paper gets to Fannie Mae and Freddie Mac, and it seems to lose courage. As everybody knows, Fannie and Freddie made a huge contribution to inflating the mortgage bubble. They plunged into low-quality mortgage credit, and pushed the top of the market much higher, and the bust subsequently became much worse, of course, including their own insolvency. Without addressing Fannie and Freddie, we cannot address the mortgage market. The new agency is proposed to have sole authority to evaluate institutions under CRA and to ``promote'' community development investment. As others have said, I believe this is a truly bad idea. Whenever credit risk and investment risk are involved, it is necessary to balance community investment and safety and soundness. Thus, in my view, it is imperative for these to be combined in one regulatory agency. To have credit risk and investment risk being promoted by people with no responsibility for safety and soundness would be an obvious mistake. Others have suggested that the idea of centralizing consumer protection is still a good idea. I think it probably is, along with these disclosure responsibilities. We can make use of a logical existing organization. My vote would be to use the Fed and to just drop the notion of the CFPA. As a final thought, I would like to repeat that any proposals which substantially increase the regulatory burden and undefinable regulatory risk must be considered in the light of the government's intense need to attract very large amounts of additional private equity capital into the banking system. Thanks very much for the chance to share these views. [The prepared statement of Mr. Pollock can be found on page 174 of the appendix.] " CHRG-110hhrg46595--515 Mr. Sherman," Thank you, Mr. Chairman. I think these hearings show that we ought to pass a bill. Our best chance to pass a bill is to write one that has tough standards to protect consumer warranties, to make sure that the U.S. Government is involved in deciding which plants get closed and which stay open, and to deal with executive compensation and perks and deal with a number of the other issues that have come up. Clearly, everybody has to give something. Now, the shareholders are going to give. We are going to dilute them if we get sufficient warrants. And if time permits, I want to ask the witnesses about how many warrants that ought to be. The executives--I think I join several of my colleagues in torturing them, and that is just a taste of what we would like to put in the bill. The unions have made substantial concessions, and have indicated they are going to make more. But we have been talking here about the creditors, and not just making the loans senior, our debt senior to theirs, but to actually write down the liability. Right now, people are buying GM debt for 15 cents on the dollar; and if everything goes swimmingly--should they get a dollar on the dollar if things go swimmingly, only because the taxpayers ride to the rescue--Professor Altman, do you see a way not only to make the taxpayers' debt senior but to actually provide for a reduction in the amount that GM, for example, has to pay on its unsecured debt. " CHRG-111hhrg49968--3 Mr. Ryan," Thank you, Chairman Spratt, for arranging this important hearing. Chairman Bernanke, you come before this committee with the financial markets in a better position than in your previous appearance last fall. The economy is finally showing some signs of stabilizing, and that is encouraging. But despite these short-term glimmers of hope, I have become more concerned about the longer-term implications of our economic policies. On the fiscal side, the Treasury is issuing record amounts of debt, over $2 trillion this year alone, to support record government spending and record deficits. Meanwhile, the Federal Reserve has injected an enormous amount of monetary stimulus into the economy and has even started purchasing longer-term Treasury bonds in an attempt to lower borrowing costs and further ease financial conditions. This can be a dangerous policy mix. The Treasury is issuing debt, and the Central Bank is buying it. It gives the alarming impression that the U.S. one day might begin to meet its financial obligations by simply printing money. And we all know what happens to a country that chooses to monetize its debt. It gets runaway inflation and a gradual erosion of workers' paychecks and family savings. There is an increased discussion in the financial press about the potential negative consequences of our economic policies. Just this week, the yield on the 10-year Treasury bond rose to a 6-month high, over 3 percent--3.7 percent--a sign that global investors are becoming concerned about debt levels and the possibility of future inflation. This is the bond market telling us that there is no free lunch. When you issue record amounts of debt in your central bank, as the monetary policy levers at full throttle, red flags begin to get raised and our borrowing costs go up. There are some faint warning bells going off. The value of the dollar has slipped recently. The price of gold is back up to nearly $1,000 a troy ounce. And inflation compensation spreads in the Treasury bond market have risen to a 9-month high. Now, I realize that some of these signs in the financial markets are likely reassuring to the Fed, since the predominant risk over the short term has been deflation, and that this could be signs of a recovery. But I am generally concerned that the Fed will be unable to unwind its considerable monetary policy stimulus in a timely manner to prevent a sharp rise in inflation over the medium term. There are a number of technical challenges associated with shrinking your balance sheet and returning to a more normal monetary policy stance. But I am more concerned about the political challenges the Fed will face when you finally have to make this call. I imagine there will be substantial political pressure on the Fed to delay tightening its monetary policy while the unemployment rate is still rising, for instance. But the Fed's political independence is critical--it is critical and essential for safeguarding its commitment to price stability, which is the chief policy concern of every central bank. This clear commitment is all the more important at a time when the fine line between monetary policy and fiscal policy seems a bit blurry. Despite the recent signs of stabilization in the economy, we policymakers should recognize that our most challenging period is going to be ahead of us as we try to right the ship and get back on the path of sustainable growth and job creation. That will clearly take a renewed sense of fiscal discipline to rein in spending and budget deficits, but it will also take a clear exit strategy on the part of the Fed and a firm commitment to price stability. We, in Congress, are committed to working with the administration to accomplish the former, and we trust the Fed will work diligently to ensure the latter. Thank you, Chairman. " 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. " CHRG-111hhrg56847--228 Chairman Spratt," Ms. DeLauro. Ms. DeLauro. Thank you very much, Mr. Chairman. Dr. Bernanke, welcome. Thank you. As expressed here and in other forums, the concern about the adverse effect of a growing deficit and debt in the coming years and its long-term effect on our economy, I worry that there is a great deal of confusion about what the concerns imply about policy choices now and over the next few years. For instance, the concerns about the economic deficits and debt led some House Members to demand that the fiscal relief for the States in the form of a temporary extension of the increase in the Federal matching rate for Medicaid be dropped from the jobs bill the House passed before the recent break. You commented in your testimony about the shortfall in State budgets. Additional layoffs--and you mentioned something a little earlier on this--additional layoffs, and there appear to be substantial layoffs coming, particularly in education and that will follow with health care workers, probably with police and fire. And States are required to balance these budgets. What that means in terms of those layoffs if we do not extend additional FMAP funding for States, will that be a drag on the economy and slow recovery? I know you shy away from, as you should, talking about specific programs, but we are at an economic crisis at the moment here. We have to connect dots between Federal Government and State government with what is happening. What is your sense of this policy with regard to assistance with States at this juncture? At this juncture, not forever. At this juncture. " CHRG-110shrg50418--123 Mr. Nardelli," Because we will generate profit and we will have to return that. Just as we will pay our debt down from our investors, we would pay it back to---- Senator Shelby. What if you don't, though? " CHRG-111shrg56376--25 Mr. Tarullo," Senator, I certainly agree with the utility of the resolution mechanism, but when you ask about market discipline, I think there is more that we need to do. The resolution mechanism comes at the end of the day. It comes at the time of failure. It would be better to create additional incentives that preclude the failure. We surely need more transparency and disclosure by financial institutions, particularly the largest. And as I have indicated a couple of times in prepared testimony, I think we also need to be looking at alternative requirements for the capital structure of at least large institutions. There are a number of ideas out there that would require certain kinds of convertible debt to be in the capital structure of a company. That is good because there is market discipline as long as it is a debt instrument. The debt holders want to be paid. And they know if the financial institution gets into trouble, that that debt will be converted into equity. It will provide a buffer against loss and they will be subject to loss. So I think that market discipline has a number of different avenues that we should pursue, and market discipline itself should be pursued alongside of some other regulatory mechanisms. Senator, if I could, you know I was not at the Federal Reserve up until a few months ago, and as I have said repeatedly, I really do believe here is plenty of blame to go around everywhere. But I don't honestly think that all roads lead to the Fed on this. I mean, Bear Stearns---- Senator Shelby. Well, which don't lead to them? [Laughter.] " 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-111hhrg53242--47 Mr. Baker," There is broad utilization of credit default swaps in the investment world, and our members do engage in utilization of those products. Ms. Waters. Did any of these CDS contracts insure consumer debt packaged as collateralized debt obligations, CDOs? " CHRG-110shrg50420--461 Mr. Nardelli," It is all secured---- Senator Corker. Yes---- " Mr. Nardelli," ----and so it is much different than an unsecured. But this is the Committee that sets the rules, so if you have got the power to consolidate an industry, you have got the power to work on, I guess, secured debt. Senator Corker. OK. So your debt is all unsecured---- " CHRG-111shrg61513--29 Mr. Bernanke," I don't--they issue bills and other kinds of debt all the time. Senator Bunning. Oh, yes, Treasury notes, Treasury bills, Treasury 2-years, 5-years, 10-years. But you are buying--you buying their debt. " CHRG-111hhrg61852--101 Mr. Meltzer," Consumers are uncertain about what the future outlook for jobs is going to be. So as long as they are uncertain about the future outlook for jobs, they are not going to spend for durables, for houses, in the rates at which we have become accustomed. Now, as a country, we have a major problem, many problems, but one is that we owe the foreigners--the Japanese and the Chinese--billions and trillions of dollars' worth of debt. To service that debt, we have to export. That is the only way we are going to be able to service that debt. So we have to become a big exporter. And that means we have to invest more. So I believe that what we are seeing is a gradual transition in that direction toward more investment, and less growth and consumption. That is going to be a hard adjustment for Americans who have gotten used to very rapid growth of consumption, and it is going to be hard as the devil on the rest of the world, which has gotten used to the idea they can make their economies grow by selling consumer goods to us. But that is an adjustment that has to be made. So I would like to see much more emphasis on getting investment up, because that is where our future has to be. Mrs. McCarthy of New York. The gentleman's time has expired. Mr. Green from Texas. " CHRG-110shrg50420--335 Mr. Wagoner," Well, I--what I can tell you, Senator, is at the time that we made the decision not to proceed, we did not have the capital, cash--we were concerned we didn't have the cash to make it until the deal could be closed and the financial institutions could not assure us that they could provide that funding. Senator Corker. OK. Let me get into your plan just briefly, and again, thank you for your patience. I looked at your plan and I would agree with others that I think your plan was fairly thoughtful. I told your COO that yesterday. And I think it is a nice first step, OK. And you can tell that the senses have been heightened a little bit over the last couple weeks and it is obvious that you guys have put a lot of thought into survival. There are a couple of things. Your debt loads are unsustainable at any level of sales, OK. I know we had 17 million sales recently. We are on about a ten million sale run now. Next year, you are projecting about 11 million. But at the debt levels you have and the liabilities you have, it doesn't matter if you were at 20 million. You can't survive, OK. So that has to change. The makeup of your capital structure has to change. So I noticed yesterday in your plan that you had about $28 billion in unsecured debt. We checked yesterday and your unsecured debt is selling for 19 to 21 cents, the bonds. And so basically you had given about a 50-cent haircut to bond holders that we understand will be glad to be taken out at 30 cents on the dollar. So again, a not very aggressive step as it relates to what could happen, if you will, by March 31. The problem is the UAW is there and bond holders are not willing to take a haircut unless he takes what I would call a real haircut. Now, there has been a lot of lauding about the changes the UAW has made. To be candid, in this proposal, not so much, OK, and so let me sort of move into that. You have got VEBA liabilities of about $21 billion, Voluntary Employment Benefit Association payments. If you go into bankruptcy, those are toast. They are gone. And I think the UAW knows that. Most of the people that are looking at your structure say that VEBA, at least half of it has got to be equitized. In other words, instead of taking money, they have got to take equity, OK, and those are the kind of things that it seems to me that we would want to put in the legislation if we did anything other than Chapter 11 debt financing. And so I guess I would ask, it starts with Mr. Gettelfinger, because the bond holders are not going to take a haircut of 30 cents on the dollar unless he is willing to change his capital structure, and I would just like for him in front of all of us right now to give us a little sense of how heightened his senses are as it relates to this company surviving. " CHRG-111hhrg74090--69 Mr. Rush," The Chair thanks the gentleman, the chairman of the FTC, and the Chair now recognizes himself for 5 minutes for the purposes of questioning the witnesses. With the continuation of the financial crisis, we see more and more scam artists preying on desperate consumers seeking to reduce their debts and to keep their homes out of foreclosure or from selling their homes at a loss, and I am concerned about this proposal in that this new agency would not do enough in the short term because we all know that it takes some time for a new agency to rev up, to get going and get running. Another option that the Administration might have considered is proposing that the FTC take on this essential role. By increasing its staff and authority, it is conceivable that FTC could be taking on these issues within weeks or months rather than years. Mr. Barr, did the Administration consider other options other than creating a new agency? " CHRG-110hhrg46596--245 Mr. Hinojosa," But you should know that this sector is huge; there was over $16 billion that was lent out in college loans. And to have banks not offering credit, not offering these student loans not only for the cars and for appliances and for many things that you have heard from my colleagues before me, these student loan programs are not working right now. And you need to know and have people report back to you on how it is not fixing the problem. I would like to ask Comptroller General Dodaro, the TALF program's aim was to increase credit availability for credit cards, auto loans, and student loans, as I mentioned. However, private lenders of the non-Federal student loans already enjoy Federal protections that auto and credit lenders do not, making it nearly impossible for student borrowers to discharge private student loans in bankruptcy. How will TALF program take into consideration these differences in the treatment of consumer debt? " FinancialCrisisInquiry--753 ROSEN: The loss number is going to be somewhere between $500 and $700 billion out of $3.5 trillion debt component. FOMC20070807meeting--28 26,MR. DUDLEY.," I guess I would characterize the situation as people having lost faith in the structured-finance product, especially the high-grade AA/AAA product that they thought was safe and therefore not subject to much market risk or liquidity risk. They found out otherwise, and so there is a total reevaluation of that market. As a consequence, since the vehicle that was used to turn non-investment-grade corporate debt and into investment-grade debt is sort of broken, now they have to sell a lot of non-investment-grade debt directly and find people who are willing to hold it. So I think about the situation as that demand has lessened at a time when supply, just by bad luck and timing, is exploding. The market should clear, because the fundamentals in the corporate sector are good as opposed to bad, but at a much higher price." fcic_final_report_full--326 On the next day, March , Treasury and White House officials received additional information about Fannie’s condition. The White House economist Jason Thomas sent Steel an email enclosing an alarming analysis: it claimed that in reporting its  financial results, Fannie was masking its insolvency through fraudulent ac- counting practices. The analysis, which resembled one offered in a March  Barron’s article, stated: Any realistic assessment of Fannie Mae’s capital position would show the company is currently insolvent. Accounting fraud has resulted in several asset categories (non-agency securities, deferred tax assets, low- income partnership investment) being overstated, while the guarantee obligation liability is understated. These accounting shenanigans add up to tens of billions of exaggerated net worth. Yet, the impact of a tsunami of mortgage defaults has yet to run through Fannie’s income statement and further annihilate its capital. Such grim results are a logical consequence of Fannie’s dual mandate to serve the housing market while maximizing shareholder returns. In try- ing to do both, Fannie has done neither well. With shareholder capital depleted, a government seizure of the company is inevitable.  Given the turmoil of the Bear Stearns crisis, Paulson said he wanted to increase confidence in the mortgage market by having Fannie and Freddie raise capital. Steel told him that Treasury, OFHEO, and the Fed were preparing plans to relax the GSEs’ capital surcharges in exchange for assurances that the companies would raise capital. On March , , Steel also reported to his Treasury colleagues that William Dudley, then executive vice president of the New York Fed, wanted to “harden” the implicit government guarantee of Freddie and Fannie. Steel wrote that Dudley “leaned on me hard” to make the guarantee explicit in conjunction with dialing back the surcharge and attempting to raise new capital, and Steel worried about how this might affect the federal government’s balance sheet: “I do not like that and it has not been part of my conversation with anyone else. I view that as a very significant move, way above my pay grade to double the size of the U.S. debt in one fell swoop.”  “THE IDEA STRIKES ME AS PERVERSE ” Regulators at OFHEO and the Treasury huddled with GSE executives to discuss low- ering capital requirements if the GSEs would raise more capital. “The entire mort- gage market was at risk,” Lockhart told the FCIC.  The pushing and tugging continued. Paulson told the FCIC that personal commitments from Mudd and Fred- die Mac CEO Richard Syron to raise capital cinched the deal.  Just days earlier, on March , Syron had announced in a quarterly call to investors that his company would not raise new capital. Fannie and Freddie executives prepared a draft press re- lease before a discussion with Lockhart and Steel. It announced a reduction in the capital surcharge from  to . Lockhart was not pleased; the draft lacked a com- mitment to raise additional capital, stating instead that the GSEs planned to raise it “over time as needed.”  It looked as if the GSEs were making the deal with their fin- gers crossed. In an email to Steel and the CEOs of both entities, Lockhart wrote: “The idea strikes me as perverse, and I assume it would seem perverse to the markets that a regulator would agree to allow a regulatee to increase its very high mortgage credit risk leverage (not to mention increasing interest rate risk) without any new capital.” The initial negotiations had the GSEs raising  of capital for each  of reduction in the surplus. Lockhart wrote in frustration, “We seem to have gone from  to  right through  to  to now  to .”  CHRG-111hhrg53021Oth--66 Secretary Geithner," Well, yes Congressman, of course, I agree that it is going to be all in the substance and the details of this. And we do carry the burden of presenting before you detailed proposals in legislative form so that you can consider those recommendations. And we are going to deliver on that commitment. " CHRG-111hhrg53021--66 Secretary Geithner," Well, yes Congressman, of course, I agree that it is going to be all in the substance and the details of this. And we do carry the burden of presenting before you detailed proposals in legislative form so that you can consider those recommendations. And we are going to deliver on that commitment. " CHRG-110hhrg34673--117 Mr. Hensarling," If Congress ignored any entitlement spending reforms and chose no other offsets within the Federal budget, using 2030 as our guideline--it is kind of a good placeholder for the next generation--have you looked at models on what type of tax burden would be necessary to be placed on our people to balance the budget, say, in 2030? " CHRG-111hhrg53245--185 Mr. Royce," I will ask one quick last question and that is on subordinated debt, we have talked before, Mr. Zandi, about how we might have avoided this in the past, but what do you think of Mr. Wallison's concept of structuring that subordinated debt, if I could ask you? I do not know if you had a chance to see his paper on that? " CHRG-111hhrg54868--122 Mr. Cleaver," So we need to do something, you would agree. Who would independently move? We have 3 banks controlling 75 percent of the credit card debt in this country. There is something wrong with that. Do you agree? More than 75 percent of the credit card debt held by 3 companies? " CHRG-111hhrg56766--10 The Chairman," I thank the gentleman from North Carolina. The gentleman from North Carolina will have 2 minutes and 10 seconds. The gentleman from Texas is now recognized, the ranking member of the Subcommittee on Domestic and International Monetary Policy, for 3 minutes. Dr. Paul. Thank you, Mr. Chairman. Welcome, Chairman Bernanke. I am interested in the suggestion that Mr. Volcker has made recently about curtailing some of the investment banking risk they are taking. In many ways, I think he brings up a very important subject and touches on it, but I think it is much bigger than what he has addressed. Back when we repealed Glass-Steagall, I voted against this, even though as a free market person, I endorse the concept that banks ought to be allowed to do commercial and investment banking. The real culprit, of course, is the insurance, the guarantee behind this, and the system of money that we have. In a free market, of course, the insurance would not be guaranteed by the taxpayers or by the Federal Reserve creating more money. The FDIC is an encouragement of moral hazard as well. I think the Congress contributes to this by pushing loans on individuals who do not qualify, and I think the Congress has some responsibility there, too. I also think there has been a moral hazard caused by the tradition of a line of credit to Fannie Mae and Freddie Mac and this expectation of artificially low interest rates helped form the housing bubble, but also the concept still persists, even though it has been talked about, that it is too-big-to-fail. It exists and nobody is going to walk away. There is always this guarantee that the government will be there along with the Federal Reserve, the Treasury, and the taxpayers to bail out anybody that looks like it is going to shake it up. It does not matter that the bad debt and the burden is dumped on the American taxpayer and on the value of the dollar, but it is still there. ``Too-big-to-fail'' creates a tremendous moral hazard. Of course, the real moral hazard over the many decades has been the deception put into the markets by the Federal Reserve creating artificially low interest rates, pretending there has been savings, pretending there is actually capital out there, and this is what causes the financial bubbles, and this is the moral hazard because people believe something that is not true, and it leads to the problems we have today because it is unsustainable. It works for a while, but eventually, we have to pay the price. The moral hazard catches up with us and then we see the disintegration of the system that we have artificially created. We are in a situation coming up soon, even though we have been already in a financial crisis, we are going to see this get much worse and we are going to have to address this subject of the monetary system and whether we want to have a system that does not guarantee that we will always bail out all the banks and dump these bad debts on the people, and that it is filled with moral hazard, the whole system is. When that time comes, I hope we come to our senses and decide that the free market works pretty well. It gets rid of these problems much sooner and much smoother than when it becomes politicized that some firms get bailed out and others get punished. It is an endless battle. Hopefully, we will see the light and do a better job in the future. " CHRG-111shrg53085--122 Chairman Dodd," Gamblers lay off debts. " CHRG-110shrg50414--161 Mr. Bernanke," This is one of the reasons, you know, in response to Senator Bennett, you know, if we narrow--if we keep the range of participants too narrow, only failing institutions, for example, then we will not have a robust, competitive auction. The more participants we have, the more people who are involved in offering these assets, we will have a competition. And auctions are good at producing, you know, relevant prices, even if individuals have an incentive to underprice. Senator Menendez. Well, let me ask you this: I have heard you both make statements today and in the past that would lead one to believe that, at the end of the day, there is minimal risk to the taxpayers here. And, in fact, I have heard you say that there are some who argue that, in fact, we could make money. Can you both look at me in the eye and tell me that, as we increase the debt limit of the United States by $700 billion, which basically means about $2,333 for every man, woman, and child in this country, that this will not cost the taxpayers anything if we pursue what you want us to do? " CHRG-109hhrg23738--57 Mr. Greenspan," I would think that will be the case, yes. Let me just say parenthetically: I do not expect that the personal savings rate will stay down this low indefinitely. Part of it is related to the fact that there is a very significant amount of extraction of equity from homes in this country financed by mortgage debt. Since the debt which is employed in doing that is a subtraction from savings, you will find that that is a major factor creating the low level of savings; and when equity extraction slows down, as eventually it will at some point, I think you will find this personal savings rate starting back up. " CHRG-109hhrg28024--6 Mrs. Maloney," Thank you, thank you. Thank you, Mr. Chairman and welcome. We on this committee are particularly honored that your first appearance before Congress is before this particular committee, and I might add that the President's choice to fill the shoes of Chairman Greenspan has been greeted with consistent bipartisan applause, and this is a true testament to your reputation as an economist, scholar, and independent thinker. First of all, I'd like to be associated with the comments of our ranking member, Frank. We are deeply concerned about the growing gap between the haves and have-nots. That is a very troubling trend for our country and I am particularly concerned that the American worker, after inflation in the past 2 years, has taken less home in their paychecks. Again, a very troubling trend. In your job on the President's Council of Economic Advisors, you were thoroughly immersed in issues of employment, jobs, wages, debts, and deficits, and I hope and expect that those issues will continue to influence your decisions now that you are on the monetary policy side. In my opinion, this Administration has made your new job much more difficult through its reckless spending and lack of fiscal discipline. On Friday, we learned that once again, this Administration has set a new record; only it's the wrong kind of record, a record for debts now over eight trillion dollars in deficits. The trade deficit for 2005 was the highest ever for the fourth year in a row, at over $700 billion. The trade deficit for this year is 18 percent higher than the year before, even though the Administration has been saying all year that it plans to do something to address this imbalance, which our allies have repeatedly said and warned us is unsustainable. Fully one-third of that debt is our trade deficit with China, which is exploding, and I don't think it's any secret that if China and Japan were to slow its purchases of U.S. debt, the Fed would be forced to tighten monetary policy beyond what the domestic market would be comfortable with. In fact, the widely discussed concern that Asian banks will slow their investment in U.S. debt because they seek diversification is now a reality. We are now actually seeing that happen. According to the Fed, in the last several, months Asian foreign central banks have shifted their purchases from Treasury debt to Government-sponsored entities and mortgage-backed bonds to such an extent that this new type of debt is now about a third of the U.S. debt held by foreign central banks. Chairman Greenspan strongly believed that our current account deficit is caused by the fact that America is saving too little and that our huge Federal budget deficit is Exhibit No. 1. Recently, the Administration has switched to saying that the real problem is that China is saving too much. I don't think that Americans particularly care about this sort of blame game, but are more concerned about the actual impact of our huge Federal budget deficit and our record trade deficit on monetary policy. American workers have not yet seen the benefits of this economic recovery. They haven't seen it in their paychecks. An international financial crisis could lead to more inflation and higher interest rates that could choke off the recovery before American workers have a chance to share in it. I hope that you will address these concerns today. We wish you well in your new position and congratulate you on your appointment. " CHRG-111hhrg56776--284 Mr. Kashyap," Well, I pointed a member of your staff earlier today towards one working paper I know that has been written on this, but I think there is still active discussion over what the trigger should be. I understood your question to Chairman Bernanke to be asking whether or not should there be a regulatory trigger that would convert the debt. Was the Fed to be the regulator to pull the trigger? I don't think that's the way he answered it, but that's what I thought you were asking. I know that the rating agencies have said that if that trigger is enacted, they may not be willing to rate the debt. So there has been some discussion about what other triggers could be used with convertible debt that would still preserve the features that would add to the loss bearing capacity of the debt, but maybe not prevent rating agencies from being able to assess the risk. So that's one area. But generally, I think, there's a holding pattern until some of the regulatory bodies, namely the Financial Stability Board in Basel, come out with their assessments, which I understand to be coming soon. " CHRG-111hhrg50289--60 Mr. Coffman," Thank you, Madam Chairman. Mr. McGannon and Ms. Blankenship, I get complaints from my local bankers and from my small businesses, but particularly from my local bankers who say that, on one hand, the federal government wants them to lend and, on the other hand, I think just the regulatory scheme is such that it is kind of the zero defects, that you know, they had a 20 percent increase, I think, in their capital reserve requirements, if I am using the proper term, ten to 12 percent, and that has caused them to pull back on their lending. I mean, have we gone too far on the regulatory side where we are not allowing bankers to exercise their own judgment in terms of the ability of the borrower to repay the loan? Could you address that issue? Ms. Blankenship, we will start with you. Ms. Blankenship. Certainly. Again, we cannot be painted with the same brush, and you know, yes, has the regulatory gone too far right now? Yes, it has because you find banks are hesitant to lend because of the increasing costs that I talked about. The FDIC, we are additionally being asked to put more money in loan loss reserve. So that takes the money out of loans, money available that could be leveraged back into loans. So all of those are challenges right now. To make this program more effective, we have to continue, as I said, to look at the initiatives and what is working and get back to less paperwork and involving more banks in this program. Additionally, you know, if we could get some Subchapter S reform, you would find that a lot of small businesses could raise their own capital. Right now they are restricted to one type of stock. If they could be allowed to issue preferred stock and increase their shareholders. So I think there are many ways that we could approach this, but again, to really answer your question, the regulatory environment, until we can get some equity there and know that the way you supervise a too big to fail bank is not the way you supervise a small business bank, which is what we are. " CHRG-110hhrg46595--327 Mr. Wagoner," We are going to have to give them things like extended warranties that are transferrable so they don't have a burden of trying out the new technology. And I think beyond that we have a very long waiting list for the Volt right now, so we have a lot of people who want to buy it. " CHRG-111hhrg55811--156 Mr. Gensler," I think that the regulator should have oversight with regard to it, but that on a first order, the clearinghouses should determine under their risk management guidelines which contracts are clearable. Also, we would not want the burden to go the other way, that we force something into a clearinghouse that they can't properly risk manage. " CHRG-110hhrg46593--292 Mr. Feldstein," Thank you, Mr. Chairman, fellow classmate. I am very worried about the U.S. economy. I think this financial crisis and the economic downturn are mutually reinforcing and that, without further action from the Congress, this recession is likely to be longer and more damaging than any that we have seen since the 1930's. The fundamental cause was the underpricing of risk and the creation of excess leverage. But the primary condition that now threatens the economy is the expectation that house prices will continue to decline, leading to more defaults and foreclosures. And those foreclosures put more houses on the market, driving house prices down further. This potential downward spiral reflects the fact that in the United States, unlike every other country in the world, home mortgages are no-recourse loans. If someone stops paying his mortgage, the creditor can take the home but cannot take other assets or look to the individual's income to make up any unpaid balance. This no-recourse feature gives individuals whose mortgages exceed the value of their homes an incentive to default and to rent until house prices stop falling. Because the number of defaults is now rising rapidly and expected to go on increasing, financial institutions cannot value mortgage-backed securities with any confidence. That is what stops interbank lending and lending by financial institutions that cannot judge the value of their own capital. The actions, I think, of the Federal Reserve and the FDIC have done a lot to prevent a runoff of funds from the banks and from the money market mutual funds and to maintain the commercial paper market. In contrast, I believe that the TARP, itself, has not done anything to resolve the basic problem of the financial sector. The Treasury's original plan to buy impaired loans as a way of cleaning the bank's balance sheet simply couldn't work. Even $700 billion is not enough to deal with more than $2 trillion of negative-equity mortgages. The plan to buy impaired assets by reverse auction couldn't work because of the enormous diversity of those securities. And even if the Treasury had succeeded in removing all of the toxic assets from the banks' portfolios, that would have done nothing to stop the flow of new impaired mortgages and the fear of more such toxic assets in the future. It was good that the Treasury abandoned this asset purchase plan. Injecting capital into selected banks is also not a way to resolve the problem and get lending going again. A bank like Citigroup has a balance sheet of $2 trillion. Injecting $25 billion of government capital does not provide a significant amount of loanable funds, nor does it give anyone confidence that Citi would have enough capital to cover any potential losses on its mortgage-backed assets. Although it does raise Citi's Tier 1 capital, that was not a binding constraint. So it was good that the Treasury abandoned the equity-infusion plan, as well. Last week, Secretary Paulson announced that he will now concentrate on propping up credit for student loans, auto loans, and credit cards. He didn't say how that would be done. But doing so will not stop the lack of confidence caused by the expected continuing meltdown of mortgage-backed securities that is driven by the process of defaults and foreclosures. In light of this poor record, the Treasury's announcement yesterday that it will not seek any of the remaining $350 billion of the original $700 billion TARP funding seems to me to be quite appropriate. What needs to be done? Stopping the financial crisis and getting credit flowing again requires ending the spiral of mortgage foreclosures and the expectation of very deep further house price declines. To do that, I think, requires two separate new programs, one for homeowners with positive equity and another for homeowners with negative equity. Here, briefly, is a possible way of dealing with each of these two groups. Consider first the problem of stopping homeowners who have positive equity from falling into negative equity as house prices decline to the pre-bubble level. Earlier this year, I suggested that the government offer all homeowners the opportunity to substitute a loan with a very attractive low interest rate but with full recourse for 20 percent of the homeowner's existing mortgage. This mortgage-replacement loan from the government would establish a firewall so that house prices would have to fall more than 20 percent before someone who now has positive equity would decline into negative equity. The key to preventing further defaults in foreclosures among the current negative-equity homeowners is to shift those mortgages into loans with full recourse, allowing the creditor to take other assets or a fraction of wages if the homeowner defaults, as banks and other creditors do in Canada, in Britain, and, indeed, in every other country in the world. But the offer of a low-interest-rate loan is not enough to induce a homeowner with a substantial negative equity to forego the opportunity to default and, thus, escape his existing debt. Substituting a full-recourse loan requires the inducement of a substantial write-down in the outstanding loan balance. Creditors now do have an incentive to accept some write-down in exchange for the much greater security of a full-recourse loan. The government could bridge the gap between the maximum write-down that the creditor would accept and the minimum write-down that the homeowner requires to give up his current right to walk away from his debt. And I described this plan in some more detail in an op-ed piece in today's Wall Street Journal that is attached to the written testimony. If these two programs are enacted, the financial sector would be stable, and credit would again begin to flow. But while that is a necessary condition for getting the overall economy expanding again, I am afraid it is not sufficient. To achieve economic recovery, the Nation also needs a program of government spending for at least the next 2 years to offset the very large decline in consumer spending and in business investment. To be successful, it must be big, quick, and targeted at increasing production and employment. I am, as you know, a fiscal conservative. I generally oppose increased government spending and increased fiscal deficit. But I am afraid that is now the only way to increase overall national spending and to reverse the country's economic downturn. If these two things are done--that is, stopping the incentive to default on home mortgages and increasing government spending--I will be much more optimistic about the ability of the economy to begin expanding before the end of next year. Thank you, Mr. Chairman. [The prepared statement of Dr. Feldstein can be found on page 173 of the appendix.] " CHRG-111hhrg58044--388 Mr. Pratt," Not really, because it is similar to asking us whether a creditor effectively uses a credit report for a lending decision. You have to have the creditor here in order to answer that question because they are the one that is going to be able to explain how they use the data, whether they include medical debts or do not include medical debts. I think that is very important. " CHRG-111shrg53822--74 Mr. Wallison," I will take that first, I think. My view is--first of all, I do not--in my prepared testimony and in my oral testimony, I said that I thought that banks were the only organizations that really required serious regulation for a variety of reasons. They can create systemic risk, but I do not think others can. On the question of this capital, what we do about banks that are growing and yet they still have the same amount of capital, which increases their leverage, I am one who does believe that we ought to increase capital requirements as growth occurs. As profitability and growth occurs, capital should go up so that it can perform the function that it was supposed to perform, which is as a buffer for the bad times. I think we are seeing today that the 10 percent risk-based capital requirement that was imposed in the United States under Basel I and Basel II, for well capitalized, was insufficient. Banks should have had more capital. But in addition, they should have added to their capital positions as a percentage, as they have grown larger and larger, and as they have more and more profits. That is something that we could very profitably do. And as a matter of fact, it would also go some distance to addressing this question of institutions getting too large and complex, because if additional capital requirements are imposed on them as they get larger and more complex, they will not get larger and more complex. They will make a judgment about what they have to do to be profitable rather than just getting larger. Senator Akaka. Mr. Baily? " CHRG-110shrg38109--87 Chairman Bernanke," Not necessarily. It can be a good method of enforcing discipline on corporations and management. By taking the firms private, they essentially create a situation where the private equity investors have a short period of time in which to create a more productive, more effective, and more profitable firm. They then usually try to bring the firm back into the public markets, so it is not in some sense an attempt to permanently escape Sarbanes-Oxley, because they do eventually want to come back into the public markets. So, generally, it is a policy development in that it creates more competition for corporate control and should increase discipline among management. There may be some circumstances where the leverages are excessive or that there are other problems associated with it. Senator Allard. When I was taking economics in college, I think full employment was considered 5 percent. Is there a figure like that that most people generally agree is a full employment figure? Or are there other variables you have to bring in, you cannot use a static number like that? " CHRG-111hhrg56766--29 The Chairman," I appreciate that. I think we are aided by the fact that inflation is not now or in the near term seeming to be a problem. The last point I would make if you could comment, we hear this threat that the rating agencies might reduce our debt rating because of the deficit. Do you think there is any realistic prospect of America defaulting on its debt in the foreseeable future? " CHRG-111hhrg56847--44 Mr. Hensarling," In your testimony, you speak about the European leaders, I think in your written testimony. Quote-unquote, European leaders have put in place a number of strong measures, countries under stress have committed to address their fiscal problems. I think it was yesterday, perhaps the day before, the new Prime Minister of the U.K. said the state of Britain's finances were, quote, even worse than we thought and warned of, quote, painful and unavoidable cuts. Germany's Chancellor Merkel was quoted as saying Germany faces, quote, serious difficult times. They announced a rather sizeable group of spending cuts to deal with their spending crisis, which she said were necessary for the future of our country. When I look at Germany's deficit-to-GDP ratio, the U.K.'s deficit-to-GDP ratio, it seems to be comparable to our own. When I look at their debt-to-GDP ratio, of Germany and the U.K., again it appears to be comparable to our own in dealing with gross debt. I am just curious, do you appear to be complimenting the European leaders for taking strong stands, yet do you see similar strong stands being taken by this particular Congress to rein in the debt? " CHRG-111hhrg54872--295 Mr. Yingling," Congressman, I just want to say I agree with you completely. I think that our industry--I will speak on behalf of the ABA--made a big mistake. We didn't look at this hard enough, we didn't look at it more globally. We looked at it previously on what does it mean for our regulatory burden on banks. And not to justify but to explain it, it is because we have such a heavy burden that we get paranoid about it, sometimes for good reason, but we should have been more aggressive in looking at this bad lending and looking at the trends and seeing what was happening in communities. And we should have worked with you at the State level; we should have worked with the Fed earlier on to say, look, something is wrong here and it is going to blow us up. One of the lessons for the future is we can't just look at what is going on in our narrow interest, but we have to look at what is going on in the economy and in neighborhoods like yours. So your criticism is justified. Going forward, we need to sit down and figure out how to make this work so we do have more focus on consumer protection, so we don't have the bubbles and bad actors that eventually gobble up all of us. And you have our pledge we are going to work with you to help solve this. We do have concerns about how it is done, but we need to make sure we have protections in place. " CHRG-111hhrg54869--46 Mr. Volcker," I agree with the thrust of what you are saying. That is the burden of my testimony here this morning is that we do need such a resolution authority, for the reasons you described. Some of the approaches that the Administration has surrounded that with, I don't agree with. But the basic idea that you need that kind of authority is, I think, central. " FOMC20070807meeting--100 98,MR. WARSH.," Thank you, Mr. Chairman. As many of us have discussed around this table and many of you already mentioned today, it has finally happened. Per earlier discussions, the much-anticipated repricing of risk is upon us, and I think what we all have quickly recognized, then and now, is that the diagnosis was the easy part. More difficult is to figure when the symptoms would manifest themselves; harder still is to understand the second- and third-order consequences; and perhaps most difficult is to determine whether any treatment is needed or whether, as the Hippocratic oath suggests, the patient will recover on its own. Even orderly repricings have fat tails, as Governor Kohn mentioned, and what we find in the marketplace is complacency replaced very quickly by deep concern. Certainly, this recent market turmoil looks particularly pronounced in contrast to previous periods when trees appeared to grow to the sky and markets were priced for perfection in a world that seemed to most of us to be decidedly imperfect. Let me discuss two distinct matters—first, the state of the financial markets, building on the presentation from Bill, Tim, and others, and then the harder part, the impact on the broader economy—before trying to summarize the situation. The financial markets have really provided wind at the back of the broader economy throughout this most recent period, even until a month ago. I think the open question, and the hardest, is whether those financial markets will prove sufficiently resilient—that is, whether the underlying shocks to the economy that might occur are exacerbated by this financial market situation or whether the worst of the outcomes are made less severe by the financial markets. Perhaps it is best to review the dynamics of different asset markets to assess their implications for credit availability during the forecast period. The threat is that these different asset classes increasingly look correlated, particularly in times of distress. Certainly, the events of recent weeks culminating in trading late Thursday and Friday of last week are troubling, driven by a combination of factors: first, symbolized perhaps by one financial institution that has unwittingly called its own liquidity into some question; second, a function of a reduction in confidence in markets themselves—a pullback in liquidity—with considerably less trust in underlying valuations, underlying collateral, and the underlying structure of markets themselves; and third, an expectation, at least in the mortgage markets, that there is still another leg down and so one way bets, at least for a period, appear insufficient to bring other opportunistic capital in at this point. The pullback was manifested in the difficulty of rolling over extendable commercial paper, as Bill and others have said, a lack of bid for anything mortgage related, a lack of trust in credit ratings, and a fear of using financial institutions as counterparties. The next period in my judgment holds out some promise, but not a guarantee, of opportunistic capital. Certainly, there are big fund raisings by investment banks and other private pools of capital at remarkable leverage levels, giving the potential that the pools of liquidity that are on the sidelines could quickly find their way back into the game. Let me now turn to different asset markets to try to assess when we will know how they will figure themselves out and make sure that we are able to get some judgments before it is too late. So I will spend a moment on the bank and leveraged-loan markets, a couple of moments on the subprime market, and another moment on a third bucket of assets, which might be everything else, as we are trying to figure out whether there is real spreading. First, in the bank and leveraged-loan market, the volume of loans, as many of you know, is somewhere between $220 billion and $320 billion of committed capital in the pipeline. The underlying credits still appear quite strong, and I will tell you that I have a reasonably high degree of confidence that, in spite of the distress, these markets should work themselves out between now and the next FOMC meeting. We certainly won’t see any return to the markets that people have gotten used to over the past several months and years, but I would be surprised if we didn’t see opportunistic capital coming into these markets and bidding prices. Just to give you some idea, off that denominator of capital committed, we might see losses on the order of $30 billion or $50 billion. I would say that’s a fairly conservative estimate. Bank debt, which is the most secured, might have discounts of 3 to 5 percent, should bids find their way into the market in the coming days; leveraged loans and high yields, discounts of about 10 percent; and second lien mortgages, discounts of 15 to 20 percent. Almost all of these are largely related to risk premiums, not credit quality. Real money is still in these businesses. Some of the hot money that was discussed earlier, some of these CLO buyers, are no doubt gone for some time. I think the most encouraging thing is the new funds that have begun capital-raising campaigns, even over the past weekend, looking to buy the distressed securities, market-force the commercial institutions that have been having it on their books, and mark it to market. Remarkably, many of the same commercial banks are prepared to stand behind these new leveraged investments with leverage of about 4 to 1. So I would expect that market to increase pretty quickly. Market functioning there is thus, in my judgment, likely to improve. Some deals are certainly likely to blow up, relieving some of these banks of their commitments. But in this market, because there are multiple gatekeepers and because valuing the underlying credit strikes me as not that time-intensive or taxing a process, it is likely in my judgment that, come fall, we will come to some new equilibrium. I can be far less confident, however, about the subprime mortgage market. My base case assessment there has a much lower confidence level, both in terms of timing and in terms of outcome. The subprime market has about $1.4 trillion in outstandings, and there is considerably less certainty about the underlying credit. It is harder to measure and appraise the underlying pools. Recovery rates will be still harder to find. As a final note, which might have struck the markets last week, apparently more fraud is endemic to these pools, making valuation increasingly difficult. As a result, I am less comfortable about suggesting what the underlying losses might be. They might be $100 billion. They could be considerably more. I’m also less confident that there will be opportunistic capital coming back to these markets over the next thirty or sixty days. With another leg down, it could take considerably longer. As a result, I am quite a bit less confident that the market functioning will return as rapidly as we would hope. I am more concerned that, unlike the multiple gatekeepers we find in the leveraged-loan markets, for those that relied on the single gatekeepers, the credit-rating agencies, given that their credibility has been shot, it is much harder to see that this market will unwind itself in a rather calm and comforting environment, at least over the balance of 2007. The final set of asset markets I’d speak a moment about is “everything else.” What about everything else that is subject to structured products? What about everything else that is subject to complex financial instruments? Some questions arose late last week about the market integrity regarding those. I think it is just too hard to judge how that is going to work out. We are seeing losses showing up in some very unlikely places. I’d like to say that what we have witnessed over the past week is transitory, but for that set of asset markets, it is probably hardest for me to come to a broader judgment. So what are the effects, then, on the broader economy? I agree with the point that President Stern made earlier that this judgment is extremely hard to make. I also agree with Governor Kohn’s judgment that there is a very real downside risk if some of these financial market turmoil issues persist. If I look at some of the credit channels and at financial intermediaries and ask whether they are under stress, I see more dispersion of risk among similarly situated institutions. Some commercial banks may well be under more distress than others. I have no doubt that some investment banks are under more distress than others. We see some of this dispersion in credit default swaps and some of it in equity prices, but my sense is that the underlying fundamentals of their core businesses are very different from each other and from their competitors than they’ve been at any point in this cycle. For some of them to take losses on their own balance sheets of $3 billion, $4 billion, or $5 billion, as an investment bank, might not be hard to do when many of them have been picking up market share and using their own proprietary trading and agency businesses to steal customers and revenue from others. But for the balance, I think it is unclear how it is going to result. With many of the investment banks’ quarters ending in August, the markets are going to put genuine pressure on them to come clean with their losses. I expect most, if not all, of them to do so. So I think come mid- September we’ll have a clearer sense of what their own marked-to-market models suggest. What about the broker-dealers? Again, not principally their regulators but I suspect the markets are going to push them to come clean with what their losses are. Large financial institutions I would expect, though with less confidence, to take writedowns of their portfolios of leveraged loans and writedowns to some extent of their mortgage products to try to assure the investing community of their financial positions. I hope that the process would work out this fall, but as I mentioned, I’m less comfortable that we’re going to get that kind of transparency with the regulated commercial banks than with some others. Private pools of capital are also undergoing a real shakeout. For those with liquidity pressures, which will tend not to be the largest hedge funds or private equity funds, we will read about their problems, and we will read about their closings, over the coming weeks and months. The good news is that the largest among them have used the period of strong liquidity over the past year to more or less have quasi-permanent capital to term out their loans and provide capital so that they could take advantage in this period. I understand that there has been very little spike in margin calls where most of the assets rest in the hedge fund community. So for many of us who have talked about hedge funds bringing resilience to these markets, this is really a time of testing. I think the early news for the largest among them is quite positive. Many of you have talked about what the other transmission mechanisms are for having GDP effects. The wealth effect is real. We have lost about $1 trillion in market capital in the past twenty trading days, and that can’t be discounted. Questions about board room confidence and cap-ex in the second half of this year are equally real. My sense is that we are going to finally use that excess cash on balance sheets that many of us have long talked about. Finally, with respect to consumer confidence, though I think the recent data suggest that it’s positive, I suspect that the next set of data we get will show a retreat from those numbers. It is very hard to judge how real consumers are going to react here. Let me make two final comments. Opportunistic capital is a key here to a smooth transition. It’s key to ensuring that what happened in the financial markets doesn’t seep its way into the real economy. Of the equity investors that were using loose credit markets to get equity returns, the most sophisticated are focusing on and looking for equity returns in the debt markets. So many investors previously investing in equity are now looking to the debt markets, where they see a risk-reward tradeoff that is better than it has been in a long time. That gives me some confidence that opportunistic capital will come back to some of these markets. That said, rating- sensitive buyers will no doubt pull back given that ratings are less authoritative. So I will end where I began, which is looking at economic fundamentals. I think Governor Kohn talked about how the capital markets, the financial markets, and the labor markets have proven to be absolutely core to the resilience of the broader economy. To the extent that there is now an unfortunate timing between weakness in the financial markets and some potential weakness in underlying credit, we can rely less on the financial markets to come to the rescue, should that circumstance occur. Thank you, Mr. Chairman." CHRG-111hhrg56776--146 Mr. Garrett," We're paying it, but do you think it is sovereign debt? " CHRG-111shrg56262--13 Mr. Davidson," Good afternoon, Chairman Reed, Ranking Member Bunning, Members of the Subcommittee. More than 2 years since the collapse of the Bear Stearns high-grade structured credit enhanced leverage fund, its name a virtual litany of woes, we are still in the midst of a wrenching economic crisis, brought on at least in part by the flawed structure of our securitization markets. I appreciate the opportunity to share my views on what regulatory and legislative actions could reduce the risk of such a future crisis. I believe that securitization contributed to the current economic crisis in two ways: First, poor underwriting led to unsustainably low mortgage payments and excessive leverage, especially in the subprime and Alt-A markets. This in turn contributed to the bubble and subsequent house price drop. Second, the complexity and obfuscation of some structured products such as collateralized debt obligations caused massive losses and created uncertainty about the viability of key financial institutions. Now to solutions. Boiled down to the essentials, I believe that for the securitization market to work effectively, bondholders must ensure that there is sufficient capital ahead of them to bear the first loss risks of underlying assets; that the information provided to them is correct; that the rights granted to them in securitization contracts are enforceable; that they fully understand the investment structures; and that any remaining risks they bear are within acceptable bounds. If these conditions are not met, investors should refrain from participating in these markets. If bondholders act responsibly, leverage will be limited and capital providers will be more motivated to manage and monitor risks. If this is the obligation of investors, what then should be the role of Government? First, Government should encourage all investors and mandate that regulated investors exercise appropriate caution and diligence. To achieve this goal, regulators should reduce or eliminate their reliance on ratings. As an alternative to ratings, I believe regulators should place greater emphasis or reliance on analytical measures of risk, such as computations of expected loss and portfolio stress tests. Second, Government should promote standardization and transparency in securitization markets. While the SEC, the ASF, and the rating agencies may all have a role in this process, I believe that transforming Fannie Mae and Freddie Mac into member-owned securitization utilities would be the best way to achieve this goal. Third, Government can help eliminate fraud and misrepresentation. Licensing and bonding of mortgage brokers and lenders, along with establishing a clear mechanism for enforcing the rights of borrowers and investors for violations of legal and contractual obligations, would be beneficial to the securitization market. However, I believe that there are superior alternatives to the Administration's recommendation of retention of 5 percent of credit risk to achieve this goal. I would recommend an origination certificate that provides a direct guarantee of the obligations of the originator to the investors and the obligation of the originator to the borrowers coupled with penalties for violations even in good markets and requires evidence of financial backing. This would be a more effective solution. If the flaws that led to the current crisis are addressed by Government and by industry, securitization can once again make valuable contributions to our economy. I look forward to your questions. Thank you. " CHRG-109hhrg28024--165 Mr. Moore," I believe about 4 years ago, our Federal debt in this country stood at about $5.7 trillion. Is that your recollection? " CHRG-111hhrg56847--183 Mr. Edwards," Right. And I think CBO projected a $1.3 trillion deficit before President Obama was sworn into office. Let me ask you, Dr. Orszag, the director of OMB, has said that the 2001 and 2003 tax cuts and the Medicare prescription drug bill, all unpaid for and passed by Republicans on a virtually partisan basis will, have added $6 trillion to the national debt over the next decade. Do you have any figures that would substantially differ from Dr. Orszag's testimony on how those three bills added to the national debt? " CHRG-111shrg62643--25 Mr. Bernanke," If the debt continues to accumulate and becomes unsustainable, as the Congressional Budget Office believes our current policies are, then the only way that can end is through a crisis or some other very bad outcome. Senator Shelby. Do you, as Chairman of the Fed, do you believe that our current continuing to have these big deficits adding to our debt is unsustainable? " CHRG-110hhrg46594--488 Mr. Slaughter," I would briefly respond by saying I think all those scenarios you lay out are possible. I can imagine another scenario, which is a firm being in Chapter 11 and the government guaranteeing some of the debt that someone might step up to provide in the same way that Treasury and to some extent the Federal Reserve have been putting guarantees on certain debt instruments in recent times. " CHRG-111hhrg55814--235 Mr. Hensarling," Initially, under this bill then, taxpayers would shoulder the initial burden of ``too-big-to-fail,'' then I believe that we hope that the institution may be resuscitated, they may be able to pay, eventually, if that doesn't happen, competitors may end up having to foot the bill. " CHRG-111hhrg48873--269 Secretary Geithner," In the model we laid out, $1 of capital from the government would come with $1 of capital from a private investor, and they would be able to get borrowing from the government in a range that is yet to be determined. But it is potentially up to 6-to-1 leverage in this basic structure, substantially less leverage than the bank normally operates with, but that is the broader magnitude that is possible. " CHRG-111hhrg56847--86 Mr. Bishop," I am here, Mr. Chairman. Thank you, Mr. Chairman for being here. Just, Mr. Garrett raised some questions that suggested that the explosion of the deficit has to do with Democratic policies. My understanding is that the CBO has conducted a study in which they have indicated that they believe that our long-term debt over the next 10 years, we are looking at an $8 trillion debt, and they have assessed that $5 trillion of that results from essentially two decisions: The 2001 and the 2003 tax cuts put on the national credit card, and the massive expansion of the Medicare part D program, again put on the national credit card. Are you familiar with that assessment from CBO? And if so, what is your take on it? " CHRG-109shrg24852--30 Chairman Greenspan," No, we do not, and the major reason is that these are not leveraged in anywhere near the extent to which the GSE's are. A critical aspect here of the problem is the fact that the GSE's have relatively small amounts of capital relative to the assets they hold. Indeed, they hold 1 to 2 percent of assets. The commercial banks, as you know, are several multiples above that. And indeed interest rate risk originally was not even hedged at all by commercial banks and savings and loans in the very early years, largely because their capital was adequate to self-insure. The GSE's cannot self-insure. Their capital segment in their balance sheet is too small. They cannot risk not fully hedging their position. Senator Reed. You raise, I think, an interesting point because the typical way risk is managed in a regulatory process is to increase capital rather than to put limits on growth portfolios. That is essentially what the Federal Reserve does. If you are concerned about the ability to manage risk in an institution, your first response, your first authority is to increase capital, which to me, frankly, is probably an appropriate response to some of the risk that has been illustrated in GSE's. Let me change the subject slightly, and that is, I presume that the current portfolio does not engender great risk since many of your institutions hold a great deal of the paper of these GSE's. They must find that these investments are prudent. " 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. " FinancialCrisisInquiry--130 They got to raise that money, and yet it didn’t impact their total indebtedness. So it was this—it wasn’t equity, it wasn’t debt security. I think what you’re asking is should we draw lines. And I think we should absolutely draw lines between equity, preferred stock, subordinated debt, and senior debt. There should be bright lines in the cap structure of U.S. companies and not all these crazy hybrid securities where no one knows where to put into the cap structure. And I guess since I’m being brief, I wanted to add one more point that I didn’t get to make in my testimony with regard to the cap structure and the debt and the equity of these companies. When the taxpayer money comes in—and this is a separate debate. But when taxpayer money comes in to a company—I realize that Treasury was dealing with pitches as they were thrown and that this was very much ala carte model of dealing with the financial crisis because we didn’t prepare for it. But going forward, I think what has to be done from the commission’s perspective is to determine a methodology for which taxpayer money is to possibly be infused in companies. It needs to be last in and first out. It needs to be senior to the bank debt. The fact that we’re buying equity with taxpayer money is an abomination to the taxpayer. So that’s a little bit different spin on debt and equity, but that’s where those loans need to go. VICE CHAIRMAN THOMAS: Thank you very much. Thank you, Mr. Chairman. Reserve the balance of the time. CHAIRMAN ANGELIDES: Thank you, Mr. Vice Chairman. I was going to hold all my questions until the end, but I want to ask one now so I don’t forget. And that is, one thing you seem to be saying is, in a world of rapid innovation, rapid change, expansion of new industries, there’s an argument, at least for the core financial sector, to have perhaps even greater stability as opposed to, for example, all the entities out there who can take greater risk without consequence to the taxpayers. FOMC20080625meeting--186 184,MR. ANGULO.," 5 Thank you, Mr. Chairman. We're now in the handout. Why don't we start on page 2, and I'll give you an overview of where we are headed this morning, at least from my section. First I'll talk a bit about the objectives and the approach of our monitoring program. Then I'll talk about how we're focusing primarily, but not exclusively, on four investment banks and where our focus is there. I'll say a few words about the extent of usage of our section 13 facilities. Again, the PDCF is primarily our focus, but for the sake of completeness, I'll also discuss and provide some highlights on TSLF usage by the primary dealers. Then I'll close by just highlighting near-term issues that we're addressing or dealing with. 5 The materials used by Messrs. Angulo, Alvarez, and Parkinson are appended to this transcript (appendix 5). On page 3, in terms of the objectives of our monitoring program, we're very cognizant that our efforts are tied closely to our section 13(3) authority in the establishment of the Primary Dealer Credit Facility. Our effort does not stem from our general supervisory examination authority. We're very clear on that. We have two key objectives. The first is the ability to exercise informed judgment about the capital and liquidity positions of the primary dealers that have access to the PDCF. Second and just as important, we're aiming to, in shorthand, mitigate the moral hazard that accompanies the creation of the PDCF in particular. So we will make sure that the PDCF does not undermine the incentives for the primary dealers and the firms that own them to manage capital and liquidity more conservatively. On page 4, in terms of our approach, our focus is on the firms that own primary dealers that are not affiliated with financial holding companies. That's primarily, but not exclusively, the four largest investment banks. I'll touch at the end of my presentation on several other primary dealers with which we've had interactions of late. Our effort does include an on-site presence, but that is limited to examiners at each of the four largest investment banks. We also have a small off-site staff, which includes staff members from our Research Group, our Markets Group, our Legal Group, and Bank Supervision. We are in direct contact with the management of these firms. We are obtaining information directly from the firms as well as from the SEC, and of course, we are communicating and coordinating closely with the SEC. It's important to point out, however, that we're not engaged in traditional bank supervision. Our scope is fairly narrow. We're not conducting examinations, and we're not providing or issuing examination reports back to the firms. Therefore, we are making assessments, I would say, without the normal range or normal complement of supervisory protections that we're accustomed to. To be frank, that carries with it some risk and some vulnerability for us. I'll touch on that at the end of my presentation as well. Our current focus is limited or narrowly focused on capital, as well as liquidity, which I'll get into in a moment. So let's turn to page 5. Page 5 gives us a view of the leverage of the four investment banks. I should note that it may be a bit confusing at first glance. Leverage is typically expressed as a multiple. We've converted that into ratios because bank supervisors tend to look at ratios. So bear that in mind. Investment bank leverage does tend to be cyclical. This graph picks up really the latter half of the last cycle, so I can orally give you some perspective. If this graph had moved back to the left, in approximately 1999 to 2001 you would have seen the investment banks deleveraging in response to the Russian default and the LTCM crisis in the third quarter of 1998. So we would see leverage coming down between then and 2001. In 2001-02, leverage was essentially flat, and then this graph picks up the increasing leverage from 2004 to the end of 2007. As you can see, 2007 marked the cyclical low point in the ratio, or high point in leverage as a multiple. Since then, the firms have been deleveraging. Right now they are clustering around 4 percent, with the trajectory, I hope, still up, and we may have something to say about that. " CHRG-109hhrg22160--255 Mr. Jones," Madam Chairman, thank you. Mr. Greenspan, I would like to pick up on what my friend from Massachusetts was speaking to. And you are a very learned man. We all have great respect for you, whether we agree or disagree. But I just have to believe with this debt of this nation, the deficit of this nation, that there is going to come a time--and maybe we won't be here--but there is going to come a time, if we don't get a handle on this, we are going to be in deep, deep trouble. This is my question: If Japan owns over $700 billion of the U.S. debt, mainland China and Hong Kong together hold over $250 billion of U.S. debt, Mr. Chairman, the question is, if this deficit continues to rise, and it looks like we are not going to do what needs to be done to hold it from rising, what would be the impact on U.S. financial markets if Japan or China were to stop buying U.S. treasury bonds? This might be a hypothetical, but I would appreciate if you would give us your opinion. " CHRG-111shrg53085--124 Chairman Dodd," A good bookie will lay off a debt. This was not even good gambling. " CHRG-111hhrg49968--48 Mr. Hensarling," Will the Federal Reserve monetize this debt? " fcic_final_report_full--81 Between  and , debt held by financial companies grew from  trillion to  trillion, more than doubling from  to  of GDP. Former Treasury Secre- tary John Snow told the FCIC that while the financial sector must play a “critical” role in allocating capital to the most productive uses, it was reasonable to ask whether over the last  or  years it had become too large. Financial firms had grown mainly by simply lending to each other, he said, not by creating opportunities for in- vestment.  In , financial companies borrowed  in the credit markets for every  borrowed by nonfinancial companies. By , financial companies were borrowing  for every . “We have a lot more debt than we used to have, which means we have a much bigger financial sector,” said Snow. “I think we overdid fi- nance versus the real economy and got it a little lopsided as a result.”  CHRG-110hhrg34673--152 Mrs. Capito," Thank you, Mr. Chairman. I have a question. You mentioned in your opening statement that there has been a large amount of consumer spending. We see a lot of credit card debt by individuals, a lot of higher education loan debt for young people coming out of college, also into the professions, medical school. How are people going to be able to overcome this debt when the wages are only rising a certain percent? Do you see this as a long-term problem that seems to be concentrated--I mean, if you are a college student, you can get a credit card like that and run it up to the maximum quite quickly and pay $20 a month, probably, for the rest of your life. What kind of problem do you think that presents to our economy? " CHRG-111shrg62643--69 Mr. Bernanke," We do not focus on bilateral trade deficits for U.S.-China. We look at the overall, and that is somewhat different. Senator Bayh. My second question has to do with the Greek debt crisis once again, and as you pointed out, the Europeans moved very aggressively and things seem to have calmed down a fair amount there. But I look with some alarm, even if they implement all these austerity measures that they are thinking about, and as you can see there is a fair amount of political turmoil around all that, it looks as if they are still going to be at about 130 percent or so of debt-to-GDP ratio, even after they have implemented all these steps. And just putting my political hat on, it could be pretty hard for them to go substantially beyond that. So that still looks like it is going to be pretty hard to sustain a situation like that. So I do not expect you to comment upon the likelihood of restructuring or anything like that. But you had mentioned that the whole episode, while it caused some disturbance, we have now kind of gone beyond that. So my question would be: In the event of an orderly restructuring of Greek debt at some point, I assume that it would also have only a marginal impact upon our own markets? " CHRG-111hhrg53245--287 The Chairman," My understanding of it was regarding the bankruptcy situation, where you were not paying off old debts but trying to get things going forward, but we will look at that. " CHRG-109shrg30354--96 Chairman Bernanke," First, I think I will comment that, in retrospect, the idea that the national debt would disappear was never all that realistic. The share of GDP that was collected in taxes in the late 1990's was over 21 percent, compared to a historical average of about 18 percent. A lot of that came basically from the stock market, which we know now was not sustainable at the pace it was rising. Nevertheless, I do think that deficits matter. I think the size of Government also matters. But deficits matter because they represent additions to debt that our children and grandchildren will either have to pay through higher taxes or reduced services. And so I think they do matter. I would add, though, that one must also think about the size of the Government and what share of the GDP we want to devote to Government services. With respect to the offshore holdings, you can look at it two different ways. From one perspective, it is a good thing that countries that are holding reserves want to hold them in the form of U.S. Treasuries because we have a deep and liquid capital market which is very attractive and very safe and very low cost to people as a way of holding wealth. And we do not want to do anything that would disturb that. We want people to want to hold our assets. It is good for our country. On the other hand, from a different perspective, I think that part of what you are getting at is the fact that with a large current account deficit, the external debt that the United States owes, whether it be held in the form of treasury debts or MBS or whatever, is growing over time. And as I agreed, I think it would be very desirable for us over a period of time to reduce that current account deficit and reduce, therefore, the growth in the holdings of U.S. assets abroad. Senator Dodd. Just a related quick question here. You mentioned earlier our trading partners and the economic circumstances in those countries where, in fact, some of the very nations that are purchasing a lot of this debt may find more attractive markets elsewhere than the United States. Does that pose a problem, in your mind, for the United States in the shorter term? " CHRG-111hhrg58044--132 Mr. McRaith," Congressman, in fact, we understand a broad range. What one company does and the weights that one company might assign to one factor like a credit score might be significantly different from another company. Of course, different States have different parameters. There is a wide variation. I think one State estimates a variance of credit score affecting a rate from 7 percent up to the high double digits. That indicates that companies use this one factor of credit scores in a way that--companies use them differently based on their proprietary or pricing formula. Medical expenses and the debt associated with medical expenses frequently is a problem for consumers. State law varies with respect to whether consumers can be penalized for that or what is the recourse the consumer might have in the event that consumer is penalized for medical debt. It is inaccurate to say that companies do not consider medical debt as part of a credit score. It is also inaccurate to say that all States allow medical debt to be exempted as an extraordinary life event. Some States do. Some States do not. Mr. Moore of Kansas. Do either of the other witnesses have a comment? Mr. Snyder? " CHRG-111shrg53822--79 Mr. Rajan," Well, this follows on the comments I just made, which is that if capital on the balance sheet is not going to work that well because banks will find ways to offset it, maybe the idea is to get capital which comes only in bad times. It might be cheaper to arrange for that kind of capital rather than have capital sitting on balance sheets through good times and bad times. And if you can do it in a clever enough way, banks will not be able to exploit that capital and take on more risks a priori, given that they know that capital will come in. So two examples of how this could be done. One, which Mr. Baily has also talked about, which comes from a common group that we work in, is this idea of what is called reversed convertible debt. And this convertible debt is debt which will convert into equity in times like the current ones. So it is a pre-assured source of buffer which will protect the taxpayer from having to fund these institutions. And that debt will convert, provided the bank's capital ratio goes below a certain level. That is one condition. The second condition is that this be a systemic crisis so that banks do not sort of willfully convert this debt and get additional buffers. Another variant of this would be what we call the capital insurance plan, which is you issue bonds, which are called capital insurance bonds. The bank issues these bonds. The proceeds from the bonds are taken and invested in Treasuries. And the holders of these bonds get the Treasury rate of return plus an insurance premium, which the banks pays. In bad times, when the bank's capital goes below a certain level and there is a systemic crisis, the bonds will start, essentially, paying out to the bank. It would be equity at that point for the bank, and the bank would be recapitalized. So the main difference is, in one, the bonds convert to equity; in the other, the bonds just pay in. There is no commensurate equity, which is issued. Both have the effect of recapitalizing the bank in bad times. Senator Akaka. Thank you. Further comment, Mr. Wallison? " CHRG-111hhrg55809--3 Mr. Bachus," Thank you, Mr. Chairman. First of all, Mr. Chairman, let me respond to say that we do not object to consumer protection being removed from the Federal Reserve. What we do object to and what we strenuously think would be a mistake is what you do with consumer protection, and that is you vest it in a new government agency and you give it tremendous power not only to protect the consumer, but you also give it power to design financial products. You give it power to dictate terms on financial agreements. You give it power to limit choice. You give it power to restrict competition. And by giving it the power to approve new products, you completely stifle innovation. America didn't get to be the largest economy in the world, 3 times bigger than the next biggest economy, by taking away individual choice, by stifling innovation, and by putting government in the business of managing financial services and making choices for both institutions and individuals. So I am sorry that we have had a miscommunication, but our objection is that you have a tremendous shift of responsibility from individuals and institutions to the government. We also object and, Chairman Bernanke, we have strenuously objected to something else, and that is vesting in the Federal Reserve the right to bail out individual non-bank financial institutions. We believe that the FDIC has the power to resolve banks through their statutory authority, but we think that is to protect depositors and not to protect the bank, its shareholders, or to protect it from risky investors. Now in the remaining time I have left, let me tell you something else that we have a great unease about. I believe it was in March of last year, not September, that I had conversations with you and Secretary Paulson; and at that time, you actually expressed tremendous concern about the overextension of debt and of leverage. And I think there was a real concern on the part of a lot of people, whether this deleveraging and constriction of debt could be done in an orderly way. So there was some forewarning of what we saw in September, I think, starting with Bear Stearns. But, I am not sure that even until this very day we have identified exactly what caused the events of last year and how to address it. Instead, we have had, almost with light speed, the Obama Administration propose a sweeping change in financial regulation, which includes and continues to include as late as this month the possibility that the Treasury would spend a trillion dollars to bail out another non-bank financial institution. Chairman Volcker--former Chairman Volcker--said he had extreme concern over that. He felt like it was a mistake; and we, as Republicans, do, too. We simply do not believe the government ought to be in the bailout business of nonfinancial--non-bank financial institutions. " FOMC20080130meeting--122 120,MS. LIANG.," One issue here is whether you want to do it relative to current capital cushions. Banks can raise capital. If they anticipate that they will need to raise capital, they can cut dividends further. I haven't done that sort of exercise. One way to think about this is that the average long-run rate is about 60 basis points on debt; in the Greenbook baseline it runs to about 1 percent, and in the alternative, it gets close to about 1� percent of debt. So, it is not outside the realm of history. It is on the high side. " CHRG-110hhrg38392--128 Mr. Mahoney," As we go through this, we may want to continue to have these discussions with your Board and with Congress as far as what policies. We can promote some of its communication and promotion of educational understanding of savings. That is a segue to a second question; in your speech today, you mentioned that consumer spending has advanced vigorously over the last number of quarters. Sort of looking at the trend over the last number of years, savings have been going down, as you have said. Many people during this boom of real estate started with a lot of home equity loans, taking equity out of their home to support consumer spending, building up more debt that way. And now with the real estate market in many parts of the country very flat, interest rates having gone up, adjustable rates, that is not available for many people, so they have debt on top of that. And then a lot of the consumer spending is on the backs of more consumer debt in terms of credit cards. Congresswoman Pryce mentioned that as well. Again, what impact do you see that having on the long-term basis of the stability of the economy when people are borrowing more and more and more and not saving? And again, what can we do through your offices or through the Congress? " CHRG-111hhrg54869--64 The Chairman," Without objection, it is so ordered. And, without objection, there will be general leave for any of the members or the witnesses to introduce into the record any material they would wish to insert. Mr. Moore of Kansas. Thank you, Mr. Chairman. Chairman Volcker, how do we end ``too-big-to-fail?'' I don't know if you have seen the recent proposal offered by Kansas City Fed President Hoenig and his colleagues. Their proposal on resolution authority lays out more explicit rules than the Administration's proposal of how a large financial institution Like Lehman Brothers or AIG could be resolved so the debt holders, shareholders, and management would be held accountable before taxpayers are asked to step in. If you haven't seen the Kansas City Fed proposal, I would like to provide to you a copy and I would appreciate your written comments, if you would please. Others suggest that we require the largest financial firms to undergo a regular stress test that would have aggregate information publicly released, even in good times. I know some have argued the list of these firms should remain confidential. But doesn't the market already know who these firms are, based on the last round of stress tests? How do you propose we create the right incentives for firms to maintain reasonable leverage ratios and strongly discourage ``too-big-to-fail?'' " fcic_final_report_full--547 PDCF see Primary Dealer Credit Facility . PLS see private-label mortgage-backed securities . pooling Combining and packaging a group of loans to be held by a single entity. Primary Dealer Credit Facility Program established by the Federal Reserve in March  that al- lowed eligible companies to borrow cash overnight to finance their securities. principal Amount borrowed. private mortgage insurance Insurance on the payment of a mortgage provided by a private firm at additional cost to the borrower to protect the lender. private-label mortgage-backed securities see non-agency mortgage-backed securities. repurchase agreement (repo) A method of secured lending where the borrower sells securities to the lender as collateral and agrees to repurchase them at a higher price within a short period, often within one day. SEC see Securities and Exchange Commission . section () Section of the Federal Reserve Act under which the Federal Reserve may make se- cured loans to nondepository institutions, such as investment banks, under “unusual and exi- gent” circumstances. Securities and Exchange Commission Independent federal agency responsible for protecting in- vestors by enforcing federal securities laws, including regulating stock and security options ex- changes and other electronic securities markets, the issuance and sale of securities, broker-dealers, other securities professionals, and investment companies. securitization Process of pooling debt assets such as mortgages, car loans, and credit card debt into a separate legal entity that then issues a new financial instrument or security for sale to in- vestors. shadow banking Financial institutions and activities that in some respects parallel banking activi- ties but are subject to less regulation than commercial banks. Institutions include mutual funds, investment banks, and hedge funds. short sale The sale of a home for less than the amount owed on the mortgage. short selling To sell a borrowed security in the expectation of a decline in value. SIV see structured investment vehicle . special purpose vehicle Entity created to fulfill a narrow or temporary objective; typically holds a portfolio of assets such as mortgage-backed securities or other debt obligations; often used be- cause of regulatory and bankruptcy advantages. SPV see special purpose vehicle . structured investment vehicle Leveraged special purpose vehicle , funded through medium-term notes and asset-backed commercial paper , that invested in highly rated securities. synthetic CDO A CDO that holds credit default swaps that reference assets (rather than holding cash assets), allowing investors to make bets for or against those referenced assets. systemic risk In financial terms, that which poses a threat to the financial system. systemic risk exception Clause in the Federal Deposit Insurance Corporation Improvement Act (FDICIA) under which the FDIC may commit its funds to rescue a financial institution. TAF see Term Auction Facility . TALF see Term Asset-Backed Securities Loan Facility . TARP see Troubled Asset Relief Program . CHRG-111hhrg48875--21 Mr. Campbell," Thank you, Mr. Chairman, and thank you, Mr. Secretary. On Monday, you released a plan to leverage, bring private capital in to deal with the toxic assets. I'm generally supportive of that plan. The question I have is, it's 6:1 leverage ratio. How did you come up with that number? Why did you come up with that number? As you just stated, a lot of the problem that we had was because there was too much risk-taking too much leverage. It seems to me that that 6:1 ratio encourages more risk-taking, more leverage, and perhaps just moves the problem from bank to non-bank entities but doesn't necessarily help it that much. " CHRG-111hhrg56766--343 Mr. Bernanke," We have talked in this hearing quite a bit about debt and deficits. I do believe it is very important. It is probably inevitable to have large deficits in the middle of a deep recession, given the loss of revenues and so on. It is very important to develop a creditable plan for restoring deficits to a sustainable level in the medium term, which I would define to be 3 or 4 years out, and that would mean getting deficits down to something on the order of 3 percent or below, to maintain a stable ratio of debt to GDP. That is very important to maintain confidence in the debt of the sovereign. Some countries around the world are having some difficulty with that right now. We certainly want to make sure that in the future some time, we will not be put into a situation where our interest payments are so large that it is very difficult for us to make those payments. " CHRG-109hhrg31539--216 Mr. Bernanke," I agree absolutely. We have seen about a tripling of energy prices over the last few years. That has raised gasoline prices, raised heating oil and other kinds of energy prices, and it has reduced our growth and been a burden on consumers and firms, and it has been inflationary for us so it has obviously been a problem for our economy. " FinancialCrisisInquiry--145 BASS: Sure. I think that it—the way that this leverage was built, when you think back to the timeframe in question, pre-crisis, you look at the securities they were levering. And again, it moves back to the ratings agencies’ kind of de facto gold standard on investment-grade, and more important AAA, which has statistically the lowest probability of impairment of any security. If you were leveraging an enormous amount of treasuries, you can hedge your interest rate risk and you can put on a fairly sizable position and not have an inordinate amount of risk on your balance sheet. And—and the same thought can iterate itself through the next layers of AAA, right? So the next layers were Fannie-Freddie, and the next layers were AAA mortgage securities that have never defaulted. So they took on enormous leverage, and the only thing they were hedging in these levered books was interest rate risk. They weren’t hedging capital risk. And you heard some of the—some of the participants this morning say, “Yes, we kind of relied on the ratings agencies to provide us their ratings and that’s how we ran our leverage books.” So when you look at the institutions that failed—if you look at my exhibit one, when you look at gross leverage to tangible common equity at Lehman, it was 52 times. At Bear, it was 38 times. At Citi, it was 68 times. You know, when you look through these leverage numbers, and if you’re 60 times levered and you lose 3 percent, you’ve lost two times your money. Right? And—and the losses are going to come in much higher than 3 percent. So I think it just boiled down to people getting lazy and people just levering the wrong securities and not being able to hedge those risks. HOLTZ-EAKIN: Mr. Mayo, you said in your list of 10 causes that one was government-provided steroids through the GSEs. What exactly were the mechanics of that? What should we have seen at the time? FinancialCrisisInquiry--83 Mr. Dimon, would you move the microphone closer to you? I’m getting signals. It’s very difficult to hear in the back. DIMON: I can’t move it any closer, but I’ll sit up here. I am saying, at no point in the market before the problem started were these firms priced like they were too big to fail. So if you look at what people lent money to at the firms, no, they were priced like there’s a potential for failure like any other company. Even after things started failing and the government—remember, they did allow firms to fail like Lehman. But there was Indy Mac, WaMu, virtual failures in Wachovia, Bear Stearns. Even after they let things fail, that was true, and even after the government did the stress tests and said they don’t want these things to fail, the market still priced them— their stock price and their debt—like they could fail. At our board level, we never had a conversation, ever, that we should rely on the government to do anything. BLANKFEIN: We never had—I don’t recall any internal conversation among the employees or with the board that—about what we would do if we would—if we would fail. I’d say on the too- big-to-fail issue, I agree about the sequence. Nobody in our company entertained government intervention and, certainly—and, certainly, we didn’t behave that way. We’re shareholders. We work for the shareholders. The equity—even in the context of a too-big-to-fail, if you take Bear Stearns, that was, quote, “rescued,” the equity failed. And we work for the shareholders, and all of the people in the firm are shareholders. And that’s how we think internally of what constitutes a failure. So for our purposes, they rescue the debt and the equity goes. That’s as much of a failure as anything could possibly be. External, I think everybody contemplated that the equity could go to zero because that was the pattern. And, in fact, it’s an interesting—and I would say on the debt, after the government—after you saw the too-big-to-fail noise came out—which only came out after Lehman, not before—you could see debt spreads contract a bit. But it’s interesting because every—there’s always unintended consequences. Our shares didn’t go down to the lows until, for us, after Buffet, after the—we did our capital raise the week after we became a bank-holding company at 123. We went down to a low under 50. That was after we got capitalized privately and after the TARP got passed because, at that point, people external to the firm started thinking they’ll be quick on the trigger, the debt will get saved perhaps, and maybe the equity will get crushed. Maybe we’ll get into the scenario of a kind of a Bear Stearns. CHRG-110shrg46629--67 Chairman Bernanke," No, they can make use of some of their capital gains by home equity loans or refinancing. Senator Menendez. But that would be accruing debt. " CHRG-111hhrg48875--197 Mr. Minnick," Yes. Please do because there is an attempt, I think, to give you tools that would accomplish what I heard you say this morning. My second question is, with respect to the new mechanism for creating liquidity of asset-backed securities that you have discussed yesterday and will continue to discuss, I am concerned that given the need for capital, which financial institutions of all types--a critical need right now if they're going to become functional, that this regime not underprice these assets. They need to be fairly priced but not underpriced. And the question I had for you: Under this regulatory scheme, if your initial auctions produce prices that in your judgment are at the low end of fair market value in a freely functioning market, are you prepared to provide additional leverage into the system which would have the impact, I think, of increasing bid prices to a point where the solution to the problem doesn't exacerbate the situation we have today, where these institutions tend to be badly under-capitalized, if they are going to perform effectively? " CHRG-111hhrg48868--365 The Chairman," And you are talking about paying off the Federal Reserve debt, the $38 billion? " CHRG-111shrg57321--182 Mr. McDaniel," The growth in the debt markets. Senator Kaufman. Right. " CHRG-110hhrg46591--387 Mr. Ellison," Just for the record, CDOs are collateralized debt obligations? " CHRG-111shrg61513--28 Mr. Bernanke," Treasury is allowed to issue debt. Senator Bunning. On its own? " CHRG-110hhrg44903--147 Mr. Cox," I think there is a lot of need for people to be able to understand what fair value accounting is all about. And depending on which investors you are talking about and in which country, sometimes those questions are very acute. There are some significantly counterintuitive results from fair value accounting that can startle some investors. For example, when fair value accounting is applied to your own debt on your own balance sheet when your debt becomes less valuable, it runs--in other words, your firm is doing worse, that generates income that you then run through the income statement. So I think there is a lot of work that we can do in terms of investor education so that people understand how to use these accounting tools. And those are all legitimate questions when it comes to fair value. " CHRG-109shrg24852--44 Chairman Greenspan," I certainly agree with you, Senator. Senator Sarbanes. Thank you. Now, first, I have a few questions I want to put to you. There is a vote on, so we will try to do the best we can within its constraints. I want to address minimum capital standards for the banks to begin with in the context of the efforts to negotiate the Basel Capital Accords. Congress has expressed concern repeatedly that the minimal capital requirements on federally insured banks should be preserved in hearing after hearing. And we have been regularly assured by the bank regulators that that would happen. Therefore, it was with some concern that we read the comments by Federal Reserve Governor Bies back in March when she spoke to the Institute of International Bankers Annual Washington Conference, and I will just quote the article reporting on that speech. ``Ms. Bies made it clear the Fed still intends to jettison the straight capital assets leverage ratio eventually. It is a position some other regulators, particularly Mr. Powell at the FDIC, oppose. Executives at the largest banks, however, have argued it makes no sense to implement Basel II without also lifting the leverage minimums. `The leverage ratio down the road has got to disappear,' Ms. Bies said. `I would say to the industry, if you work with us and be patient, we understand the concerns about leverage ratios, and as we get more confidence in the new risk-based approach, it will be easier for us to move away from the leverage ratio.' '' And at a hearing before this Committee, you were asked about the minimum capital issue, and you responded as follows, and this was to Senator Bunning: ``I think the issue that is raised with respect to the leverage ratio is that it duplicates numbers of other types of measures of capital. As you move into the Basel II framework, which is a far more sophisticated capital ratio, the need to get the old-fashioned leverage ratio, which has worked for many generations--we basically employed as a sole measure of capital--the need for that is significantly diminished.'' So we had that indication of the attitude at the Fed on this issue. Recently, at the end of May, Governor Bies gave another speech. She said, ``While the regulatory capital requirements ultimately produced by Basel II would be, we believe, considerably more risk-sensitive than the current capital regime, this is not the only capital regulation under which U.S. institutions would operate.'' More than a decade ago, the Congress, as part of the FDIC Improvement Acts, prompt corrective action to find a critically undercapitalized insured deposit institution by reference to a minimum tangible equity to asset requirement, a leverage ratio. The agencies have also used other leverage ratios because experience has suggested there is no substitute for an adequate equity to asset ratio. Federal Deposit Insurance Corporation, which was responsible to the Congress for the management of the critical deposit insurance portion of the safety net, has underlined the importance of that minimum leverage ratio. The Federal Reserve concurs with the FDIC's view. Just to be clear, what is the Fed's view on the minimum capital issue, and does the Fed take the position that the leverage ratio down the road has to disappear? " FinancialCrisisInquiry--454 BASS: Sure. I think that it—the way that this leverage was built, when you think back to the timeframe in question, pre-crisis, you look at the securities they were levering. And again, it moves back to the ratings agencies’ kind of de facto gold standard on investment-grade, and more important AAA, which has statistically the lowest probability of impairment of any security. If you were leveraging an enormous amount of treasuries, you can hedge your interest rate risk and you can put on a fairly sizable position and not have an inordinate amount of risk on your balance sheet. And—and the same thought can iterate itself through the next layers of AAA, right? So the next layers were Fannie-Freddie, and the next layers were AAA mortgage securities that have never defaulted. So they took on enormous leverage, and the only thing they were hedging in these levered books was interest rate risk. They weren’t hedging capital risk. And you heard some of the—some of the participants this morning say, “Yes, we kind of relied on the ratings agencies to provide us their ratings and that’s how we ran our leverage books.” So when you look at the institutions that failed—if you look at my exhibit one, when you look at gross leverage to tangible common equity at Lehman, it was 52 times. At Bear, it was 38 times. At Citi, it was 68 times. You know, when you look through these leverage numbers, and if you’re 60 times levered and you lose 3 percent, you’ve lost two times your money. Right? And—and the losses are going to come in much higher than 3 percent. So I think it just boiled down to people getting lazy and people just levering the wrong securities and not being able to hedge those risks. HOLTZ-EAKIN: Mr. Mayo, you said in your list of 10 causes that one was government-provided steroids through the GSEs. What exactly were the mechanics of that? What should we have seen at the time? January 13, 2010 FOMC20070807meeting--17 15,MR. DUDLEY.,"1 Thank you. As you all know, there has been considerable financial market turbulence since the last meeting: Problems in subprime mortgage credit have persisted and intensified; credit-rating agencies have begun to downgrade asset-backed securities and CDOs (collateralized debt obligations) that reference subprime debt; the problems in subprime have spread into the alt-A mortgage space and into parts of the prime mortgage market; corporate credit has been infected, with high-yield bond and loan spreads moving out sharply; and stock prices have faltered. Although markets generally have been functioning well in terms of liquidity and the ability to transact, there have been some important exceptions. The nonconforming residential mortgage market and the structured-finance product markets—especially the CDO and CLO (collateralized loan obligation) markets—have been significantly impaired, and there are concerns about the ability of some asset-backed commercial paper programs to continue to source funding via that market. As a consequence, market expectations with respect to monetary policy have shifted sharply, with market expectations consistent with considerable monetary policy easing over the next year. Market participants are worried about the effect of tightening credit standards on housing and about the deterioration in the market function in structured finance, which could broaden and be self-reinforcing, ultimately damaging the macroeconomy. I am going to be referring to this handout as we go through these comments. In tracing the source of the turmoil that we have experienced recently, we find that the deterioration of the subprime mortgage sector continues to play an important role in several ways. First, the deterioration in underlying credit quality continues unabated. As shown in exhibit 1, delinquencies of more than sixty days for recent ABX index vintages have continued to move higher, and the pace of deterioration—measured by the steepness of the curves—has, if anything, worsened. Note that the newest vintage—07-2, so the second half of 2007—does not show any benefit from improved underwriting standards. That stems mainly from the fact that the pipeline to build these securities is relatively long—with the average loan referenced by this index more than six months old at this point. It also may reflect the fact that this newest vintage gets—in contrast to earlier vintages—less benefit from earlier home- price appreciation. As a consequence of this poor credit performance, ABX spreads have continued to widen sharply. This is shown in exhibit 2, which shows the performance for ABX BBB- tranches across vintages, and exhibit 3, which shows the performance for the various tranches of the 07-1 vintage. The deterioration in the 1 Materials used by Mr. Dudley are appended to this transcript (appendix 1). higher-rated tranches has been much more severe than earlier in the year. In part, this greater deterioration reflects the fact that loss estimates have been trending higher, putting the higher-rated tranches more in harm’s way. It also reflects efforts to hedge subprime risk by going short these indexes by people who can’t liquidate securities easily. Translating these ABX spreads back into price, July was a very rough month for ABX. Price declines of 20 points or more occurred in the ABX BBB- tranches of some more-recent vintages. Second, the disturbing delinquency trajectories shown in exhibit 1 have caused the rating agencies to downgrade a significant number of residential asset-backed securities and CDOs that have exposure to the subprime sector. However, most of the downgrades apply to vintages before 06-2. For more- recent vintages, the loss experience is worse but still hard to estimate. This means that many more downgrades lie ahead. Third, some of the credit-rating agencies have made changes to their structured-finance rating models. That, combined with huge marked-to-market losses even in highly rated subprime tranches, has led to a fundamental reevaluation of what a credit rating means and how much comfort an investor should take from a high credit rating on an opaque structured-finance CDO or CLO product. The problems in subprime have spread into other mortgage markets, including alt-A, certain types of prime residential mortgage products, and commercial mortgage-backed securities (CMBS). Countrywide, for example, announced a deterioration in its second-lien prime mortgage book. Meanwhile, American Home Mortgage, which had operated primarily in the alt-A and nontraditional prime mortgage space as both a large monoline mortgage issuer and a REIT investor, was forced to shut down its operations last week and filed for bankruptcy yesterday. Market liquidity for nonconforming residential mortgage products is poor, and this has contributed to a further tightening in underwriting standards. For example, a number of mortgage originators indicated that they will no longer offer 2/28 and 3/27 adjustable-rate mortgage products, and some have indicated that they will not buy any alt-A mortgages originated by brokers. At the same time that we have seen turmoil in the subprime market, it has spread into the corporate sector as well. Credit spreads in the corporate sector have also widened sharply. For example, in July, high-yield corporate bond spreads widened about 150 basis points (see exhibit 4). Similarly, the spreads on key hedging indexes that reference credit default swaps on corporates have also gone up sharply. For example, in July the spreads on three of these major indexes rose nearly 200 basis points. This is illustrated in exhibit 5. The ITRAXX crossover index references fifty European nonfinancial names with ratings below BBB- or at BBB- and on negative watch. The high-yield CDX index references credit default swaps on 100 high-yield U.S. names. The LCDX index references credit default swaps on 100 U.S. leveraged loans. In contrast to the residential mortgage sector, corporate credit fundamentals still look good. In particular, as shown in exhibit 6, corporate default rates for both investment-grade and below-investment-grade borrowers have been at very low levels. Of course, as we saw in the subprime market, readily available credit can depress default ratios. One should expect that the tightening of credit standards in the corporate sector would generate some rise in default rates independent of other developments. Nevertheless, other measures also underscore the positive fundamentals of the corporate sector—in contrast to the poor fundamentals in residential mortgages. For example, global growth has been unusually strong with little volatility, and corporate profit margins are unusually wide, both in the United States and elsewhere. Moreover, the slowdown in profit growth expected for the United States has been milder than anticipated. This can be seen in the rise in the median equity analysts’ bottom-up earnings forecasts for the S&P 500 companies for 2007, which is shown in exhibit 7. It was falling through about April. Since then, expectations for this year have actually increased, and they have been increasing recently, even over the past month. So how does one explain the contagion to corporate credit from the subprime market given the disparity in fundamentals between these two sectors? Although the answer is complex, one factor stands out: There has been a loss of confidence among investors in their ability to assess the value of and risks associated with structured products, which has led to a sharp drop in demand for such products. The loss of confidence stems from many sources, including the opacity of such products; the infrequency of trades, which makes it more difficult to judge appropriate valuation; the difficulty in forecasting losses and the correlation of losses in the underlying collateral; the sensitivity of returns to the loss rate and the degree of correlation; and the problem that the credit rating focuses mainly on one risk—that of loss from default. The CLO and CDO markets have facilitated the transformation of low-rated paper—for which there is a limited investor appetite—into a high proportion of high- grade-rated debt. For example, in a typical CLO structure, the underlying loan quality averages a rating of about B. Yet through the magic of structured finance and the corporate rating agencies, the resulting CLO tranches are rated predominately investment grade. Exhibit 8 shows the structure for a representative CLO: More than two-thirds is AAA-rated debt, and 87 percent is investment grade. The loss of confidence among investors in the ability to assess the value and risks associated with this structured product has led to a sharp drop in CDO and CLO issuance. As shown in exhibit 9, CLO and CDO issuance plummeted in July. This is very important because the CLO and CDO markets represent the bulk of the demand for non- investment-grade debt. With this demand falling away at a time when the forward supply of high-yield corporate loans and debt exceeds $300 billion by some measures, a huge mismatch between demand and supply has developed. The underlying problem is that the depth of the market for non-investment-grade rated loans and debt—excluding CDO and CLO demand—is far shallower than the market for investment-grade products. Where do we go from here? Presumably buyers and sellers in the corporate sector are in the process of finding appropriate market-clearing prices. But it may take time for the market to settle down, especially given the August doldrums that are upon us. Moreover, we still may have further scope for market dislocations. After all, some single-strategy hedge funds that emphasize corporate credit may have been caught out by the sharp widening in spreads that has occurred over the past few weeks. When such results become known, investor redemptions could follow— leading to forced selling to generate the cash to fund these redemptions. In addition, the asset-backed commercial paper market is very skittish in two areas—structured investment vehicles and extendable commercial paper programs. Yesterday at least two commercial paper programs were subject to extension. It is not clear whether or to what degree these extensions will further unsettle the commercial paper market, but that is clearly a risk. The effective shutdown of the CDO and CLO markets has, in turn, raised questions about the sustainability of the strong bid by private equity firms to conduct leveraged buyouts. This uncertainty has undoubtedly been a factor behind the recent weakness of the U.S. stock market. The importance of the buyout bid can be seen in the relative underperformance of the Russell 2000 index compared with the S&P 500 index during the past few weeks (see exhibit 10). The problems in corporate credit and the virtual shutdown of the CLO and CDO distribution mechanism have caused investors to reevaluate both the business opportunities and the risks associated with large investment and commercial banks. Investment bank and commercial bank shares have underperformed the broader stock market indexes. In addition, as shown in exhibit 11, the CDS spreads for the major investment and commercial banks have widened considerably over the past month. The CDS spreads for financial guarantors have widened as well, even though the exposures of these firms appear to be concentrated in the most senior portions of the subprime and structured-finance debt structures. Perception of the strength of the financial guarantors could prove important given the key role that they play in some markets, such as the municipal debt sector, that lie far afield from either the subprime mortgage market or the corporate debt markets. Only in the past few weeks have the problems in the subprime and corporate debt markets led to broader risk-reduction activities. These risk-reduction efforts are similar to the adjustments that we saw in late February and early March. A matrix that shows the correlation of returns across different asset classes over the past few weeks (see exhibit 12) looks very similar to the correlation matrix that we saw following the late February risk-reduction period (see exhibit 13). It looks very different from the very calm period we had from late March through the first part of July, which is shown in exhibit 14. But the adjustments are not uniform across markets. In some ways, the risk reduction that we are seeing this time is a little more U.S. specific, a little more corporate credit specific, and a little more mortgage specific. For example, as shown in exhibit 15, implied volatility in interest rate swaps—the SMOVE index—and in equities—the VIX index—has climbed well above the late February peak. In contrast, the foreign exchange markets have experienced a less-pronounced rise in volatility. In the United States, the turmoil in financial markets has been accompanied by a shift in monetary policy expectations. Exhibit 16 illustrates the Eurodollar futures strip. As can be seen, the futures curve has shifted down about 40 basis points since the last FOMC meeting. We are back where we were before the May FOMC meeting. Currently, market prices imply a bit more than 50 basis points of easing by year-end 2008. The shift in expectations appears to reflect, in part, a revival of the “downside risks to growth” idea rather than that the Federal Reserve will absolutely cut interest rates. This can be seen in several ways. The shift in market expectations implicit in Eurodollar futures yields has not been accompanied by a substantial change in dealer forecasts. As shown in exhibits 17 and 18, which show the federal funds rate projections of the primary dealers before the June and the current FOMC meetings, the average dealer forecast and the range of dealer forecasts have not changed much over the past six weeks. Instead, a gap has opened up between the average dealer forecasts, represented in the exhibits by the green circles, and the forecasts implicit in market yields, represented by the horizontal black lines. The most recent dealer survey does not capture the minor forecast changes that occurred late last week. For example, two dealers with tightening forecasts pushed back the timing of the first tightening, and one dealer with an easing forecast moved it closer and increased the magnitude (not shown in exhibits 17 or 18). The dealers’ forecasts are modal forecasts. In contrast, the expectation embodied in market yields represents the mean of the distribution of expected outcomes. Presumably, it includes some possibility that the current market turbulence could lead to a weaker growth outcome and a reduction in the FOMC’s federal funds rate target. Options on Eurodollar futures contracts 300 days forward show a sharp downward skew in the distribution of rates (see exhibit 19). Although the mode is at 5.25 percent, the same as it was before the June meeting, the probability distribution has shifted down drastically below that 5.25 percent mode. So it may not be correct to say that market participants now expect much more monetary policy easing. Instead, a more proper characterization might be that the perceptions of downside risks have reemerged, and this characterization is reflected in the downward skew below what is still a 5.25 percent modal forecast for the Eurodollar rate. 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 June FOMC meeting. Of course, I am very happy to take questions." fcic_final_report_full--543 Italicized terms within definitions are defined separately. ABCP see asset-backed commercial paper . ABS see asset-backed security . ABX.HE A series of derivatives indices constructed from the prices of  credit default swaps that each reference individual subprime mortgage–backed securities ; akin to an index like the Dow Jones Industrial Average. adjustable-rate mortgage A mortgage whose interest rate changes periodically over time. affordable housing goals Goals originally set by the Department of Housing and Urban Develop- ment (now by the Federal Housing Finance Agency) for Fannie Mae and Freddie Mac to allo- cate a specified part of their mortgage business to serve low- and moderate-income borrowers. ARM see adjustable-rate mortgage . ARS see auction rate securities . asset-backed commercial paper Short-term debt secured by assets. asset-backed security Debt instrument secured by assets such as mortgages, credit card loans or auto loans. auction rate securities Long-term bonds whose interest rate may be reset at regular short-term intervals by an auction process. bank holding company Company that controls a bank. broker-dealer A firm, often the subsidiary of an investment bank, that buys and sells securities for itself and others. capital Assets minus liabilities; what a firm owns minus what it owes. Regulators often require fi- nancial firms to hold minimum levels of capital. Capital Purchase Program TARP program providing financial assistance to -plus U.S. finan- cial institutions through the purchase of senior preferred shares in the corporations on stan- dardized terms. CDO see collateralized debt obligation . CDO squared CDO that holds other CDOs. CDS see credit default swap . CFTC see Commodity Futures Trading Commission . collateralized debt obligation Type of security often composed of the riskier portions of mort- gage-backed securities . commercial paper Short-term unsecured corporate debt. Commercial Paper Funding Facility Emergency program created by the Federal Reserve in  to purchase three-month unsecured and asset-backed commercial paper from eligible companies. Commodity Futures Trading Commission Independent federal agency that regulates trading in futures and options. 539 FinancialCrisisInquiry--297 WALLISON: I fully agree, but—but the leverage tests have been published in the newspapers—not tests, but leverage numbers have been published in the newspapers. People are under the impression that the investment banks became very highly leveraged after the SEC began to regulate them. And I’m trying to get at... FOMC20080625meeting--96 94,MR. KROSZNER.," Thanks a lot. Well, as I've mentioned many times before, I have thought about this as sort of a long, slow burn scenario; and as we well know, the embers are still smoldering. It seems to be less of a risk that they could re-ignite, causing a major conflagration; but there is still some chance of re-ignition, and I think there's still a fair amount of heat. Consistent with that, my central tendency view is probably closer to the Greenbook's ""delayed credit recovery"" alternative scenario than to the main Greenbook forecast. In looking at the alternative scenario, there's not much of a real effect on growth, but that response is due to a lower fed funds path. Given the discussions that we've had, I think it may be very difficult to pursue something like that in this environment, particularly given higher uncertainty about inflation and inflation expectations, even if, as a number of people have mentioned, inflation expectations haven't moved up that much or you pick your favorite measure and some have moved up more than others. Given that it's likely that we had some transitory factors keeping core and headline inflation down a little lower than they otherwise might have been and they probably are going to go up, I think that dealing with the ""delayed credit recovery"" alternative scenario in the way that's discussed in the Greenbook makes our policy choices particularly difficult. So let me focus briefly on why I think the delayed credit recovery or slow burn scenario is a reasonable central tendency one. I think it relates largely to our continuing challenges on banks' balance sheets, liquidity, and capital. Banks are facing very high short-term financing costs. Those LIBOR�OIS spreads are still at extremely elevated levels compared with what they're used to in funding themselves, and this is true whether they are commercial banks or investment banks. The forwards suggest that this ain't going away anytime soon. So one thing that this does is simply to cut into profitability and the ability to earn your way out of the challenges. An easy way to do it-- of just allowing the machine to go forward--is going to produce less than it otherwise would. A lot of institutions rely on the Federal Home Loan Banks, but those are largely tapped out as another source of financing. We know that the monoline issue has sort of come back, and the challenges there are great. It is undoubtedly going to be leading to a lot more write-downs over the next couple of quarters. On the other hand, as President Lockhart, Governor Warsh, and some others have mentioned, there have been a few areas that seem to have opened up. The leveraged-loan market seems to have opened up a bit. People seem to be getting those leveraged loans off their books-- and not even at effectively subsidized financing rates. They were proud of getting these off their books before, but they were doing it by basically just making another loan, which effectively doesn't get them off the books. Now it seems as though they are legitimately able to move this, and obviously that book is not growing. That book is shrinking. Of course, one of the biggest challenges is in housing, and I see the shocks of some of the resets from the nontraditional mortgages continuing through '09. We're seeing very significant increases in delinquencies and foreclosures, not only in the subprime space but also in the adjustable rate space generally--that's both subprime and prime, although the levels for prime are dramatically lower. The increases are quite significant for prime ARMs, and that starts to raise some challenges for the institutions that didn't do subprime but may still have a reasonable amount of prime ARMs on their books. HELOCs have been mentioned and the inability to securitize anything that's nonconforming. We've seen very little benefit yet from the changes that allow Freddie Mac and Fannie Mae to raise those limits. Also, as many of you know, from my visits around the country to your Districts, I see that conditions in different areas are dramatically different, but in general a lot of markets remain in very difficult circumstances. One of the largest mortgage lenders in the country said that, over the last couple of months, their average FICO score on what they've been originating outside the conforming market has been 800. That's astonishingly high--so that gets back to President Yellen's comment about even with FICO scores in the stratosphere--and they claim that's an average FICO score, and they have been pulling back on the HELOCs et cetera. On rising delinquency rates for credit cards, I didn't hear quite as bleak a view as Governor Warsh described. I wouldn't want to say a positive view. They seemed to say that it is where they would have expected it to be in this part of a cycle with increasing delinquencies. One thing that they were seeing was a little increase in payments, and so that may be one of the consequences of the stimulus check coming--that people are using it to pay down some of their credit card debt. But a big challenge that they have been seeing is the so-called roll rates--that once someone begins to go delinquent, they tend to roll right to full loss rather than getting some recovery. It suggests that, when people get into trouble, they are in fairly deep trouble. All of this means that the demand for capital is going to be very high going forward at these institutions as provisioning has to go up. You know, we've tapped sovereign wealth funds, institutional investors, and a lot of others. As Governor Warsh said, tapping other sources, encouraging perhaps private equity to come in, is something that's important. But how long are these guys willing to invest when over the past nine months every single investment has seen a reduction rather than an increase in value? I'm borrowing a prop from President Fisher--we have been going around and saying, ""Raise capital. You're worth it."" [Laughter] I hope the investment banks are going around to their shareholders and saying that also. So far there's not a lot of evidence that they have been. I think in the long run they will, but we have to worry about that. This slow burn scenario is even more problematic in the context of what Vice Chairman Geithner mentioned about some slowing of foreign demand that I think may be coming and in the context of a fair amount of increases in interest rates that may be coming in a lot of these countries. You're going to be seeing some credit tightening globally, as I think a number of people have mentioned. It is more likely, unless there's a major shock, to be more on the tightening side going forward. This makes it more difficult to deal with some of the issues in the ""higher inflation expectations"" alternative scenario that was in the Greenbook because, when you have this financial fragility, it's harder perhaps to raise interest rates as quickly or as much as you would like because of the concerns about what might happen in the financial markets. On inflation, I think much like President Stern and a number of others--it depends on which particular series you look at. It is hard to say that things have really become unmoored, but I think there's a lot more uncertainty in the minds of both the public and the market participants about where inflation may go. That's particularly problematic when you have the likely increase in the actual numbers coming that the Greenbook is forecasting for the next quarter or so; and in that context, dealing with some of the challenges is more difficult. But we'll talk about that more tomorrow. On the projections, I think it is important that we continue to increase transparency over time. We structured what we did last time to make it part of a process, and I think it makes sense to periodically revisit whether we want to continue on that road. I very much prefer a gradualist approach, in principle, to add year 5 or so--as the Chairman said--but I think there's a bit of a problem in doing that because too much meaning may be attributed to it. It may be too difficult to avoid saying, ""Well, we're just doing a target."" If we add year 4 and year 5, even though there's not a lot of information content in year 4, I think it helps to reduce the kind of shock value of seeing that fifth year out there. Now, that's potentially a negative because, in some sense, we want to provide more information that way. But given the fragile conditions, as Vice Chairman Geithner mentioned, I don't think that we want to generate a debate on inflation targets, employment targets, and other things like that particularly right now. So maybe having a gradualist approach, by which we just extend things to year 4 and year 5, which is seen as a natural outgrowth, wouldn't be as much of a shock. Not that I think it would be shocking, but I think it might raise as many concerns and as much of a debate and distract us from the key issues that we have before us. Thank you. " CHRG-110shrg38109--111 Chairman Bernanke," So, in particular, over the economy as a whole, the average loan-to-value ratio for homes is about 50 percent. That is, the mortgage companies own half the housing stock and the public owns half the housing stock. But there are certainly segments of the population who are facing very high debt loads, either through their mortgage borrowing or through credit card revolving debt, and for them it is obviously a hardship. " CHRG-111hhrg53241--91 Mr. Paulsen," Going back to what Mr. Posey had mentioned earlier, he talked about the 17 different commissions or agencies that were charged with this. And it is interesting as I talked to one of my banks back home--and I just have this one chart and it lists a number of the regulatory burdens and I am not going to read every one as he had gone through each of these agencies that they have to deal with. But it is extremely frustrating I think for a lot of these organizations, because we hear about the frustrating flow of credit that has to go to small businesses for job creation, which we don't see happening right now. And this chart clearly shows and illustrates the burden that is posed on hundreds--or hundreds of these regulations that are posed and many of which are already dealing with consumer protection agencies. So I understand the goal of having it be smart, having it be strategic to make sure these consumers are protected, but I am not convinced that, at least given the details that have yet to emerge on this one, the devil is in the details, that we are going to be able actually fix this; and, if anything, I think we are going to be able to potentially make it worse. If a bank is engaged in unscrupulous lending, we need to find them out. Safety and soundness, most critical, and that should be the focus I think of all regulation. What I would like to do is actually yield my time to Mr. Hensarling, if I could, because I know he had one follow-up question. " CHRG-111shrg57322--824 Mr. Viniar," Not as close as we would have liked, but a lot closer than we were. Senator Coburn. OK. And were there collateralized debt obligations on these, and were there mortgage-backed securities on these, as well? " FinancialCrisisReport--257 Both companies also saw their share prices shoot up. The chart below reflects the significant price increase that Moody’s shares experienced as a result of increased revenues during the years of explosive growth in the ratings of both RMBS and CDOs. 999 Moody’s percentage gain in share price far outpaced the major investment banks on Wall Street from 2002 to 2006. 994 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 18 - 19. 995 Id. at 19. 996 Id. 997 “Debt Watchdogs: Tamed or Caught Napping?” New York Times (12/7/2008). The operating margin is a ratio used to measure a company’s operating efficiency and is calculated by dividing operating income by net sales. 998 “Revenue of the Three Credit Rating Agencies: 2002-2007,” chart prepared by Subcommittee using data from thismatter.com/money, Hearing Exhibit 4/23-1g. 999 “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers,” Frank Partnoy, University of San Diego Law School Legal Studies Research Paper Series (5/2006), at 67. FinancialCrisisInquiry--132 SOOMON: It would please every business school to know that management matters. And so one of the things we realize is—and you saw it today—is that people who are better managers did better in times. But what we have to also acknowledge is many of these firms have very large hedge fund proprietary trading operations. And they have shifted from becoming agents to dealers—to proprietary traders. And this has changed the nature of their view. This is certainly affecting compensation as you get to that issue. It’s affecting risk. It has to be affecting risk. And it’s probably affecting judgment. And you heard the folks this morning talk about that and say that, “Yeah, we didn’t use all the good judgment we could have.” But acknowledge today that what is the difference between some of these folks who talked today and what we call hedge funds? You have a totally different view of those, but if you look at the income statements and proprietary trading, you will find that they’ve increased materially and they have two different forms of regulation and of recognition. I would argue that hedge funds should be privately—should be private and should be not in the same structure as, for example, the lending business. BASS: I think I would respectfully disagree with Mr. Mayo on this. I think we need to determine—if an institution is systemically important to the United States and to our system, we need to determine what appropriate level of leverage are, and we need to force those companies to live within those leverage bounds. You know, today, as I mentioned, it’s somewhere between 16 and 25. And I will just assert to you that that is— that’s too high. So what we need to determine is—to Mr. Solomon’s point—if you’re going to be a proprietary trading firm and you want to engage in risk and it is the U.S. way and it’s capitalism, go do it. But there will be no safety net for you if you fail. All right. Don’t become systemically important. CHRG-111hhrg48674--157 Mr. Bernanke," Thank you. First, I would like to make the point that the $2 trillion Fed balance sheet is not government debt. In fact, the $2 trillion Fed balance sheet is a source of income for the government because we lend at higher interest rates than we pay, and that difference, so-called seigniorage, is paid in the tens of billions of dollars to the Federal budget every year. So that is a profit center, not a loss center. With respect to the other issues, though, in terms of the deficits, you are absolutely right that the deficits planned for this year and next year are extraordinarily large. They reflect the severity of the overall economic situation. Partly they are caused by the recession itself, which is hitting tax revenues and so on. And as the President and others have emphasized, it is very important that discipline be regained as soon as possible consistent with getting this economy going again and getting the financial system going again. Because if we leave the system in kind of a stagflation kind of situation, without growth, then the debt will be that much harder to service in the long term. But your point is absolutely right, that the deficits are an issue and a concern. It will raise the debt to GDP ratio of the United States probably by about 15 percent points. That is tolerable for a growing economy, but we do need to make sure, first, that we are growing and, secondly, that we have mechanisms to unwind these fiscal expenditures and loans as the economy improves. " CHRG-109hhrg28024--94 Mr. Bernanke," Congressman, first, you're absolutely right. We do look at a wide variety of indicators, and money aggregates are among those indicators. In particular, M2 has proven to have some forecasting value in the past, and I think the slowdown this year is consistent with the removal of accommodation that's been going on. In regard to your references to M3, a still broader measure of money, we have done, and I'm now speaking about the Federal Reserve before my arrival, but we have done periodic analyses of the various data series that we collect to see how useful they are. And our research department's conclusion was that M3 was not being used by the academic community, nor were we finding it very useful ourselves in our internal deliberations. Now it's not just a question of our own cost; although, of course, we do want to be fiscally responsible on our own budget, but it's also I think important for us to recognize the burden that's placed on banks that have to report this information. And so when we can reduce that burden, we would like to do so. And that was one of the considerations in the decision that was made about M3. Would we reconsider it? If there were evidence that this was an informative series and that it was useful to the public and to the Federal Reserve in forecasting the economy, naturally we would look at it again. There's nothing dogmatic going on here. Dr. Paul. If the Congress expressed an interest in receiving this information, would you take that into consideration? " CHRG-111shrg53822--40 Mr. Stern," Well, one suggestion that has a lot of appeal to me is something called ``contingent capital,'' where a firm would issue a debt instrument which would have, as its capital diminished at some point, with a formal trigger or perhaps under regulatory instructions, that debt instrument would convert to equity. That is why it is called ``contingent capital.'' So you would have additional capital, in fact, when you needed it most, when your capital was diminishing and your position was deteriorating. And I think that is an attractive idea, and I would certainly advocate and support it. Senator Shelby. In your tenure as President of the Reserve Bank there, have you known any banks in the area to fail that were well capitalized, well managed, and well regulated? " CHRG-111hhrg55809--262 Mr. Green," Final comment, with reference to small banks and community banks, I want to thank you for your efforts to avoid having them become--bear the burden, if you will, of a lot of what has happened when they in fact were, in the main, not the cause of this downturn that we are suffering from. I have had an opportunity to meet with many of the community bankers, and one of the things they continually say to me is, look, don't have us punished for the sins of others. We have been here. We are doing a good job, and we are maintaining a lot of loans in our portfolios, so please don't let it happen to us. And I thank you for your efforts in this area. I yield back, Mr. Chairman. " FOMC20081216meeting--16 14,MR. DUDLEY.," This is total. In fact, when you look at the issuance of investment-grade corporate debt recently, there's quite a bit of it, but most of it is the guaranteed stuff. " CHRG-109shrg21981--109 Chairman Greenspan," Yeah. No, no, I am not disagreeing with you. I say that that is correct. I just want to make sure that you are not talking about a new entitlement. Senator Schumer. No, I am not. And furthermore, we would have an easier time fixing Social Security if our debt went down. It would have been easier to fix it 6 years ago or in 1983 than it is today because one of the great problems is all the debt we have right now. Is that not fair to say, too? " CHRG-109hhrg28024--47 Mr. Bernanke," Current account deficit. The current account deficit, I should first say, I was asked about it earlier, is a very complicated phenomenon. There are many factors underlying it. And perhaps I'll have an opportunity to talk more about those factors. The immediate implication, though, is that the U.S. economy is consuming more than it's producing, and the difference is being made up by imports from abroad, which in turn are being financed by borrowing from abroad. So the concern is that over a period of time, we will be building up a foreign debt to other countries which will lower national wealth and lower our ability to consume in the future. So it is a concern. I do believe that the current account deficit can and should come down gradually over a period of time. I think it's neither possible nor desirable to have it shift radically in a short period of time. But over a longer period of time, a combination of higher national savings in the United States, increased demand by our trading partners, and greater exchange rate flexibility, taken together, will allow the current account deficit to come down in a way that I hope would not be disruptive to our economy. " CHRG-111hhrg55811--78 The Chairman," The gentlewoman from California. Ms. Waters. Thank you very much, Mr. Chairman. Mr. Hu, I want you to help me understand something about credit default swaps. From everything that I have learned, I came to the conclusion that they should be banned. So I am very pleased that the chairman has included language which would allow the CFTC and the SEC to ban abusive swaps, including credit default swaps. However, I am concerned with the problem of what I have come to know and I understand of empty creditors. And let me read an article to you that was recently in Financial Times. There have been a lot of articles on this. ``The relationship between Goldman Sachs and ailing commercial lender CIT provides further evidence of the dangers of the credit default swap market. Credit default swaps have become an increasingly contentious issue in debt restructuring, such as one that CIT is now trying to complete. Many creditors who hold such insurance make more if a company files for Chapter 11 bankruptcy protection than they make on their debt if the company succeeds in restructuring its debt outside of bankruptcy. In the case of CIT, the market has bought more insurance than the company's $30 billion in debt. These holders include Goldman Sachs, which purchased such a credit protection to hedge against a June 2008 rescue financing of up to $3 billion to CIT, Goldman said. Goldman also held other CIT debt, although the company declined to comment on these other exposures.'' Now, we bailed out Goldman, and we bailed out AIG. We bailed out AIG to the tune of $100 billion, I believe. We--and it appears that they ended up paying Goldman about--I think about $13 billion. Now we see the CIT situation. How will the Commission be able to use this new authority to prevent empty creditors or lenders who are net short their own clients? Would the Commission need any additional statutory authority to address this problem, or does this bill provide you with enough tools to prevent empty creditors from triggering defaults and bankruptcies? " CHRG-111hhrg56766--181 The Chairman," I recognize the gentleman from Kansas and ask for 10 seconds to say that the amendment to the House bill embodies precisely the approach that the Chairman just recommended with regard to proprietary trading, and it is in our bill. The gentleman from Kansas. Mr. Moore of Kansas. Thank you, Mr. Chairman. And Mr. Chairman, the economist Mark Zandi testified yesterday that policy uncertainty is playing a role in the business community's lack of confidence. It will be 2 years next month since the financial crisis started in full with the failure of Bear Stearns, and Republicans and Democrats have been in agreement of the key principles of financial reg reform, including increased consumer and investor protections, strong oversight of derivatives and executive compensation, new dissolution of authority to safely unwind the next AIG while protecting tax payers, stricter capital and leverage standards, and a financial reg structure that monitors systemic risk. The House recently passed a strong bill that accomplished all of these principles, in my judgment, that the Senate is now considering. And we need to eventually reform housing finance after considering the best ideas and the ways to do that. Mr. Chairman, will uncertainty increase or decrease in the business community if Congress delays these important reforms, or should Congress enact these reforms into law this year, now, so businesses know what the rules of the road will be? Won't that encourage investment and hiring in your judgment? " FinancialCrisisInquiry--40 And he said he couldn’t answer that question now himself at his level. And he then said it never came back up again to him. And as I said, it never came back to me. MURREN: Did he further that question up the chain of command at your firm at any point? BLANKFEIN: I think he—I can say I didn’t get it. I—I—I didn’t get it. He might have—he might have told his boss. MURREN: Could we talk a little bit about your—your interactions with the regulators? In particular, when you think back on the events of 2007, 2008, there are obviously a lot of people that participate in risk management that are either internal or external at your firm. They’re regulators. They’re auditors. There’s internal audit. There are your external auditors. They’re committees of your board. At any point did any of those entities or individuals raise the issue of the quality of the assets on your balance sheet or of the leverage that you had at any point during 2007 or—or later? BLANKFEIN: We’re a mark-to-market firm. So—and we have businesses, important businesses that—we have distressed businesses. We have businesses that specifically go out and buy distressed assets. But they’re marked correctly. So our auditors wouldn’t say I like this asset, I don’t like that asset. Our auditors would say is this—is this asset appropriately marked. And we engage on them. And—and I think I talk to the auditors each time. And they—you know, they tell me we do a very, very good job. We not only mark them, we go out and the best I can, get external benchmarks and go out and test the marks. So it’s not a matter of—we will today—today we would go out and if a client came to us and wanted to sell us a very distressed portfolio, Lehman Brothers debt or anything like that, we would have a bid for it. That’s our role in the market. We buy it. They could get it off their balance sheet. We’d have it on our balance sheet. But it has to be marked correctly. That’s the real issue. Is it marked correctly? 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. fcic_final_report_full--64 One reason for the rapid growth of the derivatives market was the capital require- ments advantage that many financial institutions could obtain through hedging with derivatives. As discussed above, financial firms may use derivatives to hedge their risks. Such use of derivatives can lower a firm’s Value at Risk as determined by com- puter models. In addition to gaining this advantage in risk management, such hedges can lower the amount of capital that banks are required to hold, thanks to a  amendment to the regulatory regime known as the Basel International Capital Ac- cord, or “Basel I.” Meeting in Basel, Switzerland, in , the world’s central banks and bank super- visors adopted principles for banks’ capital standards, and U.S. banking regulators made adjustments to implement them. Among the most important was the require- ment that banks hold more capital against riskier assets. Fatefully, the Basel rules made capital requirements for mortgages and mortgage-backed securities looser than for all other assets related to corporate and consumer loans.  Indeed, capital re- quirements for banks’ holdings of Fannie’s and Freddie’s securities were less than for all other assets except those explicitly backed by the U.S. government.  These international capital standards accommodated the shift to increased lever- age. In , large banks sought more favorable capital treatment for their trading, and the Basel Committee on Banking Supervision adopted the Market Risk Amend- ment to Basel I. This provided that if banks hedged their credit or market risks using derivatives, they could hold less capital against their exposures from trading and other activities.  OTC derivatives let derivatives traders—including the large banks and investment banks—increase their leverage. For example, entering into an equity swap that mim- icked the returns of someone who owned the actual stock may have had some up- front costs, but the amount of collateral posted was much smaller than the upfront cost of purchasing the stock directly. Often no collateral was required at all. Traders could use derivatives to receive the same gains—or losses—as if they had bought the actual security, and with only a fraction of a buyer’s initial financial outlay.  Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., testified to the FCIC about the unique characteristics of the derivatives market, saying, “they accentuated enormously, in my view, the leverage in the system.” He went on to call derivatives “very dangerous stuff,” difficult for market participants, regulators, audi- tors, and investors to understand—indeed, he concluded, “I don’t think I could man- age” a complex derivatives book.  fcic_final_report_full--252 When JP Morgan contacted Bear’s co-president Alan Schwartz in April about its up- coming margin call, Schwartz convened an executive committee meeting to discuss how repo lenders were marking down positions and making margin calls on the basis of those new marks.  In early June, Bear met with BSAM’s repo lenders to explain that BSAM lacked cash to meet margin calls and to negotiate a -day reprieve. Some of these very same firms had sold Enhanced and High-Grade some of the same CDOs and other securities that were turning out to be such bad assets.  Now all  refused Schwartz’s appeal; instead, they made margin calls.  As a direct result, the two funds had to sell collateral at distressed prices to raise cash.  Selling the bonds led to a complete loss of confidence by the investors, whose requests for redemptions accelerated. Shortly after BSAM froze redemptions, Merrill Lynch seized more than  mil- lion of its collateral posted by Bear for its outstanding repo loans. Merrill was able to sell just  million of the seized collateral at auction by July —and at discounts to its face value.  Other repo lenders were increasing their collateral requirements or refusing to roll over their loans.  This run on both hedge funds left both BSAM and Bear Stearns with limited options. Although it owned the asset management busi- ness, Bear’s equity positions in the two BSAM hedge funds were relatively small. On April , Bear’s co-president Warren Spector approved a  million investment into the Enhanced Leverage Fund.  Bear Stearns had no legal obligation to rescue either the funds or their repo lenders. However, those lenders were the same large invest- ment banks that Bear Stearns dealt with every day.  Moreover, any failure of entities related to Bear Stearns could raise investors’ concerns about the firm itself. Thomas Marano, the head of the mortgage trading desk, told FCIC staff that the constant barrage of margin calls had created chaos at Bear. In late June, Bear Stearns dispatched him to engineer a solution with Richard Marin, BSAM’s CEO. Marano now worked to understand the portfolio, including what it might be worth in a worst- case scenario in which significant amounts of assets had to be sold.  Bear Stearns’s conclusion: High-Grade still had positive value, but Enhanced Leverage did not. On the basis of that analysis, Bear Stearns committed up to . billion—and ulti- mately loaned . billion—to take out the High-Grade Fund repo lenders and be- come the sole repo lender to the fund; Enhanced Leverage was on its own. During a June Federal Open Market Committee (FOMC) meeting, members were informed about the subprime market and the BSAM hedge funds. The staff reported that the subprime market was “very unsettled and reflected deteriorating fundamen- tals in the housing market.” The liquidation of subprime securities at the two BSAM hedge funds was compared to the troubles faced by Long-Term Capital Management in . Chairman Bernanke noted that the problems the hedge funds experienced were a good example of how leverage can increase liquidity risk, especially in situa- tions in which counterparties were not willing to give them time to liquidate and possibly realize whatever value might be in the positions. But it was also noted that the BSAM hedge funds appeared to be “relatively unique” among sponsored funds in their concentration in subprime mortgages.  CHRG-109hhrg28024--17 Mr. Bernanke," The suspension of the bond occurred at a time when there predictions that the U.S. Government debt was going to be declining rather than rising and, therefore, considerations of maintaining liquid markets at different horizons suggested the idea of reducing the number of issuances that the Treasury made. Now with the U.S. Government debt rising again, I think it actually makes good sense for the Treasury to afford itself of the low real interest rates that are available on these long-term bonds, and I think the Treasury is well-served, the American public is well-served, and the investor community is well-served by the reissuance of these bonds. " CHRG-111hhrg56778--81 Mr. Greenlee," We follow what's outlined in the Gramm-Leach-Bliley Act, which compels us to rely to the fullest extent possible on primary bank regulators or functional regulators. We will get information at times that will cause us to go back and ask more questions. If there are concerns, we can always go to the audit function of the bank and find out what they think. We always have the right to go ahead and do our own review and look into it under the law. The burden is on us to say why we think this is a threat to the depository; and, at times we will do that if we are sufficiently concerned. " CHRG-111hhrg49968--7 Mr. Bernanke," Thank you, Mr. Chairman. Chairman Spratt, Ranking Member Ryan, and other members of the committee, I am pleased to have this opportunity to offer my views on current economic and financial conditions and on issues pertaining to the Federal budget. The U.S. economy has contracted sharply since last fall, with real gross domestic product having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous cost of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market, the number of new and continuing claims for unemployment insurance through late May, suggests that sizeable job losses and further increases in unemployment are likely over the next few months. However, the recent data also suggests that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, household spending power will be boosted by the fiscal stimulus program. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past 2 years, and the still-tight credit conditions. Activity in the housing market, after a long period of decline, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes seem to have flattened out in the past couple of monthly readings, though they remain at depressed levels. Meanwhile, construction of new homes has been sufficiently restrained to allow the backlog of unsold new homes to decline, a precondition for any recovery in homebuilding. Businesses remain very cautious and continue to reduce their workforces and their capital investments. On a more positive note, firms are making progress in shedding the unwanted inventories that they accumulated following last fall's sharp downturn in sales. The Commerce Department estimates that the pace of inventory liquidation quickened in the first quarter, accounting for a sizeable portion of the reported decline in real GDP during that period. As inventory stocks move into better alignment with sales, firms should become more willing to increase production. We continue to expect overall economic activity to bottom out and then to turn up later this year. Our assessments that consumer spending and housing demand will stabilize and that the pace of inventory liquidation will slow are key building blocks of that forecast. Final demand should also be supported by fiscal and monetary stimulus, and U.S. exports may benefit if recent signs of stabilization in foreign economic activity prove accurate. An important caveat is that our forecast also assumes continuing gradual repair of the financial system and an associated improvement in credit conditions. A relapse in the financial sector will be a significant drag on economic activity and could cause the incipient recovery to stall. I will provide a brief update on financial markets in a moment. Even after recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum, and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes. In this environment, we anticipate that inflation will remain low. The slack in resource utilization remains sizeable. And notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation. Conditions at a number of financial markets have improved since earlier this year, likely reflecting both policy actions taken by the Federal Reserve and other agencies, as well as a somewhat better economic outlook. Nevertheless, financial markets and financial institutions remain under stress, and low asset prices and tight credit conditions continue to restrain economic activity. Among the markets where functioning has improved recently are those for short-term funding, including the interbank lending markets and the commercial paper market. Risk spreads in those markets appear to have moderated, and more lending is taking place at longer maturities. The better performance of short-term funding markets in part reflects the support afforded by Federal Reserve lending programs. It is encouraging that the private sector's reliance on the Fed's programs has declined as market stresses have eased, an outcome that was one of our key objectives when we designed these interventions. The issuance of asset-backed securities, backed by credit card, auto, and student loans, has also picked up this spring, and ABS funding rates have declined--developments supported by the availability of the Federal Reserve's Term Asset-Backed Securities Loan Facility, or TALF, as a market backstop. In markets for longer-term credit, bond issuance by nonfinancial firms has been relatively strong recently. And spreads between Treasury yields and rates paid by corporate borrowers have narrowed some, though they remain wide. Mortgage rates and spreads have also been reduced by the Federal Reserve's program of purchasing agency debt and agency mortgage-backed securities. However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen. These increases appear to reflect concerns about large Federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight to quality flows, and technical factors relating to the hedging of mortgage holdings. As you know, last month, the Federal bank regulatory agencies released the results of the Supervisory Capital Assessment Program. The purpose of the exercise was to determine for each of the 19 U.S.-owned bank holding companies with assets exceeding $100 billion a capital buffer sufficient for them to remain strongly capitalized and able to lend to creditworthy borrowers, even if economic conditions over the next 2 years turn out to be worse than we currently expect. According to the findings of the SCAP exercise, under the more adverse economic outlook losses of the 19 bank holding companies would total an estimated $600 billion during 2009 and 2010. After taking account of potential resources to absorb those losses, including expected revenues, reserves, and existing capital cushions, we determined that 10 of the 19 institutions should raise, collectively, additional common equity of $75 billion. Each of the 10 bank holding companies requiring an additional buffer has committed to raise this capital by November 9th. We are in discussions with these firms on their capital plans, which are due by June 8th. Even in advance of those plans being approved, the 10 firms have among them already raised more than $36 billion of new common equity, with a number of their offerings of common shares being oversubscribed. In addition, these firms have announced actions that would generate up to an additional $12 billion of common equity. We expect further announcements shortly, as their capital plans are finalized and submitted to supervisors. The substantial progress these firms have made in meeting their required capital buffers and their success in raising private capital suggests that investors are gaining greater confidence in the banking system. Let me turn now to fiscal matters. As you are well aware, in February of this year, Congress passed the American Recovery and Reinvestment Act, or ARRA, a major fiscal package aimed at strengthening near-term economic activity. The package included personal tax cuts, increases in transfer payments intended to stimulate household spending, incentives for business investment, increases in Federal purchases, and Federal grants for State and local governments. Predicting the effects of these fiscal actions on economic activity is difficult, especially in light of the unusual economic circumstances that we face. For example, households confronted with declining incomes and limited access to credit might be expected to spend most of their tax cuts. But then again, heightened economic uncertainties and a desire to increase precautionary saving or pay down debt might reduce households' propensity to spend. Likewise, it is difficult to judge how quickly funds dedicated to infrastructure needs and other longer-term projects will be spent and how large any follow-on effects will be. The CBO has constructed a range of estimates of the effects of the stimulus package on real GDP and employment that appropriately reflects these uncertainties. According to the CBO's estimates, by the end of 2010, the stimulus package could boost the level of real GDP between about 1 percent and a little more than 3 percent and the level of employment by between roughly 1 million and 3.5 million jobs. The increases in spending and reductions in taxes associated with the fiscal package and the financial stabilization program, along with the losses in revenues and increases in income support payments associated with the weak economy, will widen the Federal budget deficit substantially this year. The administration recently submitted a proposed budget that projects the Federal deficit to reach about $1.8 trillion this fiscal year before declining to $1.3 trillion in 2010 and roughly $900 billion in 2011. As a consequence of this elevated level of borrowing, the ratio of Federal debt held by the public, to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis, to about 70 percent in 2011. These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II. Certainly our economy and financial markets face extraordinary near-term challenges, and strong and timely actions to respond to these challenges are necessary and appropriate. Nevertheless, even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets require that we, as a Nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby boom generation and continued increases in medical costs. The recent projections from the Social Security and Medicare trustees show that, in the absence of programmatic changes, Social Security and Medicare outlays will together increase from about 8.5 percent of GDP today to 10 percent by 2020 and 12.5 percent by 2030. With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands. Addressing the country's fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the administration, and the American people must confront is how large a share of the Nation's economic resources to devote to Federal Government programs, including entitlement programs. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability--defined, for example, as a situation to which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth--requires that spending and budget deficits be well-controlled. Clearly, the Congress and the administration face formidable near-term challenges that must be addressed, but those near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth. And let me close briefly with an update on the Federal Reserve's initiatives to enhance the transparency of our credit and liquidity programs. As I noted last month in my testimony before the JEC, I have asked Vice Chairman Kohn to lead a review of our disclosure policies, with the goal of increasing the range of information that we make available to the public. That group has made significant progress, and we expect to begin publishing soon a monthly report on the Fed's balance sheet and lending programs that will summarize and discuss recent developments and provide considerable new information concerning the number of borrowers at our various facilities, the concentration of borrowing, and the collateral pledged. In addition, the reports will provide quarterly updates of key elements of the Federal Reserve's annual financial statements, including information regarding the system open market account portfolio, our loan programs, and the special-purpose vehicles that are consolidated on the balance sheet of the Federal Reserve Bank of New York. We hope that this information will be helpful to the Congress and others with an interest in the Federal Reserve's actions to address the financial crisis and the economic downturn. We will continue to look for opportunities to broaden the scope of the information and supporting analysis that we provide to the public. Thank you, Mr. Chairman. [The statement of Ben Bernanke follows:] Prepared Statement of Hon. Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System Chairman Spratt, Ranking Member Ryan, and other members of the Committee, I am pleased to have this opportunity to offer my views on current economic and financial conditions and on issues pertaining to the federal budget. economic developments and outlook The U.S. economy has contracted sharply since last fall, with real gross domestic product (GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market--the number of new and continuing claims for unemployment insurance through late May--suggests that sizable job losses and further increases in unemployment are likely over the next few months. However, the recent data also suggest that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, households' spending power will be boosted by the fiscal stimulus program. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions. Activity in the housing market, after a long period of decline, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes seem to have flattened out in the past couple of monthly readings, though both remain at depressed levels. Meanwhile, construction of new homes has been sufficiently restrained to allow the backlog of unsold new homes to decline--a precondition for any recovery in homebuilding. Businesses remain very cautious and continue to reduce their workforces and capital investments. On a more positive note, firms are making progress in shedding the unwanted inventories that they accumulated following last fall's sharp downturn in sales. The Commerce Department estimates that the pace of inventory liquidation quickened in the first quarter, accounting for a sizable portion of the reported decline in real GDP in that period. As inventory stocks move into better alignment with sales, firms should become more willing to increase production. We continue to expect overall economic activity to bottom out, and then to turn up later this year. Our assessments that consumer spending and housing demand will stabilize and that the pace of inventory liquidation will slow are key building blocks of that forecast. Final demand should also be supported by fiscal and monetary stimulus, and U.S. exports may benefit if recent signs of stabilization in foreign economic activity prove accurate. An important caveat is that our forecast also assumes continuing gradual repair of the financial system and an associated improvement in credit conditions; a relapse in the financial sector would be a significant drag on economic activity and could cause the incipient recovery to stall. I will provide a brief update on financial markets in a moment. Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes. In this environment, we anticipate that inflation will remain low. The slack in resource utilization remains sizable, and, notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation. conditions in financial markets Conditions in a number of financial markets have improved since earlier this year, likely reflecting both policy actions taken by the Federal Reserve and other agencies as well as the somewhat better economic outlook. Nevertheless, financial markets and financial institutions remain under stress, and low asset prices and tight credit conditions continue to restrain economic activity. Among the markets where functioning has improved recently are those for short-term funding, including the interbank lending markets and the commercial paper market. Risk spreads in those markets appear to have moderated, and more lending is taking place at longer maturities. The better performance of short-term funding markets in part reflects the support afforded by Federal Reserve lending programs. It is encouraging that the private sector's reliance on the Fed's programs has declined as market stresses have eased, an outcome that was one of our key objectives when we designed our interventions. The issuance of asset-backed securities (ABS) backed by credit card, auto, and student loans has also picked up this spring, and ABS funding rates have declined, developments supported by the availability of the Federal Reserve's Term Asset-Backed Securities Loan Facility as a market backstop. In markets for longer-term credit, bond issuance by nonfinancial firms has been relatively strong recently, and spreads between Treasury yields and rates paid by corporate borrowers have narrowed some, though they remain wide. Mortgage rates and spreads have also been reduced by the Federal Reserve's program of purchasing agency debt and agency mortgage-backed securities. However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen. These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-toquality flows, and technical factors related to the hedging of mortgage holdings. As you know, last month, the federal bank regulatory agencies released the results of the Supervisory Capital Assessment Program (SCAP). The purpose of the exercise was to determine, for each of the 19 U.S.-owned bank holding companies with assets exceeding $100 billion, a capital buffer sufficient for them to remain strongly capitalized and able to lend to creditworthy borrowers even if economic conditions over the next two years turn out to be worse than we currently expect. According to the findings of the SCAP exercise, under the more adverse economic outlook, losses at the 19 bank holding companies would total an estimated $600 billion during 2009 and 2010. After taking account of potential resources to absorb those losses, including expected revenues, reserves, and existing capital cushions, we determined that 10 of the 19 institutions should raise, collectively, additional common equity of $75 billion. Each of the 10 bank holding companies requiring an additional buffer has committed to raise this capital by November 9. We are in discussions with these firms on their capital plans, which are due by June 8. Even in advance of those plans being approved, the 10 firms have among them already raised more than $36 billion of new common equity, with a number of their offerings of common shares being over-subscribed. In addition, these firms have announced actions that would generate up to an additional $12 billon of common equity. We expect further announcements shortly as their capital plans are finalized and submitted to supervisors. The substantial progress these firms have made in meeting their required capital buffers, and their success in raising private capital, suggests that investors are gaining greater confidence in the banking system. fiscal policy in the current economic and financial environment Let me now turn to fiscal matters. As you are well aware, in February of this year, the Congress passed the American Recovery and Reinvestment Act, or ARRA, a major fiscal package aimed at strengthening near-term economic activity. The package included personal tax cuts and increases in transfer payments intended to stimulate household spending, incentives for business investment, increases in federal purchases, and federal grants for state and local governments. Predicting the effects of these fiscal actions on economic activity is difficult, especially in light of the unusual economic circumstances that we face. For example, households confronted with declining incomes and limited access to credit might be expected to spend most of their tax cuts; then again, heightened economic uncertainties and the desire to increase precautionary saving or pay down debt might reduce households' propensity to spend. Likewise, it is difficult to judge how quickly funds dedicated to infrastructure needs and other longer-term projects will be spent and how large any follow-on effects will be. The Congressional Budget Office (CBO) has constructed a range of estimates of the effects of the stimulus package on real GDP and employment that appropriately reflects these uncertainties. According to the CBO's estimates, by the end of 2010, the stimulus package could boost the level of real GDP between about 1 percent and a little more than 3 percent and the level of employment by between roughly 1 million and 3\1/2\ million jobs. The increases in spending and reductions in taxes associated with the fiscal package and the financial stabilization program, along with the losses in revenues and increases in income-support payments associated with the weak economy, will widen the federal budget deficit substantially this year. The Administration recently submitted a proposed budget that projects the federal deficit to reach about $1.8 trillion this fiscal year before declining to $1.3 trillion in 2010 and roughly $900 billion in 2011. As a consequence of this elevated level of borrowing, the ratio of federal debt held by the public to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis to about 70 percent in 2011. These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II. Certainly, our economy and financial markets face extraordinary near-term challenges, and strong and timely actions to respond to those challenges are necessary and appropriate. Nevertheless, even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs. The recent projections from the Social Security and Medicare trustees show that, in the absence of programmatic changes, Social Security and Medicare outlays will together increase from about 8\1/2\ percent of GDP today to 10 percent by 2020 and 12\1/2\ percent by 2030. With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands. Addressing the country's fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation's economic resources to devote to federal government programs, including entitlement programs. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability--defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth--requires that spending and budget deficits be well controlled. Clearly, the Congress and the Administration face formidable near-term challenges that must be addressed. But those near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth. federal reserve transparency Let me close today with an update on the Federal Reserve's initiatives to enhance the transparency of our credit and liquidity programs. As I noted last month in my testimony before the Joint Economic Committee, I asked Vice Chairman Kohn to lead a review of our disclosure policies, with the goal of increasing the range of information that we make available to the public.\1\ That group has made significant progress, and we expect to begin publishing soon a monthly report on the Fed's balance sheet and lending programs that will summarize and discuss recent developments and provide considerable new information concerning the number of borrowers at our various facilities, the concentration of borrowing, and the collateral pledged. In addition, the reports will provide quarterly updates of key elements of the Federal Reserve's annual financial statements, including information regarding the System Open Market Account portfolio, our loan programs, and the special purpose vehicles that are consolidated on the balance sheet of the Federal Reserve Bank of New York. We hope that this information will be helpful to the Congress and others with an interest in the Federal Reserve's actions to address the financial crisis and the economic downturn. We will continue to look for opportunities to broaden the scope of the information and supporting analysis that we provide to the public.--------------------------------------------------------------------------- \1\ Ben S. Bernanke (2009), ``The Economic Outlook,'' statement before the Joint Economic Committee, U.S. Congress, May 5, www.federalreserve.gov/newsevents/testimony/bernanke20090505a.htm. " CHRG-111hhrg56847--256 Mr. Connolly," My final question, because my time is up and so is yours. Taxes. There was a study released a few weeks ago that showed that the cumulative aggregate tax burden, State, local and Federal, on the average household in America is now at its lowest point since 1950 when Harry Truman was in the White House. Is that your understanding as well? " CHRG-111hhrg74090--137 Mr. Barr," I think what we are able to do is create a high, consistent, clear standard. We are able to reduce regulatory burden in many cases, for example, combining the TEAL and RESPA forms that drive everybody crazy and don't help consumers. We need a single, uniform, simple standard for disclosure that applies---- " FOMC20080625meeting--23 21,MR. DUDLEY.," This is just assets divided by equity, so I think it is pretty good. When the investment banks start proposing their adjusted leverage ratios, then I think you have a problem--you know, apples and oranges--because the different investment banks calculate those kinds of adjusted leverage ratios a bit differently. Usually you see two leverage ratios-- one that is gross and another one that excludes the matched book--and the leverage ratio falls pretty significantly when you exclude the matched book. " CHRG-110hhrg41184--6 The Chairman," And Chairman Bernanke's full remarks will be submitted as well. Dr. Paul. Welcome to the hearing this morning, Chairman Bernanke. Obviously, the world, and especially we in this country, have come to realize that we are facing a financial crisis, and I think very clearly it is worldwide. That of course is the first step in looking toward solutions, but I would like to remind the committee and others that there were many who anticipated this not a year or two ago when the crisis became apparent, but actually 10-plus years ago when this was building. The problem obviously is in--the major problem is obviously in the subprime market, but, you know, in the last--in one particular decade, there was actually an increase, in $8 trillion worth of value in our homes, and people interpreted this as real value, and $3 trillion was taken out and spent. So we do live in an age which is pushed by excessive credit, and I think that is where our real culprit is. But traditionally, when an economy gets into trouble, and they have inflation or an inflationary recession, the interpretation is always that there is not enough money. We can't afford this, we can't afford that. And the politics and the emotions are designed to continue to do the same thing that was wrong, that caused our problem in the first place; that is, it looks like we don't have enough money. So, what does the Congress do? They appropriate $170 billion and they push it out in the economy and think that's going to solve the problem. We don't have the $170 billion, but that doesn't matter. We can borrow it or we can print it, if need be. But then again, the financial sector puts pressure on the Fed to say, well, there's not enough credit. What we need to do is expand credit. But what have we been doing for the past 2 years? You know, it used to be that we had a measurement of the total money supply, which I found rather fascinating, and still a lot of people believe it's a worthwhile figure to look at, and that is M3. Two years ago, the M3 number was $10.3 trillion. Today it is $14.6 trillion. In just 2 years, there has been an increase in the total money supply of $4.3 trillion. Well, obviously, if you pump that much money into the economy and we're not producing, but the money we spend comes out of borrowed money against houses, where the housing prices are going down, and that is interpreted as increasing our GDP, I mean, it just doesn't make any sense to come back and put more pressure on the Congress and on the Fed to say what we need is more inflation. Inflation is the problem. That has caused the distortion. That has caused the malinvestment, and that is why the market is demanding the correction in the malinvestment and the excess of debt which is not market-driven. " CHRG-111hhrg49968--107 Mr. Garrett," Thank you, Mr. Chairman. Chairman Bernanke, the other hat I wear is in Financial Services. And when you come over there, the issue that is often discussed is the term ``the system risk,'' the systemic risk regulator. And as you know, of all the hearings that we have had, no one has really yet defined exactly what it is, what authority they will have, what they will regulate, so on and so forth. But one thing out of both of these committees that I serve on seems to be pretty emphatic--and I will be taking a page out of Paul Ryan's comments here--and that is that one thing that is a systemic risk is the unfunded debt that is out there, as Paul was alluding to before. For this country, it is up to $56.4 trillion, and the numbers vary on that. Interestingly enough, we have had expert after expert for the last 6 years come before the committee. They all say the same thing, and we hear it from both sides of the aisle. But in the budget that we got this year, unfortunately it really isn't addressed. Obviously, we spend more. The numbers you already said before. We are looking at the national debt would double in just 10 years, pushing the debt north of 100 percent of GDP. And interestingly, on those numbers--maybe somebody else referenced this--is what has happened over in the United Kingdom with S&P's downgrading them, going from stable to negative. And their situation, in some perspective, one economist is saying not quite as bad as where we are, and where our trajectory is, that we are going to be worse than them. So your comment already is, I think, that this is probably the looming largest issue that we need to address? " FinancialCrisisInquiry--298 BLANKFEIN: I’ll have to get you what our leverage was at each time. But the investment banks, as a gross term, there was comments—and I read some of the materials -- 40-, 60-times leverage. I think the high water mark of our leverage, which we never sat at, I think was in the mid-20s—ever—as a high water mark, for example. CHRG-111hhrg54872--294 Mr. Driehaus," Thank you very much, Mr. Chairman. And thank you, gentlemen, for testifying today for the umpteenth time for some of you. I spent the better part of the last 8 years in the State legislature in Ohio. And I fully agree with you that the community banks and the small independent financial institutions were not part of the problem. But I think you would concede that you have not been part of the solution either. For years, we tried to pass predatory lending legislation in the State of Ohio, and were stopped. We were stopped in large part because so many financial institutions said, look, we are already the most regulated industry in the country, the last thing we need is more regulations. And the legislature too often bought into that. It wasn't until Governor Strickland was elected in 2006 that we finally created a foreclosure task force in the State of Ohio, and finally started actually doing something. And even then, I served on the task force, the bankers were very reluctant to work on legislation that would have gotten at some of the predatory lending issues. Now, I grant you that the vast majority of the legislation should have been Federal in nature because the State-chartered institutions were few, and they weren't causing the problem. But I just have a problem with this revision as history. I agree, and I have been fighting for the community banks and this legislation. I was on the phone with the FDIC yesterday, talking about assessments and trying to protect community banks. But my problem is that in the last 8 years, we saw this thing run away; we saw predatory lending legislation introduced in this body in 2001 and every year since, and we did nothing about it. We saw the problem, but people were making money off the system when real estate was increasing. And until the bubble burst, that is when everybody said, okay, we need to do something about it. Well, we were paying the price in foreclosures in Cincinnati back in 2001 and in 2002 and 2003. I now live in a neighborhood that has hundreds of homes that have been foreclosed on because we failed to act back then, and the banks were part of that inertia. What I am trying to get at is I want to come up with a solution that works. I believe very strongly in consumer protection. I also believe you don't need another regulatory burden. Is there a way that we structure this that we are achieving the consumer protection--and maybe it is not by giving the CFPA examination authority, maybe it is by allowing them to create rules and regulations, and they then have enforcement authority but they don't have examination authority, because you don't need another examiner. I want to make this thing work because the consumers are demanding it, and the consumers deserve it. We in our neighborhoods are paying the price for it. It is not those folks who were foreclosed on, it is not the big banks that have the mortgage-backed securities, it is the neighborhoods who are paying the price. And we continue to pay the price. So I want you to help me make this work. And I think many of us are willing to work with you in trying to reduce the regulatory burden, but help us understand how we make that happen. Mr. Yingling? " CHRG-110hhrg44901--84 Mr. Sherman," Okay. Now a question for the record relating to Bear Stearns. The rules of capitalism which are applied with a vengeance on Main Street would have said that in a situation like that, the shareholders and the subordinated debt holders should take the losses long before anybody else. But in the deal that was worked out, not only did the shareholders get $10 a share, which I realize is far less than they had hoped for, but the subordinated debt holders are going to get every penny with interest. And I wonder whether giving you the right to demand the conservatorship immediately would put us in a position where we could impose the risks and costs not on the taxpayer but on those who are supposed to bear them. " CHRG-111hhrg56776--147 Mr. Bernanke," Whether it's legally sovereign debt or not, I am not equipped to tell you. I don't know. " FOMC20050630meeting--86 84,CHAIRMAN GREENSPAN.," It sounds like a CDO [collateralized debt obligation]. That’s what it is, isn’t it?" CHRG-111hhrg53245--189 Mr. Royce," But basically the way it would work is that the largest banks would be required to issue the subordinated debt, and it could not be bailed out. And so if the interest rate on these instruments were to rise above the rate on Treasury, substantially above the rate on Treasury securities, it certainly would be one signal to regulators that the market perceives excessive risk taking by that bank, and it would then--you could set up a structure so at least there would be an objective way to monitor this, and at the same time you would have the advantage of the subordinated debt out there. " FinancialCrisisInquiry--253 BLANKFEIN: We never had—I don’t recall any internal conversation among the employees or with the board that—about what we would do if we would—if we would fail. I’d say on the too- big-to-fail issue, I agree about the sequence. Nobody in our company entertained government intervention and, certainly—and, certainly, we didn’t behave that way. We’re shareholders. We work for the shareholders. The equity—even in the context of a too-big-to-fail, if you take Bear Stearns, that was, quote, “rescued,” the equity failed. And we work for the shareholders, and all of the people in the firm are shareholders. And that’s how we think internally of what constitutes a failure. So for our purposes, they rescue the debt and the equity goes. That’s as much of a failure as anything could possibly be. External, I think everybody contemplated that the equity could go to zero because that was the pattern. And, in fact, it’s an interesting—and I would say on the debt, after the government—after you saw the too-big-to-fail noise came out—which only came out January 13, 2010 after Lehman, not before—you could see debt spreads contract a bit. But it’s interesting because every—there’s always unintended consequences. Our shares didn’t go down to the lows until, for us, after Buffet, after the—we did our capital raise the week after we became a bank-holding company at 123. We went down to a low under 50. That was after we got capitalized privately and after the TARP got passed because, at that point, people external to the firm started thinking they’ll be quick on the trigger, the debt will get saved perhaps, and maybe the equity will get crushed. Maybe we’ll get into the scenario of a kind of a Bear Stearns. And so we were running—in other words, that put some pressure on the equity of our shares which, again, didn’t—went through—went to those lows after the—after the government inserted money into the firms. CHRG-111hhrg51585--75 Mr. Street," Chairman Frank and honorable members of the committee, I am Chriss Street, Orange County Treasurer. Together, as we tackle the challenges that confront the Nation and navigate the financial sinkholes that have created uncertainty and instability, it is important to remember that each and every one of our actions will have consequences both intended and unintended, anticipated and unforeseen. Whatever we do, it should be reasoned and rational. I, more than most, understand what the local officials who are testifying here today are facing: angry constituents; an uncertain future; and the paralyzing fear of facing a seemingly insurmountable fiscal black hole. Fifteen years ago, bad investments forced Orange County, California into bankruptcy. In one of the Nation's most affluent communities, taxpayers remain on the hook for $1 billion of bankruptcy debt. I stood in the shoes of these local leaders. But as a result of directly facing these challenges, Orange County came together to solve the problems and overcome the obstacles that financial collapse posed. Labor and management, conservatives and liberals, businesses and unions, the entire community, pulled together and solved our problems without government intervening to cover our investment losses. Today, because of compromise and teamwork, Orange County holds the prestigious AAAM rating from Standard & Poor's, the highest rating in the Nation, and is the only county in America to have achieved this recognition. The pleas that you hear today are heart-wrenching but the actions these people are asking you to take are nonetheless wrong. We, as State and locally elected officials, must live with the intended and unintended consequences of our decisions. If we do not live with the decision and accept those consequences, we are shirking our responsibility as leaders. We must not look to someone else to blame for our current condition or solve our current problems. Bailouts will not instill the virtue of fiscal responsibility at the local level. A bailout simply masks the problems and permits leaders to avoid the consequences of financial mismanagement. We must meet today's challenges today, not push them down the road to our children. And what are the known and unknown consequences if we cover municipal losses? Realistically, just how much more debt can the United States of America assume without threatening the AAA full faith and credit of our Nation? If the cost of the Federal Government for issuing debt increases dramatically due to a downgrade in our credit rating, all the assumptions upon which the anticipated recovery are based will be rendered irrelevant and moot. In the last few weeks alone, the 10-year Treasury bond yields, despite billions of dollars of Fed purchases, have climbed to 3.2 percent. That is a 25 percent increase in a very short period of time. Rising obligations reinforce the market's concerns about the solvency of the debt of the United States of America. To add billions more in commitments could be the tipping point that crushes the fragile and embryonic recovery. If we are going to shelter local leaders from consequences of their investment in Lehman Brothers, how can we stop there? Why not reimburse cities and counties for the mistaken bond and stock investments in Chrysler, General Motors, AIG, Washington Mutual, and others? And why stop at government entities? Why shouldn't we cover the losses of our own citizens who have seen their 401(k)s decimated and retirement dreams destroyed by the economic tsunami. How do we determine which constituencies merit a government bailout? When we create laws, no matter our good intentions, to exempt individuals from the consequences of their actions, we eliminate responsibility and promote irresponsibility. Bailouts, no matter how lofty the original goal, encourage bad behavior. Pain, however uncomfortable and difficult, is part of the healing process. From experience, I can say that living through it and managing short-term pain gave Orange County the resolve and fortitude to bring about financial rehabilitation and community healing. I caution you as our Nation's leaders to be deliberate in evaluating the legislation before you today and mindful of potential unintended consequences. I urge you to vote ``no'' on this legislation. [The prepared statement of Mr. Street can be found on page 66 of the appendix.] " CHRG-111shrg53085--187 Mr. Whalen," If one was creative, you might lessen the burden on institutions by going to a product-focused regulatory regime. In other words, don't make it a compliance checklist sort of exercise for the bank. Take that away from the bank management having to go through that as part of their exam process and instead just have a product focus by another agency. That might be a quid pro quo for the industry. " CHRG-109shrg26643--135 FROM BEN S. BERNAKE Mr. Chairman, I noted in a press release dated November 10, 2005 that the Federal Reserve would cease publication of the M3 money aggregate, the broadest measure of the U.S. money supply. I have carefully read your testimony in the House Financial Services Committee on this topic. I have some follow-up questions:Q.1. You noted in your testimony to the House Financial Services Committee that money aggregates are among the many indicators that the Federal Reserve Board uses to determine monetary policy. In your opinion, would discontinuing the M3 aggregate deprive the Board of information useful in the formation of U.S. monetary policy? Has the M3 aggregate become obsolete?A.1. Over time, the Federal Reserve continuously assesses the usefulness of the various statistics that it monitors in the conduct of monetary policy. In cases in which the Federal Reserve compiles and publishes the data, the Board seeks to revise its statistical program appropriately, taking into account ongoing developments in the economy and the financial system as well as both the benefits and the costs of data collection. For example, in the early 1980's the Federal Reserve redefined the monetary aggregates to reflect changes in the financial environment. Similarly, for a time research suggested that a broad measure of nonfinancial sector debt should receive considerable attention in monetary policymaking, and the Board began to publish monthly data on such an aggregate. Over subsequent years, policy experience and accumulating empirical evidence indicated that some of these aggregates--in particular, domestic nonfinancial sector debt at a monthly frequency, and the broadest monetary aggregate--were not particularly useful in the conduct of policy. Accordingly, the publication of those aggregates was either scaled back or dropped. Similarly, the Board over time recognized that M3 was not providing information that was useful to policymakers. Recently, the Board decided that discontinuing the compilation of that aggregate would not deprive the Federal Reserve of information useful in the formulation of U.S. monetary policy and, given the costs involved in compiling the aggregate, it decided to discontinue M3.Q.2. Reducing regulatory burden for our Nation's banks is a laudable goal and an effort I support. How many financial institutions are currently required to provide data to the Fed to calculate the M3? Do these same institutions report data to calculate the M1 and M2 aggregates? Is there any quantitative data on the savings achieved by reporting institutions once publication of the M3 has ceased?A.2. A complex system of reports is employed to collect the data necessary to compile the monetary aggregates, and discontinuing M3 will allow two reports--the FR 2415 and the FR 2050--to be dropped. The FR 2415 form (Report of Repurchase Agreements [RP's] on U.S. Government and Federal Agency Securities with Specified Holders) is reported by approximately 450 institutions (270 reporting annually, 90 quarterly, and 90 weekly). The FR 2050 form (Weekly Report of Eurodollar Liabilities Held by Selected U.S. Addressees at Foreign Offices of U.S. Banks) is reported by about 35 institutions. The discontinuation of the FR 2415 and the FR 2050 is estimated to reduce annual reporting burden by a total of 4,487 hours. These reports are used to obtain data only for M3, not M1 or M2. I should note that discontinuing M3 will also allow two of our fellow central banks, the Bank of Canada and the Bank of England, to stop collecting, editing, compiling, and transmitting additional data on Eurodollars--a task that no doubt involved the expenditure of significant resources for which those institutions were not compensated. We do not have estimates of the savings that will accrue to the Bank of Canada and the Bank of England, or of any of the entities that report to those central banks, as a result of the elimination of M3.Q.3. Is there any indication of how useful the M3 aggregate is to the U.S. public? How did the Fed determine the public's demand for this data?A.3. Federal Reserve staff conducted a search to determine the extent to which M3 was used in the professional literature on monetary economics. The staff found that the vast majority of academic papers published between 1990 and 2000 that referenced ``M3'' actually referred to foreign versions of M3, which correspond most closely to the Federal Reserve's M2 aggregate rather than our M3 aggregate. The remaining papers, which actually did use U.S. M3, fell into the following categories: Papers testing new methods of creating monetary aggregates (for example, so-called ``Divisia monetary aggregates''). These papers did not demonstrate any important indicator properties of M3. Papers testing new methods of estimating long-run econometric relationships. Some of these papers estimated equations based on the quantity theory of money for a range of monetary aggregates. Again, these papers suggested that M3 played no particularly valuable role. Papers testing the forecasting properties of various financial or other variables. M3 would be one of hundreds of variables used in such tests. In all cases, M3 was studied only in combination with M2 and other monetary aggregates. In summary, our review of the academic literature revealed no evidence that M3 was particularly useful in macroeconomic analysis or forecasting. The Board believes that it has a responsibility to the taxpayer to weigh carefully the costs and benefits of all of the various activities of the Federal Reserve, including data collection and publication, to determine whether the Federal Reserve is performing its responsibilities most efficiently. In the course of such a review, the Board recently judged that the costs to the Federal Reserve of collecting and processing the data necessary to publish M3 exceeded the benefits. Moreover, discontinuing two of the reports that need to be filed in order to construct M3 will permit a small reduction in the burden on some depository institutions. As the Nation's central bank, the Federal Reserve recognizes the importance of carefully monitoring as well as releasing to the public data on useful concepts of the money supply, and the Board will continue to publish timely data on the monetary aggregate M2. Of the various monetary and debt aggregates, in our view M2 has exhibited the most stable, explicable, and useful relationship with measures of nominal spending and interest rates. In addition, the Board will continue to publish the monetary aggregate M1, which is a component of M2, as well as the other components of M2. The Board will also continue to publish data on shares issued by institution-only money market mutual funds, which are currently included in the non-M2 component of M3." CHRG-110hhrg45625--20 Mr. Barrett," Thank you, Madam Chairwoman. Thank you, Ranking Member Bachus. I firmly subscribe to the belief that Main Street and Wall Street are inextricably linked. Instability in the financial markets leads to instability in taxpayers' retirement accounts, pension funds, and people who are concerned about if and how their jobs, student loans, and car loans will be affected. The caliber that flows through our financial markets is vital to the continued success of our businesses large and small. We should all agree that a failure of our credit markets could and would be catastrophic. However, I am not convinced that the Treasury's plan to purchase $700 billion worth of illiquid assets is the solution. And I am not sure that this proposal gets to the root of the problem. I fear that it will only treat the immediate symptoms. While I understand that these are symptoms, and the symptoms that would shut down the credit markets are potentially disastrous, I worry if we go forward with this plan we will have to come back again and again with more and more money to treat symptoms that may pop up. We instead need to treat the cause of the problem which may be long and possibly painful. The whole crisis started around a type of credit, subprime mortgages, and it still resolves around this debt. Mortgage-backed securities and other debt instruments are the root of this problem. We need to do something to restore access to credit, which means more debt. But the proposal brought to us involves even more debt, the government borrowing another $700 billion. Consumers, like the government, have borrowed too much. We must cut government spending. We must also institute pro-growth policies to help our economy grow so that Americans and their government can get out of debt. It makes sense that when people have good jobs they do not need to borrow as much, whether to buy a mortgage, a home, credit card, pay for school supplies, or even gasoline. Too much of our recent economic growth has been built on debt. We see that businesses have been massively overleveraged as American consumers have. If debt was at a safe level, we would never have been in this fix in the first place. When consumer spending makes up 70 percent of GDP, I think that indicates an unsustainable form of economic growth, especially when it is financed by credit card debt and increasingly unaffordable mortgages. We need to start producing, whether that is energy, computers, or intellectual property. I think the road map to get us there is pretty clear. We must shore up our balance sheet, we need to reduce our capital gains taxes to spur investment, we need to reduce our corporate taxes which are among the highest in the world, and we must move toward energy independence as high energy prices are increasingly a dangerous drag on this economy. We should take this opportunity to do the right thing and help America grow in the long run. I appreciate that there is a panic in the market, but policies derived from panic are never sound. I strongly believe in the superiority of the free market and the ability of the markets to correct themselves. However, the government does not and has not always had a role in ensuring the market's function to correctly and efficiently make sure that we are free of fraud and malfeasance to minimize market failures. For example, we are all familiar with the important role that the FDIC plays in insuring bank accounts. I think that we should be more actively exploring other options where the government can take a role in helping the credit markets find order, but allow the free market to do most of the heavy lifting and provide more capital. One option that should be explored in greater detail is to allow the private entities, private equity, hedge funds, and other partnerships to participate in a competitive bidding process for the distressed assets that will be off-loaded by banks and other financial institutions rather than having the Treasury as the only potential buyer. This proposal should include a traditional auction which might include the government as well as other qualified buyers, with the assets going to the highest bidder. There is no doubt that we find ourselves in a precarious situation, but like many of my colleagues, I think it would be a mistake to rush into a huge new expenditure. Just as the markets are now panicking, the government does not need to do so, too. Thank you, Madam Chairwoman. I yield back. Ms. Waters. Thank you. The gentleman from Missouri, Mr. Cleaver.STATEMENT OF THE HONORABLE EMANUEL CLEAVER, A REPRESENTATIVE IN CHRG-109hhrg22160--260 Mr. Crowley," So the President's options are--and I will just repeat them--would either be a massive tax increase on the American public--we are talking about massive, anywhere between $1 trillion and $2 trillion, or twice what the IRS took in tax revenues last year. And I believe you stated yesterday that anything over $1 trillion is considered--$1 trillion is large, a large tax increase on the American public. That was A. B, there would be a huge, potentially huge cut to benefits to both current and future, I am assuming, retirees, including the disabled, as well as the dependent children, which is a real possibility. But those benefit cuts would have to come to today's retirees, as I mentioned before, almost immediately in order to pay the $1 trillion to $2 trillion in borrowing that is needed for the Social Security privatization plan. Or--and this, I think, is the most egregious--massive new deficits. And in essence my colleagues on the other side, I think very effectively, use the issue of the death tax politically incredibly well, and I think cornered us in many respects. What I think is even more immoral and more egregious is the fact--I have two children, 4 and 5, and, quite frankly, I am expecting a third child, although I don't think my wife expected me to say that on national television. But if you take the fact that my children today owe $26,000, theoretically, in national debt, each, as we all do, my unborn child to be, once it comes out of the womb, will have a price tag of $30,000 that he or she will have to pay--you know, we are all going to die some day, and maybe we are going to need the death tax benefit to pay for our birth tax. And I think that is the most egregious thing about what we are doing to ourselves with this mess of deficit that we are putting our children and our children's children into fiscal disability in the future. Can you comment on that? " CHRG-109hhrg31539--157 Mr. Bernanke," If you are referring to external debt. I don't think it is true in terms of share of GDP, it would be in terms of actual dollars. Mr. Moore of Kansas. I am talking about actual dollars. " CHRG-109hhrg23738--128 Mr. Greenspan," It is going up very much more rapidly---- Mr. Miller of North Carolina. For the supervisory employees? " Mr. Greenspan,"--for the supervisory workers, the 20 percent; the supervisory, professional, et cetera, the more skilled aspects of our labor force. So we are getting a bivariate income distribution. And as I have said many times in the past: For a democratic society, this is not healthful, to say the least; and as I have indicated on numerous occasions, I believe this is an education problem that requires us to get the balance of skills coming out of our schools to match the skills that our physical facilities require. So there is a reconciliation, and the reconciliation is that we are getting some really divergent trends. Mr. Miller of North Carolina. Mr. Greenspan, Mr. Chairman, you did testify about home mortgages and about the concerns about exotic mortgages and said that home equity extraction was occurring, mortgage market finance withdrawals of home equity--in other words, people were borrowing against their homes--and it seems to be that homeownership, as Chairman Oxley said, is good news, but it is about the only good news in the American economy for most workers--about 80 percent--whose wages remain subdued or increasing modestly. All of your testimony appears to go to the effect this is having on the safety and soundness of lenders or on the effect on housing prices. Have you looked at what these exotic mortgages, particularly for refinancing, are doing to the economic status of most American families? You pointed out we have a 1 percent savings rate. The latest figure I have seen on credit card debt is $800 billion. Wages for 80 percent of American workers are very modest or subdued, and their increase--and the good news that 69 percent of American families own their homes but the equity in their homes is the bulk of their net worth. What are these exotic mortgages for refinancing doing to the financial position of American families? " CHRG-111hhrg48867--266 Mr. Silvers," Well, you know, one of my observations from being on the Oversight Panel for TARP, which I think is, sort of, what you are getting at, is that what is a healthy institution can be a puzzling thing. Every recipient, with the exception of AIG, of TARP money has in some respect been designated a healthy institution by the United States Government. So perhaps your question is, well, we are just giving money to healthy institutions already. I am not sure that is a very plausible statement, but it is, more or less, what the record shows. The question of increasing lending, I think, is complex. There is no question that there is a need for more credit in our economy right now. On the other hand, the levels of leverage we had in our economy during the last bubble are not ones we ought to aspire to returning to or sustaining. Getting that balance right is extremely important. And, furthermore, it is also the case, I believe, that allowing very, very large institutions to come apart in a chaotic fashion would be very harmful to our economy. The punch line is I think that we have not learned enough about to what extent TARP's expenditures have produced the increased supply of credit that your question indicates and to what extent that is because of, I think as you put it, the fact that a majority of that money has gone to a group of very large institutions. Those are questions that I know the Oversight Panel is interested in and questions that I am very interested in. I can't tell you what I believe the answer to them to be today. " CHRG-110hhrg46596--474 Mr. Kashkari," We have looked at rules such as that. And, in fact, by going with capital, if you will permit me for just a moment, many of these banks are leveraged, you know, say, 10 to one. So you put in a dollar of capital, you could get many more than a dollar of loans out the door. " CHRG-111shrg61513--119 Mr. Bernanke," We have been working on the charges and they have been substantially increased. We are currently testing out the implications of that. On the particular issue of these off-balance sheet vehicles, as you know, the new accounting standards will force banks to consolidate most of those onto their own balance sheet and so they will have to have a full capital charge against them. Senator Reed. And one final question, Mr. Chairman, and that is we have talked a lot about derivatives. We all do recognize there is a long-term value to derivatives. My recollection is the Chicago Board in 1848 started trading agricultural futures. In fact, I think I recall a story where General Grant and General Sherman showed up to congratulate one of the architects for helping them win the Civil War because of being able to guarantee supply. So that is the question of the utility in that sense, and other senses, is not at stake here. But there also is the growing perception, and I am coming to a conviction, that many times these devices are used to avoid regulatory constraints. In the case of Greece, it might have been strictly legal, but clearly the intent was to avoid the budget limitations and the budget restrictions of joining the European Community. With respect to many other derivatives, for example, even commercial derivatives, because they are not typically recorded as lending, or in some cases not even on the books, it is borrowing that is not in violation of covenance with other lenders. It is borrowing that allows additional leverage. And one of the problems we are trying to recognize now is over-leverage. So to the extent that we have to deal with these derivatives, any thoughts our guidance about how we prevent them from being used not for economic hedging but for clearly and very deliberately--maybe legally, maybe not--avoiding your capital requirements, the lending covenants of a bank, and many other examples. " CHRG-110hhrg44901--24 The Chairman," The gentleman from Texas, who may not be quite so lucky in getting the answer that he wants. Dr. Paul. Thank you, Mr. Chairman. I want to address the subject of the inflation being actually a tax. Today, most of us who go home and talk to our constituents hear a major complaint, and that is the rising cost of living, especially the cost of gasoline, medical care, food, and education. Most economists from all fields, whether they are monetarists or Keynesians, they generally recognize that inflation is a monetary phenomenon. But it is interesting that once we get rising prices, very few people talk about the real source and the cause of the inflation, and they go to saying, well, it's the oil companies. They charge too much. That is inflation. Labor makes too much money, and it is a labor problem. Others just say, well, it's just pure speculation, if we didn't have the speculators, we wouldn't have the inflation. Yet, most people conclude not that we have too much money, but that we don't have enough. If we only had more money, we could pay all these bills, which I think is absolutely the wrong conclusion. What we need is more value in the money. In terms of gold and other commodities, prices aren't really going up. Sometimes they actually even go down. In terms of paper money worldwide, whether the euro or the dollar, the prices are going up. But I maintain really that inflation is a tax. If the Federal Reserve and you as Chairman have this authority to increase the money supply arbitrarily, you are probably the biggest taxer in the country. You are a bigger taxer than the Congress, because they are talking now about a bailout package of $300 billion, and we will have to raise the national debt to accommodate to take care of the housing crisis. But you as the Federal Reserve Chairman and the Federal Reserve Board and the system create hundreds of billions of dollars without even the appropriations process. Then this money gets circulated, and some people benefit--the people who get to use it first benefit, and the people who get to use it last suffer the consequence of the higher prices. So every time people go and complain about these higher prices, they should say to themselves, I am paying a tax. Because whether you are monetizing debt or whatever or catching up for buying up securities, we have had a free ride for all these years. We have been able to export our inflation. We have the Chinese buying up our securities. We haven't had to monetize it. But now it is coming home, and you have to buy these things to prop them up. So I maintain that inflation, as the increase in the supply of money for various reasons is a tax, it is an unfair tax, it is a regressive tax, it hurts the poor, it hurts the retired people more because labor never goes up and keeps up with inflation. We never keep up with the need for retired individuals to keep up with the cost of living. So I would like you to comment on this. Is this completely off base, or is there something really to this? Every time we see the cost of living going up, we indirectly are paying a tax. " CHRG-111hhrg51592--142 Mr. Sherman," I have to try to squeeze in one more question. That is, I'm going to propose that the SEC identify which credit rating agencies are qualified. In fact, they have already identified 10, but which are qualified for particular categories of debt instruments. And then, every issuer, when they want to take an issue public, of debt, they call the SEC and the SEC assigns one at random, the same way the league assigns a team of umpires. Mr. Joynt, this would mean that you would never have to please an issuer. As a matter of fact, if you regard it as a really tough rater, that might be fine, because it would improve your image with the SEC. That would change your business model. It would allow perhaps other competitors to emerge, in that having a big name like your company does wouldn't matter as much as being rated as qualified by the SEC. Do you see--what disadvantage do you see to someone like myself who would like to invest $10,000 or $20,000 in debt instruments and get a rating that I can rely on? " CHRG-109shrg21981--22 STATEMENT OF SENATOR CHRISTOPHER J. DODD Senator Dodd. Thank you, Mr. Chairman, and I will join my colleagues in welcoming you, Mr. Chairman. It is a pleasure to have you before this Committee again. In the words of Morris Udall, ``Everything has been said, but not everyone has said it,'' here this morning. So let me just associate my remarks, briefly, with those of Senator Reed, Senator Schumer, and Senator Stabenow. I know you are here to talk about monetary policy, but, obviously, because of the high regard in which we hold you and the tremendous respect we have for your knowledge about broader economic issues, while the subject matter is of monetary policy, obviously, these other issues are of keen interest to all of us here. I can recall only 4 years ago talking about we have not had hearings about the dangers of too steep a glide path on retiring the national debt. It sounds difficult to believe that only 4 years ago we had that hearing to talk about those issues. Senator Sarbanes. I remember it as though it was yesterday. [Laughter.] Senator Dodd. But here we are in a very different situation, obviously. With estimates now, we have had to raise the debt ceiling twice in the last 3 years in excess of $8 trillion. I am worried, as well, about the amount of resources, the amount of this debt being held off-shore. And I know you have talked about that in the past, but the numbers seem to be going up. And the concern I see with some of these countries purchasing assets, not dollar-denominated assets, but looking more to the euro and whether or not we should be worried about that as a country, and so I will be looking forward to your comments on these matters that have been raised by others, and thank you again for your service. " CHRG-110shrg50414--56 Mr. Lockhart," Chairman Dodd, Senator Shelby, and Members of the Committee, thank you for the opportunity to testify on the Federal Housing Finance Agency's decision to place Fannie Mae and Freddie Mac into conservatorship. Fannie Mae and Freddie Mac share the critical mission of providing stability, liquidity, and affordability to the Nation's housing market. Between them, these enterprises have $5.3 trillion of guaranteed mortgage-backed securities and debt outstanding, which is equal to the total publicly held debt of the United States. Their market share earlier this year reached 80 percent of all new mortgages made. During the turmoil that started last year, they had played a very important role in providing liquidity to the conforming mortgage market. They required capital to support a very careful and delicate balance between safety and soundness and mission. That balance was upset as house prices, earnings, and capital have continued to deteriorate. In particular, the capacity to raise capital without Treasury Department support vanished. That left both enterprises unable to fill their mission. Worse, it threatened to further damage the mortgage and housing markets if they had to sell their assets. Rather than letting those conditions worsen and put the financial markets in further jeopardy, FHFA decided to take action. The goal of these dual conservatorships is to help restore confidence in Fannie Mae and Freddie Mac, enhance their capacity to fulfill their mission, reduce systemic risk, and make mortgages--and this is the most important--make mortgages available at lower cost for the American people. FHFA based its determination on five key areas, each of which worsened significantly over the last several months: First, there were accelerating safety and soundness weaknesses. Second, there was a continued and substantial deterioration in equity, debt, and MBS market conditions. Third, the current and projected financial performance and condition of each company, as reflected in the second quarter financial reports and our ongoing examination. Fourth, the inability of the companies to raise capital or to issue debt according to normal practices and prices. And, last, the critical importance of each company in supporting the country's residential mortgage market. I shared our growing concerns with Federal Reserve Chairman Bernanke, who was made our consultant in the law you passed in July, and with Secretary Paulson. They agreed that a conservatorship was necessary, as did the boards of both firms. A detailed list of events leading to our conclusion to appoint a conservator is provided in my written statement. I will just highlight a few. It became apparent during this intense supervisory review that began in July that market conditions were deteriorating much more rapidly than anybody expected. We supplemented our examination team with senior examiners from the Fed and the OCC. All three sets of examiners corroborated that there was a significant deterioration in the credit environment and it was a threat to the capital of these two companies. We also finished our semi-annual examination ratings of the companies and, across the board, there were significant and critical weaknesses. The companies themselves disclosed in their second quarter filings how rapidly the environment had deteriorated and was negatively affecting their outlook and their ability to raise capital. Freddie Mac reported losses of $4.7 billion over the last year. Fannie Mae reported losses of $9.7 billion. Now, let me turn to the conservatorships. The first signs are that the conservatorships are positive. The enterprise funding costs and the spreads on MBS have declined. This lower cost has been passed on to homebuyers, with 30-year mortgage rates well below 6 percent for the first time since January. On the first day, business opened as normal but with stronger backing for the holders of their mortgage-backed securities, their debt, and their subordinated debt. Over the next 15 months, they are allowed to increase their portfolios to provide support to the housing market. They will also be able to continue to grow their guaranteed MBS books. As the conservator, FHFA assumed the power of the board and management. Highly qualified new chief executive officers and non-executive chairmen have been appointed. They will be delegated significant powers. In order to conserve over $2 billion in annual capital, the common stock and preferred dividends were eliminated. The U.S. Treasury financing facilities, which are critical to this conservatorship, are all in place and will provide the needed support to Fannie Mae and Freddie Mac to fulfill their mission over the long term, while giving upside potential for taxpayers. FHFA will continue to work expeditiously on the many regulations needed to implement the new law. The new legislation adds, importantly, affordable housing, a trust fund, and mission enforcement to the responsibilities of the safety and soundness regulator. We are also continuing to work with the enterprises on loan modifications, foreclosure preventions, pricing, and credit issues. The decision to appoint a conservator for each enterprise was a tough but necessary one. They can now become part of the solution. Unfortunately, all the good and hard work put in by the FHFA and the enterprises was not sufficient to offset the consequences of the antiquated regulatory structure which was overwhelmed by the turmoil in the housing markets. Conservatorship will give the enterprises the time to restore the balances between safety and soundness and their mission. Working together with the enterprises, Congress, the administration, and other regulators, I believe we can restore confidence in the enterprises and, with the new legislation which you passed, build a stronger and safer future for the mortgage markets, homeowners, and renters in America. Thank you. I would be pleased to answer questions. " CHRG-111hhrg56847--195 Mr. Austria," And if we can bring up a figure. I am looking at chart number one. I believe that is the chart on the Tidal Wave of Debt right there. This chart right here. I wanted to get your opinion as far as the debt crisis that we are seeing across Europe right now. You know, how this could occur in the U.S. if we don't change the way we are going right now. You know, there are projections right now that payments are projected to reach 20 percent of the tax revenue or higher by 2020, as far as our payments continue to grow. And when you look at this chart, I wanted to get your thoughts on that. " CHRG-110shrg50414--203 Secretary Paulson," That is--I certainly, sir, did not say we are going to focus on this and that that was going to be the major focus---- Senator Bunning. I didn't say you said it. I said I read it. " Secretary Paulson," OK. OK. Well, I am not sure what you read. Senator Bunning. I read that included because someone insisted on it, that you were dealing with--included that we were going to deal with credit card debt and student loan debt. " Secretary Paulson," I---- Senator Bunning. It is untrue? " CHRG-111hhrg48868--733 Mr. Liddy," When you lose that money, it reduces the equity that the company has. Think of a home; you need so much equity to support the debt. We have all the debt, but the equity shrunk because of the loss. So as a result of that, the Treasury restructured the TARP arrangement, the original TARP arrangement, in such a way that accounted for more equity and made the $30 billion available to us if we needed it. That kept the rating agencies calm so they don't downgrade the company and we don't get into an extraordinarily negative spiral. " CHRG-110hhrg34673--29 Mr. Bernanke," The government needs to address both the fiscal implications of aging--certainly a part of that is the cost of medical care, which is a big part of the economic cost of aging--and also of the fiscal burden. And to the extent that outside of the fiscal arena we can find ways to encourage savings more broadly, and asset-building, I think that would be very constructive. " FinancialCrisisInquiry--374 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. CHRG-111shrg53085--175 Chairman Dodd," Yes. Ms. Hillebrand. Mr. Chairman, there is one other issue that will need to be looked at in how this is done, and it will be in the details that come out after today. If these assets are bought and held until they are paid off, it won't be an issue. But if they are bought by people who intend to liquidate them promptly, there will be some significant questions about responsibilities in debt collection, so that we don't get the kinds of problems that we already have when very old debts are bought by someone who hasn't got the paperwork, can't prove what was owed, and doesn't have the records. That puts the consumer in an impossible situation. " Chairman Dodd," OK. " CHRG-111hhrg56847--173 Mr. Edwards," So what you are saying then is, without TARP, we could have actually had larger deficits and a greater national debt than we have today? " CHRG-111hhrg56766--308 Mr. Perlmutter," Part of our debt problem is there was a contraction in the revenues stream to the United States of America. " CHRG-111hhrg48873--356 Mr. Capuano," No, I understand why you are doing it. Answer my question. Are they going to fund these things by floating collateralized debt obligations? " CHRG-111hhrg53244--192 Mr. Bernanke," The deficit is obviously an issue. We have to worry about the long-term debt ratio, certainly. " CHRG-110hhrg46591--227 Mr. Yingling," Thank you for the opportunity to present the views of the ABA on regulatory reform. Clearly, changes are needed. The recent turmoil needs to be addressed through better supervision and regulation in parts of our financial services industry. The biggest failures of the current system have not been in the regulated banking system, but in the unregulated or weakly regulated sectors. Indeed, while the system for regulating banks has been strained in recent months, it has shown resilience. In spite of the difficulties of this weak economy, I want to assure you that the vast majority of banks continue to be strongly capitalized, and are opening their doors every day to meet the credit and savings needs of their customers. As the chairman has noted many times, it has been the unregulated and less regulated firms that have created problems. Given this, there has been a logical move to begin applying more bank-like regulation to the less regulated parts of the financial system. For example, when certain securities firms were granted access to the discount window, they were subjected to bank-like leverage and capital requirements. The marketplace has also pointed toward the banking model. The biggest example, of course, is the fact that Goldman Sachs and Morgan Stanley have moved to the Federal Reserve for holding company regulation. Ironically, while both the regulatory model and the business model moved toward traditional banking, bankers themselves are extremely worried that the regulatory and accounting policies could make traditional banking unworkable. Time after time, bankers have seen regulatory changes aimed at others result in massive new regulations for banks. Now, thousands of banks of all sizes are afraid that their already crushing regulatory burdens will increase dramatically by regulations aimed at less-regulated companies. We appreciate the sensitivity of this committee and the leadership of this committee toward this issue of regulatory burden. As you contemplate changes in regulation to address critical gaps, ABA urges you to ask this simple question: How will this change impact those thousands of banks that are making the loans needed to get our economy moving again? There are gaps in the current regulatory structure. First, although the Federal Reserve generally looks over the entire economy, it does not have explicit authority to look for problems and take action to address them. A systemic oversight regulator is clearly needed. The second type of gap relates to holes in the regulatory scheme where entities escape effective regulation. It is now apparent to everyone that the lack of regulation of independent mortgage brokers was a critical gap, with costly consequences. There are also gaps with respect to credit derivatives, hedge funds, and others. Finally, I wish to emphasize the critical importance of accounting policy. It is now clear that accounting standards are not only measurements designed for accurate reporting; they also have a profound impact on the financial system. So profound that they must now be part of any systemic risk calculation. Today, accounting standards are made with little accountability to anyone outside the Financial Accounting Standards Board. No systemic regulator can do its job if it cannot have input into accounting standards, standards that have the potential to undermine any action from a systemic regulator. The Congress cannot address regulatory reform in a comprehensive fashion if it does not include accounting policymaking. ABA therefore calls on Congress to establish an accounting oversight board, chaired by the chairman of the systemic regulator. The SEC Chairman could also sit on this board. The board could still delegate basic accounting standards-making to a private sector body, but the oversight process would be more formal, transparent, and robust. I believe this approach would accomplish the goal that the chairman mentioned a few minutes ago in his comments about separating mark to market from the consequences of mark to market. And I appreciate your recent letter, Congressman Bachus, on this subject. That is a good goal. But I don't think that that goal can be accomplished if you have the current regulatory situation on accounting. Clearly, it is time to make changes in the financial regulatory structure. We look forward to working with Congress to address needed changes in a timely fashion, while maintaining the critical role of our Nation's banks. Thank you. [The prepared statement of Mr. Yingling can be found on page 177 of the appendix.] " CHRG-111shrg61513--81 Mr. Bernanke," It is, of course, very hard to know, and we are very different from Greece in terms of the type of our economy, the size of our economy, the fact that we have our own currency and all those sorts of issues. Just to give you one number, Ken Rogoff and Carmen Reinhart's book about financial crisis has been discussed in many quarters, mentioned a 90 percent debt-to-GDP ratio as a level at which growth becomes impacted after that. Now, saying that, we have got a wide variety of experience among industrial countries, ranging up to very high levels in Japan and in other countries. But our historic levels, we were down to the 30s in terms of debt-to-GDP and I think heading toward a 100 percent debt-to-GDP ratio would be very undesirable, particularly given the aging of our society and those obligations we are facing longer term. Senator Bayh. And we are estimated to get up close to, what, 65, 70 percent here over the next five to 10 years, something like that? " CHRG-110hhrg38392--6 The Chairman," The gentleman from Texas, Mr. Paul, the ranking member of the subcommittee. Dr. Paul. Thank you, Mr. Chairman, and welcome Chairman Bernanke. I share your concern for the inequality that has developed in our country. I think it is very real, I think it is a source of great resentment, and unfortunately, I think it is one of those things that puts a lot of pressure on Congress to increase the amount of government programs and government spending, which I do not think is the answer. I believe the inequality comes specifically from the type of currency we have. When there is a deliberate debasement of a currency, it is predictable that the middle class is injured, the poor are hurt, and there is a transfer of wealth to the wealthy, and until we understand that, I do not believe we can solve this problem. And if we resort to continued monetary inflation and more government programs, we will only make this inequality worse. This is exactly the opposite of what happens when you have a sound currency and free markets, because it is the sound currency and free markets which creates the middle class and creates prosperity and allows the best distribution of this wealth. Inflation is a monetary phenomenon. It comes from the Federal Reserve system. The Federal Reserve has tremendous pressure put on them, because almost everybody wants low interest rates, except if you happen to be a saver, then you might not like artificially low interest rates. But, of course, that contributes to the lack of savings, which is another problem that we have in this country. We concentrate on inflation by implying, and everybody casually accepts that inflation is a price problem. But the prices that go up are one of the consequences of inflation. Inflation causes malinvestment, it causes excessive debt, and it causes financial bubbles that we have to deal with. But we have a lot of information today available to us to show that there is a lot of monetary inflation going on. For instance if you look at MZM, it is growing at almost a 9 percent rate. M3 is no longer available to us from official sources, but private sources tell us it is growing at a 13 percent rate. Of course, we can reassure ourselves and say that the CPI is growing at a 2.6 percent rate. But if you go back to the old method of calculating the CPI, closer to what the average person is suffering, and one of the reasons why there is inequality going on, is it is growing at over a 10 percent rate. The fact that the dollar is weak on the international exchange markets cannot be ignored. For instance, in just 6 months, the Canadian dollar increased 11 percent against our dollar. This should stir up some concerns. But one concern that I have, that I think is causing more problems and keeps us from coming to a solution, is the divorce between the exchange value of a dollar on the international exchange markets and the effort to lower the value of a dollar in order to increase exports, which can only be done through inflation, at the same time, believing that we can have stability in prices at home, because that is a disconnect that is not possible. If we strive for a lower dollar in exchange markets, we will have price increases here at home and we have to deal with it. I yield back. " CHRG-111hhrg72887--121 Mr. Barton," I won't take the 5 minutes. I have looked--of course, this panel is talking about the Consumer Credit and Debt Protection Act. The next panel will talk about the mercury bill. I think it is a good thing to have these legislative hearings. I can tell you, Mr. Chairman, that the Republicans on the subcommittee are on board on moving these bills, but we certainly think we should take a look at them. My only question on the Consumer Credit and Debt Protection Act would be to Mr. Beisner. Your testimony talks about the potential abuse of giving the attorneys general the authority to enforce a Federal statute. Is there anything you would care to elaborate about that? " CHRG-111hhrg74090--89 Mr. Barr," With respect, sir, our strong view is that it does not. It continues to provide for financial innovation. Consumers can get access to whatever products and services providers want to offer. Our basic approach is to improve disclosure, reduce regulatory burden, for example, by merging authorities so you can have one simple mortgage form at the time of disclosure, improve---- " CHRG-111hhrg63105--199 Mr. Conaway," The comments about, you, your members, are they willing to accept higher prices for transaction costs as a result of limiting the number of speculators in a market? Is that a--does that have any--I will ask Mr. Duffy and Mr. Sprecher. You both mentioned higher transaction costs. Are those--is that one of the burdens that we talk about if we mess this market up? And can you measure those higher transaction costs? " CHRG-111shrg62643--35 Mr. Bernanke," The market, I think, takes appropriate comfort from the fact that there is a considerable amount of appropriated funds backing up those two companies. Senator Shelby. What risk does the Fed face in holding GSE debt? " CHRG-111hhrg56847--158 Mr. Bernanke," One simple rule of thumb is that the primary deficit, which is the deficit excluding interest payments, should be about in balance. If that is true or, to put another way, that the deficit equals interest payments, so in practice, that might be at a 2 percent of GDP type deficit. If that is true, then arithmetically, with some other assumptions, it turns out that the ratio of the debt outstanding to the GDP remains constant. So I think keeping our debt relative to our income constant or declining would be a good indicator of sustainable policy. " CHRG-111hhrg48874--27 Mr. Gruenberg," Mr. Chairman, we do currently charge premiums on a risk basis. We are looking for ways, if possible, to respond, particularly to the community bank concerns. In the interim final rule that we issued on the special assessment, we actually asked for public comment on the possibility of imposing assessments based on the assets of the institution rather than the deposits of the institution. That would have a consequence of shifting some of the burden toward the larger institutions. We asked for comment on that. " CHRG-111hhrg51585--140 Mr. Royce," I said gentlelady. Excuse me, ma'am. You know, I think the point he was making here, you made the point it was a savings account that they were invested in. No, they weren't investing in a savings account. They were investing in a highly leveraged institution that was Lehman Brothers, just as Orange County was highly leveraged in 1994. And what we are talking about in terms of market discipline is getting county treasurers away from the concept of leveraging and investing in these institutions that are so highly leveraged. I thought that was one of the underlying themes here, so I just-- Ms. Speier. Would the gentleman yield? " CHRG-111hhrg72887--21 Mr. Rush," The Chair will recognize himself for 5 minutes for the purposes of opening statements. Today, as I said before, the subcommittee is conducting yet another legislative hearing on two more bills, H.R. 2309, the Consumer Credit and Debt Protection Act, and H.R. 2190, the Mercury Pollution Reduction Act. This hearing continues our trend to hold legislative hearings with the intent of moving bills towards eventually becoming law. H.R. 2390, the Mercury and Pollution Reduction Act, was introduced by the Vice Chair of the subcommittee, my friend and colleague from Chicago Ms. Schakowsky. The bill effectively bans the use of mercury in the production of chlorine and caustic soda and prohibits the export of mercury effective immediately. Mercury is well known to cause neurological damage, especially to children. The toxin is also found in fish, and when people eat contaminated fish, they also consume the mercury. Pregnant women who ingest the mercury in fish pass the toxic effects along to their developing fetus, which can lead to long-term neurological harm. Furthermore, studies indicate that unsafe mercury levels are more prominent in people of color and in poor communities, and this disparate impact along ethnic and racial lines is likely the result of fish and seafood consumption. It is my understanding that only four manufacturing plants still use mercury in the production of chlorine. It is also my understanding that the chlorine industry has made the transition away from mercury as a result of increased efficiency in alternative methods of manufacturing. As such, I am interested to know why Ms. Schakowsky's bill shouldn't become law as soon as possible due to the harmful effects of mercury and the cost savings associated with producing chlorine from other methods. I want to commend Ms. Schakowsky for her work on this bill. I am the author of the second bill we are considering today. H.R. 2309, the Consumer Credit and Protection Act, is a result of two oversight hearings this subcommittee has held on consumer credit issues this year. The bill provides the Federal Trade Commission with normal rulemaking authority under the Administrative Procedures Act, for all consumer credit and debt-related issues as opposed to its current cumbersome rulemaking authority under the Magnuson-Moss Act. This authority will empower the Commission to nimbly respond to current and future abuses perpetrated on consumers. My bill also directs the Commission to specifically address current abuses in the automobile and debt consolidation industries. It is my intent, during an eventual markup, to also add a directive rulemaking on pending legislation as well. I hope the witnesses will provide the information the subcommittee needs on how effective H.R. 2309 would be in protecting consumers not only from the credit and debt scams of today, but the scams of tomorrow, also. It is important that the FTC have the requisite flexibility and authority to address numerous credit fraud that plagues consumers. Moreover, I believe it is extremely important that the Commission retain this aggressive posture of consumer credit and debt regardless of the political leadership at the top. Both Democrats and Republicans are guilty of being asleep at the switch, and difficulties in the financial and housing market have shown us that we can no longer afford this type of political negligence. It is vital that we revitalize the Federal Trade Commission's work on behalf of consumers in order to prevent the types of widespread abuses that weren't addressed in the past. Today I hope to have an informative legislative hearing on these two bills and work with all of the affected stakeholders and my friends on the other side of the aisle. We may end up disagreeing, but as always, I believe in disagreeing in a civil and politically honest manner. With that, I yield back the balance of my time. [The prepared statement of Mr. Rush follows:] [GRAPHIC] [TIFF OMITTED] T2887A.018 CHRG-111shrg55278--57 Mr. Tarullo," So I will start, Senator. I do not think any of us probably wants to be speaking with reference to any particular entity, so let me just try to speak in more abstract terms. I think we do need to draw a distinction between entities that are economically significant and entities that pose systemic financial risk. There are many entities in this country whose failure would have very adverse economic consequences on a lot of people who deal with them--a lot of employees, communities, suppliers, and the like--but that do not create systemic financial risk in the sense that their failure leads to a kind of immediate cascading effect, in which leverage that is consecutively held by a lot of institutions that have counterparty relationships with one another suddenly becomes a problem. As asset values deteriorate and margin calls increase, you have to put up more collateral or you have to sell assets because you do not have enough collateral to put up. That is the pattern that we saw with Bear, Lehman, and AIG, and, in fact, you can go back 11 years and say that is the pattern you saw with Long Term Capital Management. Senator Menendez. So a cascading of thousands of businesses that would not have access to capital would not be a systemic risk? " CHRG-111hhrg48868--362 Mr. Liddy," Yes. It's really important for us, sir, to pay the debt down first so the rating agencies remain-- " CHRG-110hhrg46591--415 Mr. Bachus," It was an incredibly leveraged guarantee with no reserves backing it. " CHRG-111hhrg48674--158 Mr. Lee," Just one last question as a follow-up. Do you have any concerns about the balance sheet of any of that debt not being paid back? You mentioned that right now it is a source of income. Are there any risks associated with that? " CHRG-111shrg54589--102 Mr. Whalen," I am not ever worried about two people on one side or another of a market. So if somebody wants to buy and sell, you know, you have heard some very good examples of the utility of credit default swaps. The concern I have is that, again, the small airline, the small company, does not have a traded market and its debt that we can use the price these contracts. So we have, again, the Liar's Poker scenario, which is you have got a trader in one firm and a trader in another, and they have decided that the implied spread on the debt of this company is a good way to price a default contract. OK? The trouble is most people on Wall Street trade these instruments like bond options. They use them for delta hedging various exposures in debt or even equity markets, and, again, these are wonderful examples. They have great utility. But the problem is I suspect the pricing is wrong. In other words, CDS is not priced like default insurance. So when that contract goes into default and the provider of protection has to come up with the money, you have got to ask yourself, going back to the question about the supervision of dealers, is that person doing the work so that they are actually cognizant of what the cost of default is versus the spread on a bond? Lehman Brothers--you could have bought protection on Lehman Brothers a week before it failed at 7 percent. The next week you had to come up with 97 percent worth of cash per dollar of exposure to Lehman. So, you know, it is the pricing issue that I think is at the core here. It is not whether there is utility in CDS. There is obvious utility in all of these strategies. " CHRG-111hhrg55814--562 Mr. Swagel," I would just briefly note that Lehman's senior debt was trading at 10 cents on the dollar before it failed, and the auction cleared at 9 cents on the dollar. So people had a pretty good sense of what was going to happen to Lehman. " FinancialCrisisInquiry--402 VICE CHAIRMAN THOMAS: A question to all of you, and it’s just from my previous job on Ways and Means and the tax code. Would it make a big difference, not much difference, if we had in the time of all of these once-in-a-lifetime events, a better understanding between equity and debt and the way in which major American corporations and even international corporations can utilize debt versus equity? And had we recognized it in the tax code, that, to a certain extent, the old cash-on-the-barrel head is, perhaps, a good way to see what’s going on, notwithstanding the complexity of the world today? January 13, 2010 CHRG-111shrg62643--89 Mr. Bernanke," That is right. The availability of funding or credit is not a constraint for most large firms. Senator Gregg. What is the constraint, of course, is the unusual uncertainties that are facing American business today, and small business especially, but all business, and that is that we are facing a Government that has got a long-term debt which is unsustainable, and so there is a huge uncertainty as a result of that. In the short term, it is a two-step dance. We understand that in the short term there is a stimulus event here that is occurring. But in the long term, we have an unsustainable debt. Is that not true? " FOMC20081216meeting--247 245,MR. LACKER.," Okay. One final question. We, in the late 1970s, adopted a set of guidelines regarding agency debt and modified that in the late 1990s. I don't have a copy with me. I think the latest adoption of that was January 2003, and I believe it is permanent. I think it is still in effect. I think it states that our purchases are not intended to channel funds to any specific sector. I am wondering about the staff's interpretation of the consistency between our GSE debt and agency-guaranteed MBS purchases, and that guidance. " fcic_final_report_full--545 System and certain of the presidents of the Federal Reserve Banks; oversees market conditions and implements monetary policy through such means as setting interest rates. Federal Reserve Bank of New York One of  regional Federal Reserve Banks, with responsibility for regulating bank holding companies in New York State and nearby areas. Federal Reserve U.S. central banking system created in  in response to financial panics, con- sisting of the Federal Reserve Board in Washington, DC, and  Federal Reserve Banks around the country; its mission is to implement monetary policy through such means as setting inter- est rates, supervising and regulating banking institutions, maintaining the stability of the fi- nancial system, and providing financial services to depository institutions. FHA see Federal Housing Administration . FHFA see Federal Housing Finance Agency. FICO score A measure of a borrower’s creditworthiness based on the borrower’s credit data; de- veloped by the Fair Isaac Corporation. Financial Crimes Enforcement Network Treasury office that collects and analyzes information about financial transactions to combat money laundering, terroristfinancing, and other finan- cial crimes. FinCEN see Financial Crimes Enforcement Network . FOMC see Federal Open Market Committee . foreclosure Legal process whereby a mortgage lender gains ownership of the real property secur- ing a defaulted mortgage. Freddie Mac Nickname for the Federal Home Loan Mortgage Corporation (FHLMC), a govern- ment-sponsored enterprise providing financing for the home mortgage market. Ginnie Mae Nickname for the Government National Mortgage Association (GNMA), a govern- ment-sponsored enterprise ; guarantees pools of VA and FHA mortgages. Glass-Steagall Act Banking Act of  creating the FDIC to insure bank deposits; prohibited commercial banks from underwriting or dealing in most types of securities, barred banks from affiliating with securities firms, and introduced other banking reforms.  In , the Gramm-Leach-Bliley Act repealed the provisions of the Glass-Steagall Act that prohibited affil- iations between banks and securities firms. government-sponsored enterprise A private corporation, such as Fannie Mae and Freddie Mac , created by the federal government to pursue certain public policy goals designated in its charter. Gramm-Leach-Bliley Act  legislation that lifted certain remaining restrictions established by the Glass-Steagall Act . GSE see government-sponsored enterprise . haircut The difference between the value of an asset and the amount borrowed against it. hedge In finance, a way to reduce exposure or risk by taking on a new financial contract. hedge fund A privately offered investment vehicle exempted from most regulation and oversight; generally open only to high-net-worth investors. HOEPA see Home Ownership and Equity Protection Act . Home Ownership and Equity Protection Act  federal law that gave the Federal Reserve new responsibility to address abusive and predatory mortgage lending practices. Housing and Economic Recovery Act  law including measures to reform and regulate the GSEs ; created the Federal Housing Finance Agency . HUD see Department of Housing and Urban Development. hybrid CDO A CDO backed by collateral found in both cash CDOs and synthetic CDOs. illiquid assets Assets that cannot be easily or quickly sold. interest-only loan Loan that allows borrowers to pay interest without repaying principal until the end of the loan term. leverage A measure of how much debt is used to purchase assets; for example, a leverage ratio of : means that  of assets were purchased with  of debt and  of capital . CHRG-111shrg56376--168 Chairman Dodd," Why weren't we invited? Senator Corker. This whole issue, I think, of leverage is one that certainly we need to look at. You know, we actually urge people in this country to use leverage, but we penalize equity. And I hope that as we move through this, that is something that we will look at more closely. I am sorry to take so much time. " CHRG-111hhrg67816--35 CONGRESS FROM THE STATE OF OHIO Ms. Sutton. Thank you so much, Mr. Chairman. Thank you for holding this hearing. It is extremely important to the people that I represent in Ohio. You know, time and time again we have learned that sometimes the people who are hurt the most by what is going on out there are the ones who need our help the most. Today there are a wide range of financial products advertised to assist consumers in paying off debt and emerging from debt from pay-day lending to car title loans, short-term loans with incredibly high interest rates all but ensure that individuals remain in debt, and these individuals, many of them, are my constituents. The American people expect their government to rein in unscrupulous and unfair lending. Last November, voters in Ohio overwhelmingly improved a referendum on pay-day lenders to end predatory loans. Our referendum capped interest rates provided borrowers with more time to pay back loans and prohibited new loans to pay off old ones which will help to break that cycle of debt. However, we are now learning that these lenders are exploring new loopholes and operating under different licenses and adding new fees such as inflated check cashing fees for checks they have just printed and even as our Attorney General, Richard Cordray, and our state legislature and our governor are working to address this situation, the Federal Trade Commission must aggressively act as the American people expect. While I used Ohio as an example, this is a problem that severely impacts people in need throughout our country and if the Federal Trade Commission does not have the tools or the authority to aggressively protect Americans, then it is our responsibility to strengthen the Commission and restore Americans' confidence, and I look forward to being a part of making that happen. " fcic_final_report_full--441 TWO TYPES OF SYSTEMIC FAILURE Government policymakers were afraid of large firms’ sudden and disorderly failure and chose to intervene as a result. At times, intervention itself contributed to fear and uncertainty about the stability of the financial system. These interventions responded to two types of systemic failure. Systemic failure type one: contagion We begin by defining contagion and too big to fail . If financial firm X is a large counterparty to other firms, X’s sudden and disorderly bankruptcy might weaken the finances of those other firms and cause them to fail. We call this the risk of contagion , when, because of a direct financial link between firms, the failure of one causes the failure of another. Financial firm X is too big to fail if policymakers fear contagion so much that they are unwilling to allow it to go bankrupt in a sudden and disorderly fashion. Policymakers make this judgment in large part based on how much counterparty risk other firms have to the failing firm, along with a judgment about the likelihood and possible damage of contagion. Policymakers may also act if they worry about the effects of a failed firm on a par- ticular financial market in which that firm is a large participant. The determination of too big to fail rests in the minds of the policymakers who must decide whether to “bail out” a failing firm. They may be more likely to act if they are uncertain about the size of counterparty credit risk or about the health of an important financial market, or if broader market or economic conditions make them more risk averse. This logic can explain the actions of policymakers  in several cases in : • In March, the Fed facilitated JPMorgan’s purchase of Bear Stearns by providing a bridge loan and loss protection on a pool of Bear’s assets. While policymakers were concerned about the failure of Bear Stearns itself and its direct effects on other firms, their decision to act was heightened by their uncertainty about po- tential broader market instability and the potential impact of Bear Stearns’ sud- den failure on the tri-party repo market. • In September, the Federal Housing Finance Agency (FHFA) put Fannie Mae and Freddie Mac into conservatorship. Policymakers in effect promised that “the line would be drawn between debt and equity,” such that equity holders were wiped out but GSE debt would be worth  cents on the dollar. They made this decision because banking regulators (and others) treated Fannie and Freddie debt as equivalent to Treasuries. A bank cannot hold all of its assets in debt issued by General Electric or AT&T, but can hold it all in Fannie or Fred- die debt. The same is true for many other investors in the United States and around the world–they assumed that GSE debt was perfectly safe and so they weighted it too heavily in their portfolios. Policymakers were convinced that this counterparty risk faced by many financial institutions meant that any write-down of GSE debt would trigger a chain of failures throughout the finan- cial system. In addition, GSE debt was used as collateral in short-term lending markets, and by extension, their failure would have led to a sudden massive contraction of credit beyond what did occur. Finally, mortgage markets de- pended so heavily on the GSEs for securitization that policymakers concluded that their sudden failure would effectively halt the creation of new mortgages. All three reasons led policymakers to conclude that Fannie Mae and Freddie Mac were too big to fail. • In September, the Federal Reserve, with support from Treasury, “bailed out” AIG, preventing it from sudden disorderly failure. They took this action because AIG was a huge seller of credit default swaps to a number of large financial firms, and they were concerned that an AIG default would trigger mandatory write-downs on those firms’ balance sheets, forcing counterparties to scramble to replace hedges in a distressed market and potentially triggering a cascade of failures. AIG also had important lines of business in insuring consumer and business activities that would have been threatened by a failure of AIG’s financial products division and potentially led to severe shocks to business and consumer confidence. The decision to aid AIG was also influenced by the extremely stressed market conditions resulting from other institutional failures in prior days and weeks. • In November, the Federal Reserve, FDIC, and Treasury provided assistance to Citigroup. Regulators feared that the failure of Citigroup, one of the nation’s largest banks, would both undermine confidence the financial system gained after TARP and potentially lead to the failures of Citi’s major counterparties. CHRG-110hhrg34673--107 Mr. Bernanke," The impact effect of large sales of treasuries would be to raise interest rates, yes, but over a longer period of time, I believe interest rates are determined by fundamentals, by Federal Reserve policy, and I would also point out that the ownership, say, by the Chinese, of dollar-denominated assets is less than 5 percent of all of the fixed-income dollar assets in the world, even though it is a larger share, as you point out, of the treasury market. So I do not consider that to be a major concern. As I mentioned earlier in response to a question, there could come a point where foreign investors become less willing to accumulate more of our debt and would begin to drive up interest rates, and in order to avoid that contingency down the road, we should probably be trying to bring our current account down gradually over time. Mr. Moore of Kansas. Well, I understand, and I appreciate the fact that you, I am sure, feel a responsibility not to alarm people by any statements you might make, but my concern again is if foreign nations decide for whatever reason to sell off our debt, that is going to--there is the old law of supply and demand in effect, and if foreign nations are not going to hold our debt, that means that we are going to have to finance that, and I would think that would cause interest rates to go like this. I remember 30 years ago there was a guy named Jimmy Carter, who was President of the United States. We had interest rates going up to 12-, 14-, 16 percent. That would be absolutely devastating for our Nation right now, and I am not trying to be an alarmist here. I just do not want to see us get in a position where anything like that happens again to our country, because that would be devastating, I think, for small businesses, for consumers, for people in this country, and that is my concern, I guess. One more question. Oh, we are out of time. Sorry. Mr. Chairman, thank you very much. " CHRG-111shrg53085--126 Chairman Dodd," A good bookie will lay off a debt. They do not assume all that risk. Senator Warner. AIG did not do any downside hedging. " CHRG-111hhrg58044--36 Chairman Gutierrez," Mr. Snyder? Am I more likely to survive cancer and have incredible debt? Is my house more likely to have a fire? " CHRG-109hhrg28024--148 Mr. Garrett," Getting to the questions on the GSEs, just a couple more points, I appreciate your comments as to the importance of them. I'm just curious, in your mind, whether you think that Fannie and Freddie are really the soundest and the best way that we have to assist homeowners in financing, or is there something else that Congress can do, as we always like to say, to level the proverbial playing field, to provide methods for S&Ls and banks and other financial institutions to get into the market on the same level field as Fannie and Freddie are right now to address the issues that have been already raised as far as increasing the housing market and to provide liquidity. Is there something else we could be doing aside from Fannie and Freddie? " Mr. Bernanke," I'd have to hear your specific suggestions. As I indicated before, Fannie and Freddie did a very important service to us, to the economy, to the country, by creating the secondary mortgage markets. They are no longer the only participants. Obviously, there are now large financial institutions which are also involved in creating and servicing these markets. I think what they do is very valuable. I have no desire to-- " Mr. Garrett," I'll follow up with some of the other models that are out there. I would appreciate your comments as to whether Congress can explore some of these other avenues as well to either supplement or eventually go down the road to a different direction. Another thing that the House did, it passed this committee, and the House passed the GSE reform legislation. As you know, one of the aspects was what I will call the five percent tax or five percent diversion, always with the laudable goal of trying to provide revenue to those most in need in the housing market. The question on the other side of that equation comes, and this involves your concerns and mine as well, with regard to portfolio size and limitations. I think we are on the same page. I was fighting for that when your predecessor was here, to try to put those stronger limitations in place. What is your comment on what the House has done in that area by diverting revenue from the normal revenue stream? Does this put an additional burden on the GSEs to basically go in the other direction that we would want them to into, and that is to increase the portfolio to make up for the lost income? " Mr. Bernanke," I'm afraid, Congressman, that is out of my purview. It's really up to Congress to decide how they want to manage these kinds of funds. My main concerns are about financial stability and, therefore, about the fact that we have such a large portfolio which has to be hedged in a complicated dynamic fashion. " CHRG-111hhrg56766--106 Mr. Bernanke," Yes. Mr. McCarthy of California. Looking at the current budget that is proposed, does that reflect the commitment of changing the growth curve of our budget deficit or our national debt? " CHRG-111shrg61513--25 Mr. Bernanke," Well, Senator, what we have been trying to do is to eliminate the extraordinary support that we have provided financial markets, and we had a wide range of programs that try to address the dysfunction in the commercial paper market, money market mutual funds, interbank markets, repo markets, and a variety of others. And as I mentioned in my testimony, on February 1, we shut down most of those programs. By June, we will have no more of these 13(3) programs---- Senator Bunning. Except--except what Senator Shelby brought up. On Tuesday, the Treasury announced that they were starting up a supplemental financing program again. It is $200 billion-plus. Under that program, Treasury issues debts and deposits the cash with the Fed. That is the effective same thing as the Fed issuing its own debt, which you know is not legal. " CHRG-111hhrg54869--157 Mr. Levitt," Thank you for the opportunity of appearing before the committee to discuss the critical issues of establishing a systemic risk regulator and a resolution authority. I will summarize my prepared statement, which I have submitted to the record. As a former Chair of the SEC and currently as an advisor to Getco, The Carlyle Group, and Goldman Sachs, I hope I can share with you important considerations to inform your efforts. Though the appetite for reform appears to move in inverse relationship to market performance, financial markets are no less risky and regulatory gaps remain. I am concerned that public investors may well be convinced because of the relative market calm of the last few months that all is well in our regulatory system, but all is not well and I am glad you are showing leadership in addressing these issues. Your success will be determined by how well you affirm the principles of effective financial regulations, principles relating to transparency and regulatory independence, the proper oversight of leverage and risk taking, the nurturing of strong enforcement, early intervention, and the imposition of market discipline. One of the key questions before this committee is how to authorize and hold accountable a systemic risk regulator and who should provide this function. I would like to suggest that the more critical question is whether any regulator or groups of regulators can have the same impact as well as a resolution authority. Such an authority would be created explicitly to impose discipline on those with the most power to influence the level of risk taking, the holders of both equity and debt in institutions which may be ``too-big-to-fail.'' A systemic risk regulator will not be effective unless you also create a resolution authority with the power to send these failing institutions to their demise and thus impact the holders of both their debt and equity. To give a simple analogy, it doesn't matter who serves as the cop on the beat if there are no courts of law to send law breakers to jail. I strongly believe that a systemic risk regulator must serve as an early warning system with the power to direct appropriate regulatory agencies to implement actions. I am agnostic about who should lead such an agency and perform this function, and I would caution against making the Federal Reserve the systemic risk regulator in its present structure. The Fed's responsibilities to defend the safety and soundness of financial institutions and to manage monetary policy creates inevitable and compromising conflicts with the kind of vigilance and independent oversight a systemic risk regulator requires. If, however, the Fed is deemed to be the best available place for this role, I would urge Congress to remove from the Fed some of its responsibilities, conflicting responsibilities, especially those of bank oversight. In many respects, the surest way to cause investors, lenders, and management to focus on risk is not to warn them about risk but to give them every conceivable way to discover risk and tell them what will happen to them if they don't pay attention. We can deal with this by establishing a resolution authority charged with closing out failed institutions which pose systemwide risk. Such an authority would have the power to do just about anything to put a failing bank in order or close it down in an orderly way without, if possible, further government assistance. It could terminate contracts, it could sell assets, cancel debt, cancel equity, and refer management for civil penalties for taking excessive risk even after multiple warnings. I would expect that managers, customers, creditors, and investors would become a good deal more careful, having foreknowledge of their potential rights and responsibilities should such a resolution authority be activated. They would see the advantage of greater transparency and developing more knowledge of individual institutions, and this market discovery may well do the work of many outside systemic risk regulators. Of course, your goal is to incentivise market discovery. You will also want to establish the value of transparency with respect to market information. I want to emphasize in particular the importance of fair value accounting for major financial institutions engaging in significant amounts of risk taking and leverage. Such accounting gives investors a true sense of the value of an asset in all market conditions, not just those conditions favored by asset holders. Greater transparency would make it possible for market participants to price risks appropriately and for a systemic risk regulator to demand fresh infusions of liquidity or higher margin requirements if needed. I would much prefer that a systemic risk regulator be so effective that a resolution authority would be unnecessary. But sadly, we know that always preventing failure is absolutely impossible. I think it is, therefore, in my opinion, your job to make failure possible. Thanks again for your attention to these issues, and I urge you to continue to accelerate your efforts. [The prepared statement of Mr. Levitt can be found on page 62 of the appendix.] " CHRG-111hhrg56776--200 Mr. Volcker," This is one area where the discussion came up earlier as to whether you have one regulator, or there is some value in having a variety of regulators. There are a lot of small banks. And we now have divided direct supervisor authority over them. I think this is one area where it is possible to argue that having more than one supervisor is not a bad thing. It doesn't pose the same kind of systemic risk that the big institutions do, but there is value to the Federal Reserve, and maybe some value in having more than one agency concern there. Because the FDIC has a legitimate interest in knowing what's going on among a lot of institutions that it may have to--does provide insurance for. Mr. Moore of Kansas. Thank you. Another issue I'm interested in is in looking at how we become dependent on debt across the board: corporations; consumers; governments; and especially financial firms. In a letter to Senators, Tom Hoenig, the president of the Kansas City Fed, wrote last month, ``This financial crisis has shown the levels to which risk-taking and leveraging can go when our largest institutions are protected from failure by public authorities. A stable and robust financial industry will be more, not less, competitive in the global economy. Equitable treatment of financial institutions will end the enormous taxpayer-funded competitive advantage that the largest banks enjoy over the regional and community banks all over the country.'' As we think of how overleveraged the largest financial firms became leading up to the crisis that we have experienced, if the Fed is disconnected from smaller financial institutions who were not overleveraged, and leaving the Fed with nothing to compare to, would that hinder the Fed's supervision of the largest institutions? Any thoughts there, Chairman Bernanke? " CHRG-111hhrg53244--91 Mr. Bernanke," Down the road, it might. As I talked about in my testimony, I do think it is very important that we look at medium-term fiscal sustainability, that we have a plan for getting back to reasonably low deficits and a sustainable debt-to-GDP ratio. Otherwise, we might see interest rates rise, which would be negative for the economy. " fcic_final_report_full--171 All along the assembly line, from the origination of the mortgages to the creation and marketing of the mortgage-backed securities and collateralized debt obligations (CDOs), many understood and the regulators at least suspected that every cog was reliant on the mortgages themselves, which would not perform as advertised. THE BUBBLE: “A CREDITINDUCED BOOM ” Irvine, California–based New Century—once the nation’s second-largest subprime lender—ignored early warnings that its own loan quality was deteriorating and stripped power from two risk-control departments that had noted the evidence. In a June  presentation, the Quality Assurance staff reported they had found severe underwriting errors, including evidence of predatory lending, legal and state viola- tions, and credit issues, in  of the loans they audited in November and December . In , Chief Operating Officer and later CEO Brad Morrice recommended these results be removed from the statistical tools used to track loan performance, and in , the department was dissolved and its personnel terminated. The same year, the Internal Audit department identified numerous deficiencies in loan files; out of nine reviews it conducted in , it gave the company’s loan production depart- ment “unsatisfactory” ratings seven times. Patrick Flanagan, president of New Cen- tury’s mortgage-originating subsidiary, cut the department’s budget, saying in a memo that the “group was out of control and tries to dictate business practices in- stead of audit.”  This happened as the company struggled with increasing requests that it buy back soured loans from investors. By December , almost  of its loans were going into default within the first three months after origination. “New Century had a brazen obsession with increasing loan originations, without due regard to the risks associated with that business strategy,” New Century’s bankruptcy examiner reported.  In September —seven months before the housing market peaked—thou- sands of originators, securitizers, and investors met at the ABS East  conference in Boca Raton, Florida, to play golf, do deals, and talk about the market. The asset- backed security business was still good, but even the most optimistic could read the signs. Panelists had three concerns: Were housing prices overheated, or just driven by “fundamentals” such as increased demand? Would rising interest rates halt the market? And was the CDO, because of its ratings-driven investors, distorting the mortgage market?  CHRG-109hhrg31539--119 Mrs. McCarthy," Thank you, Mr. Chairman. I would like to bring this back down to a little perspective. I happen to think that the average person is having a hard time, and I will just--I know how much money I take out of my ATM. I go to the ATM once a month, and that is my budget, and I have always done it since I have been here, and I have done fine with it. I am a little thrifty, but I have to tell you, I have to go to my ATM machine now twice a month, mainly because the cost of my gasoline has gone up. In the New York area we have probably gone up a little bit higher; we are probably comparable to New York. But it is also when I go food shopping. Now, I am a single woman. I go food shopping on Saturday morning, and I basically pick up my regular things, with a little bit more fruit. Fruit. The prices of fruit have gone up. This is what the daily life of someone is going through. So I have seen my costs go up. Certainly we in Congress, we get a COLA every year, so our pay increase has gone up 2 point something. But I have to tell you, my fuel costs--and I have gas at my home, and even though it was a mild winter, I ended up paying almost $1,800 more this past winter because of the surcharge. So you take that out of my yearly schedule, and you wonder why the middle-income families are having a hard time. They are; this is not a myth. If I am feeling a squeeze, and I probably make more money than a lot of my middle-income families, then certainly they are feeling the squeeze, because my medications have gone up, certainly dramatically, in the last 6 months. So there is pain out there for my middle-income families, and it is real pain. So with that, though, I actually wanted to talk to you about--we are now in the hurricane season. We suffered a terrible loss financially here in the Treasury with Katrina. We are predicting more storms this year. And there are many of us who are basically looking at a reinsurance program. And I guess, Mr. Chairman, my question to you is has the Federal Reserve looked at the potential impact of another major natural catastrophe on the U.S. economy? Can the Treasury afford another 50- or $100 billion response to any kind of natural disaster? Could a natural disaster reinsurance program protect the economy? And risk management insurance is better than debt. And I guess the final part of the question is, given the limited resources, is the cost of limited insurance better than the cost of unlimited debt? " CHRG-111hhrg51585--154 Mr. Lance," We issued debt in New Jersey over the last decade for the general operating portions of our State budget, over my strong objection; I was the minority leader in the State Senate before I came here. And a constitutional amendment was passed last November in New Jersey, under my authorship, to prohibit that in the future, because it has been so devastating to our State. If you are not able to issue debt for the general operating portions of the budget, is it your understanding, sir, that the general operating portions of your State budget are exclusively funded through ongoing revenues? " CHRG-110shrg46629--68 Chairman Bernanke," I am sorry? Senator Menendez. If you take a loan out in order to get to your accrued appreciation, now you are going into debt to do that. " CHRG-110hhrg46591--388 Mr. Ryan," Correct, collateralized debt obligations. And when you had multiple CDOs collected and then securitized and sold, they were called CDO squares. " CHRG-111hhrg48875--198 Secretary Geithner," You are right. Providing more leverage would help against that risk. But we have to worry about the other risk, that we are not leaving the taxpayer too exposed in this context. But this--like about alternatives, you have to think about this relative to the alternatives. This proposal is better than what exists today because today, you have a market where there is a very stark absence of financing, absence of leverage from private sources, and that is leaving at least some of these markets with a large liquidity risk premium. And this will make that substantially better. " FOMC20060920meeting--146 144,MR. WARSH.," Thank you, Mr. Chairman. I’d like to make four points, a couple of which have been stated by my colleagues this morning, and then spend a little time on each of them. First, like many of you, I am more concerned about the upside risks to inflation than downside risks to output and employment. Second, the markets responded quite positively to the last FOMC, so they’ve been going in the right direction. The stock market has been up, the bond market has been up, energy and commodities are down, and TIPS inflation compensation measures are down. Six months ago I would have taken some comfort from that; now, six months into being a central banker, I’m worried. [Laughter] So I join the ranks of Jack and the rest of you who have been here a bit longer than I have. Third, for the first time since I’ve been here, I’m a little less sanguine about the supply side of the economy in looking at the business base, the cap-ex base, and the manufacturing base. But I find myself today probably more comfortable, or at least as comfortable as I’ve been, with the strength and resilience of consumer demand. The fourth point I would like to spend a couple of minutes on is that I think we are at the beginning of a major test of market liquidity that’s happening in real time in the fixed-income markets. So let me take each of those in turn. First, on the consumer side, consumer spending appears to be strong and resilient. As was noted at the outset, there was a strong July PCE reading, on par with the strongest gains of the year, suggesting to me that consumer demand may actually be accelerating from the second quarter into the third quarter. The Greenbook estimate of 3 percent PCE for the third quarter and 2.75 percent PCE for the fourth quarter may actually be understating the strength of the consumer, particularly with falling gas prices. I’m also comforted by income growth and labor market conditions, which I see as likely to be far more important to consumer spending than housing wealth. Consumer income gains appear to be rising. I’ve made note previously of very strong tax receipts. Although they’ve tapered off somewhat, they continue to be robust. Tax receipts for the year are up about 12.4 percent. The past couple of months would suggest they are in the high single digits, and though there is some noise in those data, I do take some comfort from them. Other recent corroboration of labor income, with the revised NIPA data and other measures, suggests that real wage and salary income again may be accelerating. It has been noted this morning that stock options and bonus payments may have had an effect in the first quarter, creating a bit of noise in those data. However, they should also remind us of the wealth effect of equity gains, which may partially offset the negative wealth effect from housing, particularly with 100 million members of the investor class. I think that’s something that needs to be considered in our thinking about the strength of the consumer during the forecast period. Finally, as I think Governor Bies noted, the labor markets remain reasonably tight. Despite the softness in housing, unemployment insurance claims and unemployment rates remain quite encouraging. Turning for a moment to business, about which I am perhaps a little less optimistic than I’ve been before, industrial production is still reasonably strong but, perhaps disappointingly, has flattened for August, even though the July numbers appeared to be on an upward trend. When I looked back over the past 24 monthly readings for 2004 and 2005, both of IP and retail sales, I found that each declined about six times, so I’m not sure that we’re seeing a new trend here. My own sense of where IP is in September is that it’s remarkably strong, but, again, I have some caution that I didn’t have before. One other note—unlike the Greenbook, I sense that exports are likely to make a real, meaningful contribution to GDP during the forecast period. In terms of capital expenditure growth rates, another survey I’d like to mention is the Business Roundtable survey that came out a couple of days ago. It was more negative on capital expenditures than it has ever been. I would say that the group has a mixed record in calling inflection points, but the survey results, nonetheless, suggest that only a little less than 40 percent expect increased cap-ex in the next six months, whereas about half said that cap-ex would remain constant over that period. Perhaps that’s an effort to protect margins with higher costs that could be only partially passed through. As I’ve noted before, earnings growth continues to meet or beat expectations, certainly through the second and third quarters, and my own sense is that fourth-quarter earnings will also be fine, probably still at the double-digit rates of about 10 or 11 percent. Perhaps that explains some of the taking the foot off the accelerator in terms of capital expenditures. In terms of housing, to add a bit to the previous discussion, my own sense is that the residential sector may have, in fact, crowded out some nonresidential loans during the most recent boom and that nonresidential construction was marked up sharply in the second quarter, to an annual growth rate of 22 percent. My sense is also that the market’s capital allocation function is working well. C&I loans are growing about 15 percent or more, perhaps the highest rate in the past 20 or 25 years, and we’ll probably see a little more capital allocation to this nonresidential sector. Whereas the Greenbook assumes a significant deceleration in this group, I think that there’s reason for some upside surprise. As a result, I expect stronger GDP for the second half of ’06 than the Greenbook does. Turning to inflation, I think that inflation risks have not materially receded, though we’ve probably seen acceleration stopping. That is, we’ve seen the top, but the new direction is not clear. One measure that I’ll look to over the next six weeks is what’s going on in the capital markets. Since we last met, ten-year yields have probably moved down about 15 basis points, and the Greenbook reports that there should be a slowdown in business debt financing. That statement of the Greenbook is probably reflected in the data that we’ve seen in July and August in terms of the capital markets. But the test of liquidity to which I referred will be a big supply/demand test over the course of the next six or seven weeks. Perhaps $150 billion in funding is coming to market from the bank loan market, the leveraged loan market, high yield and investment grade. Admittedly, in that $150 billion number, which stacks up as a big number even compared with only a couple of years ago, when we would see financings over a year of $175 billion, there are some elephant deals, and they are probably distorting that number a bit. HCA is coming to market with a $20 billion deal, as well as a couple of other major leveraged buyouts. The liquidity in those capital markets appears to be incredibly robust at this moment; there are massive pipelines. You hear words like “euphoria.” I would say that the capital markets are probably more profitable and more robust at this moment, or at least going into the six-week opportunity, than they have perhaps ever been. A significant variety of participants are playing. This is a function of huge sovereign debt inflows and of significant liability management by issuers—some of the CFOs to whom Governor Bies was speaking. Investors at this moment appear to have very little leverage in terms of the pricing of these deals or in terms of some of the covenant protections that were referenced at an earlier meeting. Previously, I had said that, particularly in the investment-grade market, we were seeing issuers hesitate to come to market because they didn’t want to negotiate their covenants away. In the event that they were to be taken out by a leveraged-buyout player, they wouldn’t want to have a change-of-control premium. Now that these markets are as robust as they are, those same brand-name issuers are coming back to the market, and at this point it seems as though they will likely get their pricing done. So, I do not yet have a final determination of what this pipeline looks like; but if all goes through, it will suggest to me that there has been rather massive liquidity during this period. Other measures of liquidity appear to be somewhat more encouraging from my perspective. The commodities markets have been mentioned. They’ve probably had some hot money come out of them, with a lot of retail investors, both directly and through pension funds, coming in too late and maybe exiting for good, as well as some very encouraging news about the TIPS markets, which were referenced previously. In sum, I would say that the markets seem to be very impressed by our letting the economy develop, particularly in the next couple of quarters, and I’m impressed by the market’s confidence in us. I think that it puts a significant responsibility on us and is probably the only way I can reconcile the rather robust gains in the equity markets and in the debt markets over this period. That is, the markets believe that somehow we’re going to manage to thread the needle and nail the perfect landing. There is, I think, increasingly a one-way bet in the bond markets in that they believe that there is a degree of accommodation and they have built in a degree of loosening in the forecast period, which we don’t have a proper understanding of. Only a couple of months ago we were describing, and the Chairman described, an economy in transition and the very wide tails around that. We still have the wide tails, but the markets seem to think that we’re going to nail this landing. I think the minutes from the last meeting faithfully captured our concerns about the appreciable upside risks remaining. Either the markets didn’t buy that description, or they were convinced that we were going to act with an incredibly deft touch to stop that inflation. All in all, I would say that in the markets there is less dispersion of views than is probably healthy and less dispersion of views over these different scenarios than we found ourselves discussing some time ago. So with that, I think we’ll have a more robust discussion in the next round. Thank you, Mr. Chairman." CHRG-111hhrg50289--20 Chairwoman Velazquez," But you feel that the way the program was structured it will unlock the secondary market? Ms. Blankenship. I think there is a ways to go yet. I think perhaps maybe a panel of bankers and broker-dealers could be brought in and maybe asked their opinion. Where is the freeze occurring? What is the holdup? Is it the paperwork? Is it the burden? And, you know, with the TALF funds, there were additional restrictions placed on banks and brokers. So that is an issue. " FOMC20050503meeting--8 6,CHAIRMAN GREENSPAN.," It’s sort of sad to look at the composition of the Lehman Brothers high-yield index. I’m looking at some of the names in the context of 30 years ago— General Motors, AT&T, and Georgia Pacific. The world is telling us that there is creative destruction out there. To what extent do the GM, Ford, and collateral issues, as they move out of investment-grade May 3, 2005 7 of 116 the supply of marginally non-investment-grade bonds. We can see the impact all over the place, because auto debt is so much larger than the debt of other issuers in that market. But I’ve heard very little about the measurement impact, for example, on the BBB or the Baa indexes. Are they affected materially by this shift?" CHRG-111hhrg53245--233 Mr. Sherman," If the gentleman will yield? I did put forward an idea, not based on whether you are mixing investment banking with insurance and the Glass-Steagall idea, but just a dollar limit. You cannot have debts to Americans in excess of $100 billion. " CHRG-111hhrg51585--259 Mr. Campbell," The last thing is why--and if this question has been asked, I apologize. But if a municipality adjacent to any of yours, or whatever, has Chrysler debt or General Motors, which was pretty highly rated at one time, or WaMu or whatever, why should only Lehman investors be carved out, versus all of the other failures that have happened or are yet to occur? " CHRG-111hhrg56847--193 Mr. Austria," Thank you, Mr. Chairman. And Dr. Bernanke, thank you for being here today and sharing your thoughts on the economy and the financial markets. And certainly I appreciate you sharing your thoughts about needing a system that is more resilient and having a plan in place for stabilization. And I appreciate the Federal Reserve being cautious about the U.S. economic outlook. Although you have also noted that there has been some recovery and it looks as though there might be modest recovery over the next couple of years, but I think there is also a growing risk out there that the economy could be dampened or even undercut by the ripple effects of the debt crisis in Europe right now, what is happening in Europe. And also, when you combine that with the concerns that I am hearing out there, from our small businesses, the concerns about getting the necessary financing, the necessary credit to continue their operations and wanting to expand their operations and businesses, the concerns about the consistently high rates of unemployment that we have right now and underemployment and the lack of private jobs that are being created right now that I believe are the long-term sustainable jobs that will turn this economy around. When you combine that with the massive government spending and debt, all those being a major threat to sustainable growth, I wanted to get your views on the spending and debt control, on the uncertainty that is bringing to our economy right now and the direction that you think that we are moving and whether or not--you know, I think there is a fundamental difference here on the types of jobs that are being created with all this, government jobs versus the private sector jobs. " FOMC20070628meeting--21 19,VICE CHAIRMAN GEITHNER.," But these guys were regarded as very smart people, who knew the business well, and this is just a good example of how little one can know in some sense and what leverage does to your exposure to liquidity risk. In this case, people were just not willing to give them the time to realize whatever value might be in these positions, and this is just a natural consequence of leverage. People think they had substantially less leverage than LTCM had in some sense, but that is hard to measure." CHRG-111shrg57322--477 Mr. Tourre," Yes. Senator Levin. So now ACA is writing Goldman. ``Gail, I certainly hope I didn't come across too antagonistic on the call with Fabrice last week but the structure looks difficult from a debt investor perspective. I can understand Paulson's equity perspective. . . .'' Where did they get that from? " FOMC20081216meeting--104 102,MR. COVITZ.," 3 Thank you. I will be using the packet of charts that starts with the staff presentation on financial markets. The charts for the other two presentations are included in this packet and follow mine. As shown in the top left panel of your first exhibit, long-term nominal Treasury yields posted their largest intermeeting decline in over twenty years. The primary explanation for this decline, outlined to the right, is that investors markedly revised down their economic outlook, leading both to a lower expected path of monetary policy and to continued flight to high-quality assets and away from securities with credit and liquidity risk. Yields also fell following Fed communications regarding alternative monetary policy tools, such as the purchase of long-term Treasury securities, agency debt, and mortgage-backed securities. One measure of flight to quality, shown in the middle left panel, is the covariance of percent changes in stock prices and Treasury yields. When investors pull back from risk-taking, stock prices fall, and so do Treasury yields, resulting in a positive covariance between the two. When flight-to-quality effects are substantial, prices in both markets are volatile, making the covariance particularly large. In recent months, the covariance soared to well beyond its 2002 peak. Since the October FOMC, it has come down somewhat but remains extremely elevated, an indication of continued and substantial flight to quality. Another perspective on investor perceptions is provided by the equity risk premium, shown by the red shaded region in the panel to the right and measured as the difference between a trend year-ahead earnings-to-price ratio on S&P 500 stocks and a real long-run Treasury yield. This measure ballooned in midNovember as stock prices and Treasury yields fell and then narrowed a bit over the past month, as indicated by the plus signs. Even so, the risk premium remains extraordinarily wide. Yield spreads on 10-year corporate bonds, shown in the bottom left panel, increased further over the intermeeting period. The spread on high-yield bonds (the red line) topped 1,600 basis points, and the spread on BBB-rated bonds (the black line) exceeded 600 basis points. The BBB spread is now comparable to average levels recorded on similarly rated bonds during the Great Depression. Changes in corporate bond spreads can be decomposed into changes in one-year forward spreads. As shown in the panel to the right, the 117 basis point intermeeting increase in the 10year BBB spread reflects increases in forward spreads across the term structure, consistent with investor flight to quality and away from risk. In addition, the forward spreads ending in two years and five years increased more than the spread ending in 10 years, suggesting that investors have become more concerned about credit risk in 3 The materials used by Mr. Covitz, Ms. Aaronson, and Mr. Ahmed are attached to this transcript (appendix 3). the medium term--that is, more concerned about the possibility of a protracted economic downturn. Your next exhibit examines recent conditions in the commercial paper market. As shown in the top left panel, outstanding financial CP and ABCP (the black and red lines) dropped in September and October but since then have partially rebounded. In contrast, nonfinancial commercial paper outstanding (the blue line) has been relatively flat, although nonfinancial programs rated A2/P2 (not shown) have contracted roughly 40 percent since early September. The noticeable increases in financial CP and ABCP around the time of the last FOMC meeting reflect the implementation of the Federal Reserve's commercial paper funding facility (CPFF), which ramped up quickly and now holds roughly $300 billion of highly rated commercial paper. The recent stability is also likely due to flows back into prime money market funds since early November (shown by the red bars above the zero line in the panel to the right). According to recent surveys of money-fund managers, prime funds have substantially increased their holdings of ABCP, reportedly reflecting the confidence provided by the asset-backed commercial paper money market mutual fund liquidity facility (AMLF), which stands ready to provide banking organizations with nonrecourse loans to fund purchases of highly rated ABCP from 2a-7 money funds. Turning to pricing, the middle left panel shows that the spread on overnight A2/P2-rated nonfinancial CP (the blue line) trended down over the intermeeting period. About half of the reduction in A2/P2 spreads reflects a sample shift toward higher quality overnight issuers, while the other half of the spread reduction is due to improvements in pricing for a constant sample of issuers, suggesting a positive spillover from sectors of the market directly affected by the Fed liquidity programs. The overnight ABCP spread (the red line) also declined, on net, over the intermeeting period. In contrast, overnight yields on CP from highly rated nonfinancial and financial programs (not shown) have traded at levels close to the effective federal funds rate for the past several weeks. To examine year-end pressures, the panel to the right shows the gap between thirty-day and overnight A2/P2 yields. This gap has been volatile but has trended up since late November, when the 30-day rate from our smoothed yield curve began to reflect trades that crossed year-end. Year-end funding pressures are explored further in the bottom left panel. The red bars show average percentages of paper that were placed over year-end as of mid-December from 2003 to 2007. The corresponding percentages for 2008 are denoted in blue. The first two bars indicate that, with respect to getting past year-end, programs rated above A2/P2 as a group are ahead of their average pace over the previous five years. In contrast, the second two bars show that lower-rated programs are behind. Overall, as outlined in the bullet points to the right, conditions in the commercial paper market appear to have been stabilized by the various policy interventions in this market. Even conditions in the nonfinancial A2/P2 sector, which falls outside the government liquidity and guarantee programs, have improved, but the sector remains strained. Year-end pressures appear substantial for lower-rated programs. The remainder of my briefing reviews funding flows in longer-term markets, starting with financing for nonfinancial businesses. As shown by the red portions of the bars in the top left panel of exhibit 3, investment-grade bond issuance has held up fairly well in recent months, while speculative-grade issuance, shown by the blue portions of the bars, has dwindled to nothing. This pace of financing does not appear to pose substantial near-term funding pressures for the nonfinancial corporate sector as a whole. As shown by the blue bars to the right, the volume of speculative-grade bonds due to mature is relatively light in 2009 and 2010 before it moves up somewhat in 2011. Moreover, the pace of investment-grade bonds that will mature in coming years, denoted by the red bars, is comparable to recent issuance levels. In addition, as shown in the middle left panel, liquid asset ratios for firms rated speculative- and investment-grade remain relatively high. Perhaps more troubling for nonfinancial businesses is that funding from banks has slowed. As shown in the middle right panel, C&I loans expanded rapidly in September and October reportedly reflecting, to a substantial extent, a wave of drawdowns on existing lines of credit. However, the expansion of C&I loans halted in November. Equally striking, the plot in the bottom left panel shows that the change in commercial mortgage debt, based on flow of funds data, turned substantially negative in the third quarter, as the outstanding amounts both at banks and in securitizations fell. Overall, nonfinancial business borrowing, shown on the bottom right, has slowed sharply this year, and with financial conditions expected to remain tight and investment projected to be weak, the staff forecast calls for borrowing to remain very tepid through at least 2010. Household credit is the subject of my final exhibit. Mortgage debt, shown by the blue line in the top left panel, is estimated to have contracted in the second and third quarters, in combination with the continued decline in house prices, shown by the thin black line. We have very little data for mortgage debt in the fourth quarter, but MBS issuance in October, shown to the right, was somewhat below the already low thirdquarter level. Other types of household debt have also begun to contract. As shown in the middle left panel, revolving and nonrevolving consumer credit rose only a bit in the third quarter and then fell in October. While the slowdown in consumer credit likely reflects, in part, a reduction in demand, the secondary market for such credit has also become substantially impaired. As shown to the right, issuance of ABS backed by auto and credit card loans slowed markedly in the third quarter and was near zero in October and November, as quoted spreads on BBB and AAA ABS (not shown) soared. Results from the Michigan survey, shown in the bottom left panel, suggest that the contraction in household debt reflects both the reduced supply of credit and weak demand. As shown by the black line, an unprecedented share of households has pointed in recent months to tighter credit as the reason that it has not been a good time to purchase an automobile. At the same time, the percentage citing concerns about the economy, plotted in red, has increased to the top of its historical range and remains the reason mentioned most often by respondents as a deterrent to purchasing an automobile. With financial markets under stress, consumer credit likely will need to be funded mainly on bank balance sheets in coming quarters. However, as shown in the panel to the right, banks' unused loan commitments for both households and businesses have declined substantially this year, as net new commitments have not kept up with drawdowns on existing lines--another indication of the tighter supply of bank credit. Stephanie will now continue with our presentation. " CHRG-111hhrg51592--195 Mr. Capuano," Content, qualitative analysis, analytical analysis, not opinion, and understanding that, at some point, there's always opinion. I get that. If that's the case, I have a proposal, at least when it comes to municipal bonds, to simply require agencies to base their opinion on the ability to repay that debt. And yet, the industry thinks that's some kind of a major problem, and opposes the bill. It simply says, ``Base your opinion on the sole factor of whether that city, town, county, or State can repay the debt.'' Where's the problem if that's all we're asking? Simply base your credit rating on that. Where's the problem with that? [no response] " CHRG-111hhrg54873--3 Mr. Garrett," I thank the chairman and the members of the subcommittee for holding this important hearing today. I also thank the chairman for all of his hard work and that of his staff as well that they put into this discussion draft. I must begin by saying I am a little disappointed, as I am sure the chairman is, that we couldn't find 100 percent complete bipartisan consensus on all portions of this proposed release, but I do sit here today and pledge to continue to work with the chairman moving forward in hopes that we can eventually reach a place where we both are able to support the eventual final legislation. One of the provisions, as the chairman just indicated, he has some concerns with deals with the national recognized statistical rating organizations, the NRSROs and removal of them from the statute. I approached this debate on the credit rating agencies reform with the belief that the two most fundamental problems with our rating system are overreliance on ratings and a lack of investors' due diligence. Investors have become increasingly all too often solely reliant on the use of these ratings in determining the safety and soundness of any investment. In literally hundreds of Federal and State government statutes and regulations, there are specific requirements mandating certain grades from the approved agencies is this formal requirement that provides an implicit stamp of approval to investors. So when an investor sees that the government is requiring a specific grade to make a safe investment, it reenforces the belief that any investment obtaining such a grade is basically safe. I know that the SEC has a similar concern as I do. So 2 weeks ago, the SEC announced it is removing references to the NRSROs in several of the regulations and studying other areas to determine where else they can be removed. And so I applaud the SEC for their actions and I urge them to continue their work. I believe that Congress should follow suit and reexamine all the areas where statute mandates the ratings of NRSROs. Credit ratings are only one piece of the puzzle in determining creditworthiness. Investors must be encouraged to do proper due diligence as well in evaluating issuer credit quality. Another way in which I believe we can help increase investor due diligence that this bill does touch on but does not go far enough is to increase disclosure through information by the issuer. When dealing with equity securities, investors have all the public information about the company because of the annual and quarterly filing requirements. So I believe that we should require the similar situation with debt securities. The issuer of debt securities should disclose the information contained in the offering more broadly so that investors have the ability themselves to delve in deeper into the submitted transaction. While there may be other things included in the proposal that I do support, like increased disclosure and better oversight, there are a couple of provisions that I have a little concern with. The provisions that I am most troubled by center around the question of liability. Unlike many of my friends across the aisle, I do not believe that the solution to some of these problems is more lawsuits. In the discussion draft, there is a provision to institute a collective liability among the NRSROs. And I must say, I am concerned about the practicality of this provision, not to mention the constitutionality as well. I don't see what positive can be obtained by holding all the NRSROs accountable for the actions of just one. The main thrust of the 2006 Reform Act was to increase competition between credit rating agencies. Now, I know that the chairman voted for final passage of that Act in 2006, not withstanding his previously stated belief that there might be a natural oligopoly as he indicated within the credit rating industry. If we institute a sharing of financial legal liability however between all the NRSROs, I cannot think of any bigger impediment to new entries into the marketplace. The second area of concern regarding legal liability is the language in Section 4 to lower the pleading standards for lawsuits against the rating agencies. By making the rating agencies subject to suits whenever they are ``unreasonable,'' you are essentially lowering the bar from fraud to negligence. The practical effect of lowering the pleading standard will be a dramatic increase in cases being filed and eventually going to court. So I don't believe that having more lawsuits brought against rating agencies is a really constructive way to improve the rating process. As Chairman Frank so often noted during the Bush Administration, that he did not realize that he was here to defend President Bush and his policies whenever there is an argument on the Floor of the House with regard to them, likewise, I must say I did not realize it would fall upon me to defend President Obama's efforts in this context as well, because the Obama Administration has submitted an extensive credit rating agency reform proposal and increasing legal liability and was nowhere to be found in his proposal. Also, a recent ruling by a Federal court judge debunks the myth that it is impossible to get the credit rating agencies into the courtroom. So we should see how that case plays out before we overreact in committee. I have another concern as well, basically the increased liability. And so while I support the SEC providing better oversight of the NRSROs, I am worried that too much SEC involvement with ratings further implies a government sign-off on the ratings themselves. At what point during the SEC examination process to review whether rating agencies are following their methodologies does the SEC start prescribing specific methodologies for the NRSROs to follow? In my opinion, this would only further the belief that government is doing the rating themselves. Also, the requirement for differentiation of ratings from structured products is a concern. All structured products are not the same. And giving them the same connotation implies that they are. The SEC has already once considered this idea and they frankly dismissed it after an overwhelming number of investors voiced their concerns. So in conclusion, I think we all agree that significant reforms for the credit rating agencies are much needed. And I, quite frankly, do wholeheartedly applaud the chairman for his hard work and again of his staff. And I do look forward to working closely with him and the members of his staff and other members from both sides of the aisle as we move forward on this extremely important issue. With that, I yield back. " CHRG-111shrg53085--182 Mr. Patterson," First, I would like to say that the Congress has been very helpful in looking at the issue of regulatory burden and testing the efficiencies and the effectiveness of regulations and giving us relief where you could and we are appreciative of that. Two points, simply. One is most of what we are here to talk about today was in the nonregulated area, and the commercial banks have not been the source of the problem and are not today and will not be in the future. But the second reason is I have a concern that if there is a separate agency that has that responsibility and the prudential agency has the overall responsibility, that you don't have the opportunity to look at the entity as one affects the other in a holistic way. " CHRG-109shrg21981--15 STATEMENT OF SENATOR DEBBIE STABENOW Senator Stabenow. Thank you, Mr. Chairman, and welcome, Mr. Chairman. It is wonderful to see you, again, and I want to join my colleagues in thanking you for your leadership and service over the last 16 years. We truly have appreciated and relied on your judgments and your thoughts, and I have appreciated, also, the opportunity to talk with you both privately in my office, as well as on other occasions, about what we are facing in terms of out-of-control deficits. I know you have warned us, since I was in the House of Representatives, and, by the way, I was very proud of the fact, coming into the U.S. House in 1997, that we balanced the budget for the first time in 30 years. We, unfortunately, now have gone from the largest surpluses in the history of the country projected in 2001 to the largest deficits, and that is deeply, deeply disturbing, and I am very interested in your current thinking as it relates to our economic environment with the deficit and the sustainability of that and, in fact, the ethic and responsibility that we all have to address that. I view that as a major moral issue. The President would have us believe that Social Security, in 13 years, is going bankrupt even though we know that is not accurate. We do know that there is a gap, 40 or 50 years down the road, and I am confident that working with my colleagues that we will address that. But what we are hearing from the President is that his suggestion as a way to fix it is to hoist an additional $5 trillion of national debt on American families over the next 20 years, and he calls it an ownership society. I would argue that what every man, woman and child will own is an additional $17,000 in debt, on top of what we already have as a birth tax right now of $15,000. Every time a child is born, that is our gift to them, in terms of the current national debt. So, I am extremely concerned about where we are going and the sustainability of that. Right now, it will require decades for this debt to be fully offset, and the projected savings being talked about in terms of the savings and the market growth, in terms of privatization of Social Security, ironically, is the same growth that would take care of the Social Security gap if, in fact, it materialized. And so I would be interested in your thoughts about that as well. I am very interested in your discussion in terms of the national debt, our chronic deficit and, also, what has been raised by my colleagues as troubling trade deficits, which are exploding, and particularly when we look at China and what is happening in terms of our inability to enforce trade laws and to address the trade imbalances that we have that are causing great havoc in my home State with manufacturers and others that are asking us for a level playing field so that they can keep and create more jobs. So, I thank you, Mr. Chairman. " CHRG-111hhrg52261--55 Mr. Robinson," Congressman, it is hard to come up with the number as to how large is a company that is too big to fail. I think more important is, how much it is leveraged, how interconnected it is; and in our business, how you manage your accumulations or how much stuff do you have out there that could cause a problem. For example, as far as leveraging goes, our company is a mutual company. The only way we can raise capital is through operations. We do not issue stock. In our business, one of the leverage measures is premium-to-capital or premium-to-surplus, which is a proxy for how many policies you write and how much exposure you have. In our business three-to-one, three times your capital, is probably the upper limit. Two-to-one is much better. My company is one-to-one because we are pretty conservative. I am told some banks get up to 30-to-1. The question really is, what is your leverage ratio? I think that is one point that is more important than absolute size. Another question is how interconnected you are. What is the counterpart of your risk if either the counterpart or yourself has a problem? In our industry rarely reinsure one another. When we buy reinsurance, kind of like laying off a bet, we go to the worldwide market. So there is not much interconnectivity in our industry, but it is something I believe you can measure. And finally, there is what we call ""accumulations"". That is, how many houses do you insure on the beach and how many businesses on an earthquake fault line and so on. You need to be able to measure precisely that and report that to regulators to make sure that you haven't overextended yourself. I think if you look at those three items instead of absolute size, you could come up with a much better result. " FOMC20080430meeting--296 294,MS. YELLEN.," Thank you. First, I do really appreciate all the excellent work the staff has done on this topic. I really learned a lot from these papers. I thought they were very clear and very comprehensive. I have just a couple of comments on the questions that Bill and Brian raised in the memo. The first one has to do with whether or not we agree with the objectives, and I do have a couple of issues. First, I think that the stated objective of reducing the burdens and dead weight losses associated with the current reserve tax is too narrowly framed in the paper. My starting point is, about burden, that to cover a given program of government spending, the Treasury has to obtain revenue from some source, and nondistortionary lump-sum taxes are not one of the available options. So the real question from the public finance standpoint is what to tax and how much. That means, to my mind, that the issue here is how the magnitude of the welfare gains that would come from lowering the dead weight loss due to the implicit tax on reserves compares with additional dead weight losses that would result from the alternative taxes that would have to be raised to make up for this lost revenue. Now the answer depends in part on the interest elasticity of demand for reserves, I believe. I think it is the case that, if the interest elasticity is relatively small, the dead weight loss from the reserve tax is relatively small, and the net welfare gain, taking into account the burdens of raising other taxes to make up for the lost seigniorage, in effect, could easily turn out to be negative. Let me give you an example of where this comes into play. There is a well-known paper by Martin Feldstein in which he looks at the benefits of moving to price stability, zero inflation, which he favors. He looks at this issue in that context, and he concludes that there would be net social losses, not gains, from the reduction in seigniorage that would be associated with a move to zero inflation from positive inflation because the dead weight loss due to the shoe-leather cost, also known as the Bailey effect, is smaller than the dead weight losses that would be associated with alternative taxes. In his analysis they are taxes on labor supply and saving. I actually think that this is a serious problem with the framing of the objectives in this paper. It is, in effect, saying, ""We think we should give a tax cut. We think we should give it to banks, and we think that, because there is a welfare loss--a Harberger triangle--associated with that, this is clear welfare gain."" Now, I am not pretending to know exactly how this would come out, but I do think that's the issue. If it were to come out that this is a net loss, not a gain, a possible implication is that if there were a fallback to option 1--I'm not saying that I favor option 1-- there could be a case for paying no interest on required reserves rather than paying interest at the federal funds rate but paying interest on excess reserves at some rate that we would determine. There are administrative costs with having voluntary target balances, and it seems to me that the paper, as we come out with it, ought to try to at least estimate what the administrative burdens associated with options 2 and 5 would be. Another comment on the issue of objectives: If we are coming out with a white paper, it seems to me that the objective that everybody is now discussing and that was just discussed-- namely, that paying interest on reserves would enable us to expand the size of our balance sheet in times of financial crisis, like now, and perhaps greatly enhance the scope for liquidity-altering interventions that would be possible without having to push the federal funds rate to zero--is a real improvement in the tool kit that is available to us to address market disruptions. I would see it as an advantage of paying interest on reserves. If you are discussing this right now with the Congress and it is much discussed in the press, I think it is kind of odd to come out with a paper that doesn't even mention it. Maybe there are disadvantages and not just advantages. But it seems to me it should be there. Also, I would just say on the question of options 2 and 5 versus options 3 and 4, an advantage that the paper attaches to having voluntary targets is the ability to moderate the volatility in the federal funds rate. So it does seem to me that--I understand it may be difficult--the possibility of intervening multiple times during the day as an alternative, if it were possible to change the procedures so that there could be multiple interventions to reduce volatility, would mean that 3 and 4 could be on the table, and there might be less burden associated with those. So I think that possibility deserves at least careful consideration. " CHRG-111hhrg53242--16 Mr. Baker," Thank you, Mr. Chairman, Mr. Hensarling, and members of the committee. I am pleased to be back in this very familiar room and enjoy the opportunity and appreciate your courtesy in asking me to participate. I am Richard Baker, President and CEO of the Managed Funds Association (MFA), which represents the majority of the world's largest hedge funds and are the primary advocate for sound business practices for professionals in hedge funds, funds of funds, and managed futures. Our funds provide liquidity and price discovery to markets, capital for companies to grow, and risk management services to investors such as our Nation's pension funds. Our work enables them to meet their commitments to their retirees. With an estimated $1.5 trillion under management, the industry is significantly smaller than the $9.4 trillion mutual fund industry or the $13.8 trillion banking industry. I make note of this fact for the reason to assess the appropriate level of risk that our sector could present to broader market function. Further, many hedge funds use little or no leverage, as has been stated earlier this morning, which additionally limits their contribution to market risk. In a recent study, 26.9 percent do not deploy leverage at all. And a recent analysis by the Financial Services Authority found that industry-wide, over a 5-year period, fund leverage averaged between two and three to one. This is certainly not the generally accepted view of leverage in our industry. The industry's modest size, coupled with the relatively low leverage, give reasons for those to view that we are not and have not been contributors to the current dislocation in the market and, unfortunately, that has led to the broad deployment of taxpayer dollars. Notwithstanding these facts, our funds have a shared interest with other market participants in restoration of investor confidence and in establishing a more stable and transparent marketplace. These important objectives we believe can be attained with careful analysis and construction of a smart regulatory structure. This will require appropriate and sensible regulation. It is aided by the adoption of industry-sound practices, which we have promoted at the MFA, and it will require investors to engage in their own due diligence. There is no substitute for asking the right questions before you write the check. Our members recognize that mandatory SEC registration for those advisers who are not currently registered for all private pools of capital is a key regulatory reform. Registration under the Investment Advisers Act, we believe, is the smartest approach. Currently, over half of our members are registered in this manner with the SEC. The Advisers Act is a comprehensive framework, and among many other elements, requires disclosure to the SEC regarding the advisers' business, detailed disclosure to clients, policies and procedures to prevent insider training, maintenance of books and records, periodic inspection, and examination by the SEC. We do believe it is important to establish an exemption from registration, however, for the smallest investment advisers that have de minimis amount of assets under management. This exemption should be narrowly drawn to ensure that an inappropriate loophole from registration is not created. Also the provision should coordinate, not duplicate, we hope, regulation at the State level. Good regulation is also efficient regulation. In that regard, we do have some concerns with the Administration's proposed legislation that would impose duplicative registration requirements on a number of our commodity trading advisers, most of whom who are already regulated by the CFTC. We hope, Mr. Chairman, that we would be able to work with the committee to remedy this particular concern. With regard to a subject of some recent interest, credit default swaps, we have worked with regulators to reduce risk and improve market efficiency. We support efforts to increase standardization and central clearing or exchange trading of OTC derivatives. However, it is essential to maintain the ability of market participants to enter into customized OTC contracts. All market participants should post appropriate collateral for OTC transactions. And that collateral should importantly be segregated, meaning that it is protected. And there should be reporting to the regulator as deemed appropriate. The subject of systemic risk is also of current concern as well. There should be a systemic risk regulator with oversight of the key elements of the entire financial system, but it should only be enabled with confidential reporting by our firms to that regulator. A clear mandate for the regulator should be established to protect the integrity of the financial system, not individual market participants. The regulator should have clear authority to act as required by his evaluation of the circumstance and in a decisive manner. We believe these views are consistent with the Administration's stated goals. I appreciate this courtesy to present these views, and look forward to working with the committee toward effective resolution. Thank you, Mr. Chairman. [The prepared statement of Mr. Baker can be found on page 30 of the appendix.] " CHRG-109hhrg28024--197 Mr. Ford," And finally, as Congress considers a variety of not only tax reform packages but even reform packages as relates to how we spend on pork spending here in the Congress or earmarks, as we like to call them, but the public calls them pork spending, you would recommend that as we look at spending and tax policies that we try our hardest--now let me say, I hate to put you on the record, Mr. Chairman, but I think it's important for all of us here who like to spend and who like to cut taxes to understand that they have real implications as the debt continues to rise. Is that fair to say? If our policies cause the debt to rise, that has real implications on what you do and what you don't do? " FinancialCrisisInquiry--660 VICE CHAIRMAN THOMAS: Have you run any comparisons in terms of those who got upside down on their homes versus also in significant debt with a credit cards? Is there a correlation there? CHRG-111hhrg53245--191 Mr. Royce," But it has the additional benefit at least of having a subordinated debt there that by definition cannot be bailed out. So it is one more indicator but it is an indicator combined with something that is going to reduce the incentive. " CHRG-111hhrg48674--229 Mr. Bernanke," In a contracting economy, all else equal, the debt-to-GDP ratio will just keep rising. The economy won't keep up with it. " CHRG-111hhrg49968--20 Mr. Bernanke," That is right. The CBO shows alternative simulations that involve the debt essentially exploding, which it would if it got so high that interest payments became unmanageable. " CHRG-111hhrg56766--17 Mr. Lee," Thank you, Mr. Chairman. Chairman Bernanke, thank you for coming before the committee today. I know there will be a number of important issues that you will be raising over the course of your testimony, but I wanted to highlight just a few specific ones that I hope you can address during your discussion. It is important for us to hear your thoughts on the significant level of spending that is currently going on in this Congress. As you know, we just raised the debt ceiling by another $1.9 trillion, and whether you believe Fannie Mae/Freddie Mac, that exposure, should be factored into the debt ceiling that we currently live by. I am also increasingly concerned with discussions by rating firms in which the AAA rating that this country currently enjoys is in jeopardy and when and if do you think that will be downgraded. We simply cannot ignore what we are doing in terms of spending in this country and the impact it may have on us. I look forward to you replying to those through your testimony. " CHRG-111shrg57322--1029 Mr. Blankfein," You might limit our leverage ratio. You might have us have certain kinds of contingent securities that cause people to have to give us money at times we need it. There are a number of proposals out to do it, but in general, the system would be made safer if financial institutions had more capital. There is, of course, a cost for this, because to the extent that you have more capital and lower leverage, loans will be more expensive. There will be less credit granted, but that is a tradeoff that after the experience of the last few years policy makers may well be interested in making, and it is a question of degree that---- Senator Coburn. Well, it is about a $10 trillion cost of what we have absorbed already, so---- " CHRG-111hhrg58044--314 Mr. Rukavina," Chairman Gutierrez, Ranking Member Hensarling, and members of the subcommittee, I thank you for the opportunity to address the committee today. My name is Mark Rukavina, and I am executive director of the Access Project. We work nationally on health care issues, and have since 1998. And our research played an instrumental role in revealing the problem of medical debt. Medical debt is money owed for any type of medical service or product. That money may be owed directly to the provider of the service, or to an agent of the provider, such as a collection agency. In my testimony today, I would like to discuss the use of medical debt in assessing one's creditworthiness. And more detailed information is found in my written testimony. First, some background on medical debt. Data gathered by the Commonwealth Fund found that during 2007, the most recent year for which data are available: 49 million working-aged Americans and 7 million elderly adults had medical debt or medical bills that they were paying off over time; and 28 million working-aged adults were contacted by collection agencies for medical bills. What makes medical bills unique? Few Americans understand that nearly two-thirds of the people who have medical debt had insurance at the time of the incident for which they owe money. While insurance provides protection, patients still have out-of-pocket obligations that they must pay. Americans are often confused by their health insurance coverage. One national study found that nearly 40 percent of Americans did not understand their medical bills or the explanation of benefits. They did not know what service they were supposed to pay for, the amount they owed, or whether that amount was correct. Nearly one-third let a medical bill go to collection, and one in six did not know whether they should pay their health care provider or their insurance company. Given this, it is not surprising when claims that are not promptly paid get sent to collection. The confusion regarding medical claims payment also carries over to credit reports. Many Americans mistakenly believe that unpaid medical bills have no influence over a credit score. The lack of clarity may stem from statements made by industry representatives. Testimony from the previous panel was an example of this. However, in recent testimony before this committee, a VantageScore representative said that their score does not factor medical debt into the calculation of a consumer's credit score. Following that hearing, a letter was sent to the committee to clarify that this only applies when that medical debt is reported directly by a health care provider. They also clarified that they include all collection accounts, including those related to medical debt, when calculating a credit score. Given this, it is important to understand how most medical data appear on people's reports. According to Experian, data provided directly by medical providers accounts for only 7/100ths of one percent of the data that they gather. TransUnion states that medical debts are not typically reported unless they become delinquent and are assigned to collections. So, here are the facts. Forty percent of Americans are confused by medical bills. Consumers and some credit scoring agencies appear confused as to whether medical data are used in calculating credit scores. Medical data can only drag down one's score. I say this because medical debts that are paid off directly to providers aren't used in calculating one's score. Medical accounts are only included on credit reports if they are deemed delinquent and sent to collection. This system is stacked against consumers, and penalizes those who experience illness. Even when proper action is taken, and one pays off a medical bill, the Fair Credit Reporting Act allows for this bill to remain on a person's report for up to 7 years. This leads me to question the predicted value of medical accounts, which has also been questioned by some of those in the financial service industry. Some lenders disregard them when reviewing loan applications. A study published in the Federal Reserve Bulletin found that nearly one-third of Americans with a credit file have a collection account on their credit report. The study found that more than half of the accounts in collection are medical accounts. It went on to state that, ``some credit evaluators report that they remove collection accounts related to medical services from credit evaluations because such accounts often involve disputes with insurance companies over liability for the accounts or because the account may not indicate future performance on loans.'' It is estimated that in 2008, Americans spent $277 billion in out-of-pocket costs. This resulted from millions of invoiced medical bills. Millions of Americans had bills sent to collection as the result of a lengthy insurance claim adjudication process or confusion due to numerous bills generated from one visit to a hospital. Those who paid their bills in full are often very surprised when they learn that despite such actions, the bills continue to plague them and peg them as poor credit risks. Such data errors harm consumers, and these inaccuracies in credit reports slow America's economic recovery. H.R. 3421 addresses this problem, it corrects these errors on credit reports. Specifically, it would require-- " CHRG-111hhrg54867--7 Mr. Gutierrez," Mr. Secretary, first of all, thank you for appearing. Exactly 1 year ago, we experienced the most agonizing week of the current financial crisis. And this committee began to address the root causes of the social and economic trauma that crippled our economy and caused millions of Americans--and we should remember this--to lose trillions of dollars of their hard-earned wealth. Let me repeat that: Trillions of dollars of hard-earned wealth were lost by the American people. Not so much the guys on Wall Street, they lost, but the people on Main Street lost. Predatory mortgage lending, combined with risky investment practices and poor underwriting standards, financed by some of the largest financial institutions in this country, created the financial and economic debacle that we must now address. Over a decade ago, the Federal Reserve was given the power by this committee--I was here; I got elected in 1993--to stop predatory mortgage practices through the Homeowners' Equity Protection Act. It took the Federal Reserve 12 years to implement the rules and regulations that could have prevented many, if not all, of the worst abuses by predatory lenders and originators, abuses that were a direct and immediate cause of our current crisis. Why did it take so long? While there were many theories to explain this, I believe it took the Fed this ridiculously long time, including the FDIC, which did absolutely nothing either, because it was distracted by their other regulatory obligations and by a sense in Washington, D.C., of do less, do nothing, leave it alone, it is okay. The default of these toxic mortgages and the securitized products based on them caused trillions of dollars in losses and caused the 2008 freeze in credit markets, which nearly destroyed not only our financial system but the entire international financial system. The message to those of us who want to restore the stability to the financial system could be no clearer or louder. If we do not include a strong, effective Consumer Financial Protection Agency within our regulatory reform legislation, Congress will have failed to address the current and any future economic challenges facing our country. We must also address the economic threat inherent in institutions known as ``too-big-to-fail.'' I believe we must work to a comprehensive, risk-based pricing regime which eliminates the incentives for these financial firms to grow to the point of becoming ``too-big-to-fail.'' One of the ways we can prevent an institution from becoming ``too-big-to-fail'' is through a pricing regime which discourages banks from growing so large and interconnected. We must not only increase capital requirements, but we should also require decreased leverage ratios and increased contributions to the Deposit Insurance Fund. Let me ask that this be submitted for the record, my complete statement, because it is clear to me, Mr. Chairman, we are going to have, you know, our classical debate. Our colleagues on the other side have already thrown health care into this, big government. I hear ``socialism'' coming any second. They are going to say, ``No, no, no. Global warming doesn't exist, no. We don't need to do anything about global warming. We really don't need to do anything about this.'' We do need to do something, and Mr. Geithner knows it probably better than anybody else. We can never allow a Lehman Brothers again to have a 30:1 ratio. We can't allow that kind of leverage. And government is the only one that is going to stop it from happening again. Thank you very much, Mr. Chairman. " CHRG-110hhrg46591--330 Mr. Cleaver," Thank you, Mr. Chairman. Whenever we begin this discussion of regulation, it always creates ideological differences. Mr. Yingling and Mr. Washburn, I am wondering, since someone here on our committee made a comment before the break that the CRA and minorities were responsible for the subprime mortgage debacle, I would like to find out from you, from the banking industry, do you believe that the CRA is a regulatory burden? Mr. Yingling or Mr. Washburn. " CHRG-111hhrg56766--71 Mr. Neugebauer," Are you concerned about what is going on in the European Union right now with Greece and some of the other countries within the Euro, their levels of debt, are those countries going to have to step in and back them up, and the implications of what the disruption within the European Union might impact the United States? " CHRG-111hhrg55814--384 The Chairman," The next witness is Jane D'Arista, from Americans for Financial Reform. STATEMENT OF JANE D'ARISTA, AMERICANS FOR FINANCIAL REFORM Ms. D'Arista. Thank you, Chairman Frank, Ranking Member Bachus, and members of the committee for inviting me. And I want to say that I'm representing a very large group of organizations that are consumer and non-financial or nonprofit and concerned with the issues of reform, not just consumer issues but the entire panoply. I would say that President Trumka has laid out many of our concerns about this draft legislation today. I'm going to take the opportunity, if I may, to go into something else, which is to say that obviously it is important that we begin by dealing with crisis management, as you have done in this legislation. But we must not forget that the important thing to do is not just manage these problems but to prevent them. And I find that the legislation so far comes up short in the preventive era. I would like to talk about two particular issues. One of them is what I see as an equally important underlying cause of the crisis, and that's the combination of excessive leverage, proprietary trading, and the new funding strategies that go into the repurchase agreements, markets and the commercial paper markets, etc., for financial institutions. We have here a situation in which leverage has, in effect, monetized debt, because assets are used as backing for new borrowing to add more assets. The evidence of this is that the financial sector has grown 50 percent in the decade from 1997 to 2007, rising to 114 percent of GDP. That is pretty shocking in and of itself. Proprietary trading is an issue that must be addressed, and it is of concern for a lot of different reasons, one of which of course is that it erodes the fiduciary responsibility of intermediaries. But equally important is the issue of the fact that what is at stake here is institutions trading for their own bottom line without any contribution to their customers or to the economy as a whole. What money goes in to the financial sector comes from our earnings and our savings, and they have skimmed it off to game it. It is our money that is at risk in this game. The funding strategies that have been used in order to support leverage and proprietary trading have been the major contribution, in my view, to the interconnectedness of the financial sector. These institutions are borrowing from one another, not from, primarily, from the outside non-financial sector, as a result of which over half of those positions are supplied by other financial institutions. This is the counterparty issue, this is what we were dealing with when we were dealing with Lehman, AIG, etc., and it is something that absolutely must be addressed. Finally, briefly, about securitization. Securitization has changed the structure of the U.S. financial system. We have gone from a bank-based system to a market-based system with new rules of the game. We have eroded the bank-based rules that shielded the consumer and the household in this country since the 1930's. These new rules expose households to interest rate risks, market rate risk, etc., but they do so to institutions as well because of the mark to market phenomena they require. You cannot have a market without marking it to market. But the chart drops against capital that we have seen here, and we have not fully evaluated, have turned capital of our financial institutions into a conduit to insolvency--not a cushion, but a conduit to insolvency. So what I think is that this committee has a very large plate to deal with going into the future as a preventive set of resolutions. I would urge you to do so not in the direction you're going now, which is to give discretion to too many institutions that we know--the Federal Reserve in particular--but to actually craft the rules of the game that need to be followed in the future. Thank you very much. [The prepared statement of Ms. D'Arista can be found on page 138 of the appendix.] " CHRG-111hhrg49968--2 Chairman Spratt," The committee will come to order. We meet today to hear the distinguished Chairman of the Federal Reserve, Benjamin Bernanke, testify on the recession that is plaguing our economy and on the prospects of recovery. Chairman Bernanke testified before our committee on October 20 of last year as we searched for ways to mitigate, if not avoid, a long recession. The Chairman acknowledged then that monetary policy has its limits. Without being specific, he welcomed a fiscal complement. Congress had just passed a bipartisan bill authorizing $700 billion to dispose of troubled assets, so-called TARP. Backed by these funds, the Treasury, the Fed, and the FDIC have made extraordinary advances to banks and other financial institutions, recognizing what Chairman Bernanke told the Joint Economic Committee last month, that, quote, ``A sustained recovery in economic activity depends critically on restoring stability to the financial system.'' This is one question we hope you will address today, Mr. Chairman: Just how strong and how stable are our financial institutions? By February of this year, it was clear that TARP relief was a necessary but not sufficient solution. So Congress passed, on a partisan basis, an even bigger boost, the American Recovery and Reinvestment Act, which packed $787 billion of fiscal stimuli in the form of spending increases and tax decreases. We would like to know, Mr. Chairman, whether from the Fed's viewpoint this huge countercyclical thrust is working. Bold action was necessary to head off a collapse of the financial system, but the steps taken also swell the Nation's deficit and the national debt. It is all but impossible to balance the budget when the economy is bucking a headwind like this recession, because what we do to make the economy better is likely to make the deficit worse. Yet, at the same time, we cannot add infinitely to the national debt without facing consequences in global credit markets or on our future capacity to borrow. One purpose of this hearing is to explore both the advantages, and the potential downside risk of our bold and unprecedented response to financial turmoil. Should we be concerned that some of our swelling debt must be financed with foreign credit? We hope that most of our outlays are for nonrecurring needs and that much of what has been advanced in recent months will in time be recovered, repaid, and used to pay down the debt that we are incurring. We would like to have your assessment, Mr. Chairman, of that possibility. Despite bold, unprecedented action, the Director of the Congressional Budget Office told this committee on May 21st that our economy is still running at 7 percent or more below its capacity, or a trillion dollars per year below its potential. Recently there have been signs, however, of a turnaround. Business inventories are down; the stock market is up a bit; and so, too, to some extent, is the housing market. Our question to you, Mr. Chairman, is whether these are glimmers of hope or flashes in the pan. To keep this recession from growing worse, the Fed has pumped enormous liquidity into the money markets, so much so that some critics even worry of inflation, lurking, to be sure, just over the horizon, but a threat nevertheless. The spread between short- and long-term Treasuries has widened to more than 2.5 percentage points. We would like to know, Mr. Chairman, if these are salutary signs of a recovery or ominous signs of inflation. A month ago, Chairman Bernanke told the JEC that, quote, ``We expect economic activity to bottom out and turn up later this year.'' But he went on to warn, ``Even after the recovery gets under way, the rate of real economic growth is likely to remain below potential for a while, only gradually gaining momentum.'' The old locomotives that pulled the economy out of the rut in the past--real estate, consumer durables--are unavailing now. This causes us to ask, Mr. Chairman, what will empower a turnaround in this dismal economy, and when can we expect to return to normality? Mr. Chairman, as you can see, we have a lot of grist for our mill today. We thank you for being here, but, most of all, we thank you for your service to our Nation at this very crucial time. Before proceeding to your statement, let me turn to Mr. Ryan for his opening remarks. Mr. Ryan? " CHRG-111hhrg53244--156 Mr. Lance," And, obviously, we do not favor monetizing the debt. I understand your point that you do not believe you are doing that. But we do have concerns in that regard; I have concerns in that regard. And I certainly look forward to working with you in that area. And, finally, Mr. Chairman--and then I will yield back the balance of my time after your response--how much, at the moment, are we in the hole regarding AIG and what you have done regarding AIG? " CHRG-111hhrg58044--6 Chairman Gutierrez," I am going to ask unanimous consent that Ms. Kilroy be allowed to sit in this hearing, and grant her 2 minutes for an opening statement. Hearing no objection, it is so ordered. Ms. Kilroy. Thank you, Mr. Chairman. Thank you for your leadership in this important issue. I thank the witnesses for their time here today. I am interested in what you have to say, particularly about medical debt and the impact it has on the credit scores for millions of Americans, and their ability to get an affordable home loan or car loan, long after they have paid their medical debt. I ask for unanimous consent to enter into the record a letter written to me from my constituent, Julia Mueller of Columbus, Ohio. She is a responsible young adult, a college student. She pays her credit cards on time. She purchased health insurance. She checked with them before she was going to have an expensive procedure to see if it would be covered. She was assured it was. That was her understanding until the bills came and her insurance company denied coverage. She ended up in a year-long dispute with them on that. It was eventually resolved, but it destroyed her credit score. Now, she is worried about her ability after college to buy a car, and to buy a house. I worry it might even affect her ability to get a job. I introduced the Medical Debt Relief Act to help hard-working Americans like Julia who play by the rules, pay or settle their medical debts, yet find their credit scores adversely affected for years to come. Today, we are taking an important step in the right direction to deal with this important issue. I want to tell Julia when she writes to me that, ``I am fiscally responsible and I would like to be treated that way,'' and that is what we are aiming to do here today. Thank you, Mr. Chairman. I yield back my time. " CHRG-110shrg50416--170 RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM NEEL KASHKARIQ.1. On October 20, 2008, Secretary Paulson said that Treasury's infusion of capital in financial institutions through the purchase of preferred stock is intended ``to increase the confidence of our banks, so that they will deploy, not hoard, their capital. And we expect them to do so.'' I share that expectation. As I indicated at the hearing, I feel that Treasury should ask banks that receive these capital infusions provided by the taxpayers to make more loans to entities in the community and to not hoard the money. You said Treasury shares this view and that you ``want our financial institutions lending in our communities.'' Within our communities, small private colleges serve important roles and many of them have borrowing relationships with banks. The credit crisis has made some creditworthy schools concerned that the banks from which they have borrowed in the past will be unwilling to lend to them on reasonable terms in the future.Q.1.a. Does Treasury believe that banks which receive capital injections should be encouraged to continue to lend to the creditworthy customers, including small private colleges and universities, with which they have done business in the past? If so, will Treasury encourage such lending?A.1.a. Treasury believes that the banks that received investments from the Capital Purchase Program (CPP) should continue to make credit available in their communities. By injecting new capital into healthy banks, the CPP has helped banks maintain strong balance sheets and eased the pressure on them to scale back their lending and investment activities. However, we expect banks to continue their lending in a safe and sound manner and that institutions must not repeat the poor lending practices that were a root cause of today's problems. To that effect, we firmly support the statement by bank regulators on November 12, 2008 to that effect. The statement emphasized that the extraordinary government actions taken to strengthen the banking system are not one-sided; all banks--not just those participating in CPP--have benefitted from the government's actions. Banks, in turn, have obligations to their communities to continue to make credit available to creditworthy borrowers and to work with struggling borrowers to avoid preventable foreclosures.Q.1.b. What specific conditions or assurances has Treasury required to ensure that banks do not hoard the capital?A.1.b. The Treasury has not imposed specific conditions on how banks can use funds obtained from the CPP. The purpose of the CPP is to stabilize financial markets and restore confidence, including by strengthening banks' balance sheets so that they can better weather the deleveraging process associated with the current economic downturn. The CPP funds were not costless to the recipient institutions: the preferred shares carry a 5 percent dividend rate and the recipients will need to put those funds to a productive use or they will lose money. The banks will have strong economic incentives to deploy the capital profitably. Banks are in the business of lending and they will provide credit to sound borrowers whenever possible. They may also use the capital to absorb losses as part of loan write-downs and restructurings. If a bank doesn't put the new capital to work earning a profit or reducing a loss, its returns for its shareholders will suffer. However, Treasury did design important features into our investment contracts to limit what banks can do with the money: one, Treasury barred any increase in dividends for 3 years; two, Treasury restricted share repurchases. Increasing dividends or buying back shares would undermine our policy objective by taking capital out of the financial system. In addition, Treasury has been working with the banking regulators to design a program to measure the activities of banks that have received TARP capital. We plan to use quarterly call report data to study changes in the balance sheets and intermediation activities of institutions we have invested in and compare their activities to a comparable set of institutions that have not received TARP capital investments. Because call report data are collected infrequently, we also plan to augment that analysis with a selection of data we plan to collect monthly from the largest banks we have invested in for a more frequent snapshot. Thus, Treasury does not believe that banks will ``hoard'' the capital, but rather utilize this additional capital in a safe and sound manner. We expect communities of all sizes to benefit from the investments into these institutions, which now have an enhanced capacity to perform their vital functions, including lending to U.S. consumers and businesses and promoting economic growth. The increased lending that is vital to our economy will not materialize as fast as many of us would like, but it will happen much faster as a result of deploying resources from the TARP to stabilize the system and increase capital in our banks.Q.1.c. What assurances have you received from these banks that they will employ the capital to prevent foreclosures?A.1.c. Treasury believes that banks will employ this additional capital in a manner that best benefits their communities. Some institutions may use the funds to continue lending to community institutions (such as private universities), while other institutions may employ the funds to originate new residential mortgages or to restructure existing mortgages. In our private conversations with bankers receiving CPP funds, many institutions have stated that preventing foreclosures is a high priority for them.Q.2. In implementing the Capital Purchase Program (CPP), what steps has the Treasury Department taken to ensure that all financial institutions that participate will receive similar accounting treatment in the determination of the value of the institution's risk weighted assets?Q.2.a. What specific steps is the Treasury Department taking to coordinate the assessments by the various primary regulators?A.2.a. The federal banking agencies, working in conjunction with the Treasury, developed a common application form that was used by all qualified financial institutions to apply for CPP funds. In addition, the Treasury worked closely with the bank regulators to establish a standardized evaluation process, and all regulators use the same standards to review all applications to ensure consistency. Applications are submitted to an institution's primary federal regulator. Once a regulator has reviewed an application, it will take one of the following three actions: (1) for applications it does not recommend, it may encourage the institution to withdraw the application; (2) for applications it strongly believes should be included in the program, it directly sends the application and its recommendation to the TARP Investment Committee at the Treasury; (3) for cases that are less clear, the regulator will forward the application to a Regulatory Council, made up of senior representatives of the four banking regulators, for a joint review and recommendation. The Treasury TARP Investment Committee reviews all recommendations from the regulators. This committee includes our top officials on financial markets, economic policy, financial institutions, and financial stability, as well as the Chief Investment Officer for the TARP, who chairs the Committee. This is a Treasury program and Treasury makes the final decision on any investments. The Investment Committee gives considerable weight to the recommendations of the banking regulators. In some cases, the Committee will send the application back to the primary regulator for additional information, or even remand it to the Regulatory Council for further review. At the end of the evaluation process, Treasury notifies all approved institutions.Q.2.b. What lessons learned can you report from the assessment process for the first nine institutions which participated in the CPP?A.2.b. This process has worked well. Each institution that has received CPP funds has been thoroughly scrutinized. Although the process is very labor and time intensive, the Treasury believes it is necessary to fully protect the interests of the taxpayer.Q.3. A stated legislative purpose of EESA is that the Treasury Department use the funds' in a manner that preserves homeownership and promotes jobs and economic growth.'' What specific steps has the Treasury Department undertaken to ensure that the funds are being used to accomplish this objective?A.3. The purpose of the EESA was to stabilize our financial system and to strengthen it. It was not a panacea for all our economic difficulties. The crisis in our financial system had already spilled over into our economy and hurt it. It will take a while to get lending going and to repair our financial system, which is essential to economic recovery. However, this will happen much faster as the result of TARP actions. The most important thing Treasury can do to mitigate the housing correction and reduce the number of foreclosures is to stabilize financial markets, restoring the flow of credit and increasing access to lower-cost mortgage lending. The actions we have taken to stabilize and strengthen Fannie Mae and Freddie Mac, and through them to increase the flow of mortgage credit, together with the CPP, are powerful actions to promote mortgage lending. Treasury is working actively to stabilize housing markets and reduce preventable foreclosures, and has succeeded by undertaking the following initiatives: HOPE NOW: In October 2007, Treasury actively helped facilitate the creation of the HOPE NOW Alliance, a private sector coalition of mortgage market participants and non-profit housing counselors. HOPE NOW servicers represent more than 90 percent of the subprime mortgage market and 70 percent of the prime mortgage market. Since inception, HOPE NOW has kept roughly 2.9 million homeowners in their homes through modifications and repayment plans, and it is currently helping more than 200,000 borrowers per month. Stabilizing Fannie Mae and Freddie Mac: Treasury took aggressive actions in 2008 to stabilize and strengthen Fannie Mae and Freddie Mac, and prevent the collapse of two institutions with $5.4 trillion in debt and mortgage-backed securities held by investors and financial institutions throughout the United States and the world. The systemic importance of these two enterprises, and the systemic impact of a collapse of either, cannot be overstated. Treasury's efforts to stabilize them by effectively guaranteeing their debt has increased the flow of mortgage credit and insulated mortgage rates from the rapid increases and fluctuations in the cost of other credit. Hope for Homeowners: On October 1, 2008, HUD implemented Hope for Homeowners, a new FHA program, available to lenders and borrowers on a voluntary basis that insures refinanced affordable mortgage loans for distressed borrowers to support long-term sustainable homeownership. Streamlined Loan Modification Program: On November 11, 2008, Treasury joined with the FHFA, the GSEs, and HOPE NOW to announce a major streamlined loan modification program to move struggling homeowners into affordable mortgages. The program, implemented on December 15, creates sustainable monthly mortgage payments by targeting a benchmark ratio of housing payments to monthly gross household income (38%). Additionally, on November 20, Fannie Mae and Freddie Mac announced that they would suspend foreclosure sales and cease evictions of owner-occupied homes from Thanksgiving until January 9th to allow time for implementation of the modification program. Subprime Fast-Track Loan Modification Framework: Treasury worked with the American Securitization Forum to develop a loan modification framework to allow servicers to modify or refinance loans more quickly and systematically. Subprime ARM borrowers who are current but ineligible to refinance may be offered a loan modification freezing the loan at the introductory rate for five years.Q.4. If there were a troubled asset that threatened the viability of critically important public infrastructure systems, would EESA provide theTreasury Department the authority to purchase such a troubled asset? Would you interpret such a purchase to be consistent with the purposes of the Act?A.4. According to the EESA, the Secretary of the Treasury may purchase from a financial institution any financial instrument, that he determines, after consultation with the Chairman of the Board of Governors of the Federal Reserve System to be necessary to promote financial market stability. In such an instance, the Secretary must transmit such a determination to the appropriate committees of Congress. The Secretary will make those decisions on a case-by-case basis.Q.5. During the discussions leading to the passage of the Emergency Economic Stabilization Act of 2008, Treasury asked for $700 billion primarily to purchase troubled assets at auction. Secretary Paulson testified that ``This troubled asset purchase program on its own is the single most effective thing we can do to help homeowners, the American people and stimulate our economy.'' [Senate Banking Committee hearing on September 23, 2008.] Days after enactment of the law, Treasury changed its main focus from asset purchases and decided to first infuse capital in large financial institutions. Please describe the analysis that supported the initial Treasury plan and identify the assumptions that later proved to be inaccurate, causing Treasury to abruptly change the principle focus of the TARP to buying preferred stock.A.5. In the discussions with the Congress in mid-September during consideration of the financial rescue package legislation, Treasury focused on an initial plan to purchase illiquid mortgage assets in order to remove the uncertainty regarding banks' capital strength. At the same time, Treasury worked hard with the Congress to build maximum flexibility into the law to enable Treasury to adapt our policies and strategies to address market challenges that may arise. In the weeks after Secretary Paulson and Chairman Bernanke first went to the Congress, global and domestic financial market conditions deteriorated at an unprecedented and accelerating rate. One key measure Treasury assessed was the LIBOR-OIS spread--a key gauge of funding pressures and perceived counterparty credit risk. Typically, 5-10 basis points, on September 1, the one-month spread was 47 basis points. By September 18th, when Treasury first went to Congress, the spread had climbed 88 basis points to 135 basis points. By the time the bill passed, just two week later on October 3, the spread had climbed another 128 basis points to 263 basis points. By October 10, LIBOR-OIS spread rose another 75 basis points to 338 basis points. During this period, credit markets effectively froze. The commercial paper market shut down, 3-month Treasuries dipped below zero, and a money market mutual fund ``broke the buck'' for only the second time in history, precipitating a $200 billion net outflow of funds from that market. Given such market conditions, Secretary Paulson and Chairman Bernanke recognized that Treasury needed to use the authority and flexibility granted under the EESA as aggressively as possible to help stabilize the financial system. They determined the fastest, most direct way was to increase capital in the system by buying equity in healthy banks of all sizes. Illiquid asset purchases, in contrast, require much longer to execute and would require a massive commitment of funds. Treasury immediately began designing a capital program to complement the asset purchase programs under development. Since launching the program on October 14, 2008, Treasury has invested $192.3 billion of the $250 billion Capital Purchase Program in 257 institutions in 42 states across the country, as well as Puerto Rico. Following that, as Treasury continued very serious preparations and exploration of purchasing illiquid assets, scale became a factor; for an asset purchase program to be effective, it must be done on a very large scale. With $250 billion allocated for the CPP, Treasury considered whether there was sufficient capacity in the TARP for an asset purchase program to be effective. In addition, each dollar invested in capital can have a bigger impact on the financial system than a dollar of asset purchase; capital injections provide better ``bang for the buck.'' It also became clear that there was a need for additional capital for non-bank financial institutions and support of the non-bank financial market. A large contingency also arose that threatened the financial system, as Treasury had to restructure the Federal Reserve's loan to AIG, using $40 billion of TARP funds. This action was taken to prevent the collapse of a systemically significant financial institution and the impact such a collapse would have on the system and economy. In addition, Treasury was required to use TARP funds to support Citigroup. Treasury also realized that it would have to take actions to support the non-banking market, a critical source of funds for consumers and small and large businesses, by supporting the securitization market. Such measures would help bring down interest rates on auto loans, credit cards, student loans and small business loans and could be achieved with a more modest allocation from the TARP. Therefore, Treasury committed to provide $20 billion of TARP resources in support of a $200 billion Federal Reserve facility--the Term Asset-Backed Securities Loan Facility (TALF). As such, Treasury's assessment at this time is that the purchase of illiquid mortgages and mortgage-related securities is not the most effective way to use TARP funds.Q.6. The conservatorship of Fannie Mae and Freddie Mac has resulted in the unintended consequence of increasing the borrowing costs for the Federal Home Loan Banks (FHLBs) since the markets apparently now view them as having a more distant relationship to the government than the GSEs in conservatorship. Additionally, the decision by the FDIC to guarantee senior debt of financial institutions has raised funding costs for Fannie Mae and Freddie Mac because the market apparently does not view the $200 billion backstop provided to the enterprises as an equivalent guarantee. Given the stated purpose of putting the enterprises in conservatorship--to ensure a stable housing market, to lower mortgage interest rates, and to make sure the enterprises could actively purchase agency MBS--what steps is the Treasury considering to address these problems?A.6. Treasury, working in concert with the Federal Reserve and FHFA, has been closely monitoring financial markets, particularly credit markets in terms of the impact and consequences of our actions. While the GSEs and not the Federal Home Loan Banks were placed into conservatorship with access to $100 billion through the senior preferred purchase agreement, all three entities have access to the GSE Credit Facility which Treasury established at the time of conservatorship. As a result, all three entities, including the FHLB, have access to enormous liquidity limited only by the amount of collateral which they have on their balance sheet. This credit facility was established specifically to level the playing field for the FHLBs. Furthermore, Treasury's purchases of MBS of FRE and FNM since September, also set up after the conservatorship, have instilled confidence in the overall mortgaged-backed securities (MBS) markets. The recent actions by the Federal Reserve Bank of New York to purchase the debt and MBS of the GSEs have also added confidence, thus lowering borrowing costs across the board, including those of FHLB. In fact, since the conservatorship was announced, the spread on FHLB 2-year debt, a benchmark issue, has declined from nearly 86 basis points above the comparable two-year Treasury to less than 45 basis points--in line with that of FNM and FRE--an enormous difference in borrowing costs and a primary result of the joint actions of Treasury and the Federal Reserve. With regard to the FDIC guaranteed debt portfolio, while these securities have an explicit FDIC guarantee, they still do not possess the liquidity and depth of the GSE Agency or Treasury markets. Hence, some large institutions cannot be as actively involved in these markets since they need to purchase in very large size. As an example, about $115 billion of FDIC bank debt has been issued, while the agencies have over $3 trillion in debt outstanding. Partially as a result of this, the GSEs are able to borrow at a lower spread to Treasuries than FDIC backed debt. In fact, as mentioned above, 2-year benchmark FDIC backed debt on average trades 60 basis points above comparable 2-year Treasuries while GSE debt trades about 45 basis points above such Treasuries--i.e. the GSE borrowing costs are cheaper. Moreover, the life of the senior preferred agreement is in perpetuity for any debt issued between now and December 31, 2009 and for any tenor, while the FDIC debt program is limited to debt issued out three years and expires June 30, 2009--a major difference.Q.7. As you know, since it was rescued by the Federal Reserve, AIG was engaged in lobbying activities at the state level. Specifically, the company was lobbying against certain requirements for mortgage brokers. The company subsequently promised to stop these activities. What steps has the Treasury Department taken to make sure that the entities receiving federal assistance are not engaged in lobbying, particularly in lobbying against important protections for borrowers? Did the Treasury Department consider putting any lobbying restrictions on the entities that it funds under the TARP?A.7. As part of the agreement with AIG announced on November 10, 2008, AIG must be in compliance with the executive compensation requirements of Section 111 of EESA. AIG must comply with the most stringent limitations on executive compensation for its top five senior executive officers, and Treasury is requiring golden parachute limitations and a freeze on the size of the annual bonus pool for the top 60 company executives. Additionally, AIG must continue to maintain and enforce newly adopted restrictions put in place by the new management on corporate expenses and lobbying as well as corporate governance requirements, including formation of a risk management committee under the board of directors.Q.8. I commend the Administration for following through with Section 112 of EESA by convening an international summit on November 15. In announcing the summit yesterday, the White House explained that leaders of the G20 and key international financial institutions will review progress on measures taken to address the financial crisis and to discuss principles for reform of regulatory and institutional regimes going forward. Please describe what the Treasury and Federal Reserve intend to accomplish through this summit and the subsequent working group meetings that will follow the summit--specifically, what types of principles for regulatory and institutional modernization will the United States pursue in the international community? Will these principles include protections for consumers and households which form the foundation of economic prosperity in our country as well as other countries?A.8. The international summit was extraordinarily successful. It resulted in a five-page statement by the participating leaders as well as a 47-point action plan of quite specific actions, both in the near term and in the longer term. There were six key takeaways from the summit. First, there was broad agreement on the importance of the countries of the G20 taking and implementing pro-growth investment--pro-growth policies to stimulate our economies. Second, the leaders pledged to improve our regulatory regimes so to ensure that all financial markets, all financial products, and all financial market participants are subject to appropriate regulation or oversight. Related to this was a pledge of enhancing international cooperation among regulators and between regulators and international financial institutions. Third, one of the significant reforms that was agreed on was the need to reform international financial institutions to give greater representation to emerging market and developing economies. Fourth, there was an affirmation of free market principles, and, also importantly, the leaders expressly rejected protectionism. The final takeaway was a recognition and commitment to address the needs of the poorest, both by honoring our aid commitments, and by ensuring that the World Bank and IMF are adequately resourced so that they can help developing countries through this crisis. And here note was taken of the new liquidity facilities of the IMF, as well as the recent very large package announced by the World Bank, to support needs for trade finance and promote infrastructure development.Q.9. The Treasury announced plans to invest $250 billion to strengthen the balance sheet of banks and the rest of the TARP money to provide relief to banks struggling with troubled assets. How much money will Treasury devote to provide relief for the millions of Americans struggling with troubled mortgages?A.9. The existing TARP programs have exhausted the $350 billion in TARP funds that already have been authorized by Congress. Not all of those funds have yet been disbursed, and given the unpredictability and severity of the current financial crisis, Treasury believes it is prudent to reserve some of our TARP capacity to maintain not only our flexibility in responding to unforeseen events, but also that of the next Administration. Separately from the TARP, Treasury has acted aggressively to keep mortgage financing available and develop new tools to help homeowners. Specifically, Treasury has achieved the following three key accomplishments: To support the housing and mortgage market, Treasury acted earlier this year to prevent the failure of Fannie Mae and Freddie Mac, the housing GSEs that affect over 70 percent of mortgage originations. October 2007, Treasury helped establish the HOPE NOW Alliance, a coalition of mortgage servicers, investors and counselors, to help struggling homeowners avoid preventable foreclosures. Treasury worked with HOPE NOW, FHFA and the GSEs to achieve a major industry breakthrough in November 2008 with the announcement of a streamlined loan modification program that builds on the mortgage modification protocol developed by the FDIC for IndyMac.Q.10. What is your position on the use of funds by financial institutions under the CPP to acquire other institutions? Does your position depend on whether the other institution is healthy or failing?A.10. The Treasury believes that banks and their management and shareholders are in the best position to determine whether acquisitions or mergers make sense. Acquisitions and mergers in the banking industry are also reviewed by the appropriate Federal banking agencies, which must consider the impact on the relevant communities as well as financial and managerial information. As noted above, the purpose and the focus of the CPP is the stability of the financial system. The program is not designed to, nor does it focus on, encourage or discourage acquisitions or mergers. More generally, Treasury believes that when failing bank is acquired by a healthy bank, the community of the failing bank is better off than if the bank had been allowed to fail. Branches and financial services in that community are usually preserved. Costs to the taxpayers via the FDIC deposit fund are also lower than had the bank been allowed to fail. Prudent mergers and acquisitions can strengthen our financial system and our communities, while protecting taxpayers.Q.11. We have received reports that insurance companies are in talks with Treasury to allow access to the TARP program.Q.11.a. Has any decision been made about whether insurance companies may take part in the TARP program, and what is the rationale for inclusion?A.11.a. The Treasury Department is analyzing the inclusion of insurance companies, including how to apply the CPP to bank holding companies and thrift holding companies with insurance company subsidiaries.Q.11.b. Given that insurance companies are not federally regulated (at least, not on their insurance business), what exact oversight will be done to ensure safety and soundness of the companies?A.11.b. Regulation of insurance companies is undertaken at the state level, not by the Treasury Department, and Treasury does not interfere in these regulatory-supervisory matters. Treasury also does not regulate the institutions which have chosen to participate in the voluntary CPP program, as they are regulated by their primary Federal regulators. Separately, in March of 2008, Treasury published an extensive Blueprint for a Modernized Regulatory Structure that proposes a framework and many specific recommendations for reforming our financial regulatory system, including in the area of insurance. However, Treasury is using TARP to stabilize the financial system today, while regulatory modernization will likely take several years to complete.Q.12. Each agency represented at the hearing has aggressively used the tools at their disposal in dealing with the crisis. However, sometimes the use of those tools has led to unintended consequences. For instance, when the Treasury Department guaranteed money market funds, it led to a concern on deposit insurance and bank accounts. When the FDIC guaranteed bank debt, it had an effect on GSE borrowing costs, which in turn directly affects mortgage rates. Acknowledging that there is often a need to act quickly in these circumstances, please explain what steps and processes you have employed to inform other agencies about significant actions you undertake to ensure that there are not serious adverse unintended consequences and that your actions are working in concert with theirs.A.12. Throughout the financial crisis, the Secretary has been in very close contact with the other members of the President's Working Group on Financial Markets (the Federal Reserve, the SEC, and the CFTC) and the heads of the FDIC, OCC, and OTS. To the maximum extent possible, programs have been developed cooperatively among these different agencies. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM BRIAN D. MONTGOMERYQ.1. You are rightly proud to have been able to launch the HOPE for Homeowners plan in so short a period of time, and I thank you and the other agencies involved for your efforts. In the end, of course, the goal is to help homeowners. Please provide the Committee with information regarding your outreach efforts to lenders, housing counselors, and borrowers. What steps have you taken to sign up lenders? How many lenders are currently participating? What steps have you taken to ensure borrowers know about the program?A.1. FHA conducted the first national training session for lenders and counselors in Atlanta, Georgia, on November 13 and 14. Approximately 600 industry representatives attended the session. FHA staff provided a comprehensive overview of the program, explaining everything from borrower eligibility criteria to servicing requirements to FHA's monitoring practices on HOPE for Homeowners loans. The attendees were very attentive, asking excellent questions and engaging in substantive dialogue. The next national FHA training session will be at the Neighborworks Training Institute, to be held in Washington, DC, from December 8th through December 12th. Additional counselor-specific training will be conducted in an on-line course offered by Neighborworks as well. Other lender and counselor training sessions will be performed on a smaller scale, at the local and regional level. FHA has posted a calendar of training and outreach events on the FHA.gov Web site, to provide consumers, counselors, and lenders with a tool to look up events by date, location, sponsor, and intended audience. The listing of events will be updated on a regular basis, as the Board agencies continue to work with industry partners to set up additional sessions. At each of the events, staff from one or several of the HOPE for Homeowners Board agencies will present information on the program. The Web-based calendar of events can be found at www.fha.gov. As of November 20, 56 sessions had been scheduled. The national training schedule and a description of the events held by headquarters staff are included as attachments. Recognizing that timely outreach from the lender community to struggling consumers is critically important, a form has been added to the Web site for FHA-approved lenders to sign up for the H4H program. There are currently more than 200 brokers included on the list, which is available for consumers on FHA.gov. Unfortunately, we have had very few originating lenders sign up for the program to date. The lending community not only needs time to understand the unique statutory requirements of the H4H Program but also to modify their protocols and practices, train their staff and update their technology systems before they can responsibly offer it to consumers. Consumers are strongly encouraged to contact their servicing lender and any subordinate lien holders since their participation is vital for a refinance into a HOPE for Homeowners mortgage. With regards to borrower outreach, FHA and our partner agencies are executing an integrated consumer advertising campaign across a variety of media including radio, print, and the Internet. We are engaging HUD's target audiences through various online channels, while maintaining the FHA.gov portal in support piece in a variety of our marketing activities communications channel. We have also leveraged HUD's field network and industry partners to expand reach. Two online applications are being developed by the Federal Reserve to post on the FHA Web site. FHA also developed an online training course for housing counselors with Neighborworks that will be posted on the Web sites of both organizations.Q.2. What impediments do you see to the use of the HOPE for Homeowners program?A.2. There are a number of specialized requirements that make this program very different from, and more difficult than, any other mortgage product the lending community has offered and/or helped consumers to access. FHA fully recognizes the challenging policy decisions that the Congress and the Administration had to make to ensure that any program designed to serve homeowners in need did not place undue financial burden on American taxpayers. Nevertheless, the lending community has consistently cited several key shortcomings and expressed concern that the program was unnecessarily complicated. The primary concerns raised repeatedly are that the program: 1. imposes excessive costs on consumers 2. directs unfair payments to the Federal government, at the expense of both lenders and consumers 3. restricts eligibility so severely that few homeowners in need can qualify In line with these general concerns, FHA makes the following specific recommendations for Congressional actions needed to modify the program to increase uptake. Eliminate SEM and SAM altogether Permit subordinate liens to be placed behind HOPE for Homeowners mortgages Reduce 1.5% annual premium Remove restrictive eligibility criteria, including: No intentional defaults No false information on previous loan No fraud over previous 10 years No ownership of other residential real estate March 1, 2008 DTI affordability measure Remove 1st payment default provision FHA looks forward to providing Congress with a full account of the concerns we have been presented to begin the dialogue about additional legislative changes that would improve program participation.Q.3. As you note in your testimony, FHA's loan volume has skyrocketed over the past two years. Its market share has grown from 2 percent to 17 percent. Please explain how FHA has handled this huge increase in volume without compromising the quality of the loans it has insured. Please provide the Committee data on the types of loans insured (purchase money, term refinance, cash out refinance, and others); the characteristics of the loans (LTVs, sources of downpayments, terms, and other relevant data); characteristics of the borrowers (credit scores and other relevant data); and any other information you think the Committee could use to evaluate the new book of business.A.3. The attached report provides statistics on FHA's increased loan volume.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]Q.4. Each agency represented at the hearing has aggressively used the tools at their disposal in dealing with the crisis. However, sometimes the use of those tools has led to unintended consequences. For instance, when the Treasury Department guaranteed money market funds, it led to a concern on deposit insurance and bank accounts. When the FDIC guaranteed bank debt, it had an effect on GSE borrowing costs, which in turn directly affects mortgage rates. Acknowledging that there is often a need to act quickly in these circumstances, please explain what steps and processes you have employed to inform other agencies about significant actions you undertake to ensure that there are not serious adverse unintended consequences and that your actions are working in concert with theirs.A.4. Developing a risk-oriented business plan early in the H4H Program's implementation was an essential element designed to assist the Oversight Board to ensure that the processes, procedures, and communication requirements are put in place to do what Congress has directed it to do. The H4H team has developed a business plan that builds on the considerable work already completed by the agencies to develop the Program. It is a living document with a key purpose to assist the Oversight Board and its member agencies to sufficiently: (1) identify and prioritize Program risks, and to (2) develop action plans and strategies to sufficiently mitigate the highest Program risks. In developing this business plan the agencies operated under the key assumptions: (1) HUD is operating the program, (2) there is a strong preference to leverage HUD's existing processes, and (3) to appropriately assess risk and provide risk mitigation strategies, it is critically important to focus on elements that are unique to the H4H program as these areas may pose the highest risks to the Program and agencies administering the Program. This includes identifying the new or adapted business processes that will be required. The risk identification also includes externalities that may be outside of the agencies' control. As the HOPE for Homeowners Program moves from its Startup Phase (July 30-October 1) into its Implementation Phase (October 1-December 31), the staffs of the Treasury Department, FDIC, and Federal Reserve have less need for active involvement in the day-to-day matters of the Program. Other than resources contributed to unfinished implementation of the Program's implementing regulations and mortgagee letters, these staff efforts will shift to a monitoring role over this transitional period. By the end of this Implementation Phase, FHA management and staff will be expected to operate the program, and the Oversight Board and its member agencies will together monitor program performance, make recommendations for refinements or enhancements based on feedback from the Program's results and (if relevant) changes in the economic and housing market environment, and their own analyses. Staffs from the agencies will continue to communicate regularly and coordinate Oversight Board meetings and affairs, including required monthly reports to Congress. The Treasury Department, FDIC, and Federal Reserve will of course be responsive to requests for resources and assistance if needed, including but not limited to possible exigent circumstances in the economy and/or housing market. To facilitate this transition and to put in motion the changed roles, the four agencies will initiate a more formal set of staff structures and processes aimed at fulfilling these responsibilities and maintaining attendant controls and information flows. The chart below summarizes these structures and processes. [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]---------------------------------------------------------------------------------------------------------------- Number of Date Event Description Audience attendees----------------------------------------------------------------------------------------------------------------10/1............................ FHA Conference Introductory Industry; 600+ Call. conference call Consumers. to announce program roll out.10/1............................ Inside Mortgage Conference call on Industry.......... 300+ Finance. FHA modernization included questions on H4H.10/2............................ Federal Reserve... H4H briefing...... Consumer affairs 12 regional banks. office and outreach staff.10/6............................ National Council H4H briefing...... State Finance 30 states. of State Housing Agencies. Finance Agencies.10/7............................ FHA Conference H4H briefing...... Counselors........ 200+ Call.10/8............................ Housing summit.... 2 sessions on H4H; Government 600+ general overview officials; and more in-depth. lenders; counselors.10/14........................... American Bankers H4H briefing...... ABA members....... 250+ Association (ABA).10/15........................... FHA Conference H4H briefing Industry; 500+ Call. targeted to top government 30 FHA lenders officials. and FHA liaisons.10/15........................... FHA Conference H4H briefing and Counselors........ 100+ Call. discussion of outreach efforts.10/16........................... National Council H4H briefing...... State Finance 20 states. of State Housing Agencies. Finance Agencies.10/27........................... FHA Field Briefing Field briefing for Government 100+ FHA and HUD staff officials. who perform outreach activities.10/30........................... Inside Mortgage H4H briefing...... Industry.......... 200+ Finance.11/5............................ FHA Conference H4H briefing...... Industry.......... 200+ Call.11/6............................ Federal Housing H4H briefing...... Government 100+ Finance Agency. officials.11/13-14........................ National H4H National 2-day Industry; 600+ Training extensive Counselors. Conference. training program on H4H.11/19........................... National Press Sec. Preston Media............. 100+ Club Event. announces programmatic changes to H4H product.11/20........................... Mortgage Bankers Issues with Industry.......... 100+ Association. implementing H4H.12/4............................ Independent H4H briefing...... Industry.......... 300+ Community Bankers of America.12/5............................ Neighborworks..... Taped three hour Counselors........ n/a online training course.12/8-9.......................... Neighborworks..... Two day training Counselors........ tbd event.---------------------------------------------------------------------------------------------------------------- ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM JAMES B. LOCKHART, IIIQ.1. There has been significant confusion in the marketplace regarding the status of debt offered by Fannie Mae and Freddie Mac. Specifically, there is confusion as to whether or not that debt is guaranteed by the federal government. Your revised testimony makes it clear that the federal government is not directly guaranteeing the debt. Rather, the government has provided a $100 billion capital backstop to each enterprise with which it can pay all its debts. However, the failure to extend this guarantee has had a number of unintended consequences in light of the government's decision to explicitly guarantee senior debt for other financial institutions. For example, the press reports that the cost of raising debt for both Fannie Mae and Freddie Mac has gone up significantly since the latter decision. In addition, the two enterprises have apparently been unable to raise anything but short-term funding. This leads to a number of questions:Q.1.a. Was FHFA consulted in the deliberations regarding guarantee of bank debt? If so, was any consideration given to the possibility that such a guarantee might undermine the ability of the enterprises to fund themselves effectively?Q.1.b. Is any thought being given, or are any discussions underway regarding providing the enterprises with the same guarantee as has been given to other financial institutions?Q.1.c. One outcome of these increased funding costs is an increase in mortgage interest rates. According to the Wall Street Journal (October 30, 2008; ``Mortgage Plan Isn't Cutting Rates''), rates for 30-year fixed rate mortgages have climbed to 6.64%, up from the prior week's 6.24%. Given the fact that one of FHFA's stated purposes for putting the enterprises into conservatorship was to support the housing market, including with increased purchases of agency MBS, what can be done about these higher funding costs? Is this funding problem undermining the ability of the enterprises to meet its mission of maintaining a stable and orderly housing market?Q.1.d. Please provide the Committee with data showing the change in funding costs for the enterprises from just prior to the conservatorship to the announcement of the guarantee for senior debt of financial institutions to the present. Please provide data on the associated mortgage rates over the same period of time.A.1.a-d Getting mortgage rates down more in line with declines in Treasury yields has the potential to provide significant benefit to troubled housing markets. As the attached chart and tables show, the establishment of the conservatorships was accompanied by a quick drop in mortgage rates of more than 40 basis points, and spreads of Enterprise yields above Treasury yields fell comparably. Those gains appeared to erode over the next few weeks, with continued bad news about financial institutions and the economy. The announcement of FDIC insurance for senior debt of insured depository institutions coincided with further widening of yield spreads and higher mortgage interest rates. However, it is important to note that yields on GNMA mortgage-backed securities (MBS), which are guaranteed with the full faith and credit of the U.S. Government performed comparably with yields on MBS guaranteed by the Enterprises. FHFA received a pre-announcement notification of the senior debt guarantees. We are unaware of any plans to extend those guarantees to the Enterprises, something that might require legislation. Subsequently, the Fed's announcement of $500 billion of MBS purchases and $100 billion of GSE debt purchases caused a significant decline in Enterprise yields spreads and in mortgage rates, bringing interest rates on 30-year fixed-rate loans to their lowest level in the nearly 38 years' history of Freddie Mac's survey.Q.1.e. In addition, the funding for the Federal Home Loan Banks (FHLB) has also been rising. In fact, it is our understanding that FHLB debt is even more expensive than debt issued by the enterprises. What is being done to address this problem?Q.1.f. All the housing GSEs are increasingly dependent on short term financing. What challenges will it pose if the GSEs are increasingly forced to depend on short-term financing to carry on their operations?A.1.e-f: Debt of the Federal Home Loan Banks initially benefitted similarly to that of the Enterprises following the establishment of the Enterprise conservatorships. Shortly thereafter, however, Bank yields rose relative to Enterprise yields. While debt yields of all GSEs had been very close, differentials of as much as 60 basis points opened up at 2, 3, and 5-year maturities. While HERA gave Treasury authority to buy unlimited quantities of debt from any of the housing GSEs, the preferred stock agreements were only made with Fannie Mae and Freddie Mac because the Banks did not need that kind of support. Nonetheless, the market seemed to view them as less protected. Since the Fed's debt purchase plans were announced in late November, though, yields spreads among the different GSEs have tightened and returned to near normal amounts. All of the housing GSEs, and especially the Enterprises depend to some extent on their ability to issue intermediate-term debt. That was nearly impossible in the fall, but recently increased investor interest has permitted GSE issues of debt with maturities of as long as five years. Conditions are still far from satisfactory, but improving. In the meantime, purchases by the Treasury under its GSE MBS Purchase Facility have augmented those of the Enterprises and the Fed.Q.1.g. In a recent story, Business Week reported that FHFA was requiring enterprises to buy troubled mortgage assets. Is this true? If so, what is the policy rationale for doing this?A.1.g The story was unfounded. We did not require the Enterprises to buy troubled assets. We believe they can best serve the housing and mortgage markets primarily by using their resources to maintain a liquid secondary mortgage through purchasing and guaranteeing new loans. In addition, we have been encouraging them to reduce foreclosures and mitigate losses by aggressively modifying their own troubled loans and setting a standard for others.Q.2 Section 110 of the Emergency Economic Stabilization Act of 2008 (ESA) requires FHFA to ``Implement a plan that seeks to maximize assistance for homeowners'' in order to avoid preventable foreclosures. Please describe in detail your agency's plan in this regard, and any steps that have already been taken to implement this plan.A.2. a. FHFA Expertise: FHFA employs examiners and executives who have expertise and/or experience in default management, non-performing loans, loss mitigation and REO management. These individuals provide supervision and oversight of both enterprises in these areas. b. Enterprise Internal Controls. For the last 18-months, FHFA has focused on the loss mitigation and REO management areas. FHFA has reviewed the enterprises' internal policies and procedures, seller/servicer guides, bulletins and announcements, as well as the internet sites and published materials to support servicers' loss mitigation efforts, activities and reporting. c. Enterprise Reporting. FHFA consistently receives internal monthly and quarterly management reports for non-performing loans that include loss mitigation efforts. To compliment these internal reports, starting in 2008, FHFA required the enterprises to submit a monthly report on loss mitigation activities. Data from those reports are aggregated with results posted to FHFA's website. FHFA's Foreclosure Prevention Report (formerly, Mortgage Metrics Reports) provides the most comprehensive data on loss mitigation efforts (in comparison to HOPE NOW and the OCC/OTC reports), and continuously reports on the loss mitigation performance ratio. This ratio has clearly brought transparency to and focus on the enterprises' efforts in assisting borrowers. For 2009 reporting, FHFA has enhanced reporting requirements effective with data for January loss mitigation actions. The additional data elements relate to expanded modification types ( as required by EESA), the reason/s for default, default status (e.g., bankruptcy, military indulgence, government seizures, probate), property condition, and occupancy status. d. FDIC Loan Modification Program. FHFA worked with the FDIC and the enterprises to pilot the FDIC/IndyMac loan modification program, announced August 20, 2008. FHFA initiated work on this effort in August 2008. Both enterprises initiated the pilot in October. e. Streamlined Modification Program (SMP). FHFA became actively involved with HOPE NOW Alliance members and the enterprises in October with the goal of rolling out a streamlined modification program. The program was announced November 11th and rolled out December 15th. To enhance the success of this program, both enterprises suspended the scheduling of and scheduled foreclosure sales on occupied properties for the period November 26th to January 31st. The suspension allows borrowers in foreclosure the opportunity to cure the serious delinquency with a loan modification. f. Loss Mitigation Programs. The enterprises, offer other loss mitigation programs to assist borrowers in saving their homes--forbearance plans, payment plans, a standard loan modification and a delinquency advance program (e.g., Fannie Mae's HomeSaver Advance program.) For borrowers who are unable to make a payment at the most liberal modified terms, both enterprises offer short sales, deeds-in-lieu and charge-offs in lieu of foreclosure. g. Loan Modification Issues. FHFA has worked with both enterprises in reviewing accounting, trust and capital issues that may disincent the enterprises from being aggressive with modifications. Those issues have been addressed. The enterprises have a solid understanding of FHFA's desired objective of keeping borrowers in their homes. In particular, Fannie Mae announced major changes to its trust that allow for more flexibility with loan modifications. h. Interagency Efforts. FHFA has continued to work with HOPE NOW Alliance members, the OCC, OTS, HUD, FDIC and Treasury to discuss industry issues and concerns, and the enterprises' in particular. Results of this communication have allowed FHFA to obtain third party views on how well the enterprises are doing, and what they could be doing better or differently. i. Non-Agency Investments. FHFA has taken an active role in communicating with PLS servicers, trustees and investors to encourage them to adopt the SMP program, or a comparable program acceptable to all PLS investors and in compliance with PLS pooling and servicing agreements. FHFA has supplemented these conversations with meetings with American Securitization Forum (ASF) officers. Doing so has not only helped borrowers whose loan are in PLS securities, but also the enterprises who own 20% of PLS securities.Q.3. Discussions with a number of entities, from major lenders and servicers to housing counselors, reveal that Fannie Mae and Freddie Mac are resisting efforts to do loan modifications. Please describe the efforts being undertaken by the two enterprises, and the FHLBs, to engage in loss mitigation. Specifically, what are the loss mitigation policies of the GSEs? What barriers do you see in these policies to moving toward a more systematic approach to loan modifications?A.3. a. Loan Modification Efforts. FHFA's oversight and supervision of the enterprises doesn't confirm the view that the enterprises are resisting efforts to do loan modifications. In fact, since the early 1990s, both enterprises have been leaders in the loss mitigation area, and set the standards for what is best practice for the industry. In discussing this observation with both enterprises, two points were made. First, many servicers were unaware of the authority the enterprises had delegated to them to review and approve loan modifications in their behalf. Second, the enterprises strongly believed the proper way to assist a borrower and modify the loan is through the standard rather than the streamlined process. The standard process requires a customized approach to working with the borrower and his/her circumstances based on a cash-flow budget. The streamlined process requires an approach that is less borrower-specific, and makes assumptions about the borrower's ability to pay at modified terms based on a ratio analysis. Initially, the enterprises resisted efforts to adopt a streamlined modification program, because it wouldn't necessarily address the individual borrower's unique situation. Because of rising delinquencies, the increase in properties in the foreclosure process, and servicers' capacity limitations, the enterprises worked actively with HOPE NOW Alliance members, and agreed to SMP program guidelines. b. Communication from External Parties. When an external party has contacted FHFA regarding the enterprises' actions, we follow up with the enterprise on the specific concern. As a result, either FHFA and/or the enterprise contacts the external party. In addition, FHFA will discuss the situation and circumstances, and determine if there is a more general or broader issue that requires attention. Recently, a housing counseling agency contacted FHFA regarding concerns around Fannie Mae's decisions on loan modification requests. FHFA met with the counseling agency, and asked it to provide specific examples (cases) where borrowers had requested modifications that were not approved by Fannie Mae. Fannie Mae was very open to this and agreed to do so. Generally, FHFA has found it to be more beneficial and productive to work with specific examples and instances, than to address broad generalizations. c. Loss Mitigation Performance. As reported in FHFA's monthly and quarterly Foreclosure Prevention Reports through September 2008: 1. Loss Mitigation Performance Ratio. The enterprises' loss mitigation ratio has fluctuated from 46.9 percent to 64.8 percent from January to September, and averaged 54.6 percent. That ratio measures the number of borrowers who were helped versus those who needed help (were destined for foreclosure.) FHFA's 2009 performance goals target a 25 percent increase in loan modifications over 2008 actuals. 2. Loss Mitigation--Borrower Retained Property. Loss mitigation actions that allowed the borrower to retain his or her property represented 93 percent of all loss mitigation actions--139,381 in total. Of that number, 49,128 were completed payment plans, 45,179 were delinquency advances, and 44,458 were loan modifications. 3. Completed Foreclosures. Completed foreclosures as a percent of new foreclosures initiated averaged 32.7 percent for the enterprises, but 41.5 percent for OCC/OTS servicers and 42.8 percent for HOPE NOW servicers. d. Loss Mitigation Policies, Procedures and Processes. Both enterprises have internal policies and procedures, seller/servicer guides, and bulletins and announcements, as well as internet sites and materials to support servicers' loss mitigation efforts and activities. To compliment those, the enterprises provide training materials and training (on-line and classes) in loss mitigation. e. Barriers. Reported barriers to effective loan modifications are not an outgrowth of enterprise policies. They are: 1. Subordinate liens. There are a high number of loans with subordinate second liens. A successful workout often requires the cooperation of the second lien holder, who may/may not be represented by the first mortgage servicer. 2. Unable to Contact/Locate. Servicers are often unable to assess the borrower's financial position and/or get him or her to commit to a loan modification because the borrower can' be contacted, is evading the servicer's calls or letters, and/or has abandoned the property. In many cases, the properties were purchased as investment properties. The borrowers never intended to live in them. If the property looses value and/or the borrower has trouble renting the property, the borrower is inclined to walk away from a bad investment. 3. Bankruptcy. Borrowers in bankruptcy cannot be contacted directly by the servicer for a workout--even though they may take this action in an effort to save their homes. Therefore, the population of borrowers who can be solicited for a loan modification is reduced. 4. Fraud/Misrepresentation. Given that some loans were originated under low or no documentation programs, a review of the defaulted borrower's situation may reveal that the borrower never made the income to support the mortgage in the first place. Efforts to modify the loan may be unsuccessful as the borrower may have no ability to pay at even the most favorable terms.Q.4. Each agency represented at the hearing has aggressively used the tools at their disposal in dealing with the crisis. However, sometimes the use of those tools has led to unintended consequences. For instance, when the Treasury Department guaranteed money market funds, it led to a concern on deposit insurance and bank accounts. When the FDIC guaranteed bank debt, it had an effect on GSE borrowing costs, which in turn directly affects mortgage rates. Acknowledging that there is often a need to act quickly in these circumstances, please explain what steps and processes you have employed to inform other agencies about significant actions you undertake to ensure that there are not serious adverse unintended consequences and that your actions are working in concert with theirs.A.4. We meet frequently with other agencies to discuss policy issues and planned significant actions. HERA specifically provided for consultation with the Federal Reserve on implementation of new powers and sharing of information about the condition of our regulated entities. It also created the Federal Housing Finance Oversight Board, which meets at least quarterly and includes the Secretaries of Treasury and HUD, as well as the Chairman of the SEC. The Senior Preferred Stock Purchase Agreements signed between the Enterprises and Treasury ensure consultation or agreement with the Treasury on many aspects of the Enterprises activities. The EESA created the Financial Stability Oversight Board, which includes the same members as the FHFA Oversight Board plus the Federal Reserve Chairman. It has met seven times, and staff have met frequently. In addition, we have met informally with these agencies and others numerous times in the past few months to discuss issues, policies, and planned actions. We worked closely, for example, with the Treasury and HUD, and consulted with the FDIC, in developing the Streamlined Modification Program adopted by the Enterprises and a majority of the portfolio lenders participating in the private sector alliance HOPE NOW to reduce foreclosures.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] ------ CHRG-111hhrg51585--149 Mr. Street," There is a requirement, constitutionally, that the State has a balanced budget. Certain debt can be issued as revenue anticipation notes to smooth out cash flow-- " CHRG-111hhrg56847--138 Mr. Jordan," Interest rates are, I believe, within 2 years, we are on a path to pay $1 billion a day just in interest on the debt. That is how out of control it is getting. " CHRG-111shrg55739--153 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BENNETT FROM STEPHEN W. JOYNTQ.1. As we move forward on strengthening the regulation of credit rating agencies, it is important that we do not take any action to weaken pleading and liability standards of the Private Securities Litigation Reform Act of 1995. This Committee worked long and hard, and in a completely bipartisan fashion, to craft litigation that would help prevent abusive ``strike'' suits by trial lawyers. These suits benefited no one but the lawyers who orchestrated these suits. This was a real problem then, and could become a real problem again if we dilute the current standard that applies to all market participants. Perpetrators of securities fraud, and those who act recklessly, can be sued under the law we passed in 1995. Is there any justification for now altering this standard just for credit rating agencies?A.1. No. Altering the pleading and liability standards of the PSLRA just for credit rating agencies is neither warranted nor justified. In passing the PSLRA in 1995, Congress struck a delicate balance between two important competing goals: to curb frivolous, lawyer-driven litigation while preserving investors' ability to recover on meritorious claims. Consistent with these principles, under current law, credit rating agencies are liable for securities fraud. A claim for securities fraud levied against a credit rating agency by an investor will survive a motion to dismiss provided the investor is able to plead the elements of securities fraud, in particular facts from which a reasonable person could strongly infer the agency acted intentionally or recklessly to a degree sufficient to meet the scienter requirement as interpreted by the courts.Q.2. Will the threat of class action litigation, and the costs of endless discovery, be at cross-purpose with the goal of fostering greater competition in credit rating markets?A.2. Amending the pleading standards of the PSLRA to allow strike suits against credit rating agencies is most certainly at cross-purpose with the goal of fostering greater competition in credit rating markets. Congress adopted the PSLRA to curb the practice of plaintiffs filing complaints for securities fraud against firms whether or not there was evidence of fraud in the hope that they would find evidence to support their claims through the discovery process. Congress acted in recognition of the fact that such lawsuits require firms to expend huge sums defending or settling claims of securities fraud, regardless of guilt, among other things, making it more difficult for smaller firms to compete. Rolling back the PSLRA reforms as they apply to credit rating agencies will place a substantial burden on all agencies, and possibly overwhelm newer entrants to the market. Ratings are forward-looking assessments of future performance. Whenever actual performance is out of line with a forward-looking assessment, in hindsight, to an investor it will always look like the NRSRO could have reasonably foreseen future problems with better stress testing, etc.Q.3. Would this potential create a disproportionate burden for smaller players in the industry?A.3. The burden placed on any one agency will depend on the size of agency's revenue base, the volume and types of credit rating products offered by the agency, and the markets in which it operates. Agencies with a smaller revenue base are typically able to support a smaller cost base and consequently are likely to bear a disproportionate burden.Q.4. Do you believe that the threat of harassment litigation could act as a barrier to entry to those considering entry into the rating agency business?A.4. Yes. Smaller agencies considering application for NRSRO status reasonably can be expected to be deterred by the threat of excessive litigation costs. The threat of harassment litigation can also reasonably be expected to have a chilling effect on agencies seeking to better serve investors through the assignment of agency initiated ratings. ------ CHRG-111shrg50815--119 ZYWICKI 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. This is the most worrisome aspect of well-intentioned consumer credit regulations that will have unintended consequences of driving borrowers, especially credit-impaired borrowers, to other less-attractive forms of credit. Those who ore unable to get a credit card will likely be forced to turn to alternatives such as payday lending. Those unable to get credit from a payday lender will likely be forced to turn to pawn shops. And those who are unable to gain access to pawn shop credit may find themselves unable to get legal credit at all. Consumers often have emergencies or necessities for which they need credit. For instance, a young person needs credit to start a life away from home--clothes for a job, furniture for an apartment, etc. Consumers may have emergencies such as car repairs, for which they will have to find credit somewhere. If good credit is not available consumers will turn toward less-attractive terms of credit instead. Q.2. Benefits of Credit Card Use: Professor Zywicki, in previous testimony you suggested growth in credit cards as a source of consumer credit has replaced installment lending, pawnshops, and payday lending. I am concerned that the newly finalized rules may result in a lack of available consumer credit. I believe that there were clearly some egregious practices that the Federal Reserve and others should appropriately eliminate, but many who have criticized the credit card industry for facilitating excessive consumer debt, fail to point out the benefits of open access to consumer credit. Does the consumer benefit from access to open ended consumer credit over other less regulated forms of credit such as pawn shops, payday lenders, and installment lending? A.2. Consumers absolutely benefit from access to open-ended consumer credit. The dramatic growth in credit card use in recent decades testifies to this fact. Installment lending, such as retail store credit is limited because it requires consumers to ``buy'' goods and credit as a bundle. Personal finance company loans are typically both more expensive for the buyer to apply for, offer higher interest rates and other costs, and impose a rigid repayment schedule. A borrower also might be unable to get a personal finance company loan at the moment that he needs it. Payday lending and pawnshops are obviously inferior to credit cards and these other options. Credit cards offer consumers many benefits that these other products do not. Credit cards have flexible use and repayment terms. Borrowers can pay as much as they want and can switch easily among alternative card issuers. They are also generally acceptable, thereby allowing the unhooking of the credit transaction from the goods transaction. This allows consumers to shop more vigorously in both markets. General-acceptance credit cards also permit small businesses to compete on an equal footing with large businesses and department stores by relieving those small businesses of the risk and cost of maintaining their own in-house credit' operations. According to one survey conduct by the Federal Reserve, 73 percent of consumers report that the option to revolve balances on their credit cards makes it ``easier'' to manage their finances versus only 10 percent who said this made it ``more difficult.'' Durkin, Credit Cards: Use and Consumer Attitudes at 623. Q.3. 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.3. This is likely to be the case, for exactly the reasons stated. If lenders are permitted only to reduce interest rates but not raise them, they will have to charge a higher interest rate to all borrowers to compensate for this risk. Moreover, this would give borrowers an opportunity to reduce their interest rates by switching to another card but lenders would be unable to raise interest rates in response to a change in the borrowers risk profile. Credit cards are structured as revolving debt for a reason: unlike other loans, it amounts to a new loan every month. Thus, every month the borrower has the option to switch to another, lower-interest card. 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. By making credit cards less-available and less-flexible, new stringent regulations will likely push more consumers into bankruptcy. Consumers in need of credit will seek that credit somewhere. Reducing access to good credit, like credit cards, will force these borrowers into the hands of much higher-cost credit, such as payday lenders. Moreover, credit cards are especially valuable because they provide a line of credit that the borrower can access when he needs it, such as when he loses his job and has medical bills. By contrast, if the borrower is required to apply for a bank loan after a job loss, he is likely to be rejected, which will accelerate his downward spiral. Moreover, credit cards are valuable in that they can be used to purchase almost any good or service. Again, the flexibility of credit cards is valuable to consumers. 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 all safety and soundness issues related to consumers are also consumer protection issues. For instance, there were obviously a number of ordinary homeowners who essentially decided to act like investors with respect to their homes by taking out nothing-down, no-interest mortgages and then walking away when those homes fell into negative equity. If the consumers failed to understand the terms of those mortgages, then that is a consumer protection issue. If, however, the consumer consciously made this choice to speculate and the lender made the loan anyway, then while this would trigger a safety and soundness concern it is difficult to see how this would amount to a consumer protection issue. 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? Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? A.6. Did not respond by publication deadline. 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. Interference with risk-based pricing makes it more difficult for lenders to tailor prices to the details of the behavior of particular consumers. As a result, lenders have to price card terms on less fine-grained assessments of risk. This leads to pricing risk across broader categories of borrowers, and in turn, increases the cross-subsidization among consumers. I can see no good policy reason why this should be encouraged. Q.8. Restriction on Access to Credit: One suggestion being made in order to encourage students not to become overly dependent on debt is to restrict access to credit to individuals under the age of 21. Mr. Zywicki, could you explain for the Committee the potential benefits and detriments of this policy? A.8. Benefit: A potential benefit, in theory, is that some younger consumers may avoid getting into debt trouble. I am not aware of any rigorous empirical evidence of how common this is. Detriments: There are several detriments: (1) LStudents who do not have access to credit cards may be tempted to take out more in the way of student loans. Because repayment on student loans is deferred until after graduation, this could cause students to take on more debt than they would if they had to pay some of their balance every month. (2) LEmpirical studies find that one major reason that causes students to drop out of college is a lack of access to credit. Many students eventually tire of ``living like a student,'' i.e., living in dorms and eating dorm food and Ramen noodles. They want an opportunity to have some sort of normal life, to go out to dinner every once in a while. Many students use credit responsibly and maturely and can have a happier student life experience if they have access to a credit card. (3) LMany students need access to credit. Although under the age of 21, many students essentially live on their own in off-campus apartments and the like. They need credit cards to pay for food, transportation, and the like. Thus, the rule sweeps far too broadly. (4) LSince the early 1990s, the fastest-rising debt on household balance sheets has been student loan debt. Students routinely graduate with tens of thousands of dollars in student loan debt. By contrast, very few students have more than a few thousand dollars in credit card debt. If Congress wants to seriously help indebted students, it should investigate the extraordinary level of student loan debt being accumulated. While credit cards can be a problem in some cases, the scope of the problem is dwarfed by the deluge of student loan debt. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM LAWRENCE CHRG-111hhrg56766--48 Mr. Watt," You are kind of in the same posture that we are in on the other side, your policies are creating some stresses on your own balance sheet that over time might have some consequences and you have to get out of it, and what you are saying is we need to be looking at those long-term consequences of more debt and more deficits so that we have an exit strategy to get back to a more normal kind of fiscal policy at the same time you are getting back to a more normal monetary policy. Am I misstating that? " fcic_final_report_full--6 From  to , the amount of debt held by the financial sector soared from  trillion to  trillion, more than doubling as a share of gross domestic product. The very nature of many Wall Street firms changed—from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By , the  largest U.S. commercial banks held  of the industry’s assets, more than double the level held in . On the eve of the crisis in , financial sector profits constituted  of all corporate profits in the United States, up from  in . Understanding this transformation has been critical to the Commis- sion’s analysis. Now to our major findings and conclusions, which are based on the facts con- tained in this report: they are offered with the hope that lessons may be learned to help avoid future catastrophe. • We conclude this financial crisis was avoidable. The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essen- tial to the well-being of the American public. Theirs was a big miss, not a stumble. While the business cycle cannot be repealed, a crisis of this magnitude need not have occurred. To paraphrase Shakespeare, the fault lies not in the stars, but in us. Despite the expressed view of many on Wall Street and in Washington that the crisis could not have been foreseen or avoided, there were warning signs. The tragedy was that they were ignored or discounted. There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread re- ports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregu- lated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not. The record of our examination is replete with evidence of other failures: financial institu- tions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mort- gage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk. What else could one expect on a highway where there were neither speed limits nor neatly painted lines? CHRG-111hhrg48674--293 Mr. Bernanke," Any investor who wants to purchase ABS on a leveraged basis could come to the Fed's program and do that. " CHRG-111hhrg54872--248 Mr. Yingling," Thank you, Madam Chairwoman. When I testified here in July, I asked the committee to look at this issue not only from the point of view of consumers, whose concern should be paramount, but also from the point of view of community banks, the great majority of which had nothing to do with causing the financial crisis, which are struggling with a growing mountain of regulatory burdens. Recently, I asked the ABA staff to determine the total amount of consumer regulations to which banks are subjected. The answer is 1,700 pages of fine print, and that is just in the consumer area. Since the median-sized bank has 34 employees, that means the median-sized bank has 50 pages of fine print for each employee. That means that half the banks in the country have more than 50 pages per employee in the consumer area alone. I want to express our appreciation for the consideration many members of this committee have given to the situation of traditional banks and to the unnecessary burden that would be placed on these banks. While there are many causes of the financial crisis, failures of consumer protection in the mortgage arena certainly contributed. As Congress moves to strengthen consumer regulation, however, it is important to focus on what the problem areas were. The two areas that have been identified as needing reform are the need for more direct focus by regulators on consumer issues and the need for more enforcement on nonbanks. The ABA agrees that reforms are needed in these two areas. On the other hand, in our opinion, no real case has been made for changes to other areas. The first area is requiring additional enforcement on banks and credit unions. While the argument is made that Federal regulators should have developed stronger regulations and sooner, there is little indication that once the regulations are issued, they are not enforced on banks and credit unions. The second area is giving the CFPA vast new powers. It is not clear why new authorities are needed. As has been talked about earlier this morning, the Fed had the mortgage regulatory authority and has the clear authority to address credit card issues, which is already done, and overdraft protection, which is in process. In fact, the expanded use of UDAP by the Fed creates a powerful tool in addition to specific consumer laws. The CFPA, unfortunately, goes well beyond addressing the two weaknesses identified. The Administration's proposal unnecessarily imposes new burdens on banks and creates an agency with vast new powers. We are pleased that the chairman's discussion draft addresses several issues the ABA has raised and seeks to lessen the additional burdens on community banks. One of our major concerns with the CFPA as proposed is that it would not adequately focus on the nonbank sector where the subprime mortgage crisis really began. The discussion draft rightly focuses regulation more on nonbanks than the original proposal did. The ABA still has major concerns in three areas. First, the ABA supports the preemption of State laws under the National Bank Act. We believe, without such preemption, we will have a patchwork of State and local laws that will confuse consumers and greatly increase the cost of financial services. Second, as I just stated, there has been little justification for the broad new powers given the CFPA. The draft removes two of these explicit powers, plain vanilla products and requiring communications to be reasonable. However, even with those changes, the proposed CFPA will be given unprecedented powers. Vague legal terms, such as ``abusive'' and ``fair dealing'' will create great uncertainty in the markets because no one will know what the new rules of the road will be. This will undoubtedly cause firms to cut back on the extension of credit and to avoid offering new products. From the broader perspective, the delegation authority of the CFPA is so vast that it renders all previous consumer laws enacted by Congress, including the recently enacted credit card law, mere floors. Several members of the committee have rightly raised concerns about this broad delegation. Third, the ABA opposes the creation of an entirely new agency on the fundamental principles that: first, you cannot separate the regulation of products from the entity; and second, that safety and soundness and consumer protection are too intertwined to be separated. ABA is committed to working with Congress to strengthen consumer protection while avoiding undermining the availability of credit and imposing new unnecessary costs on consumers and financial service providers. Thank you. [The prepared statement of Mr. Yingling can be found on page 151 of the appendix.] Ms. Bean. Thank you. And now we will hear from Mr. Bill Himpler, executive vice president of the American Financial Services Association. STATEMENT OF BILL HIMPLER, EXECUTIVE VICE PRESIDENT, THE AMERICAN FINANCIAL SERVICES ASSOCIATION (AFSA) " 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-111hhrg56847--154 Mr. Bernanke," Well, we have the debt commission that Mr. Ryan is on and Mr. Spratt, and I hope that they will come up with some good recommendations. But right now, there is not anything on the table at this point. " CHRG-111shrg51303--88 Mr. Polakoff," Correct. Senator Corker. There have been no losses--this is kind of interesting. So you are saying that there have been no losses whatsoever on any of those obligations as far as the debt actually not being repaid to these particular individuals. " CHRG-111hhrg61852--30 Mr. Koo," Yes. And when that process is going on, we are in a very different world, because these people would be minimizing debt instead of maximizing profits. And that is why we have to be super careful with this disease compared with ordinary recessions. " CHRG-111hhrg54869--210 Mr. Perlmutter," We liquidate them. We liquidate them and sell and then we offload whatever are the bad debt and we tried to sell them, parcel them out, do something with them. Mr. Cochrane, how do we liquidate or how do we resolve insurance companies? " CHRG-109hhrg28024--201 Mr. Ford," So those who continue to cite the debt as a small percentage of, or they cite it as 2.5 or 3.5, only 4.5 percent of all that we spend, you think the number itself, so 8 trillion versus this number compared to the economy, is as important as the percentage of our overall spending? " FOMC20080430meeting--294 292,MR. STERN.," I have only two comments. I would drop option 1. I just think it doesn't do enough to reduce the burdens and dead weight losses. As long as it's there, there will be a tendency to fall back to it for all sorts of reasons, given bureaucratic tendencies. So I would just discard it. I would not discard option 4, so I would include options 2, 4, and 5. I was originally attracted to 4. I read the reservations in the report and thought, okay, it's not worth pursuing. But I listened to President Lacker, and he reconvinced me that there are some significant merits there. " CHRG-110shrg50410--142 PROTECTING ANY FEDERAL GOVERNMENT INVESTMENT IN THE GSES Chairman Cox, presently Fannie Mae and Freddie Mac are exempt from the registration and disclosure provisions of the Federal Securities Laws.Q.1. If the Federal government purchases GSE debt or stock as set forth under Secretary Paulson's proposal, should the exemptions for the GSEs be removed so that U.S. taxpayers have the full protection of the Securities Laws?A.1. Whether or not the Federal government purchases GSE debt or stock, it is my longstanding recommendation to the Congress that both Fannie Mae and Freddie Mac should be required to become public companies essentially like any other private entity. I believe this will benefit the strength and liquidity of the market by ensuring the timely availability of information for investors and other market participants and help to restore overall market confidence in these entities. CHRG-111hhrg58044--2 Chairman Gutierrez," This hearing of the Subcommittee on Financial Institutions and Consumer Credit will come to order. Good morning and thanks to all of the witnesses for agreeing to appear before the subcommittee today. Today's hearing will examine the impact that the use of credit reports and information has on consumers outside of the traditional use for lending and credit purposes. We will examine the use of credit-based insurance scores, where the medical debt is predictive of a person's chances of defaulting, and finally, whether or not a consumer's credit information should be used to determine their employability. We will be limiting opening statements to 10 minutes per side, but without objection, all members' opening statements will be made a part of the record. We may have members who wish to attend but do not sit on the subcommittee. As they join us, I will offer an unanimous consent motion for each to sit with the subcommittee and for them to ask questions when time allows. I yield myself 5 minutes for my opening statement. This morning's hearing is about the use of credit information in areas such as insurance underwriting and employment purposes. We will hear about important yet complex and often opaque processes concerning credit board insurance and insurance scores in the first panel. In the second panel, we will hear about issues that are equally important to a vast number of consumers--the little known or understood use of credit information for hiring and even firing decisions, and the effect medical debt has on one's consumer report, even after you paid the medical debt off. When legislators or regulators attempt to fully grasp an issue such as credit-based insurance scores, they see a complex system laden with ever-changing computer applications and models, but it is precisely this complexity that should make us here in Congress delve further into an issue that affects every single American who owns or rents a house, a car, has insurance, has a job or is looking for a job, or is likely to incur medical debt. Do most consumers know that their car or homeowner's insurance rates may go up due to their credit score? Do they know that if one of their medical bills goes to a collection agency and they pay it in full and settle it, it will still affect their credit report for up to 7 years? Do people realize that even in these tough economic times, pre-employment consumer credit checks are increasingly widespread, trapping many people in the cycle of debt that makes it harder for them to pay off their debts and harder for them to get the job that would allow them to pay off the debt? I wonder--when you go to State Farm or Allstate or GEICO to get your insurance and they have a credit score, and that credit score was negative, so they are going to charge you more for your insurance, do they send you a note in the mail telling you that you are going to pay more for that insurance? I think these are all very important questions that the American public should know. Indeed, the current system facilitates the denial of employment to those who have bad debt, even though bad debt oftentimes results from the denial of employment, a vicious cycle. You cannot get a job, so you get a bad credit score. You have a bad credit score, so you cannot get a job. I wonder who is most likely to be affected, especially in these economic times. What? Extend unemployment compensation? What about the national debt? I have a way maybe we could settle unemployment compensation, how about letting somebody get a job and prove who they are without some mysterious number coming out of a black box somewhere where nobody knows about it. That is why the subcommittee is holding this hearing, the second so far this year on the issue of credit reports, credit scores, and their impact on consumers. We will look at reports and studies about the predictive nature of insurance scores and traditional scores among other things. As we do so, we also need to look at the basic guiding principles of equity, fairness and transparency. Some have contended that there is no disparate treatment of minorities in credit-based insurance scores. Some will say that even if there is a disparate impact on some groups, the system still does not need to be changed. The question of how predictive a credit-based insurance score is on an insured's likelihood to file a claim is important, as it is the predictive value of traditional credit scores used for credit granting. As long as there continue to be disparities in the outcomes of the current system for racial and ethnic groups and along class and geographical lines, I believe the system needs strenuous oversight and may need fundamental change. How to correct the disparities in the system with this disproportionately negative impact on minorities and low-income groups while maintaining the core framework of credit information as a risk management tool is a challenge we should take on. For example, on issues like the use of credit information for developing insurance pricing and the inclusion of medical debt collection in determining a consumer's risk of default, I have doubts as to whether there are biased uses of data. The Equal Employment Opportunity Commission, the Federal Reserve, the Brookings Institution, the Federal Trade Commission, and the Texas Department of Insurance have all found that racial disparities between African Americans, Latinos and Whites in credit scores exist, and we will see this has wide ranging implications beyond simply obtaining consumer credit. Defending a system where decisions such as determining car insurance rates or even something as vital as to whether or not to hire someone is based on something that has shown to possess a degree of bias is difficult, to say the least. I welcome the testimony this morning of those who believe the system works, and of those who believe the system needs to be changed to work in a more equitable, fair, and transparent fashion. In the same spirit of transparency, I am making it clear at the outset that I side with the latter group. I do not think you need any sort of score to predict that, from my point of view. In order to persuade this committee not to move forward on legislation that would strongly limit what we believe to be unfair practices, the industry witnesses before us must prove to me that not only are the practices we call into question scientifically predictive, but more importantly, they are fair and equitable to all Americans. The ranking member, Mr. Hensarling, is recognized. " CHRG-111shrg53822--82 Mr. Rajan," The quick response is this is a clear problem that Mr. Wallison has pointed out. And the answer is that the holders of this debt should not be levered financial institutions. It should not be other banks. It should not be insurance companies. So who would hold? It would be un-levered financial institutions, such as pension funds, mutual funds, sovereign wealth funds. Now, the immediate question, then, is, well, is there any evidence that there are people who buy this kind of instrument? And the answer is yes. There is a very liquid market in credit-default swaps on bank debt. That credit-default swap on bank debt has exactly the properties of the kind of insurance we are talking about. That is, it pays out when the bank is doing really badly, which typically is when the economy is in trouble. And there are people who are willing to buy this instrument, so much so, that this market has gone beyond bounds. It has become extremely large and we are trying to contain it. But it is suggesting demand is not going to be a problem if we do this right. And we can try and regulate so that the costs are borne by financial institutions that are not levered. And the costs are not forced to be borne by the taxpayer, which, to my mind, is worse than getting some people who bear it, knowing that they have been paid for bearing that risk. Senator Akaka. Mr. Baily? " CHRG-111hhrg48875--23 Mr. Campbell," So you're open to a little less leverage, then? " CHRG-110shrg50417--103 Chairman Dodd," Thank you, Senator Casey. Before I turn to Senator Brown, I just want to pick up on this bankruptcy provision. I appreciate Senator Martinez's raising it. This Nouriel Roubini is a noted economist, and just to quote him, he said, ``When a firm is distressed with excessive debt, it goes into bankruptcy court and gets debt relief that allows it to resume investment, production, and growth. When a household is financially distressed, it also needs debt relief.'' The lack of debt relief to the distressed households is the reason why this financial crisis is becoming more severe, and the economic recession with a sharp fall now in real consumption spending is worsening. The idea that you can go into bankruptcy court and protect your boat, if you want to, your car, and your vacation home--you can do that. Those are all contracts, and you can protect those in a bankruptcy court. But you cannot protect your primary residence. There is something fundamentally false about that notion. Your boat, your car, and your vacation home, I can protect. But I cannot protect your primary residence and let you get back on your feet, work this thing out, and get on your feet again. So I just hope--and I do not know whether we are going to do it next week or not, but I certainly intend, along with others here, to try and raise this. And I hope in the context--we are talking about distressed mortgages. We are not talking about doing it for a limited period of time. But we ought to be able to build a bipartisan coalition of support. That is the one single thing I know of that I think could make a difference, that we could make a difference on, aside from the efforts by the Treasury to step forward. Senator Brown. Senator Brown. Thank you, Mr. Chairman. Thank you for your passionate and very sensible words there. Mr. Eakes, I want to follow up on Senator Casey's question to you about the loan modification and the FDIC proposal. Do you believe if Treasury and FDIC and Sheila Bair and the administration can work on that under the provisions that we wrote into the bill a month or so ago, do you think that would deter banks from participating? And if it did have that effect, would it matter? Since this does not seem to trigger Treasury's concern about possible---- " CHRG-111hhrg56847--45 Mr. Bernanke," Well, countries have different amounts of fiscal capacity, if you will. Countries like Greece, which are clearly being shut out from the market because of their debt and deficit ratios, need immediate and sharp changes in their position. The United States, as I said in my remarks, is favored in that we are a safe-haven currency, we are a large diversified economy, and we have a long record of paying our debts, paying our interest. So we have a little more breathing space potentially, but I don't know exactly how much we have. And what I am just trying to say--I don't think I am disagreeing with you--is that we need a program for returning our trajectory of fiscal policy to a sustainable path. " CHRG-111hhrg61852--4 Mr. Koo," Thank you, Chairman Frank, and members of the committee. I really appreciate this opportunity to present my case that what the whole world has caught is the same Japanese disease that Japan had to struggle with for the last 15, 20 years. And I was grateful that I was in this room when the morning session took place. All the debate that took place here actually took place in Japan 15, 20 years earlier. That was about zero interest rates, liquidity injections, quantitative easing, capital injections, guaranteeing bank liabilities, fiscal stimulus, large budget deficits, problems with rating agencies, and small companies not getting the funds. We went through that debate in Japan 15 years earlier, and after going through this very difficult period, we came to the conclusion that this is a very different disease. It is a completely different disease compared to what we are used to. And in this disease, where the recession is caused by a bursting of a nationwide asset price bubble, financed with debt, when that bubble bursts, asset prices collapse, liabilities remain, and the private sector finds out their balance sheets are all underwater--or many of them are underwater. And when the balance sheets are underwater, if you have no income or revenue, of course you are out of business. But if you still have some income or revenue or cash flow, then the right thing to do is to use that cash flow to pay down debt, because if you have a business, you don't want to tell your shareholders that well, we are bankrupt. We are out of business. Here is this piece of paper. You don't want to tell the bankers that it is a nonperforming loan. You don't want to tell your workers that they have no more jobs tomorrow. So for all the stakeholders involved, the right thing to do is to use the cash flow to pay down debt. But when everybody does this all at the same time, we enter a very different world where the economy would be continuously losing demand until private sector balance sheets are repaired. And I see the same thing happening in this country. There was a lot of discussion about corporate holding cash in this economy. I don't think they are just holding cash; they are paying down debt. And when this happens with zero interest rates, we enter a very different world. Because there is no name for this type of recession in economics, I call it balance sheet recession. And it happens in the following way: In the usual economy, if you have $1,000 of income, and I spent $900 myself and decide to save $100, the $900 is already someone else's income. The $100 that comes into the bank in the financial sector is lent to someone who can use it. That person then spends the money. That is $900 plus $100, and the economy moves forward. When there are too many borrowers, you raise interest rates. Some drop out. If too few, you bring rates down, and then someone will pick up the remaining sum, and that is how the economy moves forward. But in the recession that we found ourselves in, in Japan 15 or 20 years ago, was that you bring rates down to zero, there are no borrowers because everybody is paying down debt. No one is borrowing money, even with a zero interest rate. And when that happens, when $900 is spent, $100 gets stuck in the banking system because there are no borrowers, even at a zero interest rate, then the economy shrinks to $900. That $900 is someone else's income. That person gets the money and decides, let us say, to save 10 percent. So $810 is spent, $90 goes into the banking system, and that $90 gets stuck. So if we do nothing about the situation, the economy will shrink from $1,000, $900, $810, $730 very, very quickly, even with a zero interest rate. That is what happened in Japan, and that is exactly what happened during the Great Depression in the United States 80 years ago. Everybody was paying down debt. No one was borrowing money because their balance sheets were all underwater. When you face a situation like this, the only way to keep the economy going is for the government to borrow the $100 and put that back into the income stream, because the government cannot tell the private sector not to repair its balance sheets. The private sector must repair its balance sheets. The private sector has no choice. So government has to then take the $100, put that back into the income stream, and then you have $900 plus $100 against the original income, $1,000. Then, the economy will move forward. This government action will have to be kept in place for the entire period of private sector deleveraging because if you pull the plug at any moment when the private sector is still deleveraging, the economy will collapse very quickly. And we, in Japan, made that mistake in 1997 and in 2001. On both occasions, when the government pulled the plug, the economy collapsed; and the budget deficit, instead of decreasing, it actually increased massively. And it took us nearly 10 years to climb out of the hole. So when the private sector is deleveraging, my advice to those countries suffering from this problem is to keep the government spending in there until private sector balance sheets are repaired, until the private sector is strong enough to move forward. And until that point, I am afraid government will have to be in there, because that will be the cheapest way to save the economy at the end of the day. Our preliminary mistake, our premature fiscal consolidation in 1997 and 2001, prolonged the Japanese recession by at least 5 years, if not longer, and added massively to our budget deficit because the economy collapsed on both occasions, and we had to pull those economies out of that hole. So I would very much like to make sure that this economy, the most important one in the world, will not make the Japanese mistake of premature fiscal consolidation while the private sector is still deleveraging. [The prepared statement of Mr. Koo can be found on page 28 of the appendix.] " CHRG-110hhrg44901--159 Mr. Ellison," Mr. Bernanke, can you tell what you think 30 years of wage stagnation, how that contributes to the current burgeoning debt that consumers are carrying today? " CHRG-109hhrg28024--44 Mrs. Maloney," And finally, this large debt, deficit, and trade deficit--what is the implication for growth for our economy, and isn't this structure bad for economic growth in the long term? " CHRG-111shrg61513--27 Mr. Bernanke," Well, legally, we are the fiscal agent of the Treasury and we hold Treasury balances that they--for all kinds of purposes, so there is no---- Senator Bunning. But they are not allowed to issue debt, Treasury. " CHRG-109shrg21981--8 STATEMENT OF SENATOR JACK REED Senator Reed. Thank you very much, Mr. Chairman, and welcome, Chairman Greenspan. Four years ago, we found ourselves at a crossroads, and the Administration chose a path that led from record surpluses to record deficits, both in our fiscal accounts and our current accounts, our trade balance overseas, and much of that is being financed now by foreign central banks. And we have the opportunity, I would suspect, the obligation to try to change that course. The Congressional Budget Office has estimated that the Federal budget deficit for fiscal year 2005 will be $368 billion. That does not include an $80-billion supplemental for Iraq and more than likely another $50-billion supplemental next year, given the troop sizes we will have in Iraq. It does not include cost of Social Security privatization, whatever they may be, and it does not include other operations. We have record deficits, stemming primarily from the tax cuts and from the steadily increasing spending for needed defense and homeland security measures. Another aspect of the President's budget for 2006 is the cutting of numerous entitlement and domestic discretionary programs without effectively reining in the deficit. And many of these programs go to the heart of building human capital, the education system, and other systems that will, I think, over time help increase our productivity. And so we are dangerously underfunding those programs. Once again, there are major issues left out--the war in Iraq, alternative minimum tax reform, $1.6 trillion in extension of expiring tax cuts, and associated debt service. So this is a rather bleak picture of fiscal discipline. You have reminded us already, Mr. Chairman, back in February 2002, that to the extent that we would be owing debt to other sovereign governments, in that respect there is a difficulty. We have a serious difficulty at the moment. You, also, state in April 2002, talking about current account deficits, countries that have gone down this path have invariably run into trouble, and so would we. Eventually, the current account deficit will have to be restrained, and no one is anticipating any restraint at the moment. Now, given this context for important decisions, we are facing critical choices about extending on a permanent basis expiring tax cuts for wealthy Americans. We are, also, according to the President's Social Security, rather, contemplating borrowing trillions of dollars to create private accounts. I am deeply concerned about the direction the President is taking in terms of our Nation's commitment to providing retirement security to the elderly and income security to disabled widows and surviving families. Many people do not recognize that about 30 percent of the recipients of Social Security are not the elderly, they are disabled or widows, or surviving families. We all acknowledge that the long-term fiscal imbalance of the Social Security trust fund must be addressed. However, it is equally critical to recognize that the concept of private accounts being advanced by the President does absolutely nothing to address this imbalance. In fact, diverting payroll tax revenues exacerbates insolvency and accelerates the date of trust fund imbalance. Now, more than ever, Social Security occupies a critical role in ensuring this retirement is secure, especially at a time when the country is saving so little and fewer employers are offering the security of defined benefit pension plans. Defined benefit pension plans comprise 61 percent of all pension plans in 1980. By 2001, that number had dropped to 25 percent, and this trend is only further exacerbated by the solvency issues faced by the Pension Benefit Guarantee Corporation, which has been absorbing more failed employer-sponsored defined benefit plans. So, Mr. Chairman, we have a serious set of issues before us and, as always, we look forward to your response to these issues. Thank you very much, Mr. Chairman. " CHRG-111hhrg56766--3 Mr. Foster," Thank you, Mr. Chairman. As a scientist, I have always found that numbers are more illuminating than ideology and talking points, so on the chart that I believe will be displayed on the monitors in a moment, I have plotted some interesting numbers that I downloaded from the Flow of Funds Report that the Federal Reserve Web site updates each quarter. It shows that from July 2007 to March 2009, roughly the last year-and-a-half of the previous Administration, the net worth of households in the United States dropped by $17.5 trillion. Our economy is suffering from the aftermath of the largest destruction of wealth in human history. Under Democratic leadership, since the passage of the stimulus and other important initiatives, this trend has been reversed. Our economy is now stabilized and household net worth has increased by more than $5 trillion. The $17.5 trillion of wealth destroyed in the last months of the previous Administration is so large that it is hard to get your arms around. Just how large is $17.5 trillion: $17.5 trillion is more than 1.5 times the entire U.S. national debt; $17.5 trillion is more than 1 year of the U.S. GDP, which is roughly $14 trillion; $17.5 trillion is more than $57,000 for every man, woman, and child in the United States; and finally, $17.5 trillion is about 200 times larger than the anticipated losses in Fannie Mae and Freddie Mac. Let's talk for a moment about the return on investment of the stimulus. When the dust settles, the total cost to taxpayers of the stimulus, TARP, and the other emergency interventions in our economy will be roughly $1 trillion. In response, household wealth has rebounded by $5 trillion. I'm a businessman as well as a scientist and it seems to me that an investment of roughly $1 trillion that generates an increase in wealth of $5 trillion represents a pretty good return on investment. If I could have the next slide, let's talk about job loss and unemployment. A year ago, over 700,000 jobs were being lost every month and the job losses were increasing by 100,000 more jobs lost each additional month. The economy was spiraling toward another great Depression. After the passage of the stimulus and the other emergency measures to rescue our economy, job losses started decreasing promptly and job growth is said to turn positive by 2010. Unfortunately, job recovery always takes longer than people would like. Most downturns take 1 to 2 years, if you look at them in the stock market, and 2 to 3 years if you look at unemployment. That is just the way it is. It is very difficult for a reasonable person to look at this data and conclude that Democratic policies have not been effective at dealing with job loss. Finally, how did we get here? " CHRG-111hhrg55814--158 Secretary Geithner," Congressman, there is one part of that quote you omitted, which is, I said, monetary policy around the world was too loose, too long. But I think it's very, you're right to say that this crisis was not just about the judgment of individuals to borrow too much or banks to lend too much. It wasn't just about failures in regulation supervision. It was partly because you had a set of policies pursued around the world that created a large credit boom, asset price boom. And I think you're right to emphasis that getting those judgments better in the future is an important part of the solution. Dr. Paul. Okay. On the issue that it's worldwide and we don't have the full responsibility, there's a big issue when you are running and managing the reserve currency in the world and other countries are willing to take those dollars and use those as their asset and expand and monetize their own debt, so it's all, we're not locked in a narrow economy, it's a worldwide economy and it's our dollar policy and our spending habits and our debt that really generated this worldwide crisis. That's why it's not a national crisis; it's a worldwide crisis. " CHRG-111hhrg48868--656 Mr. Liddy," No, it is a debt of AIG. Mr. Miller of North Carolina. Okay. There has been a study by economists on what works and what doesn't when a nation's banking system collapses, its financial system collapses, and one of the characteristics is transparency. The second is maintaining market discipline. And that means that shareholders bear the loss, but it also means that unsecured creditors bear the loss. Anyone who is in a position to determine the ability of the corporation they are doing business with to pay their debts should bear the loss, not presumably taxpayers. Are we maintaining market discipline by continuing to give money to AIG to pay unsecured creditors, to pay the counterparties to your credit default swaps? " CHRG-111hhrg53021Oth--332 Mr. Green," Thank you, Mr. Secretary. I will get right to it. We have 8,246 depository institutions in this country. We require that they be well-capitalized. We have a coffer within which they pay an assessment, so as to provide the capital to wind them down when they go out of business. Is it true that what you plan to do is provide a similar circumstance for nondepository institutions such that, when they become troubled, we can wind them down, they are not to be over-leveraged, they can engage in hedging without being over-leveraged, such that we can wind them down in a similar fashion? " CHRG-111hhrg53021--332 Mr. Green," Thank you, Mr. Secretary. I will get right to it. We have 8,246 depository institutions in this country. We require that they be well-capitalized. We have a coffer within which they pay an assessment, so as to provide the capital to wind them down when they go out of business. Is it true that what you plan to do is provide a similar circumstance for nondepository institutions such that, when they become troubled, we can wind them down, they are not to be over-leveraged, they can engage in hedging without being over-leveraged, such that we can wind them down in a similar fashion? " CHRG-111shrg61513--13 Mr. Bernanke," Well, currently Senator, inflation looks to be subdued. We are not expecting inflation to rise significantly in the near or medium term. On the one hand, the unemployment and the low use, utilization, the low rate of utilization of labor has been a force keeping wage gains very lower, which, of course, from a worker' perspective is a problem. From the perspective of employers, they are seeing both very slow wage growth and because of all the cuts and cost-cutting measures, they are also seeing very strong increases in productivity, which are quite remarkable. So the combination of slow wage growth and high productivity gains means that the unit labor costs, the costs of production are, if anything, falling for most firms. So that, together with very weak demand in many industries, means that firms have very little ability or incentive to raise prices, which would, of course, tend to moderate inflation. On the deficit, the impact on inflation in the near term I think is limited. Of course, it is important that Congress, the Administration, find solutions to our longer-term debt problems. Otherwise, it is conceivable--and I am not anticipating anything in the near term, but it is conceivable that it could lead to a loss of confidence in aspects of the U.S. economy. It could affect interest rates. It could affect the value of the dollar. And those things could directly or indirectly affect the state of the economy, the recovery, and, of course, the rate of inflation. Senator Johnson. As the Federal Reserve begins to wind down purchases of mortgage-backed securities, what steps, if any, are needed to ensure stability in the housing market during this transition? " CHRG-111hhrg53245--127 Mr. Zandi," My view is bubbles are created largely by leverage, that if they have a very clear ability to control or manage leverage throughout the entire financial system, which they would have as the systemic risk regulator, then they would have the tool they need to be able to manage that aspect of monetary policy. Ms. Rivlin. May I? " CHRG-111hhrg51591--116 Mr. Harrington," Any compartmentalization, I think, would be broadly between insurance-type products and other products. I think there are lots of gains from diversification within insurance-type products. It is when you get into all sorts of ancillary products where the regulatory burden really becomes large. And of course, that is also true in banking. And in my comments before, I think we have to really think about whether or not we shouldn't maybe have more restrictions on activities. If you want to go to the deposit insurance till and be able to get that type of protection for depositors, maybe you have to give up some of your choices about what activities your overall entity would undertake. " CHRG-111shrg50814--104 Mr. Bernanke," Well, it is by no means the only factor. There are plenty of things that went wrong. But it was certainly one factor, and as we look at regulatory reform, we need to ask the question, are all the sectors of the economy that need oversight, are they being watched by somebody or are there major gaps where there is no effective oversight where there needs to be, and that is, I think, a very basic aspect of the reform that Congress needs to address. Senator Kohl. Thank you. Thank you, Mr. Chairman. Chairman Dodd [presiding]. Thank you very much, Senator. Senator Hutchison. Senator Hutchison. Thank you, Mr. Chairman and Mr. Chairman. I want to go back to the inflation threat, which I think today and also previously you have said that it is not a worry, that half of your obligations are short-term. But I am looking at the overall picture, where some economists are beginning to look at the $10.6 trillion debt that we have plus last week's stimulus, or 2 weeks' ago stimulus with interest is another trillion, and starting to look at the tipping point. Twenty-five percent of our debt is held by foreign entities. What if they start saying, hey, this risk is too high and they want a higher interest rate? That, on top of half of your obligations being somewhat long-term. Are you concerned in looking at the overall picture about the possibility of inflation and what could you do to keep that from happening through any kind of policy, because obviously that would be a devastating turn for our country. " CHRG-110hhrg46595--2 The Chairman," This hearing will come to order. We are going to be very strict with time today. Because this is an important issue, there is a lot to be done. Members will be held strictly to 5 minutes, which means if you ask a question that takes 4 minutes and 47 seconds to ask, you will get a 13 second answer. And we cannot accommodate, frankly, sloppiness in asking questions, and then let that be an excuse for extending the time. Under our rules, the minimum amount of time we can do for opening statements is 40 minutes. The Minority has requested the full allocation, so we will proceed immediately to our 40 minutes of opening statements. We started a half hour early, so we will get started at 10:00. We are going to dismiss this panel at 12:30. Because we did not want it to be simply the auto industry itself, we have a second panel as well, so we will move as quickly as we can under the 5-minute rule. I will begin with my opening statement, and the clock starts now. Context is especially important this morning. A failure to some extent of three of our major domestic manufacturing entities would be a very serious problem in any case, but in the midst of the worst economic situation since the Great Depression, it would be an unmitigated disaster. The Labor Department reported this morning that during the month of November, there was an increase in unemployment that was quite substantial; 533,000 jobs were lost. On a year-to-year basis from December of last year to December of this year, we are down 1.9 million jobs. We are on track now to lose well over 2 million jobs obviously in that period. We will lose close to 2 million jobs in this year alone. Given that, any effort to denigrate the negative impact of substantial job loss and economic cutbacks in this industry has to fall. We operate, as we said, in this very difficult context. It is important to note here that--and, again, I guess the issue is, should we just be very hard-nosed and say let them go bankrupt? There is a consensus that substantial reorganization is needed, there is a consensus that a change in the product mix is needed, there is a consensus, and I congratulate Mr. Gettelfinger in the Union that economic times being what they are, everything has to be looked at, including further concessions which the Union had already made, and there was some very important ones that were put out there. All of that can be done by rational people in a sensible atmosphere. What bankruptcy adds is the ability to walk away from debt. The fact is that while we have this serious job loss, we continue to have a serious credit crisis in this country. We have a double whammy. And permission to these three large entities to stop paying their debts, that is called bankruptcy, would greatly exacerbate the credit crisis. I was given by my colleague from Michigan, Mr. Levin, who has been, along with the other Members from Michigan, both Democratic and Republican obviously, very much involved in this, as well as the Members from Ohio, very important numbers about what the impact would be if we were to have these entities stop paying their debts. Now, we have had a pattern of intervention that this Administration has led of trying to prevent people from not paying their debts. Not because of concern for them, but because of the impact it would have on other people, on the creditors. We have not, on the whole, bailed out debtors. We have gone to the rescue of creditors. In every one of those cases, there have been restrictions imposed on the debtors. That will clearly have to be done here, and everyone should understand that. The companies have made some proposals. I hope we will do something, because I think for us to do nothing, to allow bankruptcies and failures in 1, 2, or 3 of these companies in the midst of the worst credit crisis and the worst unemployment situation that we have had in 70 years would be a disaster. And one of the things that I do want to note, that people have said, well, you know, a lot of mistakes were made, the companies made mistakes, Congress made some mistakes, we didn't increase CAFE standards, etc. Yes, a lot of mistakes were made. The relevance of that it is partly this. It would be nice if we could line up all the people who made the mistakes and punish them in a way that would make no impact on the innocent. I think all of us remember in school the teachers we hated most were the teachers who said if one person misbehaved, the whole class would get extra homework. I don't want to give the whole country extra homework because automobile executives in the past misbehaved. We have to separate out unhappiness and anger over things not done in the past from the consequences now, and that is what we have focused on. Yes, a lot of mistakes were made. The auto companies made mistakes, unions made mistakes, politicians made mistakes. The media hasn't always distinguished itself, although you are not supposed to say that. The consequence of all those mistakes is that the country is to some extent held hostage. We need to free the country. And that is the focus. Yes, there have to be changes that are made and sacrifices made. But the focal point is not to punish those who made the mistakes. It is to prevent further damage to the country, and it is in that context that this committee will proceed. The gentleman from Alabama is now recognized for how many minutes? " CHRG-111shrg57322--1031 Mr. Blankfein," And I think at least a third level, after you try to avoid all the problems and after you try to have more capital to absorb the problems, you have to have a resolution authority to make sure if No. 1 and No. 2 don't work, that an individual institution that was poorly run or undercapitalized doesn't bring down the system, and so no institution should be too big to fail or have to burden the public with the cost of its failure or being saved. Senator Coburn. Which brings to mind, do you think that the FDIC presently has the capable staff that would be able to come in and run Goldman Sachs if you got into trouble? " CHRG-111shrg50814--52 Mr. Bernanke," Well, leverage is the inverse of the capital ratio, and that boils down to making sure that our capital standards are strong and appropriately adjust for risk and the like. And as I said to Senator Shelby, we need to make sure going forward that our capital standard is---- Senator Schumer. There are a lot of institutions with no capital standards, but they were not banks and regulated by you, who used huge leverage, 30:1, 40:1, 50:1. So even the lowly mortgage became very risky at that level. " CHRG-111shrg51395--100 Mr. Silvers," Senator, these are very acute observations you have made about this set of questions. First, I am pleased to see that a moment of disagreement has emerged. My colleagues on the panel who wish to put the burden of regulating unregulated markets, like hedge funds and derivatives, on the systemic risk regulator are, in my opinion, making a grave mistake. What we need is routine regulation in those areas. That is what closing the Swiss cheese system is about, is routine regulation, not emergency regulation, not, you know, looking at will they kick off a systemic crisis. Just an observation about that. I think that the Fed's refusal to regulate mortgages was rooted somehow in the sense that consumer protection was a kind of--something that was not really a serious subject for serious people. It turned out to be, of course, the thread that unraveled the system. I think that we should learn something from that. When we talk about routine regulation in these areas, I think to your question, we have got to understand that it is more than one thing. For example, a credit default swap contract is effectively a kind of insurance. And if someone is writing that insurance, they should probably have some capital behind the promise they are making. That is what we learned not just in the New Deal but long before it about insurance itself, which was once an exotic innovation. But we learned we had to have capital behind it. But that is not the extent of what we need to do. If, for example, there are transparency issues, there are disclosure issues associated with these kinds of contracts, for contracts in which public securities are the underlying asset, it is clear that we need to have those kinds of disclosures, because if we do not, then we have essentially taken away the transparency from our securities markets. Now--two final points. One, derivatives and hedge funds have something profound in common. They do not have any substantive content as terms. They are legal vehicles for undertaking anything imaginable. You can write a derivative contract against anything. You can write it against the weather, against credit risk, against currency risk, against securities, against equity, against debt. It is just a legal vehicle for doing things in an unregulated fashion. A hedge fund is the same thing. The hedge fund is not an investment strategy. It is just a legal vehicle, and it is a legal vehicle for managing money any way you can imagine, in a way that essentially evades the limits that have historically been placed on bank trusts and mutual funds and so on and so forth. What is smart regulation here is not specific to those terms. It is specific to those activities. It is specific to money management. It is specific to insurance. It is specific to securities. And that is why it is so important that when we talk about filling these regulatory gaps, we do so in a manner that is routine, not extraordinary. Thank you. " CHRG-111hhrg56766--185 Mr. Hensarling," Thank you. Chairman Bernanke, I want to follow up on a question that one of my colleagues had that I am not sure I heard a precise answer to. I think the question was a variant of, what is the level of desirable or necessary leverage within the banking system on a macroeconomic level to hopefully ensure we don't repeat what we have just been through? Clearly, there are those within Congress who believe in artificial limits to the size of financial institutions, who believe that Federal regulators should have power to prohibit certain credit offerings. But some of us believe that hopefully out there is a proper application of risk-based application of capital and liquidity standards that would hopefully, perhaps, lead to a more prudent leveraging within our economy. But the question is, from your perspective, on a macroeconomic level, what is the amount of leverage the system can handle a cyclical downturn? " FOMC20070918meeting--107 105,MR. LOCKHART.," Thank you, Mr. Chairman. In the Sixth District, we indulge ourselves with the conceit that our District looks a lot like the nation as a whole. We have 45 million consumers and an industrial composition that does resemble the country, so you can process my regional remarks with that conceit in mind. Housing markets continued to deteriorate in August in the Sixth District. Housing market weakness was most pronounced in Florida, as you might expect, followed by Atlanta and middle Tennessee. The consensus view is that the recent tightening in mortgage credit availability will exacerbate the region’s housing market problems, and most regional contacts believe that housing markets will continue to weaken, bottoming out no earlier than mid-2008, and some see a much longer adjustment period. Aside from housing, real economic readings in the Sixth District were mixed. Anecdotal feedback across a number of industries suggested that business spending has not yet slowed markedly, but the majority of contacts indicated that they are now approaching new capital spending more cautiously. That said, most contacts acknowledge that tighter credit standards have not significantly affected business capital investment outlays. Reports of factory activity were mixed, with defense and export industries doing well, while industries linked to housing were predictably weak. Transportation contacts indicated ongoing weak domestic demand. Consumer activity in the District was flat to slightly up in August compared with a year ago. Housing-related home product sales were especially weak, as were auto sales. Perhaps the most notable change from previous months was a turn to pessimism on the part of directors, reflecting their soundings of business contacts in their communities. I will mention that we have five Branches, so we actually get director feedback from more than forty directors across the District. Sixty percent believe that economic activity will be slower six months out, twice the percentage recorded in July. Even factoring out idiosyncratic conditions in localities such as south Florida and the Gulf Coast, the outlook, based on these anecdotal reports, has turned to the negative. To summarize my regional comments—current fundamentals are mixed, and the outlook is pessimistic. In our view, the economic outlook has changed since the last meeting, and the balance of risk has clearly shifted to the downside. We do not see a near-term recession as a high likelihood, but we do anticipate that growth will approach trend much more slowly with employment edging up as a consequence. So in direction and tone, if not magnitude, we are in agreement with the Greenbook, but our forecast differs from the Greenbook baseline forecast in the depth of the below-trend growth, ours being somewhat milder because we condition our forecast on deeper cumulative cuts in the fed funds rate over the coming months. Turning to capital markets, my recent conversations with a number of capital market participants suggest that the adjustment process in financial markets is far from complete. Their anecdotal feedback reflects a range of views about the severity of the current problems and the outlook for stabilization. Here is the overall picture I gleaned from these conversations. Some debt markets have firmed a bit. The leveraged-loan market, for example, is likely to renew trading in the coming weeks, but structured-debt security markets are not yet clearing. The principal reason—and this has been mentioned earlier by Bill and others—that debt markets remain illiquid is weak counterparty transparency and, therefore, uncertain counterparty risk, as well as uncertainty regarding the performance of collateral pools that back securities. The process of achieving adequate clarity and stabilization of the markets will likely take many more weeks. Markets will remain volatile while the condition of heightened uncertainty persists. There has been some spillover into markets that are unrelated to structured debt and subprime, but creditworthy borrowers are getting credit. There is sufficient buyer liquidity currently on the sidelines awaiting greater clarity regarding counterparties, market pricing of securities, and the depth and scope of the difficulties. Widespread deleveraging, particularly by SIVs and hedge funds and nonbank entities, is occurring and is likely to continue. One party argued, however, that all the news of financial distress has not pushed risk spreads to the extremes of historical bands. This party argued, “We are experiencing a painful adjustment from excessively high leverage to more-rational or more-realistic pricing in line with historical averages.” But all contacts believe—and this is perhaps not unexpected—that prolonged credit market problems will affect the broad economy, mostly through the consumer credit channel. So I believe our decision today boils down to whether we cut ¼ percentage point or ½ percentage point, obviously in combination with careful wording of the statement that conveys a rationale focused on economic fundamentals while signaling some recognition that the problems in the capital markets have the potential to deliver a credit shock to the broad economy. I consider it appropriate to adjust the federal funds rate to the now-weaker economic outlook, and I support a 50 basis point move with the rationale that at least 25 basis points of that represents recognition of a lower equilibrium rate and the remainder is a preemptive, preventive measure designed to renew confidence, facilitate conditions that resolve uncertainty, and shorten the necessary adjustment timeline in a deleveraging financial sector. It is a fair question whether the process of information revelation—that is, removing uncertainty—will be accelerated by an aggressive rate cut. My view is that this action, along with other liquidity actions, removes the psychological barrier—that being the concern that the Fed might fail to ensure enough upfront liquidity and might be pursuing an inadvertently tight policy, compounding problems by putting undue stress on the real economy. I think a distinction can be drawn between trying to influence the psychology around dangerous financial sector circumstances and bailing out the markets, and care should be taken to reflect this in the minutes. Let me add that I agree with the earlier comments of President Fisher that we perhaps should be looking at any policy move in the context of a total package that includes the auction credit facility. So I do have, let’s say, some sympathy for the view that the total package must be discussed. Thank you, Mr. Chairman." CHRG-111hhrg51698--472 The Chairman," Thank you. Is it not true that, by utilizing these derivatives and swaps or whatever, that these firms were allowed or were able to leverage themselves a lot further than they would have been had they not been available? I mean, it just looks pretty obvious to me that, without them ostensibly laying off these risks with these credit default swaps and so forth, that they wouldn't have been able to leverage themselves as far as they did. I mean, it did have some effect on this. The underlying problem are the CDOs and all that, I understand that, the mortgages that shouldn't have been made in the first place. But my concern is that this exacerbated the problem. " CHRG-111hhrg63105--107 Mr. Neugebauer," If you look at it, it says, as the Commission finds as necessary to diminish, eliminate, or prevent such burden. In other words, in what you have told this Committee today you don't have data that says that there are abuses or excessive speculation going on. I think the intent of Dodd-Frank was, if you find it, address it certainly. I agree with the gentleman from Missouri. The job for government is transparency and integrity. But what we haven't heard today--and several of the people on the panel have asked this question. We haven't heard you say we have identified where there is excessive speculation going on that could manipulate the pricing in the marketplace. " FinancialCrisisInquiry--391 SOLOMON: Thank you, Chairman—Vice Chairman Angelides and Vice Chairman Thomas and members of the commission. Thank you for asking me to appear before the commission. Before I begin, I want to commend the leadership of the House and the Senate for creating this bipartisan commission to examine the causes of the current financial and economic crisis in the United States. When I entered Wall Street in the early 1960s, security firms and commercial banks had not changed much since the 1930s. Stock ownership was not widespread. Pension funds and endowments did not invest broadly. January 13, 2010 The average volume on the New York Stock Exchange was about the same as 40 years earlier. There wasn’t a large public bond market. The business of commercial banks was lending. The securities firms were usually private partnerships. Investment funds were separate from banks and security firms. I’ve been afforded the opportunity over 50 years to observe the dramatic changes in the financial world from a number of perspectives. My career at Lehman Brothers spanned 29 years. I rose to vice chairman of the firm in the 1980s and was co-chairman of the Investment Banking Division and chairman of the Merchant Banking Division. I have held financial positions in the public sector, as deputy mayor of the city of New York during the financial crisis of the 1970s, and as counselor to the secretary of the treasury in the Carter administration. I have been active on corporate boards, not-for- profit foundation boards, where I’ve been involved in investment decisions. For the past 21 years, I have been chairman of the Peter J. Solomon Company, a private independent investment bank and member of FINRA. Our firm is a throwback to the era of the early 1960s when investment banks functioned as agents and fiduciaries, advising their corporate clients on strategic and financial matters such as mergers and raising of debt and equity capital. Unlike today’s diversified banks, we do not act as principals, nor do we take proprietary positions. We do not trade and we do not lend. For a moment, let me set the scene of the 1960s investment bank. The important partners of Lehman Brothers sat in one large room on the third floor of Number One William Street, the firm’s headquarters. Their partners congregated there not because they were eager to socialize, an open room afforded and enabled the partners to overhear, interact and monitor the activities and particularly the commitments of their partners. Each partner could commit the entire assets of the partnership. You may be interested to know that Lehman’s capital at the time of incorporation in 1970 was $10 million. The wealth and thus the liability of the partners like Robert Lehman exceeded the firm’s stated capital by multiples. Since they were personally liable as partners, they took risk very seriously. January 13, 2010 The financial community changed dramatically in the 1980s. Incorporation and public ownership by security firms enabled them to compete with commercial banks. Innovations like junk bonds, for example, allowed securities firms to lend to non- investment-grade companies. All the firms accelerated the push into global markets, far- flung operations, mathematical modeling, proprietary dealings in debt and equity, and the growing use of leverage and derivatives to hedge risk. As the commission investigates the causes of the 2007-2009 crisis, it is important to remember that market crises occur periodically. To name a few in the last 20 years, the markets have been roiled by Asian, Russian and Mexican crises, the crash of ‘87, the collapse of long-term capital, the 2000 dot-com bubble collapse, and of course, Enron’s bankruptcy. The question before the commission is: What events or actions occurred within the capital markets or the environment which allowed this crisis to become a debacle? First, every legislative and regulatory move in the last 20 years has been towards obliterating the distinctions between providers of financial services and freeing the capital markets. The shining example, of course, is the Gramm-Leach- Bliley Act of 1999, which removed the last vestiges of Glass-Steagall. Second, financial institutions used the more lenient regulatory environment to build scale and extend scope. Citigroup, Bank of America, J.P. Morgan, and Lehman Brothers, for instance, acquired competitors and expanded their operations into new fields. Concentration created institutions too big to fail. Government regulation in terms of oversight and coherence did not keep pace with innovation, leverage and the expanded scope of the banks. Three, access to new capital permitted the banks and security firms to shift the nature of their business away from agency transactions and towards more proprietary trading that took positions in marketable and less liquid securities and assets such as commercial real estate. Combined with greater leverage, earnings volatility increased. January 13, 2010 Fourth, scale, scope and innovation created an interdependency, most noticeable in credit default swaps, disproportionate to the equity capital of all banks. Management misjudged their capabilities and the capabilities of their elaborate risk-management systems, like VaR, to keep their institutions solvent. Even for insiders in those institutions, transparency diminished so much that firms were not prepared for the extraordinary, the so- called black swan event. Paul Volcker has suggested that financial firms might be categorized between activities with ongoing relationships, such as lending, and transactional interactions, such as trading. He has proposed that these functions be separated. A corollary question is whether it would be preferable from a public policy perspective, and adequate from a capital markets point of view, to require proprietary investing to be in private partnerships. Until it went public, for example, Goldman Sachs remained a private partnership and was able to attract sufficient capital and weather a series of large losses. In closing, my hope is that the commission will determine that the 21 st century model is consistent with the need for stable banks and capital markets sufficient to finance the world economy. The commission has an opportunity to approach this challenge in a bipartisan manner and produce unanimous recommendations. These conclusions can have a profound effect on legislation, as did the recommendations of the 9/11 Commission. In doing so, the commission will make a major contribution to the stability of financial markets and we will have a chance to mitigate future crises. Thank you very much. FinancialCrisisInquiry--417 BASS: I think I would respectfully disagree with Mr. Mayo on this. I think we need to determine—if an institution is systemically important to the United States and to our system, we need to determine what appropriate level of leverage are, and we need to force those companies to live within those leverage bounds. You know, today, as I mentioned, it’s somewhere between 16 and 25. And I will just assert to you that that is— that’s too high. So what we need to determine is—to Mr. Solomon’s point—if you’re going to be a proprietary trading firm and you want to engage in risk and it is the U.S. way and it’s capitalism, go do it. But there will be no safety net for you if you fail. All right. Don’t become systemically important. January 13, 2010 So you can make that happen. You can separate those two. And it goes back to the Glass- Steagall argument. But I think, of the institutions—we have four banks in the United States that owns 45 percent of the assets. We have 8,300 others that own the balance. Our whole system is very top-heavy here, and the reason that they’re systemically important is they’re that big. So I think, more holistically, we need to figure out what the structure of the system needs to look like, and we need to set what the leverage ratios are of those systemically important institutions. That’s my opinion. FOMC20081216meeting--230 228,MR. FISHER.," Mr. Chairman, thank you. President Rosengren talked about micro behavior, and at the beginning, First Vice President Cumming talked about the hunkering-down mentality. I have been focused on the microeconomic behavioral responses to our current situation. As one of my CEO contacts outside my region said, we are basically all, in his words, ""chasing the anvil down the stairs,"" and that is that the behavioral responses of both businesses and consumers are driving us into a slow-growth cul-de-sac and a deflationary trap. One CEO I talked with was quite pleased that he could borrow $40 million over the weekend for a total of $250. That is great from a commercial paper standpoint; he is an A1/P1 issuer. However, were he to go to the longer-term debt markets, it would cost him 7� percent. So they can finance their daily operations easily. But in terms of their long-term planning, they and others are responding--and I see this uniformly across my contacts--out of concern about the high cost of debt and the spreads over Treasuries, by doing what any businesswoman or businessman would do. They are planning on less cap-ex, and they are cutting back on their plans for acquisitions of the weak, which they would like to take advantage of under the current circumstances. They are also responding to the situation by cutting back on head count. So, Chris, there is very much a hunkering-down mentality, not just in my District but across the country. That leads to further economic weakness--that plus the fact that they are chary about issuing and paying for things with shares in a very weak market. I am hearing more and more worries about their pension liabilities and how they are going to be able to finance those. Obviously this is leading to the kind of economic behavior that none of us would like to see. On the consumer side, you see a similar behavioral pattern. It seems that after Black Friday, according to my sources, there was weaker behavior than one had expected. The spending pulse data that I get from one of the large credit card companies reflect what one would expect under these circumstances--that is, a shift to nonbranded products, smaller purchases of items, a rotation out of credit cards to debit cards and cash payments according to the pay cycle, and overall an expectation, on both the business and the consumer side, that things will get cheaper if they wait longer and they postpone either their cap-ex or their consumer purchases. The one ray of sunshine that I was able to find is that one large law firm, Cravath, has announced that it is not increasing its billing rates in 2009, [laughter] and other law firms are actually planning to respond by cutting their billing rates. One woman whom I know summarized it this way: ""This is the divorce from hell. My net worth has been cut in half, but I am still stuck with my husband."" [Laughter] " CHRG-111hhrg56766--163 Mr. Bernanke," We will still continue to hold $1.25 trillion of mortgage-backed securities, plus additional agency debt, and we think that is going to continue to keep mortgage rates down. There are a lot of differences of view about how much mortgage rates might go up after the end of this program. So far, we haven't seen much, so I think we need to look and see if there is a big reaction, if it does affect the housing market. It may not be a significant reaction, so we are going to continue to watch that. " FinancialCrisisInquiry--453 BASS: I don’t have it here in front of me, but I have a full data set for you. HOLTZ-EAKIN: OK. That would be great. And so this is 2007, we have leverage at 68 to one. And what we heard from the panel this morning again and again in their written testimonies, oral remarks, were everyone became too levered. We’re, you know, going the other way now. But what I did not hear, even in the discussion of their risk management practices, is how the leverage got determined, how internal calculations were done about appropriate levels of leverage, and how they affected their risk management regimes and their expected outcomes. So I was wondering if you could give us your perspective on how that was done in the industry if there have been significant changes in it, and the extent to which this can only be imposed externally. January 13, 2010 CHRG-111hhrg51592--154 Mr. Neugebauer," Thank you, Mr. Chairman. Mr. Smith, have you ever used credit default swaps to insure any of the securities, debt securities that you bought to provide additional protection for the organization that you represent? " CHRG-110hhrg46595--255 Mr. Wagoner," Can I make one more comment, sir? It is important. We were hoping to use the 90-day period to do exactly what you suggested, which is to work with debt holders, to work with UAW, to use that time period-- " CHRG-111hhrg56766--54 Mr. Bernanke," I have not. Dr. Paul. The Federal Reserve under the law is capable of doing this. Is it not correct that the Fed can buy debt of other nations, and under the Monetary Control Act of 1980, is that not permissible? " CHRG-111shrg50815--107 Chairman Dodd," But doesn't it also basically--in other words, the incentive for the issuer to make sure that the borrower is going to be more creditworthy diminishes when you know you are going to be able to sell that debt off. Isn't that also true? " CHRG-111shrg57322--1150 Mr. Blankfein," They--AIG had--yes. Yes. AIG owed us margin, most of which we had collected. Senator Levin. Right. But they owed you some money, and the TARP funds ended up paying their debt to you, did it not? " CHRG-111hhrg48873--195 Mrs. Bachmann," Mr. Secretary, as I understand it, approximately 90 to 95 percent in the new program that you have just announced yesterday of the funding would come from the taxpayers; is that true? Or perhaps the leveraging is a 6 to 7-to-1 leveraging on the purchasing of the public-private partnership, the toxics assets that are available. When the returns come back to the American people, will the American people be receiving 90 to 95 percent of the benefit, or will it be another figure? " CHRG-111hhrg54867--248 Mr. Marchant," Thank you, Mr. Chairman. Mr. Secretary, I would like to go and talk about Lehman Brothers for a minute. In the Lehman Brothers case, it was not the amount of leverage that they had, but it was the fact that they were funding that leverage with overnight funds. I think it probably was the case with Bear Stearns, as well. As a result of that, you had the money market accounts went bust. And while a decision was made that there was no systemic risk--I guess that decision was made--and there would be no intervention on the part of Lehman Brothers, there was subsequently an intervention to guarantee the buck, basically, on money market accounts. And since that, basically, money market accounts have not been the preferred vehicle of investment by Americans. Is there anything in this regulation that would have regulated, not the percentage of leverage with Lehman, but the fact that Lehman and most of these guys were keeping major parts of their portfolio in their capital portfolio, these mortgage-backed securities, and then holding 30-year maturity instruments and funding them with overnight funds? Is there something that will regulate that? Who would be the regulator? And do you see that as--I mean, to me, that was the systemic risk involved. " CHRG-110hhrg44901--3 Mr. Bachus," I thank the chairman. Chairman Frank, I am going to follow your lead and restrict my remarks to the real economy, which is the purpose of this hearing, and not some of the recent developments in the past week or two. Chairman Bernanke, looking at the economy, we had an overextension of credit. We had too easy of credit, it wasn't properly underwritten, and the risks were not taken into account. As a result of that, we have had, I think, massive debt accumulation in this country, and we are going through what is inevitable when people borrow more than they can repay. I think a second factor, and it may be in your remarks or questions, you can address this, but a tremendous amount of leverage and risk-taking and other risky and speculative investment practices and a lot of fortunes were made on the way up, but there is pain on the way down. As I see it, it is not an easy thing to go through, but it is a part of a market cycle. The third factor, and this is a factor that I think is the most important, is the high commodity prices, and particularly energy prices that have been a particular hardship on importing nations, and we are obviously an importing Nation. It has been a financial windfall to exporting countries. I have been to Abu Dhabi and Dubai, and the fabulous wealth that has been created out of really a desert society there in the past 40 years is just almost beyond belief. I think T. Boone Pickens, he is running a commercial right now, and he calls this, I think rightly so, the largest transfer of wealth in the history of the world. That, to me, and the effect it is having on Americans day-to-day, is our biggest problem. I believe it is the largest source of instability in our financial markets. I think that the consumers are stressed, they are paying high gas prices, high diesel prices, and they can't pay their other bills. They are even having trouble putting food on their tables. Finally, while we require the American people to live within their budget, we had deficit spending here, and have for some time, and there is a tremendous lack, I think, in Washington of financial discipline. The Federal Government has more obligations than it can fund today, but it continues to obligate itself, it continues to expand and create new programs, and it continues to assume responsibility for funding services that were traditionally in the province of local or State governments or families themselves. Obviously, all of these problems, the problem of tremendous mushrooming of extension of credit and debt accumulation, of overleveraging and risk-taking, of high energy costs, high food costs, high gas prices, and then a Federal Government that spent beyond its means, obviously there is no single approach we can take to getting ourselves out of this. I think the banks have repriced for risk. There has been a lot of--they have raised capital. I will state right here that I know there is a debate in this country on the overall financial stability of our financial system, but I, for one, think that we are well on our way to recovery in the financial system. I think the present stock prices of our banks don't accurately reflect the value of those banks. I think the stock prices are too low. The banks are sound, they are solid. I think the stock prices, right now you may have--I think there is a real--it is just a confidence factor. Anyway, we have had a retrenching and a correction, and I do worry about some attempts that we are doing to short-circuit the correction and the period of adjustment. I think long term they can deepen the damage. But, in contrast, there is something that I think we should do, and we can do now, and that is to address high energy prices. High energy prices mean higher production and transportation costs. Those increases are passed on to the consumers, and we saw that this morning, causing inflationary pressures. Particularly hard hit are those Americans, a million-and-a-half Americans, whose adjustable-rate mortgages are adjusting. Those families are facing a double whammy. To sum up, what I believe is needed now is a concerted bipartisan effort by Congress and the Administration to develop and implement a comprehensive energy and conservation initiative. It needs to be done now. It should have been last year or the year before that. I believe until we get a handle on our dependency on foreign oil, we are going to continue to have real severe problems. Thank you. " CHRG-111shrg53822--43 Chairman Dodd," Thank you. I am glad you made that point, Sheila, because I can think of several institutions today that have very high capital standards but are in trouble. And the assumption because they have a lot of capital that they are not in trouble is the conclusion, and that is not the case. But I agree with my friend from Alabama that is an important--capital standards are critically important, but I am glad you mentioned the market discipline as well in all of that. Senator Reed. Senator Reed. Thank you, Mr. Chairman. Thank you both not only for your testimony but particularly, Chairwoman Bair, for your very effective leadership. Do you think we should return to something much closer to Basel I capital standards rather than continue the Basel II regime? Ms. Bair. Well, I absolutely think that the structure of Basel II, the Advanced Approaches, continues to be highly problematic. There has been a lot of work to try to fix it. At some point you wonder, well, should we just start over as opposed to trying to fix it? Thank goodness we have always maintained the leverage ratio in the United States, and that we are still under Basel I. I think there is increasing international agreement that we need an international leverage ratio. We are calling it a ``supplemental capital standard'' now, but that is in essence what we are talking about. And, in terms of the capital standard based on risk-weighted assets, it could be made more nuanced and more granular. But we can do that by building on the Basel I framework of buckets of different asset categories with hard and fast risk weights and capital requirements as opposed to this more subjective model-based regimen that we had with the Advanced Approaches under Basel II. The basic approach under Basel I is workable. It needs to be improved. It needs to be more granular. But, making enhancements to Basel I might be more productive at this point than continuing to try to work with Basel II. Senator Reed. We have operated under Basel I. It is a known entity. Rather than inventing a new third approach, it might be better to return back to something that we have operated under. Ms. Bair. I think that would be a very viable path. It is just one opinion. Obviously, there are a lot of voices on capital standards. But I think that would be faster and get us to a stronger capital regime. Yes, I do. Senator Reed. Mr. Stern, do you have any views? " CHRG-111shrg61513--87 Mr. Bernanke," Well, the markets seem to have confidence. I mean, we can sell 20- and 30-year debt at relatively low interest rates and I think that is a vote of endorsement for the long-term ability of this country to respond to these challenges. But we have to make good that trust. We have to follow through. Senator Gregg. And if we look at the issue of how you get the money out of the market, you have put $2 trillion, basically, into the economy. Is that about right? " CHRG-111shrg57709--19 Mr. Wolin," That is right, and Mr. Chairman, I think to the extent that they are doing proper hedging activity--and right now, regulators and accountants and so forth look at hedging activity and make judgments about whether it is true hedging activity or not all the time--I think that a big burden is to be placed on regulators in implementing the basic principle that I have just articulated and that Chairman Volcker has articulated, and I think they do this in a range of ways, including with respect to hedging currently and whether it is legitimate hedging activity or whether it is something else, with the basic principle again being whether it is customer-related or whether it is for the firm's own balance sheet. " FOMC20080625meeting--228 226,VICE CHAIRMAN GEITHNER.," I was just going to say that it's a very delicate balance. We want this set of firms to get themselves to the point where, in the eyes of the market, they have a more conservative mix of leverage (appropriately measured) and funding risk so that they are less likely, even in a pretty adverse shock, to need to finance illiquid stuff with their central bank as a defense against that liquidity pressure. We're trying to do that without forcing a level of deleveraging that would be adverse to our broader objectives of trying to get markets back to some point where they're functioning more normally. We're not going to get that perfect. By definition, our facilities by design should allow them to run with a mix of leverage and liquidity risk that is above what the market probably now would permit. In the absence of our facilities, leverage and liquidity risk, if you measured it on a scale, would have to be lower in some sense. But that's the purpose and the necessary complement of the facility, and it is a delicate balance. But just to come back to President Plosser's point, I don't think that the stigma is the result of how we're applying the discretion we preserved for ourselves around use. It is really the result of the fact that, particularly if you're at a point when you perceive escalating concern about your viability, people don't want to risk that their pattern of use, if disclosed, would magnify the concern. That's really what accounts for the care in use, particularly as concern about viability has been intensified these last few weeks or so. " fcic_final_report_full--243 COMMISSION CONCLUSIONS ON CHAPTER 11 The Commission concludes that the collapse of the housing bubble began the chain of events that led to the financial crisis. High leverage, inadequate capital, and short-term funding made many finan- cial institutions extraordinarily vulnerable to the downturn in the market in . The investment banks had leverage ratios, by one measure, of up to  to . This means that for every  of assets, they held only  of capital. Fannie Mae and Freddie Mac (the GSEs) had even greater leverage—with a combined  to  ratio. Leverage or capital inadequacy at many institutions was even greater than re- ported when one takes into account “window dressing,” off-balance-sheet expo- sures such as those of Citigroup, and derivatives positions such as those of AIG. The GSEs contributed to, but were not a primary cause of, the financial crisis. Their  trillion mortgage exposure and market position were significant, and they were without question dramatic failures. They participated in the expansion of risky mortgage lending and declining mortgage standards, adding significant demand for less-than-prime loans. However, they followed, rather than led, the Wall Street firms. The delinquency rates on the loans that they purchased or guar- anteed were significantly lower than those purchased and securitized by other fi- nancial institutions. The Community Reinvestment Act (CRA)—which requires regulated banks and thrifts to lend, invest, and provide services consistent with safety and sound- ness to the areas where they take deposits—was not a significant factor in sub- prime lending. However, community lending commitments not required by the CRA were clearly used by lending institutions for public relations purposes. CHRG-111hhrg58044--150 Mr. Hinojosa," Thank you, Mr. Chairman. Chairman Gutierrez, I want to thank you for holding this important hearing on a very important issue, consumer credit. I commend my colleague, Congresswoman Mary Jo Kilroy, for introducing H.R. 3421, the Medical Debt Relief Act of 2009. The intent of her legislation is admirable. I agree with her that medical debt should be removed from credit reports 30 days after that debt has been repaid or settled, and that it not continue to hurt the credit rating of that individual, having gone through so many difficulties with sickness. I am concerned about one issue involving credit reporting agencies. They buy and sell information from virtually all adult residents in the United States. For a long time, we have been encouraging them to provide credit reports in languages other than English, especially Spanish. Mr. Chairman, I would ask that each credit reporting agency provide in writing their proposals to provide credit reports in languages other than English or that we at least have an opportunity to debate that. I would like to ask my question to Mr. Snyder. I am interested in legislation that would require that every adult American citizen 21 years or older receive a free credit score on an annual basis. Would the American Insurance Association support such legislation? " CHRG-111hhrg52406--23 Mr. Delahunt," Thank you, Chairman Frank and Mr. Bachus, for allowing me to testify today. There should be no doubt that we need a new regulatory framework and as importantly sustained supervision of the financial system. The current system failed us and we must avoid a repeat. While the near collapse of the financial system began on Wall Street, it quickly spread to Main Street, taking a devastating toll on families everywhere. Consumers have lost trillions in investment income and home equity. Investors both domestically and internationally have lost confidence. But I am confident that with your leadership and the excellent work of this committee, coupled with the commitment from the White House, we can extricate ourselves from this mess and move forward. Let me speak to the proposed Consumer Financial Protection Agency in the President's plan. It creates a consumer watchdog and in many respects reflects a proposal put forth by my friend and colleague from North Carolina and a member of this committee, Brad Miller. It is charged with ensuring that financial products sold to consumers are safe, responsible, accountable, and transparent. I also want to acknowledge the presence of the intellectual author of this concept, Harvard Professor Elizabeth Warren, who will testify on the next panel. There are currently 10 different Federal regulators that have some responsible for protecting consumers from predatory or deceptive financial products, but none have consumer protection as their simple sole primary objective. As a consequence, debt instruments have become increasingly risky. American families have been steered often deceptively into overpriced credit products including credit cards, car loans, and subprime mortgages. And as a result, Americans are overwhelmed with debt. These levels of personal debt have not only played a significant role in the financial crisis, but represent a significant impediment to full economic recovery. Today, one in four families are worried about how they will pay their credit card bill each month and nearly half of all credit cardholders have missed payments in the past year. There are more than 2 million families who have missed at least one mortgage payment and one in seven families are currently dealing with a debt collector. Like other government agencies, the Consumer Financial Protection Agency would seek to shield the consumer from unreasonable risk. The Agency would review financial products for safety, modify dangerous products before they hit the market, establish guidelines for consumer disclosure, and collect and report data about different consumer loans. I am sure Professor Warren will outline the specific provisions of the proposal. Undoubtedly credit helps dreams come true. Consumers can buy homes, cars and pay for a college education. But when seeking a loan consumers should not have to understand the nuances of complex financial instruments just as they don't need to understand how a toaster works, how a drug acts in our bodies or whether the food they eat is safe. By creating an agency whose primary role is to help the consumer people can again borrow with confidence that they are protected from fraudulent unsafe credit products. This will increase overall consumer confidence, will create demand, and stimulate the markets and spur investments. It is a win-win, not just for the consumer, but I believe will accelerate the recovery that is our common goal. Let me conclude with this: The Congress has attempted to enact reforms in the past but to no avail. Sensible reforms were thwarted by special interests and some will come before this committee to say that our regulations go too far, that this is simply too much. I say to them, give me a break. Just look at what has occurred. For too long, we have frankly let the American people down by failing to create a prudent regulatory regiment to protect the consumer from dangerous financial products. And we have seen the results. We can't let it happen again. And the consequences are simply too profound. Thank you, Mr. Chairman. [The prepared statement of Representative Delahunt can be found on page 78 of the appendix.] " CHRG-111shrg50815--6 STATEMENT OF SENATOR MENENDEZ Senator Menendez. I will make a brief statement. I don't know about very brief, Mr. Chairman. I will make a brief statement. Senator Schumer. Moderately brief. [Laughter.] Senator Menendez. Moderately brief. Let me thank the Chairman for holding this hearing. Credit card reform has been one of the top priorities that I have had both in the House and in the Senate since I arrived here, and I think this hearing couldn't come at a more important time, when millions of Americans are increasingly using their credit cards to float their basic necessities from month to month. As a result, Americans have almost $1 trillion of credit card debt outstanding. It seems to me that it is a dangerous cycle that is piling up. And while that debt is piling up, people in our State and across the country are discovering that their credit card agreements often conceal all kinds of trap doors behind a layer of fine print. If you take one false step, then your credit rating plummets and your interest rate shoots through the roof. Many of my constituents have contacted me after facing sky-high interest rates they never expected after accepting one offer, only to learn later that the terms seem to have been written in erasable ink, or after watching in horror as their children in college get swallowed in debt. So for far too many people, credit card is already a personal financial crisis and I believe it is a national crisis. Our economy will not recover if debt ties down consumers tighter and tighter, and making credit card lending practices fairer would be the right thing to do under any circumstances, but under these economic conditions, it is an absolute necessity. Mr. Chairman, I have legislation, as well. Some of it has been incorporated in what I think Chairman Dodd is going to include. I appreciate those efforts and I hope that the Federal Reserve's guidelines, which are a good step, could actually be accelerated, because waiting a year and a half to get those guidelines into place at a critical time in our economy is only buying us more and more challenges. With that, Mr. Chairman, I ask that the rest of my statement be included in the record. Senator Johnson. Senator Schumer, do you have a very brief statement? CHRG-111hhrg55811--282 Mr. Johnson," So when I hear the testimony today that are largely two financial institutions and end-users, I believe that I represent a third group that comes to the table, which is the taxpayers, the working people of the United States. And while I expect if you put a proper structure in place in the derivatives markets, it will impose burden or cost at the margin, because we have had too much incentive for private risk-taking relative to public risk-taking-- Ms. Bean. I do need a final comment. " CHRG-109hhrg28024--239 Mr. Bernanke," I don't have a target range to give you. If you have a higher share of Government spending in the economy, I think a lot depends on how well the money is spent. Is it being spent in ways that promote growth, for example, by creating skills or supporting research? If it's being spent in wasteful ways, obviously, that's a heavy burden on the economy, not only because of the resources being directly used, but because higher taxes in themselves will distort economic decisions and make the economy less efficient. " CHRG-110shrg50410--18 Chairman Dodd," Well, let me ask Chairman Bernanke the question. In fact, if the GSE debt can be used as collateral for other institutions that come and have access to the window, why not allow the GSEs to have access directly to that? " CHRG-111hhrg67816--87 Mr. Leibowitz," We do. I think debt negotiation would be one area. We would want to work with the committee in thinking about other areas, but, yes, we do and we can get back to you with some more thoughts on that. " Mr. Radanovich," OK. What would be the most prevalent consumer fraud violations in financial services that you think the FTC should be pursuing that it currently can't? " CHRG-111hhrg72887--31 CONGRESS FROM THE STATE OF GEORGIA Dr. Gingrey. Mr. Chairman, thank you so much for calling this hearing today so we can hear testimony on H.R. 2190, the Mercury Pollution Reduction Act. It is my hope that moving forward on these two bills, including H.R. 2309, the Consumer Credit and Debt Protection Act, we can work in a bipartisan manner to accomplish our shared goal of increased and enhanced consumer protection. H.R. 2309 would expand the role of the Federal Trade Commission by changing the rulemaking authority that relates to consumer credit and debt from the established and rigorous Magnuson-Moss procedures to the authority under the administrative procedures at APA. Mr. Chairman, at a hearing on this topic on March the 24th, I urged my colleagues to take caution in making this change in rulemaking procedure. Magnuson-Moss was designed in the 1970s to be onerous so as to avoid whimsical changes in FTC regulations. While I think the end goal here is commendable, I still have concerns that a simple legislative change will open the door to future unraveling of the Magnuson-Moss procedures. H.R. 2190 bans the manufacturer of chlorine using the mercury cell process, including the export of any mercury, within 2 years. As a physician for nearly 30 years, I believe it is critically important that we take proactive steps to ensure the health and safety of our citizens. During the 110th Congress, President Bush signed into law Senate bill 906, the Mercury Export Ban of 2008, that was introduced by then-Senator, now President, of course, Barack Obama. This legislation specifically outlawed the export of elemental mercury starting in 2013, similar, very much, to what is proposed in 2190. Therefore, given the duplicative nature of H.R. 2190 in regard to at least that section, I am concerned that we would be stretching our Federal resources too thinly on this important matter if the bill is enacted. Mr. Chairman, on both bills before us today, I urge my colleagues to exercise due caution, to consider the possible unintended consequences that we always should. I do look forward to hearing from our two panels today on these issues. " CHRG-111hhrg54867--63 Secretary Geithner," Well, again, it was very significant. The biggest part of the failure of our system was to allow very large institutions to take on leverage without constraint. And that is what really causes crises, what makes them so powerful. And that is why a centerpiece of any reform effort has to be the establishment of more conservative constraints on leverage applied to institutions whose future could be critical to the economy as a whole. " CHRG-111shrg62643--23 Mr. Bernanke," Well, Senator, as I responded to the Chairman, I absolutely agree that this is a concern, that if there is a loss of confidence in the financial markets that the United States is committed to and will achieve long-term fiscal sustainability, then the implications could be bad, not only for our long-term growth prospects, but they could actually hurt the current recovery for higher interest rates or higher inflation expectations. So it is very important to demonstrate as best we can, given the difficulties of committing future Congresses and so on, but to demonstrate as best we can that we are serious about addressing long-term issues. And so I don't think it is either/or. I think you really need to do both. Senator Shelby. But accumulating debt after debt each year is not good for anybody in this country, is it---- " CHRG-110shrg50369--142 PREPARED STATEMENT OF SENATOR ELIZABETH DOLE Thank you, Chairman Dodd and Ranking Member Shelby for holding this very important hearing today. Chairman Bernanke, I join my colleagues in extending you a warm welcome. Since last August, our financial markets have experienced tremendous uncertainty. Credit and capital markets around the world have struggled to comprehend the ramifications of the U.S. subprime lending and housing crisis. Fortunately, the Federal Reserve has been quick to act, lowering the federal funds rate from 5.25 percent to 3 percent. Congress also is working to help boost our economy. Several recent reports have highlighted ongoing economic challenges. Such as last week, the Wall Street Journal said that the ``leading economic indicators'' fell for the fourth straight month. Since its July 2007 high, the index has fallen by 2 percent, which is the largest 6-month drop since 2001. Additionally, for the week ending on February 16, the 4-week average of initial unemployment claims rose by 10,750 to 360,500, pointing to a softening of the labor market. Furthermore, by the third quarter of 2007, household debt rose to $13.6 trillion from $7.2 trillion in 2001, a 10-percent annual increase. Over this same time period, mortgage borrowing more than doubled. As a result, one out of every seven dollars of disposable income earned by Americans goes towards paying down debt. Fears loom of higher inflation and more ``pain at the pump.'' The price of a barrel of oil has hovered around the $90 mark and recently closed above $100 per barrel. If these higher gas prices and inflationary pressures continue, coupled with the well-known weakness in across our housing sector, I--like many folks I hear from--am very concerned that future economic growth could be hindered. No question, the health of our economy is influenced by many complex issues and expected and unexpected events. That said, I would like to highlight a few areas where I am focused to help spur growth and job creation. I strongly support Trade Adjustment Assistance, which helps ensure that displaced workers have the ability to train for new careers. In recent years, my home state of North Carolina has undergone a difficult economic transition, as our state continues to evolve from a manufacturing and agriculture-based economy to a more services-oriented economy. In North Carolina and across the country, there is a need to address the growing gap between skilled and unskilled workers. Senator Cantwell and I have introduced legislation that would allow more workers to receive TAA benefits, including training, job search and relocation allowances, income support and other reemployment services. Additionally, with respect to current regulation of financial institutions, it has come to my attention that some smaller banks are overburdened by compliance with Sections 404 and 302 of the Sarbanes-Oxley corporate accountability law. Mr. Chairman, these financial institutions are already highly-regulated, and it has become increasingly apparent that these regulations, while well-intended, only increase their costs of doing business. I hope this committee will soon consider legislation that would provide true regulatory relief for all financial institutions. Chairman Bernanke, thank you again for being here today. I look forward to hearing from you--and working with you--on these and other important issues. FOMC20081029meeting--6 4,MR. BASSETT.," 2 Thank you, Nathan. I will be referring to the exhibits labeled in red, ""Staff Presentation on Financial Developments."" The intermeeting period was characterized by persistent strains in financial markets and a sharp drop in asset prices. Although some markets have improved in recent days, the ongoing disruptions have generated intense pressures on financial institutions and have contributed to a significant further tightening of credit conditions for households and businesses. As Bill Dudley noted, spreads on credit default swaps (CDS) for financial institutions have been quite volatile. As shown by the top left panel of your first exhibit, median spreads for large bank holding companies (the black line) and regional commercial banks (the red line) declined substantially after the announcement of the Treasury's capital purchase program and the FDIC's temporary liquidity guarantee program on October 14; they ended the period almost 70 basis points lower, on balance. The median CDS spread for insurance companies (the blue line) increased substantially over the latter part of the intermeeting period amid concerns about the financial condition of these firms. Judging from the wide range of dealers' price quotes on CDS for the same firms (shown in the top right panel), liquidity and price discovery in the CDS market remain strained. The functioning of markets for corporate debt is also impaired. As shown by the blue line in the middle left panel, the staff's proxy for the bid-asked spread on highyield bonds spiked to more than 4 percent before partially reversing course over the past week. This spread is also unusually elevated for investment-grade bonds (the black line). As shown to the right, the average bid-asked spread on syndicated loans traded in the secondary market (the black line) jumped up over the intermeeting period. Secondary market prices for syndicated loans (the blue line) dropped to unprecedented levels, reportedly reflecting heavy sales by hedge funds that were forced to meet investor redemptions as well as the unwinding of some types of structured investments. Municipal finance, the subject of the bottom two panels, was significantly disrupted by dislocations in money market mutual funds in September and record 2 The materials used by Mr. Bassett are appended to this transcript (appendix 2). withdrawals from long-term municipal bond funds in early October. Markets for structured products, such as tender-option bonds, that issued short-term variable-rate debt backed by longer-term municipal bonds were particularly affected. Yields on those short-term instruments (shown by the black line in the bottom left panel) jumped for a time, and the sales of the underlying long-term bonds as the structures unwound boosted long-term municipal bond yields (the blue line). As shown to the right, issuance slowed substantially until mid-October, when a few states--notably California--placed a sizable amount of new debt, though they paid fairly elevated interest rates to do so. In recent days, however, liquidity conditions have shown signs of improvement, yields have decreased somewhat, and issuance has moved back up from the extremely slow pace seen in the second half of September and the first half of this month. Please turn to exhibit 2. As noted by Bill Dudley, prime money market funds suffered a wave of redemptions in mid-September, shown by the red bars in the top left panel. Although the flows diminished after the Federal Reserve and the Treasury announced steps to support money funds on September 19, prime funds lost about one-fifth of their assets, on net, over the intermeeting period. As a result, prime funds have dramatically reduced their holdings of commercial paper, generating significant disruptions in that market. As shown by the black line in the top right panel, unsecured financial commercial paper outstanding has declined sharply since midSeptember, and the ongoing contraction in ABCP (the blue line) has continued. In contrast, the amount of unsecured commercial paper placed by nonfinancial firms (the yellow line) was little changed, on net, over the period. As shown in the middle left panel, broad equity prices (the black line) dropped about 30 percent over the intermeeting period as the outlook for both economic growth and earnings dimmed, and implied volatility increased to record levels. As depicted by the red bars to the right, those developments were accompanied by record outflows of about $60 billion from equity mutual funds in September. Weekly data indicate that, over the first half of October, investors withdrew more than $100 billion from long-term mutual funds, including about $70 billion from equity funds, but outflows have slowed in recent days. As shown in line 1 in the bottom left panel, M2 expanded rapidly in September and early October as some firms and households shifted toward safer assets. Liquid deposits (line 2) increased significantly in September and stayed about flat in October. In contrast, retail money funds (line 3) were little changed in September but have grown briskly this month. The sizable increases in small time deposits in both months (line 4) were widespread, in contrast to the more concentrated gains seen over the summer in response to elevated yields at a few financial institutions. Currency (line 5) began increasing rapidly in recent weeks, apparently supported by higher demand from both foreign and domestic holders. As a result of the disruptions in short-term funding markets, a range of borrowers turned to banks for funding. The ""other loans"" category (the blue line in the bottom right panel) rose sharply beginning in mid-September as a result of both unplanned overdrafts and draws on existing credit lines by nonfinancial businesses, money market mutual fund complexes, foreign banks, nonbank financial institutions, and municipalities. C&I loans at banks (the black line) have also increased significantly in recent weeks, as a broad spectrum of nonfinancial firms tapped existing credit lines. According to the October Senior Loan Officer Opinion Survey, however, about 25 percent of the largest banks and 35 percent of other banks surveyed indicated that C&I loans not made under previous commitment accounted for some of the recent increase. Additional results from the survey are the subject of your next exhibit. Large net fractions of institutions reported having continued to tighten their lending standards and terms on all major loan categories over the previous three months, with some banks reporting that they had tightened lending policies considerably. As shown by the black line in the top left panel, about 80 percent of domestic respondents tightened their lending standards on C&I loans since July, and all but one of the 54 banks surveyed reported charging higher spreads over their cost of funds on such loans (the red line). As noted to the right, nearly all the banks that tightened standards or terms did so in response to a more uncertain or less favorable economic outlook and a reduced tolerance for risk. Almost 40 percent of domestic banks tightened in part because of concerns about their capital or liquidity position, somewhat more than had cited those pressures in July. As indicated in the middle left panel, a large fraction of domestic banks again reported tightening standards on commercial real estate loans over the past three months. Moving to loans to households, almost 70 percent of respondents tightened standards on residential mortgages to prime borrowers (the red line in the middle right panel). As shown by the blue line, nearly 90 percent of the institutions that originated nontraditional mortgages tightened standards on such loans. As shown by the short black line in the bottom left panel, about 75 percent of the respondents tightened lending standards on home equity lines of credit, and about 60 percent tightened standards on both credit cards (the blue line) and other consumer loans (the red line). As noted to the right, almost 25 percent of banks, on net, reported reducing the credit limits on existing credit card accounts of some prime customers over the past three months, and about 60 percent of banks reported cutting existing lines of some of their nonprime borrowers. Banks that had trimmed the limits on existing credit card accounts most often cited the more uncertain economic outlook as a very important reason followed, in turn, by a reduced tolerance for risk and deterioration in the credit quality of individual customers. Business finance is the subject of your next exhibit. The spread on BBB-rated bonds issued by nonfinancial corporations (the blue line in the top left panel) rose about 275 basis points over the intermeeting period, to more than 600 basis points, whereas that on bonds of financial firms (the black line) reached nearly 1,000 basis points before easing some in recent days. As spreads spiked and volatility increased, bond issuance by both nonfinancial and financial corporations (shown in the table to the right) dropped appreciably in the third quarter (row 3) relative to the pace seen in the first half of the year (row 2). As shown in the last row, there has been no highyield issuance by nonfinancial firms so far this month, and bond issuance by financial firms has come to a near halt. In commercial mortgage markets, secondary market spreads on AAA-rated commercial mortgage-backed securities (CMBS), shown in the middle left panel, continued to increase on net, and no new CMBS have been issued for several months. As noted to the right, using announced earnings for about 200 firms and analysts' estimates for the rest, the staff expects third-quarter S&P 500 earnings to come in about 10 percent below the level posted in the third quarter of last year. Losses at financial companies account for the drop. Bank holding companies reported further substantial write-downs on mortgage-related and other securities as well as higher loan-loss provisions necessitated by widespread deterioration in credit quality. In contrast, earnings of nonfinancial companies are projected to have risen about 12 percent from a year earlier, but increased profits of energy companies account for virtually all of those gains. As indicated in the bottom left panel, analysts have revised down significantly their expectations for earnings of nonfinancial firms (the red line) over the next year, likely in response to the worsening economic outlook. Expected earnings for financial firms (the black line) also have been cut further this month. A rough estimate of the equity premium (shown in the bottom right panel) stands at an extremely high level. The household sector is the subject of your last exhibit. As shown by the top left panel, interest rates on conforming residential mortgages have been volatile--partly in response to the renewed pressures on GSE debt noted by Bill Dudley--but ended the period only slightly higher at around 6 percent. The staff expects home prices (the black line to the right) to decline significantly further through the end of 2010 and mortgage debt (the red line) to be about flat over that period. Both paths have been marked down from the September forecast to reflect a weaker economic outlook and tighter credit conditions. Spreads on asset-backed securities backed by credit card loans (the black line in the middle left panel) and auto loans (the red line) have risen more than 150 basis points since mid-September, moving well above their spring peaks. The cumulative increase in spreads since midyear has hindered issuance of such securities, and the volume of new deals, shown to the right, dropped more than 50 percent in the third quarter. The latest data, available through October 17, suggest that very little issuance has occurred this month. As shown in the bottom left panel, consumer credit has decelerated recently. With lending conditions likely to remain tight and with spending on durables expected to be soft, the staff sees significant further weakness in consumer credit in coming quarters. Summing up, although there has been modest improvement in several financial markets recently, the worsening of the global financial crisis sharply increased pressures on financial firms and markets over the intermeeting period as a whole. Those pressures have led to further deleveraging, diminished liquidity, increased concerns among investors about the economic outlook, and a reduced tolerance for risk-taking. The resulting sharp fall in asset prices and the further tightening of credit conditions have had substantial adverse effects on nonfinancial businesses and households. That concludes my prepared remarks. " CHRG-111shrg57923--4 Mr. Tarullo," Well, Senator, I think that one of the lessons that the international community drew from some of the sovereign debt crises of the late 1990s and the very early years of this century was that there needed to be more transparency associated with a lot of sovereign debt issuance. And the International Monetary Fund undertook to create special data dissemination standards which would provide more such information. Generally speaking, I would distinguish between the sovereign information and private financial system firm information since we as regulators obviously have a mandate over private firms rather than certainly over sovereigns. It is relevant, though, for us in thinking about systemic risk because, to the degree that our large institutions have significant exposures to sovereigns which may conceivably have difficulty in servicing their debt, that becomes a matter of concern for the private financial regulators as well. Senator Reed. One of the issues that repeatedly is made--points, rather than issues--is that, you know, too big to fail is the first chapter, but the second chapter is too interconnected to fail. And that raises the issue of a focal point on large institutions might miss small institutions that could cause systemic risk. In fact, you know, there is the possibility that multiple failures in small institutions could have a systemic problem. So how do we sort of deal with that in terms of these interconnections? I mean, traditionally, it is easy for us to go to a big financial institution and say report X, Y, and Z. " CHRG-110hhrg45625--95 Mr. Bernanke," Well, we really had two stages in this credit cycle. The first stage was the write-downs of subprime and CDOs and those kind of complex instruments. We are now in the stage, with the economy slowing down, where we are seeing increased losses in a variety of things, ranging from car loans and credit cards, to business loans and so on. And that is going to put additional pressure on banks. It is another reason why they are pulling back, building up their reserves, building up their capital, de-leveraging their balance sheets, and that is going to prevent them from providing as much credit as our economy needs. Ms. Velazquez. Thank you. Secretary Paulson, we are hearing about small business loans being called in, and up to a third may have a callable provision and not be delinquent. Lenders are also reducing credit to entrepreneurs, and we are aware that the Federal Reserve reported that 65 percent of lending institutions tightened their lending standards on commercial and industrial loans to small firms. Given these challenging conditions, how will the current proposal specifically address the challenges facing small business? Before, you said in your intervention how this is going to help small businesses. Well, they too are victims now of the financial market mess that we are in. " CHRG-111hhrg49968--153 Mrs. Lummis," Mr. Chairman, you mentioned just a few minutes ago that many of the programs at the Fed are temporary and could be wound down. Well, such is the case with the Congress also, and this stimulus bill comes to mind. If Congress were to freeze spending at 2009 fiscal year levels and freeze release of the TARP funds at the end of the this fiscal year, do you believe the economy will have recovered adequately that we could then begin to address the debt and deficit problem and focus on it? Because you mentioned that as a very important looming issue. So I am looking at the point at which we can actually, as a Congress, also enact an exit strategy from trying to stimulate economic growth because the economy is finally leveling out, and then begin to address that great looming issue that you mentioned as a concern--that I agree is a huge concern--that being both the deficit and the debt. " CHRG-111hhrg48868--973 Mr. Liddy," Well, on the credit default swaps, the way that was solved was we put it into a financing vehicle with the Federal Reserve. The Federal Reserve--we put equity in. The Federal Reserve put debt in. They own those at a number of 50 cents on the dollar. If they are worth more than 50 cents on the dollar, the American taxpayer will do very, very well on it. That was Maiden Lane III. My personal assessment is that they will be worth more than what the Federal Reserve paid for them. Ms. Kaptur. All right. And what about the derivatives? " CHRG-110hhrg34673--11 The Chairman," Thank you, Mr. Chairman. I have to say that when you say you would be happy to take questions, you were somewhat more persuasive than when your predecessor used to say that. And I will apologize in advance to the media, because you have, I think, over the past months in particular, said some very reasonable things from my standpoint, so I have less to complain about than they might have hoped, I am sure, in Karl Rove's eyes, so they should not lose heart. I particularly want to begin by thanking you for the very appropriately nuanced discussion of wages. It has troubled me for some time, and particularly when I read some of the financial pages, that there is a good news, bad news story. The good news is that profits are up; the bad news is that wages are up. And wages are too often written about as if they were simply a constraint on prosperity. I particularly appreciate on page 7 of your testimony where you note that an increase in wages, certainly to the level of productivity, should not be a problem, and that in general, there is nothing automatic about a rise in wages leading to inflation. It depends on the impact on prices. And in that context, I especially welcome your noting that not only the underlying productivity trends appear favorable--and this is in your discussion of wages and inflation. Underlying productivity trends appear favorable and the markup of prices over unit labor costs is high by historical standards. I hope this is widely noted, your statement that, in fact, it would not appear to be wage driven pressure to raise prices, because as you note, the markup of prices over cost in this regard is high by historical standards. I would add you did not cover that, it was not in your topic, that there has also been a reduction in the tax burden. So we ought to be clear that this simplistic notion that if wages go up, that is going to cause inflation, is not the case, and that, in fact, there is, as you say, and I appreciate this, some reason, some room for legitimate wage increases to be absorbed without that being inflationary. Now, there is, however, some bias still in the way we talk about things. And I did note that there was great relief that you apparently indicated yesterday that it is unlikely that you will be presiding over increases in interest rates in the future. But as I read your report, it seems to me that frankly, the question ought to be whether or not there are decreases. In the Monetary Policy Report, on the first page of your--let me read two statements: ``On balance growth of real Gross Domestic Product appears likely to run slightly below that of the economy's potential over the next few quarters, and then to rise to a pace around that of the long run trend.'' Next paragraph. ``Regarding inflation increases in core consumer prices are expected to moderate on balance over the next 2 years.'' In other words, the prediction is, economic growth below the economy's potential for a while, and then reaching potential but not going above it. Similarly, ``inflation is going to moderate an economy performing somewhat'', not enormously, but ``somewhat below potential tending towards potential and inflation that is expected to moderate.'' I suppose that would be an argument for balance if nothing changes. But I don't see how we get a concern of inflation as the major concern here. And as you say, well, but you're still worried more about inflation and the sense is, stop him before he raises again, but no likelihood of a drop. I don't understand why this shouldn't make it at least as likely as a drop. Again, we have an economy that is running below potential and we have moderating inflation. Why is that not at least an equal chance for there to be a reduction in the time ahead? " FOMC20080310confcall--103 101,MR. MADIGAN.," Okay. ""Since the coordinated actions taken in December 2007, the G-10 central banks have continued to work together closely and to consult regularly on liquidity pressures Yes Yes Yes Yes Yes Yes Yes Yes Yes in funding markets. Pressures in some of these markets have recently increased again. We all continue to work together and will take appropriate steps to address those liquidity pressures. To that end, today the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing specific measures."" There is a section called ""Federal Reserve Actions."" ""The Federal Reserve announced today an expansion of its securities lending program. Under this new term securities lending facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA-rated privatelabel residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008. The Federal Reserve will consult with primary dealers on technical design features of the TSLF. In addition, the Federal Open Market Committee has authorized increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank and the Swiss National Bank. These arrangements will now provide dollars in amounts of up to $30 billion and $6 billion to the ECB and the SNB, respectively, representing increases of $10 billion and $2 billion. The FOMC extended the term of these swap lines through September 30, 2008. The actions announced today supplement the measures announced by the Federal Reserve on Friday to boost the size of the term auction facility to $100 billion and to undertake a series of term repurchase transactions that will cumulate to $100 billion."" Finally, there's a section on related actions being taken by other central banks with links to the other central banks' websites. " CHRG-111shrg62643--171 Mr. Bernanke," Well, first, it is certainly true that States and localities are under a lot of fiscal and financial stress. Their revenues have fallen considerably, and they are trying to maintain services and so on. So clearly we have seen some deficits and some cuts at the State and local level. My view is first of all that the municipal debt market is functioning pretty well, that at least States and localities that have good credit or seem to be sound are not having any difficulty accessing the municipal market, and that yields are pretty low, which is fortunate because there are a number of States and localities that are being forced to borrow under the current circumstances. Certainly there may be some localities in particular that will have trouble, but I would draw a distinction between say California and Greece, which is that because of these budget balance requirements, the outstanding debt of States is generally much less than the United States or other countries. So we always have to pay close attention, and there are a lot of stresses at the State and local level, but I do not at this point view the municipal debt market as being a major risk to the economy. Senator Shelby. Deflation and the Japanese experience, some people express fear that the U.S. could find itself in a period of deflation and, like Japan, have difficulty escaping. What do you believe are the differences between the U.S. and Japan in terms of structure of economic policy that would ensure that we do not follow the Japanese experience? And is that a concern of the Fed? " FOMC20060131meeting--62 60,MR. SHEETS.," Your first international exhibit focuses on the dollar. As indicated by the red line in the top-left panel, despite widening U.S. external imbalances, the dollar rose strongly against the major currencies through much of 2005. As seen on the top right, against the euro and the yen, the dollar has recorded net gains of more than 10 percent over the past year, even after tailing off some during the last two months. The dollar’s rise against these currencies occurred as interest rate differentials (shown on the bottom left) moved strongly in favor of dollar assets, and market commentary has pointed to this as a key factor supporting the dollar. Against the Canadian dollar, however, the greenback has moved down since mid-2005, and—as displayed on the bottom right—the dollar has also fallen against an array of emerging-market currencies, as market confidence in these countries has climbed. On balance, the broad nominal dollar has strengthened about 1¾ percent over the past year. As shown in the top panels of exhibit 10, the dollar’s resilience last year came in the context of a shift in the composition of reported U.S. financial inflows, away from official financing and toward private financing. In 2005, foreign official inflows (line 1 on the left) were down sharply from their 2004 pace. A plunge in official inflows from the G-10 countries (line 2) led this decline, as the Japanese authorities ceased intervening in foreign exchange markets. In contrast, inflows from emerging Asia (line 3) continued to move up, reflecting massive reserve accumulation by China. Purchases of U.S. securities by private foreigners (the top right panel) surged last year to more than $700 billion. All major categories of instruments saw increased foreign purchases, with particularly large gains in Treasury securities (line 2) and corporate bonds (line 4). The positive sentiment toward the emerging market economies, which was seen in foreign exchange markets, has also been manifest in global debt markets. As shown on the bottom left, the EMBI+ spread—which had hovered above the U.S. double-B corporate spread in recent years—cut below the double-B spread in mid-2005 and has now sunk to historical lows of just above 200 basis points. These favorable conditions, however, have not triggered a rise in external borrowing. As shown on the bottom right, net issuance of international debt securities by the emerging Asian economies has remained stable over the last year or two, and the Latin American countries have been paying down debt on net. Moreover, a sizable fraction of these economies continue to run current account surpluses. Your next exhibit focuses on the outlook for activity abroad, which in our view is quite favorable. As shown in line 1 of the top left panel, we estimate that total foreign growth in the second half of last year climbed to 4.1 percent, as growth in the emerging market economies (line 6) exceeded 6 percent. Going forward, we expect the foreign economies on average to expand at a strong pace of 3½ percent. Recent data have pointed to renewed signs of life in the euro-area economy (line 3), particularly in Germany, as strengthening in the export sector appears to have jump- started investment. We expect this impetus eventually to feed through to increased employment and consumer spending. Accordingly, we have marked up our forecast for the euro area and now expect growth there to remain near the 2 percent pace posted in the second half of 2005. Our forecast for Japan (line 4) calls for the expansion to broaden and for growth to remain above our estimate of potential. As shown in the middle left panel, over the past decade, Japanese corporations have dramatically reduced their debt burdens (the blue line). As balance sheets have strengthened, business investment (the black line) has risen and labor market conditions (the red line) have improved. More recently, as shown on the right, urban land prices—after many years of sharp contraction—appear to have stopped falling, and bank credit seems to be following a similar pattern. These developments suggest that conditions in the Japanese financial sector may finally be normalizing. The bottom panels focus on China. Over the intermeeting period, the Chinese authorities reported that GDP in 2004 was $280 billion (or 17 percent) larger than they had previously realized. Given these revisions, China’s GDP last year now appears to have exceeded that of France and the United Kingdom, making China the world’s fourth-largest economy. Other recent data indicate that China’s trade surplus (displayed on the right) jumped to $100 billion in 2005, as import growth declined sharply. Returning to the top left panel, this deceleration in imports did not reflect a slowing in the overall pace of Chinese activity last year, as GDP growth (line 8) remained near 10 percent. We see growth there notching down to around 7¾ percent in 2006, as the authorities are expected to implement administrative measures to restrain investment. As displayed in the top right panel, average foreign inflation is projected to remain well contained, cycling near 2½ percent through the forecast period. Inflation rates in the foreign industrial countries are seen to step down in mid-2006, as the run- up in oil prices plays through. For the emerging market economies, oil price increases typically pass through into consumer prices more slowly, as a number of these countries have price controls or subsidies in place that temporarily cushion the upward pressure on prices. As such, the rise in oil prices should continue to push up consumer price inflation through the next few quarters, but these pressures should abate in 2007. The top panels of exhibit 12 focus on trade prices. As shown on the left, the spot price of West Texas intermediate (the black line) has surged about $20 per barrel over the past year and now trades above $65 per barrel. Oil prices have been driven up both by strong global demand and by concerns about the reliability and adequacy of global supplies. Recent developments in Iran, Iraq, and Nigeria have further intensified these concerns. Tracking futures markets, our forecast calls for the price of WTI to remain elevated through the end of 2007. Nonfuel commodity prices (the red line) have also risen sharply over the past year, as metals prices have surged in response to strong global demand. In sync with futures markets, our forecast calls for commodity prices to flatten out near current levels, as supply responses help cap further price rises. The center panel displays our projection for the broad real dollar. After rising somewhat on balance last year, the dollar is projected to depreciate slightly, at an annual rate of about 1⅓ percent, through the forecast period. We see the expanding current account deficit and associated financing concerns—as well as monetary tightening by some foreign central banks—as likely to be sources of downward pressure on the dollar. Core import prices (the right panel) spiked in the fourth quarter, driven largely by a surge in natural gas prices following the hurricanes. Given that natural gas prices have already retreated, the run-up in core import price inflation should quickly unwind. Smoothing through these fluctuations, we see core import price inflation moving down to around 1 percent by early next year, consistent with flat commodity prices and only modest dollar depreciation. Recent data on U.S. nominal trade (the bottom left panel) indicate that the trade deficit has widened further. In October and November, exports of goods and services (line 2) increased $17 billion, led by a rise in capital goods exports (line 3), owing in part to a rebound in aircraft exports following the Boeing strike in September. Notably, exports of industrial supplies in October and November (line 4) were down relative to the third quarter. A large share of U.S. firms that produce these goods are located in hurricane-affected areas, and their production has been temporarily impaired. As shown on the right, this circumstance is highlighted by a sharp drop in real exports from several industries that were particularly affected by the hurricanes. Nominal imports of goods and services (line 6 on the table) rose a hefty $80 billion in October and November, notwithstanding soft growth in consumer goods (line 7) and capital goods (line 8). The recent rise in imports primarily reflected large increases in industrial supplies (line 9) and oil (line 10). These gains were due both to higher import prices, particularly for oil and natural gas, and to rising import quantities (which have substituted for impaired domestic production). Notably, as seen on the right, real imports have risen sharply in some of the same hurricane-affected industries in which exports have been particularly weak. As shown in the top left panel of your final international exhibit, we estimate that the growth of U.S. real exports of goods and services (the blue bars) dipped during the second half of 2005, as the hurricanes contributed to softness in goods exports and as last year’s dollar appreciation reduced the stimulus to services exports. Imports (the red bars), in contrast, expanded at a solid rate in the second half of last year, with a boost from the hurricanes. This pattern is expected to reverse in the first half of 2006, with exports recovering from the effects of the hurricanes and imports of oil and industrial supplies moderating. Thereafter, imports and exports are projected to grow at comparable paces, in line with solid U.S. and foreign growth and with the dollar projected to depreciate only mildly. As shown by the black line in the top right panel, the contribution of net exports to U.S. GDP growth in the second half of last year is estimated to have been around negative 0.6 percentage point, but it is projected to swing slightly positive in the first half of this year. Subsequently, the subtraction due to net exports should run at roughly ⅓ percentage point; imports and exports grow at comparable rates, but with imports more than 50 percent larger than exports, a sizable subtraction from growth results. As shown in the middle left panel, the U.S. current account deficit widened from about $150 billion in 1997 to $780 billion in the third quarter of last year. Over the forecast period, we see the deficit increasing further, to over $1 trillion, or about 7½ percent of GDP. The bottom panel provides some additional perspective on the widening of the current account deficit. As shown in the first column, from 1997:Q1 to 2001:Q4—a period of dollar appreciation—the current account balance fell $217 billion, which was more than accounted for by a decline in the non-oil trade balance. Over the next four years (the second column), the current account balance dropped another $421 billion, largely because of a continued decline in the non-oil trade balance (despite a net depreciation of the dollar) and a sharp rise in oil imports. As shown in the last column, we expect the current account deficit to widen nearly $300 billion over the forecast period, with all four major components contributing to the decline. Notably, net investment income is expected to fall sharply, as growing U.S. indebtedness and rising short-term interest rates push up our payments to foreigners. The middle right panel shows that our current account projections for 2006 and 2007 are markedly gloomier than those of other forecasters. Thus, there is a distinct possibility that investors will be surprised by the extent that the current account deficit widens. We see this as representing an important downside risk for the dollar." CHRG-111hhrg51585--132 Mr. Street," In fact, most of it would be defined as extremely prudent as far as the instrument he bought. He bought 5-year U.S. Government agencies. He simply leveraged them. He had some number of derivatives, but 90 percent of Mr. Citron's investment philosophy was leverage. Ms. Speier. Well, he did invest in derivatives and inverse and floaters; is that not true? " CHRG-111shrg55739--154 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BENNETT FROM JAMES H. GELLERTQ.1. As we move forward on strengthening the regulation of credit rating agencies, it is important that we do not take any action to weaken pleading and liability standards of the Private Securities Litigation Reform Act of 1995. This Committee worked long and hard, and in a completely bipartisan fashion, to craft litigation that would help prevent abusive ``strike'' suits by trial lawyers. These suits benefited no one but the lawyers who orchestrated these suits. This was a real problem then, and could become a real problem again if we dilute the current standard that applies to all market participants. Perpetrators of securities fraud, and those who act recklessly, can be sued under the law we passed in 1995. Is there any justification for now altering this standard just for credit rating agencies?A.1. Senator Bennett, I agree that there are broad implications for the treatment of liability standards for the ratings agencies, and more widely for participants in the securities industry. The rating agencies are popular targets currently and the popular ground swell for them to be accountable for their alleged mistakes leading to the subprime crises is likely to grow, not diminish. I believe the focus on liability runs the risk of being disproportionately central to attempts to ``fix'' the ratings business. This isn't to say that malfeasance or negligence should be acceptable; it is simply to note that the threat of liability has rarely been an effective deterrent for bad behavior in the finance industries.Q.2. Will the threat of class action litigation, and the costs of endless discovery, be at cross-purpose with the goal of fostering greater competition in credit rating markets?A.2. Anything that increases the costs of entering the ratings business has the risk of hindering competition. A basic challenge to building any new business is projecting costs. The specter of the costs associated with internal and external counsel necessary to protect against class action litigation and discovery is ominous and difficult to project. Ironically, the firms that benefit the most from a new and more litigious ratings environment are the Big Three, S&P, Moody's and Fitch, and these are the ones theoretically most in the crosshairs of this initiative. All three of these firms continue to generate large profits from their businesses and two of the three have massive multination corporations backing them. Increased legal costs are rounding errors in their businesses and are cheap prices for them to pay for further solidifying their oligopoly.Q.3. Would this potential create a disproportionate burden for smaller players in the industry?A.3. The costs of insurance, not to mention actual legal costs, could exponentially increase the costs of running a competing firm in the earlier years of development. It would almost certainly become the largest cost line-item in our firm's budget, since we use no analysts and do not have the commensurately high personnel costs that a traditional firm would have. As I have outlined in my written testimony, the NRSRO designation is currently the supposed carrot on the stick for aspiring ratings firms. All of the direct and contingent costs associated with increased legal liability create further disincentive to firms like Rapid Ratings and make applying for NRSRO status less appealing. This isn't to avoid responsibility, this is to avoid the potentially punishing costs to which we'd be subject with the NRSRO status. This is a dramatic unintended consequence of the currently contemplated increased liability standards and other rule revisions being contemplated.Q.4. Do you believe that the threat of harassment litigation could act as a barrier to entry to those considering entry into the rating agency business?A.4. Absolutely. ------ CHRG-110hhrg45625--155 Mr. Feeney," I want to thank both of you for being here. I know these are difficult times. I actually liked Mr. Ackerman's analogy. But for all too many Americans, this looks like it turns the play on its head. It is Little Orphan Annie who is being taxed to prop up Big Daddy Warbucks. And the average American out there believes very much that is what they are being forced to participate in as part of this proposal. But I want to look at a bigger picture. We have some huge expertise here, and I am going to mention two dirty words, the Great Depression. Virtually every major market crisis in 100-some years in America has been caused by easy credit, a bubble bursting, and then a credit tightening crisis. That is exactly what we are facing now. There were the Roaring Twenties with easy money. And for the last 6 or 8 years, we have had not only very easy money, there is plenty of blame to go around. It has been the United States Congress that passed the Community Reinvestment Act and browbeat every lender they could into making risky loans and then turned around and accused the lenders of being greedy. It is almost amazing, but that is what we do here, unfortunately, almost all too often. Congress also refused to reform Fannie and Freddie, despite the urging of many of us, and Secretary Paulson, for example, you have huge expertise in what happened after the October 29th stock market crash. In this case, we had a subprime lending bubble that started the crisis. But in 1929, the reaction to that was very real, and it wasn't just a failure to provide liquidity. Credit tightened by some 33 percent. The money supply shrank in America. And I know we are trying to fight that. I don't necessarily agree with your proposal. I know what you are trying to do. But simultaneously, Herbert Hoover raised marginal tax rates from 25 percent to 63 percent. This Congress just passed an impending largest tax increase in history. Hoover signed into law the largest anti-free trade act in history, Smoot-Hawley. This Congress has sat on free trade bills, sending a horrible message to our trading partners. There were huge regulatory increases that started in the aftermath of the 1929 market bubble that, in my view, contributed to taking a short-term, 18-month, 2-year recession, and turned it into a 15-year depression before the stock market fully recovered. I believe that the failure to pass an energy bill here is huge. So I would ask you gentlemen, in addition to dealing with the liquidity crisis, as we turn over these enormous regulatory powers and socialize much of the lending industry, even though we have already socialized Fannie and Freddie for all intents and purposes, how do you intend on these other huge issues, tax increases, huge new spending increases which accompanied the aftermath of the 1929 market crash, how do you in the name of fighting demagoguery explain to the average American that what really needs to be done here? This was not, in my view, a huge failure of the marketplace. This was bad policy by the Fed, easy credit, and Congress browbeating people into making terrible loans. Just like investors speculated with other peoples' money in the 1929 market crash, and bet on margin, it is exactly what happened in our subprime crisis. And so my view is that it was horrible government policy, anti-capitalist policy, that largely led to this crisis. I would like you to address as historians and economists, how we can avoid all of these other things, big tax increases, fighting free trade, huge regulatory burdens, socializing much of the market. Back then, it was utilities and other areas. Today, of course, it is the AIG, it is the banking lenders. And I would like you to address the broader picture. How do we avoid taking an 18-month market recession and turning it into a 15-year Great Depression? " fcic_final_report_full--152 Thomas Maheras, co-CEO of the investment bank, had become a leader in the nas- cent market for CDOs, creating more than  billion in  and —close to one-fifth of the market in those years. The eight guys had picked up on a novel structure pioneered by Goldman Sachs and WestLB, a German bank. Instead of issuing the triple-A tranches of the CDOs as long-term debt, Citigroup structured them as short-term asset-backed commercial paper.  Of course, using commercial paper introduced liquidity risk (not present when the tranches were sold as long-term debt), because the CDO would have to reissue the paper to investors regularly—usually within days or weeks—for the life of the CDO. But asset-backed commercial paper was a cheap form of funding at the time, and it had a large base of potential investors, particularly among money market mutual funds. To mitigate the liquidity risk and to ensure that the rating agencies would give it their top ratings, Citibank (Citigroup’s national bank subsidiary) pro- vided assurances to investors, in the form of liquidity puts. In selling the liquidity put, for an ongoing fee the bank would be on the hook to step in and buy the com- mercial paper if there were no buyers when it matured or if the cost of funding rose by a predetermined amount.  The CDO team at Citigroup had jumped into the market in July  with a . billion CDO named Grenadier Funding that included a . billion tranche backed by a liquidity put from Citibank.  Over the next three years, Citi would write liquidity puts on  billion of commercial paper issued by CDOs,  more than any other com- pany. BSAM’s three Klio CDOs, which Citigroup had underwritten, accounted for just over  billion of this total,  a large number that would not bode well for the bank. But initially, this “strategic initiative,” as Dominguez called it, was very profitable for Citigroup. The CDO desk earned roughly  of the total deal value in structuring fees for Citigroup’s investment banking arm, or about  million for a  billion deal. In addition, Citigroup would generally charge buyers . to . in premiums annu- ally for the liquidity puts.  In other words, for a typical  billion deal, Citibank would receive  to  million annually on the liquidity puts alone—practically free money, it seemed, because the trading desk believed that these puts would never be triggered.  In effect, the liquidity put was yet another highly leveraged bet: a contingent lia- bility that would be triggered in some circumstances. Prior to the  change in the capital rules regarding liquidity puts (discussed earlier), Citigroup did not have to hold any capital against such contingencies. Rather, it was permitted to use its own risk models to determine the appropriate capital charge. But Citigroup’s financial models estimated only a remote possibility that the puts would be triggered. Follow- ing the  rule change, Citibank was required to hold . in capital against the amount of commercial paper supported by the liquidity put, or . million for a  billion liquidity put. Given a  to  million annual fee for the put, the annual return on that capital could still exceed . No doubt about it, Dominguez told the FCIC, the triple-A or similar ratings, the multiple fees, and the low capital requirements made the liquidity puts “a much better trade” for Citi’s balance sheet.  The events of  would reveal the fallacy of those assumptions and catapult the entire  billion in commercial paper straight onto the bank’s balance sheet, requiring it to come up with  billion in cash as well as more capital to satisfy bank regulators. CHRG-110hhrg46593--325 Mr. Royce," They do the securitization, but they aren't leveraged 100 to 1. " FOMC20080625meeting--187 185,CHAIRMAN BERNANKE.," Art, could you define ""leverage"" in this picture. " CHRG-111hhrg53244--225 Mr. Ellison," Should Congress consider setting a leverage ratio? " CHRG-111shrg50815--121 PLUNKETT Q.1. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. As I mentioned in my testimony before the Committee, it is important to note that the lack of regulation can also lead to detrimental market conditions that ultimately limit access to credit for those with less-than-perfect credit histories. Credit card issuers have recently reduced the amount of credit they offer to both existing and new cardholders, for reasons that have virtually nothing to do with pending regulation of the market. Issuers losses have been increasing sharply, in part because of unsustainable lending practices. (Please see my written testimony for more information.) Had Congress stepped in earlier to require issuers to exercise more responsible lending, they might not be cutting back on available credit as sharply right now. Regarding access to affordable credit for individuals with an impaired or limited credit history, CFA has urged mainstream financial institutions to offer responsible small loan products to their depositors. We applaud FDIC Chairman Sheila Bair's leadership in proposing guidelines for responsible small loans and her call for military banks to develop products that meet the test of the Military Lending Act predatory lending protections. Banks and credit unions should extend their line of credit overdraft protection to more account holders. The FDIC has a pilot project with 31 participating banks making loans under the FDIC guidelines for responsible small-dollar lending. Offering affordable credit products is not the only strategy needed to help households more effectively deal with a financial shortfall. Borrower surveys reveal that many households are not using high-cost credit because of a single financial emergency, but instead have expenses that regularly exceed their income. For these households who may not be able to financially handle additional debt burdens at any interest rate, non-credit strategies may be more appropriate. These may include budget and financial counseling; getting help from friends, family, or an employer; negotiating with a creditor; setting up different bill payment dates that better align with the person's pay cycle; and putting off a purchase for a few days. Toward this end, it is very important that banks and credit unions encourage make emergency savings easy and attractive for their low- and moderate-income customers. Emergency savings are essential to keep low-income consumers out of the clutches of high-cost lenders. CFA's analysis based on Federal Reserve Board and other survey data found that families earning $25,000 per year with no emergency savings were eight times as likely to use payday loans as families in the same income bracket who had more than $500 in emergency savings. We urge banks and credit unions to make emergency savings easy and attractive for their customers. Q.2. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.2. Absolutely. Credit card issuers must do a better job of ensuring that borrowers truly have the ability to repay the loans they are offered. As I mention in my testimony, card issuers and card holders would not be in as much financial trouble right now if issuers had done a better job of assessing ability to repay. This is why CFA has supported legislation that would require issuers to more carefully assess the repayment capacity of young borrowers and potential cardholders of all ages. Q.3. 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.3. Under the Federal Reserve rules, card issuers will certainly have to be more careful about who they extend credit to and how much credit they offer. Given the current levels of indebtedness of many card holders--and the financial problems this indebtedness has caused these borrowers and card issuers--it is hard to argue that this is a bad thing. However, the Federal Reserve rules still preserve the ability of card issuers to price for risk in many circumstances, if they wish. They can set the initial rate a cardholder is offered based on perceived financial risk, reprice on a cardholder's existing balance if the borrower is late in paying a bill by more than 30 days, and change the borrower's prospective interest rate for virtually any reason, including a minor drop in the borrower's credit score or a problem the borrower has in paying off another debt. In addition, issuers can manage credit risk in more responsible ways by reducing borrowers' credit lines and limiting new offers of credit. Q.4. Do you believe that borrowers' rates and fees should be determined based on their own actions and not on those of others? A.4. It is certainly reasonable to base offers of credit on legitimate assessments of borrowers' credit worthiness. As I mention in my testimony, however, many of the pricing methods that card issuers have used to arbitrarily increase borrowers' interest rates and fees do not appear to be based on true credit risk, but rather on the judgment of issuers that they can get away with charging what the market will bear. Q.5. 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.5. As I mention in my response above, the Federal Reserve rules leave plenty of room for card issuers to price according to borrower's risk, so I do not think it is likely that we will see a return to the uniform, undifferentiated pricing policies of the past." CHRG-110hhrg46595--114 Mr. Royce," Thank you, Mr. Chairman. I would like to ask a question of Mr. Wagoner and also Mr. Mulally. And it goes more to the long-term question of Ford and GM because over the last few years, Ford and GM internationally have performed very, very well. And one of the questions I have is what is it about the business environment or the tax structure or the operating costs, as you go down the reasons for the success for Ford and GM in past years and looking forward over the long haul, why they are projected to do well overseas and international competition and why it is a greater burden here. I would like a discussion from each of you in terms of what some of those determinants are. " fcic_final_report_full--337 Lehman’s unreliable valuation methods, the bankers had good reason for their doubts. None of the bankers at the New York Fed that weekend believed the  bil- lion in real estate assets (excluding real estate held for sale) on Lehman’s books was an accurate figure. If the assets were worth only half that amount (a likely scenario, given market conditions), then Lehman’s  billion in equity would be gone. In a fire sale, some might sell for even less than half their stated value. “What does solvent mean?” JP Morgan CEO Jamie Dimon responded when the FCIC asked if Lehman had been solvent. “The answer is, I don’t know. I still could not answer that question.”  JP Morgan’s Chief Risk Officer Barry Zubrow testified be- fore the FCIC that “from a pure accounting standpoint, it was solvent,” although “it obviously was financing its assets on a very leveraged basis with a lot of short-term fi- nancing.”  Testifying before the FCIC, former Lehman Brothers CEO Richard Fuld insisted his firm had been solvent: “There was no capital hole at Lehman Brothers. At the end of Lehman’s third quarter, we had . billion of equity capital.”  Fed Chairman Ben Bernanke disagreed: “I believe it had a capital hole.” He emphasized that New York Federal Reserve Bank President Timothy Geithner, Treasury Secretary Henry Paul- son, and SEC Chairman Christopher Cox agreed it was “just way too big a hole. And my own view is it’s very likely that the company was insolvent, even, not just illiq- uid.”  Others, such as Bank of America CEO Ken Lewis, who that week considered acquiring Lehman with government support, had no doubts either. He told the FCIC that Lehman’s real estate and other assets had been overvalued by  to  bil- lion—a message he had delivered to Paulson a few days before Lehman declared bankruptcy.  It had been quite a week; it would be quite a weekend. The debate will continue over the largest bankruptcy in American history, but nothing will change the basic facts: a consortium of banks would fail to agree on a rescue, two last-minute deals would fall through, and the government would decide not to rescue this investment bank—for financial reasons, for political reasons, for practical reasons, for philo- sophical reasons, and because, as Bernanke told the FCIC, if the government had lent money, “the firm would fail, and not only would we be unsuccessful but we would have saddled the taxpayer with tens of billions of dollars of losses.”  “GET MORE CONSERVATIVELY FUNDED” After the demise of Bear Stearns in March , most observers—including Bernanke, Paulson, Geithner, and Cox  —viewed Lehman Brothers as the next big worry among the four remaining large investment banks. Geithner said he was “con- sumed” with finding a way that Lehman might “get more conservatively funded.”  Fed Vice Chairman Donald Kohn told Bernanke that in the wake of Bear’s collapse, some institutional investors believed it was a matter not of whether Lehman would fail, but when .  One set of numbers in particular reinforced their doubts: on March , the day after JP Morgan announced its acquisition of Bear Stearns, the market (through credit default swaps on Lehman’s debt) put the cost of insuring  million of Lehman’s five-year senior debt at , annually; for Merrill Lynch, the cost was ,; and for Goldman Sachs, ,. CHRG-110shrg50420--345 Mr. Wagoner," Yes on the first one, and on the second, we do have some secured debt, but we have a lot of collateral that is not secured, and so for that piece, we could cover any near-term funding. So yes to the second one, as well. Senator Casey. And Mr. Nardelli? " fcic_final_report_full--72 But leverage works both ways, and in just one month after Russia’s partial default, the fund lost more than  billion—or more than  of its nearly  billion in capi- tal. Its debt was about  billion. The firm faced insolvency.  If it were only a matter of less than  billion, LTCM’s failure might have been manageable. But the firm had further leveraged itself by entering into derivatives contracts with more than  trillion in notional amount—mostly interest rate and equity derivatives.  With very little capital in reserve, it threatened to default on its obligations to its derivatives counterparties—including many of the largest commer- cial and investment banks. Because LTCM had negotiated its derivatives transactions in the opaque over-the-counter market, the markets did not know the size of its posi- tions or the fact that it had posted very little collateral against those positions. As the Fed noted then, if all the fund’s counterparties had tried to liquidate their positions simultaneously, asset prices across the market might have plummeted, which would have created “exaggerated” losses. This was a classic setup for a run: losses were likely, but nobody knew who would get burned. The Fed worried that with financial mar- kets already fragile, these losses would spill over to investors with no relationship to LTCM, and credit and derivatives markets might “cease to function for a period of one or more days and maybe longer.”  To avert such a disaster, the Fed called an emergency meeting of major banks and securities firms with large exposures to LTCM.  On September , after considerable urging,  institutions agreed to organize a consortium to inject . billion into LTCM in return for  of its stock.  The firms contributed between  million and  million each, although Bear Stearns declined to participate.  An orderly liquidation of LTCM’s securities and derivatives followed. William McDonough, then president of the New York Fed, insisted “no Federal Reserve official pressured anyone, and no promises were made.”  The rescue in- volved no government funds. Nevertheless, the Fed’s orchestration raised a question: how far would it go to forestall what it saw as a systemic crisis? The Fed’s aggressive response had precedents in the previous two decades. In , the Fed had supported the commercial paper market; in , dealers in silver futures; in , the repo market; in , the stock market after the Dow Jones In- dustrial Average fell by  percent in three days. All provided a template for future interventions. Each time, the Fed cut short-term interest rates and encouraged finan- cial firms in the parallel banking and traditional banking sectors to help ailing mar- kets. And sometimes it organized a consortium of financial institutions to rescue firms.  During the same period, federal regulators also rescued several large banks that they viewed as “too big to fail” and protected creditors of those banks, including uninsured depositors. Their rationale was that major banks were crucial to the finan- cial markets and the economy, and regulators could not allow the collapse of one large bank to trigger a panic among uninsured depositors that might lead to more bank failures. CHRG-111shrg57320--306 Mr. Doerr," Well, we did not specifically discourage those products. I, for one, can see a problem with certain of those products. You have been talking during the hearings with stated income loans, and I certainly see some holes in those. But as an agency, FDIC did not take the position to prevent institutions from making those loans. What we did is we provided Non-Traditional Mortgage Guidance in October 2006. We set out in the guidance certain safe and sound principles under which institutions should approach these non-traditional mortgages. For example, one should qualify borrowers at the fully indexed rate, not at the teaser rate. Also, that when evaluating a borrower's capacity to handle increased amounts accruing in a negative amortization loan, you have to evaluate the borrower's ability to pay the loan through to maturity. Avoidance of over-reliance on collateral or the ability to refinance was another big mistake made by a number of firms. And when it comes to risk layering, which you mentioned, what we did was encourage quality controls and risk mitigation for risk layering items such as stated income loans, no documentation loans, high loan-to-value, high debt-to-income, and those sort of items. So that was the interagency statement that was issued. Senator Levin. Right. Now, that interagency position is not binding, is that correct? " CHRG-111hhrg55811--147 Mr. Hu," Two differences. One is that in contrast to merely doing due diligence in terms of other counterparties--that is, that one bank trying to figure out whether another bank is reliable, here we have government actually coming in and saying, you have to do ``X,'' ``Y,'' and ``Z.'' So it goes beyond just the screening, informational element. Very important. The second issue involves flipping it around. We are talking about reducing burdens to end-users and the like, those who use these products that are on clearinghouses. Flipping it around--if you have assurance that, in fact, the central clearinghouses worked, you don't need to spend money investigating. " fcic_final_report_full--13 While many of these mortgages were kept on banks’ books, the bigger money came from global investors who clamored to put their cash into newly created mortgage-re- lated securities. It appeared to financial institutions, investors, and regulators alike that risk had been conquered: the investors held highly rated securities they thought were sure to perform; the banks thought they had taken the riskiest loans off their books; and regulators saw firms making profits and borrowing costs reduced. But each step in the mortgage securitization pipeline depended on the next step to keep demand go- ing. From the speculators who flipped houses to the mortgage brokers who scouted the loans, to the lenders who issued the mortgages, to the financial firms that created the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had enough skin in the game. They all believed they could off-load their risks on a moment’s no- tice to the next person in line. They were wrong. When borrowers stopped making mortgage payments, the losses—amplified by derivatives—rushed through the pipeline. As it turned out, these losses were concentrated in a set of systemically im- portant financial institutions. In the end, the system that created millions of mortgages so efficiently has proven to be difficult to unwind. Its complexity has erected barriers to modifying mortgages so families can stay in their homes and has created further uncertainty about the health of the housing market and financial institutions. • We conclude over-the-counter derivatives contributed significantly to this crisis. The enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis. From financial firms to corporations, to farmers, and to investors, derivatives have been used to hedge against, or speculate on, changes in prices, rates, or indices or even on events such as the potential defaults on debts. Yet, without any oversight, OTC derivatives rapidly spiraled out of control and out of sight, growing to  tril- lion in notional amount. This report explains the uncontrolled leverage; lack of transparency, capital, and collateral requirements; speculation; interconnections among firms; and concentrations of risk in this market. OTC derivatives contributed to the crisis in three significant ways. First, one type of derivative—credit default swaps (CDS)—fueled the mortgage securitization pipeline. CDS were sold to investors to protect against the default or decline in value of mortgage-related securities backed by risky loans. Companies sold protection—to the tune of  billion, in AIG’s case—to investors in these newfangled mortgage se- curities, helping to launch and expand the market and, in turn, to further fuel the housing bubble. Second, CDS were essential to the creation of synthetic CDOs. These synthetic CDOs were merely bets on the performance of real mortgage-related securities. They amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread them throughout the financial system. Goldman Sachs alone packaged and sold  billion in synthetic CDOs from July , , to May , . Synthetic CDOs created by Goldman referenced more than , mortgage securities, and  of them were referenced at least twice. This is apart from how many times these securities may have been referenced in synthetic CDOs created by other firms. FinancialCrisisInquiry--157 Maybe—Mr. Bass, I know you’ve talked about it a lot. BASS: Sure. Gosh, I don’t even know where to start with that question. Number one, you should never be 95 times levered, right? When you talk about what they did and management and competence or gross incompetence, they were pushed, as you know, by the fair housing authorities. They were pushed by Congress. They were—again, you can’t—you can’t allay blame to any one person in that situation. I just think you need to look at all the participants. But when you look at Fannie and Freddie particularly, that’s $5.5 trillion of liabilities, OK? To put that into perspective, the mortgage market, at the end of ‘07, was about $10 trillion prime, $1.2 trillion subprime, $1.5 trillion Alt-A. Five and a half trillion dollars is almost as many bonds as exist from the U.S. government—well, not any more, you know, but it’s close to $7 trillion or $8 trillion, right now, growing about $1.5 trillion a year. But I think, when you—when you’re talking about prioritizing what to look at, clearly, they’re the biggest by a mile, right—or 50 miles. So when you look at Fannie and Freddie and what happened, you know, they still sit in this gray area today. And taxpayer money’s at risk. And to put it into perspective, you know, the S&L crisis that was so enormous—the FDIC concluded that that cost taxpayers $124 billion. We’ve already given Fannie and Freddie $183 billion alone, and we’ve opened the spigots, as of Christmas Eve, for as much capital as they need. We at Hayman think they’ll lose $375 billion or more in the crisis. So the interesting thing is, why is the taxpayer on the hook with Fannie and Freddie when Fannie’s cap structure today has $890 billion in it. It has $55 billion of equity and it has the rest in preferreds and debt. Why don’t we force the losses on some of these debt holders? CHRG-111hhrg52261--117 STATEMENT OF DAWN DONOVAN Ms. Donovan. Good afternoon, Chairwoman Velazquez, Ranking Member Graves, and members of committee. My name is Dawn Donovan, and I am testifying today on behalf of the National Association of Federal Credit Unions, NAFCU. I serve as the President and CEO of Price Chopper Employees Federal Credit Union in Schenectady, New York. Our credit union has seven employees, approximately 4,500 members in six States and just over $19 million in assets. NAFCU and the entire credit union community appreciate the opportunity to participate in this discussion regarding financial regulatory restructuring and its impact on America's credit unions. It is widely recognized that credit unions did not cause the current economic downturn; however, we believe we can be a important part of the solution. Credit unions have fared well in the current economic environment and as a result many have capital available. Surveys of NAFCU member credit unions have shown that many are seeing increased demand for mortgage and auto loans as other lenders leave the market. Additionally, a number of small businesses who have lost important lines of credit from other lenders are turning to credit unions for the capital that they need. Our Nation's credit unions stand ready to help in this time of crisis and unlike other institutions have the assets to do so. Unfortunately, an antiquated and arbitrary member business cap prevents credit unions from doing more for America's small business community. It is with this in mind that NAFCU strongly supports H.R. 3380, the Promoting Lending to America's Small Businesses Act of 2009. This important piece of legislation would raise the member-business lending cap to 25 percent of assets, while also allowing credit unions to supply much-needed capital to underserved areas which have been among the hardest hit during the current economic downturn. NAFCU also strongly supports the reintroduction of the Credit Union Small Business Lending Act, which was first introduced by Chairwoman Velazquez in the 110th Congress. As the current Congress and administration mull regulatory reform, NAFCU believes that the current regulatory structure for credit unions has served the 92 million American credit union members well. As not-for-profit member-owned cooperatives, credit unions are unique institutions in the financial services arena and make up only a small piece of the financial services pie. We believe that NCUA should remain the independent regulator of credit unions and are pleased to see the administration's proposal would maintain this independence as well as the Federal credit union charter. NAFCU also believes that the proposal is well intentioned in its effort to protect consumers from the predatory practices that led to the current crisis. We feel there have been many unregulated bad actors pushing predatory products onto consumers, and we applaud efforts to address this abuse. It is with this in mind that we can support the creation of the Consumer Financial Protection Agency, CFPA, which would have authority over nonregulated institutions that operate in the financial services marketplace. However, NAFCU does not believe such an agency should be given authority over regulated federally insured depository institutions, and opposes extending this authority to credit unions. As the only not-for-profit institutions that would be subject to the CFPA, credit unions would stand to get lost in the enormity of the proposed agency. Giving the CFPA the authority to regulate, examine, and supervise credit unions, already regulated by the NCUA, would add an additional regulatory burden and cost to credit unions. Additionally, it could lead to situations where institutions regulated by one agency for safety and soundness find their guidance in conflict with the regulator for consumer issues. Such a conflict will result in diminished services to credit union members. Credit unions already fund the budget for NCUA. As not-for-profits, credit unions cannot raise moneys from stock sales or capital markets. This money comes from their members' deposits, meaning credit union members would disproportionately feel the cost burden of a new agency. However, NAFCU also recognizes that more should be done to help consumers and look out for their interests. We would propose that rather than extending the CFPA to federally insured depository institutions, each functional regulator create a new strengthened office on consumer protection. We were pleased to see the NCUA recently announce its intention to create such an office. Consumer protection offices at the functional regulators will ensure those regulating consumer issues have knowledge of the institutions they are examining and guidance on consumer protection. This is particularly important to credit unions as they are regulated and structured differently from others. We believe such an approach would strengthen consumer protection while not adding unnecessary regulatory burden. Part of avoiding that burden will be to maintain a level of Federal preemption so small institutions like mine, with members in several States, are not overburdened by a wide variety of State laws. In conclusion, while there are positive aspects to consumer protection and regulatory reform, we believe Federal credit unions continue to warrant an independent regulator handling safety and soundness and consumer protection matters. I thank you for the opportunity to appear before you on behalf of NAFCU and would welcome any questions that you may have. " CHRG-111shrg57322--549 Mr. Birnbaum," The typical way that I would synchronize with other people within the firm was with a research group that might help me in the evaluation of some of these securities. Senator Coburn. Well, the research group would certainly know about whether or not the firm had been advised to take a different position in terms of collateralized debt obligations and residential mortgage-backed securities? " FinancialCrisisInquiry--93 All right. In consistent terms, though, what you were leveraged before the SEC began to regulate you in post-Basel II... BLANKFEIN: Yes. We are now, and today we sit here literally on a gross basis with about half of our high water mark. WALLISON: OK. Thank you. And Mr. Mack, would you answer the same question? And that is, at least there have been reports that the investment banks became much more highly leveraged after the SEC took over regulation in about 2004, and imposed Basel II regulations. Could you respond to that—why that happened? Or if it didn’t happen, see if you can explain why these allegations are out there? MACK: I think it happened, but I don’t think it was tied to the oversight of the SEC. I just think that you had a robust period of low interest rates and a consistency of movement in markets on the upside so people took more and more risk. But I don’t see the connection. We’ll be more than happy to go back and look through our files and talk to my general counsel and try to give you a more specific answer, but I’m not aware that that was a trigger point for more leverage. WALLISON: Back to you, Mr. Blankfein. When was Goldman, in your knowledge, first alerted to the fact that there was serious problems with subprime mortgages? BLANKFEIN: I would have to look—as Goldman Sachs, I just wasn’t—I wasn’t at all focused on it until it started getting into the press. CHRG-110shrg50420--460 Mr. Nardelli," Well, if we use your suggestion, then the best thing, I think, for you to do and for the auto industry is to provide us the $4 billion that we said we needed to get us through March 31. Senator Corker. And you would agree to all of the things that just were said? I don't know what we would do about--your debt issue is very different, obviously---- " CHRG-111shrg61651--78 Mr. Scott," I think addressing Long-Term Capital Management, the first issue is protecting the institution from failing, capital. But then we come to, well, maybe we will not succeed at that, it is failing. Now we have to deal with interconnectedness. We have done all we can, it wasn't enough. If you look at the present world of interconnectedness, it is not about equity. Equity is not an interconnectedness problem. I do not think it is about debt. I do not think that we are worried particularly from an interconnected point of view who is holding the bank debt. We may have other issues about that. It is really counterparty. It is really derivatives, in my view. And the answer to this is clearinghouses. If you go back to the years when Mr. Corrigan was serving very adequately in the Federal Reserve Bank of New York, his major concern was the payment system, and particularly the clearinghouse interbank payment system, because if there was a default, you would have a systematic chain reaction of failures. What did we do about that? Well, we managed to figure out a way that that thing could function without causing that problem. It now settles continuously. You do not have end of the day large net positions that could endanger the system if there is a settlement failure. So we have to address the same problem now in the context of derivatives. And I think that needs to be the focus here, because that is, in my view, the interconnectedness problem today. Senator Merkley. I am over my time. Shall I allow Mr. Johnson to respond, as well? " CHRG-111hhrg54867--255 Secretary Geithner," Well, again, banks operate with that mismatch. What they do is they take deposits and they lend them to people who need to buy a home or a business who wants to finance investment. That is inherent in any well-functioning financial system. But what you need do is to make sure that, again, you constrain leverage so that there is enough capital against risk and that there is as stable a funding base as you can achieve. And what we did not do well as a country is that there were large institutions, very important, very complicated, very risky, that didn't have effective constraints on leverage and, as you said quite correctly, were allowed to fund themselves overnight with very, very high vulnerability to a run in a panic. And so, you need to make sure that both the capital requirements and the liquidity requirements, margin, etc., are applied to that set of institutions who present those kind of risks. If you don't do that, we will be in this mess again. " CHRG-110hhrg46595--215 The Chairman," So that is $38 billion, if I add correctly, more than you are asking for in health care. That is very relevant. One of the questions we have is if we were to provide some bridge financing now, this Congress has already been burned by financing a bridge to nowhere, and I think we don't want to repeat that. So we would like some assurance that it is a bridge that has another terminus. The relevance of that is I hope that in the next Congress, working with the new President, we will be doing something about health care. Is it then the case that to the extent we could have a national health care plan--because I don't think anyone thinks it makes any sense to do anything that is specific to one group of employees. But if we were able to establish some form of health care at the national level which shifted the burden away from this employment nexus to the extent that we could reduce this, we would be enhancing the likelihood of success; is that accurate? " CHRG-110shrg46629--64 Chairman Dodd," Thank you, Senator. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Chairman Bernanke, I appreciate the testimony you have given on the subprime issue and the actions. But I am wondering if the actions reflect the crisis at hand. I find it hard to believe that months of hearings and reviews, a pilot project that will not commence until the end of the year, and guidance after guidance that seems to take only small steps, is a swift enough response for a crisis that has led to over one million foreclosures last year and ruined the American Dream of owning a home for too many people in this country. With all due respect, when, as part of that challenge, we are talking about predatory lending, I am not convinced that the proposals the Fed has put forward will be enough to stop predatory lenders dead in their tracks. I also hope that we have at least prospectively a better monitoring system because it is my personal opinion that, in many respects, the Fed was somewhat asleep at the switch, that we could have been more proactive in this process. It seems to me we are coming to the table with a plan after a tornado has already ripped through a community. So, I hope that the one message I think many of our colleagues have for you and the Reserve is that you will be as swift and use the powers that were given to you under the Home Ownership and Equity Protection Act as vigorously as we would like to see you use them. I hope that that is both your intent, your mission, and in terms of timing within the context of being judicious but not be judicious to the point that we err on the side of being able to protect more people in this country. I would like to hear your response to that in a moment. Let me get my second line of question and give you the balance of the time to answer. In my mind, I always ask who is this economy working for? Is inflation tame or is it still a significant problem? I guess that depends upon where you sit. Consumer prices rose at a moderate rate in June with a key factor keeping things under control is collapsing clothing costs. They have dropped for the past 4 months. But after energy, clothing is probably about the next most volatile component in the Consumer Price Index. So, I would not be surprised if sometime soon we see a major increase in prices in that regard. In addition, we already know that the pullback in gasoline prices in June has been unwound so energy will be adding greatly to consumer woes in July. And then there is food. As you mentioned yourself, prices jumped again and since June 2006 food and beverage costs have risen by 4 percent. With that, with the ethanol issues that are spiraling through food costs, I do not know that we can be looking for relief anytime soon, at least if you are looking at it from the context of the consumer. It seems to me that pain for the consumer is still there. When I look at household debt in America that has risen to record levels over the past 5 years. In the first quarter of 2007, household debt relative to disposable income stood at 130.7 percent. That is the third highest ratio on record. That means the average family in America is in debt for over $130 for every $100 it has to spend. Compounding this, the average household savings rate has actually been negative for the past seven quarters, averaging a negative 1 percent for 2006. One last measurement, one measure of this economic insecurity that I hear New Jerseyans talk to me about, that I hear other Americans talk about, is the percentage of middle-class families who have at least 3 months of their salary in savings. That percentage of middle-class families who had three or more months salary in savings rose over 72 percent from 16.7 percent in 1992 to 28 percent in 2001. But unfortunately, in the span of less than 4 years that percentage has dropped to 18.3 percent in 2004. So, I am looking at this and I am saying to myself so you have rising food costs, you have rising energy costs, rising health costs. You have stagnant median income for the last 5 years for families in this country. You have more debt, the third-highest ratio on record, and you have less families in quite some time that have 3 months and savings or more. Who is this economy working for? And is inflation tame or is it still a significant problem? " 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-111hhrg51585--126 Mr. Royce," Yes, it was very highly leveraged derivatives, actually, at the time. " CHRG-111hhrg52397--267 Mr. Duffy," I did not know what the leverage balance sheet of AIG was, sir, no. " CHRG-111shrg62643--170 Chairman Dodd," Well, I agree, and, again, you have already addressed this in passing, so I will leave it for a later gathering to look at all of this and how supervisory functions need to change under our legislation--I know you are giving a lot of thought to that already--as well as how we ought to handle the expanded mandates that we have saddled you with. And, again, I have a great deal of confidence it can be done, and I appreciate your response to Senator Bunning when he asked the question of whether or not you can do this. I am confident you can. Again, we have differences of opinions because I was looking at this a bit differently with more of a single prudential regulator where we sort of evolved from that back in November to what we have ended up here, and I accept that. That is how the process works here with people. I think even my views changed and were modified a bit as we went through the process. So I started out in one place. I would have been closer maybe to where I started out from than what we ended up, but, nonetheless, I accept the fact we are where we are and believe the capacity exists to get this right. And the fact that there is more of a holistic approach to this thing, where we have the capacity and the ability of talented people all driving toward the same goals, maintaining a strong, safe, and sound financial system with the kind of stability that is necessary in it, as well as restoring that level of trust and confidence in the system, which to me is the most critical element of all, that if the American people and others feel that sense of trust and confidence in our financial system, that in itself will have its own reward. So, again, I am very grateful to you and your staff and others for the tremendous amount of work you have put into this effort. I appreciate it very much. I look forward to getting together with you again in a couple of months here to really get down to the details of how this is going to work. Senator Shelby. Senator Shelby. Mr. Chairman, some observers warn of growing risk in the $2.8 trillion municipal debt market. Parts of California as well as municipalities in Illinois, Michigan, and New York seem to have been vulnerable to market-driven widening of spreads on their bonds relative to Treasuries, especially when market anxiety over fiscal conditions in the euro zone grew. I have two questions regarding municipal debt. What is your assessment of the state of the U.S. municipal debt markets? Second, do you believe there is any merit to a recent characterization by Warren Buffett that there is potentially ``a terrible problem'' ahead for municipal bonds? " fcic_final_report_full--407 The standards for credit card loans, another source of financing for small busi- nesses, also became more stringent. In the Fed’s April  Senior Loan Officer Sur- vey, a majority of banks indicated that their standards for approving credit card accounts for small businesses were tighter than “the longer-run average level that prevailed before the crisis.” Banks had continued to tighten their terms on business credit card loans to small businesses, for both new and existing accounts, since the end of .  But the July  update of the Fed survey showed the first positive signs since the end of  that banks were easing up on underwriting standards for small businesses.  In an effort to assist small business lenders, the Federal Reserve in March  created the Term Asset-Backed Securities Loan Facility (TALF), a program to aid se- curitization of loans, including auto loans, student loans, and small business loans. Another federal effort aimed at improving small businesses’ access to credit was guidance in February  from the Federal Reserve and other regulators, advising banks to try to meet the credit needs of “creditworthy small business borrowers” with the assurances that government supervisors would not hinder those efforts. Yet the prevailing headwinds have been difficult to overcome. Without access to credit, many small businesses that had depleted their cash reserves had trouble pay- ing bills, and bankruptcies and loan defaults rose. Defaults on small business loans increased to  in , from  in .  Overall, the current state of the small business sector is a critical factor in the struggling labor market: ailing small busi- nesses have laid people off in large numbers, and stronger small businesses are not hiring additional workers. Independent finance companies, which had often funded themselves by issuing commercial paper, were constrained as well. The business finance company CIT Group Inc. was one such firm. Even . billion in additional capital support from the federal Troubled Asset Relief Program (TARP) program did not save CIT from filing for bankruptcy protection in November . Still, some active lenders to smaller businesses, such as GE Capital, a commercial lender with a focus on middle- market customers, were able to continue to offer financing. GE Capital’s commercial paper borrowing fared better than others’.  Nonetheless, the terms of the company’s borrowing did worsen. In , it regis- tered to borrow up to  billion in commercial paper through one government pro- gram and issued . billion in long-term debt and . billion in commercial paper under another program.  That GE Capital had trimmed commercial paper be- fore the crisis to less than  of its total debt, or about  billion, also softened the effects of the crisis on the company. “A decision was made that it would be prudent for us to reduce our reliance on the commercial paper market, and we did,” Mark Barber, the deputy treasurer of GE Company and GE Capital, told the Commission. CHRG-111shrg61513--82 Mr. Bernanke," Yes. Senator Bayh. My last question. My time is about to expire. And we also finance our debt. Japan is mostly internal, isn't it? We have a lot of external, which makes it a little bit different. Are you at all concerned about Japan's recent steps to constrain demand there? What impact might--their economy is obviously growing very robustly. Does that present any risks to the global economy, the fact that they are moving in that direction? " CHRG-110hhrg46591--283 Mr. Yingling," I would agree with that. In the dual banking system, the diversity of charters has been critical. It is one area where we differ from some other countries. One of the advantages of it is that there is much more lending and capital available to small businesses and to entrepreneurs in this country because we have such a diverse system. I think another thing--and this committee has worked hard on it--is to recognize that when you pass rules designed to solve a problem, that they quite often apply most heavily to your analogy that did not cause the problem. One of the really big problems for community banks, and it may be the biggest problem in competing today, is just the huge regulatory burden. There are great economies of scale in dealing with these regulations, and the small banks just cannot deal with that. " CHRG-111hhrg53244--317 The Chairman," The gentlewoman from Florida. Ms. Kosmas. Thank you, Mr. Chairman. And thank you for being here. As the chairman said, I represent the Central Florida area, and have been sort of raising the flag for quite a few months since Florida is one of the highest in mortgage foreclosures and also one of the highest now in unemployment. But I have been concerned about what I saw as a deeper problem in the economy looming over Florida as well as the Nation with regard to commercial lending and the renewing or rolling over of commercial loans for larger businesses. Some are smaller businesses. But when we look at our economy in Florida and we recognize that it is a $70 billion tourism trade, and we have situations where resorts, hotels, timeshares, cruise ships, and even our leisure parks are relying of course on commercial credit lines in order to function, and the numbers of people that they employ and the factor of the potential for them to be in jeopardy is quite frightening to me. So I have been trying to raise that red flag for several months here and talking to people about it, while at the same time people are dealing with other issues. I know that the TALF program was intended to provide an opportunity for increased securitized debt in those markets. And I was wondering whether you might be--and some of this I think was addressed by an earlier question but I will ask mine anyway. Do you feel that the TALF program is large enough and sufficient enough? Is it working? And is it working quickly enough, that we could consider that it might alleviate some of these looming credit problems for commercial real estate? " FinancialCrisisInquiry--365 CHAIRMAN ANGELIDES: I mean did you scour loan tapes? Did you dig deep into looking at what you were moving, the actual product? And I guess the question is, isn’t that—you know in the 1920s everything’s different. But Wall Street banks were selling bad Latin American debt. I guess at what point do you have a responsibility? What is the sense of responsibility... CHRG-111shrg55278--116 RESPONSE TO WRITTEN QUESTIONS OF SENATOR MENENDEZ FROM SHEILA C. BAIRQ.1. A recent media article (New York Times, June 14th) states there have been strong disagreements between the FDIC and the OCC over whether the proposal to impose new insurance fees on banks is unfair to the largest banks, with the FDIC arguing that the largest banks contributed to the current crisis and should have to pay more. Can you elaborate on your rationale for requiring big banks to pay more than community banks?A.1. The New York Times article referred to the emergency special assessment, adopted on May 22, 2009, which imposes a 5-basis point special assessment rate on each insured depository institution's assets minus Tier 1 capital as of June 30, 2009. The Federal Deposit Insurance Reform Act of 2005 requires the FDIC to establish and implement a restoration plan if the reserve ratio falls below 1.15 percent of insured deposits. On October 7, 2008, the FDIC established a Restoration Plan for the Deposit Insurance Fund. The Restoration Plan was amended on February 27, 2009, and quarterly base assessment rates were set at a range of 12 to 45 basis points beginning in the second quarter of 2009. However, given the FDIC's estimated losses from projected institution failures, these assessment rates were determined not to be sufficient to return the fund reserve ratio to 1.15 percent. On May 22, 2009, therefore, the FDIC Board of Directors adopted a final rule establishing a 5 basis point special assessment on each insured depository institution's assets minus Tier 1 capital as of June 30, 2009. The special assessment is necessary to strengthen the Deposit Insurance Fund and promote confidence in the deposit insurance system. The adoption of the final rule on the special assessment followed a request for comment that generated over 14,000 responses. The final rule implemented several changes to the FDIC's special assessment interim rule, including a reduction in the rate used to calculate the special assessment and a change in the base used to calculate the special assessment. The assessment formula is the same for all insured institutions--big and small. However, it produces higher assessments for institutions that rely more on nondeposit liabilities. These institutions do tend to be the larger institutions. The FDIC considers this appropriate as in the event of the failure of institutions with significant amounts of secured debt, the FDIC's loss is often increased without any compensation in the form of increased assessment revenue. The amount of the special assessment for any institution, however, will not exceed 10 basis points times the institution's assessment base for the second quarter 2009 risk-based assessment. We believe that the special assessment formula provides incentives for institutions to hold long-term unsecured debt, and for smaller institutions to hold high levels of Tier 1 capital--both good things in the FDIC's view. ------ CHRG-111hhrg48674--45 Mr. Neugebauer," Thank you, Mr. Chairman. Chairman Bernanke, I have a couple of questions. I think the first question is an overall concern that I have. When you look at the meltdown in the economy, it is just not a domestic issue, it is a global issue, and we are seeing major contractions in the Chinese economy, the Japanese economy, and the European economy. Many of these countries were countries that we enjoyed them being able to buy our debt because we had a credit deficit or surplus with them. Now, with their economies shrinking and our need to borrow more and more money, some of the countries that were selling us oil at $150 a barrel, those prices have gone down. So a couple of things. One is, what happens when we get to the point where there aren't any buyers for Treasuries out there and we continue to move down the road of throwing trillions and trillions of dollars at this problem and trying to borrow that? Now, one of the things, when you look at the overall bailout of the markets, some people are quoting $7- to $8 trillion that is committed to this. You have expended your bank at a pretty rapid rate. With the balance sheet, you are now about $2 trillion with a $42 billion, I guess, net worth. The question that I have is, what happens when we can't issue debt and there is more pressure then on the Fed to intervene in these? And when I look at your balance sheet, I see the monies that you have actually advanced, but I know, for example, you are on the hook for $37 billion if Bank of America has some additional losses; and with Citi, I believe it is $308 billion. I think with Fannie and Freddie, it is half-a-trillion dollars or maybe more we have committed to backstop them. I don't see those numbers on your balance sheet. So when I look at your balance sheet, you have a 2 percent net worth; you have these contingent liabilities out there. You would be on a watch list if you weren't the Federal Reserve. So I guess the question is, what happens if we get to that point, and what is the real number that the Fed is in this game? " CHRG-111hhrg52400--36 Chairman Kanjorski," Subsequently, that holding company defaulted on bonds and bank debt. How would you rate the effect of what happened there with that particular company? Is that a failing of the State regulation, State-to-State? Would that have occurred if we had a Federal regulator in place? Or do you see any difference? " CHRG-111hhrg51698--160 Mr. Gooch," The insurance companies did historically for a long time sell debt insurance, but it is not a dynamic marketplace. You can get the debt insurance on an entire issue from an insurance company, but you don't have the ability, therefore, to tap additional pools of capital that are willing to effectively be synthetic lenders if you restrict it to just insurance companies. What I would say has occurred, in that respect, is that this is innovation in the marketplace. Throughout history we have had innovation. We had stock market crashes in the 1920s. We had the introduction of futures in the early 1970s. The over-the-counter markets are five times as big as the future markets. This is all innovation that has helped contribute to the prosperity of the free world. That is why I am a free marketeer. Now I do recognize that there is always the time in any free market where you will have certain speculative bubbles. I mean, I do agree with this Committee in looking to bring regulation and transparency to that market. We are totally, 100 percent, in support of transparency and also in order--not order limits but limits on the degree of risk-taking that entities are allowed to take subject to their balance sheets. " fcic_final_report_full--48 In , bank supervisors established the first formal minimum capital standards, which mandated that capital—the amount by which assets exceed debt and other lia- bilities—should be at least  of assets for most banks. Capital, in general, reflects the value of shareholders’ investment in the bank, which bears the first risk of any po- tential losses. By comparison, Wall Street investment banks could employ far greater leverage, unhindered by oversight of their safety and soundness or by capital requirements outside of their broker-dealer subsidiaries, which were subject to a net capital rule. The main shadow banking participants—the money market funds and the invest- ment banks that sponsored many of them—were not subject to the same supervision as banks and thrifts. The money in the shadow banking markets came not from fed- erally insured depositors but principally from investors (in the case of money market funds) or commercial paper and repo markets (in the case of investment banks). Both money market funds and securities firms were regulated by the Securities and Exchange Commission. But the SEC, created in , was supposed to supervise the securities markets to protect investors. It was charged with ensuring that issuers of securities disclosed sufficient information for investors, and it required firms that bought, sold, and brokered transactions in securities to comply with procedural re- strictions such as keeping customers’ funds in separate accounts. Historically, the SEC did not focus on the safety and soundness of securities firms, although it did im- pose capital requirements on broker-dealers designed to protect their clients. Meanwhile, since deposit insurance did not cover such instruments as money market mutual funds, the government was not on the hook. There was little concern about a run. In theory, the investors had knowingly risked their money. If an invest- ment lost value, it lost value. If a firm failed, it failed. As a result, money market funds had no capital or leverage standards. “There was no regulation,” former Fed chair- man Paul Volcker told the Financial Crisis Inquiry Commission. “It was kind of a free ride.”  The funds had to follow only regulations restricting the type of securities in which they could invest, the duration of those securities, and the diversification of their portfolios. These requirements were supposed to ensure that investors’ shares would not diminish in value and would be available anytime—important reassur- ances, but not the same as FDIC insurance. The only protection against losses was the implicit guarantee of sponsors like Merrill Lynch with reputations to protect. Increasingly, the traditional world of banks and thrifts was ill-equipped to keep up with the parallel world of the Wall Street firms. The new shadow banks had few constraints on raising and investing money. Commercial banks were at a disadvan- tage and in danger of losing their dominant position. Their bind was labeled “disin- termediation,” and many critics of the financial regulatory system concluded that policy makers, all the way back to the Depression, had trapped depository institu- tions in this unprofitable straitjacket not only by capping the interest rates they could pay depositors and imposing capital requirements but also by preventing the institu- tions from competing against the investment banks (and their money market mutual funds). Moreover, critics argued, the regulatory constraints on industries across the entire economy discouraged competition and restricted innovation, and the financial sector was a prime example of such a hampered industry. CHRG-111shrg50815--4 STATEMENT OF SENATOR BROWN Senator Brown. Mr. Chairman, I would like to make a couple of comments. Thank you, Mr. Chairman, Senator Johnson. I think a lot of us--I appreciate the comments both of Senator Shelby and the Chairman. A lot of us are particularly concerned about credit card targeting of young people. Go to any college campus across this country, in my State, Ohio State, the largest university in the country, you will see that college students are inundated with credit card applications. Ohio State's own Web site counsels students to, quote, ``avoid credit card debt while you are a college student.'' We know what kind of debt students face anyway and I think that just paints the picture of how serious this is. There are other examples of what has happened with small business and it is so important. I just underscore how important this issue is and that we move forward on more consumer protections. I yield my time back. Senator Johnson. Senator Akaka, you have a comment to make? FinancialCrisisInquiry--177 And so, Mr. Zandi, if you would commence your testimony. Thank you very much. ZANDI: Well, thank you, Mr. Chairman and other distinguished members of the commission. I—I want to thank you for the opportunity to testify today. The views I express are my own and not those of the Moody’s Corporation. The purpose of my testimony is to assess the economic impact of the financial crisis that began nearly three years ago. While the financial crisis has abated and the financial system has stabilized, the system remains troubled. Failures at depository institutions continue at an alarming rate and likely will continue for several years more to come. The securitization markets also remain dysfunctional as investors anticipate more loan losses and are uncertain about various legal and accounting rule changes and regulatory reform. Without support from the Federal Reserve’s TALF program, private bond issuance and securities backing of consumer and business loans would be completely dormant. Households and businesses are struggling with the resulting severe credit crunch. The extraordinary tightening of underwriting standards by nearly all creditors is clear in the lending statistics. Here’s a very astounding statistic. The number of bank credit cards outstanding has fallen by nearly 100 million cards in just over the past year and-a-half, a 20 percent decline. Total household debt, including credit cards, auto loans and mortgage debt has declined a stunning $600 billion, or 5 percent. And outstanding C&I loans, commercial investor loans, have declined by some 20 percent since peaking in late 2008. Some of this reflects the desire of households and businesses to reduce their debt loads. But it also stems from lenders’ inability and unwillingness to lend. Small banks are vital to consumer and small- business lending. And without the ability to sell the loans they originate to investors in the securities market, banks and other lenders don’t have the capital sufficient to significantly expand their lending. The economic recovery will struggle to gain traction until credit flows more freely, which won’t occur until bank failures abate and there’s a well functioning securities market. CHRG-110hhrg41184--201 Mr. Bernanke," That's correct. Mr. Miller of North Carolina. And I wanted to pursue a question that Mr. Moore of Kansas asked you. He said that there was legislation now pending that would treat home mortgages and bankruptcy the same way credit card debt was treated. I don't know of any legislation like that. There is, however, legislation pending in both the House and the Senate that would make the treatment of home loans and bankruptcy the same as any other form of secure debt, including debt on investment property, mortgages on investment property, mortgages on vacation property, car loans, boat loans, loans on a washer and a dryer, or debt secured by any other asset. You said that you thought one result might be changing the bankruptcy law, higher interest rates. And in fact the opponents of that legislation have made some pretty dire predictions that no lender would lend with less than 20 percent equity, that they would make more than an 80 percent loan and the interest rates would go up a point and a half or two points, two and a half points. But they have not produced any kind of economic analysis to support that. I know one member who has said that they offered to let him see--they had an analysis, they'd let him see it privately, which sounded more the way you got offered to look at dirty pictures in the old days, not how you looked at economic analysis. A couple of weeks ago, there was a Georgetown study by a fellow named Levitan, that compared the terms of availability of mortgage lending in places in the United States at the same time that had different laws in effect. Between 1978 and 1994, the courts in different parts of the country interpreted the bankruptcy laws differently, interpreted whether mortgages could be modified differently, so in some parts of the country they're being modified fairly freely, in some not at all. And the result of that study was that there was no real difference in the terms of availability of credit, and estimated that if there was any real difference at all, it might be 0.1 percent of an interest rate. Are you familiar with any economic study--and again, I assume that I'm correct that the way economists do things is they publish, they let others look at their factual assumptions, follow their logic, and how they reach their conclusions; I think at the Ph.D. level that's called ``peer review``; in 8th-grade math class we called that ``showing your work.'' It's the same concept. Are you familiar with any economic analysis that shows a substantial difference in the availability or terms of credit, based upon how mortgages are treated in bankruptcy? " CHRG-111shrg54589--137 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM MARY L. SCHAPIROQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. The primary function of derivatives is to facilitate the efficient transfer of risk exposure among market participants. Trading of risk exposure through derivatives enables parties who have natural risk exposures as part of their business or investment operations to reduce or eliminate that risk by transferring it to somebody who has a natural offsetting risk, or to somebody else who is more willing to bear that risk. Some sources of fundamental business risk are closely related to the prices of assets that are traded in an active cash market, such as stock or foreign currency. Other risks lack robust cash market pricing sources. Derivatives based on these risks, however, can be important tools for managing these risks. As with any derivative product, the key challenge for policy makers will be determining when and whether the value of these products for risk management purposes outweighs potential concerns about the products' underlying market integrity.Q.1.b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. This issue raises important public policy concerns. Products without an active cash or derivatives market may have less robust price discovery. These products, nevertheless, may be useful to hedge or transfer real economic risks and, therefore can play a beneficial role in facilitating risk management and risk transfer activities. Policy makers should consider whether risk management and distribution purposes outweigh concerns with weak or unreliable pricing sources. Traditionally, the SEC has used disclosure to identify valuation risks associated with securities.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?A.2. The best way to improve market understanding and ``value'' determinations for derivatives is to standardize and centrally clear them (to the extent possible) and encourage them to be traded on exchanges. This would provide great transparency. Where standardization or exchange trading is less likely, I believe policy makers should endeavor always to maximize market transparency through reporting or other mechanisms. The argument for making models public when no cash market exists is an interesting way to provide a valuation check, but there are costs to this approach as well. For example, would investors continue to innovate and alter their models if they were public and available to their competitors? Would models become more similar--decreasing market style diversity and increasing the risk that major participants engage in the same trades (increasing volatility and risk)?Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. Drawing a line, based on trading positions, between hedgers and speculators will necessarily be arbitrary because we cannot determine the intent of a trader from their portfolio holdings. Some market participants will hold derivative positions as part of a well-defined hedge (e.g., they also have large current or anticipated exposure to the prices of securities or debt instruments). Others have no exposure at all and hold a derivatives position strictly to gain exposure, that is to speculate, on price movements. However, drawing a line between the two motives is difficult and may yield unintended consequences. First, there are a number of entities that do not hold large securities or debt holdings, who may, nonetheless have a legitimate risk management purposes: For example, they may want to hedge their ``exposure'' to a major supplier or customer. Second, even if a reasonable line is drawn, there may be significant market consequences: For example, ``speculators'' can often provide liquidity for hedgers--so eliminating speculators can raise the cost of risk management and make hedges less effective. In developing a regulatory framework for OTC derivatives these and other complexities will need to be addressed in a manner that seeks to prevent the potential for market abuses while also creating a system that facilitates legitimate transactions.Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. Clearly we need to move forward with our regulatory framework, even if other jurisdictions do not follow. However, financial markets today are global markets and coordinating with our international counterparts will be critical. Absent a response coordinated with foreign regulators exercising similar authority, the effectiveness of any regulatory limits would be constrained significantly by the international nature of the derivatives market. Because there is the potential for trading business to move to less regulated markets, we are working with our counterparts internationally to ensure that all derivatives dealers and large participants in OTC derivatives market are subject to prudential regulation and supervision.Q.5. Do over-the-counter or custom derivatives have any favorable accounting or tax treatments versus exchange traded derivatives?A.5. There is no difference in the financial statement accounting principles applied to exchange traded versus other types of derivatives. With respect to the financial accounting treatment, contracts or other arrangements that meet the accounting definition of a derivative are ordinarily recognized and measured at fair value with changes recognized in income each period whether the derivative is exchange traded or customized. However, accounting rules allow companies to achieve hedge accounting and defer recognizing the impact of changes in value of derivatives used for hedging purposes when changes in the value of a derivative match and offset changes in the value of the hedged item to a sufficient degree. It is possible, in some cases, that a customized derivative may be more likely to economically offset changes in the value of the exposure a company is trying to hedge. Thus for certain applications, customized derivatives may be more likely to offset the exposure and thus may be more likely to meet the requirements for hedge accounting. In all cases where a derivative serves as a highly effective hedge, accounting standards clearly permit the entity to reflect the reduction in risk in the measurement of income.Q.6. In addition to the Administration's proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?A.6. Even before the credit crisis, financial accounting for derivatives had been identified as deserving additional consideration. In this regard, the Financial Accounting Standards Board (FASB) issued new disclosure requirements in 2008 that provide greater transparency about derivative and hedging activities to investors, including a substantial amount of additional information about credit default swaps. Derivatives accounting also represents a component of the FASB's current project to reconsider the accounting principles for all financial instruments, recently undertaken in concert with the International Accounting Standards Board. This project was added to the FASB's agenda, in part, as a response to issues identified by the SEC and others during the credit crisis. Many have argued that the hedge accounting rules are overly complex and could be improved to make hedge accounting easier to apply and more understandable to investors. While we are supportive of such simplification, we would expect that because of their volatile nature, derivatives will continue to be measured at fair value each period on the balance sheet, and significant disclosures will continue to be needed for investors to understand the exposures, strategies, and risks of companies that utilize them. The tax treatment of different types of derivatives is outside of the SEC's area of expertise and may be better addressed by tax professionals and/or the IRS.Q.7. Should parties to derivative contracts be required to post cash collateral, or is other collateral acceptable? And is there any reason not to require segregation of customer collateral?A.7. Provided that positions are marked to market and collateral calls are made daily, cash collateral is one prudent type of collateral. In certain circumstances, though, highly liquid securities that tend to move in price consistent with the underlying reference asset may be as desirable for collateral as cash. Guidelines for acceptable forms of collateral will need to reflect the risks and circumstances associated with each type of acceptable collateral, including, but not limited to, price volatility and liquidity, and be agreed to by both parties to the transaction. Accordingly, under certain circumstances, noncash collateral may be acceptable. A priority of a regulatory framework for OTC derivatives should be ensuring a process that allows for the prompt return of customer collateral. Properly constructed regulations governing the segregation of customer collateral can provide customer protection while still promoting the operation of efficient OTC derivatives markets.Q.8. Is there any reason standardized derivatives should not be traded on an exchange?A.8. In building a framework for the regulation of OTC derivatives, the goal should be to encourage all standardized derivatives to be traded on exchange or equivalent exchange-like venues that provide full regulatory and market transparency. The regulatory scheme for trading OTC derivatives should be designed to achieve vital public policy objectives for such instruments, including transparency, efficiency, and prevention of fraud and manipulation. The regulatory scheme for standardized derivatives should, however, retain sufficient flexibility to allow market mechanisms to develop that meet varying trading needs for products (such as products that may lack sufficient liquidity to be traded on an exchange), while ensuring all dealers and trading markets (including for nonstandardized products) are subject to a unified regulatory scheme that establishes a framework for fair competition among markets, protects the public interest and is sufficiently transparent to allow for regulatory oversight.Q.9. It seems that credit default swaps could be used to manipulate stock prices. In a simple example, an investor could short a stock, and then purchase credit default swaps on the company. If the swaps are not heavily traded, the purchase would likely drive up the price of the swaps, indicating higher risk of default by the company, and lead to a decline in the stock price. Is there any evidence that such manipulation has taken place? And more generally, what about other types of manipulation using derivatives?A.9. The Commission is very concerned about potential manipulation of the equity markets through the use of credit default swaps or other derivative instruments. Because there is no central reporting or audit trail requirement for OTC derivatives, including securities-related OTC derivatives, there is no organized surveillance by any Federal regulatory agency or self-regulatory organization. This regulatory gap substantially inhibits the Commission's examination and enforcement efforts, and the lack of surveillance creates substantial risk to the markets collaterally affected by swap transactions, such as the market for debt and equity securities related to credit default swaps. The antifraud prohibitions in the Federal securities laws currently apply to all securities-related OTC derivatives, including credit default and other swaps related to securities. The Commission, however, needs better tools to enforce existing prohibitions over all securities-related OTC derivatives, including authority to promulgate reporting and record keeping rules and prophylactic antifraud rules. Currently, if Commission enforcement or examination staff suspects illegal conduct in the derivatives market, staff must engage in the time-consuming process of manually recreating activity in this unregulated market, which is challenging in a market without uniform documentation, transparent pricing, and time-stamped records. Under these circumstances, it is difficult to identify violations and prove the intent required to support charges under the Federal securities laws. Uniform record keeping and reporting would provide the type of information needed to identify suspicious trading patterns and to investigate or examine misconduct. With uniform audit trail and record keeping requirements, Commission staff could, for example, better pinpoint where manipulative credit derivative trading occurs in tandem with other trading strategies, such as short selling.Q.10. Credit default swaps look a lot like insurance when there are unbalanced, opportunistic sellers. However, life and property insurance requires an insurable interest for the buyer and reserves for the seller. Why should we not regulate these swaps like traditional insurance?A.10. Although credit default swaps are frequently described as insurance (buying protection against the risk of default) and may have certain elements similar to traditional insurance, we believe that securities-related credit default swaps are more appropriately considered, and regulated, as securities. The value of the payment in the event of default is determined by reference to a debt security, so that the payment is tied directly to a security. As noted in the CDS example in question #9, securities-related credit default swaps are tied directly to the securities markets and issuers of securities. As a result, manipulative activities in the credit default swap market would affect U.S. issuers in the underlying equity market. Congress recognized the impact of these instruments on the primary markets that are regulated by the SEC when it applied the antifraud and antimanipulation provisions of the securities laws to securities-related OTC derivatives, such as securities-related credit default swaps, in 2000. That authority needs to be extended to provide the SEC the regulatory tools to regulate these products. Regulating securities-related credit default swaps as insurance would actually undermine the protections provided by the Federal securities laws by creating the potential for arbitrage between two different types of regulation for economically related products.Q.11. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.11. Some commenters have identified a phenomenon they characterize as the ``empty creditor'' problem. These commenters have noted that credit default swaps, among other products, allow a creditor holding a debt obligation to reduce or eliminate its economic exposure to the debtor while still retaining the rights as a creditor. As a result, creditors who hold significant credit default swap positions may prefer that the debtor enter into bankruptcy because the creditor will receive payments in connection with its CDSs that exceed any benefit the creditor would get if the debtor restructured its debt. The Federal securities laws do not establish any duties of a creditor to a lender or to other creditors. The motivation of a creditor to take any action with respect to its debt holdings in a particular company may be guided by many different economic and investment factors that are unique to such creditor, with credit default swaps being just one such factor. For example, a creditor that also is a significant equity holder may have different motivations in making credit decisions as compared to a creditor that holds only debt. Focusing only on a creditor's actions as influenced by its holding of credit default swaps does not take into account these other motivating factors.Q.12. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.12. As the financial crisis illustrates, it certainly appears that some major market participants may have used credit protection as an alternative to engaging in more robust traditional credit research and review regarding their credit exposures--leading to hidden/higher credit risk and the risk that the credit protection provider cannot perform. This tension is real. However, this moral hazard that exists in credit protection exists in a number of contexts in the financial arena. For example, this hazard exists when investors rely on a credit rating or an analyst's research report instead of engaging in their own research. Although inherent, this problem is exacerbated by a number of factors in the credit arena--such as when information is limited to a small number of creditors or unavailable to the public; when traditional credit standards are reduced; or when investors and creditors become less vigilant due to perceptions (or misperceptions) of market safety. In the short term, the financial crisis itself has certainly reduced these risks, but it is important that regulators (as well as investors and other market participants) remain vigilant to help avoid the next crisis. To better ensure that vigilance, we believe more accountability and transparency will do a lot to keep investors informed of the flaws of overreliance on credit protection, credit ratings, or a similar third-party validator before making investment or credit decisions.Q.13. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn't they?A.13. Sellers of credit protection typically carry a liability on their balance sheets for the obligation to compensate the guaranteed party if a credit event occurs on the referenced asset. Some types of credit protection are considered insurance contracts under the accounting rules and the resulting obligation is measured based on insurance accounting principles. Other types of credit protection, such as credit default swaps, meet the accounting definition of a derivative and the resulting liability is marked to market each period. Unless an insurer or guarantor controls the referenced asset, accounting rules do not permit or require the referenced assets to be recognized on the guarantor's balance sheet. In other words, simply guaranteeing or insuring the value of an asset does not require a guarantor to record the insured asset on its balance sheet under generally accepted accounting principles. On the other hand, guarantors that control the insured or guaranteed assets will generally be required under new off-balance sheet accounting rules to report on their balance sheets the controlled assets effective for 2010 financial reports.Q.14. In your testimony you mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.14. Synthetic exposure through derivatives can be a good idea, or a bad idea--depending on the circumstances. While they can be used to increase leverage, they can also be used to reduce transaction costs, achieve tax efficiencies, or manage risk. Synthetic exposure through derivatives is a component of many arbitrage strategies that help align prices of related assets across markets. A key question for policy makers, I believe, will be determining how best to utilize the ``good'' aspects of derivatives use (e.g., as a risk management tool for individual institutions); while minimizing the ``bad'' aspects (unclear pricing, hidden leverage, and increased counterparty and systemic risk). It is also important to keep in mind that when synthetic exposure through securities-related derivatives products is used to replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves, the markets for these derivatives directly and powerfully implicate the policy objectives for capital markets that Congress has set forth in the Federal securities laws, including investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. Given the impact on the regulated securities markets--and the arbitrage available to financial engineers seeking to avoid oversight and regulation--it is vital that the securities laws apply to securities-based swaps.Q.15. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.15. This is an interesting question. I believe policy makers should consider carefully whether/how the creation of these synthetics affect demand for the underlying securities. Traditionally, the view is that dealers and other financial intermediaries provide liquidity to the market and help make markets more efficient by reducing the extent to which asset prices are subject to excess volatility that may arise from short-term trading imbalances. The ability of liquidity providers to improve market quality is significantly enhanced when they are able to engage in activities that involve synthetic exposure. Constraints on the ability of intermediaries to provide liquidity increase the propensity for asset prices to deviate significantly from fundamental value. These deviations can lead to a misallocation of capital, and can be harmful to the investors. For example, investors are harmed when they buy an asset at a price that is temporarily inflated due to a demand shock.Q.16. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.16. On average, large debt issues tend to be more liquid than small ones because they tend to be held by a greater number of investors and there are more units available for trading. This does not mean, however, that an issuer would have the ability to improve the liquidity of its bond issue by issuing more debt. Market liquidity depends mainly on the ability and willingness of financial intermediaries to take on inventory positions in response to demand shocks.Q.17. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.17. The primary justifications I have seen for permitting the purchase of credit protection beyond an entity's ``exposure'' are (1) these participants provide liquidity to those who are themselves hedging; (2) a participant may use credit protection based on one reference asset to hedge risks on other related assets; and (3) investors may wish to take a position expressing a view that the market is underestimating the probability or severity of default.Q.18. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.18. The term ``swap'' generally refers to over-the-counter derivative instruments, a category that encompasses a wide range of products, including forward contracts, interest rate swaps, total return swaps, equity swaps, currency swaps, credit default swaps and OTC options, including both traditional and digital (or binary) options. In contrast, futures are a specific kind of standardized, exchange-traded derivative. Swaps may be tailored to address specific risks in ways not available with standardized products such as futures. For example, customized swaps involving foreign currency, interest rates, and hard commodities may play an important risk management role for companies and other end users because standardized contracts, in these circumstances, may not address the needs of a company with respect to the specific risks being hedged.Q.19. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.19. Commercial businesses will often individually customize OTC derivatives to meet the company's specific risk management needs. Companies may use OTC derivatives to manage fluctuations in materials prices, equity OTC contracts, commodities, fuel, interest rates and foreign currency. For example, a company that borrows money at a variable interest rate might enter into derivatives contracts to turn the borrowing into fixed-rate debt or as protection against swings in currencies or the price of commodities such as food and oil. The company can customize the contract to mature on a specific date or for a nonstandard notional amount, creating a more effective hedge. The inability to create perfect hedges can introduce basis risk. Basis risk can also occur when the asset being hedged is different from underlying asset of the derivative that is being used to hedge the exposure. Allowing firms to continue to bilaterally negotiate customized OTC derivatives contracts can help mitigate these risks. Standardizing OTC derivatives may increase costs in certain instances and decrease costs in others. Standardized derivatives, particularly those that are cleared through central counterparties, require the posting of cash or cash equivalent collateral. This is a cost not faced by financial firms when they enter into OTC derivatives contracts with other large financial firms. Conversely, standardizing OTC derivatives could result in tightening of the bid-ask spread of the instruments due to fewer individual terms that need to be negotiated between counterparties. This could potentially lower costs faced by purchasers and sellers of those contracts. Standardization could also lead to less effective hedges, but would allow a party to trade out of its position as opposed to negotiating a separate termination agreement. These termination agreements can be extremely expensive for the party seeking to exit customized deals.Q.20. On the second panel, Mr. Whalen suggests that Congress should subject all derivatives to the Commodity Exchange Act, at least as an interim step. Is there any reason we should not do so?A.20. To the extent that derivatives are securities-related, the securities laws should continue to apply. Without application of the securities laws, the derivatives market could be used to manipulate the securities market by circumventing securities laws protection against insider trading and improper short selling, among other things. Secretary Geithner recognized that multiple Federal regulatory agencies should play critical roles in implementing the proposed framework, including the SEC and the CFTC. In my testimony, I recommended that primary responsibility for ``securities-related'' OTC derivatives be retained by the SEC, which is also responsible for oversight of markets affected by this subset of OTC derivatives. Primary responsibility for all other OTC derivatives, including derivatives related to interest rates, foreign exchange, commodities, energy, and metals, could rest with the CFTC.Q.21. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.21. We agree that all derivatives trades should be reported. Information reported should include the identity of the contract traded, the size of the contract, the price, the parties to the contract (and which party was the buyer and which was the seller), and the time of trade. Additional analysis by appropriate regulators may identify other data elements that should be reported. Where a trade is reported depends on where it is traded. If a product is traded on a regulated exchange or an exchange-like facility (such as an alternative trading system), the details of the trade will be captured by the trading system. If a product is traded elsewhere, trades in that product should be reported to another regulated entity, such as a trade repository or self-regulatory organization. Entities to which trades are reported could disseminate information to the public individually. This approach would likely be the easiest to implement in the near term. However, it would mean that trading and reporting data would be fragmented, and it is unclear how easily or well it could be aggregated by private data vendors. Different entities could adopt different standards for trade reporting and dissemination (such as adopting different identification codes for the same derivatives contracts). Significant regulatory efforts could be necessary to promote uniform standards for these various entities to obtain the full benefits of post-trade reporting and transparency. One way to address these potential problems would be for the appropriate regulator to designate a central information processor to collect trade input from various sources and to disseminate trade information publicly in a uniform manner and subject to regulatory standards that ensure that access to the trade data is on terms that are fair and reasonable, and not unreasonably discriminatory. The SEC relies on and regulates such central information processors in the markets for cash equities, securities options, corporate debt securities, and municipal securities. We believe that these trade reporting and dissemination systems work very well and deliver a robust information stream in a timely and cost-efficient manner. As your question notes, some information that is reported may not be appropriate for public dissemination. One such item may be the names of the counterparties. The systems for cash equities, securities options, corporate debt securities, and municipal debt securities that are regulated by the SEC currently do not disseminate such information.Q.22. Is there anything else you would like to say for the record?A.22. I appreciate the opportunity to testify on this important topic and I look forward to working with the Committee to fill the gaps in regulation of OTC derivatives. These efforts are critical to furthering the integrity of the U.S. capital markets. ------ CHRG-111hhrg49968--14 Chairman Spratt," Has the Fed done any work to determine what the likely pool of savings available for borrowing may be--foreign markets, world markets, global credit markets--and to what extent we will have to borrow substantially from those savings pools, capital pools, in order to meet our debt requirements in the foreseeable future? " CHRG-110shrg50409--108 Mr. Bernanke," Well, that bond spread opened up last week. It has generally come in since Paulson announced these actions. I think that is very important, both because Fannie and Freddie obligations, both MBS and corporate debt, are held all over the world, including large amounts by banks, so that is very important. And, second, that determines their marginal cost of finance for mortgages, which ultimately we want to make sure that mortgages are available at a reasonable price. So the announcements have been generally good for the debt because of the sense that the Government is going to become involved in these agencies. The stock prices are also important because they affect the ability of Fannie and Freddie to raise capital. And I think at this point, there is probably a lot of uncertainty for shareholders as to exactly what is going to happen and to what extent that will affect the value of their shares. Senator Schumer. One final question. There has been a lot of talk now about somehow limiting short selling, particularly in financial companies, because of all the problems. Now, a while ago we had something called the uptick rule, which provided some measure of restraint on short sellers. When we changed from selling stocks from eighths to hundredths, an uptick of one one-hundredth does not mean much. But I have heard some ideas recently--I have been toying with it--of recommending that we go back to the uptick rule and say you don't need a one one-hundredth uptick, but you need 12 upticks, and you get back to the one-eighth. Do you have any thoughts, preliminary thoughts, on whether that would be a good idea and, in general, your view on short selling as it affects the markets here? " CHRG-111hhrg56766--342 Mr. Campbell," Thank you. Thank you, Chairman Bernanke. I am last and perhaps least as well. Two questions. One is the public sector, governments at all levels, currently represent, I believe, about 36 percent of GDP, which is a high since World War II. Governments at all levels are in some trouble. One could say they are overleveraged. You spoke earlier about the unsustainability of the current debt at the Federal level. My home State of California is obviously in deep fiscal trouble and has been for a long time, and so are many States and local communities. I have a concern about the public sector kind of being in a position that the private sector was in a few years ago, as being overleveraged, overextended, too much debt, too much spending, and actually the public sector being one of the drags and problems on the economy in the near future. Your thoughts on that? " CHRG-111hhrg53245--174 The Chairman," And I assume the rationale for that is that if you raise capital, reduce leverage, particularly in a kind of disproportionate way, you are making failure both less likely and less costly if it happens? " CHRG-110shrg50415--49 Mr. Levitt," Well, what derivatives essentially are, they represent leverage on leverage, having narrowed the margin of error. If you traded stocks or bonds or mortgages in the past, and a mistake was made, you had time to correct that mistake. With derivatives it is a millisecond. And the problem is that we are talking about trillions of dollars without a clearing facility to be able to tell us whether Customer A can complete a transaction with Customer B. And I dare say that a lot of these contracts without a clearinghouse simply do not have counterparties to account for them. We will find out more about that as the Lehman Brothers bankruptcy winds its way through the courts. The key issue here is a clearinghouse. The ultimate failure that we talk about in terms of systemic failure in the United States in my judgment is a clearance failure. We have clearinghouses with respect to stocks and bonds and options. It is unthinkable that we have yet to have a clearing facility for these derivatives. " CHRG-110shrg50417--52 Mr. Campbell," Quickly, as it relates to the senior debt guarantees, we are still in an evaluation phase, and so I am not in a position to answer that. But we would be happy to get back to you on that. As it relates to the commercial paper guarantee, it clearly made a very positive difference in the marketplace. There were numbers of companies who had depended upon that market for many years for liquidity that were frozen out. That market has---- " CHRG-109hhrg22160--242 Mr. Greenspan," I said that because of the difficulty of making judgments as to how markets would behave when you are moving funds out of the U.S. treasury into a private account, even though it is forced savings--meaning, you can't do anything with it--and from a technical point you have not changed the national savings rate, have not changed the balance of supply and demand of securities, and have not therefore presumably affected the price level of bonds, there is still the issue of how that is perceived by the marketplace, which is not all that easy to make a judgment on. My general concern is that if we knew for sure that the contingent liabilities that now exist are viewed in the private marketplace as similar to the real debt of the federal government, then technically moving funds in a carve-out of the way that the President is talking about would have no effect on interest rates, no effect, indeed, which would then be an accounting system which would be based on accrued receipts. The problem is caused by the fact that we are running unified budget---- Mr. Moore of Kansas. Moving aside from the interest rates concern right now, which I understand is a huge concern, if we were to borrow $2 trillion or $1 trillion right now--and I am saying right now, over the next several years--to finance these partially private accounts and divert money out of present retirement benefits being paid to Social Security recipients, wouldn't that just pass a debt along to our children and grandchildren? And is that fair? " CHRG-111hhrg55809--11 Mr. Garrett," I thank the chairman for holding this hearing, and I welcome Chairman Bernanke back again to the committee. I note in the Chairman's testimony you continue to advocate that the Federal Reserve should be given authority for consolidated oversight for all ``systemically important financial institutions.'' And, quite candidly, I do have a number of concerns about this proposal, many that I have expressed before. Among them, first of all, specifically designating institutions as systemically critical leads to unfair competitive agendas, disadvantages, increased moral hazard, and makes it more likely such institutions will be considered ``too-big-to-fail.'' Secondly, the Federal Reserve already has consolidated supervision over many of the large bank holding companies, including Citi and Bank of America, which the Federal Government has pumped billions of dollars into due to the fact that such consolidated supervision apparently failed in the past. Furthermore, Fed policy itself--that is, keeping interest rates too low for too long, primarily before you were here--was one of the major factors leading to this crisis. I am not alone in my concerns about the Fed as a systemic regulator. There seems to be a universal distaste for the Fed in such a role on the Senate Banking Committee. Such a political reality would seem to make it less likely that the House would confer such new powers on the Fed either. And as has been stated previously, rather than give the Fed additional powers, Republicans on the committee have proposed as part of a reform plan that the powers of the Fed be focused primarily on monetary policy and others be reduced. So preventing future taxpayer-funded bailouts is a primary aim of the GOP plan and is also the primary aim of a piece of legislation I plan to introduce later today that will call for raising the minimum downpayment for the FHA loans as well as a study to examine what is an appropriate leverage ratio for the FHA. There have been increasing reports of a likely necessity of a taxpayer-funded bailout for the FHA, and this legislation aims to implement-- " CHRG-111hhrg51698--474 The Chairman," No, I am not saying unlimited, but I am saying it allowed them to leverage themselves further than they would have been able to otherwise. " CHRG-111shrg62643--32 Mr. Bernanke," Uncertainty and other factors. In other cases, the firm might like to expand, but its collateral value has declined and it is financially weaker and it is no longer viewed as being creditworthy at the current credit standards. So there are certainly a number of reasons why the demand for credit or the attractiveness of some borrowers has declined in this recession. At the same time, we want to be sure that every creditworthy small business or borrower is able to obtain credit, and while there are many issues to look at as regulators, one that we are particularly concerned about is that bank regulators might somehow be putting the thumb on the scale on the wrong side and being excessively cautious about not letting banks issue what are even marginally risky loans and not taking into account the importance to our economy that creditworthy borrowers receive credit. And so much of our effort has been focused on instructing and training our examiners to take a balanced approach, where they both are taking appropriate caution, but also making sure that creditworthy borrowers can get credit. Senator Shelby. My time is running and has run. GSE debt reform--do you believe that the debt of Fannie and Freddie is backed by the full faith and credit of the United States of America? " FinancialCrisisReport--5 WaMu also originated an increasing number of its flagship product, Option Adjustable Rate Mortgages (Option ARMs), which created high risk, negatively amortizing mortgages and, from 2003 to 2007, represented as much as half of all of WaMu’s loan originations. In 2006 alone, Washington Mutual originated more than $42.6 billion in Option ARM loans and sold or securitized at least $115 billion to investors, including sales to the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). In addition, WaMu greatly increased its origination and securitization of high risk home equity loan products. By 2007, home equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase from 2003. 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 produced billions of dollars in high risk, poor quality mortgages and mortgage backed securities. Those practices included qualifying high risk borrowers for larger loans than they could afford; steering borrowers from conventional mortgages to higher risk loan products; accepting loan applications without verifying the borrower’s income; using loans with low, short term “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 own 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. As a result, WaMu, and particularly its Long Beach subsidiary, became known by industry insiders for its failed mortgages and poorly performing residential mortgage backed securities (RMBS). Among sophisticated investors, its securitizations were understood to be some of the worst performing in the marketplace. Inside the bank, WaMu’s President Steve Rotella 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 was provided with compelling evidence of deficient lending practices in internal emails, audit reports, and reviews. Internal reviews of two high volume WaMu loan centers, for example, described “extensive fraud” by employees who “willfully” circumvented bank policies. A WaMu review of internal controls to stop fraudulent loans from being sold to investors described them as “ineffective.” On at least one occasion, senior managers knowingly sold delinquency-prone loans to investors. Aside from Long Beach, WaMu’s President described WaMu’s prime home loan business as the “worst managed business” he had seen in his career. CHRG-110shrg46629--27 Chairman Dodd," That is right. Senator Shelby. So, I will move on to some other things. Subprime problems. The subprime problems are real, not just in New Jersey and Ohio but in Alabama and everywhere else. There has been a huge expansion, Mr. Chairman, as you know, of structured financial products. We call what, collateralized debt obligations backed by subprime debt. In concept these projects involve converting highly risky loans, as I understand it, into a collection of securities that have a range of risk from AAA to junk. The rating agencies provide the AAA ratings based on the idea that the structure of the products satisfactorily dissipates or spreads the risks associated with the underlying prime loan. That is the basis of that. But it appears that is not always working. It appears that many of the assumptions here regarding these structured products, collateralized, have significantly underestimated the true risk. We have seen what the rating agencies, it has been talked about, at least Senator Menendez and also Senator Brown brought it up. We have seen S&P--and I believe Senator Reed. We have seen S&P and Moody's already downgrading the debt that they invited as AAA. How did they get to the point to rate a lot of these collateralized obligations AAA grade with so much underlying junk you might say? You cannot make gold out of lead. We know that. That has been tried. Does all of this deeply concern you, how this came about to begin with? Because I think the subprime not only has deep repercussions when a lot of people, our constituents that have been victimized I think to some extent by this. But a lot of it has been brought about by very ingenious financial people. And then looks like the rating agencies fell right in line with them, knowing that this is not really AAA stuff. This is questionable stuff. Now it is coming home to roost. And, as someone else said earlier here, a lot of those loans are going to be reset not downward but upward. Senator Dodd is very much out front on this, and should be as the Chairman of this Committee. And we are deeply concerned that the subprime problem is not going to just be contained so easily but could deeply spread and have some repercussions out there. What do you think? " 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-111hhrg52400--147 Chairman Kanjorski," The gentlelady from New York, Ms. McCarthy. Mrs. McCarthy of New York. Thank you, Mr. Chairman. I appreciate it. I think many of my colleagues have said that this has actually been a very interesting journey that many of us have taken on this committee over the last several months. But, Mr. Baird, I wanted to ask you, as an alternative to Federal regulations, some have recommended moving to Federal minimum standards that would enforce by the current State insurance regulatory structure. Would that solve the regulatory burden in areas such as licensing, market conduct, and speed to market? If not, please explain why. " CHRG-111hhrg56776--86 Mr. Volcker," Let me make a general point. We have a lot of discussion about supervision and gaps and supervisory policies. Supervision is a tough job. You are dealing with a very complex situation with some known and some unknown factors in a political world where your tools are limited and you have to be able to explain what you are doing, which is very hard to take restrictive rules when things are going well. Do not put more burdens on the supervisors than are necessary. If there are some structural factors in the market that you want to promote or eliminate, do it by legislation and do not leave everything up to the supervisor, or give the supervisor a very clear framework within which to work. The more you do that, I think the better off we will be in terms of supervision. " FinancialCrisisInquiry--491 BASS: Sure. Gosh, I don’t even know where to start with that question. Number one, you should never be 95 times levered, right? When you talk about what they did and management and competence or gross incompetence, they were pushed, as you know, by the fair housing authorities. They were pushed by Congress. They were—again, you can’t—you can’t allay blame to any one person in that situation. I just think you need to look at all the participants. But when you look at Fannie and Freddie particularly, that’s $5.5 trillion of liabilities, OK? To put that into perspective, the mortgage market, at the end of ‘07, was about $10 trillion prime, $1.2 trillion subprime, $1.5 trillion Alt-A. Five and a half trillion dollars is almost as many bonds as exist from the U.S. government—well, not any more, you know, but it’s close to $7 trillion or $8 trillion, right now, growing about $1.5 trillion a year. But I think, when you—when you’re talking about prioritizing what to look at, clearly, they’re the biggest by a mile, right—or 50 miles. So when you look at Fannie and Freddie and what happened, you know, they still sit in this gray area today. And taxpayer money’s at risk. And to put it into perspective, you know, the S&L crisis that was so enormous—the FDIC concluded that that cost taxpayers $124 billion. We’ve already given Fannie and Freddie $183 billion alone, and we’ve opened the spigots, as of Christmas Eve, for as much capital as they need. We at Hayman think they’ll lose $375 billion or more in the crisis. So the interesting thing is, why is the taxpayer on the hook with Fannie and Freddie when Fannie’s cap structure today has $890 billion in it. It has $55 billion of equity and it has the rest in preferreds and debt. Why don’t we force the losses on some of these debt holders? January 13, 2010 Why is the taxpayer taking a penny of a loss if in fact the losses are going to be a couple hundred billion a piece? I don’t understand. CHRG-111shrg51395--14 Mr. Coffee," Well, good morning, and thank you, Chairman Dodd, Ranking Member Shelby, and fellow Senators. I have prepared an overly long, bulky, 70-page memorandum for which I apologize for inflicting on you. It attempts to synthesize a good deal of recent empirical research by business school scholars, finance scholars, and even law professors, about just what went wrong and what can be done about it. I cannot summarize all that, but I would add the following two sentences to what Senators Dodd and Shelby very accurately said at the outset. The current financial crisis is unlike others. This was not a bubble caused by investor mania, which is the typical cause of bubbles. It was not a demand-driven bubble; rather, it was more a supply driven bubble. It was the product of a particular business model, a model known as the ``originate-and-distribute model,'' under which financial institutions, including loan originators, mortgage lenders, and investment banks, all behaved similarly and went to the brink of insolvency and beyond, pursuing a model. What is the key element of this originate-and-distribute model? You make lax loans. You make non-creditworthy loans because--because you do not expect to hold those loans for long enough to matter. You believe that you can transfer these loans to the next link in the transmission chain before you will bear the economic risk. When everyone believes that--and they correctly believed that for a few years--then all standards begin to become relaxed, and we believe that as long as we can get that investment grade rating from the credit rating agencies, we will have no problem, and weak loans can always be marketed. There is no time for statistics here, but let me add just one. Between 2001 and 2006, a relatively short period, some of the data that I cite shows you that low-document loans in these portfolios went from being something like 28 percent in mortgage-backed securities in 2001 to 51 percent in 2006--doubling in 4 or 5 years. Investment banks and credit rating agencies are not responding to that change. That is the essential problem. This gives rise to what I will call and economists call a ``moral hazard problem,'' and this moral hazard problem was compounded by deregulatory policies that the SEC and other institutions followed that permitted investment banks to increase their leverage dramatically between 2004 and 2006, which is only just a few years ago. This is yesterday we are talking about. They did this pursuant to the Consolidated Supervised Entity Program that you have already been discussing, and it led to the downfall of our five largest, most important investment banks. All right. Essentially, the SEC deferred to self-regulation, by which these five largest banks constructed their own credit risk models, and the SEC deferred to them. The 2008 experience shows, if there ever was any doubt, that in an environment of intense competition and under the pressure of equity-based executive compensation systems that tend to be very short-term oriented, self-regulation alone simply does not work. The simplest way for a financial institution to increase profitability was to increase its leverage, and it did so to the point where they were leveraged to the eyeballs and could not survive the predictable downturn in the economic weather. So what should be done from a policy perspective? Well, here is my first and most essential point: All financial institutions that are too big to fail, which really means too entangled to fail, need to be subjected to prudential financial oversight, what I would call ``financial adult supervision,'' from a common regulator applying a basically common although risk-adjusted standard to all these institutions, whether they are insurance companies, banks, thrifts, hedge funds, money market funds, or even pension plans, or the financial subsidiaries of very large corporations, like GE Capital. In my judgment, this can only be done by the Federal Reserve Board. That is the only person in a position to serve as what is called the ``systemic risk regulator.'' I think we need in this country a systemic risk regulator, and specifically to define what this means, let me say there are five areas where their authority should be established. The Federal Reserve Board should be authorized and mandated to do the following five things: One, establish ceilings on debt-to-equity ratios and otherwise restrict leverage for all major financial institutions. Two, supervise and restrict the design and trading of new financial products, including, in particular, over-the-counter derivatives and including the posting of margin and collateral for such products. Three, mandate the use of clearinghouses. The Federal Reserve has already been doing this, formulating this, trying to facilitate this, but mandating it is more important. And they need the authority to supervise these clearing houses, and also if they judge it to be wise and prudent, to require their consolidation into a single clearinghouse. Four, the Federal Reserve needs the authority to require the writedown of risky assets by financial institutions, regardless of whether accounting rules mandate it. The accountants will always be the last to demand a writedown because their clients do not want it. The regulator is going to have to be more proactive than are the accounting firms. Last, the Federal Reserve should be authorized to prevent liquidity crises that come from the mismatch of assets and liabilities. The simple truth is that financial institutions hold long-term illiquid assets which they finance through short-term paper that they have to roll over regularly, and that mismatch regularly causes problems. Now, under this ``Twin Peaks'' model that I am describing, the systematic risk regulator--presumably, the Federal Reserve--would have broad authority. But the power should not be given to the Federal Reserve to override the consumer protection and transparency policies of the SEC. And this is a co-equal point with my first point, that we need a systemic risk regulator. Too often, bank regulators and banks have engaged in what I would term a ``conspiracy of silence'' to hide problems, lest investors find out, become alarmed, and create a run on the bank. The culture of banking regulators and the culture of securities regulators is entirely different. Bank regulators do not want to alarm investors. Securities regulators understand that sunlight is the best disinfectant. And for the long run, just as Senator Shelby said, we need accounting policies that reveal the ugly truth. We could not be worse off now in terms of lack of public confidence. This is precisely the moment to make everyone recognize what the truth is and not to give any regulator the authority to suppress the truth under the guise of systematic risk regulation. For that reason, I think SEC responsibilities for disclosure, transparency, and accounting should be specially spelled out and exempted from any power that the systematic risk regulator has to overrule other policies. Now, two last points. As a financial technology, asset-based securitization, at least in the real estate field, has decisively failed. I think two steps should be done by legislation to mandate the one policies that I think will restore credibility to this field. First, to restore credibility, sponsors must abandon the originate-and-distribute business model and instead commit to retain at least a portion of the most subordinated tranche, the riskiest assets. Some of them have to be held by the promoter because that is the one signal of commitment that tells the marketplace that someone has investigated these assets because they are holding the weakest, most likely to fail. That would be step one. Step two, we need to reintroduce due diligence into the process, into the securitization process, both for public offerings and for Rule 144A offerings, which are private offerings. Right now Regulation AB deregulated; it does not really require adequately that the sponsor verify the loans, have the loan documentation in its possession, or to have examined the creditworthiness of the individual securities. I think the SEC can be instructed by Congress that there needs to be a reintroduction of stronger due diligence into both the public and the private placement process. Last point. Credit rating agencies are obviously the gatekeeper who failed most in this current crisis. The one thing they do not do that other gatekeepers do do is verify the information they are relying on. Their have their rating methodology, but they just assume what they are told; they do not verify it. I think they should be instructed that there has to be verification either by them or by responsible, independent professionals who certify their results to them. The only way to make that system work and to give it teeth is to reframe a special standard of liability for the credit rating agencies. I believe the Congress can do this, and I believe that Senator Reed and his staff are already examining closely the need for additional legislation for credit rating agencies, and I think they are very much on the right track, and I would encourage them. What I am saying, in closing, is that a very painful period of deleveraging is necessary. No one is going to like it. I think some responsibility should be given to the Federal Reserve as the overall systematic risk regulator, but they should not have authority to in any way overrule the SEC's policies on transparency. Thank you. " CHRG-110shrg50420--266 Mr. Nardelli," Sir, as you said, Congress has the authority to do a lot of things, so if that is what Congress determines, then obviously all of the constituents would be held under that. I am not burdened of being a lawyer, and so I do not know the technical answer to it. But certainly if that is a prerequisite and if that is the understanding, Chrysler would certainly obviously try to comply. Senator Crapo. In that context, an argument that each of you have made--and many others--is that people will not buy cars if any one or all of the Big Three are in a bankruptcy proceeding. They will not buy a car from a company in bankruptcy. But if we were, in essence, to create an oversight board that was basically a Federal restructuring trustee, would that impact the confidence level in your ability to meet your assumptions about people being willing to come back and purchase cars? " fcic_final_report_full--154 Starting in , AIG Financial Products, a Connecticut-based unit with major op- erations in London, figured out a new way to make money from those ratings. Relying on the guarantee of its parent, AIG, AIG Financial Products became a major over-the- counter derivatives dealer, eventually having a portfolio of . trillion in notional amount. Among other derivatives activities, the unit issued credit default swaps guar- anteeing debt obligations held by financial institutions and other investors. In exchange for a stream of premium-like payments, AIG Financial Products agreed to reimburse the investor in such a debt obligation in the event of any default. The credit default swap (CDS) is often compared to insurance, but when an insurance company sells a policy, regulations require that it set aside a reserve in case of a loss. Because credit de- fault swaps were not regulated insurance contracts, no such requirement was applica- ble. In this case, the unit predicted with . confidence that there would be no realized economic loss on the supposedly safest portions of the CDOs on which they wrote CDS protection, and failed to make any provisions whatsoever for declines in value—or unrealized losses—a decision that would prove fatal to AIG in .  AIG Financial Products had a huge business selling CDS to European banks on a variety of financial assets, including bonds, mortgage-backed securities, CDOs, and other debt securities. For AIG, the fee for selling protection via the swap appeared well worth the risk. For the banks purchasing protection, the swap enabled them to neutralize the credit risk and thereby hold less capital against its assets. Purchasing credit default swaps from AIG could reduce the amount of regulatory capital that the bank needed to hold against an asset from  to ..  By , AIG had written  billion in CDS for such regulatory capital benefits; most were with European banks for a variety of asset types. That total would rise to  billion by .  The same advantages could be enjoyed by banks in the United States, where regu- lators had introduced similar capital standards for banks’ holdings of mortgage- backed securities and other investments under the Recourse Rule in . So a credit default swap with AIG could also lower American banks’ capital requirements. In  and , AIG sold protection on super-senior CDO tranches valued at  billion, up from just  billion in .  In an interview with the FCIC, one AIG executive described AIG Financial Products’ principal swap salesman, Alan Frost, as “the golden goose for the entire Street.”  AIG’s biggest customer in this business was always Goldman Sachs, consistently a leading CDO underwriter. AIG also wrote billions of dollars of protection for Merrill Lynch, Société Générale, and other firms. AIG “looked like the perfect customer for this,” Craig Broderick, Goldman’s chief risk officer, told the FCIC. “They really ticked all the boxes. They were among the highest-rated [corporations] around. They had what appeared to be unquestioned expertise. They had tremendous financial strength. They had huge, appropriate interest in this space, backed by a long history of trading in it.”  CHRG-111hhrg54868--205 Mr. Bowman," Congresswoman, your question is exactly the kind of questions we are posing to our Minority Depository Institution Advisory Committee, asking them for some additional insight and ideas that might help other minority depository institutions going forward. And we would be happy to share the results of some of those discussions with you if you would like. Ms. Waters. Okay. I was just--my staff who works on this just passed me a note about the Temporary Liquidity Program. That is under what, FDIC? Ms. Bair. Yes, that is a debt guarantee program and a transaction account guarantee program. Ms. Waters. Would you explain to me how you use this program to guarantee debt? As I understand it, the banks sell debt and raise capital. How does the program work? Ms. Bair. We are winding it down actually. It is scheduled to expire October 31st. This is an emergency program we put in place early last October after the Lehman situation when the market was seizing up. It allowed most bank holding companies and thrift holding companies, for a temporary time period to issue debt, unsecured debt, that was guaranteed by the FDIC for a fee. We have collected over $9 billion so far from charging our guarantee fee. We have had no losses on the debt program. Also, as part of that, we added a transaction account guarantee. This was particularly helpful for the smaller banks. This enables participating banks to cover noninterest-bearing transaction accounts with unlimited deposit insurance--insurance without caps. That program will go to June 30th. Ms. Waters. Should it be extended? Ms. Bair. We have extended it until June 30th of next year. It is Congress' call if it should go beyond that. Congress sets our deposit insurance limits. This is something we did under a very extraordinary systemic risk procedure, which I am advised that we don't have the authority to make permanent. But we have extended it to June 30th of next year, and hopefully we will be stabilized by then. Ms. Waters. Is this something we should explore for assistance to the small and minority-owned banks between now and June 30th? Ms. Bair. They have until June 30th of next year. It would be an open question whether they would feel there was a need after that. It does cost; obviously we charge a premium for it, because there are losses associated with that particular program. But, again, our deposit insurance limits typically are defined by Congress. We did this in an extraordinary process. So it really would be Congress' call whether the program should be extended beyond June 30th. A lot of banks are feeling that they will be able to exit it and will not need it after that. Ms. Waters. Let me just close by saying I know that you have had a number of seminars around the country. I understand there was one in Irvine, California, and that you have a database of minority-owned banks that invited small banks--that was invited to that conference? Ms. Bair. Yes. Ms. Waters. We were not aware of it, and some of our small banks were not aware of it. I would like to--at some point in time, would each of you perhaps meet to talk about how we can perhaps share some information? And I would like to know more about how your programs work under FIRREA in particular, who the people are, how the programs are executed. And perhaps I can visit your institutions and you can have me talk with your people. They can talk with me about how they do this, and how it all works, and perhaps we can see how we can use some of our experiences to advise you about some possibilities for being more effective with FIRREA and other programs that are not necessarily under FIRREA. With that, thank you very much. The Chair notes that some members may have additional questions for this panel which they may wish to submit in writing. Without objection, the hearing record will remain open for 30 days for members to submit written questions to these witnesses and to place their responses in the record. With that, this hearing is adjourned. Thank you very much. [Whereupon, at 5:31 p.m., the hearing was adjourned.] FOMC20061212meeting--98 96,MR. WARSH.," Thank you, Mr. Chairman. Let me confine my remarks to a couple of discussions of the economy that bolster the themes that several of you have noted. At the outset, I’ll say that I continue to be more concerned with the level of inflation and our progress regarding it than I am with growth. The economy appears to be on track, and I think, unlike the Greenbook projections, that there’s a prospect for some upside surprises on growth. So let me spend a few moments looking at the labor markets, the corporate profit markets, household balance sheets, and consumer spending before coming back to the capital markets a little more broadly. First, on the labor market side, as has been noted previously, we continue to have surprisingly strong job gains, particularly at this point in the cycle. The trend on revisions, regardless of the data series, tends to be continuing upward. The labor markets continue to accept new workers into the labor force more smoothly, with the participation rate the highest since 2003, which suggests a dynamism in that market. Hiring plans of small businesses have moved to their highest level in nearly two years and tend to be a pretty good forward-looking indicator, perhaps a better indicator than large companies. In light of all that, I think the Greenbook rightly acknowledges that the household survey may imply even greater strength than the payroll data suggest. Second, turning to the profits picture, there continue to be remarkable profits for the S&P, the Dow, and the broader markets, predicated on strong cash flows and record profit margins. Broad-based NIPA profits are up 30 percent pre-tax for the third quarter. S&P delivered 20 percent profit gains in the third quarter. I think the trend there is particularly telling. That is, estimates by earnings analysts continue to surprise on the upside. As we move through the quarter, those bottom-up estimates continue to track very, very positively. I think that’s probably a good indication of why we’ve seen equity prices increase. When we look at where estimates are for the fourth quarter, bottom-up estimates for the S&P 500 are at about 9.1 percent. For 2007, year-over-year increases of about 9.3 percent are expected. These numbers are very strong, but they are significantly down from the high double-digit numbers that we’ve seen over the past couple of quarters. My own sense is that continues to suggest good news for the equity markets and good news for corporate profits. I expect that equity prices will outperform over the next couple of months if the numbers move up from 9 percent into the double digits. If that trend is reversed and we see disappointing corporate earnings, we could see a pretty rapid pullback in the equity markets, with some implications for the broader economy. I mention this discussion of profits and recognize that, though there is some correlation between corporate profits and the broader economy, we are continuing to see a disproportionate share of total income coming from this sector. So it’s a sector that we need to continue to evaluate. Third, turning to household balance sheets, net worth grew $3½ trillion over the past four quarters, as the Fed’s flow of funds data suggest. Assets are growing faster than liabilities, whether we include or exclude housing, if we look at just the past four quarters. Continuing remarkable levels of household and corporate liquidity continue to suggest very good news. Although in these data we do see growth of household debt relative to income, this is a trend over the past twenty-five years, and I don’t really note anything overly disturbing there. So when we look at those three measures—labor, profits, and balance sheets—I come to a pretty encouraging conclusion in terms of an underlying sturdiness to the economy, particularly in regard to individual consumption. Let me turn to consumption, with a bit of a short-term focus here on the fourth quarter. I think the Greenbook suggested anecdotally that November might turn out to be a little softer than October and a little softer than expectations. My own sense is that some real upside surprises are there. I had discussions with contacts and reviewed data from two large credit card companies, which in total represent about 35 percent of all of consumer buying over this period. This real- time information ends in November and looks across demographics. It excludes subprime lenders: The only subprime folks in these two portfolios are those who began in the primary market and found their way into the subprime market. So I recognize that we are missing an important piece. However, when you look at consumer spending for November, you see little to no deterioration in credit quality—credit is still incredibly strong across regions and income groups. I pushed each of the two companies to find areas of weakness, and they found this exercise to be pretty tough. Their own internal credit measures have not shifted. They had built in some softening in November and December Christmas spending, which they have not seen. They continue to see a huge reservoir of untapped credit, and they do see some de-leveraging by folks in key consumer groups, which they think suggests that consumers are in very good shape. The consumer spending trend from these two contacts continues to be very positive. They expected to see growth in November on the order of 4 percent; they saw growth of 5½ and 6 percent. Though it’s too early to call this Christmas season a success, they are much more positive than they were before November began, in terms of both dollar purchases and transaction swipes. So my own sense is that the consumer appears to be quite strong. Having now listed four areas that I think have rather remarkable strength, I want to spend a moment on another topic that has been discussed around this table, which is manufacturing. As we look at the manufacturing base and we try to evaluate how we will know which inflection point the economy turns on, the manufacturing data are likely to be quite telling. I’ve been surprised and disappointed by poor manufacturing ISM (Institute for Supply Management) data and other weak data, and I’ve asked myself whether the weakness shows some spreading beyond autos and housing, which we’ve all discussed for some time. When I look behind those data, I am comfortable that much of the weakness that we see in manufacturing really is consistent with that theme—that is, second-order and third-order suppliers into the auto and housing sectors. Other weakness does appear to be related to certain machinery and equipment, but I have seen that weakness more in the data than in the anecdotes. As President Minehan suggested, I think that these data end up being somewhat weak, but the weakness is transitory. The share prices of most of these large multinational manufacturing companies continue to outperform. The tone that these companies have when they’re meeting with their analysts continues to be quite positive, so this signal may well be false, but we have to focus a bit more on it. By the time we meet in the first quarter we’ll have a better sense of whether the manufacturing base, in terms of volume and productivity, is giving us any indication of what’s happening in the broader economy. Let me turn, finally, to the capital markets. Capital markets, as has been mentioned around this table, continue to function well. The Board staff has rightly observed that long-term forward corporate credit spreads are widening somewhat, showing that these markets, while awash in liquidity, are responding to price signals and are starting to focus increasingly on credit. In a couple of instances, issuers that tried to come to market, both in Europe and in the United States, were beaten back, which was, frankly, good news from the perspective of market discipline. The securities that they were trying to issue were PIK notes. These are paid-in-kind securities by which the company can pay off the investors either in cash or through additional paper, and the pool of liquidity for such notes is not so deep. That kind of discipline in the markets should encourage us. Having said that, I consider the debt capital markets to be incredibly robust. I talked previously about remarkable pipelines that were at record levels. They have all now priced at significantly beneficial terms. In November, as I think Dino noted, high-yield corporate issuances were at a record. The leveraged-loan market was also at a record, and we found instances in which issuers obtained better terms by issuing in larger volumes. That tells us that some people in the investor base really want to get their full allocations. If they can get their allocations, they’re willing to pay a premium for doing so. The backlogs priced remarkably well, and I think those markets are functioning well. Let me enter the discussion about trying to reconcile the bond markets and the equity markets by making four points. First, the leveraged buyout data that Dino discussed are one explanation. That is, you don’t need to have a leveraged buyout of a vast majority or of even a significant number of companies in the S&P for those values to find their way into the markets. My view is that an LBO floor valuation now exists across more sectors than we could have anticipated before—into technology, for example—and companies that, because of their size, were previously out of reach for the private equity players. Part of the growth that we’ve seen in the equity markets has occurred because the LBO prices that could theoretically be paid, with balance sheets that are probably much less conservative, have raised the prices that are paid in the capital markets for these same companies. Second, the difference between the equity and the bond markets is about earnings growth and not multiples growth. On a price-to-earnings basis, the suggestion is that earnings in 2007 will be up something like 9 percent over this year, and the price-earnings multiples don’t look out of whack. You end up with earnings that, if they are delivered for another year or two, don’t make these companies look all that expensive. Third, in reconciling these markets, I’d suggest that the difference is really about us. The markets think that, if the trajectory for the economy softens significantly, the Fed will be responsive to it, notwithstanding what we’re saying currently—that dependence on the data means that we will be agile and we won’t be stuck in our words of yesterday in judging the economy that’s forthcoming. So they believe that we will effectively lower rates to achieve a very soft but successful landing. Finally, expectations are built into the bond markets that rate cuts are ahead. The discount rate in evaluating cash flows for these companies obviously comes down as well, further bolstering their value. So I suspect that these markets are perhaps a bit more consistent than some market prognosticators would say. But we must continue to evaluate them over the next several weeks and months. Thank you, Mr. Chairman." CHRG-110hhrg46595--520 Mr. Altman," I wouldn't recommend that. It is much better. And I think GM has a good plan in that respect to write down the debt. $30 billion, I think, was in their plan to reduce it; and I think that makes sense. But I ran it through my model, and they still come up a bankrupt entity even after doing that. " CHRG-109hhrg28024--191 Mr. Ford," Let me ask you this. You've mentioned the deficit, then, and so forth, so in light of what Mr. Moore said, would that mean--I don't want to put words in your mouth, but we're going to probably have a vote here soon on raising the debt ceiling. Is that something Congress should do? " CHRG-111hhrg56776--142 Mr. Garrett," Thank you, Mr. Chairman. Thank you, both of you Chairmen. A quick question off point in all this. I have a bill in that deals with the GSEs, that suggested the GSEs should be on budget by the OMB, the same way the CBO does it. So, a quick question to you is, do the GSE's obligations--are they sovereign debt? " CHRG-111hhrg53244--284 Mr. Adler," Would you agree that cost containment concept applies not just but in health care context but in the overall government spending context, that we have to at some point level off our amount of Federal spending to manage our Federal debt and not have it balloon beyond what we can sustain? " CHRG-110hhrg34673--222 Mr. Perlmutter," Well, yours has been remarkable, Mr. Chairman. Thank you. On page 2 of your report, you say that consumer spending continues to be the mainstay of the current economic expansion. Where are we on consumer debt? I mean, have you seen a trend in that, and can you tell me where we are? " CHRG-110shrg50415--99 Mr. Rokakis," Senator Casey touched on it, and I think it is so important, and we are going to look to you for leadership on this. We are being told now that we do not know what this format will look like when these mortgages get bought back, but we are being led to believe--we have been told that we cannot expect any additional leveraging or negotiating power once the Government steps in and buys these mortgages back because of the complex way in which these mortgages were held and sliced and because of the trust agreements in place and need to get cooperation from all the other bondholders. And I just have to ask you, if I could, Mr. Chairman, to please look more closely at this, because what Senator Casey has said is, in fact, true. We are getting a sense that the negotiations, which are so difficult--difficult? I run a program. We have done 4,000 mortgage saves since March of 2006. It is difficult as it is. It is often hand to hand combat. But the fact that we will have no additional leverage once these mortgages are purchased makes us very concerned. " CHRG-110shrg50414--264 Secretary Paulson," I would say we will design the process that has as many protections around this as possible to bring in experts, and we will have the proper oversight. Senator, that is how we are going to work through this. Senator Dole. Publicly, you have stated that the long-term fate of Fannie and Freddie rests with the subsequent Congress and next administration. In addition, you have expressed that these GSEs are a relic of the past and burdened by various conflicts of interest. Given this, before leaving in January, will this administration commit to releasing its own recommendations as to what it believes should be the Federal Government's role in supporting the U.S. mortgage market? " CHRG-111hhrg56766--33 Mr. Bernanke," Congressman, as to sustainability, you are talking about the medium-term structural deficit that remains even after the economy is returned close to more normal levels of activity, estimates of the structural deficit range from 4 percent by the OMB to up to 7 percent of GDP in some scenarios run by the CBO. Those numbers are above a sustainable level. I think in order to maintain a stable ratio of debt to GDP, you need to have a deficit that is 2\1/2\ to 3 percent, at the most. I think yes, under current projections, we have a deficit and a debt that will continue to grow, interest rate costs will continue to grow. I do think it is very important that we begin to look at the path, the projectory of the deficit as it goes forward, and there could be a bonus there to the extent that we can achieve creditable plans to reduce medium- to long-term deficits, we will actually have more flexibility in the short term if we want to take other kinds of actions. " CHRG-110shrg50414--202 Secretary Paulson," I would say the reason we want flexibility to, if we need to, buy some other classes of assets would be that if the banks--if capital starts to--as capital flows more freely, it will help the housing, because the fact that the financial system is gummed up and there is illiquidity hurts it and it may be that to deal with---- Senator Bunning. Student loans and then credit card debt are messing up the housing? " FOMC20081216meeting--34 32,MR. DUDLEY.," Well, there were certain leveraged utility companies that you could argue were pretty junky. " FOMC20081216meeting--443 441,MR. DUDLEY., The demand is low for these securities today. It is low because of lack of leverage. FOMC20051101meeting--16 14,CHAIRMAN GREENSPAN.," Okay. Thank you. On page 2 in the upper left-hand chart, I notice that the relationship among these sovereign debt yields, which we’ve been looking at for a long time, have gradually morphed from fairly low correlation to extremely high correlation. Do we have any rolling correlation coefficients that suggest when that happened and the presumptive hypotheses as to why? Are we looking at the same issues that I inadvertently called a conundrum early this year? Or is this going back well before then?" 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-109hhrg22160--142 Mr. Garrett," Then I feel good, that we are on the same--at least on that aspect we are on the same level. The question with regard to GSEs was brought a little earlier ago by the Chairman. And just three quick areas that if you could touch on. You began to touch on the aspect, as far as the problems, as far as the almost trillion dollars in outstanding debt, and you basically focused your talk at that point as far as the regulatory aspect and the need for caps and the regulation aspect of it. Could you, first of all, maybe just elaborate a little bit on the aspect of if we do nothing on that area what the impact is on the overall market and the economy? " CHRG-111hhrg52406--39 Mr. Yingling," Thank you, Mr. Chairman, Mr. Bachus, and members of the committee for inviting me to testify on behalf of the banking industry. Members of this committee are looking at this consumer agency proposal from the point of view of consumers, who should be paramount in your deliberations, but today I would also ask you to take a look at this issue from an additional point as well. While banks of all sizes would be negatively impacted, please think of your own local community banks. These banks never made one subprime loan, and they have the trust of their local consumers. As this committee has frequently noted, these community banks are already overwhelmed with regulatory costs that are slowly but surely strangling them. Yet last week, these community banks found the Administration proposing a potentially massive new regulatory burden. While the shadow banking industry, which includes those most responsible for the crisis, is covered by the new agency, their regulatory and enforcement burden is, based on history, likely to be much less. The proposed new agency is to rely first on State regulation and enforcement. Yet we all know that the budgets for such State enforcement will be completely inadequate to do the job. Therefore, the net result will be that the community banks will pay greatly increased fees to fund a system that falls disproportionately and unfairly on them. The new agency would have vast and unprecedented authority to regulate in detail all bank consumer products. The agency is even instructed to create its own products, whatever it decides is plain vanilla, and mandate that banks offer them. Further, the agency is urged to give the products it designs regulatory preference over the bank's own products. The agency is even encouraged to require a statement by consumers that the consumer was offered and turned down the government's product first. Thus, community banks, whether it fits their business model or not, would be required to offer government-designed products, which would be given a preference over the bank's own products. On disclosure, the proposal goes beyond simplification, which is badly needed to require that all bank communication with consumers be ``reasonable.'' This term is so vague that no banker would know what to do with it, but not to worry. The proposal would allow, even encourage, thousands of banks and others to preclear communications with the agency. So, before a community bank runs an ad in the local newspaper or sends a customer a letter, it would apparently need to preclear it with the regulator to be legally safe. CRA enforcement is also, apparently, to be increased on these community banks, although they already strongly serve their communities, and that is not to mention the inherent conflicts that will occur between the prudential regulator and the consumer regulator with the banks caught in the middle. Please recognize that all of this--cost, conflicting requirements, and uncertainty--would be placed on community banks that in no way contributed to the financial crisis. More generally, the fundamental flaw in the proposal is that consumer regulation and safety and soundness regulation cannot be separated. You cannot separate a business from its product. A good example is check hold periods. Customers would like the shortest possible holds, but this desire needs to be balanced with the complex operational issues in clearing checks and with the threat of fraud, which costs banks, and ultimately consumers, billions of dollars. Another example is the Bank Secrecy Act, which protects against money laundering and terrorist financing. These critical regulations must be coordinated with consumer and safety and soundness regulation. Take the account opening process. A consumer regulator would focus on simplicity in disclosures, while the prudential regulator would also want to consider the potential for fraudulent activity and for implementing the Bank Secrecy Act to protect against terrorist financing. What is the bank in the middle supposed to do? What about conflicts over CRA lending? We agree that CRA has not led to material safety and soundness concerns, but that is because it is under one regulator. There is often debate about individual CRA loans as to the right balance between outreach and sound lending. However, that debate, that tension, is resolved in a straightforward manner because the same agency is in charge of CRA and of safety and soundness. To separate the two is a recipe for conflicting demands, with the bank again caught in the middle. The great majority of consumer problems, as has been noted by both Democrats and Republicans on this committee, occurred outside the highly regulated traditional banks, but there are legitimate issues relating to banks as well. In that regard, my written testimony outlines some concepts that we hope you will consider to address the banking side of it. Thank you, Mr. Chairman. [The prepared statement of Mr. Yingling can be found on page 235 of the appendix.] " CHRG-111shrg55278--112 PREPARED STATEMENT OF ALICE M. RIVLIN Senior Fellow, Economic Studies, Brookings Institution July 23, 2009 Mr. Chairman and Members of the Committee, I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. I will focus on changes in our regulatory structure that might prevent another catastrophic financial meltdown and what role the Federal Reserve should play in a new financial regulatory system. It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic well-being and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and overborrowing, excessive risk taking, and outsized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world's economic well-being.Approaches To Reducing Systemic Risk The crisis was a financial ``perfect storm'' with multiple causes. Different explanations of why the system failed--each with some validity--point to at least three different approaches to reducing systemic risk in the future.The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system charged with spotting perverse incentives, regulatory gaps and market pressures that might destabilize the system and taking steps to fix them. The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.The system crashed because large interconnected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms--or even break them up--and to expedited resolution authority for large financial firms (including nonbanks) to lessen the impact of their failure on the rest of the system. Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier 1 Financial Institutions. I believe it would be a mistake to identify specific institutions as too-big-to-fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.The Case for a Macro System Stabilizer One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, antiregulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in. Perverse Incentives. Lax lending standards created the bad mortgages that were securitized into the toxic assets now weighting down the books of financial institutions. Lax lending standards by mortgage originators should have been spotted as a threat to stability by a Macro System Stabilizer--the Fed should have played this role and failed to do so--and corrected by tightening the rules (minimum down payments, documentation, proof that the borrow understands the terms of the loan and other no-brainers). Even more important, a Macro System Stabilizer should have focused on why the lenders had such irresistible incentives to push mortgages on people unlikely to repay. Perverse incentives were inherent in the originate-to-distribute model which left the originator with no incentive to examine the credit worthiness of the borrower. The problem was magnified as mortgage-backed securities were resecuritized into more complex instruments and sold again and again. The Administration proposes fixing that system design flaw by requiring loan originators and securitizers to retain 5 percent of the risk of default. This seems to me too low, especially in a market boom, but it is the right idea. The Macro System Stabilizer should also seek other reasons why securitization of asset-backed loans--long thought to be a benign way to spread the risk of individual loans--became a monster that brought the world financial system to its knees. Was it partly because the immediate fees earned by creating and selling more and more complex collateralized debt instruments were so tempting that this market would have exploded even if the originators retained a significant portion of the risk? If so, we need to change the reward structure for this activity so that fees are paid over a long enough period to reflect actual experience with the securities being created. Other examples, of perverse incentives that contributed to the violence of the recent perfect financial storm include Structured Investment Vehicles (SIV's) that hid risks off balance sheets and had to be either jettisoned or brought back on balance sheet at great cost; incentives of rating agencies to produce excessively high ratings; and compensation structures of corporate executives that incented focus on short-term earnings at the expense the longer run profitability of the company. The case for creating a new role of Macro System Stabilizer is that gaps in regulation and perverse incentives cannot be permanently corrected. Whatever new rules are adopted will become obsolete as financial innovation progresses and market participants find ways around the rules in the pursuit of profit. The Macro System Stabilizer should be constantly searching for gaps, weak links and perverse incentives serious enough to threaten the system. It should make its views public and work with other regulators and Congress to mitigate the problem. The Treasury makes the case for a regulator with a broad mandate to collect information from all financial institutions and ``identify emerging risks.'' It proposes putting that responsibility in a Financial Services Oversight Council, chaired by the Treasury, with its own permanent expert staff. The Council seems to me likely to be cumbersome. Interagency councils are usually rife with turf battles and rarely get much done. I think the Fed should have the clear responsibility for spotting emerging risks and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and possible threats to it. The Fed should consult regularly with the Treasury and other regulators (perhaps in a Financial Services Oversight Council), but should have the lead responsibility. Spotting emerging risks would fit naturally with the Fed's efforts to monitor the State of the economy and the health of the financial sector in order to set and implement monetary policy. Having explicit responsibility for monitoring systemic risk--and more information on which to base judgments would enhance its effectiveness as a central bank. Controlling Leverage. The biggest challenge to restructuring the incentives is: How to avoid excessive leverage that magnified the upswing and turned the downswing into a rout? The aspect of the recent financial extravaganza that made it truly lethal was the overleveraged superstructure of complex derivatives erected on the shaky foundation of America's housing prices. By itself, the housing boom and bust would have created distress in the residential construction, real estate, and mortgage lending sectors, as well as consumer durables and other housing related markets, but would not have tanked the economy. What did us in was the credit crunch that followed the collapse of the highly leveraged financial superstructure that pumped money into the housing sector and became a bloated monster. One approach to controlling serious asset-price bubbles fueled by leverage would be to give the Fed the responsibility for creating a bubble Threat Warning System that would trigger changes in permissible leverage ratios across financial institutions. The warnings would be public like hurricane or terrorist threat warnings. When the threat was high--as demonstrated by rapid price increases in an important class of assets, such as land, housing, equities, and other securities without an underlying economic justification--the Fed would raise the threat level from, say, Three to Four or Yellow to Orange. Investors and financial institutions would be required to put in more of their own money or sell assets to meet the requirements. As the threat moderated, the Fed would reduce the warning level. The Fed already has the power to set margin requirements--the percentage of his own money that an investor is required to put up to buy a stock if he is borrowing the rest from his broker. Policy makers in the 1930s, seeking to avoid repetition of the stock price bubble that preceded the 1929 crash, perceived that much of the stock market bubble of the late 1920s had been financed with money borrowed on margin from broker dealers and that the Fed needed a tool distinct from monetary policy to control such borrowing in the future. During the stock market bubble of the late 1990s, when I was Vice Chair of the Fed's Board of Governors, we talked briefly about raising the margin requirement, but realized that the whole financial system had changed dramatically since the 1920s. Stock market investors in the 1990s had many sources of funds other than borrowing on margin. While raising the margin requirements would have been primarily symbolic, I believe with hindsight that we should have done it anyway in hopes of showing that we were worried about the bubble. The 1930s legislators were correct: monetary policy is a poor instrument for counteracting asset price bubbles; controlling leverage is likely to be more effective. The Fed has been criticized for not raising interest rates in 1998 and the first half of 1999 to discourage the accelerating tech stock bubble. But it would have had to raise rates dramatically to slow the market's upward momentum--a move that conditions in the general economy did not justify. Productivity growth was increasing, inflation was benign and responding to the Asian financial crisis argued for lowering rates, not raising them. Similarly, the Fed might have raised rates from their extremely low levels in 2003 or raised them earlier and more steeply in 2004-5 to discourage the nascent housing price bubble. But such action would have been regarded as a bizarre attempt to abort the economy's still slow recovery. At the time there was little understanding of the extent to which the highly leveraged financial superstructure was building on the collective delusion that U.S. housing prices could not fall. Even with hindsight, controlling leverage (along with stricter regulation of mortgage lending standards) would have been a more effective response to the housing bubble than raising interest rates. But regulators lacked the tools to control excessive leverage across the financial system. In the wake of the current crisis, financial system reformers have approached the leverage control problem in pieces, which is appropriate since financial institutions play diverse roles. However the Federal Reserve--as Macro System Stabilizer--could be given the power to tie the system together so that various kinds of leverage ratios move in the same direction simultaneously as the threat changes. With respect to large commercial banks and other systemically important financial institutions, for example, there is emerging consensus that higher capital ratios would have helped them weather the recent crisis, that capital requirements should be higher for larger, more interconnected institutions than for smaller, less interconnected ones, and that these requirements should rise as the systemic threat level (often associated with asset price bubbles) goes up. With respect to hedge funds and other private investment funds, there is also emerging consensus that they should be more transparent and that financial derivatives should be traded on regulated exchanges or at least cleared on clearinghouses. But such funds might also be subject to leverage limitations that would move with the perceived threat level and could disappear if the threat were low. One could also tie asset securitization into this system. The percent of risk that the originator or securitizer was required to retain could vary with the perceived threat of an asset price bubble. This percentage could be low most of the time, but rise automatically if Macro System Stabilizer deemed the threat of a major asset price bubble was high. One might even apply the system to rating agencies. In addition to requiring rating agencies to be more transparent about their methods and assumptions, they might be subjected to extra scrutiny or requirements when the bubble threat level was high. Designing and coordinating such a leverage control system would not be an easy thing to do. It would require create thinking and care not to introduce new loopholes and perverse incentives. Nevertheless, it holds hope for avoiding the run away asset price exuberance that leads to financial disaster.Systemically Important Institutions The Obama administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier 1 Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go. It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the Federal Government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late. Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks. Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ``too-big-to-fail'' and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures. Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the U.K.'s FSA, but structured to be more effective than the FSA proved in the current crisis. In the U.S. one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies. I don't pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier 1 Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy. Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macroeconomists--Paul Volcker, Alan Greenspan, Ben Bernanke--who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort--including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed's control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown--and the Fed has been more transparent about its objectives. Although respect for the Fed's monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives. If the Fed were to take on the role of consolidated prudential regulator of Tier 1 Financial Holding Companies, it would need strong, committed leadership with regulatory skills--lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan, or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed's budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed's effectiveness and credibility in containing inflation. In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system--again in coordination with the Council. I would not create a special regulator for Tier 1 Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank. Thank you, Mr. Chairman and Members of the Committee. ______ CHRG-109shrg24852--92 Chairman Greenspan," Let me be very explicit. It has to do with the extent of leverage. In commercial banks, for example, I should say capital is several multiples, many multiples higher than what the GSE's are holding. As a consequence, banks do not, in our judgment, raise the level of systemic risk that the GSE's raise. It is a different order of magnitude largely because of, one, the size of the leverage and two, the extent to which the financial markets grant the GSE's effective U.S. Treasury status with respect to their bond issuance, when they do not do for commercial banks. Senator Corzine. Okay, so if it were capital, then risk capital associated with the underlying assets should put them on an equal playing field, I would think. If their regulator chose risk capital measures---- " CHRG-111shrg50814--53 Mr. Bernanke," Whose leverage are you referring to? Senator Schumer. You know, when somebody would put $1 of capital and borrow $30 and invest $31, and yet they lose that $1 and they are kaput. " CHRG-111hhrg53245--175 Mr. Zandi," Exactly, also I think you might want to also in addition to capital ratios or leverage ratios, the deposit insurance fee or another insurance premium so that you are self-insured. " fcic_final_report_full--290 Hundreds of billions of dollars were trapped by ARS instruments as investors were obligated to retain their investments. And retail investors—individuals invest- ing less than  million, small businesses, and charities—constituted more than  billion of this  billion market.  Moreover, investors who chose to re- main in the market demanded a premium to take on the risk. Between investor de- mands and interest rate resets, countless governments, infrastructure projects, and nonprofits on tight budgets were slammed with interest rates of  or higher. Problems in the ARS market cost Georgetown University, a borrower,  million.  New York State was stuck with interest rates that soared from about . to more than  on  billion of its debt. The Port Authority of New York and New Jersey saw the interest rate on its debt jump from . to  in a single week in Febru- ary.  In  alone, the SEC received more than , investor complaints regarding the failed ARS auctions. Investors argued that brokers had led them to believe that ARS were safe and liquid, essentially the equivalent of money market accounts but with the potential for a slightly higher interest rate. Investors also reported that the frozen market blocked their access to money for short-term needs such as medical expenses, college tuition, and, for some small businesses and charities, payroll. By , the SEC had settled with financial institutions including Bank of America, RBC Capital Markets, and Deutsche Bank to resolve charges that the firms misled in- vestors. As a result, these and other banks made more than  billion available to pay off tens of thousands of ARS investors.  FOMC20081216meeting--505 503,MR. DUDLEY.," Also how you go through the cycle and what the loss experiences on these securities are going to be are hugely important. If this is the worst recession in 30 years, that's going to be a very interesting data point in terms of what the credit losses on the securities are. If it turns out that the credit losses are low and the securities are robust, I think that will create more demand for these securities over time. You have to weigh that, of course, in terms of what leverage we are going to require financial institutions to carry and how leveraged they can be, and where we set those two standards will determine what goes through the capital markets versus what goes through depository institutions. " fcic_final_report_full--195 In the September , , memo that would recommend that Fannie be placed into conservatorship, OFHEO would expressly cite this practice as unsafe and un- sound: “During  and , modeled loan fees were higher than actual fees charged, due to an emphasis on growing market share and competing with Wall Street and the other GSE.”  : “Moving deeper into the credit pool” By the time housing prices had peaked in the second quarter of , delinquencies had started to rise. During the board meeting held in April , Lund said that dis- location in the housing market was an opportunity for Fannie to reclaim market share. At the same time, Fannie would support the housing market by increasing liq- uidity.  At the next month’s meeting, Lund reported that Fannie’s market share could increase to  from about  in .  Indeed, in  Fannie Mae forged ahead, purchasing more high-risk loans.  Fannie also purchased  billion of sub- prime non-GSE securities, and  billion of Alt-A.  In June, Fannie prepared its  five-year strategic plan, titled “Deepen Seg- ments—Develop Breadth.” The plan, which mentioned Fannie’s “tough new chal- lenges—a weakening housing market” and “slower-growing mortgage debt market”—included taking and managing “more mortgage credit risk, moving deeper into the credit pool to serve a large and growing part of the mortgage market.” Over- all, revenues and earnings were projected to increase in each of the following five years.  Management told the board that Fannie’s risk management function had all the necessary means and budget to act on the plan. Chief Risk Officer Dallavecchia did not agree, especially in light of a planned  cut in his budget. In a July , , email to CEO Mudd, Dallavecchia wrote that he was very upset that he had to hear at the board meeting that Fannie had the “will and the money to change our culture and support taking more credit risk,” given the proposed budget cut for his department in  after a  reduction in headcount in .  In an earlier email, Dallavecchia had written to Chief Operating Officer Michael Williams that Fannie had “one of the weakest control processes” that he “ever witnessed in [his] career, . . . was not even close to having proper control processes for credit, market and operational risk,” and was “already back to the old days of scraping on controls . . . to reduce expenses.” These deficiencies indicated that “people don’t care about the [risk] function or they don’t get it.”  CHRG-110shrg50417--110 Mr. Eakes," And I will bet that Larry Litton's redefault--he is a great guy--that his redefault, once you get a borrower to the 31-percent level, which is more affordable, is much lower than the modification plans that allowed a much higher portion of your monthly income to go to the debt. I bet you---- " CHRG-110shrg50414--200 Secretary Paulson," I would say that is a major cause. I have called it the root cause, the housing correction. Senator Bunning. OK. Then why did I read in the paper this morning that we are now going to include student loans and credit card debt? How does that fit the housing? " CHRG-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. CHRG-111hhrg53246--34 Mr. Gensler," I think that the unregulated derivative dealers, the affiliates at Lehman Brothers and Bear Stearns and, for that matter, even that which was in the back allowed for a great deal extra leverage in the system. " CHRG-111hhrg51698--82 Mr. Greenberger," I don't, I don't, and I want to make a point about the worry about credit. We know today there is no credit in the markets. Why is there no credit in the markets? Because everybody is worried that somebody else holds these private, bilateral contracts that have nothing to do with helping people get mortgages. They are simply bets that people won't pay the mortgages, but they are trillions of dollars of debts. If Lehman Brothers fails, if Bear Stearns fails, if Fannie and Freddie fail, if Citigroup has spent $300 billion of their troubled assets thing, everybody is saying to themselves, we can't loan to anybody because anybody may fail. " CHRG-111hhrg58044--376 Mr. Rukavina," We have talked with people from the lending industry who have been confused by the credit scores of individuals, that they feel are quite good credit risks, and when they look at the credit report, find there are oftentimes several either zero balance medical accounts that are in collection or medical accounts that have a very small balance in collection. This to us, based on our experience, indicates oftentimes not a problem in terms of credit, but a problem regarding the health care billing system and frankly, the insurance adjudication process. These bills are then sent to collection and we have been told by some in the collection industry that a significant number of people whom they contact pay off those bills promptly. We believe they are doing the right thing by paying their bills, which is advised by those in the credit scoring industry, that is something people should do. We believe they are doing that. In spite of those bills having a zero balance, they continue to drag down people's credit scores. We have worked with some in the industry who have run people's credit history through a credit score simulator and have found that by removing medical trade lines in collection, people's credit scores have increased by 50 to 100 points. These are for medical accounts that have a zero balance due. Ms. Kilroy. Would you agree that hurting people's credit scores with paid medical debt for the 7-year period could have an adverse effect on America's economic recovery and people's ability to get a loan, buy a car, buy a house? " CHRG-111shrg54589--147 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM KENNETH C. GRIFFINQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. No. There are many legitimate derivative instruments that serve important economic functions that have no ``cash'' market. Examples of these include: weather derivatives, which, for example, can be used by farmers to manage exposure to adverse climate changes; reinsurance derivatives, which allow a broad array of market participants to mitigate the risk of natural catastrophes; and macroeconomic derivatives on measures of inflation, GDP growth and unemployment which give a wide range of firms important tools to manage their risk exposure to changes in the broad economy.Q.1.b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. The value of many derivatives is determined solely by observed values of indices, such as measures of inflation, weather observations and other objectively determined variables.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?A.2. The models and principals used in the pricing of OTC derivatives are widely available. For example, the University of Chicago's Master of Science in Financial Mathematics describes its program as (http://finmath.uchicago.edu/new/msfm/prospective/ourprogram_program.php): Theory Applied to the Real World This program teaches applied mathematics and its applications in the financial industry. Students learn the theoretical background for pricing derivatives and for managing assets, but also attain a real understanding of the underlying assumptions and an ability to critically ascertain the applicability and limitations of the various models. Courses are taught by faculty of the University of Chicago and by professionals from the financial industry.In the CDS market, participants historically have used arbitrage-free pricing models based on spreads, default probabilities and recovery rates. ISDA has published a spread-based model with standardized inputs that is widely used to drive consistency in calculating trade settlement amounts. Of course, many firms have spent considerable resources developing models superior to the general market models and these models appropriately constitute trade secrets. No end user of derivatives should use derivative instruments without an understanding of the risks involved in the use of the instrument. Note finally that, apart from the uses of models in pricing derivatives and managing risk, over the life of the derivative instrument, realization in value based upon the observed underlying variables will ultimately take place.Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. Restricting the use of OTC derivatives to ``legitimate hedges'' will significantly impair the valuable economic function that such markets perform in allowing participants to hedge and transfer risk. It would be a very unlikely and a costly undertaking for a dealer to find a willing buyer and willing seller of the same risk exposure at the same time if trading were limited to those only with ``legitimate'' hedges. Investors (which here, though being characterized as ``speculators,'' really represent all those who are willing to take risk in seeking return on investment capital) and market makers serve an important role in absorbing risk from hedgers. Furthermore, the price discovery of the derivatives markets send important signals to producers and consumers about the future prices of goods, encouraging investment where appropriate and conservation where appropriate. In the CDS market, there are a tremendous number of ``natural'' or hedged buyers of credit protection (all those who own bonds), but there are virtually no natural sellers of protection who are doing so solely to hedge a specific credit risk. As such, the CDS market would not exist if the only users of the product would be those market participants who owned the underlying cash bonds. Liquidity of CDS, one of the most important financial innovations of the past two decades, would disappear, undermining the ability to hedge risks and likely materially raising the cost of capital for corporate America, which could lead to additional job losses In addition to the near impossibility of a market structure as described above, it also is quite difficult to determine and enforce an appropriate definition of ``legitimate'' hedging. Consider a firm that does not own a bond of one of its suppliers or clients. It may be a wise business decision for that firm to buy protection against a possible bankruptcy of that supplier or client. But what would the extent of the ``insurable interest'' have to be to qualify to trade in the market? What if CDS offers the best way of hedging against the credit risks posed by a given sector to which a firm is particularly exposed through a range of commercial relationships? How again could the extent of ``insurable interest'' be defined here?Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. Regulatory arbitrage is a very real issue in a global economy where capital can flow freely. The U.S. should take the lead and act while working with and through international bodies such as the Financial Stability Board, the Basel Committee on Banking Supervision, the European Union and the G20 to ensure safe and sound markets that do not disadvantage U.S. firms. Regulating only contracts written in the U.S. and allowing American firms to only buy and sell regulated contracts will not solve the problem when U.S. firms can operate subsidiaries or affiliates offshore free of such restrictions. Also, this could invite a retaliatory response from non-U.S. regulators that would put U.S. firms at a disadvantage if they, but not their international competitors, are excluded from financial markets and products abroad. International coordination is essential.Q.5. Do over-the-counter or custom derivatives have any favorable accounting or tax treatments versus exchange traded derivatives?A.5. From an accounting perspective, many financial participants follow mark-to-market accounting and therefore recognize gains and losses on their derivative contracts in current earnings, irrespective of whether such contracts are exchange-traded or not. For firms that do not follow mark-to-market accounting, however, certain accounting provisions, such as FAS 133, may favor customization of certain derivative instruments for certain users. A clearinghouse for derivatives should be able to provide the level of customization needed--for example in notional amount or maturity date--to meet the needs of the significant portion of the users who require FAS 133 accounting treatment. From a tax perspective, exchange-traded derivatives are generally subject to mark-to-market treatment, whereas OTC derivatives are governed by rules, depending on how they are structured, for notional principle contracts, forwards or options. Contingent swap contracts such as CDS present a different case. Specifically, there is substantial uncertainty as to how contingent swap contracts should be treated for tax purposes.Q.6. In addition to the Administration's proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?A.6. As noted, certain hedge accounting rules have the effect of discouraging the use of standardized derivatives as compared to more customized solutions, even when the risk profile and economic considerations of the standardized derivatives are equal to or better than the customized instrument. FAS 133, and any other hedge accounting rules, should be broadened to permit corporate users to use the standardized products, if the hedging basis risk is minimal. The societal benefits of deeply liquid and transparent markets, driven largely through increased use of standardized products and CCPs, justify the absorption of a higher level of basis risk under FAS 133. The tax treatment of contingent swap contracts (which may encompass CDS) should be clarified and legislators and regulators should work with industry groups such as ISDA which has already proposed clarifications to the tax code on this issue.Q.7. Is there any reason standardized derivatives should not be traded on an exchange?A.7. Exchanges are an important step in the evolution of the CDS market. Moving from the current bilateral market to a CCP will dramatically reduce systemic risk and increase the stability of the financial markets. The enhanced liquidity and standardization brought about by clearing will further facilitate an exchange-trading mechanism. Exchanges work best when there is a concurrency in interest between natural buyers and sellers. For the liquid index CDS product, which accounts for approximately 70 percent of all CDS trading volume, and for the most liquid single name CDS, the introduction of exchange trading will facilitate a more efficient and transparent market. However, for the less liquid single name CDS products, it will be necessary to allow market makers to continue to play a vital role in providing liquidity outside the exchange model, at least until the markets for these products evolve to the stage where there is sufficient concurrency of interest for exchange trading.Q.8. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.8. In today's market, holders of a corporate debt security utilize a variety of investment products that may alter debt holders' payoffs to make bankruptcy preferable to debt restructuring. Examples include shorting junior debt instruments in the capital structure, shorting the underlying stock, buying equity default swaps and buying puts or selling call options on the stock. CDS are no different than these other instruments in their ability to alter the economic preference of a debt holder with respect to a bankruptcy or a restructuring. Although beyond the scope of this question, research suggests that under current rules bankruptcy itself is quite costly and reduces a firm's value, independent of and in addition to the financial and operational problems that brought the firm to distress. Accordingly, streamlining of the bankruptcy process to minimize the deadweight loss incurred in a bankruptcy proceeding would potentially more directly address the concern raised with this question.Q.9. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.9. As there are always two sides of every trade, even if a specific investor chooses not to perform credit research on a particular issuer, the seller of credit protection for the debt securities of such issuer will have a strong economic incentive to perform extensive credit research. Where the risks of CDS are properly managed by a central counterparty and when a diverse set of participants create a liquid, transparent market, CDS can also provide a benchmark for pricing the probability of default of a firm or index of firms. By aggregating market participants' views on creditworthiness, CDS performs an important role in the pricing of a wide range of vital credit instruments.Q.10. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn't they?A.10. Sellers of credit protection record their exposure on their balance sheet under their applicable accounting rules. Generally, for CDS contracts, the net seller's economic exposure is better described as the fair market value of the open contracts and not the notional amount. This is similar to a wide range of traded derivatives, such as options, where the relevant valuation for balance sheet purposes is the fair market value of the contract, not the notional value of the option. For financial reporting purposes, the fair market value of the open contracts is presented in the financial statements, often along with additional information in the financial footnotes. GAAP accounting rules typically require disclosure of the gross and net notional exposure for off balance sheet derivatives.Q.11. In her testimony Chairman Schapiro mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.11. ``Synthetic exposure'' through derivatives is a cornerstone of our modern financial markets, enabling investors to secure an economic exposure without needing to own the underlying asset. For example, a retiree may want to hedge against the risk of inflation by buying gold futures. It is far more efficient to purchase a gold future than to acquire gold. The leverage created by derivatives is a function of margin and capital requirements. A central clearing solution for CDS would establish appropriate margin and capital requirements for the instruments, helping to reduce systemic risk.Q.12. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.12. One of the central tenets of our economy is that supply and demand are largely balanced through free market forces. The same can be said of supply and demand for financial products; that is, free market forces bring equilibrium to supply and demand. Synthetic exposures created through derivatives are an important means by which the market arrives at a more stable equilibrium. Without derivatives instruments, we would be likely to see markets characterized by much higher levels of volatility and far lower levels of liquidity. In addition, if there is increased demand for credit exposure, for example, the net effects of trading in the synthetic exposure will flow through to the owner of related assets and the issuer of that asset. For instance, if the market perceives a company to have a low probability of default and the supply of credit protection outweighs the demand for the bonds, then the cost CDS protection will decrease. When the cost of CDS protection decreases, it is easier for investors manage their bond credit risks, leading to an increase in demand for the bond, resulting in a decrease in borrowing costs for the issuer and higher bond prices for owners of the bonds.Q.13. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.13. With respect to the credit markets, it is fundamental to emphasize that corporations focus on achieving the capital structure that meets the needs of their stakeholders, as opposed to meeting ``the demand for debt securities'' of investors. Corporate CEOs and CFOs have a fiduciary duty to limit issuance of debt that, although potentially satisfying investor demand, would leave the company dangerously over-leveraged and at risk of bankruptcy. Synthetic exposure to corporate credit through CDS thus helps to satisfy investor and hedging demand for such risks without distorting corporate balance sheets. The CDS market allows investors with a viewpoint on the price of risk for a given issuer to actively express their view by use of CDS contracts. Such trading increases liquidity and encourages more investors to focus on the merits of any given issuer's creditworthiness. As noted in the response to the preceding question, the increase in liquidity and the broadening of investor participation works to reduce the cost of capital for corporations. Conversely, if CDS trading was restricted or eliminated, liquidity in the bonds would almost certainly be reduced, leading to a higher cost of capital for American corporations.Q.14. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.14. There are numerous well-functioning markets where derivative exposure exceeds the value of underlying assets; certain equity options and commodity futures are two such examples. The presence of this alone does not cause any systemic risk to the economy. In fact, it very well can be a sign of a healthy and robust marketplace where many participants come together to provide consensus pricing. Moreover, as noted above, there are many circumstances in which one party may not own the reference asset but have a legitimate demand to hedge, e.g., a firm that wants to buy protection against the possibility of bankruptcy of a major customer or supplier. As stated previously, CDS in particular serve several critical market functions that lead to stronger economic growth by lowering the cost of capital for America's corporations. Examples of these critical market functions include: (a) the ability to efficiently and effectively manage credit risk, which (i) permits investors (including financial institutions) to diversify their holdings, and (ii) increases liquidity in the marketplace; (b) balancing of the supply and demand for credit risk, which helps to moderate asset prices to reflect appropriate risk-based returns; and (c) providing credit risk price transparency, which increases investor confidence and market liquidity. Events of 2008 have highlighted weaknesses in the market structure for CDS, and underscore the valuable role of a CCP for users of CDS. By swiftly introducing and promoting CCP clearing of CDS, the important societal benefits of CDS can be maintained while at the same dramatically reducing the systemic risk inherent in noncleared derivative products.Q.15. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.15. Futures are highly standardized contracts that are traded on exchanges and centrally cleared by a clearinghouse. Futures offer a proven template for operational and risk management of standardized derivatives, providing for efficient and well-understood processing, margining, netting and default management. Swaps, historically, are more customized, bespoke trades that are individually negotiated in the OTC market. However, with the significant progress towards standardization over the last several years, many bespoke, customized swaps have become standardized. Examples include the CDS market where 90-95 percent of trading volume is now in ``standardized'' contracts. All the terms of such contracts are fixed by convention, and the contracts trade purely on price and volume. Such ``standardized'' CDS contracts can be centrally cleared in a futures-like framework, subject to the standard rules of the central counterparty and provide similar risk management and customer segregation protection and portability. Individually negotiated swaps may still be utilized to meet the limited need for customized CDS contracts. With central clearing of standardized CDS in a futures-like framework, most market participants agree that electronic trading, at least of the leading CDS indices and most highly liquid single names, will shortly follow. If it does not, then regulators should intervene to remove any artificial barriers to such market evolution.Q.16. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.16. The most liquid of the OTC derivatives markets, such as the interest rate swap markets and CDS markets, have already embraced standardization as a means of increasing liquidity, reducing operational risk and reducing costs. In both the interest rate swap markets and the CDS markets, the vast majority of contracts are traded according to standardized market conventions. What has not evolved is a central clearinghouse readily available to the end users of such products. Such a central clearinghouse would reduce the banks' privileged role as the providers of credit intermediation (and undermine the economic rents associated with such concentrated power). Depending upon the OTC market, customization may be desirable to reflect specific underlying commodities or instruments, delivery locations, quantity, quality or grade, payment dates, maturity dates, cash flows or other payment terms, any or all of which may or may not be reflected in standardized agreements. It is a fallacy that standardized and cleared contracts are more costly than customized, noncleared OTC contracts. There are three primary economic costs in trading contracts: (i) operational costs of managing and processing such contracts; (ii) trading costs, as measured by the bid-offer spread; and (iii) capital and margin costs for investing in such contracts. Standardization and clearing significantly reduces the first two costs and can be expected to reduce the third. Numerous studies have documented the economies of scale that are gained by centrally processing and managing contracts through a central counterparty. Moreover, standardized contracts also enable standardized processes that reduce costs. Additionally, as contracts are standardized and move to a CCP (increasing price transparency and making it easier to transact in such instruments), liquidity increases and the bid-offer spread decreases--reducing the cost for all investors, including corporations, pension funds, insurance companies and hedge funds. The posting of collateral for standardized cleared contracts does not necessarily increase costs compared to noncleared OTC contracts. Central clearing provides significant capital efficiency through multilateral netting and the elimination of counterparty risk. Of greatest importance, a clearinghouse will all but eliminate the externalities inherent in today's market structure--externalities that are borne by taxpayers. A clearinghouse will roll back the emergent paradigm of ``too interconnected to fail'' and dramatically reduce the probability of a future AIG-like financial black hole.Q.17. Who is a natural seller of credit protection?A.17. The natural sellers of credit protection would be best described as the broad array of investors who generally invest in the cash corporate bond markets. These investors generally have demonstrated credit analysis capabilities and strong balance sheets with which to underwrite risk.Q.18. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.18. Cleared derivative transactions are, of course, recorded on the books and records of the clearinghouses and details of these transactions are readily available to regulators. Noncleared derivative transactions should be reported to a non-CCP based central warehouse such as DTCC to ensure that the details of these transaction are readily available to regulators. In addition to facilitating the appropriate monitoring of systemic risk in the financial system, an accurate and readily accessible warehouse of transaction details is important to facilitate the dissolution of a financial institution that is in financial distress. Regulators and others, however, need to closely guard the information at both the CCPs and trade warehouses such that no information that would compromise the identity or specific positions of institutions is publicly divulged. The public disclosure of such information could have significant negative effects on liquidity in the market. CCPs' publishing of end of day settlement prices, and the progressive publishing of transaction prices for liquid traded CDS, will bring highly beneficial transparency to the CDS market. However, for certain less-liquid contracts, immediately releasing the details of a trade could serve to reduce liquidity. In relatively illiquid markets, or where an individual trade may be large relative to daily trading volume, dealers or others may be reluctant to commit large amounts of capital if their actions become immediately known to other market participants. In this case, requiring such information to be immediately disclosed could discourage trading and thus impair liquidity. In these circumstances, such information should be made available to the public only on a lagged basis, and, depending on the circumstances, potentially also only on an aggregated basis.Q.19. What is insufficient about the clearinghouse proposed by the dealers and New York Fed?A.19. Well-functioning markets are efficient, open, and transparent. Well-functioning standardized derivatives markets utilize a CCP to significantly reduce counterparty risk exposure, facilitate liquidity, protect customer collateral, and facilitate multilateral netting and monitoring of positions. ICE U.S. Trust (ICE), the first U.S.-based clearinghouse to be sponsored by the dealers does, to some extent, improve upon the current market by reducing counterparty risk and facilitating multilateral netting and the monitoring of positions among and for the select group of 10 ICE clearing members. At the same time, certain elements of the ICE model do not help as much as they could to improve the CDS market structure, because of: Lack of regulatory and legal clarity on the protection of customer margins and positions in the case of a clearing member default, which dramatically limits the value of such clearinghouse for customers; Inability to process trades directly into clearing without any daylight counterparty exposure post execution; Reliance upon bilaterally negotiated ISDA agreements that limit the ability of one firm to trade with another firm; and Inability of nonbank CDS dealers to directly face ICE as a clearing member and receive the benefits of such clearing membership. ICE's structural lack of straight through processing and immediate review and acceptance for clearing creates a very significant barrier to the evolution of electronic matching. Additionally, ICE's clearing solution lacks buy-side stakeholders and participation in governance. This general lack of inclusion of buy-side firms has lead to the development of a solution that does not currently meet the needs of most buy-side firms, whose positions and trading volume comprise a substantial portion of the CDS market and the vast majority of the aggregate net risk held in the market place. It is important for any clearinghouse or any other central industry facility to include the voice of all market participants--buy-side and sell-side alike.Q.20. How do we prevent a clearinghouse or exchange from being too big to fail? And should they have access to Fed borrowing?A.20. CCPs have a very long track record of surviving wars, depressions, recessions and failures of major members. In fact, there has never been a clearinghouse failure in the U.S. in the over 100-year history of U.S. clearing organizations. When Lehman's default was declared, the CME as central counterparty to Lehman's futures positions moved all futures customer positions to other clearing members and auctioned Lehman's positions quickly and efficiently. As a result of these actions there was no disruption in the market and no loss to any customer or CME clearing member or to the CME's pool of security deposits and other assets that stand as a backstop to protect the clearinghouse and its members against loss in extreme scenarios. By contrast, Lehman's bilateral, interconnected derivatives positions and counterparty margin a year later are still locked up in bankruptcy and Lehman's customers suffered significant losses. This is why a clearinghouse is critical to these markets and reduces systemic risk. The robustness of CCPs is a testament to their independence and incentives to be expert in managing risks. The clearinghouse imposes a consistent, neutral margin and risk management discipline on each counterparty, and will work very proactively to prevent default. The clearinghouse has its own capital at stake if the margin is insufficient. The clearinghouse continually assesses its clearing members, and can at any time reduce trading limits or take other measures to reduce risk. This is not always the case in the bilateral world, where commercial relationships, historical agreements and other factors have been proven to lead to inconsistent margining or credit assessment practices, as was the case with AIG. AIG was not required by its counterparties in many instances to post any margin, including mark-to-market margin. While clearinghouses have grown considerably in size as markets have flourished, their maintenance of proportionate capital and margin has ensured their survival. The right way to keep this track record of success unbroken is to ensure the close regulatory supervision of clearinghouses, and the maintenance of their independence so that their incentives remain to be proactive and conservative. Clearinghouses have not required the ability to borrow from the Fed and, if they were, we believe that this would introduce a moral hazard problem. If the CCP believed that the government would bail out any defaults, there is the risk that clearing members would seek to reduce their capital and ease risk-management standards and the CCP would lose its neutral discipline. This is exactly the opposite of what regulators and taxpayers would call for.Q.21. What price discovery information do credit default swaps provide, when the market is functioning properly, that cannot be found somewhere else?A.21. CDS are the most accurate indicators of corporate credit risk and provide capital market participants with robust, real-time, and consensus-driven estimates of corporate default probabilities and recovery rates. No other market, including the bond market, or research institutions such as rating agencies, can provide a similar depth of information that is so critical to debt issuance and economic growth. This is largely because: CDS are in many instances far more liquid than individual bonds, due, in part, to the fact that the CDS represent the credit risk of the underlying entity, whereas that entity may have many distinct bond issuances. IBM, for example, has over 20 different bond issuances. The vast majority of CDS are standardized instruments. Valuation of the CDS are not complicated by specific market technical factors or unique contractual features or rights that are associated with a specific bond issue. In addition, CDS represent the price of credit risk bifurcated from the compensation demanded by investors for committing cash to the acquisition of a debt security. Rating agencies' analytics are driven by analysts that cover the specific corporate bonds. The market price of CDS, on the other had, reflect the market's consensus view of real-time credit risk as determined by investors with financial capital at risk.Q.22. Selling credit default swaps is often said to be the same as being long in bonds. However, when buying bonds, you have to provide real capital up front and there is a limit to the lending. So it sounds like selling swaps may be a bet in the same direction as buying bonds, but is essentially a highly leveraged bet. Is that the case, and if so, should it be treated that way for accounting purposes?A.22. Please see the answer to questions #11, which is restated below for reference. ``Synthetic exposure'' through derivatives is a cornerstone of our modern financial markets, enabling investors to secure an economic exposure without needing to own the underlying asset. For example, a retiree may want to hedge against the risk of inflation by buying gold futures. It is far more efficient to purchase a gold future rather than to acquire gold. The leverage created by derivatives is a function of margin and capital requirements. A central clearing solution for CDS would establish appropriate margin and capital requirements for the instruments, helping to reduce systemic risk.Q.23. Why should we have two regulators of derivatives, with two interpretations of the laws and regulations? Doesn't that just lead to regulation shopping and avoidance?A.23. If we were starting with a clean sheet of paper, we might agree to have a single regulator of derivatives. This is not the case, however. The SEC and CFTC are two large and well-established regulatory bodies that would be difficult and time-consuming to combine. More could be accomplished sooner by focusing on fixing the regulatory gaps--such as exclusion of certain derivatives from oversight and allowing participants to transact in markets without holding or putting up sufficient capital and/or collateral--that contributed to the problems seen in the markets over the past 18 months. We believe the necessary regulatory infrastructure and tools are in place, with support of appropriate legislation, to rapidly implement the reforms needed. In this context, please see the answer to Senator Reed's question #1, with an excerpt of relevant material from that answer below, affirming the immediate value to the market of building from the CFTC's proven account segregation framework: A critical feature of any central clearing structure from the perspective of the buy-side--asset managers, corporations, pension funds, hedge funds, and all other end users--is proven account segregation. Buy-side accounts represent a substantial portion of any derivative's systemic exposure. With proper account segregation for cleared products, the buy-side's positions and margins are protected from the bankruptcy of a defaulting clearing member and transferred to other clearing members, securing the orderly functioning of the markets. The buy-side has confidence in the time-tested CFTC account segregation rules, which were amply proven in the case of the rapid workout, without market disruption, of Lehman's CFTC-regulated futures positions. This was in stark contrast to the losses suffered by end users who faced Lehman in bilateral, noncleared positions that were trapped in Lehman's bankruptcy.Q.24. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.24. Please see answer to question #11, which is restated below for reference. ``Synthetic exposure'' through derivatives is a cornerstone of our modern financial markets, enabling investors to secure an economic exposure without needing to own the underlying asset. For example, a retiree may want to hedge against the risk of inflation by buying gold futures. It is far more efficient to purchase a gold future rather than to acquire gold. The leverage created by derivatives is a function of margin and capital requirements. A central clearing solution for CDS would establish appropriate margin and capital requirements for the instruments, helping to reduce systemic risk.Q.25. What is good about the Administration proposal?A.25. We support the broad principles articulated in the Administration proposal, which include moving towards more efficient and transparent markets, enacting necessary regulatory oversight to prevent market manipulation and fraud, and reducing the concentrated systemic risk that exists today. Specifically, with regard to regulation of the OTC derivative market, we support: The aggressive promotion of clearing of all standardized transactions through capital and other incentives, with higher risk-based capital charges for noncleared derivatives; The need to regulate all significant OTC derivative market participants to prevent systemic risks, while making such regulation transparent and fair to all market participants; The need for greater market transparency, openness and efficiency; and The facilitation of exchange trading for derivatives, where appropriate, and the removal of any artificial barriers to market evolution towards exchange trading if such trading has not naturally evolved.Q.26. Is the Administration proposal enough?A.26. We believe the critical question is not whether the Administration proposal is enough, but whether legislators and regulators can quickly implement key aspects of the proposal (as articulated in the answer to question #25 above) across a broad OTC product set (e.g, credit default swaps, interest rate swaps, and foreign exchange swaps). Unfortunately, certain incumbent market participants seek to delay the movement of noncleared products to clearing, for reasons driven by profitability irrespective of the systemic risks created. These interests should not drive legislative outcomes. Legislators and regulators should not exempt certain market participants from having to post margin or collateral. There is no principled basis for such carve-outs. No market participant should be exempt from posting risk-based capital and/or margin sufficient to protect its counterparties and the market from the risk it incurs. No counterparty should be exempt from the requirement to clear transactions when they can be cleared. But also no qualifying counterparty who meets these requirements should be excluded from the benefits of CDS. Separately, as discussed in more detail in response to Senator Reed's question #6, because dealers today do not post margin for noncleared trades, and buy-side participants do, dealers should be obliged to set aside sufficient capital to secure the exposure they take on, while buy-side participants already meet this requirement through margin. Imposing capital or other requirements on these buy-side firms, would therefore only serve to create impediments to investment, increase the cost of hedging, and reduce liquidity. Please note answers to questions #6 and #16 above that discuss the significant benefits of using standardized contracts and CCPs, such as lower costs of trading and deeper, more liquid markets. The Administration and Congress should work closely to define the most inclusive practical standards for trades to be subject to mandatory clearing, driven primarily by the clearinghouses' independent willingness to accept such trades, on reasonable commercial margining terms. Regulatory carve outs and differential treatment of certain participants, such as exclusion of certain derivatives from regulatory oversight and inconsistent collateral policies, greatly contributed to the problems seen in the derivatives market over the past 18 months and cannot be allowed to continue.Q.27. Mr. Whalen suggests that Congress should subject all derivatives to the Commodity Exchange Act, at least as an interim step. Is there any reason we should not do so?A.27. It is most important that all OTC derivatives be subject to some form of robust regulation that ensures proper transparency, adequate capital and collateral requirements, and clearing by a strong CCP. We support whichever regulatory regime can best and most rapidly achieve these imperatives, provided it recognize the needs of all market participants, including buy-side investors. Please also see the answer to Senator Reed's question #1, from which relevant material is restated below for reference. A critical feature of any central clearing structure from the perspective of the buy-side--asset managers, corporations, pension funds, hedge funds, and all other end users--is proven account segregation. Buy-side accounts represent a substantial portion of any derivative's systemic exposure. With proper account segregation for cleared products, the buy-side's positions and margins are protected from the bankruptcy of a defaulting clearing member and transferred to other clearing members, securing the orderly functioning of the markets. The buy-side has confidence in the time-tested CFTC account segregation rules, which were amply proven in the case of the rapid workout, without market disruption, of Lehman's CFTC-regulated futures positions. This was in stark contrast to the losses suffered by end users who faced Lehman in bilateral, noncleared positions that were (and remain) trapped in Lehman's bankruptcy.Q.28. Is there anything else you would like to say for the record?A.28. The time to act is now. The experience of the current crisis provides us with a tremendous opportunity to learn from past mistakes and correct the fundamental flaws in the financial system. What we saw was that participants in free markets were subsidized, perhaps unjustly, by public resources and investors lost substantial sums of money, not because of their investment strategies, but because of the bankruptcy of their counterparties. It is well established that CCPs will mitigate or eliminate many of the weaknesses inherent in the bilateral trading of derivatives, reducing systemic risk and placing the ``too interconnected to fail'' genie back into the bottle. CCPs can best meet the needs of our society and our capital markets, and can do so now. ------ CHRG-111hhrg54873--15 Mr. Royce," Thank you, Mr. Chairman. As we dissect the proliferation of the exotic mortgages throughout our financial sector, it is hard to overlook the role played by the ratings issued by the various rating agencies. Certainly there were flaws in the actual ratings. In January of 2008, there were 12 AAA rated companies in the world. At that time, there were also 64,000 structured finance instruments like collateralized debt obligations holding that AAA rating. Further, many of those products were based on nothing more than junk mortgages. Of the $3.2 trillion of subprime mortgage securities issued, 75 percent were awarded AAA ratings. But the rating agencies missing the mark when assessing the potential risk associated with these products was not the core problem. I believe the major failure over the years was the blind reliance on the rating agencies by investors, financial institutions, and by the Federal Government. In many respects, the government has institutionalized these failed ratings. Looking back, this overreliance was as misguided as the ratings being issued by the NRSROs. Going forward, nothing will replace due diligence by investors and institutions and regulators. Alternative risk indicators must supplant what was previously an oligopoly by the NRSROs. I think a more competitive market with alternatives to the NRSROs ratings is the most effective alternative. And, for instance, I would raise the issue that many economists for some time have advocated for mandating large institutions to issue subordinated debt. Credit default swap spreads have also been used as an alternative to agency ratings. I look forward to discussing the draft legislation issued by the chairman as well as other potential reforms with my colleagues here today and hearing from these witnesses and I thank you, Mr. Chairman. And I think in retrospect, Mr. Chairman, had we never codified under law some of the references to rating agencies that essentially put government behind the rating agencies there might have been more due diligence. Going forward, I hope we learn from that. Thank you, Mr. Chairman. I yield back the balance of my time. " fcic_final_report_full--246 These institutions had relied for their operating cash on short-term funding through commercial paper and the repo market. But commercial paper buyers and banks became unwilling to continue funding them, and repo lenders became less and less willing to accept subprime and Alt-A mortgages or mortgage-backed securities as collateral. They also insisted on ever-shorter maturities, eventually of just one day—an inherently destabilizing demand, because it gave them the option of with- holding funding on short notice if they lost confidence in the borrower. Another sign of problems in the market came when financial companies began to report more detail about their assets under the new mark-to-market accounting rule, particularly about mortgage-related securities that were becoming illiquid and hard to value. The sum of more illiquid Level  and  assets at these firms was “eye- popping in terms of the amount of leverage the banks and investment banks had,” ac- cording to Jim Chanos, a New York hedge fund manager. Chanos said that the new disclosures also revealed for the first time that many firms retained large exposures from securitizations. “You clearly didn’t get the magnitude, and the market didn’t grasp the magnitude until spring of ’, when the figures began to be published, and then it was as if someone rang a bell, because almost immediately upon the publica- tion of these numbers, journalists began writing about it, and hedge funds began talking about it, and people began speaking about it in the marketplace.”  In late  and early , some banks moved to reduce their subprime expo- sures by selling assets and buying protection through credit default swaps. Some, such as Citigroup and Merrill Lynch, reduced mortgage exposure in some areas of the firm but increased it in others. Banks that had been busy for nearly four years cre- ating and selling subprime-backed collateralized debt obligations (CDOs) scrambled in about that many months to sell or hedge whatever they could. They now dumped these products into some of the most ill-fated CDOs ever engineered. Citigroup, Merrill Lynch, and UBS, particularly, were forced to retain larger and larger quanti- ties of the “super-senior” tranches of these CDOs. The bankers could always hope— and many apparently even believed—that all would turn out well with these super seniors, which were, in theory, the safest of all. With such uncertainty about the market value of mortgage assets, trades became scarce and setting prices for these instruments became difficult. Although government officials knew about the deterioration in the subprime markets, they misjudged the risks posed to the financial system. In January , SEC officials noted that investment banks had credit exposure to struggling subprime lenders but argued that “none of these exposures are material.”  The Treasury and Fed insisted throughout the spring and early summer that the damage would be lim- ited. “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,”  Fed Chairman Ben Bernanke testified before the Joint Economic Committee of Congress on March . That same day, Treasury Secretary Henry Paulson told a House Appropriations subcommittee: “From the standpoint of the overall economy, my bottom line is we’re watching it closely but it appears to be contained.”  FinancialCrisisInquiry--194 For example, my bank’s lines of credit usage is down to the lowest utilization in 25 years. I am pressing my loan officers daily to find more loans, but demand is not there. All community banks want to lend. Less lending hurts profits and income. For the first time in my 44 years in banking I have witnessed a decline in assets in my banks due to lower loan demand. In total, my loans were down from $600 million to $585 million this past year. Most businesses I work with are using cash flow only and are not interested in taking on new debt. The key reason they cite for not seeking credit is their uncertainty of the economic climate and the cost of doing business going forward. Until their confidence in the economic outlook improves, businesses will be unlikely to borrow from any bank. The financial meltdown should be a lesson learned in supporting diversity in the banking and in community banks. Community banks represent the other side of the financial story in credit markets. Community banks serve a vital role in small-business lending and local community activity not supported by Wall Street, who has only an international view. For their size, community banks are enormous small-business lenders. Community banks represent only about 12 percent of all bank assets, they currently make up 31 percent of the dollar amount of all small business loans less than a million dollars. Notably, more than half of all small business loans under $100,000 are made by community banks. In contrast, banks with more than $100 billion in assets, the nation’s largest financial firms, make only 22 percent of small business loans. Community banks in general rely more on local deposits to fund local lending. So they don’t rely on the Wall Street capital markets for funding. In fact, small banks of $1 billion in asset size or less were the only segment to show any increase in net loans and leases year over year in the latest third quarter 2009 quarterly FDIC data. However, small business loan demand is down in general, because businesses and individuals are deleveraging and reducing their reliance on debt after the current meltdown. The FDIC quarterly banking profile for the third quarter of 2009 showed a record $210 billion quarterly decline in outstanding loan balances. Net loans and leases declined across all asset size groups on—in a quarterly basis in the third quarter of 2009. FOMC20060808meeting--179 177,MR. WARSH.," Thank you, Mr. Chairman. Just a few brief comments. First, with respect to the concision of our statement and the minutes, I guess in a perfect world the minutes would come out much sooner after our statement, but I recognize all the work that needs to get done to get consensus and understanding on those. I have a modest suggestion, which we can take back up in October. The minutes could end up being released somewhat sooner but also be more corporate in nature. It strikes me that a lot of the communication that we do through the minutes is useful for history and for an understanding of many of the nuances that we’ve talked about but is probably not that useful for some of the other communication purposes discussed here. It would certainly be useful if the crucial arguments in the discussion we had today were available in the minutes before three weeks have elapsed. That would take some of the burden off figuring out what goes into the statement. Without burdening the staff by getting the same product done sooner, we could think rather about what should be part of a corporate-style set of minutes. We’ve taught the market that a full set of the minutes would come out, but my own suggestion is that the full set could be somewhat delayed. That’s just a sort of provocative suggestion without as much discussion and thought as we’d want, but I think it partly addresses the statement issue. Second, on striking the right balance between individuals and the Committee, I’m more convinced than ever, now that I have gone through four FOMC meetings, that the diverse views that people express on monetary policy outside this meeting are important and are critically independent. What I’m going to say is not an attempt to break that divergence of views or dissuade people from sharing them. I think it’s actually more problematic when FOMC participants say similar things between meetings. For example, Mr. Chairman, let’s say that you said X and that 18 of us went out and repeated X more or less identically after the meeting. The market understanding of that is no longer X or 2X but perhaps 10X or 12X, and I think that does prove problematic. A burden should be on each of us, when we take our messages to different places between meetings, to be thinking about the consequences, in particular, when we’re saying similar things. None of that means to say that if you believe Y instead of X you should not be able to go scream that from the hills; but if you believe a nuance of X, you really have to consider how the markets are going to understand the repetition that they’ve heard. Third, just a brief point about market discipline—I think President Yellen and President Minehan made reference to this. We’ve been fairly cognizant over the past several meetings about getting the markets to do their own work and not to rely on us. That market discipline is very important. Governor Kohn said at the outset that the purpose of this discussion is not to have transparency for transparency’s sake but to try to get to the right monetary policy objectives. It strikes me as though we could well test the limits of transparency by sharing too much information and getting the markets in a position where they stop doing much of the homework we’ve only started getting them to do at this point. The right place to come to that judgment is somewhere around where that transparency ends up making them more lemmings than we’d ideally like. I must admit that I’m not exactly sure how to pull that off, but it strikes me that’s the way to structure or to think about that discussion. Thank you." CHRG-111hhrg54867--252 Mr. Marchant," So that there will be consideration given to--in all financial institutions, the consideration given to the source of the leverage? " FOMC20080318meeting--49 47,MR. HOENIG.," Thank you, Mr. Chairman. I thought I would talk a bit about some events in our region that I think have global implications--that is to say, I will talk a bit about agriculture. You have heard others here this morning talk about some of the price movements, and I think it is worth perhaps spending a few minutes on their effects. First of all, agricultural commodity prices have surged to record highs, driven by obviously strong demand, lean supplies, and a weak dollar. Since the fall of 2007, winter wheat prices have doubled, and corn and soybean prices have risen about 70 percent, to record highs. Rising crop prices are boosting farm income. In real terms, U.S. net farm income is expected to climb to the second highest level on record, trailing only 1972, when abrupt sales of U.S. wheat to Russia pushed up farm income. An emerging concern is the growing disarray in futures markets for agricultural commodities caused by a surge in investment by index and hedge funds going forward. Recent reports indicate that hedge and index fund investment in futures markets for corn, soybeans, and wheat rose from $10 billion in January 2006 to $45 billion this past January. Early this month, index funds held more than 40 percent of the long positions on wheat contracts on the Chicago Board of Trade. At this rapid pace of investment--since the beginning of this year averaging $1 billion per week--the funds would own the nation's entire 2008 corn, wheat, and soybean crops by early 2009. Now, that is obviously theoretical, but that is how much money is going into this market. The resulting market disarray is constraining the traditional use of commodity futures to hedge market risk. Grain elevators, which use futures to hedge their contracts to purchase crops from producers for future delivery, are facing much larger than normal margin calls on their futures positions. Some reports indicate that lenders are beginning to restrict their funding of elevator hedges. As a result, an increasing number of elevators are limiting their contracts for crop purchases to no more than sixty days in advance of the delivery instead of the normal one to two years. Now, this surge in crop prices and farm income is pushing up farmland values. According to our bank's agricultural credit survey in the fourth quarter of 2007, non-irrigated cropland values jumped 20 percent over 2006 levels, with strong gains also reported in irrigated cropland and ranchland. Our directors and other contacts report a further strong gain since the beginning of the year, and some have reported as much as a 20 percent increase in the first quarter alone. Adjusted for inflation, the average price of farmland across the nation now tops the early 1980s peak, which immediately preceded the plunge in the early to mid 1980s. To date, crop production budgets suggest that the recent run-up in farmland values is supported by current revenues from crop production. However, farm input costs have also risen sharply, driven by higher energy costs, suggesting that a drop in crop prices could quickly erode farm cash flow and undermine these values. District bankers report a surge in farm capital spending. In February, sales of four-wheeled major equipment rose 45 percent above 2007 levels, and combine harvester sales were up 13 percent. Farm equipment prices have risen sharply, and our directors and other contacts report that some equipment dealers are rationing purchases among their customers. In the past month, anecdotal reports from District contacts indicate that nonfarm investors have boosted their farmland purchases. Our contacts at a national farm management company based in Omaha stated that the number of inquiries for farmland purchases by corporate interests has jumped significantly recently. Similarly, one of our directors reported that a hedge fund with assets of more than $7 billion is expected to invest $500 million in cropland from Texas and Nebraska. This fund recently purchased nearly 25 square miles of corn acreage in western Nebraska. Now, we continue to watch for signs of rising leverage, but to date farm debt levels have risen modestly only, and agricultural banks seem to remain healthy. Bankers report continued use of cash to finance farmland purchases, but I would note that leverage is being brought into the picture, and I think that will accelerate as opportunism and greed have their way. Total farm lending in the District banks has increased a modest 14 percent over the past four years, with most of that growth being in farm real estate lending. But District bank examiners and respondents to our surveys reported that the Farm Credit System was being more aggressive in funding farm real estate transactions. Real estate mortgage loans held by the Farm Credit System rose about 12 percent in 2007. Asset quality at our ag banks remains, at this point, solid. Noncurrent assets--all assets, not just farm loans--at ag banks are up only slightly from a year ago and remain well below historical averages. Net loan losses are still very low. Earnings have remained solid primarily because of cost control and very low loss provisions. I am very pleased, but I will tell you that, going forward, in terms of the surveys with the kinds of pressure and price appreciation going on, I think the push for leverage is just beginning. At the national level, in terms of the Greenbook, every indication is that the economy is slowing. Whether it is recession or very slow growth is a matter of degree, but I think our projections are in the same direction as the Greenbook. Turning to the inflation outlook, I am concerned, as I have said before, about the upside risk to inflation. Though I certainly agree with others around the table that weaker economic activity may put some downward pressure on goods price inflation, I think we can also agree that a number of factors could push inflation higher, including rapidly rising commodity prices worldwide and a weaker dollar. As discussed in the Bluebook, there is some indication that inflation expectations may be moving higher as well. As I have indicated before, I am increasingly concerned that, in our need to respond to signs of economic weakness, we risk losing our hard-won credibility on inflation. For the past four years, core PCE inflation has averaged about 2.1 percent, considerably above the numbers that this Committee has put forward in its long-term projections. Frankly, I do not think that many people outside this room think that this Committee can deliver the longer-run projections that we have put forward. I don't think that we can keep inflation expectations anchored only by talk if actual inflation rises further in the months ahead and we continue to ease policy in a rising inflationary environment. This is something that we need to keep in mind as we discuss our policy options today. Thank you. " CHRG-111hhrg48868--62 Mr. Clark," Thank you, Mr. Chairman, Ranking Member Garrett, and members of the subcommittee. Good morning. My name is Rodney Clark. I serve as a managing director in Standard & Poor's rating services business and from 2005 until very recently, I served as S&P's lead rating analyst covering AIG. I am pleased to appear before you today. Let me begin by speaking generally about our ratings process and the nature of our credit ratings. S&P's credit ratings are current opinions on the future credit risk of an entity or debt obligation. Our ratings do not speak to the market value of a security or the volatility of its price and they are not recommendations to buy, sell or hold a security. They are one tool for investors to use as they assess risk and differentiate credit quality of issuers and the debt that they issue. S&P analysts gather information about a particular issuer or debt issue, analyze the information according to our published criteria, form opinions and then present their findings to a committee of experienced analysts that votes on what ratings to assign. S&P publishes its ratings opinion in real time and for free on our Web site and we also generally publish a narrative that provides additional information about our opinion. This is the process by which S&P arrived at its ratings on AIG, which I will now discuss in more detail. Attached to my written submission is a table listing our global ratings history of AIG since 1990, as well as a more detailed description of our rationale for our rating changes. For many years, S&P had a triple A rating on AIG. Our opinion began to change in 2004 and since March 2005, we have lowered our ratings on AIG 4 times. In February of last year, S&P announced a negative outlook on the company's ratings related to the way AIG was determining the fair value of credit default swap contracts or CDS. AIG's CDS guaranteed an array of structured finance securities. Several months later, in May 2008, we lowered AIG's rating to double A minus following the company's announcement of further losses in their CDS portfolio and we maintained a negative outlook on AIG throughout the summer of 2008. In August, S&P announced that its view of the actual expected credit losses in the CDS area would likely amount to around $8 billion, significantly higher than the mark-to-market losses. AIG's financial condition continued to deteriorate sharply amid the substantial market turbulence in September 2008 leading to a sudden drop in the market value of AIG's investments and its CDS portfolio. In light of these events, on September 12, 2008, S&P placed its ratings on AIG and its subsidiaries on credit watch with negative implications. On September 15, 2008, as AIG's condition continued to deteriorate, S&P lowered its rating further to A minus in light of the increase in CDS related losses and AIG's reduced flexibility in meeting its collateral needs. Since then, AIG has benefitted from government support. Our rating on AIG remains at A minus, but includes a six notch uplift for the government support. Thus, without government support, our rating on AIG today would be double B minus. S&P recently affirmed its A minus rating on AIG; however, we maintain a negative outlook on the company's rating going forward. I have also been asked to address the effect of AIG's troubles on creditworthiness of its insurance subsidiaries. We believe those subsidiaries are, to some extent, protected by insurance regulations from AIG's financial problems. Nevertheless, we believe there is increased reputational risk for the subsidiaries at this time, which may eventually affect their earnings. Moreover, they may have reduced access to capital in the event AIG's condition should worsen. I have also been asked to address whether S&P's ratings may have contributed to the decline of AIG. We believe that AIG's difficulties resulted from the convergence of many factors, including the unprecedented and substantial deterioration in the market value of AIG's CDS portfolio. While some have argued that S&P's downgrade was too slow, others have said that we acted too aggressively and that our downgrades contributed to AIG's decline. We would not refrain from taking any rating actions simply out of deference to a particular issuer or at the request of a market participant. Our ratings are not driven by market sentiment; rather, our role to act as an independent observer offering our views on creditworthiness. Finally, you have asked me to describe any involvement S&P may have had in connection with the structuring or restructuring of the government support packages to AIG. Although S&P has been informed by government officials about the actions that have been taken, we have had no participation in the structuring or restructuring of these packages, nor has S&P provided or been asked to provide any advice or consultation to the government in connection with its support of AIG. I think you for the opportunity to participate in this hearing and I would be happy to answer any questions you have. [The prepared statement of Mr. Clark can be found on page 148 of the appendix.] " CHRG-111shrg54675--85 PREPARED STATEMENT OF ARTHUR C. JOHNSON Chairman and Chief Executive Officer, United Bank of Michigan, Grand Rapids, Michigan, On Behalf of the American Bankers Association July 8, 2009 Chairman Johnson, Ranking Member Crapo, and Members of the Subcommittee, my name is Arthur C. Johnson. I am Chairman and Chief Executive Officer of United Bank of Michigan, headquartered in Grand Rapids, Michigan. I serve as Chairman-Elect of the American Bankers Association (ABA), and I chair the ABA Community Bank Solutions Task Force, a committee dedicated to finding ways to address problems most acutely affecting community banking during this economic downturn. I am pleased to be here today representing ABA. ABA brings together banks of all sizes and charters into one association. ABA works to enhance the competitiveness of the Nation's banking industry and strengthen America's economy and communities. Its members--the majority of which are banks with less than $125 million in assets--represent over 95 percent of the industry's $13.5 trillion in assets and employ over 2 million men and women. We are pleased to share the banking industry's perspective on the current economic situation in rural America and the effects the recession is having on rural community banks. We strongly believe that community banks are one of the most important resources supporting the economic health of rural communities. Not surprisingly, the banks that serve our Nation's small towns also tend to be small community banks. Less well known is that over 3,500 banks--41 percent of the banking industry--have fewer than 30 employees. This is not the first recession faced by banks; they have been in their communities for decades and intend to be there for many decades to come. My bank, United Bank of Michigan, was chartered in 1903. We have survived the Great Depression and all the other ups and downs for over a century. We are not alone, however. In fact, there are 2,556 other banks--31 percent of the banking industry--that have been in business for more than a century; 62 percent (5,090) of banks have been in existence for more than half a century. These numbers tell a dramatic story about the staying power of community banks and their commitment to the communities they serve. My bank's focus, and those of my fellow bankers throughout the country, is on developing and maintaining long-term relationships with customers. We cannot be successful without such a philosophy and without treating our customers fairly. In spite of the severe recession, community banks located in rural communities have expanded lending. In fact, during 2008--the first year of the recession--loans from banks headquartered outside of metropolitan statistical areas \1\ increased by $17 billion, or 7 percent. Loan growth last year was also reflected in a smaller subset of community banks: farm banks. Lending for these banks expanded by $4.7 billion, or 9.2 percent, in 2008.--------------------------------------------------------------------------- \1\ Metropolitan statistical areas are defined as areas that have at least one town over 50,000 inhabitants.--------------------------------------------------------------------------- Considerable challenges remain, of course and these trends are not likely to be sustained. While many areas of our country have benefited from strong exports which have helped agricultural exports in particular, other rural areas of the country have not been as lucky. The downturn has continued to impose hardships on small businesses and manufacturers. In my home State of Michigan, we are facing our eighth consecutive year of job losses. The necessary--but painful--restructuring of the auto industry will likely cause this job erosion to continue for some time, leading to a long recovery in these areas. Other rural areas with a manufacturing employment base are also suffering similar problems. In this environment, it is only natural for businesses and individuals to be more cautious. Individuals are saving more and borrowing less. Businesses are reevaluating their credit needs and, as a result, loan demand is also declining. Banks, too, are being prudent in underwriting, and our regulators demand it. Accordingly, it is unlikely that loan volumes will increase this year, and in fact, the total loans in rural areas declined slightly in the first quarter. With the economic downturn, credit quality has suffered and losses have increased for banks. Fortunately, community banks entered this recession with strong capital levels. As this Committee is aware, however, it is extremely difficult to raise new capital in this financial climate. Without access to capital, maintaining the flow of credit in rural communities will be increasingly difficult. We believe there are actions the government can take to assist viable community banks to weather the current downturn. The success of many local economies--and, by extension, the success of the broader national economy--depends in large part on the success of these banks. Comparatively small steps taken by the government now can make a huge difference to these banks, their customers, and their communities--keeping capital and resources focused where they are needed most. Importantly, the amount of capital required to provide an additional cushion for all community banks--which had nothing to do with the current crisis--is tiny compared to the $182 billion provided to AIG. In fact, it takes only about $500 million in new capital today to bring all banks under $10 billion in assets above the well-capitalized levels for Tier 1 capital. Even under a baseline stress test, the additional capital needed is less than $3 billion for all these smaller banks to be well-capitalized. Without new capital, banks under $10 billion in assets would have to shed nearly $9 billion in loans to achieve the same capital-to-assets ratio. Simply put, capital availability means credit availability. A small investment in community banks is likely to save billions of dollars of loans in local communities. Before discussing these points in more detail, I did want to thank Members of the Subcommittee for their tireless support of S. 896, the Helping Families Save Their Homes Act of 2009, legislation that expanded the insurance limits for deposits to $250,000 for 4 years and expanded FDIC's line of credit with the Treasury from $30 billion to $100 billion. Expanding the deposit insurance limit provided additional protection to small businesses, retirees, and other bank depositors that need to protect their payrolls or life-savings. Expanding the FDIC's line of credit helped to reduce banks' expenses, thus preserving resources in communities across this Nation. Without this expanded line, the FDIC would have imposed a special assessment on the banking industry totaling more than $15 billion dollars. By enacting this expanded line of credit, the FDIC has an additional cushion to rely upon--particularly for working capital purposes necessary to resolve bank failures quickly and to ensure that depositors have immediate access to their money. This increase in borrowing authority enabled the FDIC to make good on its promise to cut the special assessment in half. The original special assessment would have devastated the earnings of banks, particularly community banks, just at the time funds are needed most in their communities. Of course, the industry still bears a considerable financial burden from both the regular quarterly premiums and the final special assessment. The vast majority of banks that will bear this cost are well capitalized and had nothing to do with the subprime mortgages that led to our financial and economic problems. Yet these banks bear much of the costs of cleaning up the problems created. We will continue to work with you to find ways to reduce the costs imposed on healthy banks and to build a strong base to support new lending as our economy emerges from this recession. In my statement, I would like to focus on the following points: Banks in rural communities continue to lend in this difficult economic environment, but the broadening economic problems will make this more difficult in the future. New and expanded programs directed at community banks can help rural America cope with the current downturn, including broadening capital programs to enable participation by a broader cross section of viable but struggling banks. Moreover, regulators should ensure that their regulatory and supervisory responses are commensurate to the risks they are seeing in banks, and that they avoid inappropriate, procyclical responses that make bad situations worse. ABA believes that it is critical for this Subcommittee and Congress to focus on creating a systemic regulator, providing a strong mechanism for resolving troubled systemically important firms and filling gaps in the regulation of the shadow banking industry. Such significant legislation would address the principal causes of the financial crisis and constitute major reform. We believe there is a broad consensus in the need to address these issues. I will address each of these points in turn.I. Banks in rural communities continue to lend in this difficult economic environment, but the broadening economic problems will make this more difficult in the future. Rural America has been bolstered in recent years by an agriculture sector that experienced one of the longest periods of financial prosperity in history. In 2007 and 2008, American farmers and ranchers in the aggregate enjoyed some of their most profitable years ever. The balance sheet for U.S. agriculture at the end of 2008 (according to USDA) was the strongest it has ever been, with a debt to asset ratio of less than 10 percent. USDA projects that, at year end 2009, farm and ranch net worth will be $2.171 trillion. This unprecedented high net worth is due in part to a robust increase in farm asset values (mainly farm real estate)--values which have not suffered the dramatic fluctuation as in some sectors during this time of crisis--but the high net worth is equally due to solid earned net worth as farmers used their excess cash profits to retire debt. However, while the past 10 years may be looked back upon by historians as an era of farm prosperity, not all sectors of the farm economy are doing well in 2009. Pressured by increases in the price of grain, the livestock sector is under considerable financial pressure. Dairy prices have dropped to below break-even levels for many producers, as demand has declined and dairy production continues to increase. The cattle feeding business has lost money for over 24 months. Poultry producers have been hurt by lower prices and by the collapse of the largest poultry integrator in the country in 2008. The hog industry, which was poised to recover from low prices in 2008, has been badly hurt by misguided fears of the H1N1 virus and the subsequent closure of some key export markets. Fortunately, rural America was well positioned at the beginning of 2009 to face the trying times they have encountered as a result of the economic crisis and other world events. In this environment, we sometimes hear that banks are not lending money. This is simply not true. As the charts on the next page show, bank lending in rural America has risen steadily over the last half-dozen years, and even during the first year of the recession, bank lending in rural areas has increased. As noted above, maintaining an expanding volume of credit will be a considerable challenge this year as the economy continues to weaken. While overall banks have continued to lend throughout this recession, that does not mean much to an individual borrower having difficulty obtaining financing. In many of these individual cases, however, upon further investigation, it appears that the primary reason for not receiving funding was either that the borrower's financial condition was vulnerable (perhaps weakened by local economic conditions), or the borrower expected to borrow money at prerecession terms when the risk of lending was considerably lower and funds available for lending were more accessible. Of course, every loan application is unique and must be evaluated that way. One thing that has clearly appened is that banks are looking carefully at the risk of a loan and reevaluating the proper pricing of that risk. This is a prudent business practice and one expected by our bank regulators. Against the backdrop of a very weak economy and in light of the troubles in the agricultural sector, it is only reasonable and prudent that all businesses--including banks and farms--exercise caution in taking on new financial obligations. In fact, farmers and ranchers have been very conscious of this financial cycle, and wisely used their excess cash profits to retire debt and to acquire new plant and equipment during the boom years. Both banks and their regulators are understandably more cautious in today's environment. Bankers are asking more questions of their borrowers, and regulators are asking more questions of the banks they examine. This means that some higher-risk projects that might have been funded when the economy was stronger may not find funding today.II. New and expanded programs directed at community banks can help rural America cope with the current downturn. The vast majority of community banks had absolutely nothing to do with the current crisis, yet as their communities have suffered, so have they. In spite of the strong agricultural economy which has helped to shield many parts of this Nation from the recession, the economic decline--and its global impact--will surely be felt over the course of the next several years. There has never been a more important time to put in place solutions that will help all community banks as they manage through this downturn. The many programs that have been initiated to calm the markets and provide capital for lending have helped to stabilize financial markets. As an example, the announcement of the Capital Purchase Program on October 14 caused risk spreads to decline from their pinnacle of 457 basis points on October 10 to 249 basis points on October 22, a drop of 45 percent. Clearly, the program to inject capital in healthy banks had a dramatic and immediate impact, and the trends begun then continue to narrow margins even further--back nearly to precrisis spreads. (See the charts on the following page.) However, the focus of the CPP and other stimulus programs has been on the largest banks and was only slowly made available to smaller banks. The changing nature of this program and the restrictive selection process has meant that banks that could have benefited from the program were unable to do so. As a result, to maintain reasonable capital levels, these banks have been forced to limit, or even reduce, their lending. As I emphasized at the outset, the amount of capital required to provide an additional cushion for all community banks is small. To reiterate, it takes only about $500 million in new capital today to bring all banks under $10 billion in assets above the well-capitalized levels for Tier 1 capital. Even under a baseline stress test to assess future needs, the additional capital needed is less than $3 billion for all banks to be well-capitalized. Without new capital, banks under $10 billion in assets would have to shed nearly $9 billion in loans to achieve the same capital-to-assets ratio. Thus, a small injection of capital goes a long way to keeping credit flowing in rural communities. Given the continued weakness in this economy and the challenges we will face in the next 18 months, it is a critical time to focus on strategies for helping community banks. ABA recommends that new programs be developed--and existing programs be expanded--to help banks in rural America. Several key changes that are needed include: Broadening capital programs to enable participation by a broader cross section of banks. Revising the risk-based capital rules to more accurately reflect the risks presented by these investments. Avoiding appraising banks into insolvency by using inappropriately conservative asset valuations and underwriting standards.Broaden capital programs to enable participation by a broader cross section of banks The Capital Purchase Program (CPP) has been implemented in a way that ignores community banks that are viable but that are experiencing significant--yet temporary--problems. The Capital Assistance Program has not yet been implemented for community banks, but reportedly will apply the same eligibility criteria that have been used with the CPP. The Legacy Loans Program has the potential to help, but the FDIC recently announced a delay in implementing the Legacy Loans Program that calls into serious question its viability outside the possible use in failed bank situations. The Legacy Securities Program is still struggling to get off the ground as well. Program after program either has failed to meet the needs of viable community banks or has languished. ABA believes that this problem can be solved through several modifications: 1. Permit banks with up to $1 billion in total assets to participate in the expanded CPP. 2. Publish the eligibility criteria for participating in the CPP and CAP. 3. Provide funding to viable banks that have significant--yet manageable--issues. 4. Revive the Legacy Loans Program and implement the Legacy Securities programs in a way that expands the universe of eligible assets to include trust preferred securities, ``real estate owned,'' and other real estate-related loans. The programs also should be implemented in a way that avoids effectively shutting small banks out (for example, minimum sizes on asset pools that no community bank could meet). The comparatively small sums of money that would be invested in these struggling but viable banks would pay big returns for the communities they serve.Revise the risk-based capital rules to more accurately reflect the risks presented by banks' investments Congress should use its oversight powers to assure that the regulators have rules and regulations that accurately reflect the risks that banks face. For example, banks' investment in mortgage backed securities and collateralized debt obligations are being severely downgraded by ratings agencies, largely due to liquidity issues (not credit or repayment risk). When the investments are downgraded below investment grade, an inappropriately conservative capital charge applies that can cause a risk weighting to go from 100 percent to 1,250 percent, regardless of the performance of the security and regardless of the amount of subordinate positions that will absorb loss before a given bank's position. Mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) are securities whose performance depends on multiple obligors; the default by one borrower is not likely to impact the performance of other borrowers whose debt has been bundled in the security. Despite this--because ratings are based primarily on the probability of loss of the first dollar--any loss in an MBS or CDO adversely affects the rating of the security. This, in turn, can trigger higher capital requirements for banks, regardless of the likelihood that a holder of an interest in the security may be repaid at 100 cents on the dollar. Moreover, the current application of the Uniform Agreement on the Classification of Assets and Appraisal of Securities causes the entire face amount of a debt security with some degree of impairment to be classified, rather than requiring classification only of the portion of the security that reflects potential loss to the banking organization. ABA believes that two changes will help this situation considerably: 1. Revise the risk-based capital rules to more accurately reflect the risks presented by these investments. 2. Classify only that portion of the security that represents the credit risk-related expected loss on the exposures underlying the security, adjusted for any credit enhancements and further adjusted for recoveries and expected loss severity. An additional problem related to bank capital is that the risk weighting of debt issued by Fannie Mae and Freddie Mac is too high. Prior to those institutions being placed into conservatorship, the debt was risk-weighted at 20 percent. Given the stated intent of the United States government to support these GSEs, a lower risk weight is appropriate and would help offset to a small degree the adverse impact that the conservatorships had on those banks that invested in Fannie and Freddie stock. The risk weight of GSE debt should be reduced to below 20 percent. The agencies proposed to lower the risk weight of Fannie and Freddie debt to 10 percent, but this rulemaking has been pending since October of last year. A third issue related to capital concerns is the extent to which a bank's allowance for loan and lease losses (ALLL) is included in the bank's capital. The agencies' capital rules permit a bank's ALLL to count as Tier 2 capital, but only up to 1.25 percent of a bank's risk-weighted assets. This fails to adequately recognize the loss-absorbing abilities of the entire allowance and creates a disincentive to banks reserving more. Both the ALLL and ``core'' capital are available to absorb losses. The Comptroller of the Currency recently acknowledged this, stating, ``loan loss reserves are a front line of defense for absorbing credit losses before capital must do so. . . . Given their primary, capital-like loss-absorbing function, loan loss reserves should get greater recognition in regulatory capital rules, a result that would help remove disincentives for banks to hold higher levels of reserves.'' \2\--------------------------------------------------------------------------- \2\ Remarks by John C. Dugan, Comptroller of the Currency, Before the Institute for International Bankers, March 2, 2009.--------------------------------------------------------------------------- These changes suggested in response to these three issues would result in a more accurate reflection of the health of institutions. ABA fully supports the system of risk-based regulation and supervision, but when the rules no longer reflect risk, the system breaks down. Our suggestions are intended to address instances where a bank's risk of loss is not fairly reflected in the rules. In the case of downgraded debt securities, the rules can, in extreme cases, threaten the viability of institutions that are directed to raise significant additional capital in a short period of time. It is bad policy to require a bank to raise capital to address the appearance of a shortfall but not the reality of one. When a rule requires more capital than the actual risk to the bank would suggest, the rule should be changed.Avoid appraising banks into insolvency by using inappropriately conservative asset valuations and underwriting standards In my role as Chairman-Elect and as chairman of the ABA Community Bank Solutions Task Force, I have heard numerous stories from bankers about issues that are coming up in exams. Banks are being told to write down the value of assets based on the sales prices of assets being dumped on the market at distressed prices. Appraisals of property that are based on comparable sales are particularly problematic when the sales do not involve a willing buyer and a willing seller. Valuations by a banker acting reasonably and in good faith are likely to be more accurate than appraisals in those situations. ABA frequently hears that examiners either are not using FASB-compliant valuation methods or are using ``personal formulas'' to downgrade or reevaluate portfolio values, even when stated values are supported by timely appraisals. We also hear that examiners are applying new, unpublished, and seemingly arbitrary ``rules of thumb'' for how much a bank must put in its allowance for loan and lease losses (ALLL). For example, in some cases examiners require 25 percent of every substandard asset; 75 percent of nonperforming assets; etc. ABA believes there are several steps that the regulators should be taking to remedy this situation and we urge this Subcommittee to use its oversight authority to encourage them: 1. Issue written guidance affirming that banks should not use distressed sales values when analyzing ``comparables.'' Guidance should address proper appraisal documentation, particularly where foreclosures or auction sales comprise a majority of the comparable transactions. Moreover, this guidance should state that banks may rely, in appropriate situations, on bank management's judgment about the value of a property. 2. Allow institutions that have rented properties at market rates to exclude them from ``nonperforming loans.'' 3. Apply clear and consistent standards to the maintenance of the ALLL that reflect a realistic assessment of the assets' likely performance. These changes are necessary to confront the natural inclination of examiners to be conservative in order to avoid the inevitable second-guessing that would arise if a bank were to fail on their watch. We are not suggesting that examiners use forbearance or otherwise relax their examination standards; rather, we are suggesting that the examiners not be harder on banks than circumstances warrant. The regulators can make things worse in their efforts to make things better. Insisting upon punitive, procyclical steps at a time when a bank is working through issues can push an otherwise viable bank over the edge. There are many more actions that could be taken to help banks throughout this period. ABA would be happy to discuss this further with the Committee.III. Creating a systemic risk regulator, providing a mechanism for resolving troubled systemically important institutions, and filling gaps in the regulation of the shadow banking industry should be the focus of Congressional action. One of the most critical needs today is a regulator with explicit systemic risk responsibility. ABA strongly supports having such a regulator. There are many aspects to consider related to the authority of this regulator, including the ability to mitigate risk-taking from systemically important institutions, authority over how accounting rules are developed and applied, and the protections needed to maintain the integrity of the payments system. ABA believes that systemic risk oversight should utilize existing regulatory structures to the maximum extent possible and involve a limited number of market participants, both bank and nonbank. Safety and soundness implications, financial risk, consumer protection, and other relevant issues need to be considered together by the regulator of each institution. To be effective, the systemic risk regulator must have some authority over the development and implementation of accounting rules. No systemic risk regulator can do its job if it cannot have some input into accounting standards--standards that have the potential to undermine any action taken by a systemic regulator. Thus, a new system for the establishment of accounting rules--one that considers the real-world effects of accounting rules--needs to be created in recognition of the critical importance of accounting rules to systemic risk and economic activity. Moreover, there must be a mechanism for the orderly resolution of systemically important nonbank firms. Our regulatory bodies should never again be in the position of making up a solution on the fly to a Bear Stearns or AIG, of not being able to solve a Lehman Brothers. The inability to deal with those situations in a predetermined way greatly exacerbated the crisis. A critical issue in this regard is ``too-big-to-fail.'' Whatever is done on the systemic regulator and on a resolution system will set the parameters of ``too-big-to-fail.'' In an ideal world, no institution would be ``too-big-to-fail,'' and that is ABA's goal; but we all know how difficult that is to accomplish, particularly with the events of the last few months. This ``too-big-to-fail'' concept has profound moral hazard implications and competitive effects that are very important to address. We note Chairman Bernanke's statement: ``Improved resolution procedures . . . would help reduce the ``too-big-to-fail'' problem by narrowing the range of circumstances that might be expected to prompt government action. . . . '' \3\--------------------------------------------------------------------------- \3\ Ben Bernanke, speech to the Council on Foreign Relations, Washington, DC, March 10, 2009.--------------------------------------------------------------------------- Finally, a major cause of our current problems is the regulatory gaps that allowed some entities to completely escape effective regulation. It is now apparent to everyone that a critical gap occurred with respect to the lack of regulation of independent mortgage brokers. Questions are also being raised with respect to credit derivatives, hedge funds, and others. As these gaps are being addressed, Congress should be careful not to impose new, unnecessary regulations on the traditional banking sector, which was not the source of the crisis and continues to provide credit. Thousands of banks of all sizes, in communities across the country, are scared to death that their already-crushing regulatory burdens will be increased dramatically by regulations aimed primarily at their less-regulated or unregulated competitors. Even worse, the new regulations will be lightly applied to nonbanks while they will be rigorously applied--down to the last comma--to banks.Conclusion I want to thank you, Mr. Chairman, for the opportunity to present the views of the ABA on the challenges ahead for rural communities and the banks that serve them. These are difficult times and the challenges are significant. In the face of a severe recession, however, bankers are working hard every day to assure that the credit needs of our communities are met. As you contemplate major changes in regulation--and change is needed--ABA would urge you to ask this simple question: how will this change impact those thousands of banks that make the loans needed to get our economy moving again? Addressing these issues will provide the most constructive avenue to assure that rural communities throughout this Nation will continue to have access to credit by local financial institutions. We look forward to working with Congress to address needed changes in a timely fashion, while maintaining the critical role of our Nation's banks. CHRG-109shrg30354--81 Chairman Bernanke," Senator, there appears to be a structural tendency for the yield curve to be flatter than it was in the past. Part of it, as I answered to Senator Bennett, is the global savings glut which is keeping long-term real interest rates lower than they otherwise would be. The second is, for a variety of reasons that I went into in a speech earlier this year and talked about in some detail, for a variety of reasons the term premium, the risk premium on long-term debt, seems to have been lower recently than historically. And for those reasons, the term structure seems to be flatter structurally than has been the case historically, although there has been a bit of an increase, I think, in the long rates in both the term premium and the portion attributable to the savings glut, I think, since the beginning of the year. Senator Carper. A question on energy independence, if I could. I mentioned in my earlier comments that over a third of the trade deficit this year now is imported oil. When we look at inflation, a significant part of what is pushing up prices is the cost of energy. Our neighbors down to the south in Brazil, about 15 years or so ago they had said they wanted to become energy independent. And they have done a fair amount of work. We hear a lot about what they have done with flexible fuel vehicles and greater reliance on ethanol. We, meanwhile, have gone in the other direction over the last 15 years. We have become more and more dependent on foreign oil and it takes an ever larger bite out, in terms of with respect to the trade deficit. Your advice for our country with respect to moving toward energy independence and whether or not it is something we should be taking seriously? And if so, what counsel would you have for us there? " FOMC20081216meeting--445 443,MR. DUDLEY.," No, I don't think that is quite right. We are in basically a market disequilibrium, where the traditional buyers of these securities have vanished. In a normal market environment, it would be completely reasonable to lend against these securities on a leveraged basis. But the people who would do that lending--banks and dealers--are balance sheet constrained, and that is why they are not willing to make those loans. If we had a normal banking and dealer situation today in which they were willing to extend loans to their counterparties, they would be providing the leverage. But that is just not happening. " CHRG-111hhrg48867--254 Mr. Ellison," Okay. She advocated the application of a global leverage capital requirement, which we already have in the United States. Could you express your thoughts on those requirements for banks both in the United States and internationally? " CHRG-111hhrg51585--94 Mr. Neugebauer," But if you could buy triple A, why would you buy an A? Ms. Rushing. The only response I can give you is that the portfolio was diversified, that we had commercial paper, that we had mortgages--as I said, Fannie Mae, Freddie Mac--and there was some portion of the portfolio that included corporate debt that was highly rated. " CHRG-111hhrg55811--320 Mr. Sherman," Let me interrupt. Do we have any proof that a majority of the debts or derivatives placed were placed by people who had real business reasons as opposed to just folks who thought they could make money because they could guess which way the price of orange juice was going to go? " FinancialCrisisReport--256 From 2004 to 2007, Moody’s and S&P produced a record number of ratings and a record amount of revenues in structured finance, primarily because of RMBS and CDO ratings. A 2008 S&P submission to the SEC indicates, for example, that from 2004 to 2007, S&P issued more than 5,500 RMBS ratings and more than 835 mortgage related CDO ratings. 987 The number of ratings it issued increased each year, going from approximately 700 RMBS ratings in 2002, to more than 1,600 in 2006. Its mortgage related CDO ratings increased tenfold, going from 34 in 2002, to over 340 in 2006. 988 Moody’s experienced similar growth. According to a 2008 Moody’s submission to the SEC, from 2004 to 2007, it issued over 4,000 RMBS ratings and over 870 CDO ratings. 989 Moody’s also increased the ratings it issued each year, going from approximately 540 RMBS and 45 CDO ratings in 2002, to more than 1,200 RMBS and 360 CDO ratings in 2006. 990 Both companies charged substantial fees to rate a product. To obtain an RMBS or CDO rating during the height of the market, for example, S&P charged issuers generally from $40,000 to $135,000 to rate tranches of an RMBS and from $30,000 to $750,000 to rate the tranches of a CDO. 991 Surveillance fees, which may be imposed at the initial rating or annually, ranged generally from $5,000 to $50,000 for these mortgage backed securities. 992 Revenues increased dramatically over time as well. Moody’s gross revenues from RMBS and CDO ratings more than tripled in five years, from over $61 million in 2002, to over $260 million in 2006. 993 S&P’s revenue increased even more. In 2002, S&P’s gross revenue for RMBS and mortgage related CDO ratings was over $64 million and increased to over $265 986 See, e.g., 3/26/2010 “Fitch Ratings Global Structured Finance 2009 Transition and Default Study,” prepared by Fitch. 987 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 20. These numbers represent the RMBS or CDO pools that were presented to S&P which then issued ratings for multiple tranches per RMBS or CDO pool. 988 Id. 989 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214. These numbers represent the RMBS or CDO pools that were presented to Moody’s which then issued ratings for multiple tranches per RMBS or CDO pool. The data Moody’s provided to the SEC on CDOs represented ABS CDOs, some of which may not be mortgage related. However, by 2004, most, but not all, CDOs relied primarily on mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director of Moody’s RMBS Group (10/29/2009). 990 Id. 991 See, e.g., “U.S. Structured Ratings Fee Schedule Residential Mortgage-Backed Financings and Residential Servicer Evaluations,” prepared by S&P, S&P-PSI 0000028-35; and “U.S. Structured Ratings Fee Schedule Collateralized Debt Obligations Amended 3/7/2007,” prepared by S&P, S&P-PSI 0000036-50. 992 Id. 993 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214. The 2002 figure does not include gross revenue from CDO ratings as this figure was not readily available due to the transition of Moody’s accounting systems. million in 2006. 994 In that same period, revenues from S&P’s structured finance group tripled from about $184 million in 2002 to over $561 million in 2007. 995 In 2002, structured finance ratings contributed 36% to S&P’s bottom line; in 2007, they made up 49% of all S&P revenues from ratings. 996 In addition, from 2000 to 2007, operating margins at the CRAs averaged 53%. 997 Altogether, revenues from the three leading credit rating agencies more than doubled from nearly $3 billion in 2002 to over $6 billion in 2007. 998 CHRG-110shrg50420--2 Chairman Dodd," The Committee will come to order. Good morning. I would ask the Committee to come to order, and our friends that cannot find a seat in the hearing room--as you all noticed, we moved the hearing this morning. The last hearing obviously drew a sizable audience of interested people, and so we moved the hearing to this room this morning. I want to thank my colleagues. I know many had planned, obviously, to be probably elsewhere this week, but I am very grateful to all of you for being here for this second hearing on the subject matter. And I am going to take a minute or so this morning and just explain some housekeeping provisions and then some opening comments on the subject matter. We are here, obviously, ``Examining the State of the Domestic Automobile Industry: Part II,'' if you will, of these hearings. This could quite possibly be, I would point out to my colleagues--and I say that with some hesitation--the last hearing of this Committee in the 110th Congress. And I want to just take a moment, if we could, all of us here, to recognize the service and valuable contributions of some of our colleagues who will be leaving. Senator Hagel, Chuck Hagel of Nebraska. He is a dear, dear friend and a great--we served on two committees together over the years, the Foreign Relations Committee and this Committee, and you have been a valued friend and a wonderful member of the U.S. Senate. We thank you immensely, Chuck, for your service. Elizabeth Dole, our good friend from North Carolina, we thank you for your service on this Committee as well and your and Bob's wonderful contribution. You are very much part of the Senate family and have been for a long time. So we thank you immensely. And, of course, Wayne Allard, my good friend from Colorado, we thank him. Where is he? He is not here yet, but he is coming, and we thank him very, very much as well for his service, and their staff members on this Committee. Tewana Wilkerson, Joe Cwiklinski, and Robbie have done a great job, and I thank them for their service. Let me make, as I said, a couple of housekeeping points, if I can. First, given this is the second hearing on the auto industry and given the large number of witnesses we have before us this morning, I would like to propose that Senator Shelby and I make our opening statements and then move immediately to our witnesses as a way of moving along here rapidly, given the number of people who will be testifying before us. And, second, the automobile companies represented here this morning have provided this Committee and the Senate with extensive information about their status and their plans. In the case of one company, in the case of Chrysler, some of that information is proprietary in nature. It is a private company, not a public company. We have left it up to that company to provide that information to each interested Senator in a manner that both parties deem consistent with protecting the privacy of proprietary data. Should any questions be raised today that might trigger a request for proprietary information, I would ask that these questions be answered by the auto companies to the member's satisfaction in a manner that preserves the confidentiality of the information sought. Today the Committee meets, as I pointed out, for the second time in as many weeks to consider the state of the domestic automobile industry. As we consider the challenges facing this industry, I want to be clear that Congress has already given the Bush administration the authority to stabilize this industry. I would like to take note that I invited the Treasury Department and the Federal Reserve Board to testify here this morning, and they have declined to do so. Yesterday I sent a letter to Chairman Bernanke requesting his comments on the industry's plans and whether there is anything that prevents the Federal Reserve from lending any of these domestic--providing any lending to any of these domestic auto manufacturing companies. When we last met, I said that the fate of the industry is an important subject matter, obviously, for our Committee's consideration. That statement even is truer today than it was a few days ago. In fact, the very purpose of this hearing is fundamentally to answer three very straightforward questions. First, are the automobile companies in dire straits? Are they in danger of failure? Second, if they were to fail, what would be the consequences for our overall economy? And, third, if the economic consequences would be severe, does the American Government have a responsibility to do anything to help? In just 2 weeks' time, the clouds on the economic horizon have grown even darker and greater in number. Just this week, we learned what many of us have believed for a long time. Our economy is mired in a deep and sustained recession--a recession that began some 12 months ago, a recession that has contributed to the greatest loss of manufacturing jobs, including in the automobile industry, in over a quarter of a century, and a recession that was in many respects precipitated by massively irresponsible actions by those in the financial sector, including lenders who are now the recipients of hundreds of billions of dollars in Federal taxpayer bailout assistance. Amidst this backdrop of intensified economic turbulence and uncertainty, the leaders of the domestic automobile industry are here once again to explain why they are seeking assistance from the Committee and from the Congress of the United States. None of us relishes this task that we are asked to consider, yet who among us believes we should risk the consequences of the collapse of one or more domestic automobile manufacturers? Make no mistake about it. Those consequences would be severe and sweeping. Tens if not hundreds of thousands of jobs would be lost in the auto industry itself. More would be lost among suppliers, dealers, and all of the other businesses, from restaurants to garages and others across our Nation in ways large and small that depend on a domestic auto industry for their livelihoods. Moreover, at a time when taxpayers are already bearing an extraordinary burden in funding economic recovery efforts, that burden would only increase in the event of a failure of one or more of these companies. Pension obligations alone could run into the tens and maybe hundreds of billions of dollars. A partial or complete failure of the domestic automobile industry would have ramifications far beyond manufacturing and pensions. It would affect virtually every sector of our economy. That includes the financial sector, which is a particular focus of this Committee. A collapse within the auto sector would unquestionably worsen the credit crisis. By some estimates, the domestic auto companies already comprise more than 10 percent of the high-yield bond market and one of the largest sectors in the leveraged finance for banks. The Big Three have hundreds of billions in outstanding debt liabilities, including tens of billions in short- and long-term debt obligations. In addition to their outstanding debt, these companies hold billions in credit default swaps. A failure in the auto industry could trigger obligations by manufacturers and counterparties that could have financial firms reeling. Ultimately, the ability of those firms to inject credit and liquidity into the overall economy could be impaired, stifling job creation and further income growth. None of us--none of us--wants to see that outcome. So let us be clear this morning. In my view, we need to act not for the purpose of protecting a handful of companies. If that were the extent of the issue, I would let them fail. I acknowledge those who advocate such a course on the assumption that pressure from the outside will produce the desired results. My concern with such an approach is that it plays Russian roulette with the entire economy of the United States. Inaction is no solution. Inaction would only add more uncertainty and instability to our economy. These are the ingredients that currently we have an overabundance, ingredients that are contributing to the crisis of confidence that has gripped the markets and precipitated the worst economic crisis since the Great Depression. It seems to me that the request being made by the automobile industry, while large by any measure, is modest in comparison to what this Committee has lately witnessed in the financial sector. If the Federal Reserve and the Treasury Department under President Bush can find $30 billion for Bear Stearns, if they can concoct a $150 billion rescue for AIG, if they can commit $200 billion to Fannie Mae and Freddie Mac, and if they can back Citigroup to the tune of more than $300 billion, then there ought to be a way to come up with a far smaller dollar figure to protect this economy from the unintended consequences that would be unleashed by a collapse of the automobile industry. With regard to the automobile industry, certainly we should not throw good money after bad, nor should we subsidize ineffective performance and inefficient production. We must demand that the auto companies demonstrate their commitment to reform. We must insist that if they are going to be backed by the American taxpayer, they owe it to those same taxpayers to make vehicles in a far more environmentally and economically sound manner. The latest plans submitted by these companies over the last several days, which I have read completely, all three of them, are not perfect by any means. But, on average, I think they represent a commitment to that kind of necessary reform that Detroit must adopt if our economy and our country is to have an automobile industry in the 21st century. Some of the companies are to be commended for going back to the drawing board, making tough decisions, and stepping forward today. You have come a long way in 2 weeks, I would say. Some may ask whether these proposed changes go far enough. In addition, I think these plans still leave many questions unanswered. In particular, will taxpayer assistance truly ensure long-term viability for these companies? Or will they be back here within weeks seeking more taxpayer assistance? But let us be clear. There is no doubt that the automobile companies have done far more--far more, I would suggest--than the financial companies to show that they deserve taxpayer support. The Treasury Department has given the Nation's largest lenders hundreds of billions of dollars, as pointed out, as this graph here behind me demonstrates. Even now, weeks after the fact, Americans are still waiting for most of them to show that they deserve the dollars they have received, still waiting for them to appropriately increase lending to consumers and businesses, still waiting--still waiting--for them to more aggressively act to mitigate foreclosures in our country, and still waiting for these lenders to rein in bonuses and other forms of excessive compensation while the American taxpayer is sacrificing on a daily basis. The Nation's largest financial institutions are among the largest culprits in causing the credit crisis, and yet Secretary Paulson and the Treasury, despite being given complete authority to condition aid to financial institutions, have in no meaningful way insisted that these banks and insurance companies adopt tough reforms to ensure that the kind of shabby lending practices they engaged in will not happen again. On the contrary, the Treasury Department's largesse with taxpayer funds has been remarkably free of conditions placed on the recipients of those funds. Indeed, in the spirit of the season, Secretary Paulson has given the Nation's largest financial institutions the biggest holiday present in the history of American capitalism. In my view, if we are going to insist on reforms by the auto industry as a condition of receiving Federal funding, we ought to do the same for the financial companies. For that reason, I will do all I can to insist that any auto company bill also place tough conditions on any loans to financial firms, including provisions that require tax dollars to be used for responsible practices, like lending that requires lenders to get much more aggressive about attacking the foreclosure crisis that is still at the root cause of the larger financial crisis and that prohibits executives from paying themselves obscene sums while they are essentially receiving a welfare check for the American taxpayer. At a time when average Americans are sacrificing mightily for the sake of our Nation's economic recovery, we must, I believe, insist that companies benefiting from those sacrifices act as if they deserved them. At the same time, I believe we need to take action to help our domestic auto industry in order to protect our Nation's economy and America's workers. Finally, I want to respond to recent stories indicating that the administration is considering asking for access to the final $350 billion we provided in the Emergency Economic Stabilization Act. We passed a bill that gave this administration broad authority to use funding to address the economic crisis we find ourselves in. Regrettably, they have misused the authority in two ways, in my view: First, they are not doing what we clearly expected them to do. Most importantly, they are not using the money to help homeowners in distress. The FDIC has put forth a program that would help 2 million homeowners keep their homes, and the Treasury Department is refusing to fund that idea. Second, they have spent the money--they have spent the money, they have done so in an ad hoc and arbitrary manner, in my view. They seem to be careening from pillar to post. Both the Treasury and the Federal Reserve have spent trillions of taxpayer dollars without adequate controls and without adequate transparency. I do not believe this administration should seek the use of this additional funding unless they can present to the Congress and the American public a comprehensive, coherent plan for addressing those concerns. Let me thank all of our witnesses again this morning for appearing here. We look forward to hearing from each of you, and with that, I want to turn to my colleague from Alabama, the former Chairman of the Committee, Senator Shelby. FinancialCrisisInquiry--429 SOLOMON: I certainly agree on leverage. They all said there was too much leverage. And I also agree that all their managements failed. So I can agree on both those. January 13, 2010 What I really disagree on is that standards change. And that’s why I gave you a little history of the 1960’s. Standards do not change. What changes is the competitive environment. And what has changed is limited liability, incentive compensation, and public ownership. And that’s what’s changed. One of the reasons those folks made those decisions is they have analysts judging how well they’re doing. And when one of them provides a leveraged loan with seven times (inaudible) to some company, the other one competes and says I can do it at eight times. And one tries to buy real estate and sees that Goldman Sachs or somebody buys, you know, (inaudible), then Dick Fuld goes out and decides he has to buy the West Coast if somebody else has bought the East Coast. And it’s the competitive nature of public ownership and limited liability that is at the essence of the problem, in my view. But I don’t agree that standards change. CHRG-111shrg61513--50 Mr. Bernanke," The Government's commitment at this point is a couple hundred billion to those institutions. Senator Johanns. Let me also draw your attention to something, and I am running out of time here, but I was just catching up on some things, and I noticed today that first-time unemployment filings have increased. That was not expected. Durable goods orders have fallen the most since August. That is not a good sign. And that excludes, I think, transportation. The market has responded by dropping at least at this point by 160, and I appreciate the market can have up days and down days. I am starting to read more and more articles about the national debt interfering with economic recovery. And yet I do not see an effort to slow that down here. In fact, if we were just to stand down and say, OK, we will adopt the President's plan, there are trillion dollar deficits over the next decade. I cannot imagine how that turns out for--you know, I will be 70 years old the next decade. I am not going to live long enough to pay that off. That means my children and grandchildren are going to have to deal with that. I am beginning to wonder, Mr. Chairman--and I do not want this to sound overly pessimistic, but I am beginning to wonder whether low interest rates really have any possibility of spurring this economy. And I will tell you what I am thinking about, and you may not even have enough time to respond. Unless there is demand, unless we can get consumers back into it, it just seems very unlikely to me that you are going to see much growth. I talked to people who handle the freight--the railroads, the trucking companies. They are not seeing much improvement. All these signs point to a situation where, quite honestly, this economy is still enormously flat. And I am not sure that offering somebody an interest rate at 2 percent versus 4 percent is going to get us on the other side of this, and I would just like your thought on that. " CHRG-111hhrg54867--266 Mr. Paulsen," Thank you, Mr. Chairman. Thank you, Mr. Secretary. An area of fertile discussion has been the area of risk management. And most firms understand the risks that they run, but they don't often have the strength or the will or the foresight to say no. The competitive dynamic among firms creates the situation. And this is where a regulator with an eye towards aggregate risk in the system would be most beneficial, I think we could agree. How do you intend to have the regulator calibrate that aggregate risk so that the benefits of competition that accrue to society will be able to go forward, as opposed to creating another disaster or go too much in the opposite direction where it is going to really burden innovation? " CHRG-111shrg53822--76 Mr. Rajan," This is probably where I part a little with my fellow panelists. I think that capital can do a little bit. I would be skeptical about putting too much weight on it. And the reason is simply that the market in good times is very tolerant of institutions that have very high levels of leverage. As you know, some banks had 30, 40 to 1 leverage. Some investment banks had that kind of leverage. The market was willing to tolerate very low levels of capital. When the market is willing to tolerate those very low levels of capital, somebody who is sitting on a lot of capital has an incentive to undertake actions, which will reduce that level of capital relative to the activities they are taking. One example of such actions include creating off-balance sheet vehicles, which banks did a lot of. The SIVs and the conduits are examples. A second example of that kind of activity is for banks to take up risks, which is not penalized. UBS did that when it took on all these sub-prime mortgages on its balance sheet. So I think capital can help a little, but I think that banks, if the market does not require them to hold a lot of capital, banks are going to offset the capital requirement in ways that the regulator will not see. Moreover, this notion that in down times, banks can reduce the level of capital because the regulator allows them to, I am skeptical about that also because in times like these, this is when the market has taken fright. This is when the market wants banks to hold much higher levels of capital. Whatever the regulators say, the markets are going to dominate. And so, banks are going to raise their capital levels at this point, which is why you see this extreme level of de-leveraging taking place in the market, in the banking sector. So my sense is capital requirements which go against what the market wants are going to have limited effect. They will have some effect, no doubt, but let's not be overly convinced about the effect it will have. Senator Akaka. Thank you. " CHRG-111hhrg54872--299 Mr. Lee," Thank you. I was pleased to hear my friend from Ohio talk about the idea of what we can do to promote less bureaucracy and greater efficiency. If we are ever going to emerge from this economic downturn, it has to be through job creation in the private sector. Your industry has been one of those bright spots, especially community banks who have been good stewards, well-capitalized, and without them during this downturn, the situation could have been much worse. I am astonished because you look at Congress and it seems that Congress has a way of adding restrictions, regulatory burdens, more bureaucracy, frankly, in some cases to industries that have done well. My concern here is how we impact, again, the community banks in getting through this. I look at what the CFPA represents, and especially with the issue on preemption. I guess maybe I can start with, Mr. Yingling, your concern. What are the potential consequences, unintended or not, if this issue of no longer having Federal preemption takes place? " CHRG-110hhrg46593--326 Mr. Blinder," They have no line to the Treasury, and, therefore, they could never operate with the kind of leverage that Fannie and Freddie did. They would have leverage, but not as much. Indeed, I can well imagine that, at the end of the day, we do both. Those are two very large institutions, so that out of the ruins of those institutions comes a new government enterprise--with no ambiguity. It doesn't have shareholders to cater to. It is just a government enterprise. On the other hand, maybe more than one purely private company can also arise. A company or companies that are in the securitization business, with no line to the Treasury, no special privileges at all. " CHRG-111shrg57322--1037 Mr. Blankfein," I said we support the direction of the bill, but with respect to this, I think it is very important for Goldman Sachs and I think it is very important for taxpayers, but let me come back and say this first--it is important for Goldman Sachs that we take away the notion that this is a very big burden on us if people think we are too big to fail. We don't think we are too big to fail. We don't want to be too big to fail. But a lot of the negativity that is associated with us is because people think we are getting the benefit of being too big to fail, and I don't think it is good for the country or for us to be in that place. Senator Coburn. Well, you would agree that $700 billion got allocated of taxpayer money to solve systemic risk problems, of which you were the beneficiary both directly and indirectly of a portion of that. " FOMC20080929confcall--5 3,MR. DUDLEY.," Okay. Thank you, Mr. Chairman. Let me start with the foreign exchange swap lines, and then I'll talk a bit about the TAF increases and about the balance sheet. I think Brian later is going to talk about interest on reserves in more detail. All of the foreign central banks that have obtained dollar swap lines in response to dollar funding pressures in their home markets have decided, with some encouragement on our part, to seek an increase in the size of these swap line authorizations. We just have to hear from the Bank of Japan--I think that's the only one that's outstanding--but we expect to hear that shortly. The actual draws on these lines may turn out to be considerably less, and the amounts that are actually drawn are likely to depend on market conditions. The large increase in authorization should be considered as insurance in case market conditions continue to deteriorate and as reassurance to market participants that the world's major central banks are determined to respond in force to mitigate dollar funding pressures. By foreign central banks, the current lines are being doubled for the larger participants and tripled for the smaller participants. The increases are as follows, very quickly: the Bank of Canada, $30 billion from $10 billion; the Bank of England, $80 billion from $40 billion; the Bank of Japan, $120 billion from $60 billion; the National Bank of Denmark, $15 billion from $5 billion; the ECB, $240 billion from $120 billion; the Bank of Norway, $15 billion from $5 billion; the Reserve Bank of Australia, $30 billion from $10 billion; the Swedish Riksbank, $30 billion from $10 billion; and the Swiss National Bank, $60 billion from $30 billion. Adding up all of this would result in an increase in our swap line authorization to $620 billion from $290 billion previously. I think that these decisions have been made in response to the increasing turmoil evident in interbank markets, especially for dollar funding; and by increasing the size of the authorization significantly, the intention is to reassure market participants that sufficient dollar funding will be available well into 2009. The staff believes that these large increases are appropriate to reassure market participants that the world's central banks are prepared to take extraordinary steps as needed to address ongoing strains in financial markets. These strains are evident in a number of ways. First, we've seen a sharp rise in overnight dollar funding rates and in term LIBOR�OIS spreads. For example, on Friday, the three-month LIBOR�OIS spread was over 200 basis points, and in fact, LIBOR may actually understate the degree of funding pressure. The NYFR index, which is the U.S.-based alternative to LIBOR, has actually been much higher than LIBOR over the past week or two. So LIBOR actually may be understated. Second, there have been many anecdotal reports of a withdrawal of counterparties' willingness to engage in term funding activity. So the tenor of almost all activity in the market now is overnight. Third, there are growing liquidity strains at major financial institutions. Obviously, Wachovia is part of that story. Fourth, we've seen a significant rise in the demand for our TSLF and TAF credit. For example, the stop-out rate for the most recent TAF auction, which was a 28-day maturity auction, was 3.75 percent, significantly above the one-month LIBOR rate at the time. Fifth, we've seen a sharp rise in PCF and PDCF borrowings. For example, on the week ending last Wednesday, PCF credit was $39.4 billion, an increase of about $18 billion from the previous week, and PDCF borrowing was $88 billion in the latest week, up $68 billion from the previous week. Last, European banking strains have been increasingly evident in recent days, especially this weekend following the announcement of the Fortis rescue and the nationalization of B&B in the United Kingdom. The European banking news has led to a sharp drop in the European equity markets--this morning they're down 2 to 3 percent--and the euro and sterling exchange rates have dropped quite sharply against the dollar, down about 2 percent. Now, along with this increase in authorized swap lines, Chairman Bernanke has approved the staff recommendation for a large increase in our term auction facility (TAF) program. We are proposing two changes in the TAF program. First, we're proposing to increase the 84-day TAF auction sizes to $75 billion per auction, from $25 billion. That will start with the next 84-day auction that was scheduled for October 6. The second change is that the Chairman has approved two forward TAF auctions totaling $150 billion. These auctions would take place in November, and they would auction short-dated TAF funds for one-week or two-week terms over year-end. Together, these two changes to the TAF program would increase the supply of TAF credit to $450 billion, from $150 billion currently. The notion is that a larger commitment to TAF funding should help ameliorate market concerns about the availability of term funding and about the availability of such funding over year-end. The effective dates for the swap lines and all the programs will be extended, I think, to April 30, 2009. This would enable the foreign central banks to extend 84-day TAF credit through year-end under their swap agreements. Obviously, these commitments are likely to put considerable further strain on the Federal Reserve's balance sheet. In recent days we have been offsetting the large reserve additions with the Treasury SFP (supplementary financing program) cashmanagement bill issuance. After this week's scheduled bill issuance, the total amount of outstanding SFP obligations will reach $400 billion. However, we cannot rely on this program indefinitely because the Treasury's room under the debt limit ceiling is about $900 billion as of early last week and is shrinking rapidly because of the SFP and other ongoing funding commitments. PARTICIPANT. It's impossible to hear. " CHRG-111shrg50815--30 Mr. Plunkett," Thank you, Chairman Dodd, members of the Committee. I am Travis Plunkett, the Legislative Director at the Consumer Federation of America. I am testifying today on behalf of CFA and five other national consumer organizations. I appreciate the opportunity to offer our analysis of the very serious national consequences that unfair and deceptive credit card practices are having on many families in this recession as well as what this Committee can do to stop these traps and tricks. American families cannot become the engine of economic recovery if they are burdened by high credit card debt that can further escalate at a creditor's whim. I would like to summarize five points that I will leave with the Committee and then come back at the end of my testimony and provide a little detail on each point. First, the number of families in trouble with their credit card loans is approaching historic highs, as Senator Dodd said. Based on loss trends the card issuers are reporting, 2009 could be one of the worst years on record for credit card consumers. Second point, credit card issuers share a great deal of responsibility for putting so many Americans in such a vulnerable financial position through their reckless extension of credit over a number of years and use of abusive and unjustified pricing practices, which seem to be accelerating at this time when consumers can least afford it. Third, the need for quick action to end abusive lending practices is more urgent than ever now because taxpayers are propping up major credit card issuers through several enormously expensive programs. If the government is going to attempt to spur credit card issuers to offer more credit, it must ensure that the loans they are offering now are fair and sustainable. Fourth, the recent credit card rule finalized by the Federal regulators is a good first step in curbing abusive practices. It does have significant gaps, though, and as we have heard, it doesn't take effect until July of 2010. Fifth, Senator Dodd's comprehensive Credit Card Act fills in many of these gaps, as do a number of other legislative proposals that have been offered by members of this Committee. It will make the credit card marketplace fairer, more competitive, and more transparent. So let us talk a little detail here. On loss trends, Senator Dodd went through some of the most worrisome factors. One thing to watch is something industry insiders look at a lot. It is called the payoff rate. This is the amount of money that credit card consumers pay on their credit card bill every month and it has just dropped at the end of last year precipitously for credit cards. It is now at one of the lowest levels ever reported, showing that cardholders are having a harder time affording their bills and that the amount of money they can pay every month is dropping. Charge-offs and delinquencies--charge-offs is the amount of money proportionate to how much is loaned that credit card issuers write off as uncollectible--it is looking like they may approach the highest levels ever by the end of this year, and they are already quite high and have shot up very fast. Personal bankruptcy is up by about a third. On the responsibility that issuers have for this problem, just so you don't think this is last year's news or old news, let me just cite a few recent problems with some of the pricing practices you have heard about. They involve issuers adding new fees, increasing the amount of fees that they are charging, using harmful rather than responsible methods to lower credit lines, and a number of other abusive practices. Citigroup last fall back-pedaled on its promise to note increase interest rates any-time for any-reason, and then increased interest rates on a large part of their portfolio. Chase, as we have heard, has suddenly started charging people $120 a year for their accounts. These are cardholders who were promised a fixed rate for the life of their balance. Bank of America has used a variety of questionable methods for cardholders who appear to have done nothing wrong to violate their agreement, citing risk-based pricing and not providing clear information to these cardholders about the problem. Capital One and a number of other issuers over the last year, year and a half, have used very vague clauses in the cardholder agreements that allow them to increase interest rates for large parts of their portfolio for so-called market conditions. Let me be clear. Issuers do have the right to try and limit their losses in a recession, but these kinds of arbitrary and unjustified practices for cardholders who thought they were playing by the rules are very, very harmful. On the need for quick action because of government support, a couple of days ago, Treasury Secretary Geithner announced the expansion of a program that is supposed to provide taxpayer dollars to support securitization of credit card loans. They want more credit card lending. We have urged the Secretary to establish minimum fair practices standards for credit cards now so that our tax money isn't supporting unfair loans. On the Federal Reserve and regulator credit card rule, several positive aspects that we have heard about to the rule related to double-cycle billing, restrictions on increasing interest rates on existing balances, payment allocation. There are gaps, though. Fees are not addressed at all. Credit extension is not addressed at all. Bringing down rates if cardholders say they have a problem, then they pay on time for, say, 6 months, not addressed. And as we have heard, it doesn't take effect for a long time. The Credit Card Act and a number of other bills introduced in the Senate address many of these gaps. No any-time, any-reason repricing. That is the excuse Chase used. Limiting unjustified penalty fees by requiring that fees be reasonably related to the cost issuers incur, a very important part of the Credit Card Act. Limiting aggressive marketing and irresponsible lending to young consumers and lowering rates if consumers perform well after a problem occurs. Let me just close by saying that we have heard a lot about fears that fair regulation of the credit card market will lead to less credit, will lead to people who need it not having access to credit, especially lower-income or minority consumers. I always get a little worried because this context, or the context for this discussion is to ignore what has happened through essentially self-regulation of the market. I mean, where are we now? Issuers have been able to write their own rules for a very long time and they are cutting back on credit, especially to more vulnerable borrowers, especially to lower-income and minority borrowers. Plus, we have to deal with the kind of uncompetitive, not transparent marketplace we have heard about. So it sounds like the worst of all possible worlds to me, and that is why we support Senator Dodd's bill and fair regulation of the marketplace. " CHRG-111hhrg52397--81 Mr. Pickel," Let me comment briefly on AIG. They, through their credit default swaps, were taking exposure to subprime debt, the collateralized debt obligations, certain tranches of those obligations, so they had an appetite for subprime exposure. In fact, through their regulated insurance companies, as Mr. Polakoff testified in the Senate Banking Committee in March, they were also taking on exposure to subprime past the time that the financial products company stopped taking on exposure, well into 2006 and even 2007. So that was the appetite that they had. They also looked at risk in a very narrow way. The head of FP, the Financial Products Division, was quoted as saying he could not imagine ever losing a dollar on these trades. And he was looking at that really only in respect to payouts on the transactions. He was not really looking at the mark-to-market exposure, which ultimately is what undermined AIG. They also traded on their triple A, which other institutions--in fact some of the institutions who have been the source of the greatest problems, Fannie and Freddie, some of the monolines, have traded on their triple A, resisted the providing of collateral, and even worse, agreed in certain circumstances to provide collateral on downgrades. And, frankly, ever since the Group of 30 Report published in 1993, it has been very clear that downgrade provisions, where you provide collateral on downgrades, are to be dealt with very cautiously because of the liquidity problems they can cause. In fact, the banking regulators discourage them, they do not prevent them but they do discourage the use of those types of provisions. So those are our observations on the AIG situation, and I think is very important as we look forward in reform. " CHRG-110shrg46629--66 Chairman Bernanke," First, on the subprime rules, as I said, I asked for a top to bottom review. We looked at every possible power that we have. We have examined each one. We have had a lot of input, a lot of hearings, and we are moving forward. We will move as expeditiously as the process allows, making sure, of course, that we do a good job. But we will move forward as expeditiously as possible to try to address these issues. With respect to inflation, I agree in the sense that certainly over 2007 food and energy prices have risen significantly so that the overall inflation rate is higher than we would like it to be. Our concern is that high food and energy prices might somehow infect the underlying trend of inflation, for example causing people's expectations--this is Senator Bunning's question--to rise and become less persuaded that inflation will be stable in the long-run. Therefore, that is part of the reason why we continue to treat inflation as our predominant policy concern. With respect to the household financial situation, it is a complicated story. Part of the reason that official saving rates for households are negative as that those saving rates do not include any capital gains in assets that households may own. So in some cases, people have had their homes appreciated, as happened over the last 5 years until recently and they took money out, the money they took out would count as spending but the appreciation in their home would not count the saving. So that has been part of the reason that saving has been so low, that people have seen increases until recently in their home equity. As that situation flattens out---- Senator Menendez. But if they took their savings on their appreciation, the only way to do that would be to sell and/or accrue debt? " CHRG-110shrg50420--291 Chairman Dodd," Thank you very much. Senator Schumer. Senator Schumer. Thank you, Mr. Chairman, and thank you to the witnesses. Just to sort of sum up, I think, where we are at, we realize just letting you fail would be cataclysmic, as Dr. Zandi says, far worse than the costs that you have outlined. Second, bankruptcy, I think it is pretty clear, is not a viable option because no one is going to buy a car from a bankrupt company, and it takes so long and it is so complicated that it does not work. And I would--this is my own 2 cents. I think one of these pre-packed bankruptcies has similar problems because you cannot bring the others in. So we have to do something. That is on the side of making sure you are viable, which I think I want to do and I think most of us want to do. On the other hand, our real problem is this: I think that there is a general view that we want to see the conditions before we give you the money, and you folks sort of want the money and say let the conditions work out. Mr. Nardelli said let us see how things are on March 1st. And in all due respect, folks, I do not think there is the faith that those next 3 months will work out given the past history. And so what I think some of us are searching for us here is a way that we can make sure you continue, make sure you are viable on into the future. My third point is make sure that the burden is spread evenly. I think the workers, Mr. Gettelfinger, have taken more of the hit, and I have not heard much about the bond holders, the lenders who are getting paid 12 percent, and people like that. And the only way this is going to work is if everybody gives. If everybody gives. And so the question I have is: Why isn't the best solution for us to pass something on Monday--and, again, I do not care where the money comes from, frankly. OK? That is a dispute that others have. I would take it out of the TARP, if need be, temporarily out of the 136 funds. That to me is not the issue. The issue is how are these real conditions that are created and imposed by someone who is overlooking you outside. So I do not like the words ``oversight board,'' like Mr. Dodaro. Second, who is going to do this negotiating? You may not have leverage, frankly, over the dealers or over the bond holders or over the others, except to threaten to go out of business? Which is not very good leverage. You are saying, well, I will cut my nose to spite my face. Why isn't the best solution the one I was sort of positing before, that we pass legislation that gives, you know, a specific amount of money, not a small sum, to a designee of the President in a certain sense. He has control. It could be the Treasury Secretary. That person quickly calls in all the players and says we have some carrots for you. We not only have money, but we have the ability. We give him the ability maybe to impose for a period of time a guarantee of the warranties and maybe even some help with the funding, because the funding is part and parcel. But, in return, every one of you around the table, you executives, the workers--which have already given quite a bit based on yesterday's statement--the bond holders, the dealers, everyone gives. That seems to me to be the best model given that we do not have much time, that there is not much taste for giving the money and then seeing if the conditions are met down the road, and that the alternatives of either letting you go under a bankruptcy are the worst. And you have said you agree with the Chrysler model when Senator Dodd posited the question to each of the three of you. Would you agree with this kind of model? What do you think of the--what are the pros and cons? Would you agree to the kind of thing that I am mentioning here? Go ahead, Mr. Wagoner. " FOMC20060808meeting--122 120,MR. WARSH.," Thank you, Mr. Chairman. From a capital markets perspective, as I think about this decision, what matters more than the pricing of this issuance—that is, the decision on 25 basis points—is really what the after-market effects are. How is this security going to trade over the next weeks and months? When I think about the decision in that context, it puts the burden on the communications, which are only in small part in the message of our statement today. At the end of the day, I am willing to agree to a pause. But, again, I think that puts the burden on laying the predicate that we are in fact poised and prepared to act as necessary. That begins with our statement, but it doesn’t end there. Given the data that are likely to come in between this meeting and the next (a couple of CPIs, a couple of PPIs, maybe a revised PCE) and what’s likely to happen to some of the forward-looking market indicators (TIPS spreads, some of the commodity prices), I think it is very important that the markets understand, before the trading in the security gets very significant, the depth of our thinking on the subject and of the discussion around this meeting. The minutes can be part of that communication. Such communication is important so that they don’t perceive us when we meet next to be reacting to one or two pieces of data, the way they seem to have overreacted to one or two pieces of data last week, but really recognize the depth of our thinking on this subject. To be consistent with that view, I think Governor Kohn’s suggestion of indicating a pause as powerfully as we can is critical. The markets, in the first days, are going to take our pause to be a stop, as reflected currently in the Eurodollar futures contracts and the fed fund futures contracts. But we need to disabuse them of that view as quickly, as frequently, and as consistently as we can so that the pause does not become read as a stop. We will then have set out the conditions for the ways in which we might react if different data arise. Again, I think that the decision today is not an easy one. It’s important that the markets recognize that it is unlikely that our work here is done. With all that said, I’m prepared to support Governor Kohn’s suggestion." CHRG-111hhrg49968--12 Chairman Spratt," In undertaking these countercyclical steps, we have advanced large sums of money and taken back, in many cases, assets like preferred stock in the major banks which were recipients of TARP funds. In addition, the Fed has a TALF lending facility for asset-backed securities. Can you give us some idea of what you expect in the way of recovery or repayment on these assets so that we can, in turn, look towards the recovery of some of these moneys to be used to pay off the debt that was incurred in advancing these loans in the first place? " FOMC20070918meeting--6 4,MR. DUDLEY.,"1 Thank you, Mr. Chairman. I’ll be referring to the handout that you have in front of you. In my mind, there are three key questions. First, how did the problems in the subprime mortgage area—with losses that probably will ultimately turn out to be in a range of $100 billion to $200 billion—lead to such broad market distress? Second, what is the cause of the dysfunction in U.S. and European money markets? Third, how far along are we in terms of the adjustment process—in other words, when might we anticipate a resumption of normal market function? Turning to the first question, the losses in subprime mortgages had wide-ranging effects because the poor investment performance made investors much less willing to invest in structured-finance products more generally. Investors lost confidence because highly rated securities that referenced subprime assets performed poorly and because investors found it difficult to value complex structured-finance products. This loss of confidence triggered several broader developments: the inability of mortgage originators to securitize nonconforming mortgage loans; the rapid 1 Materials used by Mr. Dudley are appended to this transcript (appendix 1). contraction of the asset-backed commercial paper (ABCP) market; the virtual shutdown of the collateralized debt obligation (CDO) and collateralized loan obligation (CLO) markets; the sharp shifts we saw into and out of Treasury-only versus prime money market mutual funds, which in turn disrupted the Treasury bill market; and the anticipated pressure on bank balance sheets and the upward pressure on term funding rates. The pressure on bank balance sheets is coming from three major sources. First, investor demand for securitized non-agency mortgage-backed securities has dried up. Bank originators now have to hold such loans in their bank portfolios. Second, bank backstop liquidity facilities have been triggered as investor appetite for asset-backed commercial paper has fallen sharply. Third, banks are expected to have difficulty syndicating the bridge loans that they provided to finance leveraged buyouts. Of these three sources of pressure, the rollup of ABCP programs has been, in my view, the most important. The magnitude of the potential funding requirement is the largest, and how much will come back onto bank balance sheets is very uncertain. The constraint on mortgage loan origination can be seen most visibly in the widening of the spread between fixed-rate prime jumbo mortgage loan rates and conforming mortgage loan rates. As you can see in exhibit 1, the spread has widened from around 25 basis points to around 100 basis points in recent weeks. The sharp contraction in the ABCP market began when commercial paper investors became aware that their investments could be vulnerable to loss but were uncertain as to the extent of their exposure in particular programs. This fear of loss had a legitimate basis for those ABCP programs that finance mortgage-related assets without full bank credit enhancement. An inability to roll over these programs in the current market would force the liquidation of the assets. In the current market, that could lead to investor losses. The problem started in extendable commercial paper market programs, where the credit enhancement backstop by banks was typically either absent or less than 100 percent. The problem then quickly migrated to structured-investment vehicle (SIV) programs, which suffered from similar shortcomings. From there, the problem spread as risk-averse investors started to shun the entire asset class. Asset-backed commercial paper rates rose for those programs that were able to roll over their outstanding commercial paper. This is shown in exhibit 2, which compares unsecured and secured commercial paper rates. The volume of outstanding asset- backed commercial paper shrank sharply as some issuers were unable to roll over their maturing paper. Exhibit 3 illustrates the downtrend in the volume of outstanding ABCP. Exhibit 4 shows the maturity structure of outstanding asset-backed commercial paper and highlights the high proportion of paper that is now being rolled on an overnight basis. The pressure on the asset-backed commercial paper market was temporarily exacerbated by the behavior of money market mutual fund investors, who shifted funds last month from prime money market funds to Treasury-only money market funds (see exhibit 5). Because the total assets in money market mutual funds are nearly four times the size of outstanding Treasury bills, these flows led to a large, albeit mostly transitory fall in Treasury bill yields. That is shown in exhibit 6. The good news is that the money flows into the prime money mutual funds have stabilized. This reflects greater discernment among investors about the risks associated with different types of asset-backed commercial paper and the widening yield differentials between prime and Treasury-only money market funds. It is noteworthy that those areas of the asset-backed commercial paper market with underlying structural problems—primarily the extendable, SIV, and SIV-lite portions of the market—represent only a small proportion of total asset-backed commercial paper outstanding. For example, as shown in exhibit 7, SIV programs represented only about 7 percent of the asset-backed commercial paper market before the recent sharp contraction. Moreover, as shown in exhibit 8, much of the asset-backed commercial paper market does not finance residential mortgage asset-backed securities, so there is less uncertainty about the underlying value of the assets. Also, much of the market has solid credit support, with 100 percent bank credit enhancement. This suggests that, as time passes, investors will gradually be able to distinguish between the different types of the ABCP programs and stability will return to the multi-seller, bank-sponsored programs. Already, the pace of contraction of the overall ABCP market has slowed significantly. However, the extendable and SIV programs are likely to continue to be under pressure. The third source of balance sheet pressure stems from the sharp contraction in CDO and CLO issuance. As can be seen in exhibit 9, CDO and CLO issuance volumes have plummeted in recent months. The virtual closure of the CDO market has led, in turn, to a virtual cessation of high-yield debt issuance—illustrated in exhibit 10. These developments have created uncertainty for commercial and investment banks about their ability to syndicate the large volume of loan and debt commitments that they have made to finance private equity buyouts. These institutions are faced with the prospect that they may have to carry such loans on their books for an extended period at a discount to par value. Syndication will be more difficult because the ability to transform a large proportion of these obligations into marketable investment-grade products through the alchemy of structured finance is not currently an available option. This pressure on bank balance sheets—both existing and anticipated—has led to significant dysfunction in financial markets. In particular, primary dealers have pulled back in their willingness to finance the security positions of investment banks, hedge funds, and other leveraged investors. Exhibit 11 illustrates the median repurchase-rate bid-asked spread by primary dealers for three types of collateral— GSE MBS, prime MBS, and high-yield corporate debt—at overnight, one-week, and one-month maturities. As can be seen, there has been an upward trend in bid-asked spreads, especially at the one-month maturity. Exhibit 12 illustrates the median haircuts applied against such collateral. Again, there has been an increase, which has been particularly pronounced at the one-month maturity. At the same time, this balance sheet pressure and worries about counterparty risk have led to a significant rise in term borrowing rates. Banks that are sellers of funds have shifted to the overnight market to preserve their liquidity, and this shift has starved the term market of funds, pushing those rates higher. As shown in exhibit 13, the spread between the one-month LIBOR and the one-month interest rate swap rate has widened sharply, and the one-month LIBOR has generally traded considerably above the anticipated level of the overnight federal funds rate. The same pressure on funding rates has been also evident in euribor rates (see exhibit 14). The rise in term rates has pushed banks that depend on funding from the interbank market into the overnight market. In addition, these depository institutions have turned to the Federal Home Loan Bank system as a source of term funding. For example, FHLB advances rose $110 billion in August. In contrast, despite the 50 basis point reduction in the spread between the discount rate and the federal funds rate target, the dollar value of discount window borrowings remains modest, as shown in exhibit 15. This reflects the lower cost of FHLB advances, the ability to borrow at longer terms from the FHLB, and the lack of stigma in using such advances as a source of funding. So where do we go from here? Clearly, the adjustment process is far from over. Asset-backed commercial paper programs are still being rolled up, and there is considerable uncertainty about how difficult it will be to roll some of this paper over quarter-end. Moreover, it remains unclear what proportion of leveraged loan commitments commercial and investment banks will be able to syndicate and at what price. Despite the big backlog and the end of the August doldrums, there has, as yet, been little syndication activity. The good news, of course, is that as time passes, the uncertainty about bank balance sheet pressures and funding requirements should lessen. Moreover, investors’ ability to distinguish between “good” and “bad” ABCP programs and structured-finance products should continue to improve. The bad news is that the stress caused by the forcible deleveraging of the nonbank financial sector could lead to further losses accompanied by headlines that could further damage investor confidence. Moreover, the increased reliance by banks on overnight funding increases rollover risk and may limit the willingness of banks to expand their balance sheets to accommodate the deleveraging of the nonbank financial sector. In the mortgage sector, depository institutions will undoubtedly—at the right price—take up the slack in the prime jumbo mortgage market. But nondepository institutions are unlikely to be able to originate and securitize nonconforming mortgages in appreciable volume for some time. The tone in financial markets has improved a bit in recent days. Nevertheless, we still appear to be in an environment in which the dominant theme is risk aversion. This can be seen in a matrix that measures the correlation among the price movements in the major asset classes (see exhibit 16). In times when markets are calm and untroubled, the correlation coefficients are generally low. As you can see in the exhibit, which examines these correlations since the August 7 FOMC meeting, the correlation coefficients have been very high recently. In the foreign exchange markets, two developments are worth noting. First, the turmoil in money markets did impair the functioning of the foreign exchange swap market. This made it more difficult for banks in Europe that are structurally short of dollars to obtain the dollar funding needed to fund their assets. In recent days, this market function has improved. Second, the dollar has weakened. As shown in exhibit 17, the dollar has fallen to a record low against the euro. But don’t be too impressed by that headline. On a broad trade-weighted basis, the decline of the dollar has been modest, with a decline of less than 1 percent from the last FOMC meeting and a fall of slightly more than 4 percent from the start of the year. Moreover, this softness in the dollar does not appear to signal any fundamental shift in the willingness of foreign investors to hold dollar-denominated assets. Instead, it appears to be driven mainly by changing interest rate expectations. As shown in exhibit 18, the exchange rate of the dollar versus the euro has continued to track changes in expected short-term interest rate differentials between the United States and Europe. Not surprisingly, our dealer survey reveals a large decline in short-term rate expectations. Exhibits 19 and 20 compare the dealer surveys before the August 7 FOMC meeting and before the current FOMC meeting. The green circles represent the average of the dealer forecasts, and the blue circles represent the range sized by the number of dealers at each value. As can be seen, the average of the dealer modal forecasts for mid-2008 has fallen more than 60 basis points. Market expectations—as reflected by the solid bold lines—have declined about the same amount and remain below the average dealer modal forecasts. With respect to the outcome of this meeting, a slight majority of dealers expect a 25 basis point reduction in the target federal funds rate rather than a 50 basis point cut. Only one dealer expects no change in the federal funds rate target. Uncertainty about the short-term interest rate path has also increased. This is evident both in the dealer survey and in the probability distribution of rate outcomes implied by options prices on Eurodollar futures. As can be seen in exhibit 21, the probability distribution of rate outcomes has become much broader since the August 7 FOMC meeting. Finally, open market operations since the last FOMC meeting warrant some discussion. As you know, in early August, following persistent upward pressure on the federal funds rate and an extraordinarily large reserve-adding provision by the ECB, we aggressively added reserves on August 10. That provision of reserves did break the upward pressure on the federal funds rate, and the federal funds rate traded notably soft over the remainder of that two-week reserve maintenance period. Since that time, we have attempted to pull back on our provision of reserves in order to push the federal funds rate back up toward its target. Notice that the blue bars in exhibit 22, which measure daily excess reserves before borrowing, have been generally in negative territory over the past month. Although we have had some success in pushing the effective federal funds rate higher, it has generally traded over the past month below the 5¼ percent target. Our efforts to push the federal funds rate back toward the target have been undermined by several factors. First, expectations about the possibility of an intermeeting cut in the federal funds rate target have caused the federal funds rate to trade somewhat soft. Also, in recent days, the effective rate has been held down somewhat by expectations of a rate cut at today’s meeting. Second, the narrower margin between the discount rate and the federal funds rate target makes it more difficult to push up the effective federal funds rate. The upper band of the corridor above 5¼ percent is now half as wide as before even as the lower bound for the federal funds rate remains at 0 percent. The lower discount rate acts as a cap on how high the federal funds rate can climb when reserves are tight. Third, we have had bad luck in the sense that most of our forecasting misses in terms of autonomous factors that affect reserves—such as float, Treasury balances, currency demand, and borrowings at the window—have caused us to inadvertently leave more reserves in the banking system than we had intended. Our difficulty in pushing up the effective rate can be illustrated by our experience last Wednesday, the last day of the two-week reserve maintenance period. Despite a consistently stingy provision of reserves that resulted in $5 billion of overnight primary credit borrowing for the day and $7.2 billion in total borrowing, the effective rate for that Wednesday was 5.18 percent. I would note, though, that in the past two days we have actually pushed the funds rate effectively up to its target. There were no foreign exchange operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the August 7 FOMC meeting. Of course, I am very happy to take questions." CHRG-111shrg54533--51 Secretary Geithner," To be honest, Senator, we have not designed yet the full details of the process we think would be helpful in terms of exploring all alternatives. But we will involve the FHFA and Department of Housing and Urban Development. Treasury will coordinate the process. We will consult not just with this Committee, but with your counterparts in the House, and we will try to consult broadly in the markets and the academic community as we think through broad options. I actually can't recall what we proposed in the paper in terms of a timeframe, but I think it would be reasonable for us to start to bring forward recommendations and options sometime in the first half of next year. Senator Martinez. Thank you, Mr. Chairman. Senator Johnson. Senator Bennet. Senator Bennet. Thank you, Mr. Chairman. Mr. Secretary, it is good to see you. Thank you for your efforts here. Over the last 5 months or 6 months or whatever it has been, what I have discovered is that with respect to the Federal intervention in the immediate crisis, I think it is fair to say there is very little consensus about the details of that or about it as a whole, and I know that presents a huge struggle for you and for the administration because everybody is a critic but not everybody has to come up with a solution and I think you have worked hard to try to get through a lot of this. I think there is also limited consensus still about what we ought to do to fix the problem we have got prospectively. What people have come to understand is that we have come out of a decade where our savings rate as consumers dropped to zero, the Federal debt ballooned from $5 trillion to $10 trillion, and banks or financial institutions on Wall Street that historically have been levered at 12 times were levered at 25 and 30 times, all of which, as you said in your testimony at the beginning, when it all came crashing down has left our families in an unbelievably vulnerable position--jobs lost, houses lost, college educations deferred for people all over my State and all over the country. And I know that we are designing this prospectively, but for the folks watching this at home, if we could rewind the movie that we just had play out of a period of an absurd amount of leverage in our economy, of risky decisions that should never have been made by people that should have been known better, of risks that were taken actually in plain sight but we missed it, all of us, in part because of the way our regulatory system was designed, as you rewind that movie in your head, looking back, let us imagine that the regime that is being proposed was in place and how would things have been different as a result of that? " CHRG-110hhrg46591--118 Mr. Ackerman," My gosh, you have it. " Mr. Johnson," --how do you know that it is safe and sound and will not add instability to the system? The truth is, you don't. But the key to that is transparency. When you register a security, you should be required to reveal every aspect of that security. The over-the-counter markets in debt securities lack in transparency. " CHRG-110shrg50420--50 Mr. Dodaro," That is correct. Senator Reed. One of the points you made--and it is reflective in several of the questions about assuring a first priority for taxpayers in terms of their investment, implicit in--at least implicit in what I have heard the companies have said--is that this is very difficult for them to do because of the ability to coordinate among debt holders, suppliers, et cetera. Do you have any comments on that? " CHRG-111hhrg48874--85 Mr. Baca," When someone loses their job and they are not getting a loan, that is tension where they are losing revenue, and we are not picking up revenue. That is tension. " Mr. Polakoff," I'm not sure I'm understanding the question, but indeed, an examiner would be very uncomfortable, rightfully so, if money was lent to an unemployed individual who didn't have the capacity to repay the debt. " CHRG-111hhrg55809--56 Mr. Royce," Thank you. Chairman Bernanke, I have a question for you. Last month, the Federal Housing Administration acknowledged that a new audit that HUD did there found that the FHA's cash reserve fund is rapidly depleting. It might drop below the congressionally mandated 2 percent by the end of the year. And so the leverage there, the ratio was 50 to 1 for FHA. And it will soon have a smaller capital cushion than Bear Stearns had on the eve of its crash. At 50 to 1, it is about halfway to where Fannie Mae and Freddie Mac were at 100 to 1 leverage ratio. And the delinquency rate for the FHA is now above 14 percent, so that is about 3 times higher than unconventional mortgages. In many respects, the reason for this financial deterioration is that the FHA is underwriting record numbers of high-risk mortgages. Between 2006 and the end of next year, the FHA's insurance portfolio will have expanded to $1 trillion from about $410 billion. The FHA's very low, I would say absurdly low, 3.5 percent downpayment policy in combination with other policies to reduce upfront costs for new home buyers means that the home buyers can move into their government-insured home with an equity stake of about 2.5 percent. So, in essence, the private market for loans with little or no money down has shifted onto the books of the Federal Government. Are you concerned with the long-term consequences of this trend and the rapidly deteriorating capital cushion of the FHA? And are you confident this will not turn into another Fannie-Freddie situation, which could have been easily prevented had we listened to the Fed in 2004 and 2005, but ends up costing taxpayers billions of dollars? I remember when the Fed came to us in 2004 and said, we need to be able to regulate for systemic risk, the leverage is 100 to 1. Basically, what you are doing in government is that the Congress has forced us into a position where half of the portfolio has to be subprime and Alt-A; this represents a systemic risk. We need the ability for the regulators to slowly bring down this over-leveraging and bring down the portfolio size by giving us the ability to regulate for systemic risk. Are you worried that we are going through that kind of a cycle again here? " fcic_final_report_full--404 The performance of the stock market in the wake of the crisis also reduced wealth. The Standard and Poor’s  Index fell by a third in —the largest single- year decline since —as big institutional investors moved to Treasury securities and other investments that they perceived as safe. Individuals felt these effects not only in their current budgets but also in their prospects for retirement. By one calcu- lation, assets in retirement accounts such as (k)s lost . trillion, or about a third of their value, between September  and December .  While the stock mar- ket has recovered somewhat, the S&P  as of December , , was still about  below where it was at the start of . Similarly, stock prices worldwide plum- meted more than  in  but rebounded by  in , according to the MSCI World Index stock fund (which represents a collection of , global stocks). The financial market fallout jeopardized some public pension plans—many of which were already troubled before the crisis. In Colorado, state budget officials warned that losses of  billion, unaddressed, could cause the Public Employees Re- tirement Association plan—which covers , public workers and teachers—to go bust in two decades. The state cut retiree benefits to adjust for the losses.  Mon- tana’s public pension funds lost  billion, or a fourth of their value, in the six months following the  downturn, in part because of investments in complex Wall Street securities.  Even before the fall of , consumer confidence had been on a downward slope for months. The Conference Board reported in May  that its measure of con- sumer confidence fell to the lowest point since late .  By early , confidence had plummeted to a new low; it has recovered somewhat since then but has remained stubbornly bleak.  “[We find] nobody willing to make a decision.  .  .  . nobody willing to take a chance, because of the uncertainty in the economic environment, and that goes for both the state and the federal level,” the commercial real estate developer and ap- praiser Gregory Bynum testified at the FCIC’s Bakersfield hearing.  Influenced by the dramatic loss in wealth and by job insecurity, households have cut back on debt. Total credit card debt expanded every year for two decades until it peaked at  billion at the end of . Almost two years later, that total had fallen , to  billion. The actions of banks have also played an important role: since , they have tightened lending standards, reduced lines of credit on credit cards, and increased fees and interest rates. In the third quarter of ,  of banks im- posed standards on credit cards that were tighter than those in place in the previous quarter. In the fourth quarter,  did so, meaning that many banks tightened again. In fact, a significant number of banks tightened credit card standards quarter after quarter until the summer of . Only in the latest surveys have even a small num- bers of banks begun to loosen them.  Faced with financial difficulties, over . mil- lion households declared bankruptcy in , up from approximately . million in .  FOMC20081216meeting--438 436,MR. LACKER.," So if spreads close in the marketplace, then they get the upside--so we are essentially lending to them to make a leveraged bet on the securities. " CHRG-111hhrg55814--519 Mr. Yingling," Yes, with careful regulation and capital requirements and leverage limits. Mr. Miller of North Carolina. Mr. Ryan, you seem to want to be recognized. Were you raising your hand? " CHRG-109shrg21981--122 Chairman Greenspan," Yes, Senator, I agree with that. Let me just reiterate that what obscures the discussion is how to handle the transition costs, which are the equivalent in one form of a huge unfunded liability. But if you set that aside as a consequence of the past and you merely ask which type of vehicle has the greater probability of adding to national savings in the example that you gave, clearly one which is forced savings and, therefore, reduced consumption will add to household or personal savings and, therefore, to national savings. If, however, you put it into the existing system and for the moment leave aside the question of changes in the trust fund, it is essentially a pay-as-you-go system, which does not create national savings. And, therefore, the two models are fundamentally different, and the complexity is how you go from here to a differing system, and to a very large extent, one's capacity to do that does rest with that issue of to what extent of the financial markets taking the $10 trillion-plus contingent liability and assumed its a cost or debt of the Government and have set long-term U.S. Treasury interest rates in the context that that is their target of what the supply of debt is and, hence, that which moves the price and not the $4 trillion, which is the debt to the public, which is what changes with the unified budget balance. Senator Bennett. Well, I run a business, and you focus on cashflow. And I remember very clearly the speech by the President of the United States who said we are going to include surpluses in the Social Security account as part of the overall cashflow. His name was Lyndon Johnson, and it was during the time he was discussing the Great Society. And Republicans were claiming that he was running a budget deficit, and he said, No, we are not running a budget deficit because we have this extra money coming into Social Security. I remember that speech very clearly because I was in town and involved in that at the time. And ever since we went to a unified budget, on a cashflow basis the surpluses in Social Security have reduced the cash needs of the Government to meet its obligations. Starting in 2008, that will begin to stop as the Social Security surplus will begin to fall in the face of the demographic arrival of the baby-boomers. " CHRG-111hhrg55814--517 The Chairman," The gentleman from North Carolina. Mr. Miller of North Carolina. Thank you, Mr. Chairman. Ms. D'Arista, before you raised the question of proprietary trading and the chairman followed up with it, I had asked the previous panel about that. Ms. D'Arista. I heard you, sir. Mr. Miller of North Carolina. In part, because while Chairman Volcker had testified last month that proprietary trading by systemically significant firms should be prohibited, that perhaps customer trading should be allowed, but not proprietary trading. And Ms. Bair seemed to agree, with respect to the depository institutions, but thought it would be okay in an affiliate within a holding company. And then Mr. Dugan, not surprisingly, found a reason not to do it at all, and that was that if you required it to be by a separate entity, the entity would still grow to be so large that it would be systemically significant. It certainly occurred to me that there are still reasons to do it, even if all the different entities end up being really big. One is the market discipline--to use the term that others have used today--that if you're dealing with a company that just does one thing, you focus on that, and do not assume that because they're so big they're going to be good for their debts. Who could imagine Citigroup not being good for their debts? Obviously, it could never ever happen--or Bank of America. It's impossible to manage a company. Obviously, the CEOs, and certainly the boards of directors, had no idea what the different parts of their companies were doing, the ones that got into trouble. And finally, it's impossible to regulate. Again, not surprisingly, we have had other discussions of Freddie and Fannie. Everybody seems to have agreed right along that the regulator for Freddie and Fannie was not up to the task, because Freddie and Fannie was so complex. And they had derivatives in case interest rates went up, they had derivatives in case interest rates went down. And there were only a handful of people on the planet who could figure out what it all meant. And the more lines of business there are that are all complex and opaque, the harder it is to regulate. Do you agree that even if the separate entities end up being really big, and probably systemically important, that proprietary trading should not be done at the same entity that's doing--that is a depository institution that's doing lending? Ms. D'Arista. I would agree, and I would think that you need to limit proprietary trading across the entire financial system, not only within the conglomerate, but with other institutions. Typically, this was the province of investment banks in the past, who have changed muchly, as we know. Mr. Miller of North Carolina. Right. Ms. D'Arista. I think as I began to say--and I will submit some information about my thinking on this--we could go at this in a number of ways: limiting leverage; limiting counterparty exposure; etc. This will reduce the amount of counterparty trading, or proprietary trading, that is going on. But you have to understand that the proprietary trading is what blew up, inflated into a balloon, our financial system. We are not Iceland, but we're getting there, if we don't do something about it. In other words, size is important Because of what it means in terms of gross domestic product, in the size of the financial institution itself, of the financial sector, etc. Where does it get to the point where we don't produce enough in the economy to cover the exposure of our financial sector? Mr. Miller of North Carolina. All right. Mr. Yingling, should depository institutions do proprietary trading? " CHRG-111hhrg53246--120 Mr. Gensler," Not specifically on the fair funds proposal. But I do think that in working to harmonize our roles, that we should look very closely at whether our fraud standard between the CFTC and the SEC should be the same. We bring about a third of our fraud cases with the SEC, we do a lot jointly, and I think it would be helpful. Mr. Moore of Kansas. Thank you. Some people have suggested we should require the largest financial firms to undergo an annual stress test that would have aggregate information publicly released even in good times, not just bad times. Is this something Congress should require, Chairman Gensler? And what about leverage? Any thoughts on how best to create incentives for firms to maintain reasonable leverage ratios? " CHRG-111hhrg54869--173 Mr. Cleaver," Thank you. We are going to have votes in maybe 15 or 20 minutes. I do think we can get all members in if the members will use the Reader's Digest version of your questions and if you will give the Cliff Notes version of the answer, I think we can get through all of these. We will begin with the gentlelady from Illinois, Ms. Bean. Ms. Bean. Thank you, Mr. Chairman, and to the witnesses for sharing your expertise today. Many of us have advocated for countercyclical capital requirements to avoid the kind of depth and width of the downfall that we recently experienced, specifically to discourage the type of leverage that we saw. And as Mr. Zandi said in his own testimony, if I understood it properly, suggesting that when we see a bubble in formation, obviously increasing capital requirements will maybe minimize how big that bubble gets. In a precipitous downfall we would ease up capital requirements as well, which we didn't do, so it doesn't get so wide as institutions divest themselves, even in this case non-subprime related assets. Given that history suggests that regulators, though they have the authority to impose those changes, tend not to want to be the buzzkill when the party is going, will regulators follow guidance from the Feds or does Congress really need to be more proscriptive in that regard and require those type of changes relative to capital requirements? I am asking Mr. Zandi specifically. " CHRG-111shrg53176--47 Mr. Breeden," Thank you very much, Chairman Dodd, Ranking Member Shelby, and Members of the Committee, for the opportunity to offer my views on enhancing investor protection and improving financial regulation. These are really, really critical subjects and it is a great pleasure to have a chance to be back before this important Committee. I was privileged to serve as SEC Chairman from 1989 to 1993. My views here today reflect that experience at the SEC as well as my White House service in 1989, when we had to craft legislation to deal with an earlier banking crisis, that involving the savings and loans. In subsequent years, my firm has worked on the restructuring of many, many companies that encountered financial difficulties, most notably WorldCom in the 2002 to 2005 range. Today, I am an investor and my fund manages approximately $1.5 billion in equity investments in the United States and Europe on behalf of some of the Nation's largest pension plans. By any conceivable yardstick, our Nation's financial regulatory programs have not worked adequately to protect our economy, our investors, or our taxpayers. In little more than a year, U.S. equities have lost more than $7 trillion in value. Investors in financial firms that either failed or needed a government rescue have alone lost about $1 trillion in equity. These are colossal losses without any precedent since the Great Depression. After the greatest investor losses in history, I believe passionately that we need to refocus and rededicate ourselves to putting investor interests at the top of the public policy priority list. We have badly shattered investor confidence at a time when we have never needed private savings and capital formation more. There is much work to be done to restore trust, and I must say, in the public policy debates, we seem to worry endlessly about the banks that created this mess and I believe we need to focus a little more on the investors who are key for the future to get us out of it. Many people today are pointing at gaps in the regulatory structure, including systemic regulatory authority. But the Fed has always worried about systemic risk. I remember back in the Bush task force back in 1982 to 1985, the Fed talking about its role as the lender of last resort and that it worried about systemic risk. And they have been doing that and we still had a global banking crisis. The problems like the housing bubble, the massive leverage in the banks, the shaky lending practices and subprime mortgages, those things weren't hidden. They were in plain sight, except for the swaps market, where I agree with the previous witnesses that there is a need for extending oversight and jurisdiction. But for the most part, the banking and securities regulators did have tools to address many of the abusive practices but often didn't use their powers forcefully enough. Creating a systemic or super-regulator, in my view, is a giant camel's nose under the tent. It is a big, big step toward industrial planning, toward central planning of the economy, and I think the very first thing that creating a systemic regulator will do is to create systemic risk. I fear very much that if you are not extremely helpful, we will have more ``too big to fail,'' more moral hazard, and more bailouts, and that is not a healthy path for us to move forward. I am very concerned that we not shift the burden of running regulated businesses in a sound and healthy manner from management and the boards of directors that are supposed to do that. Unfortunately, in the wake of this crisis, we have seen boards of directors that failed miserably to control risk taking, excessive leverage, compensation without correlation to performance, misleading accounting and disclosure, overstated asset values, failure to perform due diligence before giant acquisitions. These and other factors are things that boards are supposed to control. But over and over again in the big failures, the boards at AIG, Fannie Mae, Lehman Brothers, CitiGroup, Bank of America, Wachovia, WAMU, in those cases, boards were not doing an adequate job. So my view is that we need to step back as part of this process and look and say, why are boards not doing what we need them to do? I think one of the important answers is that we have too much entrenchment of board members, too many staggered boards, too many super voting shares, too many self-perpetuating nominating committees, and a very, very high cost to run a proxy contest to try and replace directors who are not doing their jobs. So I think one of the important things that Congress can look at, and I hope you will look at in the future, is to enact a shareholder voting rights and proxy access act that would deal with proxy access, uninstructed votes by brokers, which is corporate ballot stuffing, majority vote for all directors every year, one share, one vote. There are a number of things where if we give a little more democracy to corporate shareholders, we can bring a little more discipline to misbehavior in corporations and not put quite so much on the idea that some super uber-regulator somewhere is going to save us from all these problems. Thank you very much. " CHRG-111shrg57322--1100 Mr. Blankfein," I don't know them well, but I have heard of the company, of course. Senator Pryor. And Jack Stevens, one of the founding brothers of that--there were two Stevens brothers that founded that company--he always said that he had the philosophy of, we want to be in business tomorrow, and what he meant by that, and apparently the way Stevens still operates is they want to service their customers, do an excellent job there, and also they want to be prudent and jealously guard the trust of their investors. So Stevens, as far as I know, has never gotten into some of these 20-1, 30-1, 40-1 type leveraged deals. They just don't do that. And I am sure they haven't made as much money as some in the industry have, but also, I think that they have remained very sound through this process. Is Goldman Sachs and/or the industry changing those really high leverage ratios and going back to something that I think is more appropriate, and you may say more conservative, but that is based more on reality rather than just how much money you can make off one transaction? " CHRG-110hhrg34673--153 Mr. Bernanke," Well, the incidence of delinquencies and bankruptcies for the economy as a whole remains quite low. Because the job market is pretty good and incomes have gone up, wealth has gone up, the stock market is up, and so on. Most families, many of them, have home equity built up and have been able to manage their finances pretty effectively, and as I said, we have not seen any significant increase in financial stress in the broader economy. Now, there are pockets of problems, as I mentioned already several times, such as the variable rate subprime mortgage area. I think there are a number of approaches. The one that the Federal Reserve is particularly involved in is disclosures. We are responsible for Regulation Z, which implements the Truth in Lending Act, and it includes such things as the famous Schumer Box and other things that show to potential credit card applicants what are the terms, you know, what are the fees and so on. We are in the process now of completely reworking Reg Z for credit cards, for revolving debt, and we anticipate going out with a proposed rule in the next couple of months, and we have worked very hard on that. In particular, one thing we have done--people find it very difficult to understand the legalese that they see in the credit card applications, the credit card contracts, and yet of course the legal information has to be there. Otherwise, it is not a legitimate contract, and so the challenge is to create disclosures that meet the legal standards but that are also understandable, and so we have gone out and done a lot of consumer focus group testing and those kinds of things to try to find disclosures that will actually work in practice, and we hope that these new disclosures we are going to put out for comment in just a couple of months will be helpful in helping people understand, you know, the terms and conditions of credit cards and make them use them more responsibly. " CHRG-110hhrg46596--395 Mr. Kashkari," Well, it is not whether it is a 38 debt-to-income or 34 or 31; different people have different views. We have adopted a similar approach with Fannie and Freddie, where they are moving people down. The key is, if you are putting insurance on an asset, that is a payout if the borrower redefaults. Think about that. The bank only gets a payout if the borrower redefaults. Does that create an incentive for the bank to encourage a default and foreclosure? So we just have to look very carefully at these incentives to make sure that they are aligned so that the taxpayer dollars are really going to help the homeowners. That is our objective. " fcic_final_report_full--83 In a few cases, such as CitiFinancial, subprime lending firms were part of a bank holding company, but most—including Household, Beneficial Finance, The Money Store, and Champion Mortgage—were independent consumer finance companies. Without access to deposits, they generally funded themselves with short-term lines of credit, or “warehouse lines,” from commercial or investment banks. In many cases, the finance companies did not keep the mortgages. Some sold the loans to the same banks extending the warehouse lines. The banks would securitize and sell the loans to investors or keep them on their balance sheets. In other cases, the finance company itself packaged and sold the loans—often partnering with the banks ex- tending the warehouse lines. Meanwhile, the S&Ls that originated subprime loans generally financed their own mortgage operations and kept the loans on their bal- ance sheets. MORTGAGE SECURITIZATION: “THIS STUFF IS SO COMPLICATED HOW IS ANYBODY GOING TO KNOW? ” Debt outstanding in U.S. credit markets tripled during the s, reaching . tril- lion in ;  was securitized mortgages and GSE debt. Later, mortgage securities made up  of the debt markets, overtaking government Treasuries as the single largest component—a position they maintained through the financial crisis.  In the s mortgage companies, banks, and Wall Street securities firms began securitizing mortgages (see figure .). And more of them were subprime. Salomon Brothers, Merrill Lynch, and other Wall Street firms started packaging and selling “non-agency” mortgages—that is, loans that did not conform to Fannie’s and Fred- die’s standards. Selling these required investors to adjust expectations. With securiti- zations handled by Fannie and Freddie, the question was not “will you get the money back” but “when,” former Salomon Brothers trader and CEO of PentAlpha Jim Calla- han told the FCIC.  With these new non-agency securities, investors had to worry about getting paid back, and that created an opportunity for S&P and Moody’s. As Lewis Ranieri, a pioneer in the market, told the Commission, when he presented the concept of non-agency securitization to policy makers, they asked, “‘This stuff is so complicated how is anybody going to know? How are the buyers going to buy? ’” Ranieri said, “One of the solutions was, it had to have a rating. And that put the rat- ing services in the business.”  Non-agency securitizations were only a few years old when they received a pow- erful stimulus from an unlikely source: the federal government. The savings and loan crisis had left Uncle Sam with  billion in loans and real estate from failed thrifts and banks. Congress established the Resolution Trust Corporation (RTC) in  to offload mortgages and real estate, and sometimes the failed thrifts them- selves, now owned by the government. While the RTC was able to sell . billion of these mortgages to Fannie and Freddie, most did not meet the GSEs’ standards. Some were what might be called subprime today, but others had outright documen- tation errors or servicing problems, not unlike the low-documentation loans that later became popular.  CHRG-111hhrg49968--155 Mrs. Lummis," Mr. Chairman, suppose if we froze spending of the Federal Government's budgets at 2009 level and then let the stimulus package continue to work, would that be a way to begin to address the deficit and the debt as well as allow the stimulus monies to continue to flow into the economy? " FOMC20081216meeting--59 57,MR. MEYER.," Thank you, Brian. By way of background, the Greenbook and many private forecasters project a sizable drop in real GDP from mid-2008 to mid2009, followed by sluggish growth into 2010, even with short-term interest rates barely above zero and with substantial fiscal stimulus. The Board staff and the median forecaster in the December Blue Chip survey predict that unemployment will peak around 8.25 percent in 2010. The Greenbook forecast shows core PCE inflation dropping below 1 percent in 2010; many private forecasters envision similar disinflation. Moreover, responses to a special question in the latest Blue Chip survey indicate that private forecasters see a sizable risk of deflation, and stochastic simulations of FRB/US that take the Greenbook forecast as the baseline suggest a roughly 1-in-4 chance that the core PCE price index will decline over one or more of the next five years. In short, forecasts generally suggest that additional stimulus would be desirable. With the target federal funds rate at 1 percent and the effective rate significantly lower, the Committee has little scope for using conventional monetary policy to stimulate the economy. As a practical matter, the System's large liquidity-providing operations and the Treasury's decision to scale back the supplementary financing program make it likely that the effective federal funds rate will remain quite low into the new year. Even so, the Committee could choose to apply some additional stimulus by reducing its target federal funds rate and pushing the effective funds rate closer to zero. The research literature strongly suggests that a central bank should quickly cut its target rate to zero when it faces a substantial probability that conventional monetary policy will, in a few quarters, be constrained by the zero lower bound on nominal interest rates. But as discussed in several of the notes you received on December 5, driving short-term interest rates to zero would have costs as well as benefits. Zero or near-zero rates cause a high volume of fails in the Treasury securities market, leading to decreased liquidity in that market and potentially in other fixed-income markets. And if short-term rates remain very close to zero, some money market funds probably will close. Such costs may argue against cutting the target funds rate to zero and driving the effective rate closer to zero. Whether or not the Committee chooses to cut its target rate to zero, policymakers may find it helpful to expand the use of nonstandard monetary tools. In the current environment, using such tools has two potential benefits. First, they may help the Federal Reserve achieve better expected outcomes on both parts of the dual mandate. Second, nonstandard tools could help mitigate the risk of an even more negative outcome. It may prove useful to group nonstandard tools into four broad categories and treat each category in turn. The first category is simple quantitative easing. This approach uses conventional open market operations such as buying short-term government debt and conducting repurchase agreements to raise excess reserves in the banking system to a level well beyond that required to drive short-term interbank rates to zero. The objective is to spur bank lending by ensuring that banks have ample funding at very low cost. The Japanese experience suggests that greatly expanding excess reserves, per se, has limited success in spurring bank lending, and thus has modest macroeconomic effects, when banks and borrowers have weak balance sheets. The second category of nonstandard policy tools is targeted open-market purchases of longer-term securities. The objective here would be to reduce term spreads or credit spreads and thus reduce the longer-term interest rates that are relevant for many investment decisions. The Committee could, for example, direct the Desk to buy a large amount of longer-term Treasuries. The Bank of Japan bought sizable quantities of Japanese government bonds; its purchases are thought to have lowered yields. The available evidence for the United States suggests that adding $50 billion of longer-term Treasury securities to the SOMA portfolio (a bit less than 1 percent of publicly held Treasury debt) probably would lower yields on such securities somewhere between 2 and 10 basis points; a substantially bigger purchase could have a disproportionately larger effect as longer-term Treasuries became scarce. Of course, what matters for the macroeconomy is the effect on private agents' borrowing costs and wealth. Those effects are difficult to predict. Corporate bond yields should decline with Treasury bond yields, though perhaps less if supply effects are the main reason Treasury yields fall. But corporate bond yields could decline more than yields on Treasuries if the Committee's action reduces investors' concerns about downside risks and thus reduces credit risk premiums. Such a boost to confidence could also lift stock prices and household wealth. Another possibility is to instruct the Desk to buy a large quantity of GSE debt and mortgage-backed securities to reduce their yields and thus drive down mortgage rates. As Bill noted, markets reacted positively to the November 25 announcement that the Federal Reserve will buy $100 billion of GSE debt and up to $500 billion of agency-backed MBS; yields on 10-year GSE debt and option-adjusted MBS yields fell about 60 basis points that day, and the spread over 10-year Treasury yields narrowed about 40 basis points. Quoted rates on conventional conforming mortgages declined a similar amount in subsequent days. The magnitude of the announcement effect, which is consistent with estimates from the research literature, suggests that additional targeted purchases of agency debt and MBS could provide further macroeconomic stimulus. The third major category of nonstandard tools encompasses special liquidity and lending facilities. The Board could choose to expand current facilities or create new ones. Special liquidity facilities for banks and other financial firms are intended to help them meet their customers' needs for credit by providing a reliable source of funding even if the markets in which those lenders usually raise funds are disrupted or if their depositors withdraw funds. Indeed, these facilities seem to be meeting these needs effectively. The Term Auction Facility, or TAF, is one example; the AssetBacked Commercial Paper Money Market Mutual Fund Lending Facility, or AMLF, is another. Liquidity facilities may also support specific funding markets. The idea is that such markets are more likely to function if borrowers are confident that they will be able to issue and roll over debt and if lenders are assured that they will be able to fund purchases of debt instruments or reduce their holdings of such instruments when necessary. The Commercial Paper Funding Facility, or CPFF, is an example of this sort of program. Although the commercial paper market has not returned to normal, the CPFF has been helpful in supporting overall credit flows and reducing some credit spreads. Direct discount window lending to creditworthy nonfinancial firms is another potential tool for supporting economic activity. The Federal Reserve Act allows such lending, on a secured basis, if the borrower is unable to obtain adequate credit from banking institutions during unusual and exigent circumstances. Significant further expansion of the System's lending programs would raise a host of issues. New facilities that lend directly to individuals, partnerships, or corporations would have to meet the requirements in section 13(3) of the Federal Reserve Act. The Reserve Banks would take on more credit risk unless the Treasury or other parties took substantial first-loss positions. Moral hazard would become a larger issue. The resulting increase in reserve balances would further complicate the implementation of monetary policy unless the FOMC were willing to accept a federal funds rate of essentially zero. Developing satisfactory exit strategies would be challenging. And the practical burdens of designing and operating a sizable number of new liquidity facilities would be substantial. Even so, some expansion might prove useful if credit conditions do not improve. Communication and commitment strategies are the fourth and final category of nonstandard policy tools. In current circumstances, the Committee might use such strategies in an effort to lower market expectations of future short-term interest rates and thus reduce long-term rates, or it might wish to prevent expectations of deflation from taking hold. I will mention three strategies that the Committee might pursue. First, research suggests that it would be helpful for the Committee to be explicit about its longer-term goals, particularly about its goal for inflation. Foreign experience supports the theoretical prediction that an explicit and credible inflation objective helps anchor longer-run inflation expectations and thus can help prevent a downward drift in expected inflation and an upward drift in real interest rates during a protracted period of high unemployment and slowing inflation. That is, an explicit longer-run inflation target can prevent the public from thinking that the Federal Reserve will allow inflation to remain persistently below rates that the Committee has previously said are desirable. The Committee has discussed the pros and cons of a numerical objective for inflation several times. You may wish to consider whether the significant risk of deflation and the near certainty that the zero lower bound will constrain conventional monetary policy have changed the cost�benefit calculus. Second, the Committee could announce that it will seek to run a somewhat higher rate of inflation for a number of years than it will seek in the long run. Such a promise, if deemed credible, would stimulate real activity by raising inflation expectations and reducing medium- and long-term real interest rates. Researchers have proposed several approaches for dealing with the zero lower bound that would operate in this fashion, including targeting a slowly rising price level. These approaches would be a significant departure from historical practice, and so their pros and cons would need to be evaluated carefully. Third, research suggests that it would be helpful for the Committee to provide more-explicit information about its views on the likely future path of the federal funds rate. Suppose, for example, that the Committee concludes that it most likely will need to keep the federal funds rate close to zero for some time to spur an economic recovery and to prevent a persistent decline in inflation. In the current environment, an announcement to that effect might lead market participants to expect the funds rate to remain near zero for a longer time than they now think likely; the announcement might also lead to an increase in expected inflation. Those changes in expectations would lower nominal and real bond yields, providing some stimulus to economic activity. Theory suggests that it would be important to make clear that the Committee's current view about the likely future path of policy is conditional on current information and the current outlook and to spell out how the actual policy path would depend on a range of possible future outcomes. Communicating this conditionality could be difficult. The bottom line from the staff's analysis is that unconventional monetary policy tools can be useful complements to well-designed fiscal stimulus and to steps to recapitalize and strengthen the financial system. Additional purchases of longer-term securities, expansion of targeted lending facilities, and explicit statements of policymakers' goals and intentions all seem likely to be useful when conventional monetary policy is constrained by the zero lower bound on nominal interest rates. Our limited experience with these tools makes it difficult to estimate the amount of macroeconomic stimulus that would be generated by each and thus makes it difficult to calibrate their application. If the Committee and the Board choose to make greater use of nonstandard tools now or in the near future, it may be appropriate to deal with the uncertainty by using the tools in combination. Finally, the Bank of Japan's experience suggests that nonstandard tools are more likely to be effective if they are used aggressively. I'll now turn back to Brian. " CHRG-111hhrg61852--83 Mr. Ellison," Let me thank the gentlelady for this hearing and thank all three witnesses for their comments. I guess my first question is this: In the Congress and in the country, we are having this raging debate. On the Republican side, they are saying the debt, the deficit, no more spending unless it is accounted for. On our side of the fence we are saying, look, in the absence of private sector investment and expenditure, the public sector has to jump in and do something. Who is right? " CHRG-111shrg53822--46 Mr. Stern," Yes, and, you know, as I commented a little bit earlier, I do think that identifying those situations is an important responsibility and a challenging one. But as I commented, even when you identify those things, taking timely action is very challenging, especially in good times, by the way, when it looks as if everything is operating smoothly, and the rationale for such a divestiture, for example, would not be immediately accepted. Senator Reed. I think you are absolutely right. I mean, I think that the irony here is it is the good times where the seeds are sown for the bigger harvest of the future, and it is hard in practice. Let me ask just a final point. One of the problems we have is we have talked about the leverage and the capital ratios of regulated entities. But what about the embedded leverage of some of their counterparties, the hedge funds, so that what looks like an appropriate loan based on the capital of the regulated entity becomes, you know, much less acceptable? How do we deal with that? Ms. Bair. Hopefully, if it is a regulated bank, they should be looking at their counterparty exposure. If their counterparty is overleveraged, then that might not be a transaction they should do. One area that a systemic risk council, with the regulators coming together, should look at is how leverage constraints apply across the board. It is very difficult to have even higher capital standards than we have now for banks. If there are other major parts of the banking sector that can lever up much higher, you are going to be creating incentives to drive activity into less regulated venues. We need some minimal standards that apply across markets, and leverage is probably one area we need to review. Senator Reed. Let me just follow up quickly. This systemic council of regulators I think--well, let me ask you: Should they also have sort of the responsibility to have an analytical staff that would try to anticipate issues? Coming from my other Committee, the Armed Services Committee, we spend a lot of time and a lot of money gaming what could happen, what might not happen, what are the pressures on systems? That I do not believe exists in any sort of consistent way within financial regulation. Ms. Bair. We do it within our respective spheres. We do that internally at the FDIC with insured depository institutions. So I absolutely think that there should be an analytical staff. That would be a key part of the council to enable it to collect the data and analyze it and identify issues to try to get ahead of them. Senator Reed. Thank you very much. Thank you, Mr. Chairman. " CHRG-110hhrg45625--103 Mr. Barrett," My fear is if there is no fear of failure, I think we do change that. When you are borrowing $700 billion--my daddy said you can't borrow your way out of debt. If you are borrowing to pay off borrowed money, what happens to our balance sheet, or imbalance sheet? What happens to the dollar? If this plan comes through, am I going to wake up January 1st and all of a sudden somebody tells me that, starting tomorrow, the world standard is going to be the euro because the dollar is worthless? Can you elaborate on that? " CHRG-111hhrg52400--181 Mr. McRaith," Well, let me answer that. I am going to get to that, but I want to--you also asked about reforms that have been undertaken. We have increased capital requirements if companies are engaged in securities lending, enhanced reporting, and we are looking at how to revise our accounting standards, and that last improvement is ongoing. In terms of $44 billion, it is important to understand that each insurer, of course, has significant capital requirements, to begin with. Their assets cannot be used to satisfy the debts of the holding company. Even if these subsidiaries--I think it's an open question, also Congresswoman, whether if the--without the $44 billion, whether these companies would have actually become insolvent. Many financial regulators will argue that they would not have been insolvent without the $44 billion, that they would have been okay. However, if there had been a question of solvency, then the companies would have been placed into receivership. And insurance is not like the FDIC, for example, where you need liquidity and cash immediately. Insurance, in the guaranty fund system, essentially replaces the contract. They don't have to--and the coverage. They don't have to generate cash immediately, because, of course, not everyone dies--God forbid, everyone dies--on the same day, or everyone has a car accident on the same day. And, for this reason, $44 billion would not have been needed immediately if, hypothetically, it would have been needed at all. It would have been managed over a period of many years, if not decades. And this is what happens--and does happen--through the course of State-based receiverships of insurance companies. The State-based system would have been able to handle it, and it would have been, again, a--protected the consumers, the policyholders, first. Ms. Bean. I appreciate your testimony on what has been done by the NAIC since that time to address the gaps that exist in the current system to protect policyholders. And again, it is those who oppose legislation to move towards a national charter who suggest that there be any weakening of consumer protections, who refuse to acknowledge the $13 billion of savings to the industry that could get passed on to consumers from the redundancies of a 50-State system. Thank you, and I yield back. " CHRG-111shrg50814--55 Mr. Bernanke," If I may---- Senator Schumer. How do we deal with the leverage issue for non-depository institutions is what I am asking. " FinancialCrisisInquiry--144 Right. So what I’ve done for you, and in my presentation, is I’ve given the salient facts of—of the time period in question. What I’m happy to supply you with is the full spreadsheet of—of these numbers. And these numbers were aggregated from 10-Ks, -Qs and their off balance sheet reporting, so it was all publicly available data. HOLTZ-EAKIN: OK. BASS: So I’m happy to just supply that with you—for you. HOLTZ-EAKIN: That would be great. Thank you. BASS: I don’t have it here in front of me, but I have a full data set for you. HOLTZ-EAKIN: OK. That would be great. And so this is 2007, we have leverage at 68 to one. And what we heard from the panel this morning again and again in their written testimonies, oral remarks, were everyone became too levered. We’re, you know, going the other way now. But what I did not hear, even in the discussion of their risk management practices, is how the leverage got determined, how internal calculations were done about appropriate levels of leverage, and how they affected their risk management regimes and their expected outcomes. So I was wondering if you could give us your perspective on how that was done in the industry if there have been significant changes in it, and the extent to which this can only be imposed externally. FinancialCrisisInquiry--136 CHAIRMAN ANGELIDES: I’ll—this discussion is going well. I’ll yield three, four minutes. You tell me what you need. I’ve got flexibility this time. MURREN: That should be perfect. CHAIRMAN ANGELIDES: Fine. Let’s do three minutes and see how it goes. And we’ll go from there. MURREN: You mentioned that you disagreed with Mr. Dimon on that particular point. I’m curious maybe if you could each just briefly mention what you most agree with that they said— the previous panelists. And I’m assuming that you had an opportunity to hear their testimony. And then, perhaps, maybe one or two things that you disagreed with. MAYO: You know, as I listened to Mr. Blankfein, he brought up one word that hit me that I think, if I’m still doing this job 20 years from now, is going to stick with me. And that’s when he said, “rationalized.” We rationalized what we were doing based on the circumstances at the time. And I think one of the conclusions of your hearings throughout this year, that’s a warning to the future. Look how much we rationalized the activities that were taking place in the industry. So I very much agreed with that. And with regard to Morgan Stanley, Mr. Mack mentioned there was just too much leverage at the firms. That’s an easy call, and you can certainly track that. Well, let me yield to... SOLOMON: I certainly agree on leverage. They all said there was too much leverage. And I also agree that all their managements failed. So I can agree on both those. CHRG-110hhrg46595--120 The Chairman," The gentlewoman from Wisconsin. Ms. Moore of Wisconsin. Mr. Wagoner, you mentioned in your last response, you talked about the legacy cost, which, as you said, in the last 15 years they have cost you $103 billion and it has constrained investment in more advanced manufacturing product technologies. And you have a very elaborate plan. Wouldn't this have been a great time for GM to say, we need a national health care program in order to stay viable? You correctly identify the problem that other markets--China, Latin America and Russia--where GM doesn't have the burden of those costs. Why did you stop short of saying that this kind of initiative would help our industry? " CHRG-111hhrg56847--197 Mr. Austria," And let me go back now in combining this debt with what I am hearing from our small businesses out there who are struggling right now. As far as bringing more certainty to the markets, as far as creating jobs within the private sector, do you believe, when we continue to spend the way we are, continuing to grow government, at that--at some point--at what point do we start to create the jobs in the private sector? I guess is my question. " CHRG-111shrg57322--1101 Mr. Blankfein," Yes. I think the industry is substantially less leveraged. I will tell you, we thought we weren't leveraged going into the crisis as much--and we weren't as much as other investment banks like ourselves. With the benefit of hindsight, we were too leveraged even at what we thought at the time was fine and we are substantially--we are less than half as leveraged as we were then. The recency of this crisis is going to reverberate with me for the rest of my career and my life. So I will be--the image of it and the fear and the anxiety that we all had. And so I agree, I think the firm--all firms will be run much more conservatively and I hope for a long time, and I tell you that society will not rely on the good will and the memory of financial firms. I think Congress and regulators will impose tighter-higher capital requirements and liquidity requirements, and I think that is appropriate, because as we also found out in the crisis, we all have interrelated obligations to each other and it wouldn't suit me to have Goldman Sachs be conservative if everybody else is going to take too much risk and put the system at risk, which is why, again, I echo making the world safer and ending too big to fail, I think, is something that is a substantial interest of society at large and also of the industry and Goldman Sachs. Senator Pryor. Thank you. Mr. Chairman, thank you for your diligence on this matter. Like I said, this didn't start with you 2 weeks ago. This has been going on for a year and a half and you have just done yeoman's work on this. Thank you. Senator Levin. Thank you so much, Senator Pryor. Senator Tester. Senator Tester. Yes. Thank you, Mr. Chairman. I want to echo Senator Pryor's remarks, and Mr. Blankfein, I appreciate you being here. I am going to get into some questions here that I have prepared, but is Goldman too big to fail? " CHRG-111hhrg48868--415 Mr. Ackerman," And say ``transparency.'' The reason this country is great and our system works better than any other, is because of transparency, and our capital markets work great, better than any others, because of transparency. And the fact that Mr. Madoff said, ``I can't tell you the secrets of my business, because they're secret, that's why I'm successful,'' that is what has everybody all screwed up, because nobody knew what he was doing and he's just too big to fail. The credit default industry is Madoff Lodge. People are buying into what they don't understand, they can't see through, it is completely unregulated by any agency that we know of or have been told today by the regulators; has no finances to back it up, and can't pay off on a bad debt, on a bad bet. It's people sitting around, shooting craps without a wallet. And I don't think that's a good financial investment, do you? " CHRG-110shrg38109--130 Chairman Bernanke," Well, over the medium-term, it is the demographic transition that we are going through. We are getting older, our society is aging. We are going to have a much larger share of the population in retirement age, or even in the oldest of the old, 80 and 90 years old. And we have not really made good preparation for that, either in terms of broader savings in the society, or in terms of fiscal policy, which I have discussed in previous context. Senator Tester. Does the $8.6 trillion debt fall into that issue then? Or is that somewhere else? " CHRG-111shrg62643--62 Mr. Bernanke," Well, I think that, first of all, adding the GSE debt is not entirely appropriate, because on the other side of the balance sheet are assets, mortgages, that are worth something. Senator Bunning. But don't we have to make good those trust fund mortgages like Social Security? Don't we, as a government, have to make good on those pieces of paper that are up in West Virginia? " FOMC20081216meeting--32 30,MR. DUDLEY.," Well, yes. It is possible that we could have default rates greater than those of the Great Depression. I'm just saying that these levels discount that kind of outcome. Obviously, the high-yield debt market today is different from general default rates. Yeah, I think that's a fair point. " FinancialCrisisInquiry--494 VICE CHAIRMAN THOMAS: Go ahead. HOLTZ-EAKIN: I’ll go fast. Is it fair to say that one of the reasons—and one of the reasons Fannie and Freddie are more interconnected than the others is the preferential regulations that allow banks to hold unlimited amounts of their debt in there? And so if we were to in fact force those losses out, their vast interconnectedness would have large implications for the system? CHRG-111hhrg56847--43 Mr. Bernanke," I don't think there is anything magic about 90 percent. However, I do think that if we were to go out as, say, the CBO's alternative scenario projects, then debt and interest payments are going to get explosive in 10 or 15 years. So I think we are close to a situation where we need to be paying very close attention to our fiscal sustainability. " CHRG-111hhrg56766--51 The Chairman," The gentleman from Texas, Mr. Paul. Dr. Paul. I thank you, Mr. Chairman. The Federal Reserve Transparency Act, which has passed the House already, is something that the Federal Reserve obviously has been opposed to, and one of the reasons they are opposed to it, as I understand it, is it would politicize monetary policy, which is not what the bill actually does. The other reason they give is that if Congress had any subtle influence, they would inflate more than the Federal Reserve might want to. It is sort of ironic, the Federal Reserve kept interest rates too low for too long and the consensus now in the financial community is that is true, interest rates are still down at 1 percent, hardly could the Congress influence the Federal Reserve in a negative way by causing them to inflate even more. There has been a cozy political relationship between Congress and the Federal Reserve, although the Congress has been derelict in their responsibilities to perform oversight. When it comes to debt, the Fed is there. They can monetize the debt and keep interest rates low. The Congress can keep spending and get re-elected. They do not have to raise taxes so the Fed can act as a taxing authority. You print the money, dilute the value of the money. Prices go up and price inflation is a tax. When people pay a lot more for their medical care than they used to, they ought to think about the inflationary tax. Also, the Fed accommodates the Congress by liquidating debt, by debasement of the currency, the real value of the money goes down, the real debt actually goes down. In many ways, the Congress and the Fed do have a pretty cozy political relationship. I would like to get to more specifics on the transparency bill because it has been reported in the past that during the 1980's, the Fed actually facilitated a $5.5 billion loan to Saddam Hussein, who then bought weapons from our military industrial complex, and also that is when he invested in a nuclear reactor. A lot of cash was passed through and a lot of people supposed it was passed through the Federal Reserve when there was a provisional government after the 2003 invasion. That money was not appropriated by the Congress, as the Constitution said. Also, there have been reports that the cash used in the Watergate scandal came through the Federal Reserve. When investigators back in those years tried to find out, they were always stonewalled, and we could not get the information. My question is, you object to this idea that I would say give us 6 months, after 6 months, we could find out what we are doing, but what about giving you 10 years? Would you grant that the American people deserve to know whether the Federal Reserve has been involved in this, and what kind of shenanigans they are involved in with foreign countries and foreign central banks, and find out possibly you are working now to bail out Greece, for all we know. Would you grant that after 10 or 15 years, the American people deserve to know? It seems if the Fed was not involved with this at all, it would be to your advantage to say no, we do not do stuff like that. Why could we not open the books up 10 years back and find out the truth of these matters? " CHRG-111hhrg56766--32 Mr. Bachus," Thank you, Mr. Chairman. Chairman Bernanke, I think Chairman Frank mentioned the deficit in passing and the debt, and that is what I want to ask you about. Really, to me, that is the elephant in the room. Our debt is going to double in the next 5 years, triple in the next 10 years, and is fueled by historic deficits. I heard this morning on TV that we have in many cases across the United States this year, children and even adults who are kind of walking out on the thin ice, and they walk out maybe day after day, and they get some comfort that nothing happens. Thin ice is dangerous. I submit that this type of budget path is dangerous and the deficits we are running are dangerous. I would ask you, number one, I do not believe our present budget path is sustainable, so my first question to you is, is our budget path sustainable, and second, is there a need for what I would consider an urgent need for the Congress--you said it was up to the Congress to come up with a concrete plan to change that budget path, and do you believe there is an urgency in that? " FOMC20080130meeting--15 13,MR. DUDLEY.,"1 Thank you, Mr. Chairman. I'll be referring to the handout that you should have in front of you. Over the past month, term funding pressures for banks have generally subsided. But the bigger story remains the continued pressure on bank balance sheets, the tightening of credit availability, and the impact of this tightening on the outlook for economic activity. The travails of the monoline financial guarantors--some of which have already been downgraded by one or more of the rating agencies--have exacerbated the worries about the potential for further bank writedowns and have created risks that some financial instruments that rely on monoline guarantees might no longer be viable. At this juncture, whether the major monoline guarantors will receive the new capital needed to keep or restore their AAA ratings remains uncertain. I'll start today by noting that U.S. and global equity and fixed-income markets have behaved in a way consistent with a darker economic outlook. As shown in exhibit 1, the major U.S. indexes have fallen sharply since the December 11 FOMC meeting. These declines in the stock markets have been mostly matched abroad, as shown in exhibit 2. At the same time, corporate credit spreads have risen in tandem with the equity markets' decline. As shown in exhibit 3, high-yield corporate bond spreads are up more than 100 basis points since the December FOMC meeting, pulling the interest rates on high-yield debt significantly higher. Investment-grade spreads have also widened. But for investment-grade debt, the decline in Treasury yields has been larger than the rise in spreads, lowering somewhat the absolute level of yields. Global credit default swap spreads have also increased sharply, as shown in 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). exhibit 4. Market price risk has increased. This is most visible in the rise of most market measures of implied volatility. For example, the VIX, which measures implied volatility on the S&P 500 index, recently climbed back to the peak level reached in August (exhibit 5) and the MOVE index, which measures volatility in the Treasury coupon market, has climbed to its highest level since 1998. The problems of the financial guarantors have been an important part of the story. In recent years, the major financial guarantors have diversified into insuring structured-finance products, including collateralized debt obligations (CDOs). Currently, their exposure to all structured-finance products is about $780 billion. Exhibit 6 shows the distribution of exposure across three buckets: U.S. public finance, U.S. ABS and structured finance, and the total non-U.S. exposure for the six major monoline guarantors. Because the structured-finance guarantees have typically been issued against the highest rated tranches at the very top of the capital structure, until recently the rating agencies did not think that these guarantees would result in meaningful losses. However, as the housing outlook has continued to deteriorate and the rating agencies have increased their loss estimates on subprime and other types of residential mortgage loan products, the risk of significant losses has increased sharply. This is particularly the case with respect to these firms' collateralized debt obligation exposures--a portion of their total structured-finance exposure. As I discussed in an earlier briefing, given the highly nonlinear payoffs built into these products, modest changes in the loss assumptions on the underlying collateral can lead to a sharp rise in expected losses on super senior AAA-rated collateralized debt obligations. Unfortunately, the CDO exposures of several of these financial guarantors are quite large relative to their claims-paying resources. As shown in exhibit 7, statutory capital for even the biggest firm is less than $7 billion; the total capital for the entire group is slightly more than $20 billion; and total claims-paying resources for this group from all sources is about $50 billion. Exhibit 8 compares these claims-paying resources with the subset of CDO exposures that contain some subprime mortgage-related collateral. For four of the six major guarantors, these CDO exposures represent more than 200 percent of their total claims-paying resources. These exposures and the uncertainty about how these exposures will actually translate into losses are the proximate cause for the collapse in the financial guarantor share prices and the widening in their credit default swap spreads. This is why new sources of capital have been either prohibitively expensive or dilutive or both to existing shareholders. As I noted in last week's briefing, credit rating downgrades of the financial guarantors would likely lead to significant mark-to-market losses for those financial institutions that had purchased protection. For example, in its fourth-quarter earnings release, Merrill Lynch wrote down by $3.1 billion its valuation related to its hedges with the financial guarantors; $2.6 billion of this reflected writedowns related to super senior ABS CDO exposures. Unfortunately, there is not much transparency as to the counterparty exposures of the guarantors on a firm-by-firm, asset-class-by-asset-class, or security-by-security basis. However, major broker-dealers have considerable nonABS CDO exposures to the financial guarantors. For example, they are thought to have hedged an even larger amount of the super senior tranches of synthetic corporate CDOs with the financial guarantors. This suggests the potential for significant additional mark-to-market losses for commercial and investment bank counterparties should the financial guarantor credit ratings get further downgraded. In addition, such downgrades would increase market anxiety about counterparty risk because there would be considerable uncertainty about the magnitude and incidence of the prospective losses such downgrades might trigger. Financial institutions are also exposed to the monoline guarantors via the wraps these guarantors have issued on certain money market securities, including auction rate securities, tender option bonds, and variable rate demand notes. The amount of these securities outstanding is significant. The total market size for these three types of securities is estimated to be about $900 billion. The major risk here is that the loss of the AAA-rated guarantee from the financial guarantor could undercut the demand for these securities. In the case of tender option bonds and variable rate demand notes, this could trigger the liquidity backstops provided by major commercial banks and dealers, leading to further demands on their balance sheets. In the case of the auction rate securities market, the dealers would be faced with a difficult Hobson's choice. They could either allow the auction to fail or take the securities onto their books to prevent a failed auction. In the case of a failed auction, the investor receives a higher interest rate but has to wait until the next auction to try to redeem the securities. If failed auctions were to persist, as would be likely, then the securities would essentially become long-term rather than short-term obligations. Failed auctions would undoubtedly distress clients that had purchased the securities on the assumption that they would be liquid and could be redeemed easily. Failed auctions would also likely lead to broader distress in the associated municipal and student loan securities markets. We have already experienced a number of failed auctions for auction rate securities. Moreover, the recent downgrades of Ambac and FSA have led to significant market differentiation among tender option bonds and some upward pressure on municipal bonds wrapped by weaker monoline financial guarantors. If the monoline guarantors are unable to find additional equity or other forms of support, these pressures are likely to intensify in coming weeks. The travails of the financial guarantors have added to the pressure on major commercial and investment banks. As shown in exhibits 9 and 10, commercial and investment bank equity prices and credit default swap spreads have generally continued to widen. The cumulative writedowns reported for a selected group of large banks has now reached $100 billion over the past two quarters (exhibit 11). Coupled with balance sheet growth and other factors, such as acquisitions, these writedowns have put significant downward pressure on bank capital ratios. For example, although all of the top five U.S. commercial banks can still be characterized as ""well capitalized,"" there has been significant erosion of their capital ratios over the past two quarters (exhibit 12). This balance sheet pressure helps to explain why commercial bank counterparties continue to complain about their access to credit, the tightening in lending standards, and the wider spreads for assets such as jumbo residential mortgages, commercial mortgages, and leveraged loans that can no longer be readily securitized and distributed into the capital markets. Shifting now to what market participants expect from us from this meeting: Monetary policy expectations continue to shift in the direction of more cuts that are delivered more quickly. As shown in exhibit 13, the federal funds rate futures market currently implies that market participants now expect additional rate cuts totaling about 100 basis points by midyear. Further out, as shown in exhibit 14, the Eurodollar futures curves indicate that about another 25 basis points is anticipated during the second half of the year. But these expectations are volatile and have been shifting considerably day to day. The primary dealer survey tells a similar story. The modal forecast of the primary dealers shows a federal funds rate trough slightly below 2.5 percent (exhibit 15). Compared with the previous dealers' survey conducted for the December FOMC meeting (exhibit 16), the trough has moved down about 75 basis points. As of last Friday, seventeen of the twenty primary dealers expected a 50 basis point rate cut at this meeting. This sentiment appears to be generally shared by market participants. As shown in exhibit 17, as of last Friday, options on federal funds rate futures implied a rate cut at today's meeting, with the highest probability on a 50 basis point rate cut to 3 percent. However, it is important to recognize that the probabilities shown in exhibit 17 put a zero weight on the notion of another intermeeting cut in February--so they should not be taken literally as to the outcome at today's meeting. The distribution of yields on Eurodollar futures 300 days ahead suggests that there has been a regime shift since the December FOMC meeting. As shown in exhibit 18, not only have expectations shifted down sharply, but the skew has reversed direction. The mode of the distribution is at 1.75 percent, and the skew of the distribution around that mode is toward less extreme rate outcomes. This could be viewed as market participants now pricing in considerable risk of a severe recession but maintaining some hope that a milder downturn might occur or that a recession could possibly be averted altogether. As shown in exhibit 19, the intermeeting rate cut was accompanied by a rise in inflation compensation at the five-year to ten-year time horizon. However, it is unclear that this represents a genuine deterioration in inflation expectations for several reasons. First, the rise occurred, in part, because breakeven inflation at the five-year horizon has fallen as nominal five-year Treasury yields have dropped sharply. It is this decline that has lifted the five-year, five-year-forward measure. I would agree with the memo by Board staff that was distributed to the FOMC yesterday on this issue: The rise in five-year, five-year-forward inflation compensation likely reflects a greater liquidity premium for nominal Treasuries. The rise in interest rate volatility is also a factor. According to TIPS traders, the rise in five-year, five-year-forward inflation reflects technical factors such as a temporary increase in the demand for shorter-dated Treasuries, month-end index extension flows, and a greater liquidity premium for nominal, on-the-run Treasuries. The general rise in interest rate volatility is probably also a factor. Second, the rise in five-year, five-year-forward expectations has not been accompanied by a broad set of other signals consistent with deteriorating long-term inflation expectations. For example, the four- to five-year-forward breakeven inflation measure shows a much smaller rise, the dollar has been relatively stable, and estimates of bond term risk premiums remain low. On the other side, gold prices have increased sharply in the past week. Third, in our primary dealers' survey, there was very little change in longterm inflation expectations. Finally, it is worth noting that following the 50 basis point rate cut in September, which was more aggressive than expected, the five-year, five-year-forward rate also rose, but the rise proved temporary. I would also like to briefly discuss the state of play in bank term funding markets--some good news. As shown in exhibit 20, the spreads between the onemonth LIBOR and the one-month OIS rate and the three-month LIBOR and the threemonth OIS rate have fallen sharply since year-end. However, over the past week, there has been considerable volatility in these spreads. This could be due to a variety of factors--including a temporary increase in the demand by Societ� G�n�rale for term funds and the sharp shift in expectations about the near-term federal funds rate path. Currently, these spreads are close to the narrowest we have seen since the market turmoil began last August. Although the passage of year-end was the predominant factor behind the decline in term funding spreads, the term auction facility (TAF) also appears to have been helpful. Exhibit 21 shows the results for the first three U.S. auctions. Completing the exhibit, the results for the fourth auction, which was conducted yesterday, were minimum bid rate, 3.10 percent; stop-out rate, 3.12 percent; propositions, $37.5 billion; bid-to-cover ratio, 1.25; and number of bidders, 52. In general, the pattern is one of declining bid-to-cover ratios and a declining spread between the stop-out rate and the overnight index swap rate. The results for the ECB and Swiss National Bank auctions show a similar pattern. At the latest auction, the ECB had $12.4 billion of bids, a bid-to-cover ratio of 1.24, and their number of bidders fell to 19 from 22 at the previous auction. The Board of Governors has said that on February 1 it will announce plans for the TAF in February. The staff has recommended to the Chairman that the auctions continue on a biweekly basis, that the size be maintained at $30 billion per auction, and that the minimum bid size be cut to $5 million from $10 million to make it easier for smaller institutions to participate. Finally, there was no foreign currency intervention activity during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the December 11 FOMC meeting. Of course, as always, I am happy to take any questions. " CHRG-111hhrg48875--22 Secretary Geithner," A very important concern. You're right. That basic concern shaped the proposal we made. And the suggestion for that leverage is really what the FDIC suggested, based on the range of experience they have with their existing mechanism. Now, it is substantially less leverage than banks run with today. And you are right, you want to get the balance carefully right. What we have put forward was a framework that, we think, leaves the taxpayer much better protected than the alternatives. And we're trying again to stretch taxpayer resources prudently and, you know, use private investment effectively and still limit those risks to the taxpayer. " FinancialCrisisInquiry--299 WALLISON: January 13, 2010 All right. In consistent terms, though, what you were leveraged before the SEC began to regulate you in post-Basel II... CHRG-111hhrg51591--120 Mr. Hunter," Well, again, I think this is the role of a solvency regulator, solvency/systemic risk regulator, and that there should be specific limits on leverage. " CHRG-111hhrg53244--191 Mr. Hensarling," Okay. I guess, Mr. Chairman, then the question is, yes, I would hope that if one committed $1.1 trillion, when you add in debt service, some good would come from it. Now, clearly, it hasn't happened on the employment front. But I am also concerned that, no matter what the positive aspects are, without the strong commitment to fiscal sustainability, might it be possible that whatever short-term good comes out of that legislation is going to be outweighed by long-term damage, as many economists believe? " CHRG-110hhrg46596--203 Mr. Meeks," Except it seems as though there is none--because we are talking about a small percentage of the TARP money that would be utilized in regards to trying to make sure that the mortgagors--that would prevent the foreclosures of these mortgages. And when you look at the number of individuals, I think it is 70 percent of subprime borrowers are not getting the help, that there are not enough servicers. And unless we start putting some money into training and having more servicers for these loans so that we can help save some more individuals from going into foreclosure, then we will never get from under this mortgage foreclosure problem, which seems to be the epicenter of all of the problems that we are having here. And then, let me ask this question also, because I think it goes to something of the perception, continuing the perception that Mr. Watt talked about. Because I am also concerned that in recent weeks the Federal Reserve has approved expedited bank holding company applications for numerous companies, including Goldman Sachs, and I think Morgan Stanley, and the Treasury Department has already awarded TARP money under the Capital Purchase Program to Goldman Sachs and Morgan Stanley, and that these companies are also issuing billions of dollars of federally guaranteed debt under the FDIC's debt guarantee program, designed specifically for banks and bank holding companies. In light of these circumstances, what I want to find out is what safeguards is the Treasury Department establishing to ensure that taxpayer money under the TARP program and the FDIC programs and the Federal Reserve discount window is not being used to support the substantial nonbank commercial activities of any of these newly formed bank holding companies? " CHRG-110hhrg46596--351 Mr. Kashkari," It is hard to know--Congressman, it is a tough question because it is hard to know with a dollar in a company, did this dollar of the taxpayers go to this use, did it go to paying expenses? Mr. Miller of North Carolina. That is really not a credible response. Who were we paying off? Who are all of the counterparties in AIG's derivative contracts? Now, with respect to other people who are getting money from us, we are getting something. We are getting warrants, we are getting preferred stock, we are getting senior debt. But with respect to AIG, the money we are paying to their counterparties, in the words of Rob Blagojevich, ``We are not getting anything except appreciation.'' " CHRG-109shrg21981--118 Chairman Greenspan," Well, we had believed we were going to run the debt down to zero not that many years ago. That would have solved the problem. Senator Stabenow. I remember your being here with us in 2001, when we were talking about the wonderful problem of having too large of a surplus and the question of what we do about that. I wonder if I might ask one further question. I know my time has expired. " CHRG-111hhrg53244--226 Mr. Bernanke," That is something we should look at. I think there is room here for the regulators, the Treasury and others, the Congress, to think about our capital regulation plan and see what changes might be made. But I wouldn't want to give an offhand comment on that. Of course we already have a leverage ratio, but the question is whether to raise it or change its format in some way. " CHRG-110hhrg46591--31 Mr. Bachus," Thank you, Mr. Chairman. Mr. Chairman, I have a real concern, and that concern is that we are going to repeat the mistakes of the past. Now, how did we get here? We did it by the overextension of credit. We did it by overleveraging. We did it by too much borrowing and by too much lending. Yet what are we talking about this week and last month? We are talking about how can we stimulate lending, about how can we stimulate consumption, about how can we stimulate spending. I believe that what we ought to be talking about is how we encourage people to save. How do we encourage people to live within their means? How do we encourage the government, not just American families but the government, to live within its means? Another concern--and I think it is wrapped up in this--is this propensity of Americans to borrow more than they can afford to repay and to spend excessively and to not live within their means and to intervene on behalf of those who do. You know, we have talked about the market. Well, the market has been brutally efficient in the past several months. If it is allowed to work--and there will be negative consequences for all of us, but it will penalize those who took excessive risk. It will penalize those who borrowed more than they could afford. It has penalized our investment banks. There are no more investment banks. They have overleveraged. The best way to discourage people from making bad loans is to let the market make them eat those losses. We need, I think, number one, to realize there are limits on what government can do to try to intervene in this market process. Over a year ago, I was interviewed by the New York Times, by one of their editorial boards. I said this is not going to be pretty. It is going to be painful, but to a certain extent--and it is not popular to say--it is cathartic. It has a certain cleansing ability in the market by doing this. But we are going to be right back here in 5 years or in 10 years or in 15 years if we, as a country, go out and we have a stimulus package where we encourage people to spend money, we encourage them to take on loans, to take on debt, as opposed to figuring out a way to encourage them to balance their budgets as families and as a government. If we are going to have an economic stimulus package, I have said it ought to be restricted to those things we have to do anyway, to those things we are going to do, like sewer projects and water projects, even tax policies, which encourage spending. We are here today because we borrowed excessively and because we did not live within our means. I have said this, and I will close with this: On this committee, Ron Paul in a debate said we are not a wealthy nation. We are a nation of debtors. We are in debt. When we are in debt, and if we take on more debt, we are actually going to restrict our ability to grow and to thrive economically. That is a negative. Lending excessively and borrowing excessively is not something we ought to encourage. We are going to probably inflate this economy. We are going to probably print a lot of money, and we are going to, in my mind, it appears that we are going to continue to go down a road that has brought us here today. And that is not living responsibly. Thank you, Mr. Chairman. " CHRG-111hhrg55811--253 Mr. Himes," Thank you. I am gratified that there seems to be an alignment now around the notion of really clearing everything that we can and, hopefully, creating as much of a standardized universe as we can. This obviously imposes quite a bit of burden as a risk manager upon the clearinghouses, and I have a couple of questions and observations related to that. First, there is I think a danger associated with the fragmentation of clearinghouses, both here in the United States and internationally. I would like to ask you about that. But I would also like to ask the chairman for unanimous consent to submit for the record some testimony by the Depository Trust and Clearing Corporation, which is just raising the question of whether there should be a central depository for this information that would be available to the regulators, if there is no objection. Mr. Moore of Kansas. Without objection, it is so ordered. " 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. " CHRG-111shrg51303--147 Mr. Kohn," I think there are ways of trying to do that. One can look at the spreads, look at the activity, see that unusual things are going on. Think of the leverage in the U.S. financial system that was growing exponentially. Senator Bennet. Another great example. " CHRG-111hhrg51592--3 Mr. Garrett," And I thank the chairman for holding this important hearing today. I believe it is critical, as he says, that this subcommittee conduct proper oversight of the credit rating agencies and examine all of the issues surrounding the role that they played, if any, in the lead-up to the Nation's current situation. I would like to thank all the witnesses of the panel attending. Unfortunately, we don't have a representative from the SEC. That's the government agency tasked with overseeing and regulating the NRSROs here with us to testify. And so I feel it's essential that before this committee does formally consider any regulatory reforms regarding the rating agencies, that we should at some point hear directly from the SEC, as to what, if any, additional powers or changes they see necessary. Over the past decade, we have seen a large increase in the role that credit rating agencies have in determining the creditworthiness of financial institutions and different type of securities. Whether it is corporate, municipal, or structured finance, any entity seeking to assure investors of the quality of the debt must receive a good grade from one of these entities. And so investors have become increasingly, and too often solely, reliant on the use of these ratings in determining the safety and soundness of an investment. This situation, like many of the other problems of this financial crisis, has, in large part been created by government policy itself. For literally hundreds of Federal and State government statutes and regulations, there are specific government requirements mandating certain grades from approved agencies. It is this formal requirement that provides an implicit stamp of approval, if you will, to the investors. When an investor sees that the government has required a specific grade to make a ``safe investment,'' it basically reinforces the belief that any investment attaining such a grade is a safe investment. But to its credit, the SEC recognizes this problem, as well, and they are moving to address it. So in December of last year, the SEC proposed several new rules, one of which would reduce the reliance on the NRSROs' ratings in the SEC's regulations. I believe it was Commissioner Casey who had it right when she said, ``These requirements have served to elevate NRSRO ratings to a status that does not reflect their actual purpose, much less the limitations of credit ratings.'' So Congress really should try to follow suit and reexamine all the areas where statutes mandate the ratings of NRSROs. Credit ratings are only one piece of the puzzle--I think we'll hear that from the panel--in determining creditworthiness. Investors must be encouraged to do their own due diligence in evaluating issuer credit quality. Now, one of the other areas that needs to be addressed is increased competition within the industry, and I hear from the panel that they may be amenable to that, as well. The 2006 Act made a number of significant improvements to the process. Unfortunately, the law was just beginning to be implemented at the time when the financial system started to hemorrhage; and the very worthwhile goals of the 2006 laws, as far as fostering more competition, enhancing transparency, and increasing accountability may still be achieved. So two things I do not think Congress or the SEC should do are to eliminate specific types of pay models or prescribe exact analytics that NRSROs must use. This would go against the intent of the legislation by providing a further reduction in competition and increasing investor reliance on the ratings. In regards to competition, a recent rule issued that also runs contrary to the goals of 2006 is from the Fed, the requirement that any securities used as collateral in their Term Asset-Backed Securities Loan Facility, the TALF, must have an A-1 rating from a major NRSRO. So this major NRSRO term is entirely new and refers to the Big Three rating agencies. While I assume that the Fed added this requirement due to the perceived better quality of the Big Three firms, I would remind the Fed that the Big Three rated Lehman, unfortunately, as A-1 on the day of bankruptcy. Another area in which I would like to see increased competition is the manner in which credit quality is determined. And I know that some of my friends on the committee would like to demonize credit default swaps as a horrific gambling bet made by fat cats smoking cigars and sitting in luxurious boardrooms, but the fact of the matter is, credit default swaps are actually additional measures of assessing the creditworthiness of different corporations or securities, and during the height of the financial panic and collapse of many major firms, credit default swaps provided a more accurate gauge or risk that some of the credit rating agencies. So in conclusion, Mr. Chairman, I believe that the government must continue to wean investors off being solely reliant on credit ratings and encourage them to conduct their own more due diligence. I do greatly appreciate the chairman holding this very important hearing, and I look forward to all the witnesses' testimony today. Thank you. " CHRG-110hhrg44900--186 Mr. Sherman," Okay. I now have quite a number of questions for the record, because I realize my time is limited and I look forward to getting responses. The first is whether off-balance sheet financially engineered instruments oppose a risk to the major corporations of this country. The second is whether we have moved to a system of capitalism for the poor and socialism for the rich. The pizzeria in my district that goes out of business, they're not going to get any kind of bailout from the Fed. And, the subordinated debt-holder, namely the guy's uncle who lent him money to start the place, he isn't going to get anything either. I understand why the Fed acted in an emergency situation, but now we are no longer in an emergency situation, and the question is what are we doing to make sure that those who should have borne the risk, the shareholders, the subordinated creditors, who are going to come out of this thing whole, even though they bought subordinated debt, and the regular debtors of Bear Stearns are not contributing and paying for this $30 billion worth of risk that the taxpayers have borne. Should we, and I would like both Treasury and the Fed to respond to this, be looking to impose a tax on the subordinated creditors, on the shareholders, to recapture for the Federal Government a fair fee for the incredible risk that the Federal Government is assuming, or should we just make this huge gift that no private sector company would ever engage in to those who are thought on Wall Street to be so important, something we would never consider doing for a pizzeria in my district. " CHRG-111hhrg54867--66 Mr. Gutierrez," Well, that is good. Because it was always interesting to me the kind of dynamics, as you were running through this, that Secretary Paulson headed up Goldman Sachs, and he was there trying to figure out how this leveraging was going to get unleveraged, the same leveraging that he went to the Securities and Exchange Commission. I want to make sure that never happens again, that we don't have people in this kind of situation. So tell me exactly what we are going to do different that isn't--okay, you are the Secretary of the Treasury. How are we going to make sure that another part, the Securities and Exchange Commission or somebody else, doesn't go and do something like this that then corrupts your ability, undermines, corrupts your ability to keep the financial markets in check? " CHRG-111shrg57322--851 Mr. Viniar," Well, I know we pay them for sure when they rate our own securities, so if Goldman Sachs issues debt, we have to pay a fee for the rating on that. And, Craig, I believe there are some other circumstances where, if they are rating a security we create, sometimes it comes out of the transaction. Sometimes we as structurer will pay them. Senator Pryor. And does that present any conflicts of interest in your mind? " CHRG-111hhrg49968--49 Mr. Bernanke," The Federal Reserve will not monetize the debt. And I think it is important to point out that, notwithstanding our purchases of Treasuries as part of a program to strengthen private credit markets, even when we complete the $300 billion purchase that we have committed to, we will still hold less Treasuries, a smaller volume of Treasuries than we had before the crisis began. " CHRG-111hhrg56847--98 Mr. Simpson," Thank you, Mr. Chairman. And thank you for being here today, Chairman. The economy seems to react to almost everything you say. Sometimes it reacts to things Congress does or fails to do. You said earlier that we need a plan to deal with our--or at least a plan to deal with our long-term financial debt as important to current economic conditions. Is that correct? " CHRG-111shrg61513--56 Mr. Bernanke," Absolutely. Absolutely. And you would be seeing debt-to-GDP ratios rising; you would be seeing crowding out of investments and other problems. Yes, absolutely. Senator Vitter. So is it fair to say, you know, we are perhaps not seeing those immediate threats because we are in a serious recession? Once we come out of that, those immediate threats, the chances of their having a real negative impact elevate enormously. " CHRG-111shrg57322--1162 Mr. Blankfein," I didn't---- Senator Levin. Two private parties owed you money, either AIG or that insurance company that you insured the AIG debt with. So why do you end up with $2.5 billion of taxpayers' money in your pocket when we don't owe you the money? AIG owes you the money or an insurance company owes you the money---- " CHRG-110hhrg46591--413 Mr. Bartlett," Well, just briefly, the problem with credit default swaps was its excess leverage to the extreme and then no systemic regulation at all. I mean none. " FinancialCrisisReport--19 Over the last ten years, some U.S. financial institutions have not only grown larger and more complex, but have also engaged in higher risk activities. The last decade has witnessed an explosion of so-called “innovative” financial products with embedded risks that are difficult to analyze and predict, including collateralized debt obligations, credit default swaps, exchange traded funds, commodity and swap indices, and more. Financial engineering produced these financial instruments which typically had little or no performance record to use for risk management purposes. Some U.S. financial institutions became major participants in the development of these financial products, designing, selling, and trading them in U.S. and global markets. In addition, most major U.S. financial institutions began devoting increasing resources to so-called “proprietary trading,” in which the firm’s personnel used the firm’s capital to gain investment returns for the firm itself rather than for its clients. Traditionally, U.S. banks, broker- dealers, and investment banks had offered investment advice and services to their clients, and did well when their clients did well. Over the last ten years, however, some firms began referring to their clients, not as customers, but as counterparties. In addition, some firms at times developed and used financial products in transactions in which the firm did well only when its clients, or counterparties, lost money. Some U.S. banks also sponsored affiliated hedge funds, provided them with billions of dollars in client and bank funds, and allowed the hedge funds to make high risk investments on the bank’s behalf, seeking greater returns. By 2005, as U.S. financial institutions reached unprecedented size and made increasing use of complex, high risk financial products, government oversight and regulation was increasingly incoherent and misguided. B. High Risk Mortgage Lending The U.S. mortgage market reflected many of the trends affecting the U.S. financial system as a whole. Prior to the early 1970s, families wishing to buy a home typically went to a local bank or mortgage company, applied for a loan and, after providing detailed financial information and a down payment, qualified for a 30-year fixed rate mortgage. The local bank or mortgage company then typically kept that mortgage until the homeowner paid it off, earning its profit from the interest rates and fees paid by the borrower. Lenders were required to keep a certain amount of capital for each loan they issued, which effectively limited the number of loans one bank could have on its books. To increase their capital, some lenders began selling the loans on their books to other financial institutions that wanted to service the loans over time, and then used the profits to make new loans to prospective borrowers. Lenders began to make money, not from holding onto the loans they originated and collecting mortgage payments over the years, but from the relatively short term fees associated with originating and selling the loans. (8/28/2009). Those banks plus Citigroup also issued one out of every two mortgages and two out of every three credit cards. Id. CHRG-111hhrg54868--89 Mr. Dugan," I am not sure that we have seen that as a rampant problem in the system. There are some rights related to set off when you have some issues, but I don't believe that banks can routinely use one account to pay the debts of another bank. But I will get back to you on that, on where we are on that, if I could, for the record. Let me just also say that earlier this week, I did spend some time with Georgia community national bankers in Atlanta, and would just echo all of the comments that my colleague just said about the situation in Georgia and some of the issues that they have. " CHRG-111hhrg55814--95 Secretary Geithner," I agree with you, and that's why this bill would provide authority to not just impose higher capital requirements on them, constraints and leverage; it would have the authority to limit the scope of their activities, to compel them to shrink and separate. That is a very important thing, and I agree with you about, and I think the chairman does too. " CHRG-111hhrg55811--138 Mr. Hu," Congressman, you raise excellent questions. The SEC has historically emphasized very much the public utility model as to clearinghouses so that we actually expect fair representation of people who use these clearinghouses so that there is active involvement in terms of making sure that the fees are not exorbitant, that they don't unfairly burden people. And we have set up this model to prevent exchanges from controlling clearinghouses. We believe that is an essential element as well. In terms of innovation, competition, the discussion draft Treasury proposal recognized both the benefits of financial innovation and some of the costs. And in terms of this balance, these are issues that the CFTC and the SEC, together with this committee and other committees, will work closely on. " CHRG-111hhrg61852--70 Mr. Koo," I think the demand has to be there for us before job creation can happen, and I think it would be a good idea for people in this room to tell the public that this is a different disease. If we do nothing about the situation, the economy will contract very, very quickly because everybody is still leveraging. When everybody is still leveraging and interest rates are zero, you know the private sector is very sick, and the public sector has to come in to keep the demand from falling. Once the private sector balance sheets are repaired and deleveraging is over, then you promise the people that then we will fix our balance sheets--the government will fix the balance sheets. " fcic_final_report_full--386 The regulators had already decided to allocate half of these funds to the nine firms assembled that day:  billion each to Citigroup, JP Morgan, and Wells;  billion to Bank of America;  billion each to Merrill, Morgan Stanley, and Goldman;  billion to BNY Mellon; and  billion to State Street. “We didn’t want it to look or be like a nationalization” of the banking sector, Paul- son told the FCIC. For that reason, the capital injections took the form of nonvoting stock, and the terms were intended to be attractive.  Paulson emphasized the im- portance of the banks’ participation to provide confidence to the system. He told the CEOs: “If you don’t take [the capital] and sometime later your regulator tells you that you are undercapitalized . . . you may not like the terms if you have to come back to me.”  All nine firms took the deal. “They made a coherent, I thought, a cogent argu- ment about responding to this crisis, which, remember, was getting dramatically worse. It wasn’t leading to a run on some of the banks but it was getting worse in the marketplace,” JP Morgan’s Dimon told the FCIC.  To further reassure markets that it would not allow the largest financial institu- tions to fail, the government also announced two new FDIC programs the next day. The first temporarily guaranteed certain senior debt for all FDIC-insured institutions and some holding companies. This program was used broadly. For example, Gold- man Sachs had  billion in debt backed by the FDIC outstanding in January , and  billion at the end of , according to public filings; Morgan Stanley had  billion at the end of  and  billion at the end of . GE Capital, one of the heaviest users of the program, had  billion of FDIC-backed debt outstanding at the end of  and  billion at the end of . Citigroup had  billion of FDIC guaranteed debt outstanding at the end of  and  billion at the end of ; JPMorgan Chase had  billion outstanding at the end of  and  billion at the end of . The second provided deposit insurance to certain non-interest-bearing deposits, like checking accounts, at all insured depository institution.  Because of the risk to taxpayers, the measures required the Fed, the FDIC, and Treasury to declare a sys- temic risk exception under FDICIA, as they had done two weeks earlier to facilitate Citigroup’s bid for Wachovia. Later in the week, Treasury opened TARP to qualifying “healthy” and “viable” banks, thrifts, and holding companies, under the same terms that the first nine firms had received.  The appropriate federal regulator—the Fed, FDIC, OCC, or OTS— would review applications and pass them to Treasury for final approval. The program was intended not only to restore confidence in the banking system but also to provide banks with sufficient capital to fulfill their “responsibilities in the areas of lending, dividend and compensation policies, and foreclosure mitigation.”  “The whole reason for designing the program was so many banks would take it, would have the capital, and that would lead to lending. That was the whole purpose,” Paulson told the FCIC. However, there were no specific requirements for those banks to make loans to businesses and households. “Right after we announced it we had critics start saying, ‘You’ve got to force them to lend,’” Paulson said. Although he said he couldn’t see how to do this, he did concede that the program could have been more effective in this regard.  The enabling legislation did have provisions affecting the compensation of senior executives and participating firms’ ability to pay divi- dends to shareholders. Over time, these provisions would become more stringent, and the following year, in compliance with another measure in the act that created TARP, Treasury would create the Office of the Special Master for TARP Executive Compensation to review the appropriateness of compensation packages among TARP recipients. FinancialCrisisInquiry--143 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. GRAHAM: Thank you. CHAIRMAN ANGELIDES: Mr. Holtz-Eakin? HOLTZ-EAKIN: Thank you, Mr. Chairman. Thank you, everyone, for coming today. Mr. Bass, you got my attention with leverage at 68 to one at Citi. Can you walk through those numbers for me again? BASS: Sure. HOLTZ-EAKIN: I just want to make sure I understand sort of the full range of your argument, which sounds to me as if, first, there’s the officially measured leverage, then a leverage measure which recognizes the off balance sheet, uncapitalized derivative positions—things like that. I’m trying to figure out where—where do the numbers... BASS: FOMC20060131meeting--55 53,MR. KOS.," I have heard a few anecdotes regarding CEOs who have been very surprised and become angry when they saw that their unfunded pension fund cost them earnings over the past few years. They basically directed the CFO and, in turn, the pension managers not to let this happen again. Thus, regardless of legislation, there has been a shift at the margin from equities into debt with matching duration." CHRG-111hhrg51592--138 Mr. Sherman," No. Anybody can register, but then the--well, the SEC then says, ``If you want to issue a debt instrument, you must get one of our registered SROs to rate you.'' But, of course, you can go out and hire 12 other people, even--what was the cousin? Sheldon. And you could even get Sheldon, and you could, you know, you got free speech. You can talk all you want about your offering. But you have to pick one from our panel if you want to sell it. " CHRG-110shrg50420--462 Mr. Nardelli," Secured. Senator Corker. Secured. So the problem, the one last component that is very problematic is we don't have a way--GM has about $20 billion in unsecured debt, but candidly, the security we would have is kind of problematic. I mean, it is franchise. It is the kind of stuff that goes away when the company goes away, so there is not a lot to secure, is there? Is there much real estate to go with that? " fcic_final_report_full--53 SECURITIZATION AND DERIVATIVES CONTENTS Fannie Mae and Freddie Mac: “The whole army of lobbyists” ............................  Structured finance: “It wasn’t reducing the risk” ..................................................  The growth of derivatives: “By far the most significant event in finance during the past decade” ..................................................................  FANNIE MAE AND FREDDIE MAC: “THE WHOLE ARMY OF LOBBYISTS ” The crisis in the thrift industry created an opening for Fannie Mae and Freddie Mac, the two massive government-sponsored enterprises (GSEs) created by Congress to support the mortgage market. Fannie Mae (officially, the Federal National Mortgage Association) was chartered by the Reconstruction Finance Corporation during the Great Depression in  to buy mortgages insured by the Federal Housing Administration (FHA). The new gov- ernment agency was authorized to purchase mortgages that adhered to the FHA’s un- derwriting standards, thereby virtually guaranteeing the supply of mortgage credit that banks and thrifts could extend to homebuyers. Fannie Mae either held the mort- gages in its portfolio or, less often, resold them to thrifts, insurance companies, or other investors. After World War II, Fannie Mae got authority to buy home loans guaranteed by the Veterans Administration (VA) as well. This system worked well, but it had a weakness: Fannie Mae bought mortgages by borrowing. By , Fannie’s mortgage portfolio had grown to . billion and its debt weighed on the federal government.  To get Fannie’s debt off of the government’s balance sheet, the Johnson administration and Congress reorganized it as a publicly traded corporation and created a new government entity, Ginnie Mae (officially, the Government National Mortgage Association) to take over Fannie’s subsidized mort- gage programs and loan portfolio. Ginnie also began guaranteeing pools of FHA and VA mortgages. The new Fannie still purchased federally insured mortgages, but it was now a hybrid, a “government-sponsored enterprise.” Two years later, in , the thrifts persuaded Congress to charter a second GSE, Freddie Mac (officially, the Federal Home Loan Mortgage Corporation), to help the  thrifts sell their mortgages. The legislation also authorized Fannie and Freddie to buy “conventional” fixed-rate mortgages, which were not backed by the FHA or the VA. Conventional mortgages were stiff competition to FHA mortgages because borrow- ers could get them more quickly and with lower fees. Still, the conventional mort- gages did have to conform to the GSEs’ loan size limits and underwriting guidelines, such as debt-to-income and loan-to-value ratios. The GSEs purchased only these “conforming” mortgages. CHRG-110shrg38109--69 Chairman Dodd," Thank you, Senator Casey. Very good questions. I appreciate your focusing attention on that. I want to just mention, before turning to Senator Martinez, your response, Mr. Chairman, to Senator Schumer's questions about Sarbanes-Oxley and competitiveness. I appreciated your answer very much to that question. There are some things clearly that could be done to try and show some balance and making sure we are not overburdening smaller public companies, but your thrust was that this is working pretty well. And, frankly, anecdotally, I suspect most of us here ask the question of every business we talk to: How is this working? And I must tell you, overall the response I get is a good one. I had one company the other day say to me that, ``Even if Congress decided tomorrow to repeal Sarbanes-Oxley, we would decide to stay with all the things that have been required of us. We have found that it has been very worthwhile for our company.'' So, I appreciate your comments about that. Senator Martinez. Senator Martinez. Mr. Chairman, thank you very much. I hate to differ with the Chairman, but I must say that the experience that I hear on the competitiveness and Sarbanes-Oxley issue is far different from that. I hear a great deal of concern about the incredible cost and the burden of competitiveness that it has created. And, in fact, I will begin with this area because I intended to get into it, but our colleague from New York, Senator Schumer, and Mayor Bloomberg recently released a report that I found quite interesting detailing an analysis of market conditions in the United States and abroad and about the concern that there is about whether New York will continue to be the financial capital of the world or whether, in fact, there seems to be others competing for that title, which might include London. And there were some rather dramatic statistics of declines and increases in New York vis-a-vis London. One of the things that was mentioned in the report was the U.S. regulatory framework being too complicated and the implementation of Sarbanes-Oxley having produced heavier costs than were expected at the beginning or when you initiated that effort. Also it was mentioned immigration policies which create problems for those abroad who might wish to come here to do business, to invest in America, and the difficulties that current immigration problems raise for that, and some of them coming to be educated, others coming just as business people and investors. In any event, I wondered if you had an opportunity to see that report and whether its finding cause the same concerns to you that they raised to me. " CHRG-111hhrg52400--269 Mr. McCarthy," I would just like to make one point. Credit--the critical part of a regulator--and, again, we think perhaps the Fed--is to analyze the instruments themselves. The difficulty with credit default swaps with AIG was leverage and the huge number of transactions that they did, and the leverage that was embedded in each one. It is critical, and it would be interesting to see what the--Mr. McRaith would say about this. But the amount of staff that it takes to analyze these financial instruments, to regulate them and to try to make sure which things are permissible or not, we think is more akin to what the Fed does than what Eric Dinallo or one of the State regulators would be able to do with staff analysis, and be able to stay on top of that particular kind of financial instrument. " CHRG-111hhrg52397--106 Mr. Pickel," We do not have a statistic on that specifically. In the credit default swap space, there is discussion about whether 10 or 12 percent or something like that would have that underlying interest. Mr. Miller of North Carolina. That is a small number, okay. There have been a lot of criticisms of naked derivatives, that it creates tremendous uncertainty about what the real economic consequences are for an event that would appear to be not that consequential. It creates an interconnectedness, it means that a great many institutions are too interconnected to fail. And some have even said that it means that there are a great many economic players who stand to profit from what appears to be an economic loss and have a power to make it happen. There was an article in the Financial Times about 6 weeks ago about a bank in Kazakhstan. I am sure you know about it. Times have been tough economically in the former Soviet space and the Kazakhstan government took over the bank. Morgan Stanley had debt. That bank owed Morgan Stanley debt, Morgan Stanley could call the debt due if there is a change of ownership. Morgan Stanley said initially, ``No, no, go ahead, just keep making the payments,'' and then they changed their mind and said, ``No, come to think of it, we want you to pay it all,'' which they could not. And shortly after that, or about the same time, they filed with the International Swaps and Derivatives Association to start the formal proceedings to settle credit default swap contracts with that bank, and the suggestion, the Financial Times' suggestion was that they actually made more money on their credit default swap positions than they would if they got paid by the bank. Is that concern a valid one? Is that something we should worry about? William Buiter, a prominent economist, despite my difficulty in pronouncing his name, has called for derivatives to become instruments of insurance risk management rather than instruments for placing bets, for gambling. What is the social value in allowing derivative positions when neither party of the contract has any interest in the underlying contract? There are obviously a lot of downsides to that, what is the advantage? " fcic_final_report_full--437 The dangerous imprecision of the term “shadow banking” Part II of the majority’s report begins with an extensive discussion of the failures of the “shadow banking system,” which it defines as a “financial institutions and activi- ties that in some respects parallel banking activities but are subject to less regulation than commercial banks.” The majority’s report suggests that the shadow banking sys- tem was a cause of the financial crisis. “Shadow banking” is a term used to represent a collection of different financial in- stitutions, instruments, and issues within the financial system. Indeed, “shadow banking” can refer to any financial activity that transforms short-term borrowing into long-term lending without a government backstop. This term can therefore in- clude financial instruments and institutions as diverse as: • The tri-party repo market; • Structured Investment Vehicles and other off-balance-sheet entities used to in- crease leverage; • Fannie Mae and Freddie Mac; • Credit default swaps; and • Hedge funds, monoline insurers, commercial paper, money market mutual funds, and investment banks. As discussed in other parts of this paper, some of these items were important causes of the crisis. No matter what their individual roles in causing or contributing to the crisis, however, they are undoubtedly different. It is a mistake to group these is- sues and problems together. Each should be considered on its merits, rather than painting a poorly defined swath of the financial sector with a common brush of “too little regulation.” BIG BANK BETS AND WHY BANKS FAILED The story so far involves significant lost housing wealth and diminished values of se- curities financing those homes. Yet even larger past wealth losses did not bring the global financial system to its knees. The key differences in this case were leverage and risk concentration. Highly correlated housing risk was concentrated in large and highly leveraged financial institutions in the United States and much of Europe. This leverage magnified the effect of a housing loss on a financial institution’s capital re- serve, and the concentration meant these losses occurred in parallel. FOMC20050809meeting--165 163,MS. BIES.," Thank you, Mr. Chairman. I want to focus my comments today on some macroeconomic perspectives and on what we’re learning in the supervisory reviews of mortgage products that we and other regulators are undertaking now. On the positive side, when we look at the large volume of ARMs in existence, most of them are of the traditional form. And currently those ARMs are at a point—whether they’re adjusted annually or they started out as 3-year fixed-rate loans and then move to annual adjustments—where they will be reset. For the ones that started out in 2002 with fixed rates for three years, this is the year when they will go to annual resets. We know all of them, since they’re indexed to short-term rates, are going to have a big increase whenever their anniversary August 9, 2005 70 of 110 To the extent that long mortgage rates or the reindexed rates are very close to those available to most borrowers on refinancings, it looks as if most of these ARMs can be converted into a fixed-rate product without a large amount of payment adjustment. There will be some, but it seems likely to be manageable for many of these borrowers. On the other hand, we’re seeing a lot of subprime ARMs where this may not be true. As you know, those ARM products that have been pushed into the subprime market are much more problematic. So the affordability for that group of customers is questionable. They are going to be hit not only by higher gas prices but higher monthly mortgage payments when their rates are reset. And that is going to be more of an issue as we go forward and as we continue to raise short-term interest rates. Also, I’m a bit more pessimistic about what is happening with regard to some of these option ARMs and the more esoteric ARMs that are being marketed and have been marketed particularly in the last nine months. Bankers as a whole I think clearly are doing a good job at underwriting these. We have some lenders on the edges, though, that we’re working on. But these mortgage market developments have some significant macroeconomic implications. Many of these loans started out with teaser rates that were below current market rates. So first of all, the rates have to catch up to the market level. Then also, the index to which the rate is tied will have moved up by about 250 or more basis points, say, by the end of the year. So if they are interest-only loans, the rate could go from something that maybe started out with a “1” and could get to something with a “4” in front of it. And all of a sudden the monthly payments are going to go up fourfold. Even if defaults don’t increase, it certainly is going to pull August 9, 2005 71 of 110 Another issue is that apparently many of these loans have limits on how much the payment can go up each year in order to try to make the annual adjustment easier. But that puts borrowers in a predicament because it throws them into negative amortization. During the teaser period, they’re in negative amortization; and the cap on the index used to reset the monthly payment could put them further into negative amortization. So if they do want to get out of the ARM and switch to a fixed-rate loan, they have to cover the additional negative amortization. Many of these loans have prepayment penalties, so the lenders recoup that. That may be problematic in moving more people into fixed-rate products as interest rates rise. And to the extent borrowers go to fixed-rate mortgages, they’ll go to fully amortizing loans, which could be a financial burden—even though we are beginning to see mortgages of 40 years and longer. The leverage that we see in households on their borrowing I think is another indication that if they’re stretching to be able to afford these houses, it will be more problematic for them to stay in the houses as their monthly payments go up—perhaps even double or triple. So, when we talk about the wealth effect of housing price bubbles, I’m getting concerned around the edges that we could see a major impact on cash flows of both subprime and prime borrowers because these ARMS are indexed to short rates and those rates are moving up. Since ARMs are a big chunk of the mortgage market today, we have to realize that we can’t just look at long-term mortgage rates and the affordability of housing. We need to look at the short rates, too, because they’re getting to be more and more important. As I look overall at the economy today—and I’m going to echo some of the comments I’ve heard around the table—I’m very comfortable that we have gotten past the soft spot of the spring. I also am a little pessimistic regarding how this recent bounce will be sustained. But I August 9, 2005 72 of 110 And in my view, that is a good pace of growth. I also believe, to echo the comments Governor Kohn just made, that the market has reacted to the understanding that we may have to push rates up even further. There is a tremendous amount of liquidity in the market, and I think that’s what the market is seeing. When we talk about accommodation, the market is looking at the liquidity that can flow into deals for both commercial activity and for consumers. So I think we need to continue to push the funds rate upward. And personally, my number for the upper limit on the funds rate is much higher today than it was three to four months ago." CHRG-111hhrg55814--29 Secretary Geithner," Congressman, the central imperative is to make sure that institutions that could threaten the stability of the system are held to tougher constraints on leverage and risk-taking. " 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. " FOMC20070131meeting--35 33,MR. DUDLEY.," I think that is definitely part of the story. Another part of the story is that in some countries, especially emerging market countries, the oil was heavily subsidized, and some of those subsidies are now coming off because continuing to subsidize as the oil price climbs entails a rather heavy budgetary burden. So you’re also seeing a sort of normalization of oil prices in a lot of places. Think about the oil that Russia used to sell to Eastern Europe or some of the surrounding countries at preferential prices. They are no longer getting those preferential prices, so there is a demand response. I think it is happening on both sides. There has been a demand response to higher oil prices, and there has been a supply response coming out of places like Africa." FOMC20070816confcall--3 1,MR. DUDLEY.," Thank you. As you noted, market turbulence has continued to spread and intensify. The strains that have emerged in the prime nonconforming home mortgage market and in the asset-backed commercial paper market have proved to be self-reinforcing. As investors have backed away from asset-backed commercial paper, this has led to a forced sale of mortgage collateral, and that has put downward pressure on the prices of private-label whole mortgages and of mortgage-backed securities. The downward pressure on prices of mortgage loans and mortgage-backed securities, in turn, has resulted in increased haircuts by prime brokers and lenders. This has provoked a rapid, forced deleveraging among many mortgage investors. This process has unfolded rapidly and has overwhelmed the ability of depository institutions to take up the slack, even though at current prices many of these assets appear to be at attractive valuations. The absence of strong offsetting demand by depository institutions not faced with these same constraints appears to have been influenced by factors that threaten to put pressure on these institutions’ balance sheets. These include leveraged loan commitments associated with private equity deals and the assets from busted commercial paper programs that might end up on their balance sheets. Over the past few days, we have seen a significant increase in market dysfunction. First, although the aggressive provision of reserves by the Desk last Friday successfully pushed the federal funds rate back down after it had climbed above its 5¼ percent target, term rates remain elevated. For example, the one-month term federal funds rate is currently quoted at 5.40 percent, even though fed funds rate futures imply an average rate over the next month of less than 5 percent. This is consistent with a significant rise in risk premiums. Second, over the past two days, we have seen a sharp decline in Treasury bill rates. Although a diminished supply may be a partial explanation, flight- to-quality concerns appear to account for most of the sharp move down in yields. Some investors have reported that dealers are very reluctant to sell Treasury bills. Third, other measures show that risk aversion has increased. For example, interest rate swap spreads have widened significantly, and the spread between on-the-run and off-the-run Treasuries has increased. Fourth, equity prices around the world have moved lower. The S&P 500 index is now down roughly 10 percent from its peak. Fifth, the so-called carry trade in currencies is unwinding with a vengeance. The yen has appreciated sharply against the dollar, even as the dollar has strengthened against many other currencies, such as the euro. The yen-dollar rate has fallen below 114. Sixth, market volatility has spiked. The VIX measure of implied volatility for the stock market has climbed above 30, well above the peak it reached in late February and early March. Implied volatility in fixed income in currency markets has also moved up sharply. The market turbulence and the rise in risk aversion have created several areas of vulnerability. First, there is the risk that money market mutual funds could suffer losses on certain asset-backed commercial paper programs that have weak backstops. This could conceivably cause some funds to “break the buck.” In the worst case, this could even result in a run from these funds by investors. Second, worries about the exposure of the financial guarantors to the mortgage market could cause problems to spread from this area to areas that have up to now been more sheltered from stress, such as the municipal securities market. The intense market turbulence has caused investors to become more worried about the downside risk to the economy. As a result, investors now anticipate significant monetary policy easing in the weeks and months ahead, much more than even a week ago. For example, September federal funds futures currently imply a 4.92 percent federal funds rate for the month, 33 basis points below the current 5¼ percent target, and the Eurodollar futures strip through mid-2008 is consistent with roughly 100 basis points of easing over this period. Thank you. I’m happy to take any questions." CHRG-111shrg57709--15 Mr. Volcker," Well, I addressed that question to some extent in my testimony, Mr. Chairman. It does put a burden, I think, inevitably, on the supervisor and the legislative intent ought to be very clear. Essentially, trading for one's own account unrelated to customer trading would be prohibited. Trading incidental to a customer relationship would be permitted. Now, how do you make that distinction? I think you can do it clearly over a period of time with sufficient accuracy to make the policy appropriate. One thing, as you said, you just look at sheer volume compared to the volume of customer business. You look at the pattern of gains and losses, which have a strong suggestion of proprietary trading, because if you are just quickly accommodating a customer, there are not likely to be big gains or losses. You don't have to have a cliff prohibition. It is clear that you want prohibition of purely proprietary trading, but if the other volume gets big enough to raise suspicion, you have the tool of capital requirements, which I think should be available and is available to the supervisor to suggest in a particular circumstance there ought to be a very heavy capital charge for this activity, and that would automatically limit it. " FinancialCrisisReport--21 Subprime loans provided new fuel for the securitization engines on Wall Street. Federal law does not define subprime loans or subprime borrowers, but in 2001, guidance issued by federal banking regulators defined subprime borrowers as those with certain credit risk characteristics, including one or more of the following: (1) two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months; (2) a judgment or foreclosure in the prior 24 months; (3) a bankruptcy in the last five years; (4) a relatively high default probability as evidenced by, for example, a credit score below 660 on the FICO scale; or (5) a debt service-to-income ratio of 50% or more. 17 Some financial institutions reduced that definition to any borrower with a credit score below 660 or even 620 on the FICO scale; 18 while still others failed to institute any explicit definition of a subprime borrower or loan. 19 Credit scores are an underwriting tool used by lenders to evaluate the likelihood that a particular individual will repay his or her debts. FICO credit scores, developed by the Fair Issacs Corporation, are the most widely used credit scores in U.S. financial markets and provide scores ranging from 300 to 850, with the higher scores indicating greater creditworthiness. 20 High risk loans were not confined, however, to those issued to subprime borrowers. Some lenders engaged in a host of risky lending practices that allowed them to quickly generate a large volume of high risk loans to both subprime and prime borrowers. Those practices, for example, required little or no verification of borrower income, required borrowers to provide little or no down payments, and used loans in which the borrower was not required to pay down the loan amount, and instead incurred added debt over time, known as “negative amortization” loans. Some lenders offered a low initial “teaser rate,” followed by a higher interest rate that 16 A Federal Reserve Bank of New York research paper identifies the top ten subprime loan originators in 2006 as HSBC, New Century, Countrywide, Citigroup, WMC Mortgage, Fremont, Ameriquest Mortgage, Option One, Wells Fargo, and First Franklin. It identifies the top ten originators of subprime mortgage backed securities as Countrywide, New Century, Option One, Fremont, Washington Mutual, First Franklin, Residential Funding Corp., Lehman Brothers, WMC Mortgage, and Ameriquest. “Understanding the Securitization of Subprime Mortgage Credit,” by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of New York Staff Report No. 318, (3/2008) at 4. 17 Interagency “Expanded Guidance for Subprime Lending Programs, (1/31/2001) at 3. See also “Understanding the Securitization of Subprime Mortgage Credit,” by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of New York Staff Report No. 318, (3/2008) at 14. 18 See, e.g., 1/2005 “Definition of Higher Risk Lending,” chart from Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302979, Hearing Exhibit 4/13-2a; 4/2010 “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” report prepared by the Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, at 8, Hearing Exhibit 4/16-82. 19 See, e.g., Countrywide Financial Corporation, as described in SEC v. Mozilo , Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 20-21. 20 To develop FICO scores, Fair Isaac uses proprietary mathematical models that draw upon databases of actual credit information to identify factors that can reliably be used to predict whether an individual will repay outstanding debt. Key factors in the FICO score include an individual’s overall level of debt, payment history, types of credit extensions, and use of available credit lines. See “What’s in Your FICO Score,” Fair Isaac Corporation, http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx. Other types of credit scores have also been developed, including the VantageScore developed jointly by the three major credit bureaus, Equifax Inc., Experian Group Ltd., and TransUnion LLC, but the FICO score remains the most widely used credit score in U.S. financial markets. took effect after a specified event or period of time, to enable borrowers with less income to make the initial, smaller loan payments. Some qualified borrowers according to whether they could afford to pay the lower initial rate, rather than the higher rate that took effect later, expanding the number of borrowers who could qualify for the loans. Some lenders deliberately issued loans that made economic sense for borrowers only if the borrowers could refinance the loan within a few years to retain the teaser rate, or sell the home to cover the loan costs. Some lenders also issued loans that depended upon the mortgaged home to increase in value over time, and cover the loan costs if the borrower defaulted. Still another risky practice engaged in by some lenders was to ignore signs of loan fraud and to issue and securitize loans suspected of containing fraudulent borrower information. FOMC20070321meeting--3 1,MR. DUDLEY.,"1 Thank you, Mr. Chairman. Financial markets have become much more turbulent since the last meeting—especially in subprime mortgages and associated securities, in U.S. and global equities, and in foreign exchange markets. The good news is that markets have generally remained liquid and well functioning, with a minor exception on the New York Stock Exchange on February 27. Moreover, there are few signs of significant contagion from the subprime mortgage market into the rest of the mortgage market or from subprime mortgage credit spreads to corporate credit spreads more generally. In general, the debt markets have been mostly unruffled by recent developments. I plan to focus my attention on four major market developments. First, the substantial turmoil in the subprime mortgage market—I talked about the risk that this market might unravel at the January FOMC meeting; that certainly occurred more quickly and more forcefully than I anticipated. Second, I want to talk a little about the decline in U.S. equity prices and the accompanying rise in actual and implied price volatility. Third is the sharp correction in the so-called “carry trade” in foreign exchange markets. The low interest rate currencies such as the yen and the Swiss franc have appreciated, with the greatest moves coming against their higher-yielding counterparts. Finally, I’ll talk a bit about the sharp downward shift in market expectations about the path of the federal funds rate target over the next year and a half. Two key questions motivate my comments. First, is the market turbulence driven mainly by fundamental developments, or does it reflect mainly a shift in the risk appetite of investors? Second, what is the ongoing risk of contagion from the market area that has experienced the most stress—the subprime mortgage market—to other markets? Regarding the subprime mortgage market, the deterioration appears driven mostly by fundamental developments. As you know, the delinquency rates for subprime adjustable-rate mortgages have risen sharply. In contrast, as shown in exhibit 1 of the handout, there has been little change in delinquency rates for fixed-rate mortgages. Most significantly, delinquency rates for the 2006 vintage of subprime adjustable-rate mortgages have climbed unusually quickly. As shown in exhibit 2, the last vintage that went this bad so fast was the 2001 vintage, and that had a much different economic environment—one characterized by a mild recession and a rising unemployment rate. The deterioration in the quality of subprime mortgage credit has led to a sharp widening in credit spreads for the ABX indexes. The ABX indexes 1 Material used by Mr. Dudley is appended to this transcript (appendix 1). represent the cost of default protection on a basket of collateralized debt obligations that are backstopped mainly by subprime mortgages. As shown in exhibit 3, although this widening has been most pronounced at the bottom end of the credit quality spectrum (BBB-minus and BBB), it has rippled upward to the higher-rated tranches that are better protected. Exhibit 4 shows how the credit deterioration initially registered in the ABX indexes as market participants sought to buy protection. In milder form, this deterioration also registered in the underlying collateralized debt obligations and asset-backed securities. The widening of the credit spread in the ABX indexes was probably exaggerated by the fact that there was an asymmetry between the many that were seeking loss protection and the few that were willing to write protection. This can be seen in two ways. First, as shown in exhibit 4, the spread widening was more pronounced in the ABX index than in either underlying collateralized debt obligations or asset-backed securities. Second, as shown in exhibit 3, the ABX spreads have come down a bit from their peaks even as the underlying market for subprime mortgages, as reflected in the ongoing viability of many mortgage originators, has continued to deteriorate. The deterioration in the subprime market has undermined the economics of subprime mortgage origination and securitization. This is especially true for those mortgage originators with poorer underwriting track records. Their loans can no longer be sold at a sufficient premium to par value to cover their origination costs. In addition, the costs that they must incur to replace loans that have defaulted early have increased sharply. In several cases, these difficulties have caused banks to pull their warehouse lines of credit. Several of the large monoline originators are bankrupt, distressed, or up for sale—they are highlighted in red in exhibit 5. Moreover, several of the diversified lenders, such as HSBC, have indicated that they are tightening credit standards and pulling back from this sector. The result is that the volume of subprime mortgage originations is likely to fall sharply this year—perhaps dropping one-third or more from the 2006 rate of slightly more than $600 billion. This tightening of credit availability to subprime borrowers is likely to manifest itself through a number of channels. These channels include (1) a drop in housing demand, as borrowers who would have been able to get credit in 2006 no longer qualify under now toughened underwriting standards; (2) an increase in housing supply, as the rate of housing foreclosures increases (notably, the Mortgage Bankers Association reported last week that the rate of loans entering the foreclosure process in the fourth quarter of 2006 reached a record level of 0.54 percent, the highest level in the history of the thirty-seven-year-old survey); and (3) additional downward pressure on home prices, which in turn threatens to increase the magnitude of credit problems, delinquencies, and foreclosures. In considering these channels, it is important to emphasize that the credit strains in the subprime sector are unlikely to have peaked yet. The reset risk on the adjustable-rate portion of the subprime loans originated in 2005 and 2006 will be felt mainly over the remainder of 2007 and 2008. Most of the adjustable-rate loans are fixed for two years at low “teaser” rates. When yields adjust upward once the teaser rate period is over, some borrowers may have insufficient resources to service these debts. The good news—at least to date—is that spillover into the alt-A mortgage and conforming mortgage areas is very mild, both in terms of credit spreads and in terms of loan performance. Although there has been some rise in delinquency and foreclosure rates for higher-quality residential mortgages, these rates are still low both qualitatively and historically. Moreover, there is little evidence that the subprime problems have hurt mortgage loan volumes. For example, the Mortgage Bankers Association index of mortgage applications for purchase has increased in the past three weeks. Turning next to the U.S. equity market, it is less clear-cut whether the decline in prices and the rise in volatility are fundamentally based. As several observers have noted, equity valuations do not appear to be excessive. If that is the case, then why have equities been more turbulent than corporate and emerging-market debt, for which spreads remain unusually narrow? Although this point is legitimate, two fundamental developments that make U.S. equity prices less attractive deserve mention. First, equity analysts have been reducing their earnings forecasts for 2007. Although the top-down view of the equity strategists for the S&P 500 index has not changed much, on a bottom-up basis, earnings expectations have dropped sharply. As shown in exhibit 6, the aggregate forecasts of the individual sector analysts now indicate a growth rate in S&P 500 earnings for 2007 of about 6 percent, down from about 9 percent at the beginning of the year. In contrast, S&P 500 earnings have grown at an annual rate of more than 10 percent for four consecutive years. It should be no surprise that falling earnings expectations could weigh on equity prices. Second, uncertainty about the growth outlook has increased. This shows up clearly, for example, in our most recent primary dealer survey. Because greater uncertainty about the growth outlook presumably implies greater risk, the rise in uncertainty should—all else being equal—result in lower share prices. In contrast, it is easier to explain the modest widening of corporate credit spreads. In theory, lower share prices and higher volatility imply a greater risk of default, which should imply wider credit spreads. Corporate credit spreads have behaved in a manner consistent with this. Josh Rosenberg from the research group at the Federal Reserve Bank of New York recently investigated this issue. He found that the spread widening in the high- yield corporate debt sector was consistent with past periods in which the implied volatility for equities rose sharply. Exhibit 7 summarizes one key result. The widening in the BB-rated corporate spreads in the week after the February 27 retrenchment was of a magnitude similar to that of other instances in which implied equity-price volatility as measured by the VIX index rose sharply. In the most recent episode, the VIX index rose 848 basis points, and the BB corporate spread rose 27 basis points. This rise compares with an average rise of 21 basis points in the BB spread in the ten cases in which the VIX rose most sharply. The rise in the most recent episode is well within the range of historical experience. In many other areas in which asset prices have moved sharply, risk-reduction efforts appear to have played the biggest role. For example, in the foreign exchange markets, the biggest currency moves were in the currency pairs associated with so- called carry trades, such as the yen and Swiss franc for the low-yielding currencies and the Australian and New Zealand dollar for the high yielders. Exhibit 8 indicates the change in the yen versus the Australian dollar, the New Zealand dollar, the euro, the British pound, and the U.S. dollar during three separate periods—the week before the February 27 stock market selloff, the week of the stock market selloff, and the past two weeks. The high-yielding currencies appreciated the most during the run-up to the February 27 selloff, fell the most during the February 27 week, and have recovered the most against the yen over the past two weeks. The changes in speculative positioning in foreign exchange future markets tell a similar story. Exhibit 9 shows the change in the share of the open interest position held by participants in the noncommercial futures market. Over the past few weeks, net short positions as a percentage of the overall open interest in the yen have dropped, and long positions in the British pound and Australian dollar have dropped. An examination of how Treasury yields, stock prices, exchange rates, and credit spreads have moved also indicates that risk-reduction efforts have been important. Exhibit 10 shows the correlation of daily price and yield movements in 2007 before February 27. As one can see, the correlations were quite low. In contrast, the correlation matrix in exhibit 11 shows the correlation of daily price moves for the period beginning on February 27. Most of the correlations have climbed sharply, suggesting that risk positioning is driving price and yield movements. Finally, short-term interest rate expectations have shifted substantially since the last FOMC meeting. As shown in exhibit 12, near-term expectations have shifted, with market participants now expecting a modest reduction in the federal funds rate target by late summer. However, the federal funds rate futures curve is still above the curve at the time of the December FOMC meeting. In contrast, longer-term expectations have shifted more sharply, with a larger move toward easing. As shown in exhibit 13, the June 2008/June 2007 Eurodollar calendar spread is now inverted by about 60 basis points. This calendar spread is more inverted than it was at the time of the December 2006 FOMC meeting. Compared with the shift in market expectations, the forecasts of primary dealers have not changed much. Exhibits 14 and 15 compare dealer expectations with market expectations before the January FOMC meeting and before this meeting. The horizontal bold lines represent market expectations. The blue circles represent the different dealer forecasts. The green circles represent the average dealer forecast for each period. The two exhibits illustrate several noteworthy points. First, the average dealer forecast has not changed much since the January FOMC meeting—the green circles in the two charts are in virtually the same position. Second, the amount of dispersion among the dealers’ forecasts has not changed much—in fact, the range of the blue circles is slightly narrower currently. Although many dealers now mention that their uncertainty about the growth outlook has increased, that does not appear to have been reflected in their modal forecasts. Third, there is now a substantial gap between the dealers’ average forecast and market expectations—the gap between the horizontal bold lines, which represent market expectations, and the green circles, which represent the average dealer’s view, has increased. Why is there a large gap between the dealers’ forecasts and market expectations? I think there are three major explanations. First, the dealers’ forecasts are modal forecasts and do not reflect the downside risks that many dealers now believe have emerged in the growth outlook. Second, dealer forecasts often lag behind economic and market developments. Only when “downside risks” grow big enough to pass some threshold are dealers likely to alter their modal forecasts. Third, some of the downward shift in market expectations may represent risk-reduction efforts. An investor with speculative risk positions that would be vulnerable to economic weakness might hedge these risks by buying Eurodollar futures contracts. This hedging could push the implied yields on Eurodollar futures contracts lower than what would be consistent with an unbiased forecast of the likely path of the federal funds rate. Nevertheless, the potential gap between market expectations and the Committee’s interest rate expectations may pose a bit of a conundrum for the Committee. If the Committee were to shift the bias of its statement in the direction of neutral, market expectations with respect to easing would undoubtedly be pulled forward and might become more pronounced. After all, most dealers expect that the Committee will not change the inflation bias of the January FOMC statement. In contrast, keeping the bias unchanged in order to keep market expectations from shifting further in the easing direction might be inconsistent with the Committee’s assessment of the relative risks regarding growth and inflation. If the Committee were to keep the bias unchanged even when its views had changed, the communication process might be impaired. On a housekeeping note, I wish to bring to the Committee’s attention the changes to the “Morning Call” with the Trading Desk. They were discussed in a memo distributed to the Committee last week. Under the new format, which we plan to implement on Thursday, the call will be open to all members of the Committee, and you will have the option of participating in the 9:10 a.m. discussion of reserve management issues, the 9:20 a.m. portion covering recent developments in global markets, or both portions. The March 15 memo outlines the new procedures for joining these calls. 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 January FOMC meeting. Of course, I am very happy to take questions." CHRG-111shrg52966--44 Mr. Sirri," For preserving the broker-dealer, that would be very helpful. Senator Bunning. Thank you very much, Mr. Chairman. Senator Reed. Thank you, Senator Bunning. Let me raise a few questions. You mentioned, Dr. Sirri, that really what happened, in your view, was a run on the bank. And I think that begs the question: What caused the run on the bank? There are some people that suggest the huge amount of leverage which the market became aware of just undercut any sort of willingness to accept even Treasury securities. And that leverage ratio was something that was approved by the SEC--at least not effectively disapproved--and I think you had the authority to do that. Can you comment on that? " CHRG-111shrg57709--70 Mr. Wolin," So the answer, Senator, is we do not have the details of that fully nailed down. We want to make sure that we get it right. We want to work with the regulators, with this Committee in coming forward with a proposal. We don't think that it ought to be a limit that is currently binding. We have said that. But with respect to what exactly is the percentage and what is the, if you will, the denominator of this fraction, we have not yet landed. We are still working on that and would want to work with this Committee on that. Senator Merkley. OK. Finally, in 30 seconds, the Basel II approach of internal risk limits that allows somewhat unlimited leverage in investment banks, do we need to rethink that and have more of a concrete leverage limit? " FOMC20061212meeting--96 94,MS. BIES.," Thank you, Mr. Chairman. I thought I’d start today talking a bit about housing markets and the condition of banks right now. As many of you have noticed, some of us are optimistic that we may be approaching a bottom in the housing market. I think we’ll see that bottom in housing sales long before we see it on the construction side because there’s a large amount of inventory still to work through. But as we’ve noted, the applications for purchasing mortgages have been level since midyear. The growth in mortgage credit has slowed significantly from where it was in the past two years, dropping to only 10 percent growth this past quarter, a growth rate that is significantly above the growth of personal income and that most of us in the past would have considered to be alarming. Part of what’s amazing in all of this is that in 2004 and 2006, particularly toward the end of that period, purchase money seconds, by which people borrowed the downpayments for homes, were a big part of mortgage financing. Banks are still getting some of this business and putting it on their balance sheets, and it is part of the growth of what you’re seeing the banks funding. But it is at a pace that I think needs to be adjusted. I’m saying that, although the number of applications may have bottomed out, the amount of leverage in each housing deal may still need some correction going forward, and so we may see some slowdown in the volume of dollars that are funded through mortgage lending. Delinquency rates are really, really low by historical standards. The one sector that has had a jump in delinquencies is subprime ARMs, and clearly the jump is related to rates that have already reset. We’ve got more to come. Even though these have jumped, they’re still not at alarming levels. But it’s something that I think the banks are watching very, very carefully. One thing I’m hearing more from some folks who have been investing in mortgage- backed securities and maybe in some CDOs (collateralized debt obligations), where they’ve been tranched into riskier positions through economic leverage, is the realization that a lot of the private mortgages that have been securitized during the past few years really do have much more risk than the investors have been focusing on. I’m hearing this from folks who understand that the quality of what goes into those pools varies tremendously when you don’t have the Fannie Mae and Freddie Mac framework for the underwriting. When a mortgage is originated through a bank, we do a lot through safety and soundness supervision to make sure, if a bank is buying loans from brokers, that the loans are underwritten in a sound manner and are therefore affordable to the borrower when they’re undertaken. We’re seeing that some of the private-label mortgage-backed securities are having very high early default rates or delinquencies in the mortgages, which usually means that the originator has to buy them back out of the pools. There isn’t a whole lot of transparency in the disclosures around some of these bonds, and some of the brokers are underwriting products that have very high early default rates, which is something that investors are starting to focus on. As more products are generated outside the banking sector, they get funneled to pools through broker-dealers as opposed to the banks. I think that we’re missing a level of due diligence regarding brokers, who may not be doing a good job. As you all know, the fraud rate on mortgages has tripled in the past two years. So I think we could see noise in some of the mortgage-backed private deals and some of the riskier CDO economic leverage positions. Bank earnings are really, really strong overall, especially by historical standards. Banks are making a lot of layoffs connected with the mortgage business. They are taking steps to get costs—whether related to originations, post-loan closings, or payoff administration—under control. Net interest margins, however, continue to be under significant pressure. I’m hearing more from banks that, since we’ve stopped raising rates, they’ve lost the nice little lag effect— the ability to wait for us to move before lagging along. In other words, they have lost that lagniappe in their liability cost that has helped them with their margin pressures. So those pressures are going to be more of a challenge for them, especially with a flat or inverted yield curve, depending on where they’re funding and lending. Loan-loss provision continues to be the best in many, many years. No one really expects it to jump, but clearly it can’t get a whole lot better than it is, and so that will also present challenges going forward. As for the economy as a whole, I, too, want to compliment President Yellen because I think she did a fantastic job of helping us think about the different signals we’re getting. When I looked again at the graph that I love in the Greenbook that shows where our forecast has been, I was struck that we’ve seen the forecast of GDP growth continuing to moderate in the past several months but our expectations of inflation are actually flat to up a bit. To me that raises questions about the tradeoff that we really have when we are running below capacity and below potential growth rates. The bit of softness that I’m hearing about from some of my contacts in sectors outside housing and mortgages warns me that we need to be a little more vigilant than I had been expecting about growth maybe softening in a broader sense. But the fact that inflation continues to be above 2 percent in the forecast period is something that does concern me, and I think part of my concern relates to the tremendous amount of liquidity that sits out there in the banking sector, in the U.S. financial markets, and clearly globally. The presence of this liquidity is something that we really need to think about. It’s not back to where it was in my money supply days, when I started my career at the St. Louis Fed; but I do worry that liquidity is, as some of you have said, causing a lot of transactions to occur that economically perhaps wouldn’t otherwise occur. That is also something we need to watch very carefully." CHRG-110shrg38109--70 Chairman Bernanke," Senator, as I indicated, I do think that we should be trying to reduce regulatory burden, and in particular ensuring that the costs of the burden are commensurate with the benefits. With respect to Sarbanes-Oxley, my intent was to say that I do believe that there are benefits from that legislation, including improved controls, improved disclosures, improved governance of corporations. So there are certainly some benefits. It is important to decide whether we can reduce the costs and retain the benefits, and in that respect, I think that the proposed change in one audit standard being put forth by the SEC and the PCAOB is a step in the right direction because it attempts to focus on the most materially important issues, and it also makes allowance for the size and complexity of a firm in setting up the audit standard. So to try to summarize, Sarbanes-Oxley accomplishes some important objectives, but I do believe those objectives can be accomplished at lower cost, and I think the new audit standard moves in that direction. And in all other regulatory areas, including those the Federal Reserve is involved, we should continually be looking to find ways to accomplish the social or economic objectives of the regulation at a lower cost. Senator Martinez. Well, I agree that there are many good features to Sarbanes-Oxley. What I was speaking of is some of the excesses, particularly in the auditing arena and some of the areas that have caused such an overburden of costs. So, I appreciate your comment on that. Shifting to the issue of home sales, I used to sit in that very chair when I was Housing Secretary before this Committee, and at times, I would be asked a question about a housing bubble and in the overheated housing market whether, in fact, we were headed for a collapse and a bubble that would burst. In fact, we have seen as significant decrease in housing starts. We have seen the market cool down significantly, but we have not seen a bursting bubble. I always said at the time that the fears of a bubble were misplaced and that the housing market is more regional than it is national, and there were many different features between that and a localized market. But do you feel that the fear of a bubble has receded given the fact that the market cooled off, that it has done so in a fairly modest way without any cataclysmic consequences? " CHRG-111shrg57322--162 Mr. Swenson," Yes, it is. Senator Coburn. Later in this document, you run through some of your biggest trades, including a $1.8 billion short on CDOs, collateralized debt obligations, and you say you oversaw and directed the covering of $9 billion in short positions. Is it accurate to say that you went extremely short and made a lot of money? " CHRG-111shrg55479--63 Mr. Verret," And, legally, Senator, I would offer that failure to seat a quorum could result in a wide variety of legal circumstances, including, for instance, it could be an event of default under the company's debt obligation. Senator Schumer. I am sure we could deal with that, particularly with the quorum issue, in the interim until there was another election. Thank you, Mr. Chairman. My time has expired. " CHRG-111hhrg56847--217 Mr. Bernanke," I am not familiar with the exact trajectory there, but I think we need to show that, within a few years, we are going to go clearly to a path where the debt-to-GDP ratio remains more or less stable. In other words, that line in that picture is flat or going down rather than rising, and as long as that can be persuasively shown to the public and to the markets, I think that would be a very important step. " CHRG-111hhrg48875--203 Mr. Minnick," And I think the taxpayer is going to be stuck with that alternative as well. And this strikes me as a better balanced and market-tested vehicle for providing the capital than a direct subsidy, and it has the advantage you are not nationalizing the system. And I would encourage you to look at your leverage and the experience of these initial auctions to see if it is yielding a fair to the taxpayers but nevertheless full price to the institutions. " CHRG-111hhrg51698--158 Mr. Gooch," Yes, sir. I am certainly in favor of free markets, but to some extent maybe I have been painted into a corner as somehow not being supportive of this proposed regulation. My strong position here today, and in my opening statement, was in this concept of disallowing naked credit derivatives, because of my knowledge about the market and my concern that you will kill the CDS market. That might be one of Mr. Greenberger's goals, but that it would be a big mistake for the American economy. Right now, as we know, it is very difficult for anyone to borrow money. The banks aren't lending. But some corporations can still issue debt. But one of the things that is going on in the marketplace right now is those debt issuances are very often now tied to CDS prices. Without the willing sellers of CDS that are your speculators, if you like, but I call them risk takers, who are willing to sell that credit risk, you take away a huge portion of willing lenders. They are synthetic lenders. When they sell a credit default swap, they are not lending the money, but they are a synthetic lender. They are effectively underwriting the risk. " CHRG-111hhrg53238--216 Mr. Sherman," Thank you, Mr. Chairman. The gentlelady from Minnesota mentioned Goldman. The one issue that I need to bring up is we own warrants in Goldman. They are worth between a quarter and a half billion dollars. And there are negotiations now in process that I fear will lead to us cashing in those warrants for far less than they are worth. We took a huge risk. Goldman is doing well. We are going to have to profit on this deal, because I know we are going to lose money on a bunch of the other deals. As to consumer ignorance being the cause of all this, I would say to my way of thinking it is investor ignorance. They treated Alt-A as triple A. They loaned $500,000 to people to buy a three-bedroom bungalow in my district, and then we counted that as increase in our worth. It increased property values, didn't exactly increase the value of that home. And I don't think the borrowers were all that dumb, even if they signed a loan that they ultimately couldn't pay. Because if they sold in 2006, they made more money on their home than they ever made working, or at least for many years of working. The people who took ridiculous risks were the investors, the lenders. They thought they were creating wealth. All they were doing is creating a bubble. The three issues that I think are going to be most contentious on regulatory reform are: first, the enhanced powers of the Fed. We are going to have to deal with Fed governance. It is absolutely absurd to put huge governmental powers in an entity that is selected, whose leadership is selected--not always one man, one vote--they will have to appoint Fed board members. But in some cases, the regional side and various other entities, the governance of the Fed is one bank, one vote; one big bank, one big vote. And last I checked the Constitution, governmental powers should be in the hands of those who are elected one man, one vote; one woman, one vote. Also a big discussion on whether the Fed should be audited like every other government agency. The more governmental power you give it, the more reason there is to audit. And, finally, the chairman has discussed Section 13.3 of the Federal Reserve Act. Mr. Bernanke was here and I facetiously questioned him about whether he would accept a $12 trillion limit on the power of the Fed to go lend money to whomever he thought ought to get it. He thought a $12 trillion limit on that power would be acceptable. The power of the purse is supposed to be in Article 1 of the Constitution, not Article 2. And the proposal of the Administration is to say, well, you need two entities in Article 2 of the Constitution, both the Fed and the Treasury Department, to go out and take--and to risk trillions of dollars. I would think that we would want a dollar limit imposed by Congress. Derivatives are often a casino. We are told that they are used as hedges, and that is the justification for them. But for every $10 billion that an airline hedges on the future fuel of costs, there seems to be $10 trillion in casino gambling. Which would be more or less fine, except, unlike Las Vegas, we have the Secretary of the Treasury, when he came before us a couple of days ago, making it plain that he reserves the right to use whatever governmental powers he might have to bail out the counterparties on derivatives being written today. So we do have an interest in minimizing the over-the-counter derivatives and minimizing what could be a risk that ultimately falls on the taxpayer. I would think at a minimum, we would limit over-the-counter derivatives to those cases where somebody has a genuine insurable risk and is unable to hedge it in the exchange-traded derivatives. For us to say we are going to have a taxpayer-insured casino involving trillions of dollars a day, just so that one or two airlines could hedge fuel costs, fails to recognize the size of this, of the casino part of the over-the-counter market. Finally, Professor, I will be introducing a bill that would deprive the issuer of a debt security from selecting the credit-rating agency. To me, that is like having the umpire selected by the home team. Which is fine if it is a beer league; not so fine if you are in the major leagues. And instead, we would select at random from a panel of SEC-qualified credit-rating agencies. Another way to go would be to make the credit-rating agencies liable for negligence. I don't know if I am allowed a response. " CHRG-111hhrg48868--337 Mr. Liddy," The exit strategy, I think, is a solid one. It has been in place for a while now. And it is: Sell whatever assets we can, use that money to pay back the Federal Reserve and the TARP money. To the extent we can't sell an asset, we're going to ring-fence it, put it in a separate trust, and actually give that asset to the Federal Reserve as satisfaction of the debt. And when that asset can be taken public or it can be sold, then the Federal Reserve would decide to sell it. " CHRG-111shrg55739--52 Mr. Barr," Senator, I think, unfortunately, the whole country is paying the price. Every consumer is paying the price today of a significant failure of our financial regulatory system. So we are all paying for it now in spades. I think we need to have a system in the future in which the level playing field and high standards are established in a way that makes it much less likely we are going to blow up our financial system and cause this amount of harm to the average American homeowner, consumer, small business person. So in our judgment, the tradeoff isn't even close. The kind of approach that we are suggesting here is not a heavy regulatory burden, but it is an essential one. Senator Johanns. Mr. Chairman, thank you very much. " CHRG-110hhrg46596--304 Mr. Roskam," We are not going to settle this in the couple of minutes that we have this afternoon, but it seems to me that the urgency with which the original TARP deliberation took place, we would have been well-served had that same urgency and that same clarity been brought about to require or to provoke--use any verb you want to--but to get a fundamental change in mark-to-market. It would seem to me there were things that were on the table that would have been substantive and very helpful, and we may have been in a very different situation right now. Let me just turn quickly, Mr. Dodaro, could you comment on that element of things? In other words, as the GAO evaluates TARP, can--or is part of your deliberation and your evaluation, regulatory burdens that may be in place, impediments to progress that Congress itself can remove, or the Securities and Exchange Commission or FASB or others? Is that part of your portfolio, so to speak? " CHRG-111shrg55278--113 PREPARED STATEMENT OF ALLAN H. MELTZER Professor of Political Economy, Tepper School of Business, Carnegie Mellon University July 23, 2009Regulatory Reform and the Federal Reserve Thank you for the opportunity to present my appraisal of the Administration's proposal for regulatory changes. I will confine most of my comments to the role of the Federal Reserve as a systemic regulator and will offer an alternative proposal. I share the belief that change is needed and long delayed, but appropriate change must protect the public, not bankers. And I believe that effective regulation should await evidence and conclusions about the causes of the recent crisis. There are many assertions about causes. The Congress should want to avoid a rush to regulate before the relevant facts are established. If we are to avoid repeating this crisis, make sure you know what caused it. During much of the past 15 years, I have written three volumes entitled ``A History of the Federal Reserve.'' Working with two assistants we have read virtually all of the minutes of the Board of Governors, the Federal Open Market Committee, and the Directors of the Federal Reserve Bank of New York. We have also read many of the staff papers and internal memos supporting decisions. I speak from that perspective. I speak also from experience in Japan. During the 1990s, the years of the Japanese banking and financial crisis, I served as Honorary Adviser to the Bank. Their policies included preventing bank failures. This did not restore lending and economic growth. Two findings are very relevant to the role of the Federal Reserve. First, I do not know of any clear examples in which the Federal Reserve acted in advance to head off a crisis or a series of banking or financial failures. We know that the Federal Reserve did nothing about thrift industry failures in the 1980s. Thrift failures cost taxpayers $150 billion. AIG, Fannie, and Freddie will be much more costly. Of course, the Fed did not have responsibility for the thrift industry, but many thrift failures posed a threat to the financial system that the Fed should have tried to mitigate. The disastrous outcome was not a mystery that appeared without warning. Peter Wallison, Alan Greenspan, Bill Poole, Senator Shelby, and others warned about the excessive risks taken by Fannie and Freddie, but Congress failed to legislate. Why should anyone expect a systemic risk regulator to get requisite Congressional action under similar circumstances? Can you expect the Federal Reserve as systemic risk regulator to close Fannie and Freddie after Congress declines to act? Conflicts of this kind, and others, suggest that that the Administration's proposal is incomplete. Defining ``systemic risk'' is an essential, but missing part of the proposal. Trying to define the authority of the regulatory authority when Congress has expressed an interest points up a major conflict. During the Latin American debt crisis, the Federal Reserve acted to hide the failures and losses at money center banks by arranging with the IMF to pay the interest on Latin debt to those banks. This served to increase the debt that the Governments owed, but it kept the banks from reporting portfolio losses and prolonged the debt crisis. The crisis ended after one of the New York banks decided to write off the debt and take the loss. Others followed. Later, the Treasury offered the Brady plans. The Federal Reserve did nothing. In the dot-com crisis of the late 1990s, we know the Federal Reserve was aware of the growing problem, but it did not act until after the crisis occurred. Later, Chairman Greenspan recognized that it was difficult to detect systemic failures in advance. He explained that the Federal Reserve believed it should act after the crisis, not before. Intervention to control soaring asset prices would impose large social costs of unemployment, so the Federal Reserve, as systemic risk regulator would be unwise to act. The dot-com problem brings out that there are crises for which the Federal Reserve cannot be effective. Asset market exuberance and supply shocks, like oil price increases, are nonmonetary so cannot be prevented by even the most astute, far-seeing central bank. We all know that the Federal Reserve did nothing to prevent the current credit crisis. Before the crisis it kept interest rates low during part of the period and did not police the use that financial markets made of the reserves it supplied. The Board has admitted that it did not do enough to prevent the crisis. It has not recognized that its actions promoted moral hazard and encouraged incentives to take risk. Many bankers talked openly about a ``Greenspan put,'' their belief that the Federal Reserve would prevent or absorb major losses. It was the Reconstruction Finance Corporation, not the Fed, that restructured banks in the 1930s. The Fed did not act promptly to prevent market failure during the 1970 Penn Central failure, the Lockheed and Chrysler problems, or on other occasions. In 2008, the Fed assisted in salvaging Bear Stearns. This continued the ``too-big-to-fail'' (TBTF) policy and increased moral hazard. Then without warning, the Fed departed from the course it had followed for at least 30 years and allowed Lehman to fail in the midst of widespread financial uncertainty. This was a major error. It deepened and lengthened the current deep recession. Much of the recent improvement results from the unwinding of this terrible mistake. In 1990-91, the Fed kept the spread between short- and long-term interest rates large enough to assist many banks to rebuild their capital and surplus. This is a rare possible exception, a case in which Federal Reserve action to delay an increase in the short-term rate may have prevented banking failures. Second, in its 96-year history, the Federal Reserve has never announced a lender-of-last-resort policy. It has discussed internally the content of such policy several times, but it rarely announced what it would do. And the appropriate announcements it made, as in 1987, were limited to the circumstances of the time. Announcing and following a policy would alert financial institutions to the Fed's expected actions and might reduce pressures on Congress to aid failing entities. Following the rule in a crisis would change bankers' incentives and reduce moral hazard. A crisis policy rule is long overdue. The Administration proposal recognizes this need. A lender-of-last-resort rule is the right way to implement policy in a crisis. We know from monetary history that in the 19th century the Bank of England followed Bagehot's rule for a half-century or more. The rule committed the Bank to lend on ``good'' collateral at a penalty rate during periods of market disturbance. Prudent bankers borrowed from the Bank of England and held collateral to be used in a panic. Banks that lacked collateral failed. Financial panics occurred. The result of following Bagehot's rule in crises was that the crises did not spread and did not last long. There were bank failures, but no systemic failures. Prudent bankers borrowed and paid depositors cash or gold. Bank deposits were not insured until much later, so bank runs could cause systemic failures. Knowing the Bank's policy rule made most bankers prudent, they held more capital and reserves in relation to their size than banks currently do, and they held more collateral to use in a crisis also. These experiences suggest three main lessons. First, we cannot avoid banking failures but we can keep them from spreading and creating crises. Second, neither the Federal Reserve nor any other agency has succeeded in predicting crises or anticipating systemic failure. It is hard to do, in part because systemic risk is not well-defined. Reasonable people will differ, and since much is often at stake, some will fight hard to deny that there is a systemic risk. One of the main reasons that Congress in 1991 passed FDICIA (Federal Deposit Insurance Corporation Improvement Act) was to prevent the Federal Reserve from delaying closure of failing banks, increasing losses and weakening the FDIC fund. The Federal Reserve and the FDIC have not used FDICIA against large banks in this crisis. That should change. The third lesson is that a successful policy will alter bankers' incentives and avoid moral hazard. Bankers must know that risk taking brings both rewards and costs, including failure, loss of managerial position and equity followed by sale of continuing operations.An Alternative Proposal Several reforms are needed to reduce or eliminate the cost of financial failure to the taxpayers. Members of Congress should ask themselves and each other: Is the banker or the regulator more likely to know about the risks on a bank's balance sheet? Of course it is the banker, and especially so if the banker is taking large risks that he wants to hide. To me that means that reform should start by increasing a banker's responsibility for losses. The Administration's proposal does the opposite by making the Federal Reserve responsible for systemic risk. Systemic risk is a term of art. I doubt that it can be defined in a way that satisfies the many parties involved in regulation. Members of Congress will properly urge that any large failure in their district or State is systemic. Administrations and regulators will have other objectives. Without a clear definition, the proposal will bring frequent controversy. And without a clear definition, the proposal is incomplete and open to abuse. Resolving the conflicting interests is unlikely to protect the general public. More likely, regulators will claim that they protect the public by protecting the banks. That's what they do now. The Administration's proposal sacrifices much of the remaining independence of the Federal Reserve. Congress, the Administration, and failing banks or firms will want to influence decisions about what is to be bailed out. I believe that is a mistake. If we use our capital to avoid failures instead of promoting growth we not only reduce growth in living standards we also sacrifice a socially valuable arrangement--central bank independence. We encourage excessive risk taking and moral hazard. I believe there are better alternatives than the Administration's proposal. First step: End TBTF. Require all financial institutions to increase capital more than in proportion to their increase in size of assets. TBTF gives perverse incentives. It allows banks to profit in good times and shifts the losses to the taxpayers when crises or failures occur. My proposal reduces the profits from giant size, increases incentives for prudent banker behavior by putting losses back to managements and stockholders where they belong. Benefits of size come from economies of scale and scope. These benefits to society are more than offset by the losses society takes in periods of crisis. Congress should find it hard to defend a system that distributes profits and losses as TBTF does. I believe that the public will not choose to maintain that system forever. Permitting losses does not eliminate services; failure means that management loses its position and stockholders take the losses. Profitable operations continue and are sold at the earliest opportunity. Second step: Require the Federal Reserve to announce a rule for lender-of-last-resort. Congress should adopt the rule that they are willing to sustain. The rule should give banks an incentive to hold collateral to be used in a crisis period. Bagehot's rule is a great place to start. Third step: Recognize that regulation is an ineffective way to change behavior. My first rule of regulation states that lawyers regulate but markets circumvent burdensome regulation. The Basel Accord is an example. Banks everywhere had to increase capital when they increased balance sheet risk. The banks responded by creating entities that were not on their balance sheet. Later, banks had to absorb the losses, but that was after the crisis. There are many other examples of circumvention from Federal Reserve history. The reason we have money market funds was that Fed regulation Q restricted the interest that the public could earn. Money market funds bought unregulated, large certificates of deposit. For a small fee they shared the higher interest rate with the public. Much later Congress agreed to end interest rate regulation. The money funds remained. Fourth step: Recognize that regulators do not allow for the incentives induced by their regulations. In the dynamic, financial markets it is difficult, perhaps impossible, to anticipate how clever market participants will circumvent the rules without violating them. The lesson is to focus on incentives, not prohibitions. Shifting losses back to the bankers is the most powerful incentive because it changes the risk-return tradeoff that bankers and stockholders see. Fifth step: Either extend FDICIA to include holding companies or subject financial holding companies to bankruptcy law. Make the holding company subject to early intervention either under FDICIA or under bankruptcy law. That not only reduces or eliminates taxpayer losses, but it also encourages prudential behavior. Other important changes should be made. Congress should close Fannie Mae and Freddie Mac and put any subsidy for low-income housing on the budget. The same should be done to other credit market subsidies. The budget is the proper place for subsidies. Congress, the regulators, and the Administration should encourage financial firms to change their compensation systems to tie compensation to sustained average earnings. Compensation decisions are too complex for regulation and too easy to circumvent. Decisions should be management's responsibility. Part of the change should reward due diligence by traders. We know that rating agencies contributed to failures. The rating problem would be lessened if users practiced diligence of their own. Three principles should be borne in mind. First, banks borrow short and lend long. Unanticipated large changes can and will cause failures. Our problem is to minimize the cost of failures to society. Second, remember that capitalism without failure is like religion without sin. It removes incentives for prudent behavior. Third, those that rely on regulation to reduce risk should recall that this is the age of Madoff and Stanford. The Fed, too, lacks a record of success in managing large risks to the financial system, the economy and the public. Incentives for fraud, evasion, and circumvention of regulation often have been far more powerful than incentives to enforce regulation that protects the public. CHRG-111hhrg51591--82 Mr. Royce," I understand the point you are making. And let me say that, Mr. Grace, I agree that counterparty due diligence or market discipline is the most important factor in all of this and that can be circumvented, unfortunately, when the assumption is made that somebody is looking at it. So I agree with that philosophy. But I have to say that in order to catch this type of over-leveraging, I think this would have been caught by a world-class regulator if they had access to all of the information. And I think it is the amount, the sheer amount of overleveraging here, which created the systemic risk. So I am not saying that this would solve all problems. I concur with you on that. But I would ask if you would grant me that point. " Mr. Grace," 170 times over-leveraging just boggles my mind. I don't see how somebody--I mean, I still agree with you. But I just don't see how someone didn't see that. " CHRG-111shrg61513--73 Mr. Bernanke," On interconnectedness, this is a place, I think, where the Federal Reserve really has a comparative advantage. We have, for example, been working very hard on strengthening the operations of the credit default swap market, the tri-party repo market, et cetera. And in doing that, we are looking at how the--it is critical to us--you know, JP Morgan plays a critical role in the tri-party repo market. DTCC plays a critical role in the securities clearing markets and so on. So we are integrating those with our analysis of the firms, and that is extremely important. We are paying a lot of attention to that. Senator Warner. Thank you, Mr. Chairman. Senator Johnson. Senator Gregg? Senator Gregg. Were you here earlier than I was, Jim? Senator Johnson. Senator DeMint? Senator Gregg. I think Senator DeMint was here. He left. I do believe he is--go ahead. Senator DeMint. Thank you, Mr. Chairman. Thank you, Mr. Bernanke, for enduring us again here. I really appreciate you being here. I apologize for missing some of the questions, but I did hear your testimony. I would just like to get a broad perspective. I know we are talking about a lot of the details of financial monetary systems, but just maybe a larger concern. As I look at what we are doing here in Washington overall and a lot of the debate about specifics, it does seem that the underlying debate is more about are we going to have a free market economy or more of a centrally planned, government-directed economy. And there are very different views on monetary policy depending really on what our paradigm is, I believe. My concern is as I look at where we are even versus 5 years ago, that the Federal Government owns two of our largest auto companies, our largest insurance company, our largest mortgage company. We are heavy in debate about expanding government control of health care. We pretty much control the energy sector, where we drill, all of those kinds of things. We are considering now a new financial reform package that would supercede State control, go all the way down to payday lenders and pawn shops. And in the process of moving in this direction, we have created huge debts, unsustainable, and 10-year projections are more than a trillion dollars a year additional debt. My concern is that in your testimony, that you didn't mention any of this. Not until we questioned the debt was it a concern. I mean, I know it is a concern. I am not suggesting it is not. But I would think that given the fact that the uniqueness of the American economic system has a lot to do with more of the Adam Smith invisible hand, bottom up, that the Chairman of our Federal Reserve would express some concern about the expansion of government ownership and controls of large sections of the private sector economy, knowing that there is a tipping point at some point where we no longer function as a free market economy. I am not sure if we have gone past that or not, but my concern and alarm is that you had not expressed any concern or alarm of the need for Congress to look at ways to devolve and divest of these things, to try to move things back in that direction. Is that not a concern, or is your focus just not--your focus is what you have to do with what you have got to work with and that is just not your area? " CHRG-110shrg50369--126 Mr. Bernanke," Well, I do not think that foreign investors have lost confidence in the United States by any means. The data you are referring to shows some desire by foreign investors to shift out of corporate credits and other credit products and into treasuries. That is the same shift that American investors are making. They are getting away from what they view as risky credits toward the safety of U.S. Government debt. And, indeed, U.S. Government debt is still the safest, most liquid, desired asset in the world. There is some effect of the dollar on commodities. Oil and other commodities are traded globally. You can think of the price as being set by global supply and demand. If the dollar depreciates a bit, then you would expect to see commodity prices rise to offset that depreciation. But it is important to understand that, for example, oil has risen in euros as well as in dollars. I mean, it is not simply an issue of currencies. It also has to do with global supply and demand for the commodity. So the European Central Bank is concerned about food and energy inflation as well. With respect to the sovereign wealth funds, that is just another indication that foreigners have not lost confidence in the U.S. economy and that there has been a good bit of inflow. In particular, about something close to half of the capital that financial institutions have raised in the last few months has come from sovereign wealth funds, from other countries. I think that, in general, that is quite constructive. If we are confident, as I think we are in this case, that the investments are made for economic reasons and not for political reasons or other noneconomic reasons, and there is no issue of national defense, which the CFIUS process takes care of, then that inflow of investment is good for our economy and certainly is helping, in this case, the financial system. At the same time, allowing inflows of foreign capital through reciprocity gives us more opportunities to invest abroad. I know that Congress is very interested in sovereign wealth funds, and you should certainly take a close look at it. International agencies, like the International Monetary Fund and the OECD, are developing codes of conduct. The basic idea there is that sovereign wealth funds should be as transparent as possible. We should understand their governance and their motivations, and, in particular, we should be confident that they are investing, again, for economic rather than political or other purposes. If we are confident in that, then it is in our interest to keep our borders open and to allow that capital to flow in. And I think it will continue to flow in. " CHRG-109hhrg28024--246 Mr. Pearce," The idea of surpluses as far as the eye could see back at the end of the Clinton time, was that a real phenomenon or was that a fictitious phenomenon? In other words, what we've heard testimony as the dotcom ramp-up and the associated capital gains off those stocks that were valued at zero and went very high, that the entire increase of revenues and projection of revenues was simply those imaginary increases which then deflated back down, and actually the revenues, when they sank, sank back to where they were consistent with the increase before--was that a fictitious thing or were those--should we have increased the size of our budget based on those surpluses? " CHRG-111shrg50814--105 Mr. Bernanke," Well, inflation is primarily the responsibility of the Federal Reserve and we consider that to be a critical element of our mandate. Our view is that over the next couple of years, inflation, if anything, is going to be lower than normal, given how much commodity prices have come down, given how much slack there is in the economy. When the economy begins to recover, it is important that we raise interest rates and do what is necessary to prevent an overheating that would lead to inflation down the road, and as I have mentioned, we are confident that we can do that. Every time we use our balance sheet to try to support the economy, we are thinking about how can we unwind that in a way that will be kindly and allow us to take the actions we need to take. That is a somewhat separate issue from the debt issue. It seems to be, at least for now, that the dollar and U.S. debt are still very attractive around the world and there is a lot of demand for holding our Treasuries. That said, it is self-evident that we can't run trillion-dollar deficits indefinitely. It is going to be very important, as we emerge from the crisis and begin to go into a recovery stage, that we get control of the fiscal situation and begin to bring down the deficit to a sustainable level. So I agree with you that we do need to address that issue. For the moment, foreign demand for U.S. securities is strong, but you are absolutely right. If we don't get control of it, eventually, they are going to lose confidence. Senator Hutchison. Let me shift to the issue that many of us have talked about and that is getting credit into the marketplace. Because the balance sheet of the banks has gone up so much now, holding their reserves in the Fed, and you are still paying interest to the banks, do you think that is having an impact on banks leaving their money in the Fed to get interest and having the reverse effect on what we all want, which is getting credit out into the marketplace? " CHRG-111shrg61513--54 Mr. Bernanke," Well, Senator as you point out, at the moment we are in a deep recession. Revenues are down to 15 percent of GDP. We have a lot of costs arising from the recession, and so deficits are extremely high. The really interesting question is: What is the structural medium-term deficit? If you look at the range of estimates provided by the OMB and the CBO over different scenarios and so on, most of them suggest that the deficit after we come out of recession, say 2013 or so and the rest of that decade, should be somewhere between--will be somewhere between 4 and 7 percent of GDP. That is not a sustainable number. A rule of thumb is that in order to keep the ratio of outstanding Government debt to our GDP more or less constant--I mean, it would be better even to reduce it, but just to keep it constant, you need to have deficits more in the area of 2 \1/2\ to 3 percent. So I think it is important--so 4 to 7 percent is not sustainable. If it were actually to happen, what we would see is increasing interest costs, and eventually the markets would just entirely lose confidence in our fiscal policy, and interest rates would spike. So it is very important for Congress--even though we are now still in a very deep recession or in a very weak economy, it is important for Congress to try to clarify how we are going to exit from our fiscal position and try to provide a credible blueprint for how our Federal deficit will be controlled over the next 10 years and 20 years. Senator Vitter. And just to follow up on that, let us say in the future we reach a point that we are truly out of this recession in a meaningful way and those deficits are where they are projected, 4 to 7 percent, versus 2 \1/2\. How quickly would that become a major problem in terms of the economy? " 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-111shrg55739--156 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BENNETT FROM LAWRENCE J. WHITEQ.1. As we move forward on strengthening the regulation of credit rating agencies, it is important that we do not take any action to weaken pleading and liability standards of the Private Securities Litigation Reform Act of 1995. This Committee worked long and hard, and in a completely bipartisan fashion, to craft litigation that would help prevent abusive ``strike'' suits by trial lawyers. These suits benefited no one but the lawyers who orchestrated these suits. This was a real problem then, and could become a real problem again if we dilute the current standard that applies to all market participants. Perpetrators of securities fraud, and those who act recklessly, can be sued under the law we passed in 1995. Is there any justification for now altering this standard just for credit rating agencies? Will the threat of class action litigation, and the costs of endless discovery, be at cross-purpose with the goal of fostering greater competition in credit rating markets? Would this potential create a disproportionate burden for smaller players in the industry? Do you believe that the threat of harassment litigation could act as a barrier to entry to those considering entry into the rating agency business?A.1. Since I am not a lawyer (and do not practice law without a license) and I have only a modest familiarity with the Private Securities Litigation Reform Act of 1995, I am really not qualified to answer these questions. However, I do believe that a blanket First Amendment protection for rating agencies is too broad--while I recognize that an increased level of liability to damages from lawsuits will make life more difficult for credit rating agencies, especially smaller firms and potential entrants. Accordingly, there needs to be a better balance than is present now in encouraging rating agencies to take the appropriate level of care in supporting their judgments. ------ CHRG-111hhrg55811--83 Mr. Gensler," Derivatives allow for risks to be managed, managed well. But also in the aggregate, particularly in the books of many financial institutions, it also allows risks to be accumulated and large leveraged to-- " CHRG-111hhrg54867--61 Secretary Geithner," Central to their vulnerability, AIG's, Bear Stearns's, broad swaths of the rest of the financial system, was excess leverage allowed to build up without constraint. " CHRG-110hhrg46595--512 Mr. Altman," Well, I do believe you can do a lot to get a senior status in this loan. One way to do it is to get the existing creditors to go away and take equity. And I think General Motors is making that plan. I think that is a good idea. And then you don't have to worry about them; they take equity in place of the debt. Then you can go in and be senior, and there is nothing wrong with that. But just to force it down them, I think that would be a mistake. " CHRG-111hhrg49968--115 Mr. Garrett," Well, regardless of how we spend them, let's assume for the moment that we spend them on all the best things in the world, the deficit numbers don't change and the debt numbers don't change. We are still going to spend that $634 billion, whether it is on health care or something else, we are still going to spend this money on something, so the bottom-line numbers don't change. " FOMC20070628meeting--16 14,MR. KOHN.," I was just going to remark that the situation was quite different. LTCM followed the Russian debt default. The markets were already in considerable disarray. All those correlations had already begun to turn, and then on top of that you had the fire sale effects of LTCM. You can see some of that in the subprime market, where this thing is concentrated. It is just not spread out now, and the whole market situation was very different at that time." CHRG-111shrg61513--96 Mr. Bernanke," Thank you. Senator Johanns. Senator Bennett. Senator Bennett. Thank you very much, Mr. Chairman, and Chairman Bernanke, I appreciate your being here. Picking up on what Senator Gregg was talking about, simply an observation so that everybody understands exactly what we are talking about. When we say political will, cut spending, two-thirds of the Federal budget is in mandatory spending, and that is a combination of the entitlements, Social Security, Medicare, Medicaid, farm subsidies, interest on the national debt. I am an appropriator. None of those items come before the Appropriations Committee. All of them are on autopilot to be spent by virtue of commitments that have been made. I once had a very wealthy man say to me, ``Explain to me why the Federal Government sends me a check every month for,'' I have forgotten the number, $250 or whatever it is. He says, ``I don't need it.'' And I said, but Sam, you are entitled to it, and by law, we are going to give it to you whether we have got it or not. And let us make it very clear that when we are talking about spending, we are talking about fiscal policy, these are terms we hide behind when we talk to our constituents and give speeches about Congress has got to get tough on spending. The real fact is that we have got to have the courage to attack the most popular programs in American history. We have got to level with our constituents and tell them we are talking about the programs you value the most and you insist are off limits. If the entitlements are off limits for any kind of discussion here on fiscal policy, we are going to hit 10 percent of GDP within 24 months unless we have the courage to deal with. It is 65 to 67 percent of the budget now. We are on autopilot to see 75 percent of the budget within 10 years and the other 25 percent includes defense. So if you take defense out of the remaining 25 percent, you have got about 10 percent of the budget that you have to get tough on in order to solve this problem. All right. I have finished my soapbox, but I think anybody who is paying attention to these hearings ought to hear that and understand that because that is the reality. Let me get to a question relating to the debt. We had our experiences, you and I and all the rest of us, a little over a year ago with respect to TARP. One of the things you said to us at the time, and we banked on as we voted for TARP, was that this was not a bailout. This was money that would come back to the Treasury, would come back to the Federal Reserve, wherever it came from. And, in fact, you were right. The money is coming back, has come back. A lot of the major players of TARP have paid it back. Now, the Treasury is recycling that money. Senator Gregg and I have been very firm about we were in the room when the conversation was made as to what would happen to that money when it came back, and we thought, naively, that we wrote into the law the requirement that when it came back, it would be used to pay down the national debt. But we have been informed by the Treasury lawyers that that is not what we did. I would like your reaction. My opinion is, TARP solved its problems. TARP did, indeed, avoid a worldwide depression--a worldwide collapse. We maybe are in a worldwide depression, but TARP did, indeed, avoid a worldwide collapse in that very difficult weekend in September when you came here and said, ``I have run out of tools,'' a very chilling kind of comment. One of my colleagues said, ``I feel like I am in a James Bond movie,'' listening to the Chairman of the Federal Reserve say we have run out of tools. I think TARP worked. My position, and I would like your reaction, is that having worked, it is now time to end it so that the Treasury does not recycle it and that when the money does come back from those people who benefited from TARP, it goes to pay down the national debt. I would like your reaction to that. " CHRG-111shrg61513--80 Mr. Bernanke," You know, this is going to sound like a dodge, but I think that if you are going to do more fiscal policy in the near term, it would be very constructive to combine that with more attention to the exit strategy 5 years down the line, because I think there is a risk that financial markets may begin to become concerned about the sustainability of U.S. Fiscal policy, and the more you can assure them of ultimate---- Senator Bayh. It is actually not a dodge. It leads to my second question. You were asked by Senator Dodd about the use of derivatives and the problems they are having in Greece. Senator Vitter touched upon the deficit. I would like to raise the question of Greece again. At what level--you know, our debt-to-GDP ratio is now going to be going up. Some of that is unavoidable because of the recession we are experiencing. But you are asking us to focus on the intermediate term, which I think is exactly right, and that is why I was a strong supporter of the Gregg-Conrad Commission and other steps. Do you have a sense, at what ratio of debt-to-GDP do we begin to approach the tipping point and really run into a risk of currency problems, interest rate spikes, the kinds of things that Greece is now experiencing? Do you have any judgment about that? " CHRG-111shrg62643--81 Mr. Bernanke," Well, Senator, you have been a leader in this area for a very long time, and, of course, you are well aware that many people, particularly in many cases immigrants or minorities, are utilizing nonmainstream financial institutions, like payday lenders or check cashers, and that frequently that is very costly for them and may involve getting trapped in a cycle of debt where they have to continue taking out more loans at high interest rates in order to pay back their previous loans. So I think it is very important--and you and I have had this discussion on a number of occasions--to bring the broader public into the mainstream financial system, not only for deposits but for credit, for saving, for all the important functions of the financial system for families. I agree that there are some useful things in the bill that will address that, including financial literacy provisions as well. I believe the Consumer Protection Bureau will have some education and literacy components. That is very complementary. The Consumer Bureau will certainly be active in trying to eliminate deceptive, misleading advertising or products, but that alone is really not sufficient for people to make the best use of financial markets and financial products. They have to be educated as well. And, you know, I think that is very positive that we are going to increase the commitment to that training. Senator Akaka. Thank you. Chairman Bernanke, as you mentioned financial literacy, the recently enacted law includes a provision to establish the Office of Financial Education within the newly created Bureau of Consumer Financial Protection. The office will craft a strategy to develop and implement initiatives to improve financial literacy among consumers. What do you think must be done to ensure that consumers are able to make informed financial decisions? " FinancialCrisisInquiry--451 BASS: Sure. HOLTZ-EAKIN: I just want to make sure I understand sort of the full range of your argument, which sounds to me as if, first, there’s the officially measured leverage, then a leverage measure which recognizes the off balance sheet, uncapitalized derivative positions—things like that. I’m trying to figure out where—where do the numbers... BASS: January 13, 2010 Right. So what I’ve done for you, and in my presentation, is I’ve given the salient facts of—of the time period in question. What I’m happy to supply you with is the full spreadsheet of—of these numbers. And these numbers were aggregated from 10-Ks, -Qs and their off balance sheet reporting, so it was all publicly available data. HOLTZ-EAKIN: OK. FOMC20080625meeting--265 263,MR. PLOSSER.," On that point, I have been reading a bit recently. It might be useful in thinking about some of these issues about how we tie our hands and the mechanism for doing that. The IMF went through an extraordinary study effort during the sovereign debt crisis and came up with some very important mechanisms for how to change the contracts that were being written by sovereign countries so as to avoid the IMF's having to step in and look for other solutions, which is, I think, along the same lines. I don't know whether or not there are things from which to learn in parallel with that to think about how we approach that issue. " FinancialCrisisInquiry--36 I agree. I sit here and read testimony to the effect of reducing our balance sheet, raising capital. Clearly, we are much less leveraged now. Consequently, I wish we were much less leveraged then, even though we were much lower leveraged than others and we had cash on our balance sheet and we did better than under those circumstances. But if you’re asking me would I do something differently, knowing what I know now with respect to that capitalization, how could you not? Of course. CHAIRMAN ANGELIDES: But I also wanted to put in context the level of risk and the level of assistance, because this is something I think no one would want repeated again. Let’s do this, then. Let’s now move to questions from other commissioners. I’m going to stop at this moment and move to Vice Chairman Thomas. Thank you very, very much. BLANKFEIN: Thank you. VICE CHAIRMAN THOMAS: Thank you, Mr. Chairman. I think context is important. You mentioned earthquakes and how familiar we are in California with earthquakes. Mr. Blankfein, you talked about context. I think as we conduct these hearings and talk about the problems that were encountered and how close we came to a catastrophe, that right now in Haiti by one of those acts of God there is an enormous catastrophe. There are thousands of people, and I think the number of deaths will shock a lot of people, if you’ve never been to Haiti or Port-au-Prince, in terms of the living conditions that were there, subject to the deathtraps available. I think the general question that everybody wants to ask, and you said it four different ways, and I’ll put it in— in the overall overarching way that if you knew then what you know now, what would you have done differently? That may or may not help us as we go forward, but I said at the beginning that what we’ve been doing is a lot like an iceberg. fcic_final_report_full--321 SEPTEMBER 2008: THE TAKEOVER OF FANNIE MAE AND FREDDIE MAC CONTENTS “A good time to buy” ..........................................................................................  “The only game in town” ...................................................................................  “It’s a time game . . . be cool” ..............................................................................  “The idea strikes me as perverse” ......................................................................  “It will increase confidence” ...............................................................................  “Critical unsafe and unsound practices” ...........................................................  “They went from zero to three with no warning in between” ............................  “The worst-run financial institution” ................................................................  “Wasn’t done at my pay grade” ..........................................................................  From the fall of  until Fannie Mae and Freddie Mac were placed into conserva- torship on September , , government officials struggled to strike the right bal- ance between the safety and soundness of the two government-sponsored enterprises and their mission to support the mortgage market. The task was critical because the mortgage market was quickly weakening—home prices were declining, loan delin- quencies were rising, and, as a result, the values of mortgage securities were plum- meting. Lenders were more willing to refinance borrowers into affordable mortgages if these government-sponsored enterprises (GSEs) would purchase the new loans. If the GSEs bought more loans, that would stabilize the market, but it would also leave the GSEs with more risk on their already-strained balance sheets. The GSEs were highly leveraged—owning and guaranteeing . trillion of mort- gages with capital of less than . When interviewed by the FCIC, former Treasury Secretary Henry Paulson acknowledged that after he was briefed on the GSEs upon taking office in June , he believed that they were “a disaster waiting to happen” and that one key problem was the legal definition of capital, which their regulator lacked discretion to adjust; indeed, he said that some people referred to it as “bullsh*t capital.”  Still, the GSEs kept buying more of the riskier mortgage loans and securi- ties, which by fall  constituted multiples of their reported capital. The GSEs  reported billions of dollars of net losses on these loans and securities, beginning in the third quarter of . CHRG-110shrg50417--79 Mr. Eakes," I wanted to put in a word of caution. I think until we fix the problems that we have with asset-backed securities, we should be careful about trying to promote its regrowth. So the ratings agencies were a problem in rating AAA paper. We are basically talking about setting up a Government-owned structured investment vehicle, SIV, that got Citibank into trouble. We need to think about the regulatory structure. We need to make sure that the loans that are made cannot be passed into a structure without responsibility or liability passed back to the people who originated it. And, finally, I think that by putting $250 billion of equity into the banking system, normally that should leverage $10 to $12 for every dollar of equity, so we have basically enhanced the balance sheet capacity of the banks in America by $2.5 to $3 trillion that they can add. The whole credit card market, the entire credit card market in America is about $1 trillion. So we have the ability to have, as the Wells representative mentioned, the ability to hold much of these assets on bank balance sheets because of the equity we have invested. So I just think we have some significant problems in the asset-backed market as we have heard the technical discussions about how do you modify loans once they are in there, what can you do; and we have in no way fixed those problems yet. Senator Crapo. Those are good cautions. Your answer to the question raises another point, though. You indicated that the injections of liquidity should have a 10 to 12 factor of leveraging in the marketplace. And I would just like to ask any of our witnesses: Has that, in fact, occurred? Have we seen that kind of---- " CHRG-111shrg54675--51 Mr. Hopkins," Well, again, I think it becomes an allocation of capital. We are required to have certain levels of capital and we would eat up our capital very quick. If we were to do 2 years' worth of mortgages, we might be done because our capital ratios would be required, particularly your leverage ratio. Senator Corker. And I see, Mr. Hopkins, you are shaking your head in agreement with what he is---- " FinancialCrisisInquiry--12 Excessive leverage by many U.S. investment banks, foreign banks, commercial banks, and even consumers pervaded the system. This included hedge funds, private equity firms banks and non-banks using off-balance sheet vehicles. There were also several structural risks and imbalances that grew in the lead-up to the crisis. There was an over reliance on short- term financing to support illiquid long-term assets, and over time, certain financing terms became too lax. Another factor in the crisis was clearly a regulatory system. I want to be clear I do not believe the regulators. While they obviously have a critical role to play, the responsibility for companies’ actions rest solely on the companies’ management. But we should also look to see what could have been done better in the regulatory system. We have known that our system is poorly organized with overlapping responsibilities. Many regulators did not have the statutory authority they needed to address the failure of large global financial companies. Much of the mortgage business was not regulated or lacked uniform treatment. Basel II capital standards allowed too much leverage in investment banks and other firms and not incorporate liquidity at all. The extraordinary growth and high leverage of the GSEs also added to the risk. We also learned that our system has many embedded pro-cyclical biases, a number of which proved harmful in times of economic stress. Loan loss reserving methodologies caused reserves to be at their lowest levels at a time when high provisioning might be needed the most. Certain regulatory capital standards are also pro-cyclical, and continuous downgrades by credit agencies also required many financial institutions to raise more capital. When all is said and done, I believe it will be found that macro economic factors will have been some of the fundamental underlying cause of the crisis. Huge trade and financing imbalances caused large distortions in interest rates and consumption. As for J.P. Morgan Chase, the last year and a half was the most challenging period in our company’s history. I’m immensely proud of the way our employees continued to serve our customers through this difficult time. Throughout the financial crisis, we never posted a quarterly loss. We served as a safe haven for depositors. We worked closely with the federal government. And we remained an active lender. CHRG-110hhrg44903--55 Mr. Geithner," It is hard to know. But my sense is that these facilities, all of them, are still providing a very important role in confidence as a backstop source of liquidity in extremis. And I don't think you can really judge the value today to the firms themselves or to the people who fund them from looking at use day-by-day. So my own sense is that there is still plenty of kind of an important role, even though use has declined progressively over time. Just to underscore one important point, we have been very careful from the beginning, along with the SEC, to try to make sure that while these facilities are in place the major investment banks move to adopt a more conservative mix of leverage and funding than they had on the eve of the Bear Stearns thing. And I think it is important to note, and I think Chairman Cox has said this, too, that they have made substantial progress in moving towards an appropriately more conservative mix, as I said, of the leverage and funding risk. " CHRG-111hhrg54868--136 Mr. Dugan," We have something called our account management guidance that applies to all credit card providers. We were seeing some real problems in our portfolio about people not making consumers even pay a very small amount due. This was masking losses over time that they were continuing to report as income. It was a truly unsafe and unsound practice, and it was also resulting in consumers getting deeper and deeper into debt. " CHRG-111shrg62643--22 Chairman Dodd," I thank you for that. Let me turn to Senator Shelby. Senator Shelby. Mr. Chairman, we all, I think, agree that long-term unemployment problems is a cancer dealing with our economy and people's operations. On the other hand, a spiraling deficit and accumulated debt like we are going through now is also a real problem. And the question is, how do we balance that and how much time do we have, isn't it? " CHRG-111hhrg56847--46 Mr. Hensarling," Chairman Bernanke, my seconds are ticking away. Real quickly. Hopefully it is a yes or no question. I thought I have heard you testify before that not only is it important to the long-term sustainability that we have a program to deal with our debt, but it is actually important to economic growth today to send a signal that we have a plan in place. Did I understand you correctly? Is it important to have a plan today? " fcic_final_report_full--335 COMMISSION CONCLUSIONS ON CHAPTER 17 The Commission concludes that the business model of Fannie Mae and Freddie Mac (the GSEs), as private-sector, publicly traded, profit-making companies with implicit government backing and a public mission, was fundamentally flawed. We find that the risky practices of Fannie Mae—the Commission’s case study in this area—particularly from  on, led to its fall: practices undertaken to meet Wall Street’s expectations for growth, to regain market share, and to ensure generous compensation for its employees. Affordable housing goals imposed by the De- partment of Housing and Urban Development (HUD) did contribute marginally to these practices. The GSEs justified their activities, in part, on the broad and sustained public policy support for homeownership. Risky lending and securiti- zation resulted in significant losses at Fannie Mae, which, combined with its ex- cessive leverage permitted by law, led to the company’s failure. Corporate governance, including risk management, failed at the GSEs in part because of skewed compensation methodologies. The Office of Federal Housing Enterprise Oversight (OFHEO) lacked the authority and capacity to adequately regulate the GSEs. The GSEs exercised considerable political power and were suc- cessfully able to resist legislation and regulatory actions that would have strength- ened oversight of them and restricted their risk-taking activities. In early , the decision by the federal government and the GSEs to increase the GSEs’ mortgage activities and risk to support the collapsing mortgage market was made despite the unsound financial condition of the institutions. While these actions provided support to the mortgage market, they led to increased losses at the GSEs, which were ultimately borne by taxpayers, and reflected the conflicted nature of the GSEs’ dual mandate. GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were cen- tral to the financial crisis. 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? " fcic_final_report_full--74 DOTCOM CRASH: “LAY ON MORE RISK ” The late s was a good time for investment banking. Annual public underwrit- ings and private placements of corporate securities in U.S. markets almost quadru- pled, from  billion in  to . trillion in . Annual initial public offerings of stocks (IPOs) soared from  billion in  to  billion in  as banks and securities firms sponsored IPOs for new Internet and telecommunications compa- nies—the dot-coms and telecoms.  A stock market boom ensued comparable to the great bull market of the s. The value of publicly traded stocks rose from . tril- lion in December  to . trillion in March .  The boom was particularly striking in recent dot-com and telecom issues on the NASDAQ exchange. Over this period, the NASDAQ skyrocketed from  to ,. In the spring of , the tech bubble burst. The “new economy” dot-coms and telecoms had failed to match the lofty expectations of investors, who had relied on bullish—and, as it turned out, sometimes deceptive—research reports issued by the same banks and securities firms that had underwritten the tech companies’ initial public offerings. Between March  and March , the NASDAQ fell by almost two-thirds. This slump accelerated after the terrorist attacks on September  as the nation slipped into recession. Investors were further shaken by revelations of ac- counting frauds and other scandals at prominent firms such as Enron and World- com. Some leading commercial and investment banks settled with regulators over improper practices in the allocation of IPO shares during the bubble—for spinning (doling out shares in “hot” IPOs in return for reciprocal business) and laddering (doling out shares to investors who agreed to buy more later at higher prices).  The regulators also found that public research reports prepared by investment banks’ ana- lysts were tainted by conflicts of interest. The SEC, New York’s attorney general, the National Association of Securities Dealers (now FINRA), and state regulators settled enforcement actions against  firms for  million, forbade certain practices, and instituted reforms.  The sudden collapses of Enron and WorldCom were shocking; with assets of  billion and  billion, respectively, they were the largest corporate bankruptcies before the default of Lehman Brothers in . Following legal proceedings and investigations, Citigroup, JP Morgan, Merrill Lynch, and other Wall Street banks paid billions of dollars—although admitted no wrongdoing—for helping Enron hide its debt until just before its collapse. Enron and its bankers had created entities to do complex transactions generating fictitious earnings, disguised debt as sales and derivative transactions, and understated the firm’s leverage. Executives at the banks had pressured their analysts to write glowing evaluations of Enron. The scandal cost Citigroup, JP Morgan, CIBC, Merrill Lynch, and other financial institutions more than  million in settlements with the SEC; Citigroup, JP Morgan, CIBC, Lehman Brothers, and Bank of America paid another . billion to investors to settle class action lawsuits.  In response, the Sarbanes- Oxley Act of  required the personal certification of financial reports by CEOs and CFOs; independent audit committees; longer jail sentences and larger fines for executives who misstate financial results; and protections for whistleblowers. Some firms that lent to companies that failed during the stock market bust were successfully hedged, having earlier purchased credit default swaps on these firms. Regulators seemed to draw comfort from the fact that major banks had succeeded in transferring losses from those relationships to investors through these and other hedging transactions. In November , Fed Chairman Greenspan said credit de- rivatives “appear to have effectively spread losses” from defaults by Enron and other large corporations. Although he conceded the market was “still too new to have been tested” thoroughly, he observed that “to date, it appears to have functioned well.”  The following year, Fed Vice Chairman Roger Ferguson noted that “the most re- markable fact regarding the banking industry during this period is its resilience and retention of fundamental strength.”  FOMC20081216meeting--236 234,MR. KROSZNER.," Thanks. President Lockhart's forecast about what members would say about the forecasts I think has turned out to be right, and I certainly don't want to disappoint. [Laughter] So I agree with what others have said, and I think most everything has been said about the intensification of the recessionary flames around the world. What I will do is just quickly look at it from the perspective of part of the banks' balance sheets and the things that may not be left on those balance sheets, to just underscore how I think this is going to be protracted for the financial services sector for a while. On the consumer side, as many people have mentioned, the very sharp step down in employment, the very large job losses, the increases in the unemployment rate, and the decreases in wealth have been leading to very significant increases in consumer delinquencies and very high roll rates--that is, people who become delinquent rolling directly into charge-off. This is happening not only on the credit card side and on a lot of different parts of the consumer side but also in mortgages, for which we are seeing exactly the same kind of thing. Although the most recent numbers that came out from the Mortgage Bankers Association suggested some stabilization in foreclosure starts, that actually had more to do with the laws in various states slowing down that process rather than any real change in the underlying economics. Of course, we still have a lot of option ARM types of resets that will be coming through in 2009. So a lot of pressure is there, and as was mentioned, housing prices are still going down. We haven't yet seen as much of an actual downturn in commercial real estate, but undoubtedly that will occur as fewer people are shopping in shopping malls and as a lot of other commercial real estate projects don't have the payoffs that people expect. Also, an enormous amount of refinancing is going to be necessary during the next few months, and having to pay an additional 600 or 800 basis points really changes the economics of a lot of these projects, if they can even get the refinancing at an additional 600 to 800 basis points. For leveraged loans, another piece of the balance sheet, as people have said, there is very little activity going on in takeovers. The only positive there is that the failure of certain deals has taken some of the pressure off certain banks' balance sheets. On the commercial and industrial side, as we have noted, the investment-grade market for debt issuance seems to have maintained itself, but that is really one of the few markets that is there. If any challenges come in there, it could be very, very difficult for firms to finance investment. We certainly have seen the spreads going up recently, even if the volume has come back a bit. But as we have seen in the non-investment-grade part, the spreads have blown out, and the financing is not there. That tends to be a little more of what many banks have on their balance sheets, and so I think that is representative of the challenges that the banks are going to have. That suggests that we have a lot of challenges in banking and financial institutions' balance sheets to come that have nothing to do with any particular level of assets or accounting issues but just real economic factors that are going to be affecting the balance sheets. So the credit headwinds are going to be very, very strong for a number of quarters going forward. The points that President Rosengren made are extremely important ones. We have to think about, as we move to the zero lower bound, how that is going to affect behavior of financial institutions. Certainly, the staff memos were good on addressing some issues, but I think that other things that have been mentioned, like imposing minimums or floors on interest rates on loans, we have not carefully analyzed or really understand well. There may be a variety of other responses that we don't understand well that we really do need to get a better handle on, both to see how the effects of traditional monetary policy change--the transmission mechanism--and to think about the nontraditional aspects of monetary policy that we would be undertaking by using our balance sheet. So where can we use it most effectively? If the financial institutions are changing their behavior, we need to be cognizant of that and think about where we need to try to unfreeze markets if we are going to be using our balance sheet in that way, and I think it is very important that we do so. I will underscore also what other people have said about the great importance of clearly articulating what we are doing. It is not that we have given up and that the Fed is impotent but that, through changes in our balance sheet, we can be quite potent in particular markets and in general. That then brings us to whether we can be too potent and raise inflation concerns. Exactly as President Stern said, we should be so lucky to have that as our problem. We do need to make sure that we maintain credibility and show that we feel that we can and do act to offset concerns about deflation. It is very difficult to tell what the price-level evolution is likely to be over the next year, but I do think that there is a real concern about that, and we have to take that very, very seriously going forward. I think we would, obviously, be able to get out of these different programs, and we need to think about getting out of them at some point. But right now the key is getting into the programs, using the nontraditional approaches, to make sure that we offset a deflationary psychology that could develop. Thank you. " CHRG-111shrg50814--51 Mr. Bernanke," No, I think that clearly one of the lessons is that uneven oversight and regulation of mortgage extension was a big issue. Senator Schumer. And would you address the leverage question I asked? " CHRG-110hhrg46596--479 Mr. Donnelly," But with $350 billion sitting there, isn't there something that can be done where we say, ``If you want these funds, you have to show us that at least an equal or more significant amount due to leverage has been loaned out?'' " CHRG-111hhrg52261--42 Mr. Loy," I don't. I think that that is up to the expertise of the people on this and other committees. I do think that there are substantial differences in the types of investing and the types of leverage that they use. Again, they use the same legal structure as us, but there are significant differences beyond that. " CHRG-111hhrg56766--306 Mr. Perlmutter," Just looking at the glass-half-full for a second, we were in free fall in terms of jobs. We were just losing jobs at a rate we had not seen. I am not sure we have ever seen job loss at that rate, including in the 1930's. We have reversed that. I would credit monetary policy, the Federal Reserve, also fiscal policy as coming out of this Congress. My friends on the other side of the aisle, for a while, they were picking on where are the jobs. Well, we have a graph to show they are coming back, which is up there on the wall as well as your slide 27. Now they have moved onto the next thing, which is the debt. We are not out of the woods yet on jobs, are we, sir? " fcic_final_report_full--169 COMMISSION CONCLUSIONS ON CHAPTER 8 The Commission concludes declining demand for riskier portions (or tranches) of mortgage-related securities led to the creation of an enormous volume of col- lateralized debt obligations (CDOs). These CDOs—composed of the riskier tranches—fueled demand for nonprime mortgage securitization and contributed to the housing bubble. Certain products also played an important role in doing so, including CDOs squared, credit default swaps, synthetic CDOs, and asset- backed commercial paper programs that invested in mortgage-backed securities and CDOs. Many of these risky assets ended up on the balance sheets of systemi- cally important institutions and contributed to their failure or near failure in the financial crisis. Credit default swaps, sold to provide protection against default to purchasers of the top-rated tranches of CDOs, facilitated the sale of those tranches by con- vincing investors of their low risk, but greatly increased the exposure of the sellers of the credit default swap protection to the housing bubble’s collapse. Synthetic CDOs, which consisted in whole or in part of credit default swaps, enabled securitization to continue and expand even as the mortgage market dried up and provided speculators with a means of betting on the housing market. By layering on correlated risk, they spread and amplified exposure to losses when the housing market collapsed. The high ratings erroneously given CDOs by credit rating agencies encour- aged investors and financial institutions to purchase them and enabled the con- tinuing securitization of nonprime mortgages. There was a clear failure of corporate governance at Moody’s, which did not ensure the quality of its ratings on tens of thousands of mortgage-backed securities and CDOs. The Securities and Exchange Commission’s poor oversight of the five largest investment banks failed to restrict their risky activities and did not require them to hold adequate capital and liquidity for their activities, contributing to the fail- ure or need for government bailouts of all five of the supervised investment banks during the financial crisis. FinancialCrisisInquiry--128 I’d say innovation always outpaces regulation, but in this case, it was just much further ahead. And, you know, you certainly need more capital for newer activities or more risky activities or other activities without a long enough track record. And you saw that. And, as Mr. Solomon said, we’ve had a lot of once-in-a-lifetime events. And you—you know, whether it’s Enron and WorldCom or Russia and Asia and Mexico or, you know, the tech bubble and then the real estate bubble. It seems as though these once-in-a- lifetime events happen every couple of years. So the idea of more capital overall makes a lot of sense for these once-in-a-lifetime events for these new activities. And as far as additional disclosure, no question. It would have been very helpful during the crisis and would still be helpful now especially with regard to problem loans at U.S. banks. I would make one point, though. We can’t be too pro-cyclical. If you try to correct all at once, then you’re going to kill the economy. So you have to do this in a balanced way. VICE CHAIRMAN THOMAS: A question to all of you, and it’s just from my previous job on Ways and Means and the tax code. Would it make a big difference, not much difference, if we had in the time of all of these once-in-a-lifetime events, a better understanding between equity and debt and the way in which major American corporations and even international corporations can utilize debt versus equity? And had we recognized it in the tax code, that, to a certain extent, the old cash-on-the-barrel head is, perhaps, a good way to see what’s going on, notwithstanding the complexity of the world today? CHRG-109hhrg31539--236 Mr. Bernanke," Well, we have a global capital market. We have domestic investors investing both here and abroad, and we have foreign investors investing here as well. I think the process of investment, creating more capital is really one of the basic means by which we increase productivity, increase job opportunities. " CHRG-109shrg21981--30 Chairman Greenspan," As usual, despite the fact that there is a DDS sign in front of the Committee, I, nonetheless, feel that it is a privilege to be here, as always, because I do find this an extraordinarily interesting discussion vehicle, and I trust that many of the issues will get clarified or, if not that, at least, the level of discussion will get heated sufficiently to engage us in considerable discussion, which I have a suspicion it may well. In the 7 months since I last testified before this Committee, the U.S. economic expansion has firmed, overall inflation has subsided, and core inflation has remained low. Over the first half of 2004, the available information increasingly suggested that the economic expansion was becoming less fragile and that the risk of undesirable decline in inflation had greatly diminished. Toward mid-year, the Federal Reserve came to the judgment that the extraordinary degree of policy accommodation that had been in place since the middle of 2003 was no longer warranted and, in the announcement released at the conclusion of our May meeting, signalled that a firming policy was likely. The Federal Open Market Committee began to raise the Federal funds rate at its June meeting, and the announcement following that meeting indicated the need for further, albeit gradual, withdrawal of monetary policy stimulus. Around the same time, incoming data suggested a lull in activity as the economy absorbed the impact of higher energy prices. Much as had been expected, this soft patch proved to be short-lived. Accordingly, the Federal Reserve has followed the June policy move with similar actions at each meeting since then, including our most recent meeting earlier this month. The cumulative removal of policy accommodation to date has significantly raised measures of the real Federal funds rate, but by most measures, it remains fairly low. The evidence broadly supports the view that economic fundamentals have steadied. Consumer spending has been well maintained over recent months and buoyed by continued growth in disposable personal income, gains in net worth, and the accommodative conditions in credit markets. Households have recorded a modest improvement in their financial position over this period, to the betterment of many indicators of credit quality. The sizable gains in consumer spending of recent years have been accompanied by a drop in the personal savings rate to an average of only 1 percent over 2004, a very low figure relative to the nearly 7-percent rate averaged over the previous 3 decades. Among the factors contributing to the strength of spending and the decline in saving have been the developments in housing markets and home finance that have spurred rising household wealth and allowed greater access to that wealth. The rapid rise in home prices over the past several years has provided households with considerable capital gains. Moreover, a significant increase in the rate of single-family home turnover has meant that many consumers have been able to realize gains from the sale of their homes. To be sure, such capital gains, largely realized through an increase in mortgage debt on the home, do not increase the pool of national savings available to finance new capital investment. But from the perspective of an individual household, cash realized from capital gains has the same spending power as cash from any other source. More broadly, rising home prices, along with higher equity prices, have outpaced the rise in household, largely mortgage, debt and have pushed up household net worth to about 5.5 times disposable income by the end of last year. Although the ratio of net worth to income is well below the peak attained in 1999, it remains above the long-term historical average. These gains in net worth help to explain why households, in the aggregate, do not appear uncomfortable with their financial position even though their reported personal savings rate is negligible. For their part, business executives apparently have become somewhat more optimistic in recent months. Capital spending and corporate borrowing have firmed noticeably, but some of the latter may have been directed to finance the recent backup in inventories. Mergers and acquisitions, though, have clearly perked up. Even in the current much-improved environment, however, some caution among business executives remains. Although capital investment has been advancing at a reasonably good pace, it has nonetheless lagged the exceptional rise in profits and internal cashflow. This is most unusual. It took a deep recession to produce the last such configuration in 1975. The lingering caution evident in capital spending decisions has also been manifested in less-aggressive hiring by businesses. In contrast to the typical pattern early in the previous business-cycle recoveries, firms have appeared reluctant to take on new workers and have remained focused on cost containment. As opposed to lingering hesitancy among business executives, participants in financial markets seem very confident about the future and, judging by the exceptionally low level of risk spreads and credit markets, quite willing to bear risk. This apparent disparity in sentiment between business people and market participants could reflect the heightened additional concerns of business executives about potential legal liabilities rather than a fundamentally different assessment of macroeconomic risks. Turning to the outlook for costs and prices, productivity developments will likely play a key role. The growth of output per hour slowed over the past half-year, giving a boost to unit labor costs after 2 years of declines. Going forward, the implications for inflation will be influenced by the extent and persistence of any slowdown in productivity. A lower rate of productivity growth in the context of relatively stable increases in average hourly compensation has led to slightly more rapid growth in unit labor costs. Whether inflation actually rises in the wake of slowing productivity growth, however, will depend on the rate of growth of labor compensation and the ability and willingness of firms to pass on higher costs to their customers. That, in turn, will depend on the degree of utilization of resources and how monetary policymakers respond. To date, with profit margins already high, competitive pressures have tended to limit the extent to which cost pressures have been reflected in higher prices. The inflation outlook will also be shaped by developments affecting the exchange rate of the dollar and oil prices. Although the dollar has been declining since early 2002, exporters to the United States apparently have held dollar prices relatively steady to preserve their market share, effectively choosing to absorb the decline in the dollar by accepting a reduction in their profit margins. However, the recent, somewhat quickened, pace of increase in U.S. import prices suggests that profit margins of exporters to the United States have contracted to the point where the foreign shippers may exhibit only limited tolerance for additional reductions in margins should the dollar decline further. The sharp rise in oil prices over the past year has no doubt boosted firms' costs and may have weighed on production, particularly, given the sizable permanent component of oil price increases suggested by distant-horizon oil futures contracts. However, the share of total business expenses attributable to energy costs has declined appreciably over the past 30 years, which has helped to buffer profits and the economy more generally from the adverse effect of high oil and natural gas prices. Still, although the aggregate effect may be modest, we must recognize that some sectors of the economy and regions of the country have been hit hard by the increase in energy costs, especially over the past year. Despite the combination of somewhat slower growth of productivity in recent quarters, higher energy prices, and a decline in the exchange rate for the dollar, core measures of consumer prices have registered only modest increases. The core PCE and CPI measures, for example, climbed about 1.25 to 2 percent, respectively, at an annual rate over the second half of last year. All told, the economy seems to have entered 2005, expanding at a reasonably good pace, with inflation and inflation expectations well-anchored. On the whole, financial markets appear to share this view. In particular, a broad array of financial indicators convey a pervasive sense of confidence among investors and associated greater willingness to bear risk than is yet evident among business managers. Over the past 2 decades, the industrial world has fended off two severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and, of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. In the United States, only five quarters in the past 20 years exhibited declines in GDP, and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward. Yet history cautions that people experiencing long periods of relative stability are prone to excess. We must, thus, remain vigilant against complacency, especially since several important economic challenges confront policymakers in the years ahead. Prominent among these challenges in the United States is the pressing need to maintain the flexibility of our economic and financial system. This will be essential if we are to address our current account deficit without significant disruption. Besides market pressures, which appear poised to stabilize and over the longer-run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction. Central to that adjustment must be an increase in net national savings. This serves to underscore the imperative to restore fiscal discipline. Beyond the near-term, benefits promised to a burgeoning retirement-age population, under mandatory entitlement programs, most notably Social Security and Medicare, threaten to strain the resources of the working-age population in the years ahead. Real progress on these issues will unavoidably entail many difficult choices. But the demographics are inexorable, and call for action before the leading edge of baby boomer retirement becomes evident in 2008. This is especially the case because longer-term problems, if not addressed, could begin to affect longer-dated debt issues, the value of which is based partly on expectations of developments many years in the future. Another critical long-term economic challenge facing the United States is the need to ensure that our workforce is equipped with the requisite skills to compete effectively in an environment of rapid technological progress and global competition. Technological advances are continually altering the shape, nature, and complexity of our economic processes. But technology and, more recently, competition from abroad have grown to a point at which demand for the least-skilled workers in the United States and other developed countries is diminishing, placing downward pressure on their wages. These workers will need to acquire the skills required to compete effectively for the new jobs our economy will create. Although the long-run challenges confronting the U.S. economy are significant, I fully anticipate that they will ultimately be met and resolved. In recent decades, our Nation has demonstrated remarkable resilience and flexibility when tested by events, and we have every reason to be confident that it will weather future challenges as well. For our part, the Federal Reserve will pursue its statutory objectives of price stability and maximum sustainable employment, the latter of which we have learned can best be achieved in the long-run by maintaining price stability. This is the surest contribution the Federal Reserve can make in fostering the economic prosperity and well-being of our Nation and its people. Mr. Chairman, I request that my full statement be included for the record, and I look forward to your questions. " CHRG-111shrg62643--76 Mr. Bernanke," Well that has certainly got to be a committee decision, but I would say that certainly one important criterion would be whether the recovery is sustainable, whether it is fading and not being self-propelling. If the recovery is continuing at a moderate pace, then the incentive to take extraordinary actions would be somewhat less. But certainly we would want to make sure that the economy continues to move back toward a more normal state of resource utilization. Senator Corker. So I know a lot of people up here have tried to sort of take you in whatever direction they think they would like to take you as it relates to the deficit. I want to sort of ask it in a neutral way, and that is, look, we have got a debt commission right now that is looking at long-term issues. It is bipartisan. No doubt in my opinion the administration has added to our concerns in that regard. But if you really look at where our debt is, a lot of that has just been building for years because of many entitlements and other things. As a matter of fact, when you look at where we are over the next 10 years, regardless of what the factors are, I think the American people look at deficit reduction almost academically today, and yet in the near term, we are talking about draconian things having to occur. I know Erskine Bowles talked about getting to 21 percent of GDP. Some of us would like to see it at 18 to 20 as it relates to expenditures. But even getting to that level is going to take draconian steps. So my question gets back to monetary policy. I think you all know full well where we are headed, and I think the American people have not really digested what it means for us to get our house in order. I am not sure if any of us really have digested fully what that means. But how does that impact the decisions that you all make as it relates to monetary policy? I mean, you know that is coming. You know it is going to be draconian to deal with it in an appropriate way. How is it affecting your internal discussions as it relates to monetary policy? " CHRG-111hhrg56847--101 Mr. Bernanke," Well, it is important for us to persuade the markets that we have the political will and the ability to address our long-term debt and deficit problems. So what you are saying is, you know, inability to pass a budget could be a negative in that respect. I have to say, in all honesty, that so far, we are not seeing it in the markets. The interest rates remain quite low. But certainly one of the things that the markets will assess is the political ability of the Congress to work together to develop a longer-term budget plan that will bring us back to sustainability. " CHRG-111shrg57923--9 Mr. Tarullo," Sure. Actually, Senator, we have been paying a good bit of attention to that in the Federal Reserve. I got together a group of Board staff and staff from some of the Reserve Banks to try to think through some of the potential options here. So let me first begin with a little taxonomy because different people mean different things when they talk about contingent capital. There are at least a couple of concepts here. One is a concept under which a firm would issue a specific kind of instrument which would have debt-like characteristics under normal circumstances, but by the terms of the instrument would itself have a conversion to equity when some trigger event happened. The concept behind that tends to be the following. There is a period during which a firm may still be somewhat healthy, but is beginning to deteriorate, and if capital levels go down to a certain level there will be a loss of confidence within the markets and counterparties with respect to that firm. So if at that point the trigger means that all of a sudden there are X-billion dollars more of common equity in the firm, that might provide a reassurance and stop a slide downward, and I will come back to that in a moment. A second concept is really one which is as much about the potential insolvency of the firm as it is stopping the slide. So some have proposed, for example, that all subordinated debtor all forms of debt other than specified senior tranches of debt would, at some moment, which would probably be the equivalent of when you are on the verge of insolvency, convert to equity, thereby, in effect, helping to move forward what would be a resolution process under another name, because now you have way less debt on the liability side of your balance sheet and more equity. The first is, I think, the concept that has intrigued some academics, some regulators, and, I must say, some investment bankers who probably see the opportunity to create some new forms of investment. The big issue there--there are a number of technical issues, but I think probably the biggest is what is the trigger going to be. If the trigger is supervisory discretion, you probably have an issue because everybody is going to be wondering whether the supervisor is going to pull the trigger for exogenous reasons, or when the supervisor would pull the trigger. It would create a good bit of uncertainty in the markets. A second option is that you have the trigger tied to the capital levels of the firm. Now, that still involves some supervisory discretion, but it is within the context of an ongoing regulatory system. The problem there has been that, as you know, capital tends to be a lagging indicator of the health of a firm. Many firms, 2 months before their insolvency, looked like they were adequately capitalized, and so unless we get a quicker adjustment of capital levels, that probably wouldn't do the trick. A third proposal is to have a market-based trigger, a trigger that might, for example, be the relationship between common equity and assets or something of the sort, or the market price of the--a lag market price of the firm related to assets, something that gets the market in as the trigger so that nobody can manipulate it in any way. The concern that one hears from a lot of people about that approach is that it can induce a kind of death spiral in the firm, whereby people begin trading against--when they see the price go to a certain level, they begin trading against it. So my personal--and this is really personal, this is not the Board--my personal view is that all three of these approaches have significant problems. I personally just have excluded full supervisory discretion as a real option. But I think it is worth pursuing the technical challenges around both the market-based trigger and the capital trigger and that is what we have asked our staffs to do within the Reserve Banks and the Board, to see if there is something here which can be--and this is important--which can be a less expensive form of capital for the banks. I don't want to create anything that costs more than common equity for the banks. That is kind of a feckless undertaking. But if we can figure out a way to have a capital instrument which is there in the exigent circumstances but which costs less than common equity on a normal basis for the firms, I think that is something worth pursuing. I am sorry I was long-winded, but as you can tell, we have actually been analyzing this. Senator Reed. Thank you. It did give me time to think of a question. [Laughter.] Senator Reed. No, just a comment, because I think Senator Corker, as always, has raised a very interesting point, and this is a comment. When push came to shove, all the varieties of capital, risk-based capital, were essentially disregarded, the stress test, the tangible capital, or am I overstating or misstating? " FOMC20061212meeting--6 4,CHAIRMAN BERNANKE.," This is Dino’s last FOMC meeting, however. He has attended fifty-eight meetings, forty-seven of which came since he was appointed the Manager of the Desk and the System Open Market Account. We owe you a great debt of gratitude for your professionalism, for your leadership, and for the very insightful market reports you’ve given us to start off every meeting for about the past six years. So, Dino, thank you very much. [Applause]" CHRG-111hhrg58044--307 Mr. McRaith," Those are real problems that people and families all over the country face every day. The States, I think, are trying to impose some requirement that insurance companies acknowledge that exceptional, extraordinary life event. Ms. Kilroy. Even if it is not an exceptional, extraordinary life event, if somebody has paid their medical debt, do you think it is reasonable to have that disparaging comment removed from their credit score? " FOMC20060328meeting--262 260,MR. WARSH.," Thank you, Mr. Chairman. I, too, support the 25 basis point increase in the federal funds rate and would just like to make a couple of points about the market and market expectations. It does strike me as a particularly inopportune time to miss market expectations. Given the changes in the economy that we have discussed over the last day and a half, particularly a slowdown in housing, potentially some growth in the business side, increased expectations of growth overseas, and, to be candid, the changes here at the Federal Reserve, it strikes me that we should be taking incremental steps both in terms of message changes and in terms of the sorts of statements we have. So this would be, I think, a very successful meeting if everyone yawned at the statement and the market reactions were somewhat boring this afternoon and tomorrow. An issue was raised about whether we’re leading the market or the market is leading us. It strikes me that the markets—and I particularly have in mind traders down on the floor—are looking to us because I think they’re also confused, and so they don’t know where else to look. This is sort of a safe place for them to cast their eyes and sharpen their pencils. I hope, over the course of the May and June meetings, that they, like us, will be seeing other data points that will give them a clearer crystal ball and that they will be looking both to us and to some other data points to inform their thinking. But right now, I think their sense of things is fairly cloudy. So with that, we have a particularly large burden of presumption in figuring out whether we make changes to what was done in January. A final point on markets and the ownership of the statement, Mr. Chairman, which you referenced earlier: The typical trader in these markets doesn’t fully appreciate what we’re voting on and the entirety of this statement, and my own view is that’s a little more than would be ideal to be aired in the public forum. For traders to be reading one paragraph and saying, “Oh, that’s Chairman Bernanke,” and to be reading the other paragraphs and saying, “Well, that’s the consensus of the Committee,” strikes me as inviting into their debate a little too much interpretation beyond the data set. So I think our discussion going forward in terms of who owns what would probably best be carried out in the same close confidence that previous discussions here were. Finally, in keeping with the suggestion that I think President Poole made about our making as few changes as possible to the January statement at present, the only wordsmithing I would offer in alternative B is the first two words of section 3: “as yet.” I’m trying to show as much congruence as possible with the January statement, and so when I see key words like “still” in alternative B, I think that’s roughly equivalent to “nevertheless.” But “as yet” really is borrowed in some ways from alternative C, which suggests to me almost an inevitability. That is, we expect inflation to be coming. “As yet” we don’t see it, but it is almost inevitable. And it strikes me that the “as yet” words are potentially market-moving words and that they will perhaps suggest more vigilance regarding inflation, more concern about inflation expectations than we had only a couple of months ago. So the minor suggestion might be to strike the words “as yet” and continue with alternative B as written before us, and that in either regard I firmly support." FOMC20080724confcall--40 38,MR. HOENIG.," I have a question that is somewhat different from that. When you brought this up, I thought that we were asking to extend this into next year but that the idea was to eventually back away from this. We are setting up this new procedure that suggests to me that it might end up needing to go longer since we are talking quarter-ends and so forth. I am not there, but I know there are other strains. Are the liquidity strains suggesting not only that we want to extend this into next year but also that there is a tightening, a worsening, of conditions that means we need to change the approach here and provide even more assurances to the market, so that we are committed to this? This seems to take us away from rather than toward backing out, and I really am a bit concerned about that. The second question I have on this is about going from 28 days to 84 days on the TAF. We in Kansas City don't have a lot of this going on, but we have some; and we haven't had a lot of concern about the fact that it's 28 days and not a longer maturity. Are things happening in the markets such that we would want to do this to help settle things out, or is it merely an administrative change to ease our burden and perhaps theirs as well? I don't have a lot of problems with 125 percent coverage ratios, but I am interested in why we are looking to change the maturity. So I have those two questions for you. " fcic_final_report_full--207 And if a relatively small number of the underlying loans were to go into fore- closure, the losses would render virtually all of the riskier BBB-rated tranches worth- less. “The whole system worked fine as long as everyone could refinance,” Steve Eisman, the founder of a fund within FrontPoint Partners, told the FCIC. The minute refinancing stopped, “losses would explode. . . . By , about half [the mortgages sold] were no-doc or low-doc. You were at max underwriting weakness at max hous- ing prices. And so the system imploded. Everyone was so levered there was no ability to take any pain.”  On October , , James Grant wrote in his newsletter about the “mysterious alchemical processes” in which “Wall Street transforms BBB-minus-rated mortgages into AAA-rated tranches of mortgage securities” by creating CDOs. He es- timated that even the triple-A tranches of CDOs would experience some losses if na- tional home prices were to fall just  or less within two years; and if prices were to fall , investors of tranches rated AA- or below would be completely wiped out.  In , Eisman and others were already looking for the best way to bet on this disaster by shorting all these shaky mortgage-related securities. Buying credit default swaps was efficient. Eisman realized that he could pick what he considered the most vulnerable tranches of the mortgage-backed bonds and bet millions of dollars against them, relatively cheaply and with considerable leverage. And that’s what he did. By the end of , Eisman had put millions of dollars into short positions on credit default swaps. It was, he was sure, just a matter of time. “Everyone really did believe that things were going to be okay,” Eisman said. “[I] thought they were certifi- able lunatics.”  Michael Burry, another short who became well-known after the crisis hit, was a doctor-turned-investor whose hedge fund, Scion Capital, in Northern California’s Silicon Valley, bet big against mortgage-backed securities—reflecting a change of heart, because he had invested in homebuilder stocks in . But the closer he looked, the more he wondered about the financing that supported this booming mar- ket. Burry decided that some of the newfangled adjustable rate mortgages were “the most toxic mortgages” created. He told the FCIC, “I watched those with interest as they migrated down the credit spectrum to the subprime market. As [home] prices had increased on the back of virtually no accompanying rise in wages and incomes, I came to the judgment that in two years there will be a final judgment on housing when those two-year [adjustable rate mortgages] seek refinancing.”  By the middle of , Burry had bought credit default swaps on billions of dollars of mortgage- backed securities and the bonds of financial companies in the housing market, in- cluding Fannie Mae, Freddie Mac, and AIG. Eisman, Cornwall, Paulson, and Burry were not alone in shorting the housing mar- ket. In fact, on one side of tens of billions of dollars worth of synthetic CDOs were in- vestors taking short positions. The purchasers of credit default swaps illustrate the im- pact of derivatives in introducing new risks and leverage into the system. Although these investors profited spectacularly from the housing crisis, they never made a single subprime loan or bought an actual mortgage. In other words, they were not purchasing insurance against anything they owned. Instead, they merely made side bets on the risks undertaken by others. Paulson told the FCIC that his research indicated that if home prices remained flat, losses would wipe out the BBB-rated tranches; meanwhile, at the time he could purchase default swap protection on them very cheaply.  On the other side of the zero-sum game were often the major U.S. financial insti- tutions that would eventually be battered. Burry acknowledged to the FCIC, “There is an argument to be made that you shouldn’t allow what I did.” But the problem, he said, was not the short positions he was taking; it was the risks that others were ac- cepting. “When I did the shorts, the whole time I was putting on the positions . . . there were people on the other side that were just eating them up. I think it’s a catas- trophe and I think it was preventable.”  CHRG-110shrg50420--347 Mr. Mulally," If we needed to access the taxpayer money, then monthly is very understandable and we would comply. On your second question, our current covenants right now with the debt we have, we would be breaking those covenants and we could be put in default. But having said that, there just has to be a way and I would be committed to figuring out that way to get us all together to figure out a way to protect the taxpayer. I understand completely. Senator Casey. On the question of credit, each of you have credit financing entities that we all know about, but my question on that is one of the ways that I think would give taxpayers some assurance here that the dollars would get to where they are supposed to get to and rectify some of the problems is that we focus on getting direct help on financing. Would it be helpful to you to have direct infusions of capital into your credit entities so that you have, and I would assume that this would be helpful, that you would have, unlike the banks, who have been sitting on a lot of our taxpayer money--without a lot of questions asked, by the way--you would be infusing an entity with dollars where you would have lending that would happen almost immediately because of the inability for most people to walk in and buy a car without access to credit. I would just ask each of the three of you to tell me briefly. " CHRG-111shrg54589--146 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED FROM KENNETH C. GRIFFINQ.1. Are there differences between the SEC and CFTC's approaches for regulating their respective markets and institutions that we should take into consideration when thinking about the regulation of the OTC derivatives markets?A.1. It is critical that there be clarity as to the rules that apply to a given market sector. No confusion should exist as to applicable rules or conflicts in overlapping rules. In view of these principles, we would ask that Congress, in enacting any OTC derivative legislation, ensure clean lines of regulatory jurisdiction and consistency of rules. It is important that the legislation eliminate and not create any new instances of regulatory arbitrage. Capital and margin requirements, for example, must be consistent across regulatory regimes. As we consider the optimum design of a central clearing structure from the perspective of the buy-side--asset managers, corporations, pension funds, hedge funds, and all other end users--one of the most critical components must be robust account segregation. Buy-side accounts represent a substantial portion of any derivative's systemic exposure. With proper account segregation for cleared products, the buy-side's positions and margins are protected from the bankruptcy of a defaulting clearing member and transferred to other clearing members, securing the orderly functioning of the markets. The buy-side has confidence in the time-tested CFTC account segregation rules, which were amply proven in the case of the rapid workout, without market disruption, of Lehman's CFTC-regulated futures positions. This was in stark contrast to the losses suffered by end users who faced Lehman in bilateral, noncleared positions that were (and remain) trapped in Lehman's bankruptcy.Q.2. The Administration's proposal would require, among other things, clearing of all standardized derivatives through regulated central counterparties (CCPs). What is the best process or approach for defining standardized products? How much regulatory interpretation will be necessary?A.2. Market forces have already created largely standardized derivatives across the credit and interest rate derivative markets, two of the largest OTC markets. In analyzing other derivative markets, legislators and regulators should consider the level of standardization to which such markets have evolved and the frequency of price discovery (i.e., trading or the placing of bids and offers) to ascertain the ability of a CCP to clear transactions. Legislators and regulators must not succumb to the rhetoric of certain incumbent market participants that wish to delay the movement to CCPs and exchange trading by arguing the market is not standardized and by establishing excessively narrow criteria for eligibility for clearing. To help define and pressure test the criteria, regulators and legislators should seek input from a broad range of market participants, which include industry associations (e.g., ISDA, MFA, and SIFMA), CCPs, and, most importantly, large and small sell-side and buy-side market participants who are the ultimate holders of the majority of the market's risk. Regardless of the final definition of what contracts should be centrally cleared, legislators and regulators must also incentivize market participants to use CCPs through higher, risk-based capital and collateral requirements for noncleared derivative trades.Q.3. Are there key areas of disagreement between market participants about how central counterparties should operate? For example, what are the different levels of access these central counterparties grant to different market participants? What are the benefits and drawbacks of different ways of structuring these central counterparties?A.3. Well-functioning markets are efficient, open, and transparent. Well-functioning standardized derivatives markets also utilize a CCP to significantly reduce counterparty risk exposure, increase liquidity, protect customer collateral, and facilitate multilateral netting and monitoring of positions. All CCPs, however, do not deliver the same benefits to the market. Key attributes of robust CCPs include: A well-tested risk management framework that includes daily mark-to-market calculations, a robust initial margin methodology, active monitoring of clearing member and customer positions, and a large guaranty fund to backstop clearing member defaults; A highly developed legal and regulatory framework for protecting customer margins and positions in the case of a clearing member default; Straight-through processing of trades into clearing immediately after execution; Ability of participants to trade with other participants so long as each participant is a clearing member or a customer of a clearing member; and Open access for all market participants to clearing membership with time-tested and risk-based standards.Q.4. One key topic touched on at the hearing is the extent to which standardized products should be required to be traded on exchanges. What is your understanding of any areas of disagreement about how rigorous new requirements should be in terms of mandating, versus just encouraging, exchange trading of standardized OTC derivatives?A.4. Exchanges are an important step in the evolution of the CDS market. Moving from the current bilateral market to a CCP will dramatically reduce systemic risk and increase the stability of the financial markets. The enhanced liquidity and standardization brought about by clearing would then likely facilitate an exchange-trading mechanism, similar to what was seen in other markets such as energy. If it does not, however, then regulators should intervene to remove any artificial barriers to such market evolution.Q.5. Can you share your views on the benefits of customized OTC derivatives products? About how much of the market is truly customized products?A.5. For CDS, customized OTC products represent approximately 5-10 percent of the notional value currently traded. Other OTC derivatives such as interest rate and foreign exchange swaps are also predominately standardized. In the case of interest rate swaps, for example, customized products (i.e., products that might at this stage be more challenging to clear centrally) likely represent no more than 25 percent of the notional value currently traded. Customized OTC derivative products are most important to end users who are trying to manage multiple risks with one derivative contract. An energy utility for example, may want to enter into a swap contract to purchase power at a fixed price which is determined based upon the average temperature for a given day. Esoteric derivatives such as this meet a real need in the marketplace, but only account for a de minimus portion of total activity. To reflect the higher systemic, operational risk and counterparty risks of the noncleared CDS, higher capital and or collateral burdens should be placed on such products. As noted in the answers to Senator Bunning's questions #6 and #16, there are significant benefits of migrating to the use of standardized contracts and CCPs, such as lower total costs of trading and deeper, more liquid markets.Q.6. The Administration's proposal would subject the OTC derivatives dealers and all other firms whose activities in those markets create large exposures to counterparties to a ``robust and appropriate regime of prudential supervision and regulation,'' including capital requirements, business conduct standards, and reporting requirements. What legislative changes would be required to create margining and capital requirements for OTC derivative market participants? Who should enforce these requirements for various market participants? What are the key factors that should be considered in setting these requirements?A.6. It is critical to distinguish dealer from nondealer participants. A proposal that imposes substantial reporting and regulatory burdens on nondealer participants as if they were dealers, while well intended, will force many investors to cease participating in the derivatives markets. The unintended consequences that must be recognized are that markets will become less efficient, the cost of capital will increase and investors will be harmed. Today's market structure, where incumbent OTC derivatives dealers act as unregulated central counterparties, and extract significant economic rents from their privileged position, creates the systemic risk that must be addressed. The introduction of a CCP would address most of the public policy goals, with almost no burden on investors and on the OTC derivatives dealers (other than the loss of oligopolistic profits). The factors to be addressed in legislation relating to appropriate margining and capital are these: 1. For noncleared trades, in light of the fact that nondealer participants generally post margin, there is no benefit, and significant harm, in imposing separate capital burdens on nondealer participants. This would effectively penalize the victims of the current crisis, imposing reporting and financing burdens that will hinder the beneficial flow of investor capital to the capital markets and raise the cost of hedging. Dealers, on the other hand, do not post margin for noncleared derivatives. As such, systemic risk would be significantly reduced by requiring dealers to hold sufficient capital against their noncleared derivative positions. 2. The key is central clearing, because a CCP independently margins and risk manages the positions, requires margin from all participants, and safeguards that margin. The margin levels are set under strict regulatory supervision, and are driven by the need to protect the CCP from default, for the neutral benefit of both the CCP and the financial system as a whole. Legislation must therefore establish appropriate incentives and requirements for participants to clear as much of the derivatives market as possible. 3. As noted, the market practice for noncleared trades is that dealers, who are on one side of every trade, do not post margin. Legislation should ensure that for noncleared trades, dealers set aside sufficient capital to cover the systemic risk generated by such trades, and to protect the dealers' customers from dealer default. The regulators that currently supervise the dealers should establish appropriate capital levels, and should coordinate amongst themselves to prevent regulatory arbitrage or gaps. 4. As also noted, the buy-side participant in every noncleared trade, unlike the dealer, generally posts margin. Today that margin is taken onto the dealer's balance sheet and is subject to dealer insolvency. Legislation should facilitate the protection of such margin through third party trust arrangements remote from dealer insolvency. For customer margin held in the trust arrangement, it may be appropriate for dealers to receive capital off-set to reflect the reduction of counterparty risk.Q.7. One concern that some market participants have expressed is that mandatory margining requirements will drain capital from firms at a time when capital is already highly constrained. Is there a risk that mandatory margining will result in companies choosing not to hedge as much and therefore have the unintended consequence of increasing risk? How can you craft margin requirements to avoid this?A.7. AIG has shown us that it is unacceptable for us to continue a bilateral system that allows certain participants not to margin when they should, or to concentrate risk without adequate collateralization in a way that can damage a wide range of interconnected parties. There must be fair, neutral margin required of all participants to avoid a repetition of the crises and losses that required government intervention in the past year. Margin is the simple price that must be paid for us to have a functioning central counterparty. A well-disciplined, well-supervised CCP structure is by far the most efficient risk management system from a margining perspective, meaning it will come closest to requiring the lowest reasonable amount of capital that will achieve the most risk management protection and will do this fairly across all market participants. This is because a well supervised CCP has as its first mandate the need to protect its default fund, so it will build an extensive risk management capability to ensure that it requires adequate margin. At the same time, that CCP is incentivized to keep the level of such margin at the most reasonable level required to achieve the appropriate protection, so that market participants will clear volume through the CCP. A CCP that has a neutral, standardized methodology will assess the same margin from all its clearing members, which it also continuously, rigorously assesses for credit strength. Those clearing members may in turn assess a higher margin requirement on the individual clearing customers they represent, based on their individualized credit assessment of those firms. Again clearing members have proper, balanced incentives. On the one hand, because they guarantee the obligations of their customers to the clearinghouse, they want to ensure they are adequately collateralized against the risk of any customer default. At the same time they are competing for customer business, so will want to calibrate that margin to be sufficiently economic to retain customers. End users clearly benefit from these structures--unlike in the current bilateral environment, the underlying margin system is transparent, so end users can determine in advance the base margin to be assessed by the clearinghouse (and of course these end users will now no longer be exposed to the credit risk of their counterparties, thanks to the CCP). At the same time, competition amongst clearing members, and the standardization of the cleared product that greatly increases end-users' flexibility in selection of clearing member, will benefit end users in keeping margin and fee levels competitive. The argument that requiring margin will cause parties not to hedge is not valid. The cost of hedging for end users will not be raised by central clearing, but meaningfully reduced--the increased transparency that will come with central clearing will reduce bid-offer spreads, which go to the real economic cost of hedging. The net capital costs associated with posting initial margin are largely inconsequential, if not completely offset by the multilateral netting benefits of a CCP. No market participants should be exempt from posting adequate margin or, in the case of dealers, sufficient capital.Q.8. Is there a risk that regulating the OTC derivatives markets will dramatically alter the landscape of market participants or otherwise have unintended consequences we aren't aware of?A.8. We see limited risk of detrimental unintended consequences or a destructive alteration of the market landscape with prudent regulation, particularly given the benefits that will result. To the contrary, we see a grave risk in delay. The conditions that gave rise to the interconnected losses generated by the Lehman collapse are still present, and granted the financial motivations of the incumbent CDS dealers, will not be corrected without intervention immediately to require clearing of standardized products. As noted in our other responses, prudent regulation can still allow for customized contracts and innovation. Customized contracts represent a small fraction of the market. It cannot be disputed that the parties that create increased systemic risk through the use of customized, noncleared contracts should be responsible for setting aside greater margin and capital to ensure adequate systemic protection against those risks. And even with such realigned reserves and incentives, we believe the evidence is overwhelming that any incremental cost will not substantially alter the market, except in the beneficial way of motivating more trading to standardized products and CCPs. ------ CHRG-111hhrg55814--393 The Chairman," You do us no service when you tell us the problem-- Ms. D'Arista. Leverage will help, and if you were to extend the idea of the National Bank Act to limit lending to financial institutions, that would be very helpful. " CHRG-111hhrg56241--202 Mr. Stiglitz," Yes. We were talking about that at the beginning of the hearing, that money that goes out in bonuses is money that is not available in, you might say, the net worth of the bank and therefore not available as the basis of the leverage that the bank can lend out. " FOMC20080625meeting--22 20,MR. STERN.," Yes. Bill, on chart 6, just a quick question on the leverage ratio: Do we know how good those data are? I mean, to the best of our knowledge, is that reliable stuff? " CHRG-109shrg24852--31 Chairman Greenspan," They hold them wholly because there is a perception they are guaranteed by the full faith and credit of the U.S. Government, despite the fact that the debentures which they buy literally say, as required by law, that this instrument is not backed by the full faith and credit. The problem basically is if you ask anybody on Wall Street, they do not care about the status of the GSE's, the financial state. It goes up and it goes down. The stock prices of these companies move all over the place, but the yield spread against U.S. Treasuries locks, and the reason is that they do not envisage their holdings of GSE's to have anything to do with the GSE's. Senator Reed. Are there some investors that buy the debt and equity of companies you regulate because they feel that you could never let them go out of business, the ``too big to fail'' phenomenon? " CHRG-110hhrg46595--226 The Chairman," I appreciate that. So you have made a significant offer here that puts off the need for that. The relevance of it is--and I do want to think about how we can be constructive--that gives us more time to fashion a consensus on a national health care plan, so that if, in fact, we were able to do that, to the extent that we have a broader plan, that deferral could then become forgiveness altogether. And I think that is very important. It shows the linkage. First of all, one of the burdens you have been under is the requirement to do health care. I always find the best comparison to be between the costs in Michigan and the costs in Ontario, because people can't blame unions. Your sister union in Canada is a pretty strong one. You can't blame environmental rules. The cost difference between Canada and the United States has to be entirely on health care. Mr. Gettelfinger, you wanted to say something else? " CHRG-110shrg50420--84 Mr. Dodaro," Absolutely. Absolutely, Senator. I think that makes all the difference. If you look at the title of our report, our title says ``Additional Actions Needed to Better Ensure Integrity, Accountability, and Transparency,'' and the conditionality is the underpinnings of that. Senator Menendez. Now, I have heard, of course, in your original testimony and some of your answers that, of course, being first in line. I think I have read some accounts, and we will hear their testimony when they come forward, but that the Federal Government needs to be paid back first and all other outstanding debt would be paid after the taxpayers get their money back. Some of the Big Three have expressed skepticism at achieving this. That was accomplished in the 1979 rescue, was it not? " CHRG-111hhrg58044--12 Mr. Manzullo," Thank you, Mr. Chairman. There is a distinction between people who incur medical debt and those who go out and charge vacations and consumer items. I practiced law for 22 years and have been through probably 1,000 bankruptcies. In several of those cases, the people I put into bankruptcy either exhausted their insurance or had no insurance and they filed bankruptcy not because they wanted to, not because they did anything intentionally, but simply because they could not pay off their medical bills. I talked to two colleagues of mine in Rockford, Illinois, who specialize in bankruptcy. The two of them have been through 30,000 bankruptcies together. One had the record for credit card debt, $140,000. Mr. Chairman, it was all medical expenses. We have to draw a distinction here between people who because of their spendthrift outrageous uncreditworthy conduct go out and buy things just because they want them, and people who are caught up, especially today, without insurance or lack of insurance or many times very high deductibles, co-pays, etc. I am a sponsor of this bill because it is the right thing to do, especially with so many credit card companies, the case that my wife and I had on a simple $150 coat that was put on layaway, it took us 4 years to clear that. It was not until I threatened a lawsuit under the Fair Credit Reporting Act that the credit companies finally backed off on it. Credit card reporting companies do a job and I understand what they are doing, but for people who are the unfortunate victims-- " CHRG-109shrg30354--8 STATEMENT OF SENATOR JACK REED Senator Reed. Thank you very much, Mr. Chairman. I would make three points. Gross domestic product has spiked up in the first quarter but there is evidence that the economy is slowing even before most Americans have benefited from the growth we have seen thus far in the recovery. As my colleagues have pointed out, strong productivity growth has shown up in the bottom lines of shareholders but not in the paychecks of workers. We are also facing soaring energy prices, record budget and trade deficits, and a negative household saving rate. All of these pose tremendous challenges to setting monetary policy which the Chairman and his colleagues are charged to do. We also have a situation where we no longer maintain the fiscal discipline that we had in the 1990's which allowed for monetary policy that encouraged investment and long-term growth. We have, I think, squandered that fiscal discipline and that complicates your job also, Mr. Chairman. I would also associate myself with the comments that Senator Sarbanes made with respect to the growing inequality of income, earnings, and wealth in this economy. It is particularly troublesome because as we pursue some of these tax policies which further increase the deficit and further erode the ability to provide basic support to middle-income Americans, like Pell grants and other programs, the difficulty of workers in this country to support their families is infinitely complicated and I think that is something that the Fed has to be concerned about, even if it does not have direct policy leverage to use. So, Mr. Chairman, I look forward to Chairman Bernanke's testimony. I thank him for his service. " CHRG-110shrg50416--37 Mr. Kashkari," Chairman, we share your view. It is a very important point. We want our financial institutions lending in our communities. It is essential. And so if you look at some of the details--terms around the preferred stock purchase agreement, there are specific contractual provisions on how they can and cannot use the capital. As an example, we are preventing increases in dividends because we do not think it is appropriate to take Government capital, the taxpayers' money, and then increase dividends. That does not increase capital in the financial system, so that is prohibited. Second, share repurchases are also prohibited. We do not want to put Government capital in and then boost the stock price by buying back a bunch of shares. That is contractually prohibited. In addition, we have got other language in there focusing on commitments around increasing lending, working hard to help homeowners. Some of them are contractual provisions. Others are more guidance in nature. But we share your view 100 percent. We want these institutions in our communities lending. " CHRG-111hhrg48875--2 The Chairman," The Committee on Financial Services will now convene for the purpose of the hearing with Secretary Geithner. I have an announcement to make regarding the order on the Democratic side when Mr. Geithner and Mr. Bernanke were here the day before yesterday; and, I apologize for not having Mr. Geithner here on Wednesday, but sometimes we have to do other things. The following Members on the Democratic side were here at a time when he and Mr. Bernanke had to leave, and I said at the time that they would get priority in questioning. After myself and the chairman of the subcommittee, we would go to the following Democrats: Let me just read them in the normal, seniority order: Mr. Ellison; Mr. Scott; Mr. Green; Ms. Kilroy; Mr. Donnelly; Mr. Klein; and Mr. Grayson. They will be the first ones to ask questions. . We will now proceed to the opening statements using the rules for hearings with a Cabinet member. The rules are 5 minutes for the chair and the ranking member; 3 minutes for the chair and ranking members of the subcommittee, and I apologize for the disruption of the transition. We will now begin. I think the announcements are over. We have before us the job of dealing with whether or not there is existing in the Federal Government today sufficient authority to deal with systemic risk. There are several aspects to that. We talked considerably about one of them on Tuesday with the Chairman of the Federal Reserve and the Secretary of the Treasury; namely, the need to have somewhere in the Federal Government the ability to use the bankruptcy authority given by the U.S. Constitution to wind down an important, non-bank, financial institution. We have long had in our laws an adaptation to bankruptcy to wind down banks; and, when banks have failed, while it has been sometimes painful, it has not been as disruptive as when the non-bank financial institutions have failed. The two glaring examples are Lehman Brothers, where nothing was done, and AIG, where everything was done. I believe we are looking for an alternative method to avoid those two polar extremes. That is, a bankruptcy authority which can honor some and not honor others. It has some discretion. The question of compensation is part of that, as is the question of whether or not people should continue to be allowed to securitize 100 percent of loans. Today--although obviously members are free to bring up whatever they wish--our focus will be on whether we need to increase the authority of some entity or entities in the Federal Government to restrict excessive leverage. We are talking in the resolving authority about what happens when there is a failure on the part of an institution that is so heavily indebted to so many parties that simply allowing it to fail without intervention could cause magnifying, negative effects. But, obviously, the preferential situation would be to keep that from happening, and this subsumes a lot of other issues, whether or not people are too-big-to-fail, or too-interconnected-to-fail. The goal should be--and obviously no system is going to prevent all failures, because it would then be too restrictive--to minimize the likelihood that entities will get so heavily indebted, so heavily leveraged with inadequate resources in case there is a need to make the payments, that their lack of success threatens the whole system. I believe that we are in a third phase here of a set of phenomena we have seen in American economic history. It is a phenomenon in which the private sector innovates. Innovations which have no real value die of their own weight, but innovations that add value thrive as they should, because we are dependent on the dynamism of the private sector to increase our wealth. But, by definition, when this comes from significant innovation, there aren't rules that contained abuses. The goal of public policy is to come up with rules that set a fair playing field that constrains abuses, and that protects legitimate and responsible entities from irresponsible competition, that can draw them away from good practices, while having as little effect as possible on diminishing the value. Thus, in the late 19th Century, the trusts were created, and they were very important. We would not have industrialized without those large enterprises such as oil, coal, and steel, and a number of other areas. But because they were new, the operated without restraint, so Theodore Roosevelt and Woodrow Wilson were more help, I think, than they get credit for from William Howard Taft. Set rules, the Antitrust Act, the Federal Trade Commission, the creation of the Federal Reserve, those were rules that tried to preserve the large industrial enterprises. Indeed, they were people who tried to get Woodrow Wilson to break them up. And he said, ``No.'' They gave a valuator that we need, but we need rules. That led to a great increase in the importance of the stock market, because you now had enterprises that could not be financed individually. And the job of Franklin Roosevelt and his colleagues during the 1930's was to set rules that allowed us to get the benefit of the finance capitalism, the stock market, but curtailed some of the abuses. I believe that securitization and the great increase in the ability to send money around the world that comes from both the pools of liquidity and the technology, CDOs and credit default swaps, these are a set of innovations on a par with the earlier set, and they have had great value. Securitization, which allows money to be relent and relent and relent without it all having to be repaid, greatly magnifies the value of money; but, there are problems, as there were with the trusts or with the stock market when there are no rules. Our job is to craft rules as did Theodore Roosevelt, Woodrow Wilson and Franklin Roosevelt that allow the society to get the benefit of these wonderful, value-added financial innovations while curtailing some of the abuses. The gentleman from Alabama. " CHRG-111shrg53176--76 Mr. Atkins," Definitely, and I tried to ring the gong down through the years. I think one thing is that the SEC probably became a little bit too focused on the equity markets and, to a lesser extent, the options markets, and did not pay enough attention to the debt side, including as Chairman Levitt was just talking about, munis. And the real question is do the equity markets still function as the primary price discovery mechanism because a lot of that has shifted to the debt side. So I think there needs to be new types of skill sets at the SEC. Second was maybe not speaking out more loudly and often about some of the backoffice and documentation issues for CDOs and the CDSs down through the years. Then, finally, with respect to the enforcement program at the SEC, I think what has happened over the years is that the senior staff has tendeding to chase headlines rather than to look at real cases that hurt real investors, Ponzi schemes and stock manipulations, really disparaging them as ``slip and fall''--or unimportant--cases. Senator Shelby. Mr. Breeden, you know, as well as everybody does, the Federal Reserve is not only the central bank but it is the regulator of our holding companies, our largest banks. I believe myself that they have utterly failed as a regulator, utterly, because most of our Wall Street banks that got in trouble, and some of them are in trouble today, still, were regulated by the Federal Reserve. So that causes me great heartburn when we start talking about the Federal Reserve as the systemic risk regulator, you know, the all powerful thing. Explain your concerns about having the Fed serve in the role as a systemic regulator. " CHRG-109shrg30354--108 Chairman Bernanke," Yes, I would. Senator Sarbanes. Now let me ask you this question. In view of the energy situation, the fact that household savings rate is now down at minus 1.7 percent, which is I think unprecedented certainly over a very long period of time. This chart I showed about new single-family housing home permits, which is way down, almost 25 percent since a year ago. And what we are hearing from the people in the housing field is that there is a real slow down. The inequality in income which we referred to earlier, which I think erodes purchasing power on behalf of the people not at just the lower end but the median portion of the income scale. The people that are getting these benefits, their consumption is not going to go up significantly because they are getting these benefits. But the people who are falling behind, it is going to impact consumer purchasing. This raise in interest rates, of course, carries with it making much more expensive servicing the national debt. We have run up the debt, the interest rates are going up. Now we have to have a bigger item in the budget to handle the interest charges. When you put all of this together, how worried are you about the possibility that we could have a substantial economic downturn? " CHRG-111hhrg58044--131 Mr. Wilson," I would agree with the gentleman. Mr. Moore of Kansas. Mr. McRaith, in your experience as a State regulator, how accurate are these credit scores? Do they get abused in how are they used by insurance firms? Do credit scores assign reasonable value if one is comparing medical debt to excessive spending habits, and do insurance firms focus more on credit scores or the inputs that provide the credit scores? What is your view? " CHRG-111hhrg48868--642 Mr. Liddy," It is profitable. Pieces of it are stable. If you sell variable annuities or fixed annuities right now, nobody in the industry is selling those. Industry sales are down maybe 40 to 50 percent on balance. So we are down the same as the industry is. But the persistency has more or less stabilized since September. That business is profitable. That's part of what we want to either take public or give to the Federal Reserve to satisfy our debt. " CHRG-110shrg50420--472 PREPARED STATEMENT OF ALAN R. MULALLY President and Chief Executive Officer, Ford Motor Company December 4, 2008 Mr. Chairman, Senator Shelby, and Members of the Committee. Thank you for the opportunity to share Ford's plan. We appreciate the valid concerns raised by Congress about the future viability of the industry. We hope that our submission and today's testimony will help instill confidence in Ford's commitment to change, including our accountability and shared sacrifice during this difficult economic period. On Tuesday, Ford Motor Company submitted to your Committee our comprehensive business plan, which details the company's path to profitability through an acceleration of our aggressive restructuring actions and the introduction of more high-quality, safe and fuel-efficient vehicles-including a broader range of hybrid-electric vehicles and the introduction of advanced plug-in hybrids and full electric vehicles. In addition to our plan, we are also here today to request support for the industry. In the near-term, Ford does not require access to a government bridge loan. However, we request a credit line of $9 billion as a critical backstop or safeguard against worsening conditions as we drive transformational change in our company. One Plan: Beginning earlier this decade, we recognized the challenges the domestic auto industry faced and began implementing a disciplined global business plan to completely transform Ford, to improve our efficiency, cut costs and champion innovation. Our plan builds on the success we have seen in the past 2 years by accelerating the development of our new products that customers want and value. Our plan is anchored by four key priorities: Aggressively restructure to operate profitably at the current demand and changing model mix; Accelerate development of new products our customers want and value; Finance our plan and improve our balance sheet; and Work together effectively as one team, leveraging our global assets. One Goal: Our team and plan is dedicated and focused on delivering profitable growth for all. While market, economic and business conditions recently have deteriorated worldwide at a rate never before seen, we have made substantial progress since we launched our plan in late 2006: We obtained financing by going to the markets in December 2006 to raise $23.5 billion in liquidity, consisting of $18.5 billion of senior secured debt and credit facilities, substantially secured by all of our domestic assets, and $5 billion of unsecured convertible debt. We have implemented our strategy to simplify our brand structure. As a result, we sold Aston Martin, Jaguar, Land Rover and the majority of our ownership of Mazda, and we're considering our options for Volvo. We have divested other non- core assets. These sales have also helped our overall liquidity and generated $3.7 billion in additional capital to re-invest in the business. To achieve maximum efficiency, we will have reduced our North American operating costs by more than $5 billion between year end 2005 and 2008. We have taken painful downsizing actions to match capacity and market share in North America, including closing 17 plants and downsizing by 12,000 salaried employees and 44,000 hourly employees. Ford is committed to building a sustainable future for the benefit of all Americans, and we believe Ford is on the right path to achieve this vision. I know the Members of the Committee have had an opportunity to review our plans over the last 2 days, so I will highlight new details about Ford's future plans and forecasts: Ford's plan calls for an investment of approximately $14 billion in the U.S. on advanced technologies and products to improve fuel efficiency during the next 7 years. Based on current business planning assumptions--including U.S. industry sales for 2009, 2010, and 2011 of 12.5 million units, 14.5 million units and 15.5 million units, respectively--Ford expects both our overall and our North American automotive business pre-tax results to be break even or profitable in 2011. As part of a continuing focus on building the Ford brand, we are exploring strategic options for Volvo Car Corporation, including the possible sale of the Sweden-based premium automaker. The strategic review is in line with a broad range of actions we are taking to focus on the Ford brand and ensure we have the resources to fund our plan. Since 2007, Ford has sold Aston Martin, Jaguar, Land Rover, and the majority of its stake in Mazda. Half of the Ford, Lincoln, and Mercury light-duty nameplates by 2010 will qualify as ``Advanced Technology Vehicles'' under the U.S. Energy Independence and Security Act--increasing to 75 percent in 2011 and more than 90 percent in 2014. We have included these projects in our application to the Department of Energy for loans under that Act and we hope to receive $5 billion in direct loans by 2011 to support Ford's investment in advanced technologies and products. From our largest light duty trucks to our smallest cars, Ford will improve the fuel economy of our fleet an average of 14 percent for 2009 models, 26 percent for 2012 models and 36 percent for 2015 models--compared with the fuel economy of its 2005 fleet. Overall, we expect to achieve cumulative gasoline fuel savings from advanced technology vehicles of 16 billion gallons from 2005 to 2015. Next month at the North American International Auto Show in Detroit, we will discuss in detail Ford's accelerated vehicle electrification plan, which includes bringing a family of hybrids, plug-in hybrids and battery electric vehicles to market by 2012. The work will include partnering with battery and powertrain systems suppliers to deliver a full battery electric vehicle (BEV) in a van-type vehicle for commercial fleet use in 2010 and a BEV sedan in 2011. We will develop these vehicles in a manner that enables it to reduce costs and ultimately make BEVs more affordable for consumers. The 2007 UAW-Ford labor agreement resulted in significant progress being made in reducing the company's total labor cost. Given the present economic crisis and its impact upon the automotive industry, however, we are presently engaged in discussions with the UAW with the objective to further reduce our cost structure and eliminate the remaining labor cost gap that exists between Ford and the transplants. As previously announced, Ford plans two additional plant closures this quarter and four additional plant closures between 2009 and 2011. We have announced our intent to close or sell what will be four remaining ACH plants. And we will continue to aggressively match manufacturing capacity to real demand. Ford will continue to work to reduce its dealer and supplier base to increase efficiency and promote mutual profitability. By year end, we estimate we will have 3,790 U.S. dealers, a reduction of 606 dealers overall--or 14 percent from year-end 2005--including a reduction of 16 percent in large markets. In addition, Ford has been able to reduce the number of production suppliers eligible for major sourcing from 3,400 in 2004 to approximately 1,600 today, a reduction of 53 percent. We eventually plan to further reduce the number of suppliers eligible for major sourcing to 750. After reducing our workforce by 50 percent in just three years, we are also canceling all bonuses and merit increases for North America salaried employees--including top management--in 2009. And should Ford need to access funds from a potential government bridge loan, I will work for a salary of $1 a year--as a sign of my confidence in the company's transformation plan and future. We are moving ahead with plans we announced this summer to leverage the company's global product strengths and bring more small, fuel-efficient vehicles to the U.S. The plan includes delivering best-in-class or among the best fuel economy with every new vehicle introduced. We are also introducing industry- leading, fuel-saving EcoBoost engines and doubling the number and volume of hybrid vehicles. This product acceleration will result in a balanced product portfolio with a complete family of small, medium and large cars, utilities and trucks. And we are increasing our investment in cars and crossovers from approximately 60 percent in 2007 to 80 percent of our total product investment in 2010. Our plan is working, but there is clearly more to do--something that is increasingly difficult in this tough economic climate. That is why we are seeking access to a $9 billion bridge loan, even though we hope to complete our transformation without accessing any of these funds. Despite the serious global economic downturn, Ford does not anticipate a liquidity crisis in 2009--barring a bankruptcy by one of our domestic competitors or a more severe economic downturn that would further cripple automotive sales and create additional cash challenges. In particular, the collapse of one or both of our domestic competitors would threaten Ford because we have 80 percent overlap in supplier networks and nearly 25 percent of Ford's top dealers also own GM and Chrysler franchises. The impact of a bankruptcy also reaches beyond Ford and the U.S. auto industry. It would cause further stress to our domestic banking industry and private retirement systems. Goldman Sachs estimates the impact at up to $1 trillion. We also believe effective restructuring involves a broader dialogue with all our stakeholders. President-elect Obama has indicated an interest in such a discussion. There are a number of complicated questions that will need to be considered, for example: How do we create a dealer body that meets market demand and is profitable for all? How do we develop a healthy and viable supplier base? How do we work with the UAW to ensure that our cost structure is competitive with the foreign transplants? How do we address the significant debt obligation of the domestic industry? We are prepared to work together with this Committee and all of the parties to address these critical issues as part of our plan. Ford has a comprehensive transformation plan that will ensure our future viability--as evidenced by our profitability in the first quarter of 2008. While we clearly still have much more to do, I am more convinced than ever that we have the right plan that will create a viable Ford going forward and position us for profitable growth. Thank you. ______ CHRG-111shrg54533--31 Secretary Geithner," Excellent questions, and we have not claimed to get the details perfectly right on this, and it is going to require a substantial amount of additional effort and care to get the balance right. Let me start with resolution authority first. Again, we are proposing a model that takes the structure that works well, we have had lots of experience with, and simply adapt it to the somewhat more complicated challenge of large institutions built around banks but are not only banks in some sense. As our funding mechanism, we are proposing no ex ante fund, no ex ante fee to fund a fund. What we are proposing is a mechanism whereby in the event the Government were to act under this authority and were to incur a loss as part of that action, then it would be able to recoup that loss--have the obligation to recoup that loss--by assessing a fee over time in the future applied to bank holding companies. That will help make sure that the burden for that is borne by bank holding companies, not by the 8,000 other financial institutions in the United States that are not smaller community banks in that case that were not responsible for that error. The scope of this authority would be limited to bank holding companies and institutions we designate at the Tier 1 financial holding companies. We expect those to be principally, at least as we see the system today, built around institutions that have banks as part of their structure. And we think that is a better model than the alternatives. And we have been careful, again, not to create something that would be unfair on the burden proposed and limit the moral hazard created by the existence of authority like that. Senator Warner. I know my time has expired, but let me just--much more on this, but that would still require, though, the public to step in with taxpayer funds as an effective short-term bridge until you can assess that. And I would--assess that additional fee. I might simply add amongst those Tier 1 financial institutions--and there are clearly questions about designating those Tier 1 financial institutions, which other colleagues have raised, I wonder if there might not be some, in effect, contingent liability that they could hold on their books rather than the public funding this in the interim and then coming back. And if they had that contingent liability on their books that they could keep as their additional equity, that also might help them self-police better amongst their colleagues. " CHRG-111shrg51395--119 Under high competition, lower ratings declined and investment grade rations soared. The authors conclude that increased competition may impair ``the reputational mechanism that underlies the provision of good quality ratings.'' \28\--------------------------------------------------------------------------- \28\ Id. at 21.--------------------------------------------------------------------------- The anecdotal evidence supports a similar conclusion: the major rating agencies responded to the competitive threat from Fitch by making their firms ``more client-friendly and focused on market share.'' \29\ Put simply, the evidence implies that the rapid change toward a more competitive environment made the competitors not more faithful to investors, but more dependent on their immediate clients, the issuers. From the standpoint of investors, agency costs increased.--------------------------------------------------------------------------- \29\ See ``Ratings Game--As Housing Boomed, Moody's Opened Up,'' The Wall Street Journal, April 11, 2008, at p. A-1.---------------------------------------------------------------------------The Responsibility of the SEC Each of the major investment banks that failed, merged, or converted into bank holding companies in 2008 had survived prior recessions, market panics, and repeated turmoil and had long histories extending back as far as the pre-Civil War era. Yet, each either failed or was gravely imperiled within the same basically 6 month period following the collapse of Bear Stearns in March 2008. \30\--------------------------------------------------------------------------- \30\ For a concise overview of these developments, see Jon Hilsenrath, Damian Palette, and Aaron Lucchetti, ``Goldman, Morgan Scrap Wall Street Model, Become Banks in Bid To Ride Out Crisis,'' The Wall Street Journal, September 22, 2008, at p. A-1 (concluding that independent investment banks could not survive under current market conditions and needed closer regulatory supervision to establish credibility).--------------------------------------------------------------------------- If their uniform collapse is not alone enough to suggest the likelihood of regulatory failure, one additional common fact unites them: each of these five firms voluntarily entered into the SEC's Consolidated Supervised Entity (``CSE'') Program, which was established by the SEC in 2004 for only the largest investment banks. \31\ Indeed, these five investment banks were the only investment banks permitted by the SEC to enter the CSE program. A key attraction of the CSE Program was that it permitted its members to escape the SEC's traditional net capital rule, which placed a maximum ceiling on their debt to equity ratios, and instead elect into a more relaxed ``alternative net capital rule'' that contained no similar limitation. \32\ The result was predictable: all five of these major investment banks increased their debt-to-equity leverage ratios significantly over the brief two year period following their entry into the CSE Program, as shown by Figure 1 below: \33\--------------------------------------------------------------------------- \31\ See Securities Exchange Act Release No. 34-49830 (June 21, 2004), 69 FR 34428 (``Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities''). \32\ The SEC's ``net capital rule,'' which dates back to 1975, governs the capital adequacy and aggregate indebtedness permitted for most broker-dealers. See Rule 15c3-1 (``Net Capital Requirements for Brokers and Dealers''). 17 C.F.R. 240.15c3-1. Under subparagraph (a)(1)(i) of this rule, aggregate indebtedness is limited to fifteen times the broker-dealer's net capital; a broker-dealer may elect to be governed instead by subparagraph (a)(1)(ii) of this rule, which requires it maintain its net capital at not less than the greater of $250,000 or two percent of ``aggregate debit items'' as computed under a special formula that gives ``haircuts'' (i.e., reduces the valuation) to illiquid securities. Both variants place fixed limits on leverage. \33\ This chart comes from U.S. Securities and Exchange Commission, Office of the Inspector General, ``SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program'' (`Report No. 446-A, September 25, 2008) (hereinafter ``SEC Inspector General Report'') at Appendix IX at p. 120. For example, at the time of its insolvency, Bear Stearns' gross leverage ratio had hit 33 to 1. \34\--------------------------------------------------------------------------- \34\ See SEC Inspector General Report at 19.--------------------------------------------------------------------------- The above chart likely understates the true increase in leverage because gross leverage (i.e., assets divided by equity) does not show the increase in off-balance sheet liabilities, as the result of conduits and liquidity puts. Thus, another measure may better show the sudden increase in risk. One commonly used metric for banks is the bank's value at risk (VaR) estimate, which banks report to the SEC in their annual report on Form 10-K. This measure is intended to show the risk inherent in their financial portfolios. The chart below shows ``Value at Risk'' for the major underwriters over the interval 2004 to 2007: \35\--------------------------------------------------------------------------- \35\ See Ferrell, Bethel, and Hu, supra note 15, at Table 8. Value at risk estimates have proven to be inaccurate predictors of the actual writedowns experienced by banks. They are cited here not because they are accurate estimates of risk, but because the percentage increases at the investment banks was generally extreme. Even Goldman Sachs, which survived the crisis in better shape than its rivals, saw its VaR estimate more than double over this period. Value at Risk, 2004-2007------------------------------------------------------------------------ 2004 2005 2006 2007 Firms ($mil) ($mil) ($mil) ($mil)------------------------------------------------------------------------Bank of America................. $44.1 $41.8 $41.3 -Bear Stearns.................... 14.8 21.4 28.8 $69.3Citigroup....................... 116.0 93.0 106.0 -Credit Suisse................... 55.1 66.2 73.0 -Deutsche Bank................... 89.8 82.7 101.5 -Goldman Sachs................... 67.0 83.0 119.0 134.0JPMorgan........................ 78.0 108.0 104.0 -Lehman Brothers................. 29.6 38.4 54.0 124.0Merrill Lynch................... 34.0 38.0 52.0 -Morgan Stanley.................. 94.0 61.0 89.0 83.0UBS............................. 103.4 124.7 132.8 -Wachovia........................ 21.0 18.0 30.0 -------------------------------------------------------------------------VaR statistics are reported in the 10K or 20F (in the case of foreign firms) of the respective firms. Note that the firms use different assumptions in computing their Value of Risk. Some annual reports are not yet avaialble for 2007. Between 2004 and 2007, both Bear Stearns and Lehman more than quadrupled their value at risk estimates, while Merrill Lynch's figure also increased significantly. Not altogether surprisingly, they were the banks that failed. These facts provide some corroboration for an obvious hypothesis: excessive deregulation by the SEC caused the liquidity crisis that swept the global markets in 2008. \36\ Still, the problem with this simple hypothesis is that it may be too simple. Deregulation did contribute to the 2008 financial crisis, but the SEC's adoption of the CSE Program in 2004 was not intended to be deregulatory. Rather, the program was intended to compensate for earlier deregulatory efforts by Congress that had left the SEC unable to monitor the overall financial position and risk management practices of the nation's largest investment banks. Still, even if the 2004 net capital rule changes were not intended to be deregulatory, they worked out that way in practice. The ironic bottom line is that the SEC unintentionally deregulated by introducing an alternative net capital rule that it could not effectively monitor.--------------------------------------------------------------------------- \36\ For the bluntest statement of this thesis, see Stephen Labaton, ``S.E.C. Concedes Oversight Plans Fueled Collapse,'' New York Times, September 27, 2008, at p. 1. Nonetheless, this analysis is oversimple. Although SEC Chairman Cox did indeed acknowledge that there were flaws in the ``Consolidated Supervised Entity'' Program, he did not concede that it ``fueled'' the collapse or that it represented deregulation. As discussed below, the SEC probably legitimately believed that it was gaining regulatory authority from the CSE Program (but it was wrong).--------------------------------------------------------------------------- The events leading up to the SEC's decision to relax its net capital rule for the largest investment banks began in 2002, when the European Union adopted its Financial Conglomerates Directive. \37\ The main thrust of the E.U.'s new directive was to require regulatory supervision at the parent company level of financial conglomerates that included a regulated financial institution (e.g., a broker-dealer, bank or insurance company). The E.U.'s entirely reasonable fear was that the parent company might take actions that could jeopardize the solvency of the regulated subsidiary. The E.U.'s directive potentially applied to the major U.S. investment and commercial banks because all did substantial business in London (and elsewhere in Europe). But the E.U.'s directive contained an exemption for foreign financial conglomerates that were regulated by their home countries in a way that was deemed ``equivalent'' to that envisioned by the directive. For the major U.S. commercial banks (several of which operated a major broker-dealer as a subsidiary), this afforded them an easy means of avoiding group-wide supervision by regulators in Europe, because they were subject to group-level supervision by U.S. banking regulators.--------------------------------------------------------------------------- \37\ See Council Directive 2002/87, Financial Conglomerates Directive, 2002 O.J. (L 35) of the European Parliament and of the Council of 16 December 2002 on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate and amending Council Directives. For an overview of this directive and its rationale, see Jorge E. Vinuales, The International Regulation of Financial Conglomerates: A Case Study of Equivalence as an Approach to Financial Integration, 37 Cal. W. Int'l L.J. 1, at 2 (2006).--------------------------------------------------------------------------- U.S. investment banks had no similar escape hatch, as the SEC had no similar oversight over their parent companies. Thus, fearful of hostile regulation by some European regulators, \38\ U.S. investment banks lobbied the SEC for a system of ``equivalent'' regulation that would be sufficient to satisfy the terms of the directive and give them immunity from European oversight. \39\ For the SEC, this offered a serendipitous opportunity to oversee the operations of investment bank holding companies, which authority the SEC had sought for some time. Following the repeal of the Glass-Steagall Act, the SEC had asked Congress to empower it to monitor investment bank holding companies, but it had been rebuffed. Thus, the voluntary entry of the holding companies into the Consolidated Supervised Entity program must have struck the SEC as a welcome development, and Commission unanimously approved the program without any partisan disagreement. \40\--------------------------------------------------------------------------- \38\ Different European regulators appear to have been feared by different entities. Some commercial banks saw French regulation as potentially hostile, while U.S. broker-dealers, all largely based in London, did not want their holding companies to be overseen by the U.K.'s Financial Services Agency (FSA). \39\ See Stephen Labaton, ``Agency's '04 Rule Let Banks Pile Up Debt and Risk,'' New York Times, October 3, 2008, at A-1 (describing major investment banks as having made an ``urgent plea'' to the SEC in April, 2004). \40\ See Securities Exchange Act Release No. 34-49830, supra note 31.--------------------------------------------------------------------------- But the CSE Program came with an added (and probably unnecessary) corollary: Firms that entered the CSE Program were permitted to adopt an alternative and more relaxed net capital rule governing their debt to net capital ratio. Under the traditional net capital rule, a broker-dealer was subject to fixed ceilings on its permissible leverage. Specifically, it either had to (a) maintain aggregate indebtedness at a level that could not exceed fifteen times net capital, \41\ or (b) maintain minimum net capital equal to not less than two percent of ``aggregate debit items.'' \42\ For most broker-dealers, this 15 to 1 debt to net capital ratio was the operative limit within which they needed to remain by a comfortable margin.--------------------------------------------------------------------------- \41\ See Rule 15c3-1(a)(1)(i)(``Alternative Indebtedness Standard''), 17 C.F.R. 240.15c3-1(a)(1). \42\ See Rule 15c3-1(a)(1)(ii)(``Alternative Standard''), 17 C.F.R. 240.15c3-1(a)(1)(ii). This alternative standard is framed in terms of the greater of $250,000 or 2 percent, but for any investment bank of any size, 2 percent will be the greater. Although this alternative standard may sound less restrictive, it was implemented by a system of ``haircuts'' that wrote down the value of investment assets to reflect their illiquidity.--------------------------------------------------------------------------- Why did the SEC allow the major investment banks to elect into an alternative regime that placed no outer limit on leverage? Most likely, the Commission was principally motivated by the belief that it was only emulating the more modern ``Basel II'' standards that the Federal Reserve Bank and European regulators were then negotiating. To be sure, the investment banks undoubtedly knew that adoption of Basel II standards would permit them to increase leverage (and they lobbied hard for such a change). But, from the SEC's perspective, the goal was to design the CSE Program to be broadly consistent with the Federal Reserve's oversight of bank holding companies, and the program even incorporated the same capital ratio that the Federal Reserve mandated for bank holding companies. \43\ Still, the Federal Reserve introduced its Basel II criteria more slowly and gradually, beginning more than a year later, while the SEC raced in 2004 to introduce a system under which each investment bank developed its own individualized credit risk model. Today, some believe that Basel II represents a flawed model even for commercial banks, while others believe that, whatever its overall merits, it was particularly ill-suited for investment banks. \44\--------------------------------------------------------------------------- \43\ See SEC Inspector General Report at 10-11. Under these standards, a ``well-capitalized'' bank was expected to maintain a 10 percent capital ratio. Id. at 11. Nonetheless, others have argued that Basel II ``was not designed to be used by investment banks'' and that the SEC ``ought to have been more careful in moving banks on to the new rules.'' See ``Mewling and Puking: Bank Regulation,'' The Economist, October 25, 2008 (U.S. Edition). \44\ For the view that Basel II excessively deferred to commercial banks to design their own credit risk models and their increase leverage, see Daniel K. Tarullo, BANKING ON BASEL: The Future of International Financial Regulation (2008). Mr. Tarullo has recently been nominated by President Obama to the Board of Governors of the Federal Reserve Board. For the alternative view, that Basel II was uniquely unsuited for investment banks, see ``Mewling and Puking,'' supra note 43.--------------------------------------------------------------------------- Yet, what the evidence demonstrates most clearly is that the SEC simply could not implement this model in a fashion that placed any real restraint on its subject CSE firms. The SEC's Inspector General examined the failure of Bear Stearns and the SEC's responsibility therefor and reported that Bear Stearns had remained in compliance with the CSE Program's rules at all relevant times. \45\ Thus, if Bear Stearns had not cheated, this implied (as the Inspector General found) that the CSE Program, itself, had failed. The key question is then what caused the CSE Program to fail. Here, three largely complementary hypotheses are plausible. First, the Basel II Accords may be flawed, either because they rely too heavily on the banks' own self-interested models of risk or on the highly conflicted ratings of the major credit rating agencies. \46\ Second, even if Basel II made sense for commercial banks, it may have been ill-suited for investment banks. \47\ Third, whatever the merits of Basel II in theory, the SEC may have simply been incapable of implementing it.--------------------------------------------------------------------------- \45\ SEC Inspector General Report, 10. \46\ The most prominent proponent of this view is Professor Daniel Tarullo. See supra note 44. \47\ See ``Mewling and Puking,'' supra note 43.--------------------------------------------------------------------------- Clearly, however, the SEC moved faster and farther to defer to self-regulation by means of Basel II than did the Federal Reserve. \48\ Clearly also, the SEC's staff was unable to monitor the participating investment banks closely or to demand specific actions by them. Basel II's approach to the regulation of capital adequacy at financial institutions contemplated close monitoring and supervision. Thus, the Federal Reserve assigns members of its staff to maintain an office within a regulated bank holding company in order to provide constant oversight. In the case of the SEC, a team of only three SEC staffers were assigned to each CSE firm \49\ (and a total of only thirteen individuals comprised the SEC's Office of Prudential Supervision and Risk Analysis that oversaw and conducted this monitoring effort). \50\ From the start, it was a mismatch: three SEC staffers to oversee an investment bank the size of Merrill Lynch, which could easily afford to hire scores of highly quantitative economists and financial analysts, implied that the SEC was simply outgunned. \51\--------------------------------------------------------------------------- \48\ The SEC adopted its CSE program in 2004. The Federal Reserve only agreed in principle to Basel II in late 2005. See Stavros Gadinis, The Politics of Competition in International Financial Regulation, 49 Harv. Int'l L. J. 447, 507 n. 192 (2008). \49\ SEC Inspector General Report at 2. \50\ Id. Similarly, the Office of CSE Inspectors had only seven staff. Id. \51\ Moreover, the process effectively ceased to function well before the 2008 crisis hit. After SEC Chairman Cox re-organized the CSE review process in the Spring of 2007, the staff did not thereafter complete ``a single inspection.'' See Labaton, supra note 39.--------------------------------------------------------------------------- This mismatch was compounded by the inherently individualized criteria upon which Basel II relies. Instead of applying a uniform standard (such as a specific debt to equity ratio) to all financial institutions, Basel II contemplated that each regulated financial institution would develop a computer model that would generate risk estimates for the specific assets held by that institution and that these estimates would determine the level of capital necessary to protect that institution from insolvency. Thus, using the Basel II methodology, the investment bank generates a mathematical model that crunches historical data to evaluate how risky its portfolio assets were and how much capital it needed to maintain to protect them. Necessarily, each model was ad hoc, specifically fitted to that specific financial institution. But no team of three SEC staffers was in a position to contest these individualized models or the historical data used by them. Effectively, the impact of the Basel II methodology was to shift the balance of power in favor of the management of the investment bank and to diminish the negotiating position of the SEC's staff. Whether or not Basel II's criteria were inherently flawed, it was a sophisticated tool that was beyond the capacity of the SEC's largely legal staff to administer effectively. The SEC's Inspector General's Report bears out this critique by describing a variety of instances surrounding the collapse of Bear Stearns in which the SEC's staff did not respond to red flags that the Inspector General, exercising 20/20 hindsight, considered to be obvious. The Report finds that although the SEC's staff was aware that Bear Stearns had a heavy and increasing concentration in mortgage securities, it ``did not make any efforts to limit Bear Stearns mortgage securities concentration.'' \52\ In its recommendations, the Report proposed both that the staff become ``more skeptical of CSE firms' risk models'' and that it ``develop additional stress scenarios that have not already been contemplated as part of the prudential regulation process.'' \53\--------------------------------------------------------------------------- \52\ SEC Inspector General Report at ix. \53\ SEC Inspector General Report at ix.--------------------------------------------------------------------------- Unfortunately, the SEC Inspector General Report does not seem realistic on this score. The SEC's staff cannot really hope to regulate through gentle persuasion. Unlike a prophylactic rule (such as the SEC's traditional net capital rule that placed a uniform ceiling on leverage for all broker-dealers), the identification of ``additional stress scenarios'' by the SEC's staff does not necessarily lead to specific actions by the CSE firms; rather, such attempts at persuasion are more likely to produce an extended dialogue, with the SEC's staff being confronted with counter-models and interpretations by the financial institution's managers. The unfortunate truth is that in an area where financial institutions have intense interests (such as over the question of their maximum permissible leverage), a government agency in the U.S. is unlikely to be able to obtain voluntary compliance. This conclusion is confirmed by a similar assessment from the individual with perhaps the most recent experience in this area. Testifying in September, 2008 testimony before the Senate Banking Committee, SEC Chairman Christopher Cox emphasized the infeasibility of voluntary compliance , expressing his frustration with attempts to negotiate issues such as leverage and risk management practices with the CSE firms. In a remarkable statement for a long-time proponent of deregulation, he testified: Beyond highlighting the inadequacy of the . . . CSE program's capital and liquidity requirements, the last six months--during which the SEC and the Federal Reserve worked collaboratively with each of the CSE firms . . . --have made abundantly clear that voluntary regulation doesn't work. \54\--------------------------------------------------------------------------- \54\ See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing, and Urban Affairs, United States Senate, September 23, 2008 (``Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions''), at p. 4 (available at www.sec.gov) (emphasis added). Chairman Cox has repeated this theme in a subsequent Op/Ed column in the Washington Post, in which he argued that ``Reform legislation should steer clear of voluntary regulation and grant explicit authority where it is needed.'' See Christopher Cox, ``Reinventing A Market Watchdog,'' the Washington Post, November 4, 2008, at A-17. His point was that the SEC had no inherent authority to order a CSE firm to reduce its debt to equity ratio or to keep it in the CSE Program. \55\ If it objected, a potentially endless regulatory negotiation might only begin.--------------------------------------------------------------------------- \55\ Chairman Cox added in the next sentence of his Senate testimony: ``There is simply no provision in the law authorizes the CSE Program, or requires investment bank holding companies to compute capital measures or to maintain liquidity on a consolidated basis, or to submit to SEC requirements regarding leverage.'' Id. This is true, but if a CSE firm left the CSE program, it would presumably become subject to European regulation; thus, the system was not entirely voluntary and the SEC might have used the threat to expel a non-compliant CSE firm. The SEC's statements about the degree of control they had over participants in the CSE Program appear to have been inconsistent over time and possibly defensively self-serving. But clearly, the SEC did not achieve voluntary compliance.--------------------------------------------------------------------------- Ultimately, even if one absolves the SEC of ``selling out'' to the industry in adopting the CSE Program in 2004, it is still clear at a minimum that the SEC lacked both the power and the expertise to restrict leverage by the major investment banks, at least once the regulatory process began with each bank generating its own risk model. Motivated by stock market pressure and the incentives of a short-term oriented executive compensation system, senior management at these institutions affectively converted the process into self-regulation. One last factor also drove the rush to increased leverage and may best explain the apparent willingness of investment banks to relax their due diligence standards: competitive pressure and the need to establish a strong market share in a new and expanding market drove the investment banks to expand recklessly. For the major players in the asset-backed securitization market, the long-term risk was that they might be cut off from their source of supply, if loan originators were acquired by or entered into long-term relationships with their competitors, particularly the commercial banks. Needing an assured source of supply, some investment banks (most notably Lehman and Merrill, Lynch) invested heavily in acquiring loan originators and related real estate companies, thus in effect vertically integrating. \56\ In so doing, they assumed even greater risk by increasing their concentration in real estate and thus their undiversified exposure to a downturn in that market. This need to stay at least even with one's competitors best explains the now famous line uttered by Charles Prince, the then CEO of Citigroup in July, 2007, just as the debt market was beginning to collapse. Asked by the Financial Times if he saw a liquidity crisis looming, he answered:--------------------------------------------------------------------------- \56\ See Terry Pristin, ``Risky Real Estate Deals Helped Doom Lehman,'' N.Y. Times, September 17, 2008, at C-6 (discussing Lehman's expensive, multi-billion dollar acquisition of Archstone-Smith); Gretchen Morgenson, ``How the Thundering Herd Faltered and Fell,'' N.Y. Times, November 9, 2008, at B4-1 (analyzing Merrill Lynch's failure and emphasizing its acquisitions of loan originators). When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing. \57\--------------------------------------------------------------------------- \57\ See Michiyo Nakamoto & David Wighton, ``Citigroup Chief Stays Bullish on Buy-Outs,'' Financial Times, July 9, 2007, available at http://www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html In short, competition among the major investment banks can periodically produce a mad momentum that sometimes leads to a lemmings-like race over the cliff. \58\ This in essence had happened in the period just prior to the 2000 dot.com bubble, and again during the accounting scandals of 2001-2002, and this process repeated itself during the subprime mortgage debacle. Once the market becomes hot, the threat of civil liability--either to the SEC or to private plaintiffs in securities class actions--seems only weakly to constrain this momentum. Rationalizations are always available: ``real estate prices never fall;'' ``the credit rating agencies gave this deal a `Triple A' rating,'' etc. Explosive growth and a decline in professional standards often go hand in hand. Here, after 2000, due diligence standards appear to have been relaxed, even as the threat of civil liability in private securities litigation was growing. \59\--------------------------------------------------------------------------- \58\ Although a commercial bank, Citigroup was no exception this race, impelled by the high fee income it involved. From 2003 to 2005, ``Citigroup more than tripled its issuing of C.D.O.s to more than $30 billion from $6.28 billion.'' See Eric Dash and Julie Creswell, ``Citigroup Pays for a Rush to Risk'' New York Times, November 22, 2008, at 1, 34. In 2005 alone, the New York Times estimates that Citigroup received over $500 million in fee income from these C.D.O. transactions. From being the sixth largest issuer of C.D.O.s in 2003, it rose to being the largest C.D.O. issuer worldwide by 2007, issuing in that year some $49.3 billion out of a worldwide total of $442.3 billion (or slightly over 11 percent of the world volume). Id. at 35. What motivated this extreme risk-taking? Certain of the managers running Citigroup's securitization business received compensation as high as $34 million per year (even though they were not among the most senior officers of the bank). Id. at 34. This is consistent with the earlier diagnosis that equity compensation inclines management to accept higher and arguably excessive risk. At the highest level of Citigroup's management, the New York Times reports that the primary concern was ``that Citigroup was falling behind rivals like Morgan Stanley and Goldman.'' Id. at 34 (discussing Robert Rubin and Charles Prince's concerns). Competitive pressure is, of course, enforced by the stock market and Wall Street's short-term system of bonus compensation. The irony then is that a rational strategy of deleveraging cannot be pursued by making boards and managements more sensitive to shareholder desires. \59\ From 1996 to 1999, the settlements in securities class actions totaled only $1.7 billion; thereafter, aggregate settlements rose exponentially, hitting a peak of $17.1 billion in 2006 alone. See Laura Simmons & Ellen Ryan, ``Securities Class Action Settlements: 2006, Review and Analysis'' (Cornerstone Research 2006) at 1. This decline of due diligence practices as liability correspondingly increased seems paradoxical, but may suggest that at least private civil liability does not effectively deter issuers or underwriters.--------------------------------------------------------------------------- As an explanation for an erosion in professional standards, competitive pressure applies with particular force to those investment banks that saw asset-back securitizations as the core of their future business model. In 2002, a critical milestone was reached, as in that year the total amount of debt securities issued in asset-backed securitizations equaled (and then exceeded in subsequent years) the total amount of debt securities issued by public corporations. \60\ Debt securitizations were not only becoming the leading business of Wall Street, as a global market of debt purchasers was ready to rely on investment grade ratings from the major credit rating agencies, but they were particularly important for the independent investment banks in the CSE Program.--------------------------------------------------------------------------- \60\ For a chart showing the growth of asset-backed securities in relation to conventional corporate debt issuances over recent years, see J. Coffee, J. Seligman, and H. Sale, SECURITIES REGULATION: Case and Materials (10th ed. 2006) at p. 10.--------------------------------------------------------------------------- Although all underwriters anticipated high rates of return from securitizations, the independent underwriters had gradually been squeezed out of their traditional line of business--underwriting corporate securities--in the wake of the step-by-step repeal of the Glass-Steagall Act. Beginning well before the formal repeal of that Act in 1999, the major commercial banks had been permitted to underwrite corporate debt securities and had increasingly exploited their larger scale and synergistic ability to offer both bank loans and underwriting services to gain an increasing share of this underwriting market. Especially for the smaller investment banks (e.g., Bear Stearns and Lehman), the future lay in new lines of business, where, as nimble and adaptive competitors, they could steal a march on the larger and slower commercial banks. To a degree, both did, and Merrill eagerly sought to follow in their wake. \61\ To stake out a dominant position, the CEOs of these firms adopted a ``Damn-the-torpedoes-full-speed-ahead'' approach that led them to make extremely risky acquisitions. Their common goal was to assure themselves a continuing source of supply of subprime mortgages to securitize, but in pursuit of this goal, both Merrill Lynch and Lehman made risky acquisitions, in effect vertically integrating into the mortgage loan origination field. These decisions, plus their willingness to acquire mortgage portfolios well in advance of the expected securitization transaction, left them undiversified and exposed to large writedowns when the real estate market soured.--------------------------------------------------------------------------- \61\ For a detailed description of Merrill, Lynch's late entry into the asset-backed securitization field and its sometimes frenzied attempt to catch up with Lehman by acquiring originators of mortgage loans, see Gretchen Morgenson, ``How the Thundering Herd Faltered and Fell,'' New York Times, November 9, 2008, at BU-1. Merrill eventually acquired an inventory of $71 billion in risky mortgages, in part through acquisitions of loan originators. By mid-2008, an initial writedown of $7.9 billion forced the resignation of its CEO. As discussed in this New York Times article, loan originators dealing with Merrill believed it did not accurately understand the risks of their field. For Lehman's similar approach to acquisitions of loan originators, see text and note, supra, at note 56.---------------------------------------------------------------------------Regulatory Modernization: What Should Be Done?An Overview of Recent Developments Financial regulation in the major capital markets today follows one of three basic organizational models: The Functional/Institutional Model: In 2008, before the financial crisis truly broke, the Treasury Department released a major study of financial regulation in the United States. \62\ This document (known as the ``Blueprint'') correctly characterized the United States as having a ``current system of functional regulation, which maintains separate regulatory agencies across segregated functional lines of financial services, such as banking, insurance, securities, and futures.'' \63\ Unfortunately, even this critical assessment may understate the dimensions of this problem of fragmented authority. In fact, the U.S. falls considerably short of even a ``functional'' regulatory model. By design, ``functional'' regulation seeks to subject similar activities to regulation by the same regulator. Its premise is that no one regulator can have, or easily develop, expertise in regulating all aspects of financial services. Thus, the securities regulator understands securities, while the insurance regulator has expertise with respect to the very different world of insurance. In the Gramm-Leach-Bliley Act of 1999 (``GLBA''), which essentially repealed the Glass-Steagall Act, Congress endorsed such a system of functional regulation. \64\--------------------------------------------------------------------------- \62\ The Department of the Treasury, Blueprint for Modernized Financial Regulatory Structure (2008) (hereinafter, ``Blueprint''). \63\ Id. at 4 and 27. \64\ The Conference Report to the Gramm-Leach-Bliley Act clearly states this: Both the House and Senate bills generally adhere to the principle of functional regulation, which holds that similar activities should be regulated by the same regulator. Different regulators have expertise at supervising different activities. It is inefficient and impractical to expect a regulator to have or develop expertise in regulating all aspects of financial services. H.R. Rep. No. 106-434, at 157 (1999), reprinted in 1999 U.S.C.C.A.N. 1252.--------------------------------------------------------------------------- Nonetheless, the reality is that the United States actually has a hybrid system of functional and institutional regulation. \65\ The latter approach looks not to functional activity, but to institutional type. Institutional regulation is seldom the product of deliberate design, but rather of historical contingency, piecemeal reform, and gradual evolution.--------------------------------------------------------------------------- \65\ For this same assessment, see Heidi Mandanis Schooner & Michael Taylor, United Kingdom and United States Responses to the Regulatory Challenges of Modern Financial Markets, 38 Tex. Int'l L. J. 317, 328 (2003).--------------------------------------------------------------------------- To illustrate this difference between functional and institutional regulation, let us hypothesize that, under a truly functional system, the securities regulator would have jurisdiction over all sales of securities, regardless of the type of institution selling the security. Conversely, let us assume that under an institutional system, jurisdiction over sales would be allocated according to the type of institution doing the selling. Against that backdrop, what do we observe today about the allocation of jurisdiction? Revealingly, under a key compromise in GLBA, the SEC did not receive general authority to oversee or enforce the securities laws with respect to the sale of government securities by a bank. \66\ Instead, banking regulators retained that authority. Similarly, the drafters of the GLBA carefully crafted the definitions of ``broker'' and ``dealer'' in the Securities Exchange Act of 1934 to leave significant bank securities activities under the oversight of bank regulators and not the SEC. \67\ Predictably, even in the relatively brief time since the passage of GLBA in 1999, the SEC and bank regulators have engaged in a continuing turf war over the scope of the exemptions accorded to banks from the definition of ``broker'' and ``dealer.'' \68\--------------------------------------------------------------------------- \66\ See 15 U.S.C. 78o-5(a)(1)(B), 15 U.S.C. 78(c)(a)(34)(G), and 15 U.S.C. 78o-5(g)(2). \67\ See 15 U.S.C. 78(c)(a)(4),(5). \68\ See Kathleen Day, Regulators Battle Over Banks: 3 Agencies Say SEC Rules Overstep Securities-Trading Law, Wash. Post, July 3, 2001, at E3. Eventually, the SEC backed down in this particular skirmish and modified its original position. See Securities Exch. Act Release No. 34-44570 (July 18, 2001) and Securities Exchange Age Release No. 34-44291, 66 Fed. Reg. 27760 (2001).--------------------------------------------------------------------------- None of this should be surprising. The status quo is hard to change, and regulatory bodies do not surrender jurisdiction easily. As a result, the regulatory body historically established to regulate banks will predictably succeed in retaining much of its authority over banks, even when banks are engaged in securities activities that from a functional perspective should belong to the securities regulator. ``True'' functional regulation would also assign similar activities to one regulator, rather than divide them between regulators based on only nominal differences in the description of the product or the legal status of the institution. Yet, in the case of banking regulation, three different federal regulators oversee banks: the Office of the Controller of the Currency (``OCC'') supervises national banks; the Federal Reserve Board (``FRB'') oversees state-chartered banks that are members of the Federal Reserve System and the Federal Deposit Insurance Corporation (``FDIC'') supervises state-chartered banks that are not members of the Federal Reserve System but are federally insured. \69\ Balkanization does not stop there. The line between ``banks,'' with their three different regulators at the federal level, and ``thrifts,'' which the Office of Thrift Supervision (``OTS'') regulates, is again more formalistic than functional and reflects a political compromise more than a difference in activities.--------------------------------------------------------------------------- \69\ This is all well described in the Blueprint. See Blueprint, supra note 62, at 31-41.--------------------------------------------------------------------------- Turning to securities regulation, one encounters an even stranger anomaly: the United States has one agency (the SEC) to regulate securities and another (the Commodities Future Trading Commission (CFTC)) to regulate futures. The world of derivatives is thereby divided between the two, with the SEC having jurisdiction over options, while the CFTC has jurisdiction over most other derivatives. No other nation assigns futures and securities regulation to different regulators. For a time, the SEC and CFTC both asserted jurisdiction over a third category of derivatives--swaps--but in 2000 Congress resolved this dispute by placing their regulation largely beyond the reach of both agencies. Finally, some major financial sectors (for example, insurance and hedge funds) simply have no federal regulator. By any standard, the United States thus falls well short of a true system of functional regulation, because deregulation has placed much financial activity beyond the reach of any federal regulator. Sensibly, the Blueprint proposes to rationalize this patchwork-quilt structure of fragmented authority through the merger and consolidation of agencies. Specifically, it proposes both a merger of the SEC and CFTC and a merger of the OCC and the OTS. Alas, such mergers are rarely politically feasible, and to date, no commentator (to our knowledge) has predicted that these proposed mergers will actually occur. Thus, although the Blueprint proposes that we move beyond functional regulation, the reality is that we have not yet approached even a system of functional regulation, as our existing financial regulatory structure is organized at least as much by institutional category as by functional activity. Disdaining a merely ``functional'' reorganization under which banking, insurance, and securities would each be governed by their own federal regulator, the Blueprint instead envisions a far more comprehensive consolidation of all these specialized regulators. Why? In its view, the problems with functional regulation are considerable: A functional approach to regulation exhibits several inadequacies, the most significant being the fact that no single regulator possesses all the information and authority necessary to monitor systemic risk, or the potential that events associated with financial institutions may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected. \70\--------------------------------------------------------------------------- \70\ Blueprint, supra note 62, at 4.--------------------------------------------------------------------------- But beyond these concerns about systemic risk, the architects of the Blueprint were motivated by a deeper anxiety: regulatory reform is necessary to maintain the capital market competitiveness of the United States. \71\ In short, the Blueprint is designed around two objectives: (1) the need to better address systemic risk and the possibility of a cascading series of defaults, and (2) the need to enhance capital market competitiveness. As discussed later, the first concern is legitimate, but the second involves a more dubious logic.--------------------------------------------------------------------------- \71\ In particular, the Blueprint hypothesizes that the U.K. has enhanced its own competitiveness by regulatory reforms, adopted in 2000, that are principles-based and rely on self regulation for their implementation. Id. at 3.--------------------------------------------------------------------------- The Consolidated Financial Services Regulator: A clear trend is today evident towards the unification of supervisory responsibilities for the regulation of banks, securities markets and insurance. \72\ Beginning in Scandinavia in the late 1980s, \73\ this trend has recently led the United Kingdom, Japan, Korea, Germany and much of Eastern Europe to move to a single regulator model. \74\ Although there are now a number of precedents, the U.K. experience stands out as the most influential. It was the first major international market center to move to a unified regulator model, \75\ and the Financial Services and Markets Act, adopted in 2000, went significantly beyond earlier precedents towards a ``nearly universal regulator.'' \76\ The Blueprint focuses on the U.K.'s experience because it believes that the U.K.'s adoption of a consolidated regulatory structure ``enhanced the competitiveness of the U.K. economy.'' \77\--------------------------------------------------------------------------- \72\ For recent overviews, see Ellis Ferran, Symposium: Do Financial Supermarkets Need Super-Regulators? Examining the United Kingdom's Experience in Adopting the Single Financial Regulator Model, 28 Brook. J. Int'l L. 257, 257-59 (2003); Jerry W. Markham, A Comparative Analysis of Consolidated and Functional Regulation: Super Regulator: A Comparative Analysis of Securities and Derivative Regulation in the United States, the United Kingdom, and Japan, 28 Brook. J. Int'l L. 319, 319-20 (2003); Giorgio Di Giorgio & Carmine D. Noia, Financial Market Regulation and Supervision: How Many Peaks for the Euro Area?, 28 Brook. J. Int'l L. 463, 469-78 (2003). \73\ Norway moved to an integrated regulatory agency in 1986, followed by Denmark in 1988, and Sweden in 1991. See D. Giorgio & D. Noia, supra note 72, at 469-478. \74\ See Bryan D. Stirewalt & Gary A. Gegenheimer, Consolidated Supervision of Banking Groups in the Former Soviet Republics: A Comparative Examination of the Emerging Trend in Emerging Markets, 23 Ann. Rev. Banking & Fin. L. 533, 548-49 (2004). As discussed later, in some countries (most notably Japan), the change seems more one of form than of substance, with little in fact changing. See Markham, supra note 72, at 383-393, 396. \75\ See Ferran, supra note 72, at 258. \76\ See Schooner & Taylor, supra note 65, at 329. Schooner and Taylor also observe that the precursors to the U.K.'s centralized regulator, which were mainly in Scandinavia, had a ``predominantly prudential focus.'' Id. at 331. That is, the unified new regulator was more a guardian of ``safety and soundness'' and less oriented toward consumer protection. \77\ Blueprint, supra note 62 at 3.--------------------------------------------------------------------------- Yet it is unclear whether the U.K.'s recent reforms provide a legitimate prototype for the Blueprint's proposals. Here, the Blueprint may have doctored its history. By most accounts, the U.K.'s adoption of a single regulator model was ``driven by country-specific factors,'' \78\ including the dismal failure of a prior regulatory system that relied heavily on self-regulatory bodies but became a political liability because of its inability to cope with a succession of serious scandals. Ironically, the financial history of the U.K. in the 1990s parallels that of the United States over the last decade. On the banking side, the U.K. experienced two major banking failures--the Bank of Credit and Commerce International (``BCCI'') in 1991 and Barings in 1995. Each prompted an official inquiry that found lax supervision was at least a partial cause. \79\--------------------------------------------------------------------------- \78\ Ferran, supra note 72, at 259. \79\ Id. at 261-262.--------------------------------------------------------------------------- Securities regulation in the U.K. came under even sharper criticism during the 1990s because of a series of financial scandals that were generally attributed to an ``excessively fragmented regulatory infrastructure.'' \80\ Under the then applicable law (the Financial Services Act of 1986), most regulatory powers were delegated to the Securities and Investments Board (SIB), which was a private body financed through a levy on market participants. However, the SIB did not itself directly regulate. Rather, it ``set the overall framework of regulation,'' but delegated actual authority to second tier regulators, which consisted primarily of self-regulatory organizations (SROs). \81\ Persistent criticism focused on the inability or unwillingness of these SROs to protect consumers from fraud and misconduct. \82\ Ultimately, the then chairman of the SIB, the most important of the SROs, acknowledged that self-regulation had failed in the U.K. and seemed unable to restore investor confidence. \83\ This acknowledgement set the stage for reform, and when a new Labour Government came into power at the end of the decade, one of its first major legislative acts (as it had promised in its election campaign) was to dismantle the former structure of SROs and replace it with a new and more powerful body, the Financial Services Authority (FSA).--------------------------------------------------------------------------- \80\ Id. at 265. \81\ Id. at 266. The most important of these were the Securities and Futures Authority (SFA), the Investment Managers' Regulatory Organization (IMRO), and the Personal Investment Authority (PIA). \82\ Two scandals in particular stood out: the Robert Maxwell affair in which a prominent financier effectively embezzled the pension funds of his companies and a ``pension mis-selling'' controversy in which highly risky financial products were inappropriately sold to pension funds without adequate supervision or disclosure. Id. at 267-268. \83\ Id. at 268.--------------------------------------------------------------------------- Despite the Blueprint's enthusiasm for the U.K.'s model, the structure that the Blueprint proposes for the U.S. more closely resembles the former U.K. system than the current one. Under the Blueprint's proposals, the securities regulator would be restricted to adopting general ``principles-based'' policies, which would be implemented and enforced by SROs. \84\ Ironically, the Blueprint relies on the U.K. experience to endorse essentially the model that the U.K. concluded had failed.--------------------------------------------------------------------------- \84\ See infra notes--and accompanying text.--------------------------------------------------------------------------- The ``Twin Peaks'' Model: As the Blueprint recognizes, not all recent reforms have followed the U.K. model of a universal regulator. Some nations--most notably Australia and the Netherlands--instead have followed a ``twin peaks'' model that places responsibility for the ``prudential regulation of relevant financial institutions'' in one agency and supervision of ``business conduct and consumer protection'' in another. \85\ The term ``twin peaks'' derives from the work of Michael Taylor, a British academic and former Bank of England official. In 1995, just before regulatory reform became a hot political issue in the U.K., he argued that financial regulation had two separate basic aims (or ``twin peaks''): (1) ``to ensure the soundness of the financial system,'' and (2) ``to protect consumers from unscrupulous operators.'' \86\ Taylor's work was original less in its proposal to separate ``prudential'' regulation from ``business conduct'' regulation than in its insistence upon the need to consolidate ``responsibility for the financial soundness of all major financial institutions in a single agency.'' \87\ Taylor apparently feared that if the Bank of England remained responsible for the prudential supervision of banks, its independence in setting interest rates might be compromised by its fear that raising interest rates would cause bank failures for which it would be blamed. In part for this reason, the eventual legislation shifted responsibility for bank supervision from the Bank of England to the FSA.--------------------------------------------------------------------------- \85\ Blueprint, supra note 62, at 3. For a recent discussion of the Australian reorganization, which began in 1996 (and thus preceded the U.K.), see Schooner & Taylor, supra note65, at 340-341. The Australian Securities and Investments Commission (ASIC) is the ``consumer protection'' agency under this ``twin peaks'' approach, and the Australian Prudential Regulatory Authority (APRA) supervises bank ``safety and soundness.'' Still, the ``twin peaks'' model was not fully accepted in Australia as ASIC, the securities regulator, does retain supervisory jurisdiction over the ``financial soundness'' of investment banks. Thus, some element of functional regulation remains. \86\ Michael Taylor, Twin Peaks: A Regulatory Structure for the New Century i (Centre for the Study of Financial Institutions 1995). For a brief review of Taylor's work, see Cynthia Crawford Lichtenstein, The Fed's New Model of Supervision for ``Large Complex Banking Organizations'': Coordinated Risk-Based Supervision of Financial Multinationals for International Financial Stability, 18 Transnat'l Law. 283, 295-296 (2005). \87\ Lichtenstein, supra note 86, at 295; Taylor, supra note 86, at 4.--------------------------------------------------------------------------- The Blueprint, itself, preferred a ``twin peaks'' model, and that model is far more compatible with the U.S.'s current institutional structure for financial regulation. But beyond these obvious points, the best argument for a ``twin peaks'' model involves conflict of interests and the differing culture of banks and securities regulators. It approaches the self-evident to note that a conflict exists between the consumer protection role of a universal regulator and its role as a ``prudential'' regulator intent on protecting the safety and soundness of the financial institution. The goal of consumer protection is most obviously advanced through deterrence and financial sanctions, but these can deplete assets and ultimately threaten bank solvency. When only modest financial penalties are used, this conflict may sound more theoretical than real. But, the U.S. is distinctive in the severity of the penalties it imposes on financial institutions. In recent years, the SEC has imposed restitution and penalties exceeding $3 billion annually, and private plaintiffs received a record $17 billion in securities class action settlements in 2006. \88\ Over a recent ten year period, some 2,400 securities class actions were filed and resulted in settlements of over $27 billion, with much of this cost (as in the Enron and WorldCom cases) being borne by investment banks. \89\ If one agency were seeking both to protect consumers and guard the solvency of major financial institutions, it would face a difficult balancing act to achieve deterrence without threatening bank solvency, and it would risk a skeptical public concluding that it had been ``captured'' by its regulated firms.--------------------------------------------------------------------------- \88\ See Coffee, Law and the Market: The Impact of Enforcement, 156 U. of Pa. L. Rev. 299 (2007) (discussing average annual SEC penalties and class action settlements). \89\ See Richard Booth, The End of the Securities Fraud Class Action as We Know It, 4 Berkeley Bus. L. J. 1, at 3 (2007).--------------------------------------------------------------------------- Even in jurisdictions adopting the universal regulator model, the need to contemporaneously strengthen enforcement has been part of the reform package. Although the 2000 legislation in the U.K. did not adopt the ``twin peaks'' format, it did significantly strengthen the consumer protection role of its centralized regulator. The U.K.'s Financial Services and Markets Act, enacted in 2000, sets out four statutory objectives, with the final objective being the ``reduction of financial crime.'' \90\ According to Heidi Schooner and Michael Taylor, this represented ``a major extension of the FSA's powers compared to the agencies it replaced,'' \91\ and it reflected a political response to the experience of weak enforcement by self-regulatory bodies, which had led to the creation of the FSA. \92\ With probably unintended irony, Schooner and Taylor described this new statutory objective of reducing ``financial crime'' as the ``one aspect of U.K. regulatory reform in which its proponents seem to have drawn direct inspiration from U.S. law and practice.'' \93\ Conspicuously, the Blueprint ignores that ``modernizing'' financial regulation in other countries has generally meant strengthening enforcement.--------------------------------------------------------------------------- \90\ See Financial Services and Markets Act, 2000, c. 8, pt. 1, 6, http://www.opsi.gov.uk/ACTS/acts2000/pdf/ukpga_20000008_en.pdf \91\ See Schooner & Taylor, supra note 65, at 335. \92\ Id. \93\ Id. at 335-36.--------------------------------------------------------------------------- A Preliminary Evaluation: Three preliminary conclusions merit emphasis: First, whether the existing financial regulatory structure in the United States is considered ``institutional'' or ``functional'' in design, its leading deficiency seems evident: it invites regulatory arbitrage. Financial institutions position themselves to fall within the jurisdiction of the most accommodating regulator, and investment banks design new financial products so as to encounter the least regulatory oversight. Such arbitrage can be defended as desirable if one believes that regulators inherently overregulate, but not if one believes increased systemic risk is a valid concern (as the Blueprint appears to believe). Second, the Blueprint's history of recent regulatory reform involves an element of historical fiction. The 2000 legislation in the U.K., which created the FSA as a nearly universal regulator, was not an attempt to introduce self-regulation by SROs, as the Blueprint seems to assume, but a sharp reaction by a Labour Government to the failures of self-regulation. Similarly, Japan's slow, back-and-forth movement in the direction of a single regulator seems to have been motivated by an unending series of scandals and a desire to give its regulator at least the appearance of being less industry dominated. \94\--------------------------------------------------------------------------- \94\ Japan has a history and a regulatory culture of economic management of its financial institutions through regulatory bodies that is entirely distinct from that of Europe or the United States. Although it has recently created a Financial Services Agency, observers contend that it remains committed to its traditional system of bureaucratic regulation that supports its large banks and discourages foreign competition. See Markham, supra note 72, at 383-92, 396. Nonetheless, scandals have been the primary force driving institutional change there too, and Japan's FSA was created at least in part because Japan's Ministry of Finance (MOF) had become embarrassed by recurrent scandals.--------------------------------------------------------------------------- Third, the debate between the ``universal'' regulator and the ``twin peaks'' alternative should not obscure the fact that both are ``superregulators'' that have moved beyond ``functional'' regulation on the premise that, as the lines between banks, securities dealers, and insurers blur, so regulators should similarly converge. That idea will and should remain at the heart of the U.S. debate, even after many of the Blueprint's proposals are forgotten.Defining the Roles of the ``Twin Peaks'' (Systemic Risk Regulator and Consumer Protector)--Who Should Do What? The foregoing discussion has suggested why the SEC would not be an effective risk regulator. It has neither the specialized competence nor the organizational culture for the role. Its comparative advantage is enforcement, and thus its focus should be on transparency and consumer protection. Some also argue that ``single purpose'' agencies, such as the SEC, are more subject to regulatory capture than are broader or ``general purpose'' agencies. \95\ To the extent that the Federal Reserve would have responsibility for all large financial institutions and would be expected to treat monitoring their capital adequacy and risk management practices as among its primary responsibilities, it does seem less subject to capture, because any failure would have high visibility and it would bear the blame. Still, this issue is largely academic because the SEC no longer has responsibility over any investment banks of substantial size.--------------------------------------------------------------------------- \95\ See Jonathan Macey, Organizational Design and Political Control of Administrative Agencies, 8 J. Law, Economics, and Organization 93 (1992). It can, of course, be argued which agency is more ``single purpose'' (the SEC or the Federal Reserve), but the latter does deal with a broader class of institutions in terms of their capital adequacy.--------------------------------------------------------------------------- The real issue then is defining the relationships between the two peaks so that neither overwhelms the other. The Systemic Risk Regulator (SRR): Systemic risk is most easily defined as the risk of an inter-connected financial breakdown in the financial system--much like the proverbial chain of falling dominoes. The closely linked insolvencies of Lehman, AIG, Fannie Mae and Freddie Mac in the Fall of 2008 present a paradigm case. Were they not bailed out, other financial institutions were likely to have also failed. The key idea here is not that one financial institution is too big to fail, but rather that some institutions are too interconnected to permit any of them to fail, because they will drag the others down. What should a system risk regulator be authorized to do? Among the obvious powers that it should have are the following: a. Authority To Limit the Leverage of Financial Institutions and Prescribe Mandatory Capital Adequacy Standards. This authority would empower the SRR to prescribe minimum levels of capital and ceilings on leverage for all categories of financial institutions, including banks, insurance companies, hedge funds, money market funds, pension plans, and quasi-financial institutions (such as, for example, G.E. Capital). The standards would not need to be identical for all institutions and should be risk adjusted. The SRS should be authorized to require reductions in debt to equity ratios below existing levels, to consider off-balance sheet liabilities (including those of partially owned subsidiaries and also contractual agreements to repurchase or guarantee) in computing these tests and ratios (even if generally accepted accounting principles would not require their inclusion). The SRR would focus its monitoring on the largest institutions in each financial class, leaving small institutions to be regulated and monitored by their primary regulator. For example, the SEC might require all hedge funds to register with it under the Investment Advisers Act of 1940, but hedge funds with a defined level of assets (say, $25 billion in assets) would be subject to the additional and overriding authority of the SSR. b. Authority To Approve, Restrict and Regulate Trading in New Financial Products. By now, it has escaped no one's attention that one particular class of over-the-counter derivative (the credit default swap) grew exponentially over the last decade and was outside the jurisdiction of any regulatory agency. This was not accidental, as the Commodities Futures Modernization Act of 2000 deliberately placed over-the-counter derivatives beyond the general jurisdiction of both the SEC and the CFTC. The SRR would be responsible for monitoring the growth of new financial products and would be authorized to regulate such practices as the collateral or margin that counter-parties were required to post. Arguably, the SRR should be authorized to limit those eligible to trade such instruments and could bar or restrict the purchase of ``naked'' credit default swaps (although the possession of this authority would not mean that the SRR would have to exercise it, unless it saw an emergency developing). c. Authority To Mandate Clearing Houses. Securities and options exchanges uniformly employ clearing houses to eliminate or mitigate credit risk. In contrast, when an investor trades in an over-the-counter derivative, it must accept both market risk (the risk that the investment will sour or price levels will change adversely) and credit risk (the risk that the counterparty will be unable to perform). Credit risk is the factor that necessitated the bailout of AIG, as its failure could have potentially led to a cascade of failures by other financial institutions if it defaulted on its swaps. Use of the clearing house should eliminate the need to bail out a future AIG because its responsibilities would fall on the clearing house to assume and the clearing house would monitor and limit the risk that its members assumed. At present, several clearinghouses are in the process of development in the United States and Europe. The SRR would be the obvious body to oversee such clearing houses (and indeed the Federal Reserve was already instrumental in their formation). Otherwise, some clearing houses are likely to be formed under the SEC's supervision and some under the CFTC's, thus again permitting regulatory arbitrage to develop. A final and complex question is whether competing clearing houses are desirable or whether they should be combined into a single centralized clearing house. This issue could also be given to the SRR. d. Authority To Mandate Writedowns for Risky Assets. A real estate bubble was the starting point for the 2008 crisis. When any class of assets appreciates meteorically, the danger arises that on the eventual collapse in that overvalued market, the equity of the financial institution will be wiped out (or at the least so eroded as to create a crisis in investor confidence that denies that institution necessary financing). This tendency was palpably evident in the failure of Bear Stearns, Lehman, Fannie Mae and Freddie Mac. If the SRR regulator relies only on debt/equity ratios to protect capital adequacy, they will do little good and possibly provide only illusory protections. Any financial institution that is forced to writedown its investment in overpriced mortgage and real estate assets by 50 percent will necessarily breach mandated debt to equity ratios. The best answer to this problem is to authorize the SRR to take a proactive and countercyclical stance by requiring writedowns in risky asset classes (at least for regulatory purposes) prior to the typically much later point at which accountants will require such a writedown. Candidly, it is an open question whether the SRS, the Federal Reserve, or any banking regulator would have the courage and political will to order such a writedown (or impose similar restraints on further acquisitions of such assets) while the bubble was still expanding. But Congress should at least arm its regulators with sufficient power and direct them to use it with vigor. e. Authority To Intervene To Prevent and Avert Liquidity Crises. Financial institutions often face a mismatch between their assets and liabilities. They may invest in illiquid assets or make long-term loans, but their liabilities consist of short-term debt (such as commercial paper). Thus, regulating leverage ratios is not alone adequate to avoid a financial crisis, because the institution may suddenly experience a ``run'' (as its depositors flee) or be unable to roll over its commercial paper or other short-term debt. This problem is not unique to banks and can be encountered by hedge funds and private equity funds (as the Long Term Capital Management crisis showed). The SRR thus needs the authority to monitor liquidity problems at large financial institutions and direct institutions in specific cases to address such imbalances (either by selling assets, raising capital, or not relying on short-term debt). From the foregoing description, it should be obvious that the only existing agency in a position to take on this assignment and act as an SRR is the Federal Reserve Board. But it is less politically accountable than most other federal agencies, and this could give rise to some problems discussed below. The Consumer Protection and Transparency Agency: The creation of an SSR would change little at the major Federal agencies having responsibilities for investor protection. Although it might be desirable to merge the SEC and the CFTC, this is not essential. Because no momentum has yet developed for such a merger, I will not discuss it further at this time. Currently, there are over 5,000 broker-dealers registered with the SEC. They would remain so registered, and the SRR would concern itself only with those few whose potential insolvency could destabilize the markets. The focus of the SEC's surveillance of broker-dealers is on consumer protection and market efficiency, and this would not be within the expertise of the Federal Reserve or any other potential SRR. The SEC is also an experienced enforcement agency, while the Federal Reserve has little, if any, experience in this area. Further, the SEC understands disclosure issues and is a champion of transparency, whereas banking regulators start from the unstated premise that disclosures of risks or problems at a financial institution is undesirable because it might provoke a ``run'' on the bank. The SEC and the Controller of the Currency have long disagreed about what banks should disclose in the Management Discussion and Analysis that banks file with the SEC. Necessarily, this tension will continue. Resolving the Conflicts: The SEC and the PCAOB have continued to favor ``mark to market'' accounting, while major banks have sought relief from the write-downs that it necessitates. Suppose then that in the future a SRR decided that ``mark to market'' accounting increased systemic risk. Could it determine that financial institutions should be spared from such an accounting regime on the ground that it was pro-cyclical? This is an issue that Congress should address in any legislation authorizing a SRR or enhancing the powers of the Federal Reserve. I would recommend that Congress maintain authority in the SEC to determine appropriate accounting policies, because, put simply, transparency has been the core value underlying our system of securities regulation. But there are other areas where a SRR might well be entitled to overrule the SEC. Take, for example, the problem of short selling the stocks of financial institutions during a period of market stress. Although the SEC did ban short selling in financial stocks briefly in 2008, one can still imagine an occasion on which the SRR and the SEC might disagree. Here, transparency would not be an issue. Short selling is pro-cyclical, and a SRR could determine that it had the potential to destabilize and increase systemic risk. If it did so, its judgment should control. These examples are given only by way of illustration, and the inevitability of conflicts between the two agencies is not assumed. The President's Working Group on Financial Markets has generally been able to work out disagreements through consultation and negotiation. Still, in any legislation, it would be desirable to identify those core policies (such as transparency and full disclosure) that the SRR could not override. The Failure of Quantitative Models: If one lesson should have been learned from the 2008 crisis, it is that quantitative models, based on historical data, eventually and inevitably fail. Rates of defaults on mortgages can change (and swiftly), and housing markets do not invariably rise. In the popular vernacular, ``black swans'' both can occur and even become predominant. This does not mean that quantitative models should not be used, but that they need to be subjected to qualitative and judgmental overrides. The weakness in quantitative models is particularly shown by the extraordinary disparity between the value at risk estimates (VaRs) reported by underwriters to the SEC and their eventual writedowns for mortgage-backed securities. Ferrell, Bethel and Hu report that for a selected group of major financial institutions the average ratio of asset writedowns as of August 20, 2008, to VaRs reported for 2006 was 291 to 1. \96\ If financial institutions cannot accurately estimate their exposure for derivatives and risky assets, this undermines many of the critical assumptions underlying the Basel II Accords, and suggests that regulators cannot defer to the institutions' own risk models. Instead, they must reach their own judgments, and Congress should so instruct them.--------------------------------------------------------------------------- \96\ See Farrell, Bethel, and Hu, supra note 15, at 47.---------------------------------------------------------------------------The Lessons of Madoff: Implications for the SEC, FINRA, and SIPC No time need be wasted pointing out that the SEC missed red flags and overlooked credible evidence in the Madoff scandal. Unfortunately, most Ponzi schemes do not get detected until it is too late. This implies that an ounce of prevention may be worth several pounds of penalties. More must be done to discourage and deter such schemes ex ante, and the focus cannot be only on catching them ex post. From this perspective focused on prevention, rather than detection, the most obvious lesson is that the SEC's recent strong tilt towards deregulation contributed to, and enabled, the Madoff fraud in two important respects. First, Bernard L. Madoff Investment Securities LLC (BMIS) was audited by a fly-by-night auditing firm with only one active accountant who had neither registered with the Public Company Accounting Oversight Board (``PCAOB'') nor even participated in New York State's peer review program for auditors. Yet, the Sarbanes-Oxley Act required broker-dealers to use a PCAOB-registered auditor. \97\ Nonetheless, until the Madoff scandal exploded, the SEC repeatedly exempted privately held broker-dealers from the obligation to use such a PCAOB-registered auditor and permitted any accountant to suffice. \98\ Others also exploited this exemption. For example, in the Bayou Hedge Fund fraud, which was the last major Ponzi scheme before Madoff, the promoters simply invented a fictitious auditing firm and forged certifications in its name. Had auditors been required to have been registered with PCAOB, this would not have been feasible because careful investors would have been able to detect that the fictitious firm was not registered.--------------------------------------------------------------------------- \97\ See Section 17(e)(1) of the Securities Exchange Act of 1934, 15 U.S.C. 78(q)(e)(1). \98\ See, e.g., Securities Exch. Act Rel. No. 34-54920 (Dec. 12, 2006).--------------------------------------------------------------------------- Presumably, the SEC's rationale for this overbroad exemption was that privately held broker-dealers did not have public shareholders who needed protection. True, but they did have customers who have now been repeatedly victimized. At the end of 2008, the SEC quietly closed the barn door by failing to renew this exemption--but only after $50 billion worth of horses had been stolen. A second and even more culpable SEC mistake continues to date. Under the Investment Advisers Act, investment advisers are required to maintain client funds or securities with a ``qualified custodian.'' \99\ In principle, this requirement should protect investors from Ponzi schemes, because an independent custodian would not permit the investment adviser to have access to the investors' funds. Indeed, for exactly this reason, mutual funds appear not to have experienced Ponzi-style frauds, which have occurred only in the case of hedge funds and investment advisers. Under Section 17(f) of the Investment Company Act, mutual funds must use a separate custodian. But in the case of investment advisors, the SEC permits the investment adviser to use an affiliated broker-dealer or bank as its qualified custodian. Thus, Madoff could and did use BMIS, his broker dealer firm, to serve as custodian for his investment adviser activities. The net result is that only a very tame watchdog monitors the investment adviser. Had an independent and honest custodian held the investors' funds, Madoff could not have recycled new investors' contributions to earlier investors, and the custodian would have noticed that Madoff was not actually trading. Other recent Ponzi schemes seem to have similarly sidestepped the need for an independent custodian. At Senate Banking Committee hearings on the Madoff debacle this January, the director of the SEC's Office of Compliance, Inspection and Examinations estimated that, out of the 11,300 investment advisers currently registered with the SEC, some 1,000 to 1,500 might similarly use an affiliated broker-dealer as their custodian. For investors, the SEC's tolerance for self-custodians makes the ``qualified custodian'' rule an illusory protection.--------------------------------------------------------------------------- \99\ See Rule 206(4)-2 (``Custody of Funds or Securities of Clients By Investment Advisers''), 17 CFR 275.206(4)-2.--------------------------------------------------------------------------- At present, the Madoff scandal has so shaken investor confidence in investment advisors that even the industry trade group for investment advisers (the Investment Advisers Association) has urged the SEC to adopt a rule requiring investment advisers to use an independent custodian. Unfortunately, one cannot therefore assume that the SEC will quickly produce such a rule. The SEC's staff knows that smaller investment advisers will oppose any rule that requires them to incur additional costs. Even if a reform rule is proposed, the staff may still overwhelm such a rule with exceptions (such as by permitting an independent custodian to use sub-custodians who are affiliated with the investment adviser). Congress should therefore direct it to require an independent custodian, across the board for mutual funds, hedge funds, and investment advisers. The Madoff scandal exposes shortcomings not only at the SEC but elsewhere in related agencies. Over the last 5 years, the number of investment advisers has grown from roughly 7,500 to 11,300--more than one third. Given this growth, it is becoming increasingly anomalous that there is no self-regulatory body (SRO) for investment advisers. Although FINRA may have overstated in its claim that it had no authority to investigate Madoff's investment adviser operations (because it could and should have examined BMIS's performance as the ``qualified custodian'' for Madoff's investment advisory activities), it still lacks authority to examine investment advisers. Some SRO (either FINRA or a new body) should have direct authority to oversee the investment adviser activities of an integrated broker-dealer firm. Similarly, the Securities Investor Protection Corporation (SIPC) continues to charge all broker-dealer firms the same nominal fee for insurance without any risk-adjustment. Were it to behave like a private insurer and charge more to riskier firms for insurance, these firms would have a greater incentive to adopt better internal controls against fraud. A broker-dealer that acted as a self-custodian for a related investment adviser would, for example, pay a higher insurance commission. Also, if higher fees were charged, more insurance (which is currently capped at $500,000 per account) could be provided to investors. When all broker-dealers are charged the same insurance premium, this subsidizes the riskier firms--i.e., the future Madoffs of the industry. Finally, one of the most perplexing problems in the Madoff story is why, when the SEC finally forced Madoff to register as an investment adviser in 2006, it did not conduct an early examination of BMIS's books and records. Red flags were flying, as Madoff (1) used an unknown accountant, (2) served as his own self-custodian, (3) had apparently billions of dollars in customer accounts, (4) had long resisted registration, and (5) was the subject of plausible allegations of fraud from credible whistle-blowers. Cost constrained as the SEC may have been, the only conclusion that can be reached here is that the SEC has poor criteria for evaluating the relative risk of investment advisers. At a minimum, Congress should require a report by the SEC as to the criteria used to determine the priority of examinations and how the SEC proposes to change those criteria in light of the Madoff scandal. Some have proposed eliminating the SEC's Office of Compliance, Inspection and Examinations and combining its activities with the Division of Investment Management. I do not see this as a panacea. Rather, it simply reshuffles the cards. The real problem is the criteria used to determine who should be examined. Credible allegations of fraud need to be directed to the compliance inspectors.Asset-Backed Securitizations: What Failed? Asset-backed securitizations represent a financial technology that failed. As outlined earlier, this failure seems principally attributable to a ``moral hazard'' problem that arose under which both loan originators and underwriters relaxed their lending standards and packaged non-creditworthy loans into portfolios, because both found that they could sell these portfolios at a high profit and on a global basis--at least so long as the debt securities carried an investment grade credit rating from an NRSRO credit rating agency. Broad deregulatory rules contributed to this problem, and the two most important such SEC rules are Rules 3a-7 under the Investment Company Act \100\ and Regulation AB. \101\ Asset-backed securities (including CDOs) are typically issued by a special purpose vehicle (SPV) controlled by the promoter (which often may be an investment or commercial bank). This SPV would under ordinary circumstances be deemed an ``investment company'' and thus subjected to the demanding requirements of the Investment Company Act--but for Rule 3a-7. That rule exempts fixed-income securities issued by an SPV if, at the time of sale, the securities are rated in one of the four highest categories of investment quality by a ``nationally recognized statistical rating organization'' (NRSRO). In essence, the SEC has delegated to the NRSROs (essentially, at the time at least, Moody's, S&P and Fitch) the ability exempt SPVs from the Investment Company Act. Similarly, Regulation AB governs the disclosure requirements for ``asset-backed securities'' (as such term is defined in Section 1101(c) of Regulation AB) in public offerings. Some have criticized Regulation AB for being more permissive than the federal housing agencies with respect to the need to document and verify the loans in a portfolio. \102\ Because Regulation AB requires that the issuer not be an investment company (see Item 101(c)(2)(i) of Regulation AB), its availability (and thus expedited registration) also depends on an NRSRO investment grade rating.--------------------------------------------------------------------------- \100\ 17 CFR 270.3a-7 (``Issuers of Asset-Backed Securities''). This exemption dates back to 1992. \101\ 17 CFR 229.1100 et seq. (``Asset-Backed Securities''). Regulation AB was adopted in 2005, but reflects an earlier pattern of exemptions in no-action letters. \102\ See Mendales, supra note 18.--------------------------------------------------------------------------- No suggestion is here intended that SPVs should be classified as ``investment companies,'' but the need for the exemption given by Rule 3a-7 shows that the SEC has considerable leverage and could condition this exemption on alternative or additional factors beyond an NRSRO investment grade rating. The key point is that exemptions like Rule 3a-7 give the SEC a tool that they could use even without Congressional legislation--if the SEC was willing to take action. What actions should be taken to respond to the deficiencies in asset-backed securitizations? I would suggest two basic steps: (1) curtail the ``originate-and-distribute'' model of lending that gave rise to the moral hazard problem, and (2) re-introduce due diligence into the securities offering process (both for public and Rule 144A offerings). Restricting the ``Originate-and-Distribute'' Model of Lending. In a bubble, everyone expects that they can pass the assets on to the next buyer in the chain--``before the music stops.'' Thus, all tend to economize on due diligence and ignore signs that the assets are not creditworthy. This is because none expect to bear the costs of holding the financial assets to maturity. Things were not always this way. When asset-backed securitizations began, the promoter usually issued various tranches of debt to finance its purchase of the mortgage assets, and these tranches differed in terms of seniority and maturity. The promoter would sell the senior most tranche in public offerings to risk averse public investors and retain some or all of the subordinated tranche, itself, as a signal of its confidence in the creditworthiness of the underlying assets. Over time, this practice of retaining the subordinated tranche withered away. In part, this was because hedge funds would take the risk of buying this riskier debt; in part, it was because the subordinated tranche could be included in more complex CDOs (where overcollateralization was the investor's principal protection), and finally it was because in a bubbly market, investors no longer looked for commitments or signals from the promoter. Given this definition of the problem, the answer seems obvious: require the promoter to retain some portion of the subordinated tranche. This would incentivize it to buy only creditworthy financial assets and end the ``moral hazard'' problem. To make this proposal truly effective, however, more must be done. The promoter would have to be denied the ability to hedge the risk on the subordinated tranche that it retained. Otherwise it might hedge that risk by buying a credit default swap on its own offering through an intermediary. But this is feasible. Even in the absence of legislation, the SEC could revise Rule 3a-7 to require, as a price of its exemption, that the promoter (either through the SPV or an affiliate) retain a specified percentage of the bottom, subordinated tranche (or, if there were no subordinated tranche, of the offering as a whole). Still, the cleaner, simpler way would be a direct legislative requirement of a minimum retention. 2. Mandating Due Diligence. One of the less noticed but more important developments associated with asset-backed securitization is the rapid decline in due diligence after 2000. Once investment banks did considerable due diligence on asset-backed securitizations, but they outsourced the work to specialized ``due diligence'' firms. These firms (of which Clayton Holdings, Inc. was the best known) would send squads of ten to fifteen loan reviewers to sample the loans in a securitized portfolio, checking credit scores and documentation. But the intensity of this due diligence review declined over recent years. The Los Angeles Times quotes the CEO of Clayton Holdings to the effect that: Early in the decade, a securities firm might have asked Clayton to review 25 percent to 40 percent of the sub-prime loans in a pool, compared with typically 10 percent in 2006 \103\ \103\ See E. Scott Reckard, ``Sub-Prime mortgage watchdogs kept on leash; loan checkers say their warnings of risk were met with indifference,'' Los Angeles Times, March 17, 2008, at C-1.--------------------------------------------------------------------------- The President of a leading rival due diligence firm, the Bohan Group, made an even more revealing comparison: By contrast, loan buyers who kept the mortgages as an investment instead of packaging them into securities would have 50 percent to 100 percent of the loans examined, Bohan President Mark Hughes said. \104\--------------------------------------------------------------------------- \104\ Id. In short, lenders who retained the loans checked the borrowers carefully, but the investment banks decreased their investment in due diligence, making only a cursory effort by 2006. Again, this seems the natural consequence of an originate-and-distribute model. The actual loan reviewers employed by these firms also told the above-quoted Los Angeles Times reporter that supervisors in these firms would often change documentation in order to avoid ``red-flagging mortgages.'' These employees also report regularly encountering inflated documentation and ``liar's loans,'' but, even when they rejected loans, ``loan buyers often bought the rejected mortgages anyway.'' \105\--------------------------------------------------------------------------- \105\ Id.--------------------------------------------------------------------------- In short, even when the watchdog barked, no one at the investment banks truly listened. Over the last several years, due diligence practices long followed in the industry seemed to have been relaxed, ignored, or treated as a largely optional formality. That was also the conclusion of the President's Working Group on Financial Markets, which in early 2008 identified ``a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors.'' \106\--------------------------------------------------------------------------- \106\ See President's Working Group on Financial Markets, Policy Statement on Financial Market Developments at 1 (March, 2008). (emphasis added). This report expressly notes that underwriters had the incentive to perform due diligence, but did not do so adequately.--------------------------------------------------------------------------- Still, in the case of the investments bank, this erosion in due diligence may seem surprising. At least over the long-term, it seems contrary to their own self-interest. Four factors may explain their indifference: (1) an industry-wide decline in due diligence as the result of deregulatory reforms that have induced many underwriters to treat legal liability as simply a cost of doing business; (2) heightened conflicts of interest attributable to the underwriters' position as more a principal than an agent in structured finance offerings; (3) executive compensation formulas that reward short-term performance (coupled with increased lateral mobility in investment banking so that actors have less reason to consider the long-term); and (4) competitive pressure. Each is briefly examined below, and then I suggest some proposed reforms to address these problems. i. The Decline of Due Diligence: A Short History: The Securities Act of 1933 adopted a ``gatekeeper'' theory of protection, in the belief that by imposing high potential liability on underwriters (and others), this would activate them to search for fraud and thereby protect investors. As the SEC wrote in 1998: Congress recognized that underwriters occupied a unique position that enabled them to discover and compel disclosure of essential facts about the offering. Congress believed that subjecting underwriters to the liability provisions would provide the necessary incentive to ensure their careful investigations of the offering.'' \107\--------------------------------------------------------------------------- \107\ See SEC Release No. 7606A (``The Regulation of Securities Offerings''), 63 Fed. Reg. 67174, 67230 (Dec. 4 1998). Specifically, Section 11 of the Securities Act of 1933 holds the underwriters (and certain other persons) liable for any material misrepresentation or omission in the registration statement, without requiring proof of scienter on the part of the underwriter or reliance by the plaintiff. This is a cause of action uniquely tilted in favor of the plaintiff, but then Section 11(b) creates a powerful incentive by establishing an affirmative defense under which any defendant (other ---------------------------------------------------------------------------than the issuer) will not be held liable if: he had, after a reasonable investigation, reasonable ground to believe and did believe, at the time such registration statement became effective, that the statements made therein were true and that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading. 15 U.S.C. 77k (b)(3)(A). (emphasis added) Interpreting this provision, the case law has long held that an underwriter must ``exercise a high degree of care in investigation and independent verification of the company's representations.'' Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 554, 582 (E.D.N.Y. 1971). Overall, the Second Circuit has observed that ``no greater reliance in our self-regulatory system is placed on any single participant in the issuance of securities than upon the underwriter.'' Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F. 2d 341, 370 (2d Cir. 1973). Each underwriter need not personally perform this investigation. It can be delegated to the managing underwriters and to counsel, and, more recently, the task has been outsourced to specialized experts, such as the ``due diligence firms.'' The use of these firms was in fact strong evidence of the powerful economic incentive that Section 11(b) of the Securities Act created to exercise ``due diligence.'' But what then changed? Two different answers make sense and are complementary: First, many and probably most CDO debt offerings are sold pursuant to Rule 144A, and Section 11 does not apply to these exempt and unregistered offerings. Second, the SEC expedited the processing of registration statements to the point that due diligence has become infeasible. The latter development goes back nearly thirty years to the advent of ``shelf registration'' in the early 1980s. In order to expedite the ability of issuers to access the market and capitalize on advantageous market conditions, the SEC permitted issuers to register securities ``for the shelf''--i.e., to permit the securities to be sold from time to time in the future, originally over a two year period (but today extended to a three year period). \108\ Under this system, ``takedowns''--i.e., actual sales under a shelf registration statement--can occur at any time without any need to return to the SEC for any further regulatory permission. Effectively, this telescoped a period that was often three or four months in the case of the traditional equity underwriting (i.e., the period between the filing of the registration statement and its ``effectiveness,'' while the SEC reviewed the registration statement) to a period that might be a day or two, but could be only a matter of hours.--------------------------------------------------------------------------- \108\ See Rule 415 (17 C.F.R. 230.415)(2007).--------------------------------------------------------------------------- Today, because there is no longer any delay for SEC review in the case of an issuer eligible for shelf registration, an eligible issuer could determine to make an offering of debt or equity securities and in fact do so within a day's time. The original premise of this new approach was that eligible issuers would be ``reporting entities'' that filed continuous periodic disclosures (known as Form 10-Ks and Form 10-Qs) under the Securities Exchange Act of 1934. Underwriters, the SEC hoped, could do ``continuing due diligence'' on these issuers at the time they filed their periodic quarterly reports in preparation for a later, eventual public offering. This hope was probably never fully realized, but, more importantly, this premise never truly applied to debt offerings by issuers of asset-backed securities. For bankruptcy and related reasons, the issuers of asset-backed issuers (such as CDOs backed by a pool of residential mortgages) are almost always ``special purpose vehicles'' (SPVs), created for the single offering; they thus have no prior operating history and are not ``reporting companies'' under the Securities Exchange Act of 1934. To enable issuers of asset-backed securities to use shelf-registration and thus obtain immediate access to the capital markets, the SEC had to develop an alternative rationale. And it did! To use Form S-3 (which is a precondition for eligibility for shelf-regulation), an issuer of asset-backed securities must receive an ``investment grade'' rating from an ``NRSRO'' credit-rating agency. \109\ Unfortunately, this requirement intensified the pressure that underwriters brought to bear on credit-ratings agencies, because unless the offering received an investment grade rating from at least one rating agency, the offering could not qualify for Form S-3 (and so might be delayed for an indefinite period of several months while its registration statement received full-scale SEC review). An obvious alternative to the use of an NRSRO investment grade rating as a condition for Form S-3 eligibility would be certification by ``gatekeepers'' to the SEC (i.e., attorneys and due diligence firms) of the work they performed. Form S-3 could still require an ``investment grade'' rating, but that it come from an NRSRO rating agency should not be mandatory.--------------------------------------------------------------------------- \109\ See Form S-3, General Instructions, IB5 (``Transaction Requirements--Offerings of Investment Grade Asset-Backed Securities'').--------------------------------------------------------------------------- After 2000, developments in litigation largely convinced underwriters that it was infeasible to expect to establish their due diligence defense. The key event was the WorldCom decision in 2004. \110\ In WorldCom, the court effectively required the same degree of investigation for shelf-registered offerings as for traditional offerings, despite the compressed time frame and lack of underwriter involvement in the drafting of the registration statement. The Court asserted that its reading of the rule should not be onerous for underwriters because they could still perform due diligence prior to the offering by means of ``continuous due diligence'' (i.e., through participation by the underwriter in the drafting of the various Form 10-Ks and Form 10-Qs that are incorporated by reference into the shelf-registration).--------------------------------------------------------------------------- \110\ In re WorldCom Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y. 2004). The WorldCom decision denied the underwriters' motion for summary judgment based on their asserted due diligence defense, but never decided whether the defense could be successfully asserted at trial. The case settled before trial for approximately $6.2 billion.--------------------------------------------------------------------------- For underwriters, the WorldCom decision was largely seen as a disaster. Their hopes--probably illusory in retrospect--were dashed that courts would soften Securities Act 11's requirements in light of the near impossibility of complying with due diligence responsibilities during the shortened time frames imposed by shelf registration. Some commentators had long (and properly) observed that the industry had essentially played ``ostrich,'' hoping unrealistically that Rule 176 would protect them. \111\ In WorldCom's wake, the SEC did propose some amendments to strengthen Rule 176 that would make it something closer to a safe harbor. But the SEC ultimately withdrew and did not adopt this proposal.--------------------------------------------------------------------------- \111\ See Donald Langevoort, Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment, 63 Law and Contemporary Problems, U.S. 62-63 (2000).--------------------------------------------------------------------------- As the industry now found (as of late 2004) that token or formalistic efforts to satisfy Section 11 would not work, it faced a bleak choice. It could accept the risk of liability on shelf offerings or it could seek to slow them down to engage in full scale due diligence. Of course, different law firms and different investment banks could respond differently, but I am aware of no firms attempting truly substantial due diligence on asset-backed securitizations. Particularly in the case of structured finance, the business risk of Section 11 liability seemed acceptable. After all, investment grade bonds did not typically default or result in class action litigation, and Section 11 has a short statute of limitations (one year from the date that the plaintiffs are placed on ``inquiry notice''). Hence, investment banks could rationally decide to proceed with structured finance offerings knowing that they would be legally exposed if the debt defaulted, in part because the period of their exposure would be brief. In the wake of the WorldCom decision, the dichotomy widened between the still extensive due diligence conducted in IPOs, and the minimal due diligence in shelf offerings. As discussed below, important business risks may have also motivated investment banks to decide not to slow down structured finance offerings for extended due diligence. The bottom line here then is that, at least in the case of asset-backed shelf offerings, investment banks ceased to perform the due diligence intended by Congress, but instead accepted the risk of liability as a cost of doing business in this context. But that is only the beginning of the story. Conflicts of Interest: Traditionally, the investment bank in a public offering played a gatekeeping role, vetting the company and serving as an agent both for the prospective investors (who are also its clients) and the corporate issuer. Because it had clients on both sides of the offering, the underwriter's relationship with the issuer was somewhat adversarial, as its counsel scrutinized and tested the issuer's draft registration statement. But structured finance is different. In these offerings, there is no corporate issuer, but only a ``special purpose vehicle'' (SPV) typically established by the investment bank. The product--residential home mortgages--is purchased by the investment bank from loan originators and may be held in inventory by the investment bank for some period until the offering can be effected. In part for this reason, the investment bank will logically want to expedite the offering in order to minimize the period that it must hold the purchased mortgages in its own inventory and at its own risk. Whereas in an IPO the underwriter (at least in theory) is acting as a watchdog testing the quality of the issuer's disclosures, the situation is obviously different in an assets-backed securities offering that the underwriter is structuring itself. It can hardly be its own watchdog. Thus, the quality of disclosure may suffer. Reports have circulated that some due diligence firms advised their underwriters that the majority of mortgages loans in some securitized portfolio were ``exception'' loans--i.e., loans outside the bank's normal guidelines. \112\ But the registration statement disclosed only that the portfolio included a ``significant'' or ``substantial'' number of such loans, not that it was predominantly composed of such loans. This is inferior and materially deficient disclosure, and it seems attributable to the built-in conflicts in this process.--------------------------------------------------------------------------- \112\ See, e.g., Vikas Bajaj and Jenny Anderson, ``Inquiry Focuses on Withholding of Data on Loans,'' New York Times, January 12, 2008, at A-1.--------------------------------------------------------------------------- Executive Compensation: Investment bankers are typically paid year-end bonuses that are a multiple of their salaries. These bonuses are based on successful completion of fee-generating deals during the year. But a deal that generates significant income in Year One could eventually generate significant liability in Year Two or Three. In this light, the year-end bonus system may result in a short-term focus that ignores or overly discounts longer-term risks. Moreover, high lateral mobility characterizes investment banking firms, meaning that the individual investment banker may not identify with the firm's longer-term interests. In short, investment banks may face serious agency costs problems, which may partly explain their willingness to acquire risky mortgage portfolios without adequate investigation of the collateral. Competitive Pressure: Citigroup CEO Charles Prince's now famous observation that ``when the music is playing, you've got to get up and dance'' is principally a recognition of the impact of competitive pressure. If investors are clamoring for ``investment grade'' CDOs (as they were in 2004-2006), an investment bank understands that if it does not offer a steady supply of transactions, its investors will go elsewhere--and possibly not return. Thus, to hold onto a profitable franchise, investment banks sought to maintain a steady pipeline of transactions; this in turn lead them to seek to lock in sources of supply. Accordingly, they made clear to loan originators their willingness to buy all the ``product'' that the latter could supply. Some investment banks even sought billion dollar promises from loan originators of a minimum amount of product. Loan originators quickly realized that due diligence was now a charade (even if it had not been in the past) because the ``securitizing'' investment banks were competing fiercely for supply. In a market where the demand seemed inexhaustible, the real issue was obtaining supply, and investment banks spent little time worrying about due diligence or rejecting a supply that was already too scarce for their anticipated needs. Providing Time for Due Diligence: The business model for structured finance is today broken. Underwriters and credit rating agencies have lost much of their credibility. Until structured finance can regain credibility, housing finance in the United States will remain in scarce supply. The first lesson to be learned is that underwriters cannot be trusted to perform serious due diligence when they are in effect selling their own inventory and are under severe time pressure. The second lesson is that because expedited shelf registration is inconsistent with meaningful due diligence, the process of underwriting structured finance offerings needs to be slowed down to permit more serious due diligence. Shelf registration and abbreviated time schedules may be appropriate for seasoned corporate issuers whose periodic filings are incorporated by reference into the registration statement, but it makes less sense in the case of a ``special purpose vehicle'' that has been created by the underwriter solely as a vehicle by which to sell asset-backed securities. Offerings by seasoned issuers and by special purpose entities are very different and need not march to the same drummer (or the same timetable). An offering process for structured finance that was credible would look very different than the process we have recently observed. First, a key role would be played by the due diligence firms, but their reports would not go only to the underwriter (who appears to have at time ignored them). Instead, without editing or filtering, their reports would also go directly to the credit-rating agency. Indeed, the rating agency would specify what it would want to see covered by the due diligence firm's report. Some dialogue between the rating agency and the due diligence firm would be built into the process, and ideally their exchange would be outside the presence of the underwriter (who would still pay for the due diligence firm's services). At a minimum, the NRSRO rating agencies should require full access to such due diligence reports as a condition of providing a rating (this is a principle with which these firms agree, but may find it difficult to enforce in the absence of a binding rule). To enable serious due diligence to take place, one approach would be to provide that structured finance offerings should not qualify for Form S-3 (or for any similar form of expedited SEC review). If the process can occur in a day, the pressures on all the participants to meet an impossible schedule will ensure that little serious investigation of the collateral's quality will occur. An alternative (or complementary approach) would be to direct the SEC to revise Regulation AB to incorporate greater verification by the underwriter (and thus its agents) of the quality of the underlying financial assets. Does this sound unrealistic? Interestingly, the key element in this proposal--that that due diligence firm's report go to the credit rating agency--is an important element in the settlement negotiated in 2008 by New York State Attorney General Cuomo and the credit rating agencies. \113\--------------------------------------------------------------------------- \113\ See Aaron Lucchetti, ``Big Credit-Rating Firms Agree to Reforms,'' The Wall Street Journal, June 6, 2008 at p. C-3.--------------------------------------------------------------------------- The second element of this proposal--i.e., that the process be slowed to permit some dialogue and questioning of the due diligence firm's findings--will be more controversial. It will be argued that delay will place American underwriters at a competitive disadvantage to European rivals and that offerings will migrate to Europe. But today, structured finance is moribund on both sides of the Atlantic. To revive it, credibility must be restored to the due diligence process. Instantaneous due diligence is in the last analysis simply a contradiction in terms. Time and effort are necessary if the quality of the collateral is to be verified--and if investors are to perceive that a serious effort to protect their interests is occurring.Rehabilitating the Gatekeepers Credit rating agencies remain the critical gatekeeper whose performance must be improved if structured finance through private offerings (i.e., without government guarantees) is to become viable again. As already noted, credit rating agencies face a concentrated market in which they are vulnerable to pressure from underwriters and active competition for the rating business. At present, credit rating agencies face little liability and perform little verification. Rather, they state explicitly that they are assuming the accuracy of the issuer's representations. The only force that can feasibly induce them to conduct or obtain verification is the threat of securities law liability. Although that threat has been historically non-existent, it can be legislatively augmented. The credit rating agency does make a statement (i.e., its rating) on which the purchasers of debt securities do typically rely. Thus, potential liability does exist under Rule 10b-5 to the extent that it makes a statement in connection with a purchase or sale of a security. The difficult problem is that a defendant is only liable under Rule 10b-5 if it makes a material misrepresentation or omission with scienter. In my judgment, there are few cases, if any, in which the rating agencies actually know of the fraud. But, under Rule 10b-5, a rating agency can be held liable if it acted ``recklessly.'' Accordingly, I would proposed that Congress expressly define the standard of ``recklessness'' that creates liability under Rule 10b-5 for a credit rating agency to be the issuance of a rating when the rating agency knowingly or recklessly is aware of facts indicating that reasonable efforts have not been conducted to verify the essential facts relied upon by its ratings methodology. A safe harbor could be created for circumstances in which the ratings agency receives written certification from a ``due diligence'' firm, independent of the promoter, indicating that it has conducted sampling procedures that lead it to believe in the accuracy of the facts or estimates asserted by the promoter. The goal of this strategy is not to impose massive liabilities on rating agencies, but to make it unavoidable that someone (either the rating agency or the due diligence firm) conduct reasonable verification. To be sure, this proposal would involve increased costs to conduct such due diligence (which either the issuer or the underwriter would be compelled to assume). But these costs are several orders of magnitude below the costs that the collapse of the structured finance market has imposed on the American taxpayer.Conclusions 1. The current financial crisis--including the collapse of the U.S. real estate market, the insolvency of the major U.S. investment banks, and the record decline in the stock market--was not the product of investor mania or the classic demand-driven bubble, but rather was the product of the excesses of an ``originate-and-distribute'' business model that both loan originators and investment banks followed to the brink of disaster--and beyond. Under this business model, financial institutions abandoned discipline and knowingly made non-creditworthy loans because they did not expect to hold the resulting financial assets for long enough to matter. 2. The ``moral hazard'' problem that resulted was compounded by deregulatory policies at the SEC (and elsewhere) that permitted investment banks to increase their leverage rapidly between 2004 and 2006, while also reducing their level of diversification. Under the Consolidated Supervised Entity (CSE) Program, the SEC essentially deferred to self-regulation by the five largest investment banks, who woefully underestimated their exposure to risk. 3. This episode shows (if there ever was doubt) that in an environment of intense competition and under the pressure of equity-based executive compensation systems that are extraordinarily short-term oriented, self-regulation does not work. 4. As a result, all financial institutions that are ``too big to fail'' need to be subjected to prudential financial supervision and a common (although risk-adjusted) standard. This can only be done by the Federal Reserve Board, which should be given authority to regulate the capital adequacy, safety and soundness, and risk management practices of all large financial institutions. 5. Incident to making the Federal Reserve the systemic risk regulator for the U.S. economy, it should receive legislative authority to: (1) establish ceilings on debt/equity ratios and otherwise restrict leverage at all major financial institutions (including banks, hedge funds, money market funds, insurance companies, and pension plans, as well as financial subsidiaries of industrial corporations); (2) supervise and restrict the design, and trading of new financial products (particularly including over-the-counter derivatives); (3) mandate the use of clearinghouses, to supervise them, and in its discretion to require their consolidation; (4) require the writedown of risky assets by financial institutions, regardless of whether required by accounting rule; and (5) to prevent liquidate crises by restricting the issuance of short-term debt. 6. Under the ``twin peaks'' model, the systemic risk regulatory agency would have broad powers, but not the power to override the consumer protection and transparency policies of the SEC. Too often bank regulators and banks have engaged in a conspiracy of silence to hide problems, lest they alarm investors. For that reason, some SEC responsibilities should not be subordinated to the authority of the Federal Reserve. 7. As a financial technology, asset-backed securitizations have decisively failed. To restore credibility to this marketplace, sponsors must abandon their ``originate-and-distribute'' business model and instead commit to retain a significant portion of the most subordinated tranche. Only if the promoter, itself, holds a share of the weakest class of debt that it is issuing (and on an unhedged basis) will there be a sufficient signal of commitment to restore credibility. 8. Credit rating agencies must be compelled either to conduct reasonable verification of the key facts that they are assuming in their ratings methodology or to obtain such verification from professionals independent of the issuer. For this obligation to be meaningful, it must be backstopped by a standard of liability specifically designed to apply to credit-rating agencies. ______ FOMC20061212meeting--19 17,MS. BIES.," Thank you, Mr. Chairman. Dino, regarding the last graph you showed, leveraged-loan growth, especially in the share held outside banks, has been happening even though, as you show, high-yield bond issuance really has been running in a fairly normal range. What is making these loan deals so much more attractive to investors?" FinancialCrisisInquiry--24 In conclusion, I want all of you and the American people to know that I fully understand and appreciate the gravity of the crisis that we are now just coming through. We are grateful for the courage shown by government leaders to take bold, unprecedented action to preserve the financial system. We support regulatory reform efforts designed to prevent any recurrence of this episode. But most of all, we as managers have to run our companies never to let this happen again. Thank you for your time. And I’d welcome any questions you might have. CHAIRMAN ANGELIDES: Thank you very much, Mr. Moynihan. Thank you very much, all of you, for your thoughtful statements. We are now going to move to questions. And we have got a lot of ground to cover, so I’m going to ask that you be as, obviously, incisive and compelling as possible, but brief, succinct, direct answers. I’ll start the questioning today. And what I’d like to do is I’d like to start by asking some questions about specific types of business practices and risk management practices that may have contributed to the financial crisis as a way of making this tangible and real. And I want to pick up on your comment, Mr. Dimon, here. I’d like to be brutally honest. Mr. Blankfein, I’m going to start my questioning with you today. And I want to actually pick up on your comment in your testimony about the fact that there were—and—and I think I’m paraphrasing this correctly. That there were financial products and practices that may have served no, essentially, good or productive purpose in the financial system. Recently you’ve made a few comments. And I’d like to just read you a couple of quotes. You said in November of last year, “Listen, there was a lot of negligent behavior and proper bad behavior that has to be fixed and sorted through. We don’t take ourselves out of that. I include ourselves in that.” You also said, “We participated in things that were clearly wrong and we have reasons to regret and apologize for.” What I’d like to ask you is can you tell me very specifically what are the two most significant instances of negligent, improper and bad behavior in which your firm engaged and for which you would apologize. (BUZZER SOUNDS) That’s a vote. January 13, 2010 BLANKFEIN: Oh I see. I’d say the—the biggest—the biggest—and I referred to this in my—in my oral testimony just now. I think we in our behavior got up—got caught up in—and this is a general remark, I’ll get specific in a second got caught up in and participated in and therefore, contributed to elements of froth in the market. So, for example, in leverage finance, which was our biggest exposure, we are a top service provider to the private equity world. We are—we are a top mergers and acquisitions firm in connection with rendering that advice for mergers and acquisitions. We helped finance those transactions. Increasingly those transactions took on higher and higher leverage, which they could not have but for the willingness of financiers to participate in that. And we were a major financier. And moreover, we held those positions for too long, too much concentration in our books. In other words, we sold them down. And if you go through a continuum of people who have had these positions I don’t think—you know, relative to our size, we had more than we should have had. And therefore, we had to—when you go back and look at them, too much leverage in transactions and too much concentration remained from that leverage on our books. CHAIRMAN ANGELIDES: OK. Would you characterize—looking back on this now—and obviously, hindsight’s 20/20. But would you look back on some of the financings as negligent or improper? BLANKFEIN: Again, in the context of the world that we were in—and when you use terms like that, I always think about standards of behavior and in the context. I think those were very typical behaviors in the context that we were in. CHAIRMAN ANGELIDES: Let me ask you, have you done any kind of internal investigation, kind of large sweep of your activities? And is that—what did you find? And is that something we could have? CHRG-111hhrg53244--86 Mr. Neugebauer," Thank you for that. The second thing is, in some of your projections of looking forward, what you think the economy is going to be like in 2009 and 2010 in relationship to jobs, for example, when you were using the numbers and assumptions you were using, did you assume that Congress would not continue this huge deficit spending where we are on track to literally double the national debt? Are your assumptions based on employment is going to get better if Congress has better fiscal policy? Or are your job assumptions based on continuing to spend money like drunken sailors? " CHRG-111shrg62643--114 Mr. Bernanke," A majority of them are emerging market economies, many of which are actually growing pretty quickly right now, so I am not sure I would want to impose a single standard on all the members of the G-20. The important thing is the overall trajectory. Is there some evidence that the debt will begin to stabilize within the next few years? Senator Tester. OK. Investors have been--I mean, the Treasury bonds have been pretty solid, and that is maybe an understatement. How long do you think this will remain this way, and is it dependent on what is going on in Europe right now that they are solid, or is there another reason for it? " CHRG-110hhrg46596--76 Mr. Bachus," I understand. Is there leverage under the law, or under the lending regulations, to require them to lend it, as opposed to, say, they pay the amount of dividend or to make acquisitions? I will ask Mr. Kashkari or either one of you gentlemen. " CHRG-110shrg50410--10 Chairman Dodd," Thank you very much, Mr. Chairman, and we appreciate your presence again here today. I will put 6 minutes on the clock here, and we will move along. Because everyone has shown up here, we will move in a normal seniority system here, as everyone has been for the last 2 or 3 hours. Let me address, if I can, the very points, Mr. Secretary, that you have raised. Again, this is our responsibility here to be probative and examine these ideas, particularly if we are going to try and act in some expeditious fashion here. Normally, there would be a period of time to really go over these issues in far greater detail, but the sense of urgency is something I think all of us, or at least most of us here appreciate. Let me begin by, first of all, asking a quick series of questions regarding the issue of the lines of credit, and then I will get to the issue of stock and then the issue of the regulator, if I could quickly. One, you are seeking an unprecedented grant of authority to purchase GSE debt and stocks. What kind of assurances can we offer taxpayers--because we do not have a number here, this is an unlimited amount we are looking at potentially. What has happened with the $2.25 billion, the present authority that exists from the Federal Reserve? Why aren't we going and just opening the discount window? Institutions that have access to the discount window--and Chairman Bernanke can respond to this as well--use GSE debt as collateral, as a basis of qualifying for borrowing at that discount window. If we do that, why not allow these GSEs to have direct access? That way we do not need legislative authority and would provide that kind of fresh capital we are looking at. Why not just go that route if we are looking for some quick action here that would reassure the markets that there will be adequate capital? " CHRG-111hhrg53248--19 Mr. Royce," Thank you. I think getting to the bottom of what caused the housing bubble should be our primary objective here. And in point of fact, it was the Fed that came to us, came to this committee, and came to the Senate committee, and said that because of the size of the portfolios of Fannie and Freddie and because of the leverage ratios of 100 to 1, 100 to 1 in leverage, because of the direction for them to have purchased a trillion in subprime mortgages for their political, for their affordable housing goals and so forth, that they had to be regulated for systemic risk. In 2003, I put in a bill to do that working with the Fed. In 2005, we in fact had my amendment on the Floor to try to give the regulators the ability to regulate for systemic risk. Fannie and Freddie opposed it. Franklin Raines opposed it. It was opposed by most of the Members of this House. But in 2006, in the Senate, they actually got it out of committee. But again, the Democratic Members on the Senate side opposed that regulation to give the regulators the ability to handle Fannie and Freddie for systemic risk. That is the history of this. We need to address it. " CHRG-111hhrg52397--162 Mr. Murphy," There are some operational things you can do in certain countries, for example, where we do not use derivatives, where the derivative markets are not developed, Latin America for example. You can change payment terms with customers, you can take out debt in certain currencies and match that against some of your assets in those currencies, but typically that takes place in those more Third World type markets. In G-20 countries where we have sophisticated competitors who have access to capital markets, we have to be more nimble, more efficient from a pricing standpoint, and so derivatives are clearly the number one way to go. " 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." CHRG-109hhrg31539--253 Mr. Hensarling," There have been a couple of questions on GSE's, and forgive me if I am applying some old ground. But your predecessor had a rather high anxiety level about the GSE's holding their own debt in their portfolios. I know there has been a couple of questions about it, but if I decide to toss and turn tonight, how much time should I spend worrying about portfolio limitations on the GSE? To what extent on the anxiety barometer, how much time should we worry about the systemic risk that that poses? " CHRG-111shrg51395--84 Chairman Dodd," Certainly. Senator Bennet. ----for Mr. Doe. I was very interested in your testimony. This is a line of conversation that Senator Warner and I have been having. I assume that your view is that there is Federal authority now to be able to intercede, either through the Treasury or the Fed, with the VRDO market in some way that may give hospitals, public hospitals, schools, and other municipal credit some relief from the lack of market that exists for variable rate debt---- " CHRG-110shrg50410--108 Secretary Paulson," Yes, Senator. As we had a discussion and Senator Shelby raised some issues there and said that, as we went through it, it is very difficult out how to structure something when we have not even made a decision. And there is no decision, no intent, at this time to put money in. I would say if we do, we will be very mindful of structuring something in a way in which it protects the taxpayer. Senator Schumer. And you know, Freddie's debt offering yesterday, as I understand it, was oversubscribed and they were able to borrow at low rates? " CHRG-111shrg54589--145 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM HENRY T. C. HUQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. Answer not received by time of publication.Q.1.b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. Answer not received by time of publication.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?A.2. Answer not received by time of publication.Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. Answer not received by time of publication.Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. Answer not received by time of publication.Q.5. Do over-the-counter or custom derivatives have any favorable accounting or tax treatments versus exchange traded derivatives?A.5. Answer not received by time of publication.Q.6. In addition to the Administration's proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?A.6. Answer not received by time of publication.Q.7. Is there any reason standardized derivatives should not be traded on an exchange?A.7. Answer not received by time of publication.Q.8. It seems that credit default swaps could be used to manipulate stock prices. In a simple example, an investor could short a stock, and then purchase credit default swaps on the company. If the swaps are not heavily traded, the purchase would likely drive up the price of the swaps, indicating higher risk of default by the company, and lead to a decline in the stock price. Is there any evidence that such manipulation has taken place? And more generally, what about other types of manipulation using derivatives?A.8. Answer not received by time of publication.Q.9. Credit default swaps look a lot like insurance when there are unbalanced, opportunistic sellers. However, life and property insurance requires an insurable interest for the buyer and reserves for the seller. Why should we not regulate these swaps like traditional insurance?A.9. Answer not received by time of publication.Q.10. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.10. Answer not received by time of publication.Q.11. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.11. Answer not received by time of publication.Q.12. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn't they?A.12. Answer not received by time of publication.Q.13. In her testimony Chairman Schapiro mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.13. Answer not received by time of publication.Q.14. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.14. Answer not received by time of publication.Q.15. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.15. Answer not received by time of publication.Q.16. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.16. Answer not received by time of publication.Q.17. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.17. Answer not received by time of publication.Q.18. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.18. Answer not received by time of publication.Q.19. Who is a natural seller of credit protection?A.19. Answer not received by time of publication.Q.20. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.20. Answer not received by time of publication.Q.21. What is insufficient about the clearinghouse proposed by the dealers and New York Fed?A.21. Answer not received by time of publication.Q.22. How do we prevent a clearinghouse or exchange from being too big to fail? And should they have access to Fed borrowing?A.22. Answer not received by time of publication.Q.23. What price discovery information do credit default swaps provide, when the market is functioning properly, that cannot be found somewhere else?A.23. Answer not received by time of publication.Q.24. Selling credit default swaps is often said to be the same as being long in bonds. However, when buying bonds, you have to provide real capital up front and there is a limit to the lending. So it sounds like selling swaps may be a bet in the same direction as buying bonds, but is essentially a highly leveraged bet. Is that the case, and if so, should it be treated that way for accounting purposes?A.24. Answer not received by time of publication.Q.25. Why should we have two regulators of derivatives, with two interpretations of the laws and regulations? Doesn't that just lead to regulation shopping and avoidance?A.25. Answer not received by time of publication.Q.26. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.26. Answer not received by time of publication.Q.27. What is good about the Administration proposal?A.27. Answer not received by time of publication.Q.28. Is the Administration proposal enough?A.28. Answer not received by time of publication.Q.29. Mr. Whalen suggests that Congress should subject all derivatives to the Commodity Exchange Act, at least as an interim step. Is there any reason we should not do so?A.29. Answer not received by time of publication.Q.30. Is there anything else you would like to say for the record?A.30. Answer not received by time of publication. ------ FOMC20080130meeting--314 312,MR. PARKINSON.," 6 Thank you, Mr. Chairman. The first exhibit provides some background on efforts to analyze the policy issues raised by recent financial developments and an overview of today's briefing. As indicated in the top panel, in response to a request from the G-7, at its meeting last September the Financial Stability Forum (FSF) created a Working Group on Market and Institutional Resilience. The working group's mandate calls for it to develop a diagnosis of the causes of the recent financial market turmoil, to identify weaknesses in markets and institutions that merit attention from policymakers, and to recommend actions needed to enhance market discipline and institutional resilience. The working group has been asked to prepare a report for consideration by the FSF at its meeting in March so that the FSF can complete a final report to the G-7 in April. The President's Working Group on Financial Markets (PWG) is conducting its own analysis along the same lines and will ensure coordination among the U.S. members of the FSF working group. Chairman Bernanke, Vice Chairman Kohn, and President Geithner asked the Board's Staff Umbrella Group on Financial Stability to organize and coordinate staff support for their participation in the FSF working group and the PWG's effort. Specifically, they asked the The materials used by Mr. Parkinson, Mr. Gibson, Ms. Hirtle, Mr. Greenlee, and Mr. Angulo are appended to this transcript (appendix 6). 6 staff to analyze the nine sets of issues listed in the middle panel. Subgroups of staff from the Board and the Federal Reserve Bank of New York were formed to address each set of issues, and work is well under way on all of them. The first four of these issues will be discussed in today's briefing. As shown in the bottom panel, today's briefing will consist of three presentations. I will start by presenting a diagnosis of the underlying reasons that losses on U.S. subprime mortgages triggered a global financial crisis. This diagnosis will suggest that among the most important factors were (1) a loss of investor confidence in the ratings of structuredfinance products and asset-backed commercial paper (ABCP), which caused structured-credit markets to seize up and ABCP markets to contract, and (2) the resulting losses and balance sheet pressures on financial intermediaries, especially many of the largest global financial services organizations. In the second presentation, Mike Gibson and Beverly Hirtle, to my left, will present an analysis of issues relating to credit rating agencies and investor practices with respect to credit ratings. Then, further to my left, Jon Greenlee and Art Angulo will make the final presentation, which will focus on risk-management weaknesses at large global financial services organizations and the extent to which bank regulatory policies contributed to, or failed to mitigate, those weaknesses. I should note that also at the table today we have Norah Barger, who worked with Art Angulo on the regulatory policy issues, and Brian Peters, who worked with Jon Greenlee on the risk-management issues. Turning to the next exhibit, the diagnosis begins with the extremely weak underwriting standards for U.S. adjustable-rate subprime mortgages originated between late 2005 and early 2007. As shown by the solid line in the top left panel, as housing prices softened in 2006 and 2007, the delinquency rate for such mortgages soared, exceeding 20 percent of the entire outstanding stock by late 2007. In contrast, the dashed line shows that the delinquency rate on the stock of outstanding fixed-rate subprime mortgages increased only 2 percentage points over the same period, to around 7 percent. Nearly all of the adjustable-rate subprime mortgages were packaged in residential mortgage-backed securities (RMBS), which were structured in tranches with varying degrees of exposure to credit losses. The top right panel shows indexes of prices of subprime RMBS that are collateralized by mortgages that were originated in the second half of 2006. The blue line shows that prices of BBB minus tranches already had fallen significantly below par in January 2007 and continued to decline throughout last year, falling to less than 20 percent of par by late October. Prices of AAA tranches (the black line), which are vulnerable only to very severe credit losses on the underlying subprime mortgages, remained near par until mid-July, but they slid to around 90 percent of par by early August. After stabilizing for a time, they fell more steeply in October and November and now trade at around 70 percent of par. As shown in the middle left panel, from 2004 through the first half of 2007, increasing amounts of subprime RMBS were purchased by managers of collateralized debt obligations backed by asset-backed securities--that is, ABS CDOs. High-grade CDOs purchased subprime RMBS with an average rating of AA, whereas mezzanine CDOs purchased subprime RMBS with an average rating of BBB. The middle right panel shows the typical ratings at origination of high-grade and mezzanine CDOs. In the case of high-grade CDOs, 5 percent of the securities were rated AAA, and a further 88 percent were ""super senior"" tranches, which would be exposed to credit losses only if the AAA tranches were wiped out. Even in the case of the mezzanine CDOs, the collateral was perceived to be sufficiently strong and diversified that 14 percent of the securities issued were rated AAA at origination and 62 percent were super senior. As delinquencies mounted and prices of RMBS slid well below par, the credit rating agencies were forced to downgrade (or place on watch for downgrade) very large percentages of outstanding ABS CDOs. The bottom left panel shows that such negative actions were quite frequent throughout the capital structures of both highgrade and mezzanine CDOs, even among the AAA-rated tranches. Moreover, the downgrades frequently were severe and implied very substantial writedowns, even of some AAA tranches. When this became apparent to investors, they lost not only faith in the ratings of ABS CDOs but also confidence in the ratings of a much broader range of structured securities. Likewise, sophisticated investors who relied on their own models lost faith in those models as writedowns significantly exceeded what the models led them to expect. As a result, large segments of the structured-credit markets seized up. In particular, as shown in the bottom right panel, issuance of all types of non-agency RMBS declined substantially over the second half of 2007. Although comprehensive data for January are not yet available, conversations with market participants suggest there has been very little or no issuance. Your next exhibit focuses on two other markets that were affected by a loss of investor confidence--the leveraged-loan market and the ABCP market. The top left panel of that exhibit shows that spreads on credit default swaps on leveraged loans (the solid black line) already had come under significant pressure in June. By July these spreads had widened about 150 basis points. Investors had become concerned about a substantial buildup of unfunded commitments to extend leveraged loans (the dashed blue line), which in the U.S. market eventually peaked at $250 billion in July. As shown in the top right panel, as many segments of the structured-credit markets seized up, issuance of collateralized loan obligations dropped off significantly in the third quarter, adding to the upward pressure on spreads on leveraged loans. Nonetheless, the CLO markets continued to function much more effectively than the non-agency RMBS and ABS CDO markets. As shown in the bottom left panel, from 2005 to 2007, the U.S. ABCP market grew very rapidly. Much of the growth was accounted for by conduits that purchased securities, including highly rated non-agency RMBS and ABS CDO tranches, rather than by more traditional ""multi-seller"" conduits that purchased short-term corporate and consumer receivables. As investors became aware that some of the underlying collateral consisted of RMBS and ABS CDOs, they pulled back from the ABCP market generally, even to some extent from the multi-seller programs. Between July and December, total ABCP outstanding declined about $350 billion, or nearly one-third. The bottom right panel provides additional information on the growth of ABCP by program type. As shown in the first column, during the period of rapid growth from 2005 to July 2007, ABCP issued by structured-investment vehicles (SIVs) and CDOs grew far more rapidly than any other program type. The second column shows that, when investors pulled back from the ABCP markets, those program types shrank especially rapidly. The only program type that declined more rapidly during that period was single-seller programs. The single-seller category included a significant amount of paper issued by nondepository mortgage companies to finance mortgages in their private securitization pipelines, and this paper has almost completely run off. The next exhibit focuses on how the seizing-up of structured-credit markets and the contraction of ABCP markets adversely affected banks, especially many of the largest global banks. As you know, a combination of balance sheet pressures, concerns about liquidity, and concerns about counterparty credit risk made banks reluctant to provide term funding to each other and to other market participants. The top left panel of exhibit 4 lists the principal sources of bank exposures to the recent financial stress: leveraged-loan commitments, sponsorship of ABCP programs, and the retention of exposures from underwriting ABS CDOs. The top right panel shows the banks that were the leading arrangers of leveraged loans in recent years. The three largest U.S. bank holding companies (BHCs) head this list. As spreads widened and liquidity declined in the leveraged-loan market, these banks became very concerned about potential losses and liquidity pressures from leveraged-loan exposures. Although these exposures were smaller at the U.S. securities firms, those firms were even more concerned because of their smaller balance sheet capacity. However, to date the adverse impact on banks and securities firms from these exposures has been relatively modest and manageable. The middle left panel shows the leading bank sponsors of global (U.S. and European) securities-related ABCP programs--that is, programs that invest in asset-backed securities, including SIVs, securities arbitrage programs, and certain hybrid programs. As the conduits that issued the ABCP encountered difficulty rolling their paper over, many of these banks, fearful of damage to their reputations, elected to purchase assets from the conduits or extend credit to them, which proved in many cases to be a significant source of balance sheet pressures. This list is dominated by European banks. Indeed, the only U.S. bank among the top nineteen sponsors is Citigroup. However, Citigroup was the largest sponsor of SIVs, which, in addition to issuing ABCP, issue substantial amounts of medium-term notes. Citigroup, like nearly all SIV sponsors, eventually felt obliged to provide full liquidity support for all the liabilities of its SIVs, which amounted to around $60 billion at year-end. The memo item shows that some other U.S. banks sponsored securities-related ABCP programs that were relatively small in absolute terms but significant as a share of their total assets. But losses from leveraged-loan commitments and conduit sponsorship have paled in comparison to the losses some banks and securities firms have incurred from the retention of super senior exposures from ABS CDOs. These include exposures that the underwriters never sold, exposures that originally were funded by ABCP issued by the CDOs that was supported by liquidity facilities provided by the underwriters, and relatively small amounts of exposures purchased from affiliated money funds for reputational reasons. The middle right panel shows the leading underwriters of ABS CDOs in 2006-07. Merrill Lynch, Citigroup, and UBS head the list. Each of those firms has suffered very large subprime CDO-related losses, and Citigroup and UBS still reported very significant exposures at year-end. As shown in the memo items, among the other very largest U.S. bank holding companies, only Bank of America has suffered significant losses or still has significant exposures from underwriting ABS CDOs. I should note that the exposures shown in the exhibit are net of hedges purchased from financial guarantors, and most of these firms have hedged a significant portion of their exposure. As you know, there are concerns about the ability of the guarantors to honor their obligations under the hedging contracts. Indeed, some firms have begun to write down the value of their hedges with the most troubled financial guarantors. The bottom left panel shows total risk-based capital ratios for the four largest U.S. bank holding companies. All four remained comfortably above the 10 percent minimum for wellcapitalized companies at year-end. Of course, Citigroup was able to do so only by raising substantial amounts of capital at a relatively high cost, and each of the other companies also announced capital-raising efforts. Moreover, Citigroup's year-end ratio of tangible common equity to risk-weighted managed assets was 5.7 percent, well below the 6.5 percent target ratio that several of the rating agencies monitor and that Citigroup seeks to meet. The bottom right panel shows credit default swap spreads for the three largest U.S. BHCs. On balance, spreads for all three have moved up about 60 to 70 basis points since the market turmoil began. The spread for Citigroup has been elevated since October, when investors began to become aware of its subprime CDO exposures. The spreads for Bank of America and JPMorgan were in line with a broad index of bank spreads at year-end but jumped in early January on Bank of America's announcement of its planned acquisition of Countrywide and JPMorgan's announcement of substantial additions to its loan-loss reserves. Spreads for all three companies fell back more in line with the index last week. Thank you. I will now take your questions on this presentation before you proceed to Mike and Beverly's presentation. " FOMC20080430meeting--304 302,MR. HOENIG.," Thank you, Mr. Chairman. I would look at this meeting as an introduction to this topic, given the breadth of the discussion here, which I found extremely interesting and useful. I think we will need to come back to another discussion of it--not necessarily with another 100-page study. I wouldn't want to put that burden on you--it might negate any savings we get from this project. [Laughter] To the point of the options, the one that was most attractive to me was option 2. It is a good transition. We have some familiarity with it, given the way we do clearing balances now, and I think we can work on it. The reason that I was a little questioning about option 1 is that in option 2 you are not quite sure what you are going to end up with, given how the banks may choose to target the amount of reserves and so forth. But with any choice we make, we are going to have to go up that learning curve. So of those, I prefer option 2. I am fascinated, though, with President Lacker's comments on option 4 and will look at it again with that in mind because I thought he made some good points. But at the moment, I think option 2 is a pretty good path to go down. " fcic_final_report_full--212 In April , the Fed raised the holding company’s supervisory rating from the previous year’s “fair” to “satisfactory.”  It lifted the ban on new mergers imposed the previous year in response to Citigroup’s many regulatory problems.  The Fed and OCC examiners concurred that the company had made “substantial progress” in im- plementing CEO Charles Prince’s plan to overhaul risk management. The Fed de- clared: “The company has  .  .  . completed improvements necessary to bring the company into substantial compliance with two existing Federal Reserve enforcement actions related to the execution of highly structured transactions and controls.”  The following year, Citigroup’s board would allude to Prince’s successful resolution of its regulatory compliance problems in justifying his  compensation increase.  The OCC noted in retrospect that the lifting of supervisory constraints in  had been a key turning point. “After regulatory restraints against significant acquisi- tions were lifted, Citigroup embarked on an aggressive acquisition program,” the OCC wrote to Vikram Pandit, Prince’s replacement, in early . “Additionally, with the re- moval of formal and informal agreements, the previous focus on risk and compliance gave way to business expansion and profits.” Meanwhile, risk managers granted excep- tions to limits, and increased exposure limits, instead of keeping business units in check as they had told the regulators.  Well after Citigroup sustained large losses on its CDOs, the Fed would criticize the firm for using its commercial bank to support its investment banking activities. “Senior management allowed business lines largely un- challenged access to the balance sheet to pursue revenue growth,” the Fed wrote in an April  letter to Pandit. “Citigroup attained significant market share across numer- ous products, including leveraged finance and structured credit trading, utilizing bal- ance sheet for its ‘originate to distribute’ strategy. Senior management did not appropriately consider the potential balance sheet implications of this strategy in the case of market disruptions. Further, they did not adequately access the potential nega- tive impact of earnings volatility of these businesses on the firm’s capital position.”  fcic_final_report_full--24 His clients included many of the largest lenders—Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experi- ence, fresh out of school and with previous jobs “flipping burgers,” he told the FCIC. Given the right training, however, the best of them could “easily” earn millions.  “I was a sales and marketing trainer in terms of helping people to know how to sell these products to, in some cases, frankly unsophisticated and unsuspecting bor- rowers,” he said. He taught them the new playbook: “You had no incentive whatso- ever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed. In fact, you were in a way encouraged not to worry about those macro issues.” He added, “I knew that the risk was being shunted off. I knew that we could be writing crap. But in the end it was like a game of musical chairs. Volume might go down but we were not going to be hurt.”  On Wall Street, where many of these loans were packaged into securities and sold to investors around the globe, a new term was coined: IBGYBG, “I’ll be gone, you’ll be gone.”  It referred to deals that brought in big fees up front while risking much larger losses in the future. And, for a long time, IBGYBG worked at every level. Most home loans entered the pipeline soon after borrowers signed the docu- ments and picked up their keys. Loans were put into packages and sold off in bulk to securitization firms—including investment banks such as Merrill Lynch, Bear Stearns, and Lehman Brothers, and commercial banks and thrifts such as Citibank, Wells Fargo, and Washington Mutual. The firms would package the loans into resi- dential mortgage–backed securities that would mostly be stamped with triple-A rat- ings by the credit rating agencies, and sold to investors. In many cases, the securities were repackaged again into collateralized debt obligations (CDOs)—often com- posed of the riskier portions of these securities—which would then be sold to other investors. Most of these securities would also receive the coveted triple-A ratings that investors believed attested to their quality and safety. Some investors would buy an invention from the s called a credit default swap (CDS) to protect against the securities’ defaulting. For every buyer of a credit default swap, there was a seller: as these investors made opposing bets, the layers of entanglement in the securities mar- ket increased. The instruments grew more and more complex; CDOs were constructed out of CDOs, creating CDOs squared. When firms ran out of real product, they started gen- erating cheaper-to-produce synthetic CDOs—composed not of real mortgage securi- ties but just of bets on other mortgage products. Each new permutation created an opportunity to extract more fees and trading profits. And each new layer brought in more investors wagering on the mortgage market—even well after the market had started to turn. So by the time the process was complete, a mortgage on a home in south Florida might become part of dozens of securities owned by hundreds of in- vestors—or parts of bets being made by hundreds more. Treasury Secretary Timothy Geithner, the president of the New York Federal Reserve Bank during the crisis, de- scribed the resulting product as “cooked spaghetti” that became hard to “untangle.”  Ralph Cioffi spent several years creating CDOs for Bear Stearns and a couple of more years on the repurchase or “repo” desk, which was responsible for borrowing money every night to finance Bear Stearns’s broader securities portfolio. In Septem- ber , Cioffi created a hedge fund within Bear Stearns with a minimum invest- ment of  million. As was common, he used borrowed money—up to  borrowed for every  from investors—to buy CDOs. Cioffi’s first fund was extremely success- ful; it earned  for investors in  and  in —after the annual manage- ment fee and the  slice of the profit for Cioffi and his Bear Stearns team—and grew to almost  billion by the end of . In the fall of , he created another, more aggressive fund. This one would shoot for leverage of up to  to . By the end of , the two hedge funds had  billion invested, half in securities issued by CDOs centered on housing. As a CDO manager, Cioffi also managed another  bil- lion of mortgage-related CDOs for other investors. FinancialCrisisInquiry--573 BASS: Yes. It was clearly the race to the bottom what we just went through. You know, when spreads are narrowing to the levels that they narrowed to between fixed-income instruments—and the only way to achieve the prior returns on equity was to just keep adding terms of leverage, you know, you hit the tipping point and, clearly, we hit the tipping point. What we have to prevent is hitting that point again. And, again, I stress bringing—I thought, during the Enron, WorldCom era, we learned that off-balance sheet equaled bad. And, clearly, we didn’t. So let’s bring off-balance sheet on-balance sheet again. Let’s compare apples to apples. Let’s set leverage limits. And let’s allow regulators and investors alike to make prudent decisions without having to read 50 sets of footnotes to figure out whether we’re coming or going. So it’s a long answer to saying I agree with you and there are things that we can put into place to change it going forward. fcic_final_report_full--151 CDOs, and leverage, Cioffi’s funds earned healthy returns for a time: the High-Grade fund had returns of  in ,  in , and  in  after fees.  Cioffi and Tannin made millions before the hedge funds collapsed in . Cioffi was rewarded with total compensation worth more than  million from  to . In , the year the two hedge funds filed for bankruptcy, Cioffi made more than . mil- lion in total compensation. Matt Tannin, his lead manager, was awarded compensa- tion of more than . million from  to .  Both managers invested some of their own money in the funds, and used this as a selling point when pitching the funds to others.  But when house prices fell and investors started to question the value of mort- gage-backed securities in , the same short-term leverage that had inflated Cioffi’s returns would amplify losses and quickly put his two hedge funds out of business. CITIGROUP ’S LIQUIDITY PUTS: “A POTENTIAL CONFLICT OF INTEREST ” By the middle of the decade, Citigroup was a market leader in selling CDOs, often using its depositor-based commercial bank to provide liquidity support. For much of this period, the company was in various types of trouble with its regulators, and then-CEO Charles Prince told the FCIC that dealing with those troubles took up more than half his time.  After paying the  million fine related to subprime mort- gage lending, Citigroup again got into trouble, charged with helping Enron—before that company filed for bankruptcy in —use structured finance transactions to manipulate its financial statements. In July , Citigroup agreed to pay the SEC  million to settle these allegations and also agreed, under formal enforcement actions by the Federal Reserve and Office of the Comptroller of the Currency, to overhaul its risk management practices.  By March , the Fed had seen enough: it banned Citigroup from making any more major acquisitions until it improved its governance and legal compliance. Ac- cording to Prince, he had already decided to turn “the company’s focus from an ac- quisition-driven strategy to more of a balanced strategy involving organic growth.”  Robert Rubin, a former treasury secretary and former Goldman Sachs co-CEO who was at that time chairman of the Executive Committee of Citigroup’s board of direc- tors, recommended that Citigroup increase its risk taking—assuming, he told the FCIC, that the firm managed those risks properly.  Citigroup’s investment bank subsidiary was a natural area for growth after the Fed and then Congress had done away with restrictions on activities that could be pur- sued by investment banks affiliated with commercial banks. One opportunity among many was the CDO business, which was just then taking off amid the booming mort- gage market. In , Citi’s CDO desk was a tiny unit in the company’s investment banking arm, “eight guys and a Bloomberg” terminal, in the words of Nestor Dominguez, then co-head of the desk.  Nevertheless, this tiny operation under the command of FOMC20051101meeting--162 160,MR. REINHART.," Let me also say, President Moskow, that the passage of time is helping in terms of providing other measures of the equilibrium real funds rate. We now have indexed debt quotes. We use them to back out an estimate of the equilibrium real funds rate. We don’t have a long enough time series to know its properties as, say, a predictor of aggregate demand or inflation. Over time, I would think that would become a more standard feature of our analysis, although this analysis is done in Dave Stockton’s area, and I wouldn’t want to commit his resources. [Laughter]" FinancialCrisisInquiry--734 ROSEN: I—I think the dot com bubble—the—the main problem there was again, I think related to the underwriting of unprofitable companies. It used to be you had to have, you know, a year of profit under your belt before you could go public. That was the Wall Street standard. They enforced it. Then that all changed. So it’s really the same thing. The lowering of standards, because you could get it done, and there were investors to buy it. This housing problem is much more serious though, because it is such a large sector as Mark said -- $11 trillion. It’s—every financial institution has this. It is larger than the public debt that we have, you know? And that’s why it’s so important, and so why the bubble is so much bigger. I would say the dot com bubble set up this bubble though. Because to clean up the last bubble, the Fed kept at rates too low too long. Their idea of not trying to do something about the bubble is either regulatory or through policy I think is—really is the core of the problem. Monetary policy is poorly—was poorly done under the last chairman. CHRG-111shrg62643--115 Mr. Bernanke," Well, there are a number of reasons why the yield is under 3 percent---- Senator Tester. Right. " Mr. Bernanke," ----currently. They include low inflation expectations, low growth expectations, but very importantly, also safe haven effects. That is, the U.S. dollar or U.S. debt is considered to be very liquid, very safe instrument, and given the amount of risks in the financial markets around the world, many investors have decided to acquire U.S. dollars, including many foreign governments who want to hold dollar reserves. So those are some of the reasons. Clearly, the bond market at this point is not focused on long-term deficits, at which point it would become more concerned. It is very hard to know. Senator Tester. Some have said that there is going to be--there is strong potential for another dip due to commercial real estate and other things. What impact does that have on the Treasury bonds? " fcic_final_report_full--23 Many people chose poorly. Some people wanted to live beyond their means, and by mid-, nearly one-quarter of all borrowers nationwide were taking out interest- only loans that allowed them to defer the payment of principal.  Some borrowers opted for nontraditional mortgages because that was the only way they could get a foothold in areas such as the sky-high California housing market.  Some speculators saw the chance to snatch up investment properties and flip them for profit—and Florida and Georgia became a particular target for investors who used these loans to acquire real estate.  Some were misled by salespeople who came to their homes and persuaded them to sign loan documents on their kitchen tables. Some borrowers naively trusted mortgage brokers who earned more money placing them in risky loans than in safe ones.  With these loans, buyers were able to bid up the prices of houses even if they didn’t have enough income to qualify for traditional loans. Some of these exotic loans had existed in the past, used by high-income, finan- cially secure people as a cash-management tool. Some had been targeted to borrow- ers with impaired credit, offering them the opportunity to build a stronger payment history before they refinanced. But the instruments began to deluge the larger market in  and . The changed occurred “almost overnight,” Faith Schwartz, then an executive at the subprime lender Option One and later the executive director of Hope Now, a lending-industry foreclosure relief group, told the Federal Reserve’s Con- sumer Advisory Council. “I would suggest most every lender in the country is in it, one way or another.”  At first not a lot of people really understood the potential hazards of these new loans. They were new, they were different, and the consequences were uncertain. But it soon became apparent that what had looked like newfound wealth was a mirage based on borrowed money. Overall mortgage indebtedness in the United States climbed from . trillion in  to . trillion in . The mortgage debt of American households rose almost as much in the six years from  to  as it had over the course of the country’s more than -year history. The amount of mortgage debt per household rose from , in  to , in .  With a simple flourish of a pen on paper, millions of Americans traded away decades of eq- uity tucked away in their homes. Under the radar, the lending and the financial services industry had mutated. In the past, lenders had avoided making unsound loans because they would be stuck with them in their loan portfolios. But because of the growth of securitization, it wasn’t even clear anymore who the lender was. The mortgages would be packaged, sliced, repackaged, insured, and sold as incomprehensibly complicated debt securities to an assortment of hungry investors. Now even the worst loans could find a buyer. More loan sales meant higher profits for everyone in the chain. Business boomed for Christopher Cruise, a Maryland-based corporate educator who trained loan offi- cers for companies that were expanding mortgage originations. He crisscrossed the nation, coaching about , loan originators a year in auditoriums and classrooms. FOMC20081216meeting--441 439,MR. DUDLEY.," Our view is that spreads are high mainly because people can't get leverage--that is number 1. Number 2, the traditional buyers of these AAA-rated assets either have disappeared completely, like SIVs and bank conduits, or have balance sheet constraints. So the risk capital hasn't really been willing to come in because they can't get the financing to make it worth their while. You know, LIBOR plus 300 is not an attractive proposition for someone who is using capital on an unleveraged basis. " CHRG-110hhrg44900--9 Mrs. Biggert," Thank you, Mr. Chairman, and thank you for holding today's hearing on systemic risk. Your responsiveness to the letter submitted in April by Mr. Garrett, Ranking Member Bachus, and more than a dozen of us on this side of the aisle is very much appreciated, and I would also like to thank Congressman Garrett for his leadership on this issue. I welcome our distinguished witnesses today: Federal Reserve Chairman Bernanke; and Treasury Secretary Paulson. Your steady leadership is helping us weather the storm that our markets and our economy are experiencing. As a side, Secretary Paulson, I would like to specifically thank you and your staff, as well as the public and private sector partners for organizing the HOPE NOW Alliance, which has helped to keep hundreds of thousands of families in their homes. And Chairman Bernanke, the Federal Reserve's actions continue to help preserve confidence and bring stability to our financial markets and institutions. Infusing liquidity into the marketplace has prevented the credit crunch from seizing the system, and facilitating the sale of Bear Stearns to J.P. Morgan is viewed by many as having been the lynchpin that prevented a run-on-the-bank type crises which could have spread throughout our financial system and caused irreparable harm. What brought us here today are these specifically and the latter actions on the part of the Fed, actions that begged the question, what can the Federal Government do to prevent future, similar bailouts that can put taxpayer dollars at risk? Is the Federal Government prepared for another Bear Stearns? Can a Federal regulator or regulators monitor specific indicators that will flag weaknesses within individual, financial institutions and prevent another Bear Stearns? And can they do so without unnecessarily increasing regulatory burdens that would diminish the competitiveness of the U.S. financial institutions in the global marketplace? It is vital that we closely examine the capacity of the Federal Government to monitor the large financial institutions like Bear Stearns, which represent not only American innovation and financial strength, but also our great vulnerability with respect to systematic risk in the financial system. I think without delay, we need to strike the right balance and create a simpler, stronger, regulatory system that preserves the resilience of our economy, protects taxpayers, and maintains the position of our financial system as the envy of the world. I look forward to the testimony and I yield back. " CHRG-111shrg55117--100 Mr. Bernanke," Well, you have put your finger on minimum payment as being an important issue for consumers to understand when they manage their own credit cards. We, of course, are writing the rules for this legislation, and as you know, we have pioneered the use of consumer testing as a way of making sure that disclosures are effective and understandable. And, in particular, we have found ways of presenting the minimum payment information on the periodic statement that we found through the consumer testing is effective. And so we are using that very actively. I would mention also that the Fed has some online resources, including a payments calculator that allows consumers to go and ask, you know, ``If I pay just the minimum payment and this is my balance and this is my interest rate, how many years will it take me to pay off my consumer credit card debt?'' So we are trying to be very responsive on that issue. I also agree that in providing disclosures to consumers, it is important to have transaction-specific information. They can see their own payment, their own loan, as opposed to some kind of generic example. And so we have been working on--we will be releasing tomorrow new disclosures for mortgages and for home equity lines of credit, which require an earlier presentation of information to consumers that includes information specific to their particular mortgage, so information about their payments, about their principal and so on. And we are using the same principle as we look at student loans and some other areas where we are working on providing new disclosures. So, again, going back to my earlier comment about counseling, when people see their own numbers, their own transaction, it is much more salient to them, and they are much more willing to pay attention. And we hope that by making these disclosures more individual specific, we will make them much more useful to consumers. Senator Akaka. Thank you. Let me ask, finally, even in these difficult financial times, many of my constituents continue to pay excessive amounts for remittances--remittances when they send a portion of their hard-earned wages to relatives abroad. What must be done to better inform consumers about lower-cost remittances? And how can remittances be used to increase access to mainstream financial institutions? " CHRG-111hhrg61852--38 Mr. Koo," I have argued that this is a very special type of recession that happens only after the bursting of a nationwide debt financed bubble as the asset prices collapsing, liabilities remaining, private sector balance sheets underwater. And in this type of recession, I believe the government will have to be in there spending to keep the GDP from falling so that people have income to repair their balance sheets. This action will have to be maintained until private sector balance sheets are repaired, and then you reverse course. Once the private sector is ready to borrow money, healthy again, then the government must reduce its deficit and at that time as quickly as possible. But we are still in the entrance part of this recession with all these people repairing their balance sheets. So I would hope that government will maintain fiscal stimulus, and that, of course, different types of fiscal stimulus--there are the tax cuts, and there is government spending. Tax cuts, I am afraid, are not very efficient. It is far better than nothing, but it is still inefficient in the sense that when people are trying to repair their balance sheets, and they get the tax cut, they use that to pay down debt, which means it doesn't add to the demand in the economy. So if the government spends the money directly, that will add more demand to the economy for the same amount of budget deficit. But if you cannot get people to agree on spending, then I will say at least keep the tax cuts from expiring because that is still better than nothing. Mrs. McCarthy of New York. Mr. Meltzer? " CHRG-111shrg50814--54 Mr. Bernanke," I think you do need to make sure there is adequate capital in financial institutions, and when they extend loans--for example, mortgages--they need to do a good job of underwriting. And that would involve adequate downpayments and verification of income, for example. Senator Schumer. But, again, I am saying there are institutions that use this leverage that you did not have any capital standards for because you were not statutorily required to do it. " fcic_final_report_full--185 In the spring of , the FOMC would again discuss risks in the housing and mortgage markets and express nervousness about the growing “ingenuity” of the mortgage sector. One participant noted that negative amortization loans had the per- nicious effect of stripping equity and wealth from homeowners and raised concerns about nontraditional lending practices that seemed based on the presumption of continued increases in home prices. John Snow, then treasury secretary, told the FCIC that he called a meeting in late  or early  to urge regulators to address the proliferation of poor lending practices. He said he was struck that regulators tended not to see a problem at their own institutions. “Nobody had a full -degree view. The basic reaction from finan- cial regulators was, ‘Well, there may be a problem. But it’s not in my field of view,’” Snow told the FCIC. Regulators responded to Snow’s questions by saying, “Our de- fault rates are very low. Our institutions are very well capitalized. Our institutions [have] very low delinquencies. So we don’t see any real big problem.”  In May , the banking agencies did issue guidance on the risks of home equity lines of credit and home equity loans. It cautioned financial institutions about credit risk management practices, pointing to interest-only features, low- or no-documentation loans, high loan-to-value and debt-to-income ratios, lower credit scores, greater use of automated valuation models, and the increase in transactions generated through a loan broker or other third party. While this guidance identified many of the problematic lending practices engaged in by bank lenders, it was limited to home equity loans. It did not apply to first mortgages.  In , examiners from the Fed and other agencies conducted a confidential “peer group” study of mortgage practices at six companies that together had origi- nated . trillion in mortgages in , almost half the national total. In the group were five banks whose holding companies were under the Fed’s supervisory purview—Bank of America, Citigroup, Countrywide, National City, and Wells Fargo—as well as the largest thrift, Washington Mutual.  The study “showed a very rapid increase in the volume of these irresponsible loans, very risky loans,” Sabeth Siddique, then head of credit risk at the Federal Reserve Board’s Division of Banking Supervision and Regulation, told the FCIC.  A large percentage of their loans issued were subprime and Alt-A mortgages, and the underwriting standards for these prod- ucts had deteriorated.  Once the Fed and other supervisors had identified the mortgage problems, they agreed to express those concerns to the industry in the form of nonbinding guidance. “There was among the Board of Governors folks, you know, some who felt that if we just put out guidance, the banks would get the message,” Bies said.  The federal agencies therefore drafted guidance on nontraditional mortgages such as option ARMs, issuing it for public comment in late . The draft guidance directed lenders to consider a borrower’s ability to make the loan payment when rates adjusted, rather than just the lower starting rate. It warned lenders that low- documentation loans should be “used with caution.”  CHRG-111shrg51395--98 Mr. Stevens," Thank you, Senator. I think it is a really excellent question, and I have asked myself this, and it is not intended as a competitive observation. If Franklin Roosevelt were to come back today and he would find we had these enormous pooled funds that were outside, virtually outside of any form of regulation, I think he would say, ``I thought we solved that problem in 1940.'' We need to make sure that the evident developments--and these are not secrets--the evident developments, major developments in our capital markets are addressed as they arise. Hedge fund investing is no doubt a tremendous innovation that can be of great value. But there were trillions of dollars in hedge funds that had no form of regulation. I think that is something that Congress was aware of, certainly the SEC was aware of. You could say the same about the major pooled funds in the money markets that will be part of the subject of our report when it is issued. Money market mutual funds are about a $4 trillion intermediary, but we're only about a third of the money market, which has many other pooled funds. So I think it is a problem--and this is how I envision it--of making sure that the capital markets regulator is staying even with market developments, and that is going to require not only nimbleness at a regulatory level, but, frankly, Mr. Chairman, it requires--it puts a burden on Committees like yours, because in many instances it is going to require the tough work of closing regulatory gaps, providing new authority, and even providing new resources. I do not think, however, that the answer, Senator is creating a new agency that only looks at products, because those products arise and exist in the context of a larger marketplace, and they need to be understood in that context. Senator Warner. Mr. Ryan. " CHRG-111shrg62643--127 Mr. Bernanke," So there are data. Some of the data that we look at are a survey we do of 100 banks of loan officers and ask them whether they are tightening or easing standards, and they have been tightening for quite a while. So some of this surely is the banks' decision to tighten their lending standards. Now, recently, we have seen a cessation of tightening. That is, standards are no longer getting tighter. In some places, they are getting a little bit easier. So there is some stabilization there. We have also seen that small business lending is still dropping, but more slowly than before. So there are some indications that credit is becoming more available. Whether that has to do with regulatory decisions or whether it has to do with the fact that the economy is looking a little better is hard to say. Senator Bennet. I wanted to, just before I lose my chance here, also talk a little bit about the deficit and the debt situation. You talked about how the markets need to see a compelling--that we are taking it seriously. You have testified to that before. Actually, they are not the only ones. My daughters have heard me talk about this so much that they are enormously agitated about this question themselves, because they don't want to make these decisions that we are failing to make. But Congress after Congress after Congress have failed to make the decisions, and we now have $13 trillion debt on the balance sheet. What is appalling about it, among other things, is that we really don't have much to show for it, I don't think. We haven't invested in this country's infrastructure, for example. We haven't built the 21st century energy infrastructure that we need. So the hole is actually even greater than I think we imagine from a fiscal point of view. You mentioned at the very beginning the difficulty of having one Congress bind the next Congress and the next Congress. What kind of thing do you think about when you are not here but in your office that we could do that would show that we are serious about this, that we are actually putting ourselves on a path of sustainability, knowing that we can't fix this overnight? What is it that we--what will do we need to demonstrate and how do we need to demonstrate it? I realize--I am not asking for specific policies, but what do you say to yourself? " CHRG-111hhrg67816--229 Mr. Rheingold," Thank you, Chairman, and thank you, Ranking Member Radanovich. It really is quite a honor to testify before you, Congressman Rush. I started my career as a consumer advocate in Chicago where I began a legal assistance foundation foreclosure prevention project, and I worked through the mid-90's dealing with all the mortgage crises that we had in Austin and Roslin, all over Chicago. And the things that we saw in Chicago in the 90's, we are seeing nationwide today. What I think disappoints me most about today's hearing is I am going to go through a litany of things that we consumer advocates saw in the 90's, saw in the early 2000's, and we see the exact same thing today. Nothing has changed except that things have gotten worse, and there has not been a federal response to it, including the FTC. I think about the world I see. I run an organization called the National Association of Consumer Advocates. We are the private attorneys, the legal service attorneys across this country who actually do the consumer advocacy work. We are on the ground every single day representing consumers who are losing their houses or having their car repossessed or being harassed by debt collectors. We see what is going on there but the federal regulatory agencies and the FTC have not talked to us. So what do we have out here? Oh, I should mention I also run a project called the Institute for Foreclosure Legal Assistance, so I am in contact and talk daily with all the private attorneys, the legal service attorneys in the community who are actually fighting foreclosures. We are on the ground. We know who the bad actors are. We see the bad practices, and we see what is going on out there. So what do we have? We have a completely broken mortgage lending industry. There is no question about it. Unfairness runs rampant. Bad lending practices are everywhere. We have a broken mortgage servicing system, completely broken. It is unaccountable. They can't figure out how much money people owe. They can't modify a loan to save their lives. We have seen, Chicago is a perfect example of it, a dual credit market. If you are middle income or rich, you have banks. If you are poor or you are low income, what do you have? You have currency exchanges and you have pay-day lenders, and you have rent to own, and you have refund anticipation loans. It is stealing wealth out of the communities that we care about most, and it has gone on unabated for the last decade with nobody really taking any real action and it is only getting worse. We have a debt collection industry that is completely out of control. We have growth of a debt buying industry that is sort of mind boggling in the way they go about collecting debts without actually even knowing--not having the contract that the person actually had that debt originally from. They don't have any proof that that is owed, yet they are using our nation's court and using our nation's private arbitration system to collect debts against people. We have a broken credit reporting system where consumers can't get real access to their credit reports. They don't get the information necessary and they can't fix those reports once they are broken. All of those things is what our credit market looks like today. And I went and talked with consumer advocates who I talk with every single day in this country. I asked them about the FTC and their role over the last 8 years and the last 10 years in protecting consumers. I will just pick some of the adjectives that I got responded, passive, antagonistic, irrelevant, disengaged, counterproductive, stuck in a world that doesn't regulate. They have not been part of the ballgame here. They can cite statistics. They can talk about some cases that they brought. In the scheme of things, it is mostly irrelevant. Now to be fair to them, they are under resourced, and there are good career attorneys there who do their best. But the fact is they have been disengaged. I have been in Washington now 7 years after I left Chicago, and some day I hope to return. And on one hand I can count the conversations I have had with the FTC. We are the people out there doing this kind of work. We are out there on--it really is sort of mind boggling to me that we sit here today with the problems that existed 10 years ago and we have had federal regulatory agencies who have done nothing except exacerbated the problem. The Federal Trade Commission, as Chris said, was using the spoon to clean out an ocean. They simply did not do the job. There is a number of things that can be done to improve them. Hopefully in the new Administration they will be more assertive and more aggressive. They have been completely passive in using their unfairness authority. They need to use it. They need to declare things--we know when things are unfair. When you give somebody a loan that they can't afford to pay back, that is unfair. It is not a really hard thing to figure out. They do need greater rulemaking authority. It is crazy. Six to 8 years to make a rule to protect consumers, that is just not the way it should work. Hopefully, they will have leadership, and I hope Chairman Leibowitz will demonstrate some leadership in terms of being assertive and aggressive in this area. They should have concurrent authority over the banks. There is a special place in regulatory hell for the federal bank regulators over the last 8 years and their complete failure to what has happened here. So hopefully the FTC can use of their consumer protection powers. I will stop there but be happy to answer any questions you might have about the FTC and the credit crisis we are facing. [The prepared statement of Mr. Rheingold follows:] [GRAPHIC] [TIFF OMITTED] T7816A.063 CHRG-111shrg57319--431 Mr. Beck," Senator, could you repeat the question, please? Senator Kaufman. If you look at Exhibit 41 where Shaw lists options, he lists a bunch--he says that the FICO--increasing delinquencies among FICOs of 700 to 739 was an 1,197-percent increase, FICOs of 780 plus a 1,484-percent increase; FICOs of 620 to 659, an 820-percent increase. So someone looking at the portfolio, the high FICOs were really the ones that were having an incredible increase in their delinquency rates. Is that fair? " FOMC20080430meeting--318 316,MR. MISHKIN.," I am very comfortable with the analysis and the approach, so I don't have any major comments there. Although in the white paper you might mention them, I would like to take options 1 and 3 off the table. Option 1 has just too much administrative burden. We have enough tsuris already. Although option 3 may work well in countries with very different structures of the banking system, I don't think it is a feasible alternative for us. So I think that we should look at options 2 and 5, and I am certainly comfortable with another look at option 4. One issue that I worry about a bit is that these markets do sort out some interbank credit risk issues. We don't want to lose that, so we have to be very aware of it. I also worry a bit about setting a price when there is a credit risk element to it. When there is no credit risk element--if you want to set the Treasury bill rate--it is no big deal. But there may be an issue there, I am not sure, and it should be one of the considerations in this context. Thank you. " CHRG-111hhrg48873--352 Mr. Capuano," I understand that. I understand what it targets. It targets all the triple A stuff, which, of course, amazes me. You are using ratings by the very credit rating agencies that have now been completely undermined. And anybody with faith in these ratings, I guess, hasn't been paying attention the last year. But so be it, you have to draw the line somewhere, and I guess that is all we have. I want to ask specifically about the FDIC's role here. The FDIC, as I understood it, but, again, without getting into glorious words, was there to protect me as a depositor up to $100,000, now $250,000. We are trying to extend that. That is what they are there for. And yet in this case, they are being used to finance the purchase of toxic assets, nothing to do with what anybody would have thought the FDIC was supposed to be used for. And they are being used, as I understand it, and correct me if I am wrong, to basically float collateralized debt obligations backed by these very toxic assets in order to fund the purchase of these toxic assets, getting them off the books of the investors and putting them on the books of the taxpayers. What am I missing? " FOMC20070807meeting--46 44,MR. FISHER.," I noted Karen’s comments about the globalized interlinkages with financial markets, and I have a simple question for maybe Karen. In terms of the alternative scenario that was sketched for greater housing correction to spill over to confidence in financial markets, in that discussion and in that model or simulation, when you talk about equity prices, stresses in the debt markets, and further weakness in aggregate spending, are you talking about the United States only?" CHRG-111hhrg56766--217 Mr. Bernanke," That is roughly right. The idea here is if you have a growing economy, you can run deficits and still maintain a flat ratio of debt to GDP, which is a sustainable situation. Normally, that would involve having what is called a primary deficit, that is deficit excluding interest payments from about zero. Normally, that would involve about 2.5 percent to 3 percent of a total deficit, including interest payments. " CHRG-110shrg38109--67 Chairman Bernanke," I recently testified before the Senate Budget Committee, and I pointed out--and it is not exactly a secret--that the long-term prospects for the U.S. fiscal situation are quite serious. In particular, we are going to start seeing--as the population ages--expanded costs of entitlements, Social Security and Medicare; those grow very quickly. And we will generate, if no action is taken, an increasing spiral of higher interest payments and debt. I quoted in that testimony several interesting, useful simulations by the Congressional Budget Office. The intermediate simulation suggests that by the year 2030 the deficit will be 9 percent of GDP, and the debt-to-GDP ratio, which is currently about 37 percent, will be closer to 100 percent of GDP--a number which we have not seen since World War II. So, obviously, there are a lot of issues that Congress will debate about short-term spending and tax proposals. But if you think about fiscal sustainability in a longer time frame, dealing with the fiscal implications of the aging population and rising health care costs are going to be dominant, and essentially there will not be any way to address fiscal sustainability without addressing that issue in some way. Senator Casey. I wanted to pick up, in the remaining time I have, on the issue of how we invest in children, pick up on what Chairman Dodd spoke of earlier. There is a great organization out there that has as its moniker, as its message, ``Fight crime, invest in kids.'' It is a great sound bite. Sometimes we need sound bites to make the point. I would also assert--and I would ask for your sense of this and your reflections on this--that you could use the same construct for the impact on how we invest in children and how we grow our economy. Instead of saying, ``Fight crime, invest in kids,'' you could say, ``Grow the gross national product'' or ``Grow GDP'' or ``Grow the economy, invest in kids.'' Now, I ask you that because we are going to be making some critically important decisions in the next couple of months and certainly in this 110th Congress. Chairman Dodd talked about the issue of the Head Start program. There have been votes cast in the U.S. Senate in the last couple of years where the choice was clearly and unambiguously a choice between investing in Head Start or investing in education or investing in any other support for children and their economic future, not to mention our future, and tax cuts. Sometimes the votes have been that stark, and there are people here who voted for the tax cuts over Head Start and over some other priorities. So, I would ask you about your opinion--and this is a policy question, but I think you can answer this--your opinion on the level of investment in children, whether it is with regard to education or Head Start, early learning, all of these initiatives to give kids a healthy and smart start in life, how you see that in the context of economic growth and GDP growth, and whether or not you think the investment currently is adequate. " FinancialCrisisInquiry--302 MACK: I think it happened, but I don’t think it was tied to the oversight of the SEC. I just think that you had a robust period of low interest rates and a consistency of movement in markets on the upside so people took more and more risk. But I don’t see the connection. We’ll be more than happy to go back and look through our files and talk to my general counsel and try to give you a more specific answer, but I’m not aware that that was a trigger point for more leverage. FinancialCrisisInquiry--450 CHAIRMAN ANGELIDES: Mr. Holtz-Eakin? HOLTZ-EAKIN: Thank you, Mr. Chairman. Thank you, everyone, for coming today. Mr. Bass, you got my attention with leverage at 68 to one at Citi. Can you walk through those numbers for me again? CHRG-110hhrg44903--114 Mr. Wilson," Thank you, Mr. Chairman. Gentlemen, I would like to address my question to both of you, if I may. One of the concerns I have had through this whole process has been the oversight and the lack of connection or the not having connection among the oversight groups. So I have two questions. One is, how important is it that the central banks, governments, and supervisors look more carefully at the interaction between accounting, tax, and disclosure, and capital requirements and their effect on the overall leverage and risks across the financial system? " FOMC20081216meeting--493 491,MR. PARKINSON.," I think it comes back to the point that Bill made earlier. If you're a hedge fund, even LIBOR plus 500 is still not a rich enough return to that hedge fund unless you can borrow against those securities and leverage it up into a higher return. And until 18 months ago you could have gotten the financing from Deutsche Bank, the Swiss banks, or any of our fine U.S. banks; but it doesn't appear at the moment that any of them are terribly interested in lending on a secured basis even to the strongest of hedge funds. They're simply hiding somewhere. " 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-111hhrg55809--9 Mr. Hensarling," Thank you, Mr. Chairman. Over the past couple of weeks, the media has been replete with 1-year anniversary stories of historic bailouts or economy recovery actions by our Federal Government. Before deciding on how we best proceed with financial markets reform, we would do well to learn the lessons of the good, the bad, and the ugly. First, the good: Within months of intervention, there is no doubt that credit spreads returned to more normal levels. Equity markets have clearly risen appreciably, and the panic we felt last September has subsided. Then, the bad: Our economy continues to contract in the face of massive government intervention. Too much private capital remains on the sidelines. After the passage of the Administration's $1.2 trillion stimulus bill, 3 million of our fellow countrymen lost their jobs, and our Nation suffers from the highest unemployment rate in a quarter of a century. And I remind all there is no such thing as a jobless recovery. No jobs, no recovery. And finally, the ugly: This orgy of spending has brought our Nation its first trillion dollar deficit, and our national debt will triple in the next 10 years. According to the Special Inspector General for the TARP program, the taxpayer is now on the hook for up to $23.7 trillion or $202,940 per household. The government's continued bailouts of Fannie Mae, Freddie Mac, AIG, Chrysler, GM--the list goes on--now hamper our economic recovery and threaten to institutionalize us as a ``bailout nation'' with no visible exit strategy in sight. There remains a huge difference between adding emergency liquidity to a panicked financial system and bailing out individual non-bank firms fortunate enough to be designated ``too-big-to-fail.'' Under the latter policy, the big get bigger, the small get smaller, the taxpayer gets poorer, and our children get saddled with the mother of all debts. Clearly, there is a better way. Reforms are needed. But the best way to end taxpayer bailouts is to end taxpayer bailouts. " CHRG-109hhrg28024--65 Mr. Sanders," Thank you, Mr. Chairman. And Chairman Bernanke, welcome to the Financial Services Committee and very best of luck on your new job. Mr. Bernanke, there is a great concern in this country that our current economic policies are not working for ordinary Americans. The middle class continues to shrink. Poverty is increasing. The gap between the rich and the poor is now wider than it has been in over 7 years. We have a recordbreaking national debt as well as a recordbreaking trade deficit. And the Bush Administration has the worst record of private job creation since Herbert Hoover. Meanwhile, while millions of American workers are seeing their real wages decline, or they're using their pensions and their health care, while they can't afford child care or college education, the wealthiest people in this country frankly have never had it so good. My own view is that the time is long overdue for the Bush Administration and Congress to start making fundamental changes in our economic policies so the Government works for everybody and not just the very wealthy and their lobbyists who descend on Capitol Hill every day. And if we don't, what we are going to see in my view is that for the first time in the modern history of America, our kids are going to have a lower standard of living than we do. Now I want to just very briefly, because time is limited, solicit your remarks, your thoughts on some very important economic questions. And my first one is the following. Since President Bush has been in office, more than five million Americans have slipped into poverty. Childhood poverty has increased by over 12 percent. We continue to have by far the highest rate of childhood poverty in the industrialized world. American house--average America household income has declined for the past 4 consecutive years. It's down by more than $1,600. Twenty percent of American jobs now pay less than a poverty level wage for a family four. My question is a very simple one. All over America, States like the State of Vermont have raised the minimum wage, which now at the Federal level remains $5.15 an hour and in fact has the lowest purchasing power that it has had in over 50 years. Chairman Bernanke, should the Congress raise the minimum wage so that every worker in America who works 40 hours a week escapes from poverty? Very simple question, sir. " fcic_final_report_full--429 VII. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance- sheet losses in its counterparties. These institutions were deemed too big and interconnected to other firms through counterparty credit risk for policy- makers to be willing to allow them to fail suddenly. VIII. Common shock. In other cases, unrelated financial institutions failed be- cause of a common shock: they made similar failed bets on housing. Uncon- nected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock. IX. Financial shock and panic. In quick succession in September , the fail- ures, near-failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned. X. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early . Harm to the real economy continues through today. We now describe these ten essential causes of the crisis in more detail. THE CREDIT BUBBLE: GLOBAL CAPITAL FLOWS, UNDERPRICED RISK, AND FEDERAL RESERVE POLICY The financial and economic crisis began with a credit bubble in the United States and Europe. Credit spreads narrowed significantly, meaning that the cost of borrowing to finance risky investments declined relative to safe assets such as U.S. Treasury securi- ties. The most notable of these risky investments were high-risk mortgages. The U.S. housing bubble was the most visible effect of the credit bubble but not the only one. Commercial real estate, high-yield debt, and leveraged loans were all boosted by the surplus of inexpensive credit. There are three major possible explanations for the credit bubble: global capital flows, the repricing of risk, and monetary policy. Global capital flows Starting in the late s, China, other large developing countries, and the big oil- producing nations consumed and invested domestically less than they earned. As CHRG-110hhrg46596--318 Mr. Clay," Thank you for that response. We understand the TARP program continues for credit card, auto loan and student loans. However, private lenders for non-Federal student loans enjoy Federal protections that auto and credit lenders do not; namely, private student loans are exempted from bankruptcy, except under extreme circumstances. How will the TARP program take into consideration these differences in consumer debt? " CHRG-111shrg53176--124 Mr. Baker," Thank you, Mr. Chairman, Ranking Member Shelby, Members. I am indeed delighted to be back after the prohibited period from my engagement with policymakers, and for the record to reflect, I did not engage anyone during the prohibited period. It is delightful to be here today. The MFA represents a majority of the world's largest hedge funds and is the primary advocate for sound business practices for industry professionals. We appreciate the opportunity to be invited and to comment today about the systemic risk concerns, and we are committed to being a constructive participant in the discussion going forward. Hedge funds do provide liquidity and price discovery to markets, capital to companies to allow them to grow or turn their businesses around, and sophisticated risk management tools for investors such as pensions, to allow them to meet their obligations. To perform these market functions, we require sound counterparties and stable market structures. The current lack of certainty regarding financial conditions of major financial institutions has limited the effectiveness of the stabilization efforts, and this uncertainty inhibits investors' willingness to put their capital at risk or transact with these firms. The relative size and scope of the industry helps explain why we believe hedge funds do not pose significant systemic risk despite the current market environment. With an estimated $1.5 trillion under management, the hedge fund industry is significantly smaller than the $9.4 million mutual fund industry or the $13.8 trillion banking industry. Because many hedge funds use little or no leverage, contrary to many public comments, their losses did not pose the same potential systemic concerns that losses at more highly leveraged institutions presented. One recent study found that 26.9 percent of hedge funds do not deploy leverage at all, and a recent 2009 report by the FSA, the Financial Services Authority, indicated that the leverage of hedge funds was, on average, less than 3:1. Mr. Chairman, the hedge fund industry was not the root cause of the ongoing difficulties in our financial markets, but we have a shared interest with all other market participants in re-establishing a sound financial system. To that end, restoration of stability can be accomplished through a careful, deliberate approach toward the goal of a smart financial regulatory construct, one which would include investor protections as well as a systemic risk analysis. Smart regulation means improving the overall functioning of the financial system through appropriate, effective, and efficient regulation, while encouraging adoption of industry best practices which promote efficient capital markets, integrity, investor protections, and enabling better monitoring of potential systemic risk events. We believe that a single systemic risk organization--and I have not been absent during the preceding discussions. I would merely want to point out that an organization charge with this responsibility would be better than multiple systemic regulators which would likely have difficulty because of jurisdictional conflicts, unintended regulatory gaps, inefficient and costly redundancies. So to the extent a regulatory shop can be constructed, it should be a single entity to have that responsibility. We do support confidential reporting to that systemic regulatory structure by entities the regulator deems to be of systemic relevance any information the regulator deems necessary or advisable for it to assess systemic risk potential. It is important for this authority to allow the regulator to be forward-looking and adaptable to ever-changing market conditions. It is critical that reported information be granted full protection from public disclosure, which we believe can be done without inhibiting the ability of the regulator to protect the overall system. In our view, the mandate of this entity should be protection of the financial system and not include investor protection or market integrity, a role that already exists in the hands of multiple existing regulatory bodies. With respect to that mandate, because systemically relevant firms likely would not pose the same risk in all circumstances, we also believe the regulators should not focus on preventing the failure of a particular firm but, rather, only in the event that firm's failure would be likely to bring about adverse financial system consequences. We strongly believe the systemic risk regulator should implement its authority in a way that avoids competitive concerns and moral hazards that could result from a firm having an ongoing established Government guarantee against its failure. Therefore, we believe a systemic risk regulator would need authority to seek to prevent systemic risk in a forward-looking manner, address systemic concerns once they have arisen in the manner it deems appropriate, the ability to ensure that a failing firm does not threaten the financial system, and we know that policymakers are also contemplating concurrently a notion of a prudential regulatory framework, including mandatory registration. We believe that well-advised regulation should be based on the following principles: regulation that is tailored to meet identified needs, not nebulous in construct; second, ongoing public-private exchange with notice, comment, and implementation so that appropriate comment may be made on proposed regulatory interventions; reporting of appropriate information, which could be left to the regulator, with confidentiality of sensitive and proprietary always being protected. Regulatory distinctions to be recognized between the various nature of the differing market participants, and encouragement of strong industry practices and robust investor diligence. I would like to mention just briefly one other area I know of concern. Short selling facilitates price discovery, mitigates asset bubbles, and increases market liquidity. It is a critical risk management tool for investors which allows them to take long positions in the market. There are absolute solutions to address the stated concerns about short-selling that would enable us to continue in our current market practices without jeopardizing the important market benefits. We look forward to a continued discussion and answering any questions you may choose to pose. Thank you, Mr. Chairman. Senator Reed [presiding]. Thank you, Congressman Baker. " Mr. Chanos," STATEMENT OF JAMES CHANOS, CHAIRMAN, COALITION OF PRIVATE fcic_final_report_full--387 Treasury invested about  billion in financial institutions under TARP’s Capi- tal Purchase Program by the end of ; ultimately, it would invest  billion in  financial institutions.  In the ensuing months, Treasury would provide much of TARP’s remaining  billion to specific financial institutions, including AIG ( billion plus a  billion lending facility), Citigroup ( billion plus loss guarantees), and Bank of America ( billion). On December , it established the Automotive Industry Financing Program, under which it ultimately invested  billion of TARP funds to make in- vestments in and loans to automobile manufacturers and auto finance companies, specifically General Motors, GMAC, Chrysler, and Chrysler Financial.  On January , , President Bush notified Congress that he intended not to access the second half of the  billion in TARP funds, so that he might “‘ensure that such funds are available early’ for the new administration.”  As of September —two years after TARP’s creation—Treasury had allocated  billion of the  billion authorized. Of that amount,  billion had been re- paid,  billion remained outstanding, and . billion in losses had been in- curred.  About  billion of the outstanding funds were in the Capital Purchase Program. Treasury still held large stakes in GM ( of common stock), Ally Finan- cial (formerly known as GMAC; ), and Chrysler (). Moreover, . billion of TARP funds remained invested in AIG in addition to . billion of loans from the New York Fed and a  billion non-TARP equity investment by the New York Fed in two of AIG’s foreign insurance companies.  By December , all nine companies invited to the initial Columbus Day meeting had fully repaid the government.  Of course, TARP was only one of more than two dozen emergency programs to- taling trillions of dollars put in place during the crisis to stabilize the financial system and to rescue specific firms. Indeed, TARP was not even the largest.  Many of these programs are discussed in this and previous chapters. For just some examples: The Fed’s TSLF and PDCF programs peaked at  billion and  billion, respectively. Its money market funding peaked at  billion in January , and its Commer- cial Paper Funding Facility peaked at  billion, also in January .  When it was introduced, the FDIC’s program to guarantee senior debt for all FDIC-insured institutions stood ready to backstop as much as  billion in bank debt. The Fed’s largest program, announced in November , purchased . trillion in agency mortgage–backed securities.  CHRG-111hhrg51591--124 Mr. Hunter," For earthquake insurance, I think you need at least two dollars of capital for every dollar of risk. For property/casualty insurance, you may need only one dollar for two dollars of risk. It depends on the line of insurance there, too. So you can come up with leverage limits. You can come up with size limits. I mean, some companies shouldn't grow beyond certain limits, particularly in markets. Ten percent--maybe a limit should be 10 percent within a line of insurance, for example. In a State, no company should get bigger that so that it would enhance both competition and to make a failure less damaging. " CHRG-110hhrg45625--41 Mr. Foster," Mr. Chairman, fellow members of the committee, as a freshman member of this panel, thank you for letting me testify. As a scientist and businessman and also one of the newest Members of Congress, I hope to provide some useful comments that may help us solve our problems and find solutions. First, I accept the need for speed and overpowering force in this situation. With the credit system locked, small and large businesses are being told to prepare contingency plans for what to do if their operating lines of credit are not extended. Banks are refusing to lend each other at normal rates, or not at all. If nothing is done, and the situation persists for even a few weeks, we are facing an economic downturn unprecedented in our lifetimes. This is not a situation where we need long and thoughtful congressional deliberations. We have no choice other than to act, and to act quickly. This is also not the time for ideological fighting about class warfare from the left or blind adherence to the principles of unfettered free marked and zero government regulation from the right. This is the time for serious people from both parties to work fast, work smart, and map a way out of this crisis. The second point I want to make is that there are two routes mapped out of this crisis by the legislation that we will be considering: The so-called auction route and the so-called equity route. I wish to express my strong preference for the equity route, and I believe that the American taxpayer and business owner will agree. In the auction route, the taxpayer funds are used to buy off toxic assets left over from bad loans at a price well above anything you can get in the current market. Financial firms are bailed out and life pretty well goes on as usual for these firms, with the exception that they have learned that whenever they make a whole batch of bad loans, that they can pretty much count on the U.S. taxpayer to at least partially come and bail them out. The government is left with the mess of managing, administering, and liquidating these toxic assets. In the equity route, also allowed by the proposed legislation, the firms are bailed out, but at the price of government getting a big share in the companies. I believe that this is a far better deal for the taxpayer. The companies will be required to write down the value of their toxic assets, essentially admitting that their worthless paper is worthless, and in exchange the government injects cash by buying a large fraction of these banks. This is not dissimilar to the recent AIG bailout. And over time, as the market recovers, then the banks are sold back to private investors. The equity route has a number of advantages. First, the government does not end up owning and managing the bank's bad assets. The government is simply a more or less passive owner in a bank that is now adequately capitalized. Nobody gets fired on the day after a government equity injection, and financial life goes on. The equity route also depends somewhat less on getting an exact evaluation for the toxic assets. If it turns out, for example, that the assets are worth a lot more than anyone thought at the time of the bailout, that is okay; the taxpayer still owns most of the bank and most of the profits as the bank's assets appreciate. Finally, the equity route has been tried before, and it works. In the 1990's, Sweden faced an almost identical crisis, bad real estate debt and banks accounting for about 4 percent of GDP, and successfully used the equity route to work their way out of the crisis at a relatively small cost to taxpayers. This process is described in Tuesday's New York Times, and I urge everyone to read these articles. The next point I wish to make regards financial compensations for CEOs. One issue that is often mentioned is the overall scope of compensation, and while this concerns me, an equally important issue is the misalignment of incentives between CEO pay and shareholder interest. This is at the route of the crisis. If you are the CEO of an investment bank that makes $1 billion a year for 5 years, and is wiped out in the 6th year, the shareholders are also wiped out, but the CEO is left personally very well off. This is a fundamental misalignment of incentives that encourages extreme risk-taking behavior. As a former small businessman, I carried an unlimited personal guarantee for the success of my business. If my business went under, I lost my house, and I guarantee you that I paid very, very careful attention to the debt situation of our company. So demanding both up-side and down-side compensation incentives for CEOs is a crucial element of any reform. Finally, I believe that more of an effort needs to be made to secure foreign assistance with this program. Given the fact that the tentacles spread globally and given the fact that foreign firms could receive assistance under proposals floating around and given the fact that foreign governments have an overwhelming interest in the stable and prosperous American economy, it is vital we do more to ensure they aid us in this effort, and share the burden. Thank you. I yield back the balance of my time. " CHRG-111hhrg72887--42 STATEMENT OF EILEEN HARRINGTON Ms. Harrington. Thank you, Chairman Rush. I am Eileen Harrington, the Director of the FTC's Bureau of Consumer Protection. I appreciate the opportunity to appear here today to discuss the Consumer Credit and Debt Protection Act and the FTC's role in protecting consumers of financial services. The Commission's views are set forth in the written testimony that we have submitted. My oral presentation and answers to your questions represent my own views. As we know, the current economic crisis continues to have a devastating effect on many consumers. Many are struggling to pay their bills, keep their homes, deal with abusive debt collectors, and maintain their credit ratings. Two months ago you asked the FTC to tell you what it has been doing to help consumers through this difficult time. We told you about how we have been using our tools, law enforcement, consumer education policy and research, to help protect consumers in financial distress from being taken advantage of by those who flout the law. When we came before you then, we recognized that we needed to do more, however, and we asked for your help. Your response, the Consumer Credit and Debt Protection Act, is directly on point. In particular, this bill would build on the new authority we obtained under the 2009 Omnibus Appropriations Act by enabling us to issue rules targeting the practices that caused the most harm to consumers in the broader credit and debt marketplace. Historically, the Commission has relied heavily on its law enforcement experience to inform its rulemakings undertaken under the Administrative Procedures Act with the express consent of Congress. This approach has served us well in the past, and will continue to do so here. Thus, in deciding which practices in the credit and debt market to target, we would rely on our casework to help identify any industrywide problems and pervasive consumer injury. The Consumer Credit and Debt Protection Act also would allow us to seek civil penalties against those who violate any such rules that the Commission issues in this area. This is significant because civil penalties deter would-be violators. The FTC strongly supports the enactment of this type of legislation. As you know, we are already using our new authority under the 2009 Omnibus Appropriations Act to develop new consumer protection regulations in the mortgage context. We expect these rules to address unfair and deceptive practices in mortgage lending, mortgage foreclosure rescue, mortgage loan modification, and mortgage servicing. The 2009 Omnibus Appropriations Act enhanced the Commission's ability to enforce these rules by allowing the FTC to obtain civil penalties against violators. Meanwhile, the Commission continues to vigorously enforce the FTC Act as well as other statutes and rules for which it has enforcement authority. In response to the current economic crisis, the FTC has intensified its focus on protecting consumers of financial services and has targeted particular illegal practices in mortgage advertising, lending and servicing. Let me give you two examples. This past Friday the Commission announced an enforcement action against Golden Empire Mortgage and its individual owner for alleged violations of the Equal Credit Opportunity Act and Regulation B. The Commission alleged that the defendants charged Hispanic consumers higher prices for mortgage loans than non-Hispanic white consumers. The FTC alleged that the credit characteristics or underwriting risk of the company's customers could not explain the differences in the prices charged. A second example. On April 6th, also since the last time we were here, the FTC joined with Treasury, HUD, the Department of Justice, and the Illinois attorney general to announce a coordinated crackdown on mortgage foreclosure rescue fraud. The Federal law enforcement component of that crackdown was done by the FTC. Although vigorous law enforcement is essential in providing more effective Federal oversight of the financial services sector, a broader legislative response may be appropriate here. Several bills have been introduced and proposals offered under which there would be some type of overall Federal regulator of financial services. There are differences in these bills and proposals to rationalize the oversight system, and there are numerous challenging issues that would have to be resolved to implement those concepts. Because of its unequaled comprehensive focus on consumer protection, its independence from providers of financial services, and its emphasis on vigorous law enforcement, we ask Congress to ensure that the FTC is considered as Congress moves forward in determining how to modify Federal consumer financial services. The Commission would be pleased to work with Congress and the subcommittee in developing and defining a new role for the FTC. Thank you for inviting the Commission to testify at this hearing. I would be pleased to answer any of your questions. " CHRG-111hhrg54867--64 Mr. Gutierrez," And I ask you that because that is what I thought, and I just wanted to see if we agree that this leveraging of 30:1, which was actually authorized by the Securities and Exchange Commission--you have never worked at an investment banking firm, though, right, on Wall Street? " 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." FOMC20081216meeting--30 28,MR. DUDLEY.," Well, if you basically take that 21 percent and compare it with the default rates in the Great Depression and write down some numbers for recoveries, if you had a default rate equal to the Great Depression default rate and you had a 20 percent recovery, you'd actually do pretty well owning high-yield debt at these levels right now. So the level of yields fully discounts horrific default rates. " CHRG-109shrg21981--84 Chairman Greenspan," Yes. In order to get savings, remember you have to get consumption declining relative to income. Senator Crapo. I appreciate that because I think that there is a lot of misunderstanding about that fact, as we discuss this issue. And when we discuss the cost, there is a lot of discussion about the transition cost being--I have heard the number of $2 trillion. The Administration says the number in terms of its proposal is more in the neighborhood of the $7 to $8 hundred billion over 10 years. Is the same not true about that transition cost in the sense that those costs are actually related to debt in out-years or obligations in out-years of the Social Security system that are being borrowed to take care of in earlier years? " CHRG-111hhrg56766--156 Mr. Manzullo," I know you are, Mr. Chairman. The problem is that it's simply not getting through and it's not your fault, and I don't think it's the fault of the regulators there either because everybody is skittish because of the economy, but the problem is we're at the beginning of a real recovery, not make-up jobs for the dumb Stimulus Bill, not creating government jobs, but the creation of real jobs of people in manufacturing going back to work and exporting and many of these are highly-paid union jobs. They just can't get the money and they're creditworthy. It doesn't make sense for us to have all this debt, all these programs, people ready to go, they're creditworthy, but they can't get the money in order to make the product to create the jobs. " CHRG-110shrg50420--470 PREPARED STATEMENT OF RON GETTELFINGER President, International Union, United Automobile, Aerospace, and Agricultural Implement Workers of America December 4, 2008 Mr. Chairman, my name is Ron Gettelfinger. I am President of the International Union, United Automobile, Aerospace and Agricultural Implement Workers of America (UAW). The UAW represents one million active and retired members, many of whom work for or receive retirement benefits from the Detroit-based auto companies and auto parts suppliers across the United States. We welcome the opportunity to appear before this Committee to present our views on the state of the domestic automobile industry: Part II. The UAW believes the situation at GM, Ford, and Chrysler is extremely dire. As is evident from the materials which have been submitted by the companies in response to the letter from Speaker Pelosi and Majority Leader Reid, it is imperative that the federal government act this month to provide an emergency bridge loan to the domestic auto companies. Without such assistance, GM could run out of funds by the end of the year, and Chrysler soon thereafter. These companies would then be forced to liquidate, ceasing all business operations. The collapse of these companies would inevitably drag down numerous auto parts suppliers, which in turn could lead to the collapse of Ford. The UAW appreciates the desire by Congress, as expressed in the letter from Speaker Pelosi and Majority Leader Reid, to ensure that any assistance from the Federal Government is conditioned on strict accountability by the companies and a demonstration that they can be viable businesses in the future. We fully support both of these key principles. Specifically, the UAW supports conditioning any emergency bridge loan on strict accountability measures, including: tough limits on executive compensation, prohibiting golden parachutes and other abuses, and making it clear that top executives must share in any sacrifices; a prohibition on dividend payments by the companies; giving the federal government an equity stake in the companies so that taxpayers are protected; and establishing an Advisory Board to oversee the operations of the companies to ensure that all funds from the emergency bridge loan are spent in the United States, that the companies are pursuing viable restructuring plans, and that the companies are meeting requirements to produce advanced, more fuel efficient vehicles. We are prepared to work with Members of this Committee to incorporate other accountability requirements that may be appropriate. In addition, the UAW supports conditioning any emergency bridge loan on the companies pursuing restructuring plans that will ensure the viability of their operations in the coming years. For such restructuring plans to succeed, we recognize that all stakeholders--equity and bondholders, suppliers, dealers, workers and retirees, and management--must come to the table and share in the sacrifices that will be needed. The UAW and the workers and retirees we represent are prepared to do our part to ensure that the companies can continue as viable operations. As indicated in our previous testimony, workers and retirees have already stepped forward and made enormous sacrifices. In 2005 the UAW reopened its contract mid-term and accepted cuts in wages for active workers and health care benefits for retirees. In the 2007 contract the UAW agreed to slash wages for new workers by 50 percent to about $14 per hour, and to exclude new workers from the traditional health care and pension plans. The UAW also allowed the companies to outsource cleaning work at even lower rates. Under the 2007 contract, beginning January 1, 2010, the liabilities for health care for existing retirees will be transferred from the companies to an independent VEBA fund. Taken together, the changes in the 2005 and 2007 contract reduced the companies' liabilities for retiree health care benefits by 50 percent. As a result of the 2005 and 2007 contracts, workers have not received any base wage increase since 2005 at GM and Ford, and since 2006 at Chrysler. All of these workers will not receive any increase through the end of the contract in 2011. Workers have also accepted reductions in cost of living adjustments. New local operating agreements at many facilities provided dramatic flexibilities and reductions in classifications, and have saved the companies billions of dollars. Reforms in the 2007 contract have largely eliminated the jobs banks. Since 2003 downsizing by the companies has reduced their workforce by 150,000, resulting in enormous savings for GM, Ford, and Chrysler. Thanks to the changes in the 2005 and 2007 contracts, and changes that have subsequently been agreed to by the UAW, the labor cost gap with the foreign transplant operations will be largely or completely eliminated when the contracts 3 are fully implemented. Industry observers applauded the sacrifices made by workers and retirees, calling the 2007 contract a ``transformational'' agreement. The UAW is continuing to negotiate with the domestic auto companies on an ongoing basis over ways to make their operations more efficient and competitive. We recognize that the current crisis may require all stakeholders, including the workers and retirees, to make further sacrifices to ensure the future viability of the companies. We are willing to do our part. In particular, we recognize that the contributions owed by the companies to the retiree health care VEBA fund may need to be spread out. The UAW has retained outside experts to work with us on how this can be accomplished, while still protecting the retirees. We also recognize that adjustments may need to be made in other areas. But the UAW vigorously opposes any attempt to make workers and retirees the scapegoats and to make them shoulder the entire burden of any restructuring. Wages and benefits only make up 10 percent of the costs of the domestic auto companies. So the current difficulties facing the Detroit-based auto companies cannot be blamed on workers and retirees. Contrary to an often-repeated myth, UAW members at GM, Ford, and Chrysler are not paid $73 an hour. The truth is, wages for UAW members range from about $14 per hour for newly hired workers to $28 per hour for assemblers. The $73 an hour figure is outdated and inaccurate. It includes not only the costs of health care, pensions and other compensation for current workers, but also includes the costs of pensions and health care for all of the retired workers, spread out over the active workforce. Obviously, active workers do not receive any of this compensation, so it is simply not accurate to describe it as part of their ``earnings.'' Furthermore, as previously indicated, the overall labor costs at the Detroit-based auto companies were dramatically lowered by the changes in the 2005 and 2007 contracts, which largely or completely eliminated the gap with the foreign transplant operations. The UAW submits that it is not feasible for Congress to hammer out the details of a complete restructuring plan during the coming week. There is simply not enough time to work through the many difficult and complex issues associated with all of the key stakeholders, including equity and bondholders, suppliers, dealers, management, workers and retirees, as well as changes in the business operations of the companies. What Congress can and should do is to put in place a process that will require all of the stakeholders to participate in a restructuring of the companies outside of bankruptcy. This process should ensure that there is fairness in the sacrifices, and that the companies will be able to continue as viable business operations. This process can begin immediately under the supervision of the next administration. By doing this, Congress can make sure that the emergency assistance is indeed a bridge to a brighter future. Contrary to the assertions by some commentators, in the current environment a Chapter 11 reorganization--even a so-called ``pre-packaged"" bankruptcy--is simply not a viable option for restructuring the Detroit-based auto companies. As previously indicated, research has indicated that the public will not buy vehicles from a company in bankruptcy. It also is doubtful that the companies could obtain debtor-in-possession financing to operate during a bankruptcy. In addition, attached to this testimony is a more detailed analysis prepared with the assistance of experienced bankruptcy practitioners explaining why a ``pre-packaged'' bankruptcy is not a feasible option for the domestic auto companies because of the size and complexity of the issues that would necessarily be involved in any restructuring, including relationships with thousands of dealers and suppliers and major changes in business operations. Thus, the UAW wishes to underscore that any bankruptcy filings by the domestic auto companies at this time would inevitably lead to Chapter 7 liquidations and the cessation of all business operations. The collapse of the domestic auto companies would have disastrous consequences for millions of workers and retirees and for the entire country. Hundreds of thousands of workers would directly lose their jobs at GM, Ford, and Chrysler, and a total of three million workers would see their jobs eliminated at suppliers, dealerships and the thousands of other businesses that depend on the auto industry. One million retirees could lose part of their pension benefits, and would also face the complete elimination of their health insurance coverage, an especially harsh blow to the 40 percent who are younger than 65 and not yet eligible for Medicare. The Pension Benefit Guarantee Corporation could be saddled with enormous pension liabilities, jeopardizing its ability to protect the pensions of millions of other workers and retirees. To prevent this from happening, the federal government could be forced to pay for a costly bailout of the PBGC. The federal government would also be liable for a 65 percent health care tax credit for pre-65 retirees from the auto companies, at a cost of as much as $2 billion per year. Revenues to the Federal, State, and local governments would drop sharply, forcing cuts in vital social services at a time when they are urgently needed. The ripple effects from the collapse of the Detroit-based auto companies would deal a serious blow to the entire economy, making the current recession much deeper and longer. There also would be a serious negative impact on many financial institutions that hold large amounts of debt from the Detroit-based auto companies and their auto finance associates. This could pose a systemic danger to our already weakened financial sector. For all of these reasons, the UAW submits it is imperative that Congress and the Bush administration act next week to provide an emergency bridge loan to the Detroit-based auto companies. The consequences of inaction are simply too devastating; the economic and human toll are too costly. The UAW believes that the recent actions by the federal government to provide an enormous bailout to Citigroup reinforce the case for providing an emergency bridge loan to the Detroit-based auto companies. The total assistance provided to Citigroup will dwarf that being sought by the domestic auto companies. Citigroup received this assistance without being required to submit any ``plan'' for changing its operations or demonstrating its future viability. It was not required to change its management. And it is still able to continue paying bonuses and other forms of lucrative executive compensation. If the Federal Government can provide this type of blank check to Wall Street, the UAW submits that Main Street is no less deserving of assistance. Since the domestic auto companies have come forward with detailed plans relating to accountability and their future viability, there is simply no justification for withholding the emergency bridge loan that is necessary for them to continue operations. The UAW also notes that other governments around the world are actively considering programs to provide emergency assistance to their auto industries. In particular, the European Union is considering a $51 billion loan program for automakers. And there are ongoing discussions with Germany, Great Britain, Sweden, Belgium, Poland, South Korea, China, and other nations about steps their governments can take to assist their auto industries. Clearly, other governments recognize the economic importance of maintaining their auto industries. The UAW submits that the economic importance of GM, Ford, and Chrysler to the U.S. economy is no less important and no less deserving of assistance. It is not enough, however, for the federal government to provide an emergency bridge loan to the Detroit-based auto companies, and to oversee and facilitate the restructuring of the companies. The 111th Congress and the Obama administration have a responsibility to pursue policies in a number of areas that will be critically important to the future viability of the domestic auto companies, as well as the well being of our entire nation. First, the UAW is very pleased that Congressional leaders and the Obama transition staff are already making plans to move forward quickly with a major economic stimulus package that will create jobs and give a boost to the entire economy. We believe this is urgently needed to prevent the economy from slipping into a deeper and more serious recession. This is particularly important for the auto sector. In order for the Detroit-based auto companies to succeed, it is vital that auto sales rebound from the record low levels we have seen in recent months. The single most important thing that can be done to increase auto sales is to reinvigorate the overall economy. Second, the UAW believes it is critically important that Congress and the Obama administration move forward quickly with plans to reform our broken health care system, and to put in place programs that will guarantee health insurance coverage for all Americans, contain costs, ensure quality of care, and establish more equitable financing mechanisms. In particular, we believe any health care reform initiative should include proposals to address the challenges associated with providing health care to the pre-Medicare population aged 55-65. There can be no doubt that one of the major financial challenges facing the Detroit-based auto companies in future years is the cost of providing health care to almost a million retirees. Although the 2005 and 2007 contracts greatly reduced the companies' retiree health care liabilities, they are still enormous and a major problem that hinders the ability of the companies to obtain financing from private lenders. All of the other major auto producing nations have national health care systems that spread the costs of providing health care across their societies. As a result, the automakers in these countries are not burdened by retiree health care legacy costs. Accordingly, the UAW is hopeful that the enactment of national health care reform in the United States would help to establish a level playing field among all employers, and alleviate the retiree health care legacy costs facing the Detroit-based auto companies. Third, during the coming year Congress and the Obama administration are likely to consider major new initiatives dealing with energy security and climate change. The UAW strongly supports prompt action in both of these vital areas. Specifically, besides requiring automakers to comply with the tougher new fuel economy standards that were enacted in 2007, we believe Congress and the Obama administration should take steps to ensure that fuel economy improvements continue in the years following 2020, and that the companies move expeditiously to introduce advanced technology vehicles. In particular, we support an aggressive program to increase domestic production of plug-in hybrids and their key components, and to expand the infrastructure that will be needed to support these vehicles. To help achieve these objectives, Congress and the Obama administration should make sure that the Section 136 Advanced Technology Vehicles Manufacturing Incentive Program (ATVMIP) continues to be fully funded, and that additional resources are provided to ensure that production of advanced, more fuel efficient vehicles and their key components is ramped up quickly. In addition, the UAW strongly supports the enactment of an economy-wide cap-and-trade program to aggressively reduce emissions of greenhouse gases that are causing climate change. Although these initiatives pose challenges for the auto industry, the UAW also believes they can provide great opportunities. Properly structured, these initiatives can not only ensure that our nation reduces its consumption of oil and emissions of greenhouse gas emissions. They also can ensure that the more fuel efficient vehicles of the future and their key components are built in the United States by the domestic auto companies and American workers. In effect, these initiatives can be an important part of the restructuring that is necessary to ensure the future viability of the domestic auto companies. Fourth, Congress and the Obama administration must make sure that our nation's trade policies promote fair trade, not so-called ``free trade'' that fails to provide a level playing field and instead places our domestic automakers at a significant competitive disadvantage. In particular, prompt action needs to be taken to eliminate unfair currency manipulation by China and Japan. In addition, Congress and the Obama administration should insist that the U.S.-Korea free trade agreement must be renegotiated to require that Korea dismantle the non-tariff barriers that have kept its market closed to U.S.-built automotive products, before it is granted any further access to the U.S. market. By pursuing all of these policies, Congress and the Obama administration can benefit our entire country. The UAW also believes that these policies can provide a basis under which a restructured domestic auto industry can remain viable and strong in the coming years. In conclusion, the UAW appreciates the opportunity to testify before this Committee on the state of the domestic automobile industry: Part II. We strongly urge this Committee and the entire Congress to act promptly to approve an emergency bridge loan to the Detroit-based auto companies to enable them to continue operations and to avoid the disastrous consequences that their liquidation would involve for millions of workers and retirees and for our entire Nation.Pre-Packaged Bankruptcy Is Not the Path To Revitalize the Domestic Auto Companies Some commentators have suggested a pre-packaged bankruptcy as an alternative to (or as part of) government-backed relief for the domestic auto companies. But the promoters have not explained how pre-packaged bankruptcy procedures can be successfully brought to bear in a case with the complexity and scope of one or all of the Detroit-based auto companies. Indeed, bankruptcy experts are skeptical that pre-packaged bankruptcy can work. As one noted business writer who has consulted with bankruptcy experts has concluded, ``it makes no sense.'' \1\--------------------------------------------------------------------------- \1\ Joe Nocera, ``Road Ahead Is Long for G.M.,'' The New York Times, November 22, 2008.--------------------------------------------------------------------------- In a pre-packaged bankruptcy, a company negotiates a financial restructuring with its major creditors outside of bankruptcy, lines up all or most of its major creditors in support of the proposed debt restructuring, and then uses the bankruptcy process to achieve a quick, consensual approval of its repayment plan. Any minority, dissenting creditors are out-voted by the pre-arranged majority support for the plan. Bankruptcy law permits pre-packaged deals as an efficient form of business restructuring. Pre-packs can work with financial restructurings, i.e., those that do not involve substantial operational issues. Where a company must restructure its balance sheet, but the business is otherwise sound, large creditors holding secured and unsecured debt are more likely to agree on the business fundamentals, and therefore more likely to reach a negotiated agreement on restructuring terms--for example, swapping debt for equity or extending debt maturities. But the domestic automobile manufacturers are in the midst of a much broader restructuring which is, to a large degree, operational. They are shifting their product mix; they are developing new-technology vehicles; and they are revamping their production locations. None of these issues can realistically be addressed in a pre-packaged bankruptcy, which is aimed at obtaining the consent of creditors to renegotiated terms on their financial debt instruments. Pre-packs were not intended for operational restructuring scenarios. In fact, no one has explained how the basic elements of a pre-packaged bankruptcy can be achieved in the case of the domestic auto companies. Who are the debt holders, and can enough of them agree on negotiated terms? The New York Times reports that the domestic automakers owe more than $100 billion to banks and bondholders. The originating banks have probably syndicated, or sold off, pieces of the debt to others. Some $56 billion in new debt securities was reportedly issued to investors such as pension funds, insurancecompanies and hedge funds. \2\ For a pre-packaged bankruptcy to work--or even get organized--the lion's share of the outstanding debt holders need to be identified, agree to come to the table, and then agree on restructuring terms. This process would be a lengthy and expensive one, undertaken in an uncertain and weak economic environment.--------------------------------------------------------------------------- \2\ Zachary Kouwe and Louse Story, ``Big Three's Troubles May Touch Financial Sector,'' The New York Times, November 24, 2008.--------------------------------------------------------------------------- The same types of problems would exist for other claimants. The various creditors engaged in the process would likely want to see a business plan before negotiating restructured terms. Thus, the pre-packaged bankruptcy would be the proverbial tail wagging the dog. Assumptions made by some proponents of a pre-pack about whether stakeholders will participate in a pre-packaged effort and what the likely outcomes would be are unsupported supposition. Also unanswered are questions about how a bankruptcy filing would deal with GMAC and the other auto finance entities or the companies' overseas operations. A pre-packaged bankruptcy could disintegrate into a regular, contested bankruptcy proceeding. First, the likelihood of obtaining the requisite consents is already challenged by the size, potential scope, and lack of transparency of the debt holders. Second, pre-packs must follow solicitation rules which are governed by securities laws, not bankruptcy law. The company would have to put together a solicitation that successfully navigates these rules. And, once in bankruptcy court, the efficient nature of the approval process would depend on sufficient compliance with the solicitation rules, and a sufficient supporting majority, to overcome challenges by dissenting creditors or others. If the approval process became prolonged, then the advantages of speed and efficiency would be lost. Pre-packaged bankruptcy would not eliminate the risks associated with a bankruptcy filing. It would not eliminate the threat of systemic risk resulting from the effects of a bankruptcy by one or all of the domestic automakers on the financial markets. \3\ Moreover, a pre-packaged bankruptcy is still a bankruptcy as far as customers are concerned. The promoters have not explained how pre-packaged bankruptcy would allay the concerns of the majority of consumers who have said they would not buy an automobile from a company in bankruptcy. Given this consumer reaction, a bankruptcy filing by any one of the domestic automakers in the current environment is a dangerous ``bet the economy'' proposition.--------------------------------------------------------------------------- \3\ Zachary Kouwe and Louse Story, ``Big Three's Troubles May Touch Financial Sector,'' The New York Times, November 24, 2008.--------------------------------------------------------------------------- None of the elements of an auto industry restructuring require a bankruptcy proceeding. Restructuring milestones, repayment terms, taxpayer protections and other conditions of a loan can be established through legislation. Moreover, legislation can establish a process under which the actual restructuring of the domestic auto companies is supervised by the next administration. This can ensure that all stakeholders come to the table and share in the sacrifices that will be required, and that the domestic auto companies will be viable businesses after the restructuring is completed. In contrast, putting the fate of an auto industry restructuring in the hands of a bankruptcy court, even if a pre-packaged plan were realistically possible, would put narrow creditor interests ahead of all other stakeholders and ahead of important national concerns, including health care and pension policy, energy and transportation policy, and the negative effects of the economic downturn. These are interests that must be addressed and balanced by our elected government. ______ CHRG-111hhrg52261--92 Mr. Loy," I would agree, with a caveat. Most of the businesses that we fund are so raw, they are pure garage start-ups, they are not eligible for credit. So we don't use credit, or companies don't, until they have grown into larger entities. And it is at that stage where, historically, we have been able to bring in credit provider to scale the job creation. That now is not happening, so we are having to supply more and more equity to later-stage start-ups, and that is causing us to not have as much ability to invest in the brand-new things. There is a falloff in seed-stage company creation because the capital that we have, that was supposed to be for that, is filling the role that debt used to play for our larger companies. " CHRG-109shrg21981--138 Chairman Shelby," Hurry. Senator Bayh. Very quickly. I want to ask you about our comparative advantage looking forward, Mr. Chairman. You have been a long-time observer of our economy. Here shortly you are going to be liberated from the burdens of public responsibility and might have a chance to reflect at greater length. But I was struck in December when my wife and I were in India, in Bangalore, and visited General Electric, who employs 6,000 people in our State. One of their worldwide innovation centers was located in Bangalore. There is a biotech company there that heretofore has been only engaged in generic production but is now getting into proprietary discover. Our economy--and my State is a good example. A hundred years ago, most people were employed in agriculture. We transitioned into manufacturing, which peaked in the 1950's. We then transitioned into a service sector economy. As succinctly as you can, how would you define, looking forward, our comparative advantage in a world in which our competitors--India, China, and the others--are rapidly moving up the innovation curve? " CHRG-110hhrg34673--71 Mr. Bernanke," Let me say this: I think it is very important that as we try to achieve the objectives of greater clarity and transparency in corporate governance and internal controls and so on that we do it at the lowest cost we can, and I think that it is a good development that the Public Company Accounting Oversight Board along with the SEC has recently promulgated for a comment a new audit standard which would be less ``checking of the box'' and more focused on the major concerns of the company, and also that would take into account the size and complexity of the company, so we wouldn't be putting these costs on the smaller companies. I think that is an important step in the right direction. I would be curious to see how that goes. More generally, you know, as a regulator, I think it is very important that we have to achieve the objectives that Congress gives us, and there are some very important ones, but we also need to do the best we can to minimize the cost and unnecessary burden created by those regulations. " CHRG-111hhrg48674--316 Mr. Bernanke," Yes, of course. There are securities markets basically. You have corporate bonds and other kinds of commercial debt like commercial paper. A very important category is asset-backed securities where it could be that the bank sort of ultimately makes the initial loan. It makes an auto loan, for example. But rather than holding it on its books against its own capital, it combines it with other auto loans, makes a security called an asset-backed security, and sells it directly to investors. Another big area is mortgages, which are mostly securitized either from Fannie and Freddie or from private-label mortgage securitizers. So a very--something on the order of half of all credit goes through either the securitization market or through other securities markets; and although banks may be involved at some point in the process, they do not hold that--those assets on their portfolios, and their capital is not forced to bear that risk. So the closing down of the securitization markets has put a lot more pressure on the banks, because they haven't got the capacity to make up the difference between the losses in the securitization markets. " fcic_final_report_full--413 THE FORECLOSURE CRISIS CONTENTS Foreclosures on the rise: “Hard to talk about any recovery” ..............................  Initiatives to stem foreclosures: “Persistently disregard” .....................................  Flaws in the process: “Speculation and worst-case scenarios” ...........................  Neighborhood effects: “I’m not leaving” .............................................................  FORECLOSURES ON THE RISE: “HARD TO TALK ABOUT ANY RECOVERY ” Since the housing bubble burst, about four million families have lost their homes to foreclosure  and another four and a half million  have slipped into the foreclosure process or are seriously behind on their mortgage payments. When the economic damage finally abates, foreclosures may total between  million and more than  million, according to various estimates.  The foreclosure epidemic has hurt families and undermined home values in entire zip codes, strained school systems as well as community support services, and depleted state coffers. Even if the economy began suddenly booming the country would need years to recover. Prior to , the foreclosure rate was historically less than . But the trend since the housing market collapsed has been dramatic: In , . of all houses, or  out of , received at least one foreclosure filing.  In the fall of ,  in every  outstanding residential mortgage loans in the United States was at least one payment past due but not yet in foreclosure—an ominous warning that this wave may not have crested.  Distressed sales account for the majority of home sales in cities around the country, including Las Vegas, Phoenix, Sacramento, and Riverside, California.  Returning to the , borrowers whose loans were pooled into CMLTI - NC: by September , many had moved or refinanced their mortgages; by that point, , had entered foreclosure (mostly in Florida and California), and  had started loan modifications. Of the , still active loans then,  were seriously past due in their payments or currently in foreclosure.  The causes of foreclosures have been analyzed by many academics and govern- ment agencies. Two events are typically necessary for a mortgage default. First, monthly payments become unaffordable owing to unemployment or other financial  hardship, or because mortgage payments increase. And second (in the opinion of many, now the more important factor), the home’s value becomes less than the debt owed—in other words, the borrower has negative equity. “The evidence is irrefutable,” Laurie Goodman, a senior managing director with Amherst Securities, told Congress in : “Negative equity is the most important predictor of default. When the borrower has negative equity, unemployment acts as one of many possible catalysts, increasing the probability of default.”  CHRG-111hhrg52406--91 Mrs. Biggert," I am sorry. I missed it because we had to go vote. " Mr. Pollock," --the best reason to have really good disclosure--and I completely agree with you, Professor Warren, about good disclosure--is that it enables personal responsibility. The main question, in my opinion, which should be addressed by all credit disclosures is to the customer: Can I afford the debt service commitments I am making? How much risk can I take? I am not against people deciding to take risks, but they ought to know and understand what risks they are taking. " FOMC20081029meeting--254 252,MS. DUKE.," Thank you, Mr. Chairman. I focused on the ""more rapid financial recovery"" scenario, not so much because I thought it was the most likely but just trying to think what it would take to bring that about. I'm not sure that the policy changes we have done recently will do that, but I am fairly certain that we are going to keep at it until we find something that restores confidence. I was shocked when I was looking at the Bluebook at how short a time has passed since the meltdown of all these major financial institutions--Fannie, Freddie, Lehman, AIG, WaMu, and Wachovia. There is a sense among those who were affected, who lost from it, that they just really didn't see it coming, at least not at this speed, and that all of them had adequate regulatory capital, and the bankers at least were used to watching a sort of gradual burndown of that capital before institutions failed. They had a sense of being unable to predict who was going to be saved, who was going to get whacked, and who would be the winners and the losers. So subsequently both the banks and their customers froze, and there has been very little activity since then. All the banks I talked to reported having stopped doing business with one or more counterparties and that one or more counterparties had stopped doing business with them, and they were shocked by both of those things. So, first and foremost, it is clear that we need to restore confidence and predictability. In this sense, the recent moves to increase deposit insurance, to guarantee interbank short-term debt, and to provide capital on the same terms to banks of all sizes should be helpful--but only as long as we can do this without creating new uncertainty about who is going to benefit and who is not. Without being too subjective or too cute, we need at this point just to create confidence in our entire system. The demonstrable and preemptive support of the nine largest financial institutions; our public support of AIG; similar support of globally important banks by their home countries; and the resolution of Wachovia and National City, the two largest troubled institutions, without loss should help us avoid shocking surprises while everybody calms down. In this light, my conversation with the banks centered mostly on their reactions to the recent policy changes. All thought the deposit insurance increase was helpful. They varied in their estimates of the importance of the increase to $250,000, with a lot of them pointing out that for consumers they had already really restructured deposits to insure fairly large amounts, and several were using the CDARS (Certificate of Deposit Account Registry Service) program for larger depositors. They were even more enthusiastic about the coverage of transaction accounts, although one banker felt as though this coverage really hadn't gotten as much visibility as it should, particularly with corporate treasurers, and many had already seen corporate and institutional deposits move into Treasuries and felt as though it was going to be difficult to get those back. There was even much more confusion about the guarantee of short-term debt. One banker questioned how they would know whether the fed funds sold to another bank actually fell inside the 125 percent cap. Another one thought that the all-or-nothing structure of the guarantee was a little difficult to work with. Interestingly, and as I pointed out yesterday when I asked about interest on reserves, nobody had even focused on it. They had bigger fish to fry. So I wouldn't read anything into those early results. As for capital injections, most were taking a hard look at it. Two large community banks had just issued private capital to support growth that had been attracted from competitors, but they thought that they could profitably deploy the new capital. Other banks were interested in having the capital just in case they had the opportunity to buy weaker competitors, particularly deposits or branches in problem resolutions. None was really concerned about the announced restrictions, but a number of them were somewhat suspicious of the possible restrictions that might come later. Some small banks with already high levels of capital somehow felt pressured to apply anyway just to show that they would qualify, although they didn't think it would give them much growth. In all cases, capital is only part of the story. They also need reliable funding if they are going to expand lending. This will have to come either from reliable deposit growth or from the reopening of secondary markets because all of them were reluctant to increase borrowing from any source. The loan-to-deposit ratio is growing new fans. In terms of lending, all reported that they were still lending to their relationship customers, and they were cutting back on credit to credit-only customers. As one defined it, if 90 percent of the revenue is coming from credit, then that was a customer relationship they wanted to exit. They still report no significant deterioration in the C&I book. I asked about drawdowns from companies, and across the board they said they had seen it in a couple of instances but really they had not seen an awful lot of that, so that might be some posturing rather than actual drawdowns on the credit. They are, however, exercising strong pricing discipline, and the pricing decisions, more than credit decisions, are being escalated up the approval chain, actively outreaching to customers that they want to keep and assuring them of credit availability. But because they have no pricing power on the funding side and pricing became very skinny on loans in recent years, there is a high level of sticker shock going on, which might explain some of the complaints about unreasonable terms. They also report very high levels of caution from their customers, with the descriptions ranging from ""hunkering down"" to ""wait and see."" There were more anecdotal reports of companies riding trade credit by trying to accelerate receivables or extend payables. Now, whether this is due to the actual or to the perceived unavailability of credit from banks is not yet clear. Real pressure is on commercial real estate lending. They are very selective in new projects. They are processing renewals for only one year, using the opportunity to shore up pricing and underwriting, and no longer writing mini-perms. Nobody is doing those. So far, the performance is holding up on commercial properties, with strong performance on apartments and weakness showing up in retail. Residential construction and land development continues to be a problem. In visiting the San Francisco and the Kansas City Banks, I was shocked to hear the same story from large builders about land sales. One builder had a 300-acre parcel with a cost of $75,000 an acre, listed it for $15,000 an acre, and sold it for $10,700. Another reported a property with a cost basis of $120 million selling for $12 million. Apparently, the impetus for both of these transactions was a judgment that the cash received from tax refunds was more advantageous than holding out for better pricing. So the outlook for lending in residential construction or commercial real estate is dim far into the future, and I would say the same thing for syndicated or participated lending. However, to the extent that banks can exit those segments, it should free up funds for normal lending for businesses and consumers. Thank you, Mr. Chairman. " CHRG-111hhrg51591--15 Chairman Kanjorski," Thank you very much, Mr. Hensarling. We will now hear from the gentlelady from California, Ms. Speier, for 2 minutes. Ms. Speier. Thank you, Mr. Chairman, and Ranking Member Garrett. The subject of today's hearing is how should the Federal Government regulate insurance? I think at first we really need to answer the question, should the Federal Government regulate insurance? Here in Washington, the common perception seems to be that Federal regulation is always preferable to State regulation. In this case, however, I believe the move towards replacing State regulatory authority with Federal, particularly if it creates a dual optional Federal structure, is seriously misplaced and misguided. AIG, the world's largest insurance company, is often cited as the poster child for the need for Federal regulation of insurance. The case of AIG proves just the opposite. AIG's insurance operations, and the fact that they were regulated by the States and required to hold risk-based reserves, is the only reason AIG was salvageable, even if it took $150 billion in taxpayer money to bail out the federally regulated holding company. If the State regulators hadn't prevented the holding company from raiding State-based reserves, even the insurance subsidiaries would have gone down, jeopardizing consumers and State-guaranteed funds all across our country. In my opinion, AIG makes the argument not for Federal regulation of insurance, but for the reintroduction of Glass-Steagall. In the words of AIG CEO Liddy before this committee, and just yesterday before the Government Oversight Committee, ``AIG needs to return to doing what it does best, insurance.'' If it had stuck to insurance and hadn't been able to buy a small savings and loan so that it could choose OTS as its regulator, we likely wouldn't be facing the crisis we are facing today. Instead, it launched into the high-risk and supposedly high-reward world of derivatives, where Federal regulators were largely asleep at the switch. OTS has admitted to this committee that they really had no idea what was going on. I think we can all agree that the regulator-shopping among financial institutions has been a disaster, and we should not now be considering giving that opportunity to insurance companies. The insurance industry chafes under State regulation not because of the onerous regulatory burden, but because States impose stringent capital reserve requirements, and because of the ability in some States like California to pass tough consumer protection laws and rate regulation. Let me be blunt. I think the discussion is all about life insurance companies being further able to leverage their positions. I served as chair of the California State Senate Banking, Finance, and Insurance Committee for 8 years. The insurance industry lobbyists were always looking to weaken consumer protections. I think one of the frequent refrains, that they needed to be free of State restrictions so they could be able to speed creative and innovative products to market so that they could compete with Wall Street, has been shown to be the fallacy that it was and is. Insurance is an essential part of our economy. It needs to be strong and robust. The protections for the consumers and taxpayers must be equally strong and robust. I yield back. " CHRG-111shrg51395--117 PREPARED STATEMENT OF JOHN C. COFFEE, JR. Adolf A. Berle Professor of Law, Columbia University Law School March 10, 2009 Enhancing Investor Protection and the Regulation of Securities Markets ``When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing.'' ----Charles Prince, CEO of Citigroup Financial Times, July 2007 Chairman Dodd, Ranking Member Shelby, and Fellow Senators, I am pleased and honored to be invited to testify here today. We are rapidly approaching the first anniversary of the March 17, 2008, insolvency of Bear Stearns, the first of a series of epic financial collapses that have ushered in, at the least, a major recession. Let me take you back just one year ago when, on this date in 2008, the U.S. had five major investment banks that were independent of commercial banks and were thus primarily subject to the regulation of the Securities and Exchange Commission: Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns. Today, one (Lehman) is insolvent; two (Merrill Lynch and Bear Stearns) were acquired on the brink of insolvency by commercial banks, with the Federal Reserve pushing the acquiring banks into hastily arranged ``shotgun'' marriages; and the remaining two (Goldman and Morgan Stanley) have converted into bank holding companies that are primarily regulated by the Federal Reserve. The only surviving investment banks not owned by larger commercial banks are relatively small boutiques (e.g., Lazard Freres). Given the total collapse of an entire class of institutions that were once envied globally for their entrepreneurial skill and creativity, the questions virtually ask themselves: Who failed? What went wrong? Although there are a host of candidates--the investment banks, themselves, mortgage loan originators, credit-rating agencies, the technology of asset-backed securitizations, unregulated trading in exotic new instruments (such as credit default swaps), etc.--this question is most pertinently asked of the SEC. Where did it err? In overview, 2008 witnessed two closely connected debacles: (1) the failure of a new financial technology (asset-backed securitizations), which grew exponentially until, after 2002, annual asset-backed securitizations exceeded the annual total volume of corporate bonds issued in the United States, \1\ and (2) the collapse of the major investment banks. In overview, it is clear that the collapse of the investment banks was precipitated by laxity in the asset-backed securitization market (for which the SEC arguably may bear some responsibility), but that this laxity began with the reckless behavior of many investment banks. Collectively, they raced like lemmings over the cliff by abandoning the usual principles of sound risk management both by (i) increasing their leverage dramatically after 2004, and (ii) abandoning diversification in pursuit of obsessive focus on high-profit securitizations. Although these firms were driven by intense competition and short-term oriented systems of executive compensation, their ability to race over the cliff depended on their ability to obtain regulatory exemptions from the SEC. Thus, as will be discussed, the SEC raced to deregulate. In 2005, it adopted Regulation AB (an acronym for ``Asset-Backed''), which simplified the registration of asset-backed securitizations without requiring significant due diligence or responsible verification of the essential facts. Even more importantly, in 2004, it introduced its Consolidated Supervised Entity Program (``CSE''), which allowed the major investment banks to determine their own capital adequacy and permissible leverage by designing their own credit risk models (to which the SEC deferred). Effectively, the SEC abandoned its long-standing ``net capital rule'' \2\ and deferred to a system of self-regulation for these firms, which largely permitted them to develop their own standards for capital adequacy.--------------------------------------------------------------------------- \1\ See John C. Coffee, Jr., Joel Seligman & Hillary Sale, SECURITIES REGULATION: Cases and Materials (10th ed. 2007) at 10. \2\ See Rule 15c3-1 (``Net Capital Requirements for Brokers and Dealers''), 17 CFR 240.15c3-1.--------------------------------------------------------------------------- For the future, it is less important to allocate culpability and blame than to determine what responsibilities the SEC can perform adequately. The recent evidence suggests that the SEC cannot easily or effectively handle the role of systemic risk regulator or even the more modest role of a prudential financial supervisor, and it may be more subject to capture on these issues than other agencies. This leads me to conclude (along with others) that the U.S. needs one systemic risk regulator who, among other tasks, would have responsibility for the capital adequacy and safety and soundness of all institutions that are too ``big to fail.'' \3\ The key advantage of a unified systemic risk regulator with jurisdiction over all large financial institutions is that it solves the critical problem of regulatory arbitrage. AIG, which has already cost U.S. taxpayers over $150 billion, presents the paradigm of this problem because it managed to issue billions in credit default swaps without becoming subject to regulation by any regulator at either the federal or state level.--------------------------------------------------------------------------- \3\ I have made this argument in greater detail in an article with Professor Hillary Sale, which will appear in the 75th Anniversary of the SEC volume of the Virginia Law Review. See Coffee and Sale, ``Redesigning the SEC: Does the Treasury Have a Better Idea?'' (available on the Social Science Research Network at http://ssrn.com/abstract=1309776).--------------------------------------------------------------------------- But one cannot stop with this simple prescription. The next question becomes what should be the relationship between such a systemic risk regulator and the SEC? Should the SEC simply be merged into it or subordinated to it? I will argue that it should not. Rather, the U.S. should instead follow a ``twin peaks'' structure (as the Treasury Department actually proposed in early 2008 before the current crisis crested) that assigns prudential supervision to one agency and consumer protection and transparency regulation to another. Around the globe, countries are today electing between a unified financial regulator (as typified by the Financial Services Authority (``FSA'') in the U.K.) and a ``twin peaks'' model (which both Australia and The Netherlands have followed). I will argue that the latter model is preferable because it deals better with serious conflict of interest problems and the differing cultures of securities and banking regulators. By culture, training, and professional orientation, banking regulators are focused on protecting bank solvency, and they historically have often regarded increased transparency as inimical to their interests, because full disclosure of a bank's problems might induce investors to withdraw deposits and credit. The result can sometimes be a conspiracy of silence between the regulator and the regulated to hide problems. In contrast, this is one area where the SEC's record is unblemished; it has always defended the principle that ``sunlight is the best disinfectant.'' Over the long-run, that is the sounder rule. If I am correct that a ``twin peaks'' model is superior, then Congress has to make clear the responsibilities of both agencies in any reform legislation in order to avoid predictable jurisdictional conflicts and to identify a procedure by which to mediate those disputes that are unavoidable.What Went Wrong? This section will begin with the problems in the mortgage loan market, then turn to the failure of credit-rating agencies, and finally examine the SEC's responsibility for the collapse of the major investment banks.The Great American Real Estate Bubble The earliest origins of the 2008 financial meltdown probably lie in deregulatory measures, taken by the U.S. Congress at the end of the 1990s, that placed some categories of derivatives and the parent companies of investment banks beyond effective regulation. \4\ Still, most accounts of the crisis start by describing the rapid inflation of a bubble in the U.S. housing market. Here, one must be careful. The term ``bubble'' can be a substitute for closer analysis and may carry a misleading connotation of inevitability. In truth, bubbles fall into two basic categories: those that are demand-driven and those that are supply-driven. The majority of bubbles fall into the former category, \5\ but the 2008 financial market meltdown was clearly a supply-driven bubble, \6\ fueled by the fact that mortgage loan originators came to realize that underwriters were willing to buy portfolios of mortgage loans for asset-backed securitizations without any serious investigation of the underlying collateral. With that recognition, loan originators' incentive to screen borrowers for creditworthiness dissipated, and a full blown ``moral hazard'' crisis was underway. \7\--------------------------------------------------------------------------- \4\ Interestingly, this same diagnosis was recently given by SEC Chairman Christopher Cox to this Committee. See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing and Urban Affairs, United States Senate, September 23, 2008. Perhaps defensively, Chairman Cox located the origins of the crisis in the failure of Congress to give the SEC jurisdiction over investment bank holding companies or over-the-counter derivatives (including credit default swaps), thereby creating a regulatory void. \5\ For example, the high-tech Internet bubble that burst in early 2000 was a demand-driven bubble. Investors simply overestimated the value of the Internet, and for a time initial public offerings of ``dot.com'' companies would trade at ridiculous and unsustainable multiples. But full disclosure was provided to investors and the SEC cannot be faulted in this bubble--unless one assigns it the very paternalistic responsibility of protecting investors from themselves. \6\ This is best evidenced by the work of two University of Chicago Business School professors discussed below. See Atif Mian and Amir Sufi, ``The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis'', (http://ssrn.com/abstract=1072304) (May 2008). \7\ Interestingly, ``moral hazard'' problems also appear to have underlain the ``savings and loan'' crisis in the United States in the 1980s, which was the last great crisis involving financial institutions in the United States. For a survey of recent banking crises making this point, see Note, Anticipatory Regulation for the Management of Banking Crises, 38 Colum. J. L. & Soc. Probs. 251 (2005).--------------------------------------------------------------------------- The evidence is clear that, between 2001 and 2006, an extraordinary increase occurred in the supply of mortgage funds, with much of this increased supply being channeled into poorer communities in which previously there had been a high denial rate on mortgage loan applications. \8\ With an increased supply of mortgage credit, housing prices rose rapidly, as new buyers entered the market. But at the same time, a corresponding increase in mortgage debt relative to income levels in these same communities made these loans precarious. A study by University of Chicago Business School professors has found that two years after this period of increased mortgage availability began, a corresponding increase started in mortgage defaults--in exactly the same zip code areas where there had been a high previous rate of mortgage loan denials. \9\ This study determined that a one standard deviation in the supply of mortgages from 2001 to 2004 produced a one standard deviation increase thereafter in mortgage default rates. \10\--------------------------------------------------------------------------- \8\ See Mian and Sufi, supra note 6, at 11 to 13. \9\ Id. at 18-19. \10\ Id. at 19.--------------------------------------------------------------------------- Even more striking, however, was its finding that the rate of mortgage defaults was highest in those neighborhoods that had the highest rates of securitization. \11\ Not only did securitization correlate with a higher rate of default, but that rate of default was highest when the mortgages were sold by the loan originator to financial firms unaffiliated with the loan originator. \12\ Other researchers have reached a similar conclusion: conditional on its being actually securitized, a loan portfolio that was more likely to be securitized was found to default at a 20 percent higher rate than a similar risk profile loan portfolio that was less likely to be securitized. \13\ Why? The most plausible interpretation is that securitization adversely affected the incentives of lenders to screen their borrowers.--------------------------------------------------------------------------- \11\ Id. at 20-21. \12\ Id. \13\ See Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant Vig, ``Did Securitization Lead to Lax Screening? Evidence from Subprime Loans,'' (http://ssrn.com/abstract=1093137) (April, 2008). These authors conclude that securitization did result in ``lax screening.''--------------------------------------------------------------------------- Such a conclusion should not surprise. It simply reflects the classic ``moral hazard'' problem that arises once loan originators did not bear the cost of default by their borrowers. As early as March, 2008, The President's Working Group on Financial Markets issued a ``Policy Statement on Financial Market Developments'' that explained the financial crisis as the product of five ``principal underlying causes of the turmoil in financial markets'': a breakdown in underwriting standards for subprime mortgages; a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors, related in part to failures to provide or obtain adequate risk disclosures; flaws in credit rating agencies' assessment of subprime residential mortgages . . . and other complex structured credit products, . . . risk management weaknesses at some large U.S. and European financial institutions; and regulatory policies, including capital and disclosure requirements, that failed to mitigate risk management weaknesses. \14\--------------------------------------------------------------------------- \14\ The President's Working Group on Financial Markets, ``Policy Statement on Financial Market Developments,'' at 1 (March 2008). Correct as the President's Working Group was in noting the connection between the decline of discipline in the mortgage loan origination market and a similar laxity among underwriters in the capital markets, it did not focus on the direction of the causality. Did mortgage loan originators fool or defraud investment bankers? Or did investment bankers signal to loan originators that they would buy whatever the loan originators had to sell? The available evidence tends to support the latter hypothesis: namely, that irresponsible lending in the mortgage market was a direct response to the capital markets' increasingly insatiable demand for financial assets to securitize. If underwriters were willing to rush deeply flawed asset-backed securitizations to the market, mortgage loan originators had no rational reason to resist them. The rapid deterioration in underwriting standards for subprime mortgage loans is revealed at a glance in the following table: \15\--------------------------------------------------------------------------- \15\ See Allen Ferrell, Jennifer Bethel and Gang Hu, Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis (Harvard Law & Economics Discussion Paper No. 612, Harvard Law School Program in Risk Regulation Research Paper No. 08-5) at Table 4. Underwriting Standards in Subprime Home-Purchase Loans, 2001-2006---------------------------------------------------------------------------------------------------------------- Debt Year Low/No-Doc Payments/ Loan/Value ARM Share Interest- Share Income Only Share----------------------------------------------------------------------------------------------------------------2001...................................... 28.5% 39.7% 84.0% 73.8% 0.0%2002...................................... 38.6% 40.1% 84.4% 80.0% 2.3%2003...................................... 42.8% 40.5% 86.1% 80.1% 8.6%2004...................................... 45.2% 41.2% 84.9% 89.4% 27.3%2005...................................... 50.7% 41.8% 83.2% 93.3% 37.8%2006...................................... 50.8% 42.4% 83.4% 91.3% 22.8%----------------------------------------------------------------------------------------------------------------Source: Freddie Mac, obtained from the International Monetary Fund. The investment banks could not have missed that low document loans (also called ``liar loans'') rose from 28.5 percent to 50.8 percent over the 5 year interval between 2001 and 2006 or that ``interest only'' loans (on which there was no amortization of principal) similarly grew from 6 percent to 22.8 percent over this same interval. Thus, the real mystery is not why loan originators made unsound loans, but why underwriters bought them. Here, it seems clear that both investment and commercial banks saw high profits in securitizations and believed they could quickly sell on a global basis any securitized portfolio of loans that carried an investment grade rating. In addition, investment banks may have had a special reason to focus on securitizations: structured finance offered a level playing field where they could compete with commercial banks, whereas, as discussed later, commercial banks had inherent advantages at underwriting corporate debt and were gradually squeezing the independent investment banks out of this field. \16\ Consistent with this interpretation, anecdotal evidence suggests that due diligence efforts within the underwriting community slackened in asset-backed securitizations after 2000. \17\ Others have suggested that the SEC contributed to this decline by softening its disclosure and due diligence standards for asset-backed securitizations, \18\ in particular by adopting in 2005 Regulation AB, which covers the issuance of asset backed securities. \19\ From this perspective, relaxed discipline in both the private and public sectors overlapped to produce a disaster.--------------------------------------------------------------------------- \16\ See text and notes infra at notes 56 to 61. \17\ Investment banks formerly had relied on ``due diligence'' firms that they employed to determine whether the loans within a loan portfolio were within standard parameters. These firms would investigate and inform the underwriter as to the percentage of the loans that were ``exception'' loans (i.e., loans outside the investment bank's normal guidelines). Subsequent to 2000, the percentage of ``exception loans'' in portfolios securitized by these banks often rose from the former level of 25 percent to as high as 80 percent. Also, the underwriters scaled back the intensity of the investigations that they would authorize the ``due diligence'' firm to conduct, reducing from 30 percent to as few as 5 percent the number of loans in a portfolio that it was to check. See Vikas Bajaj & Jenny Anderson, ``Inquiry Focuses on Withholding of Data on Loans,'' N.Y. Times, January 12, 2008, at p. A-1. \18\ See Richard Mendales, ``Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent the CDO Meltdown And How To Fix It'' (Working Paper 2008) at 36 (forthcoming in 2009, U. Ill. L. Rev.). \19\ See Securities Act Release No. 8518 (``Asset-Backed Securities'') (January 7, 2005, 79 FR 1506). Regulation AB codified a series of ``no action'' letters and established disclosures standards for all asset-backed securitizations. See 17 C.F.R. 229.1100-1123 (2005). Although it did not represent a sharp deregulatory break with the past, Regulation AB did reduce the due diligence obligation of underwriters by eliminating any need to assure that assets included in a securitized pool were adequately documented. See Mendales, supra note 18.---------------------------------------------------------------------------Credit Rating Agencies as Gatekeepers It has escaped almost no one's attention that the credit rating agencies bear much responsibility for the 2008 financial crisis, with the consensus view being that they inflated their ratings in the case of structured finance offerings. Many reasons have been given for their poor performance: (1) rating agencies faced no competition (because there are really only three major rating agencies); (2) they were not disciplined by the threat of liability (because credit rating agencies in the U.S. appear never to have been held liable and almost never to have settled a case with any financial payment); (3) they were granted a ``regulatory license'' by the SEC, which has made an investment grade rating from a rating agency that was recognized by the SEC a virtual precondition to the purchase of debt securities by many institutional investors; (4) they are not required to verify information (as auditors and securities analysts are), but rather simply express views as to the creditworthiness of the debt securities based on the assumed facts provided to them by the issuer. \20\ These factors all imply that credit rating agencies had less incentive than other gatekeepers to protect their reputational capital from injury. After all, if they face little risk that new entrants could enter their market to compete with them or that they could be successfully sued, they had less need to invest in developing their reputational capital or taking other precautions. All that was necessary was that they avoid the type of major scandal, such as that which destroyed Arthur Andersen & Co., the accounting firm, that had made it impossible for a reputable company to associate with them.--------------------------------------------------------------------------- \20\ For these and other explanations, see Coffee, GATEKEEPERS: The Professions and Corporate Governance (Oxford University Press, 2006), and Frank Partnoy, ``How and Why Credit Rating Agencies Are Not Like Other Gatekeepers'' (http://ssrn.com/abstract=900257) (May 2006).--------------------------------------------------------------------------- Much commentary has suggested that the credit rating agencies were compromised by their own business model, which was an ``issuer pays'' model under which nearly 90 percent of their revenues came from the companies they rated. \21\ Obviously, an ``issuer pays'' model creates a conflict of interest and considerable pressure to satisfy the issuer who paid them. Still, neither such a conflicted business model nor the other factors listed above can explain the dramatic deterioration in the performance of the rating agencies over the last decade. Both Moody's and Standard & Poor were in business before World War I and performed at least acceptably until the later 1990s. To account for their more recent decline in performance, one must point to more recent developments and not factors that long were present. Two such factors, each recent and complementary with the other, do provide a persuasive explanation for this deterioration: (1) the rise of structured finance and the change in relationships that it produced between the rating agencies and their clients; and (2) the appearance of serious competition within the ratings industry that challenged the long stable duopoly of Moody's and Standard & Poor's and that appears to have resulted in ratings inflation.--------------------------------------------------------------------------- \21\ See Partnoy, supra note 20.--------------------------------------------------------------------------- First, the last decade witnessed a meteoric growth in the volume and scale of structured finance offerings. One impact of this growth was that it turned the rating agencies from marginal, basically break-even enterprises into immensely profitable enterprises that rode the crest of the breaking wave of a new financial technology. Securitizations simply could not be sold without ``investment grade'' credit ratings from one or more of the Big Three rating agencies. Structured finance became the rating agencies' leading source of revenue. Indeed by 2006, structured finance accounted for 54.2 percent of Moody's revenues from its ratings business and 43.5 percent of its overall revenues. \22\ In addition, rating structured finance products generated much higher fees than rating similar amounts of corporate bonds. \23\ For example, rating a $350 million mortgage pool could justify a fee of $200,000 to $250,000, while rating a municipal bond of similar size justified only a fee of $50,000. \24\--------------------------------------------------------------------------- \22\ See In re Moody's Corporation Securities Litigation, 2009 U.S. Dist. LEXIS 13894 (S.D.N.Y. February 23, 2009) at *6 (also noting that Moody's grossed $1.635 billion from its ratings business in 2006). \23\ See Gretchen Morgenson, ``Debt Watchdogs: Tamed or Caught Napping?'' New York Times, December 7, 2008, at p. 1, 40. \24\ Id.--------------------------------------------------------------------------- Beyond simply the higher profitability of rating securitized transactions, there was one additional difference about structured finance that particularly compromised the rating agencies as gatekeepers. In the case of corporate bonds, the rating agencies rated thousands of companies, no one of which controlled any significant volume of business. No corporate issuer, however large, accounted for any significant share of Moody's or S&P's revenues. But with the rise of structured finance, the market became more concentrated. As a result, the major investment banks acquired considerable power over the rating agencies, because each of them had ``clout,'' bringing highly lucrative deals to the agencies on a virtually monthly basis. As the following chart shows, the top six underwriters controlled over 50 percent of the mortgage-backed securities underwriting market in 2007, and the top eleven underwriters each had more than 5 percent of the market and in total controlled roughly 80 percent of this very lucrative market on whom the rating agencies relied for a majority of their ratings revenue: \25\--------------------------------------------------------------------------- \25\ See Ferrell, Bethel, and Hu, supra note 15, at Table 2. For anecdotal evidence that ratings were changed at the demand of the investment banks, see Morgenson, supra note 23. MBS Underwriters in 2007-------------------------------------------------------------------------------------------------------------------------------------------------------- Proceed Amount + Rank Book Runner Number of Market Overallotment Sold in U.S. Offerings Share ($mill)--------------------------------------------------------------------------------------------------------------------------------------------------------1....................................................... Lehman Brothers 120 10.80% $100,1092....................................................... Bear Stearns & Co., Inc. 128 9.90% 91,6963....................................................... Morgan Stanley 92 8.20% 75,6274....................................................... JPMorgan 95 7.90% 73,2145....................................................... Credit Suis109 7.50% 69,5036....................................................... Bank of America Securities LLC 101 6.80% 62,7767....................................................... Deutsche Bank AG 85 6.20% 57,3378....................................................... Royal Bank of Scotland Group 74 5.80% 53,3529....................................................... Merrill Lynch 81 5.20% 48,40710...................................................... Goldman Sachs & Co. 60 5.10% 47,69611...................................................... Citigroup 95 5.00% 46,75412...................................................... UBS 74 4.30% 39,832-------------------------------------------------------------------------------------------------------------------------------------------------------- If the rise of structured finance was the first factor that compromised the credit rating agencies, the second factor was at least as important and had an even clearer empirical impact. Until the late 1990s, Moody's and Standard & Poor's shared a duopoly over the rating of U.S. corporate debt. But, over the last decade, a third agency, Fitch Ratings, grew as the result of a series of mergers and increased its U.S. market share from 10 percent to approximately a third of the market. \26\ The rise of Fitch challenged the established duopoly. What was the result? A Harvard Business School study has found three significant impacts: (1) the ratings issued by the two dominant rating agencies shifted significantly in the direction of higher ratings; (2) the correlation between bond yields and ratings fell, suggesting that under competitive pressure ratings less reflected the market's own judgment; and (3) the negative stock market reaction to bond rating downgrades increased, suggesting that a downgrade now conveyed worse news because the rated offering was falling to an even lower quality threshold than before. \27\ Their conclusions are vividly illustrated by one graph they provide that shows the correlation between grade inflation and higher competition:--------------------------------------------------------------------------- \26\ Bo Becker and Todd Milburn, ``Reputation and Competition: Evidence from the Credit Rating Industry,'' Harvard Business School, Working Paper No. 09-051 (2008) (http://ssrn.com/abstract =1278150) at p. 4. \27\ Id. at 17. CHRG-111hhrg53248--197 Mr. Bernanke," Well, Chairman Bair has also spoken on this topic, but I think we would all agree that an effective resolution regime would take value from shareholders and impose costs and losses on creditors. So, I think that would be an important part of it. An alternative, a close alternative, would be to require firms to have securities like contingent capital or convertible debt that, in the event of one of these resolution events, would be converted into a less valuable, more junior liability, and therefore indirectly impose costs on the lenders to the company. But I think we all agree that imposing costs on the shareholders and the creditors is an important part of this idea. " CHRG-110shrg46629--30 Chairman Bernanke," Capital standards, I am sorry. Capital standards, thank you. The system we have now, Basel I, was designed 20 years ago for a very different kind of banking world. Banks are far more obligated. They use much more off balance sheets types of operations. The existing Basel I Accord, as the GAO study that just came agrees, and as the international banking community strongly agrees, is not safe for the largest and most sophisticated international banking organizations. And so it is not a question of going to lower capital standards. It is a question of finding a new system that will provide capital on a risk-adjusted basis that will match the capital against the risk, and therefore make these banks safer not less safe. So we take a backseat to nobody in the importance of making sure that these banks are safe and sound. That is our primary objective. And we believe that making this change to Basel II will increase, not decrease, the safety of these banks. In addition, of course, in any change from one system to another there is going to be a period of uncertainty as we work through the new methods and so on. And so we have been very careful to include a wide variety of protections including, as you know, the leverage ratio, prompt corrective action, the transition floors, Pillar II, a wide variety of things that will make sure that we have the control that we need to begin to see any unsafe drops in capital, we can make the changes to ensure that the banks are operating safely and soundly. So, I would just very strongly urge you to consider that Basel II is not about lowering capital, it is about making banks safer. Senator Shelby. But some banks believe it is about lowering capital. There has been a lot of stuff written about it. At the end of the day they said it would free up their capital, in other words lower the capital. That is some of our concerns. " CHRG-110hhrg46591--411 Mr. Bachus," Let me credit default swaps, and correct me if I'm wrong--I would compare in the real world with sort of insurance or a guarantee. I mean it is a form of where you are issuing insurance on an obligation. Now, the problem with it was, unlike insurance, where there are reserves and it is regulated, when you make a guarantee you have to have reserves to stand behind it. It was so highly leveraged that you may issue some on a $100 million obligation. When it went wrong there was only, you know, $200,000 worth of capital backing that guarantee and it was blown through almost immediately. " fcic_final_report_full--546 LIBOR London Interbank Offered Rate, an interest rate at which banks are willing to lend to each other in the London interbank market. liquidity Holding cash and/or assets that can be quickly and easily converted to cash. liquidity put A contract allowing one party to compel the other to buy an asset under certain cir- cumstances. It ensures that there will be a buyer for otherwise illiquid assets. loan-to-value ratio Ratio of the amount of a mortgage to the value of the house, typically ex- pressed as a percentage. “Combined” loan-to-value includes all debt secured by the house, in- cluding second mortgages. LTV ratio see loan-to-value ratio. mark-to-market The process by which the reported amount of an asset is adjusted to reflect the market value. monoline Insurance company, such as AMBAC and MBIA, whose single line of business is to guarantee financial products. mortgage servicer Company that acts as an agent for mortgage holders, collecting and distribut- ing payments from borrowers and handling defaults, modifications, settlements, and foreclo- sure proceedings. mortgage underwriting Process of evaluating the credit characteristics of a mortgage and bor- rower. mortgage-backed security Debt instrument secured by a pool of mortgages, whether residential or commercial. NAV see net asset value . negative amortization loan Loan that allows a borrower to make monthly payments that do not fully cover the interest payment, with the unpaid interest added to the principal of the loan. net asset value Value of an asset minus any associated costs; for financial assets, typically changes each trading day. net charge-off rate Ratio of loan losses to total loans. non-agency mortgage-backed securities Mortgage-backed securities sponsored by private compa- nies other than a government-sponsored enterprise (such as Fannie Mae or Freddie Mac ); also known as private-label mortgage-backed securities. notional amount A measure of the outstanding amount of over-the-counter derivatives contracts, based on the amount of the underlying referenced assets. novation A process by which counterparties may transfer derivatives positions. OCC see Office of the Comptroller of the Currency . Office of Federal Housing Enterprise Oversight Created in  to oversee financial soundness of Fannie Mae and Freddie Mac ; its responsibilities were assumed in  by its successor, the Federal Housing Finance Agency . Office of the Comptroller of the Currency Independent bureau within Department of Treasury that charters, regulates, and supervises all national banks and certain branches and agencies of foreign banks in the United States. Office of Thrift Supervision Independent bureau within Treasury that regulates all federally chartered and many state-chartered savings and loans/thrift institutions and their holding companies. OFHEO see Office of Federal Housing Enterprise Oversight . originate-to-distribute When lenders make loans with the intention of selling them to other fi- nancial institutions or investors, as opposed to holding the loans through maturity. originate-to-hold When lenders make loans with the intention of holding them through maturity, as opposed to selling them to other financial institutions or investors. 543 origination Process of making a loan, including underwriting, closing, and providing the funds. OTS see Office of Thrift Supervision . par Face value of a bond. payment-option adjustable-rate mortgage (also called payment ARM or option ARM ) Mort- gages that allow borrowers to pick the amount of payment each month, possibly low enough to increase the principal balance. CHRG-111hhrg48867--235 Mr. Bartlett," I guess I am not familiar with that exact recommendation. I think the G30 report was, by and large--we don't agree with all of it--was, by and large, a step in the right direction. Those two institutions became bank holding companies. As I understand, they have several years with their primary regulator to conform with all the capital requirements. It is clear that more capital is one of the trends in this, or less leverage. And that is one of the outcomes of becoming a bank holding company. " CHRG-111hhrg52261--131 Mr. Roberts," I would--my response to you is, I think there is a practical level of capital that can satisfy both sides of that particular equation. We talked earlier--I think at the prior panel--that some people were leveraged 30-to-1; that is probably too much. Is 5-to-1 too little? I would suggest that it is. I think there is a capital level that is a reasonable balance that continues funds able to be lent and still provides that safety to the taxpayer. " CHRG-111hhrg52261--96 Mr. Loy," We are looking and we want to, precisely for that reason. We don't provide credit; we provide investment equity capital. But because these start-ups cannot get a home equity loan to finance their start-up, they are needing $500,000 from us; and it is getting harder and harder for us to provide that for the reasons I just said. And the potential for this regulation would be disproportionately felt on the smallest firms that provide that earliest stage of capital. So there is a good chance that entire swath of $500,000 to $1 million of seed-stage capital, if we are forced to follow hedge funds regulation, the cost of that will drive the firms who do that out of business. Ms. Fallin. Can I ask, also, another question? I am hearing from our local bankers that the fee increases to recapitalize FDIC is causing them not to have as much capital and loans to put out into the marketplace. And they have told me, like in my State, that $37 million has gone out in fee increases which they could be lending out to our small businesses and even to those who are wanting to have mortgages. And they are concerned about another fee increase on those small bankers that will once again drive capital and take it out of the marketplace. Are you seeing that back in your individual organizations and States, that it is taking the capital out of the marketplace, lending ability? " CHRG-111shrg56415--51 Mr. Tarullo," Well, I think--so, Senator, that is probably one of the open questions, and exactly what do we mean, I think there is--I think what is important is that there be real prospects of losses for shareholders and creditors when their large institution gets in that circumstance. Senator Corker. Mr. Chairman, I thank you, and I am sorry we didn't get to each of you. I do hope that what we are doing with the smaller banks, that some assistance was being sought through TARP here earlier, I hope that we are encouraging them, while they can, those who can, to raise capital. I have seen this taking place now and shareholders are being deluded and we are going ahead and raising the capital necessary to weather this storm. I thank each of you and I look forward to seeing you again soon. Senator Johnson. Senator Schumer. Senator Schumer. Thank you, Mr. Chairman. I want to thank you for holding this hearing. I thank the witnesses. I would like to talk a little bit about fees and consumer protection, Consumer Protection Agency. Many of the banks we know have reacted to lost profits from their mortgage problems by raising fees on consumers, one of which is overdraft fees. There is no transparency. They don't give consumers a real chance to decide if they want--even want this kind of protection. Banks raked in about $24 billion in overdraft fees last year. That was up 35 percent from the year before. That ought to stick out. Even accounting for higher debit card use, a worsening credit environment due to the economy, that is a massive increase. It indicates to me that consumers are bearing a disproportionate burden in maintaining the health of many banks' balance sheets. They are also raising ATM fees, as you know. Bank of America recent raised its fee for other bank customers to $3. That would have been unheard of a few years ago. Maybe one of these fly by-night machines would have done that, but not a major bank. And the average cost of an ATM transaction is also now over $3. Even if you withdraw $100, that is a high fee in percentage terms, and, of course, the overdraft fees, you buy a $2 cup of coffee and they charge you $35 without even telling you. It makes your blood boil. So, my question is this. This is to really to Comptroller Dugan, Mr. Ward. As regulators, you are responsible for not only safety and soundness, but consumer protections. Maybe Mr. Tarullo also has a role here. What are you doing to ensure that consumers don't bear the brunt of banks' efforts to repair balance sheets, particularly in these two instances? " CHRG-111hhrg56776--103 Mr. Bernanke," This is a very large and deep market. Indeed, when you see stress in other areas around the world, perhaps in other countries' fiscal positions, for example, the dollar tends to strengthen because money flows into U.S. Treasuries. I have not seen any reduction in demand for U.S. Treasuries. The foreign demand remains quite strong. I do not anticipate any problem. I guess there is always the question of price. There, the question is, will all our creditors, including domestic creditors, remain confident in the long-run fiscal stability of the United States, and there, I think it is very, very important for the Congress to be devising a plan to create a trajectory whereby we have a more stable debt position going forward. That is very important. " CHRG-110hhrg46596--491 Mr. Foster," Well, it strikes me as a very high-leverage application of your funds, because these things--you know, the frustrating thing is these things have a near-zero historical default rate, and there is no reason for these not to be trading. And it is very frustrating, and it seems like there is some hope that a very limited application of recapitalization might have a huge effect. " CHRG-111hhrg51585--131 Mr. Street," About 7.6 billion, I believe, is about right. He had a portfolio of about $26 billion. It was essentially leveraged up from that point. Ms. Speier. If I recall correctly, the investments that were being made in Orange County would not be defined as prudent; is that correct? " CHRG-111shrg57709--98 Mr. Volcker," Right. Senator Warner. You talk about three different areas: proprietary trading, private equity and hedge funds. I mean I know you have talked a little bit about definition on the proprietary trading act. I do wonder. I used to be in the private equity business. There are private equity, subordinated debt, different types of instruments that kind of fall along that continuum of what we now broadly define as private equity. Some of those traditionally had been kind of traditional banking functions. " CHRG-111hhrg51698--59 Mr. Gooch," I think having the instruments in a central environment where you can see everything optically is helpful for regulators so they can see where the risk lies. But, certainly, margining for credit default is very complex. I mean, I give the example of Lehman. Their senior debt was trading at 85 cents on the Friday before they went into bankruptcy, and on Monday morning it was trading at 11 cents. I don't see how you could effectively margin for that level of price move over the weekend. " CHRG-110shrg50418--282 Mr. Morici," I know you like to talk about strings, and I would admonish you, whatever solution you come up with, don't try to micromanage these companies from here. Although I understand your concern about fuel economy, if you want to talk about strings, the most significant string you could tie to resurrect these economies would be on some of that money from the Federal Reserve to the nine largest banks to get them back into securitizing the debt that their finance companies generate. Senator Tester. OK. So just the last point, and that is a very good point, but the last point is, in your opinion, has the $300 billion that has been spent by the Treasury so far done anything to help your business from a credit standpoint? Yes or no would be fine. " Mr. Wagoner," I--yet, we haven't seen any measurable change, except for we have had the capability to use the commercial paper facility at the Fed, so that has helped some. Senator Tester. OK. " 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 CHRG-110shrg50417--37 Mr. Zubrow," Thank you very much, Mr. Chairman. With respect to your first question about the guarantee of senior bank debt and whether or not JPMorgan Chase is going to opt out of that program, we are still evaluating that and have not yet made a determination on that. Obviously, once we do, we are happy to come back to you and let you and your staff know how we have decided to handle that. With respect to the commercial paper funding facilities, we certainly think that those have been very helpful in the marketplace, and certainly we have been an active issuer of commercial paper, and many of our clients have been active issuers of commercial paper. And it is absolutely clear that those facilities have been very helpful in bringing back investors into that marketplace, and I think that has been a very helpful step forward. Then with respect to your third question with respect to the Federal guarantee program, you know, there again, you know, we think that that has been a helpful addition to liquidity in the marketplace, and we think that it is going to make a big difference for bringing investors back into the market. " CHRG-111shrg51395--130 PREPARED STATEMENT OF THOMAS DOE Chief Executive Officer, Municipal Market Advisors March 10, 2009Introduction Chairman Dodd, Senator Shelby and Committee Members: It is a distinct pleasure that I come before you today to share my perspective on the U.S. municipal bond industry. I am Thomas Doe, founder and CEO of Municipal Market Advisors, that for the past 15 years has been the leading independent research and data provider to the industry. In addition from 2003 to 2005, I served as a public member of the Municipal Securities Rulemaking Board (MSRB), the selfregulatory organization (SRO) of the industry established by Congress in 1975.The Market There are nearly 65,000 issuers in the municipal market that are predominantly states and local governments. Recent figures identify an estimated $2.7 trillion in outstanding municipal debt. This is debt that aids our communities in meeting budgets and financing society's essential needs, whether it is building a hospital, constructing a school, ensuring clean drinking water, or sustaining the safety of America's infrastructure. A distinctive characteristic of the municipal market is that many of those who borrow funds, rural counties and small towns, are only infrequently engaged in the capital markets. As a result, there are many issuers of debt who are inexperienced when entering a transaction, and unable to monitor deals that may involve the movement of interest rates or the value of derivative products.The Growth According to the The Bond Buyer, the industry's trade newspaper, annual municipal bond issuance was $29B in 1975 whereas in 2007 issuance peaked at $430B. In the past 10 years derivatives have proliferated as a standard liability management tool for many local governments. However, because derivatives are not regulated it is exceptionally difficult, if not impossible, to identify the degree of systemic, as well as specific, risk to small towns and counties that have engaged in complex swaps and derivative transactions.Systemic Risk Emerges Municipal issuers themselves sought to reduce their borrowing costs by selling bonds with a floating rate of interest, such as auction-rate securities. Because state and local governments do not themselves have revenues that vary greatly with interest rates, these issuers employed interest rate swaps to hedge their risk. Issuers used the instruments to transform their floating risk for a fixed-rate obligation. A key factor in the growth of the leverage and derivative structures was the prolific use of bond insurance.The Penal Rating Scale Municipal issuers are rated along a conservative ratings scale, resulting in much lower ratings for school districts and states than for private sector financial or insurance companies. Although most state and local governments represent very little default risk to the investor, the penal ratings scale encouraged the use of insurance for both cash and derivatives to distribute products to investors and facilitate issuer borrowing. So instead of requiring more accurate ratings, the municipal industry chose to use bond insurance to enhance an issuer's lower credit rating to that of the higher insurance company's rating. The last 18 months have exposed the risks of this choice when insurance company downgrades, and auction-rate security failures, forced numerous leveraged investors to unwind massive amounts of debt into an illiquid secondary market. The consequence was that issuers of new debt were forced to pay extremely high interest rates and investors were confused by volatile evaluations of their investments.Steps To Improve the Regulatory Context The 34-year era of the municipal industry's self regulation must come to an end. Today, the market would be in a much better place if: First, the regulator were independent of the financial institutions that create the products and facilitate issuers' borrowing. Second, the regulator were integrated into the national regime of regulation. Third, the regulator's reach and authority were extended to all financial tools and participants of the municipal transaction: ratings agencies, insurers, evaluators, and investment and legal advisors for both the cash and swaps transactions. Fourth, the regulator were charged with more aggressively monitoring market data with consumers' interests in mind, both investors and issuers. The good news is that this new era of regulatory oversight can be funded by the MSRB's annual revenue $20-plus million, collected from bond transactions, and can be staffed by the current MSRB policy and administrative infrastructure.Caution I should be clear. The innovations of derivatives and swaps have a useful application and have been beneficial for those for which they are appropriate. However, it is also important that these instruments become transparent and regulated with the same care as the corresponding cash market.Get This Done It is critical to get this right. There is too much at stake. Thank you for asking me to testify today, and I welcome your questions during this session.Municipal Market Advisors Founded in 1995, MMA is the leading independent strategy, research and advisory firm in the municipal bond industry. MMA's intelligent approach to timely issues and analysis of market events has proven invaluable to a wide range of clients. As conditions have become more complex and difficult, MMA's recognized ability to concisely comment on the key issues of the market is of critical importance and value. The firm's independent research, data, market coverage and insight educate and inform without bias or product agenda. Our Clients: Investors, Dealers, Financial Advisors, Issuers and Individuals: MMA's business has been predominantly portfolio managers and dealer firms (with a focus on sales, trading and underwriting). However, in 2007, demand for our services expanded to include issuers, financial advisors, individuals and public finance professionals who have recognized the increased value of accurate and insightful coverage of current historical market conditions. MMA does not advocate on behalf of its clients, we educate on behalf of the market. Washington, DC--Educating and Working With Decision-Makers: MMA's Washington DC office has enabled our firm to provide more direct information to policy makers, regulators, trade associations and the Federal Reserve. MMA's role is that of an educator to provide immediate uncompromised assistance to entities that are actively engaged in working on issues pertaining to the municipal industry. Informing the Media: In 2008, more than 200 publications and media outlets have sought MMA's expertise for definitive comment on the issues confronting the industry. At no other time has accurate market coverage been more valued, and trusted resources considered indispensable. Unbiased information is important for correct representation of market conditions, policy decisions and management of portfolios. Thomas G. Doe, Founder and CEO: Mr. Doe has been an analyst in the municipal industry for 25 years with a consistent focus on pricing data and information flows, investor and issuer behavior, and contextual investing. He has addressed all of the leading groups in the municipal industry, as Mr. Doe's insight, candor and historical context is sought to establish a clear perspective of current conditions affecting investors and issuers in the municipal cash and derivative markets. He has been a featured speaker at numerous industry conferences and has been frequently quoted in industry and national media. Mr. Doe's leadership was recognized when he was named to a 3-year term with the Municipal Securities Rulemaking Board, (MSRB) the regulatory entity of the municipal securities industry in 2002. Mr. Doe received an undergraduate degree from Colgate University in 1980 and a Masters degree from Harvard University in 1984.Background on How the Credit Crisis Has Affected the Municipal Market The municipal market has suffered repeated shocks from the credit crisis since August 2007. In a very primary sense, our sector was, and in many ways continues to be, exposed to the same systemic risks that collapsed the housing and securitization markets and undermined our nation's banks. The deep interconnectedness of the municipal market with the global financial and interest rate markets was unforeseen by most municipal regulators, issuers, investors, advisors, lawyers, and dealer banks; their surprise at, and misunderstanding of, the systemic risks at work has consistently exacerbated problems over the last two years. Further, there is little provision being made at present to create a more resilient and stable market in the future. The initiation of the credit crisis in municipals, as it was elsewhere, began in 2001 and 2002, with the integration of leverage into municipal bond buying strategies. Leveraged investment vehicles, called Tender Option Bond (TOB) programs, borrowed low interest (floating-rate) cash from the tax-exempt money market funds to invest in higher yielding (fixed-rate) municipals. Not only does this strategy capture the simple difference between the high long and low short interest rates (the carry), but also TOB sponsors--which included hedge funds, dealer banks, mutual funds, liquidity providers, and many others--are placing bets on the tax-exempt market's outperformance of carefully selected taxable bonds or swaps via interest rate hedging. However, one of the key conditions for the safe operation of a TOB was not implicit in the municipal market: liquidity. Because TOBs are subject to mark-to-market accounting, margin calls, and periodic adjustments of their leverage, they benefit from a well-traded and accurately priced bond market. A TOB invested in securities with unpredictable or volatile prices will itself provide unpredictable and volatile returns. The municipal bond market, as we have detailed elsewhere in this report, comprises 65,000 potential bond issuers and 1.5 million individual securities, most of which are rated along an overly cautious rating scale that intentionally exaggerates the risks and differences between individual issuers and bonds. Further, municipal issuers have long sold bonds in serial maturities, with a variety of interest rate coupons, call structures, security pledges, etc. And finally, the bulk of municipal investors are households, who either directly or indirectly though a manager, prefer to buy and hold small pieces of multiple bond offerings: these are not active securities trading operations. This context was not conducive for TOBs, but, because their use of leverage they were permitted to purchase municipal bonds at substantially higher prices than other investors were willing to pay, so the primary market rapidly adjusted to their needs. This entailed the pervasive use of AAA-rated bond insurance and bank guaranties (creating the appearance of safe homogeneity) and the facilitation of very large, governmental-oriented bond sales carrying a standardized 5 percent coupon. For the period between 2002 and 2007, these adjustments permitted the near doubling of annual bond issuance (from about $200Bn to about $400Bn), and the amount of par volume municipal bonds outstanding swelled 77 percent from $1.5T in 2001 to $2.7T today. What's more, the rapid growth of TOB (and related strategy) investment--along with a large increase in demand from property casualty insurance companies riding post-9/11 waves of premiums and profitability--allowed municipals to be priced more and more aggressively, fulfilling the TOB investor's aim of outperformance of the taxable bond market and encouraging ever larger allocations to this strategy. At the same time, the interest rates that tax-exempt money market funds were receiving from the TOBs were better than an investor could receive in a regular savings account, and aggressive TOB creation meant a surfeit of product in which the money funds could invest. This attracted more money fund deposits which, along with monetary policy, kept short-term interest rates low. Municipal issuers themselves sought to reduce their borrowing costs by selling long maturity, AAA-insured bonds with a floating rate of interest, including variable-rate demand obligations (VRDOs), which can be purchased by the money market funds, and auction-rate securities, which were largely bought by individuals and corporate cash managers. However, because state and local governments do not themselves receive much revenue that floats with short-term interest rates, these issuers also employed interest rate swaps with these floating-rate bonds in an attempt to exchange their floating-rate liability for a fixed one (but with the addition of increased counterparty exposure to both a bank and the a bond insurer). By these means, issuer interest rate swaps and derivatives became a fundamental, but unregulated part of the municipal industry's standard machinery, and systemic exposure to the financial sector, the bond insurers, and, more importantly, the rating agencies' opinions of the financial sector, and the bond insurers grew rapidly. In addition, our market had become substantially vulnerable to fluctuations in the value of taxable securities: remember that much if not all of the massive investment by TOBs (estimated to have peaked near $500Bn although little was done by the municipal regulators to even tabulate this exposure) was hedged against the performance of Treasuries, LIBOR swaps, or other slightly more muni-centric derivatives. The problems with this arrangement were exposed in August 2007 with the first surge of flight-to-safety buying of Treasury securities on news of worsening damage to the housing sector. Stronger Treasury (and LIBOR) prices created losses in TOB hedges, forcing margin calls that rapidly consumed available cash. In addition, sharp increases in the overnight lending rates pushed floating-rate product credit spreads wider: the source of TOB leverage, loans from the money funds, grew much more expensive, to the point where the money funds were demanding almost as much (or more) interest than the TOBs were receiving from their long-term, fixed-rate municipal position. Some TOBs thus began to liquidate their positions, forcing sales of their fixed-rate bonds into a municipal secondary market that quickly became oversupplied and illiquid. Keep in mind that, up until that point, the TOBs had been purchasing bonds at (and driving market clearing prices and statement evaluations to) higher levels than traditional institutional investors were reasonably willing to pay. Thus, when the TOBs needed to quickly sell their bonds to these same traditional buyers, large price concessions were required. Dealer banks helped soften the effects by acquiring bonds into their own trading inventories, but ultimately market pressures forced municipal bond yields sharply higher (while Treasury yields were moving sharply lower). Higher yields attracted enough demand to stabilize the market by the end of the month, but, through the end of the year, nervous investors repeated this pattern of fast selling/recovery, heightening volatility in prices, and encouraging a steady reduction in TOB investment. For substantially more detail on the daily and weekly evolution of our the market, please see the complete catalog of published MMA research, available to subscribers on our Web site and to Congressional staffs on request. Importantly, market participants had by this time also become increasingly concerned about the future of the bond insurers, who had guaranteed subprime residential mortgage securitizations. Research firms such as MMA and private investors amplified former warnings about these companies. In particular, more cautious corporate cash managers began selling auction-rate securities that had been marketed to them, in part, based on the apparent safety of AAA-rated bond insurance. Once again, dealer banks managing auction-rate programs provided liquidity in the absence of incremental investor demand, but in December 2007, the rating agencies sounded formal warnings about the bond insurers. This precipitated vast selling pressure among auction-rate investors that, in January, overwhelmed dealers' risk tolerances for buying back additional auction paper, and auctions began to fail (please see Auction Rate Securities, below). Auction-rate securities paying high penalty rates attracted investors away from other fixed- and floating-rate products, forcing both fixed and floating rates up sharply. At the end of February 2008, TOB programs were once again forced to sell bonds to pay margin calls, to unwind their leverage that had grown too expensive, and to afford investor redemptions. Extreme selling and uncertainty led to widely divergent pricing decisions across the industry; liquidity was almost completely interrupted, and state and local issuers were temporarily shut out of the capital markets. Once again, high yields galvanized demand in March, and from that point until December 2008, the municipal market continued to face boom and bust pricing cycles of sometimes extraordinary depth. In general, these entailed yield-fueled, or media-driven demand bubbles that were ultimately pricked by yet another bond insurer downgrade that renewed fears and sometimes forced selling by leveraged bondholders. The worst of these cycles began in September, when the collapse of Lehman Brothers, plus concerns over other broker-dealer counterparties were realized in investor redemptions from municipal money markets, which put large numbers of variable rate obligations back to dealers. The flow of bonds initially overwhelmed dealer balance sheets, forcing the unwind of some proprietary positions, but was ultimately managed through dramatically higher floating rates (the municipal industry's 7-day floating rate reset from about 2 percent to 8 percent and credit spreads to that rate widened sharply, in particular for TOBs because of their reliance on multiple layers of bank support) and the temporary withdrawal of a large number of floaters from active markets onto liquidity provider balance sheets. Still, higher floating rates forced many tender option bond programs to unwind their trades for perhaps the final time, as investors now began demanding their money back in earnest. The excess supply created by forced TOB selling in September to November, along with downgrades to the bond insurers, pushed municipal yields sharply higher, prices lower. Institutional buyers retreated from the public markets until the end of the year (although many large buyers were able to buy portfolios of highly discounted bonds in the evenings and weekends, muffling the implications of these very cheap trades on broader market pricing), causing credit spreads to widen dramatically. Spread widening and price declines hurt tax-exempt mutual fund net asset values, giving the appearance of undue credit risk to their investors and initiating perhaps the largest sequence of mutual fund investor outflows (and thus forced selling of related holdings by the funds) on record. And, as was well covered by the media, with fixed-rate yields having risen to extraordinary heights, many state and local issuers chose to table the majority of their planned primary market loans, waiting for conditions to improve. Indeed, smaller, lower-rated, and riskier credit issuers may have at least temporarily been unable to access capital at all, but large states and cities were always able to raise money; their decisions were based on price. MMA estimates that, in 2008, more than $100Bn of planned new-money infrastructure projects were delayed, the majority of that occurring in the fourth quarter. Persistent institutional demand has not yet returned to the municipal market, but since the start of 2009, municipal fund managers and brokerages have been highly successful attracting retail investment on the back of both flight-to-safety allocations (out of equities) and, more importantly, on speculation that the stimulus will ultimately drive up municipal bond prices. In fact, yields on the kind of bonds favored by retail investors touched two-decade lows in mid-January, although they have since begun to retreat again. Lower-rated, risky credit issuers (like hospitals) still face difficulty finding cost-effective market access and even highly rated state and local governments are commonly required to downsize new bond issues or risk pushing market yields higher.Summary of Regulation IssuesIntroduction The Municipal Securities Rule-making Board (MSRB) is a self-regulatory organization (SRO) and was formulated by Congressional statute in 1975. Please see the attached National Federation of Municipal Analysts White Paper``Federal Securities Law Relating to Municipal Securities,'' for background and more detail. During Thomas Doe's tenure as a Board member from 2003 to 2005, there was rarely a Board meeting where the subject of derivatives was not discussed and the risks to the industry and investors were not addressed. However, the outdated statute limited the Board's regulatory purview to municipal cash securities and to activities of dealers and dealer banks. Proactive action was inhibited for three reasons: (1) it was exceptionally difficult, however well intended, for Board members representing security firms to advocate for change that would reduce the revenue of its firm; (2) the volunteer nature of the Board resulted in a consistent deferral of strategy, tactics and policy to staff; (3) the Chairman of the Board served only one year and dictated the Board's focus, which, in our opinion, was to sustain the status quo and could again be heavily influence by staff. Since staff, especially the Executive Director, worked for the Board, it appeared to be exceptionally difficult for innovation and proactive regulation to occur. To be fair, there is now new leadership of the MSRB's staff. However, the negative characteristics of a: (1) short-tenured Chairman; (2) volunteer Board; and (3) the tremendous challenge to advocate for the investor or issuer interest, which could hurt an employer's revenue stream, are still present. These conditions can be inhibitive toward regulation in the best interest of the consumer--both issuers and investors.Opportunity In 2009, led by the catalysts of curtailed institutional demand, limited issuer access to the capital markets and the allegations revolving around municipal finance practices in New Mexico, the MSRB has suggested a review of the Congressional regulatory statute created 34 years ago. Specifically the Board has suggested an expansion of entities to be regulated swap advisors. The willingness of the Board to advocate change is applauded however, the action falls short.Necessary Change More entities should not alone be regulated, but rather legislative language should be expanded to be inclusive of all practices and products in which financial institutions would be involved related to municipal finance. By regulating the products, all entities involved with municipal finance--from creation to distribution--would be governed by transparency and regulations, which would advance and define a context for transactions in the municipal industry for the protection of issuer, dealer and investor. Only in this manner can responsibility and integrity be promoted and transparency ensured. The byproduct of such attention to derivatives would accomplish the disclosure required by issuers to both inform investors and those who choose to provide capital to public entities.Action Items 1. End the MSRB as an SRO. 2. Integrate the MSRB formally and directly into a larger entity, possibly the Securities Exchange Commission, Treasury or Federal Reserve. 3. Congress expand the regulatory purview of municipal regulation to include all participants in municipal finance and all financial tools involved in a municipal finance transaction--this would include derivatives and swaps in addition to the cash market. Along with dealers: advisors, ratings agencies, and evaluation services would be included in the new regulatory scheme. 4. Ensure that the regulatory statue was adaptable and flexible to allow regulation to be proactive and timely. 5. Include the municipal industry within an organization, where its regulatory framework, data and action can be more easily coordinated with larger markets. (Too often critical regulation may not have been enacted or suggested as the industry is small relative to equities and taxable fixed-income. One might argue that the vulnerability of the eclectic resources of the 65,000 municipal issuers/borrowers of the industry demands more vigilant protection because of the critical importance of the financings to essential services and projects for town, counties and states in the US.) 6. Mandate better regulatory coordination with its consumers-- specifically issuers and investors--not simply the dealer community. 7. Demand greater financial forensics to mine the vast municipal transaction data created by the Real-Time Transaction Reporting System in order to better indentify market behavior that can adversely impact (i.e., volatility) issuer pricing and investor evaluations. In addition, better data analysis can better define conditions of market liquidity to assist market participants in risk management strategies and investors to better use performance data measurements, specifically indices of price performance and returns. This report highlights significant areas where more robust data collection would have helped manage and avert systemic risks exposed in the credit crisis.Conclusion The municipal industry has evolved outside of a confined regulatory context that is outdated and biased, and been consistently challenged by the temptation to regulate in its self-interest. The evolution resulted in detrimental practices and products that have proved penal to investors, issuers and the financial institutions. The opportunity to broaden the current regulatory framework has presented itself and in acting to take steps to protect the public entities, which require access to capital for infrastructure, the new broad regulation of the municipal industry with specific attention to both derivatives and cash financial products will provide precedence for global regulatory reform of all derivatives. The best news is that the MSRB's current major funding mechanism, fees from municipal transactions (more than $20 million in 2008), provides a revenue stream to fund expansion and transition of the regulatory purview. In addition, the existing organizational infrastructure of the MSRB allows for experienced personnel, technology and data to be powerfully integrated in a revitalized context. The municipal regulatory entity must be independent of those it regulates and integrated within a regular Federal entity where the industry can be included and coordinated with regulation of the larger markets.Disclosure and Investor Protection For a background on municipal disclosure, MMA here quotes from the National Federation of Municipal Analysts March 2008 ``White Paper on Federal Securities Law Relating to Municipal Securities.'' The full paper is attached at the end of this report. The SEC promulgated Rule 15c2-12 (the ``Rule'' or ``Rule 15c2- 12'') in 1989 and amended the Rule in 1994 to include continuing disclosure requirements. . . . Direct regulation of issuers would have required repeal of the Tower Amendments, so the Rule instead applies to municipal broker-dealers and generally applies to financings where the principal amount offered is $1 million or greater. The Rule applies indirectly to issuers, effectively denying their access to the market unless the Rule's requirements are satisfied. The Rule contains primary disclosure requirements and continuing disclosure requirements. With respect to continuing disclosure, the Rule prohibits the purchase and sale of municipal securities by an underwriter in a public offering unless the issuer or an ``obligated person'' undertakes to provide continuing disclosure. Continuing disclosure obligations include both periodic reporting of financial and operating information and disclosure of the occurrence of any of a specified list of 11 events, if material. The annual information is required to include audited financial statements when available and material financial information and operating data of the type included in the official statement for the securities. . . . Independent of contractual undertakings made by issuers and conduit borrowers and continuing disclosure obligations under Rule 15c2-12, the SEC maintains that issuers of municipal securities and conduit borrowers have continuing disclosure responsibilities under Section 10(b) of the Exchange Act and Rule 10b-5. While issuers and conduit borrowers have no affirmative duty to disclose information (unless they are engaged in the offering, purchase or sale of securities or unless disclosure is required under a continuing disclosure undertaking), if an issuer or conduit borrower chooses to disclose information to the market it is prohibited from disclosing information that is materially untrue or misleading, or that contains a material omission, ``in light of the circumstances'' in which such information is disclosed. There are no other limits on the issuer's or the conduit borrower's disclosure. We also reference DPC Data's report, ``The Consequences of Poor Disclosure Enforcement in the Municipal Securities Market'' that provides more information on how disclosure is disseminated. Currently disclosure occurs through a regime of several repositories (Nationally Recognized Municipal Securities Information Repositories, or NRMSIRs), but, with recent change in law, a single repository will exist: the Municipal Securities Rulemaking Board. In MMA's opinion, the state of disclosure in the municipal sector should be regarded as poor, and recent changes in the law are unlikely to make much difference here. Issuers, as detailed by DPC data's important (and accurate) study on the topic, regularly fall out of compliance with stated disclosure requirements, undermining liquidity in selected bonds and hurting smaller investors (those without credit analysts trained to track down, or mitigate the impact of, absent financial and operating data) who buy bonds, in part, based on statements in the prospectus that regular information will be disclosed. In MMA's opinion, disclosure gaps occur because: (1) many issuer representatives are not capital markets professionals and lose track of their responsibilities, and (2) there is little penalty to be suffered by the industry for not policing compliance. A specific failing of SEC Rule 15c2-12 is its leaving the decision on whether an issuer is in disclosure compliance to the individual participants trading the issuer's securities. In our experience, firms have generally ignored this requirement and continued to trade likely safe, but disclosure-gapped bonds, albeit at a slight discount. Further, we note a pattern of smaller issuers falling out of compliance almost immediately after a new offering, remaining out of compliance for several years until, just prior to another new primary market loan, the issuer will send its past due financial information to the information repositories. Again, MMA believes a solution to municipal disclosure problems is available: 1. We believe Congress should require that the SEC act as arbiter to determine whether each issuer is in compliance with their stated disclosure requirements. This would be a very large undertaking, potentially requiring a large staff increase by the SEC. Should the SEC subsume the MSRB, the MSRB's funds could offset at least a portion of the cost. 2. Bonds found to be not in compliance would be flagged, and registered firms would be prohibited in trading in such until either the issue's original underwriter or any other investor can succeed in getting the issuer to remedy the gap. We are reluctant to advise that the SEC be able to compel disclosure directly from the issuers for fear of abridging state autonomy. 3. The SEC would keep a database to track, for every Cusip and borrower, the number and percent of days it has been out of compliance on all of its outstanding bond issues. This statistic would be vitally important for potential buyers evaluating new purchases of the borrower's securities. 4. Additionally, all firms trading municipal bonds, regardless of their status, would need to track how many trades, and the volume of par traded, that firm had made with disclosure- flagged municipals Cusips. Again, this could be very important data for investors evaluating with which firm to invest their money. 5. MMA also believes that all tax-relevant calculations and investigations should be included in required disclosure topics. These include how tax-exempt bond proceeds are being spent, on a weekly basis, the precise formula by which bond counsel determines that a bond issue is tax exempt, and the presence and status of any SEC investigations.The Undisclosed Risk of Bank Bonds and Swaps MMA's principal concern for the municipal sector in 2009 is that variable-rate related problems will set off a wave of downgrades and even defaults among risky sector credits (such as hospitals and private universities), creating incremental economic loss and threatening more investor aversion to municipal bonds generally. But the risks in variable-rate demand obligations are not exclusive to hospitals; many state and local governments also issued these securities and face very similar credit challenges. VRDOs are long maturity bonds where the interest rate is periodically (weekly, daily, etc.) reset by a remarketing agent--usually a dealer bank--who also attempts to make proprietary markets in these securities among a universe of the firm's clients with a strong focus on tax-exempt money market funds. VRDOs also entail some form of liquidity support (structured via a letter of credit or standby purchase agreement) from a highly rated bank. In other words, a bank is contractually obligated to become the immediate buyer of last resort for a VRDO, giving money market funds confidence in the liquidity of a VRDO investment. MMA estimates that there are about $500Bn of outstanding VRDOs at present; this number has likely increased from $400Bn since the start of 2008 reflecting numerous post-collapse ARS restructurings into VRDOs. Yet today's financial markets entail substantially more investor caution among banks and between credits generally, and large numbers of VRDOs have been rejected by the money funds because of their reliance on a damaged or downgraded liquidity provider (most notably DEPFA and Dexia) or connection to a downgraded bond insurer. In the absence of other investors or remarketing agents' inability to bring yet more bonds onto their own balance sheets, many of these rejected bonds have triggered their liquidity features, requiring the liquidity providers to buy these securities directly. Provider-purchased VRDOs are referred to as ``bank bonds,'' which the liquidity providers hold as available for sale for a period of time (for example, 90 days), but then convert to accelerated maturity term loans between the liquidity provider and the issuer. It is unclear whether any municipal bank bonds have actually yet converted to term loans, but their acceleration of principal and penalty interest rate would reasonably require either an immediate restructuring or a default forbearance agreement between provider and issuer. Because there is little hope for market interest in Dexia or DEPFA to improve, at some point, issuer defaults may become public. MMA estimates, based on our polling of industry sources, that there have been as many as $50Bn of rejected floaters, with perhaps $50Bn more being kept away from liquidity providers through special--and thus potentially temporary--intervention by securities dealers. MMA believes that the amount of bank bonds has fallen in 2009, as issuers are actively restructuring their bank bond obligations, although we underscore that we are unaware of any information being collected by any regulator or data provider on this topic. Interestingly, the rejection of many VRDOs by the money funds has worsened problems elsewhere in the municipal floating-rate markets. First, it has required liquidity providers to become more cautious in writing new policies, increasing the scarcity and cost of same for municipal issuers. Second, by removing large swathes of floaters from money fund ``approved'' lists, and noting: (1) the near complete absence of TOB-related lending by the money funds (see ``Background'' section above), and (2) large, fear driven investor inflows into the money funds, has created a severe supply/demand imbalance. Approved and available securities are scarce and--because the funds' alternative is not investing their funds at all--are being bid up to extremely low yields (weekly interest rates have been close to, or well below 1 percent since November). Low benchmark floating rates, along with very strong demand for long-maturity LIBOR swap rates, an unwinding of arbitrageurs' interest rate hedges, and a dearth of new municipal issuer derivative activity, has pushed the related long-maturity municipal swap rates to very low levels. And this movement in swap rates has greatly increased issuers' cost of terminating any outstanding swap, complicating the restructuring of any distressed VRDO position. Further, higher issuer swap termination costs have produced substantial cash drains away from issuers via requirements that the issuers collateralize their potential termination liability to their counterparty. (Many issuers had purchased bond insurance AAAs to ward off credit- or rate-driven collateralization requirements. But with the insurers' losing their ratings, many issuers are no longer shielded, sometimes removing cash to the detriment of normal operations.) As not-for-profit hospitals have been particularly large users of this debt structure, and as these same hospitals also face lower private pay revenues and strained governmental reimbursements, defaults are likely in the near term. Because swap positions are only dimly disclosed, even sophisticated municipal investors remain largely without information on their own portfolios' related risks. Once again, these municipal issuer exposures to systemic risks were accreted with little public disclosure or regulatory insight. Further, MMA is unaware of any municipal regulator or information provider systematically collecting information on the size and scope of this problem. This not only inhibits better projection of potential losses, but also prevents a more robust response from national regulators (e.g., Treasury, the Federal Reserve, the SEC) who are struggling to grasp the depth of the problem and coordinate their response with those in other asset classes. Solutions are well within Federal abilities. MMA recommends that Treasury extend subsidized loans to municipal issuers to terminate difficult swap positions, with the cost of those loans recouped by Treasury via a surcharge on all future issuer swap activity. This would allow issuers to restructure their obligations into fixed rate bonds, relieving liquidity provider balance sheets of troubled exposures, and potentially encouraging future policy writing.Auction-Rate Securities and Unchecked Systemic Risks Auction-Rate Securities (ARS) are long maturity bonds where the interest rate is periodically reset by auction among potential investors, or failing that, set manually by a bank pursuant to an index or (typically very high) fixed rate. Because they are valued at par, ARS were typically purchased by individual investors as a higher-yielding alternative to cash deposits. However, higher yields reflected the fact that an ARS holder cannot sell their bond without an identified buyer: a sharp distinction from other ``cash like'' instruments that required dealer banks to periodically step in as a buyer to prevent auctions from failing. In part because of this reliance on bank intervention, ARS programs were (and still are) set up as proprietary trading exchanges by individual dealers, inhibiting the easy flow of capital and information from program to program. The implications of the ARS structure, in the context of the municipal industry's systemic exposure to the bond insurers and the financial counterparties were little understood by issuers, investors, or the dealer banks themselves prior to 2007. It was the collapse of the bond insurers in 2007 that undermined investor confidence in ARS issuers and precipitated vast selling. (Remember that individual investors had long been sold on the AAA virtues of bond insurance; this myth was not so easy to dispel when bond insurer downgrades began). Banks were initially able to use their own cash to buy back securities, but in January 2008, bank risk tolerances prevented further purchases, and ARS auctions began to fail. Thus, current holders were left without a means to get out of their positions, and issuers were forced to pay sometimes highly punitive fixed interest rates. Since that time, MMA estimates that about two thirds of ARS issuers have restructured or refinanced their securities, although many remain unable to do so as: (1) refinances with liquidity-supported floating-rate debt require the purchase of a liquidity policy from a highly rated bank--these policies have become both scarce and expensive as U.S. banks have reduced lending; and (2) refinances with fixed-rate debt are prevented not only by the high fixed rates many lower-rated issuers must now pay, but also the sometimes staggering cost of terminating the interest rate swap most municipal issuers have connected to their bond sales (please see bank bonds section, above). Thus, many investors still remain stuck with highly illiquid securities that are paying well-below-market, index-linked interest rates. At issue is an unwillingness to allow ARS to trade at a discount to entice potential buyers, because of the increase in potential liability and because sub-par pricing of these holdings could result in additional waves of mark-to-market losses for the already stressed banks. Although private trading venues have emerged to provide emergency assistance to distressed clients needing to liquidate their holdings at any price, we are unaware of any broker dealer making sub-par markets in any ARS. On the other hand, several of the large banks have, on the intervention of state securities regulators, settled with their individual and small institutional investors, in effect buying ARS securities back at par. Indeed, the largest current holders of ARS are likely the dealer firms themselves that are still carrying their swollen inventories from 2008 and now the bonds purchased via settlement. ARS shows another breakdown in the municipal regulatory framework. While there are initiatives to improve ARS price discovery, no market participant (including investors, dealer banks, nor the regulators themselves) knows precisely how many ARS are outstanding (MMA's estimate was about $200Bn municipal ARS at the market's peak), how many bonds were being placed through each dealer program, how many ARS issuers were reliant on bond insurance for their marketing to investors, the extent and means by which these issuers were leveraging counterparty credit through interest rate derivatives, and how much dealer support was being directly extended to the market. The implications for systemic risk management, as now being discovered in the credit crisis, are clear in these questions, which can (and should) be extended to the still healthy, but periodically threatened, municipal VRDO market.Municipal Bond Ratings and Bond Insurance Most municipal bonds are rated on a different, more conservative rating scale than corporate bonds. Moody's and Standard & Poor's have shown that triple-A U.S. corporate bonds have up to 10 times the historical default rate of single-A municipals. In MMA's opinion, neither municipal issuers, nor the individual investors who own the large majority of outstanding paper or fund shares, understands this point. But instead of requiring more accurate ratings, the municipal industry (i.e., issuers, investors, and underwriters) has instead chosen to make bonds appear safer and more similar through bond insurance (the insurers are rated along the more generous corporate rating scale; much of the bond insurance model distills to simple arbitrage between the two rating scales). At its peak, the municipal bond insurance industry entailed just nine companies whose ratings were applied to more than 50 percent of annual municipal bond sales. And this invited massive systemic exposure into the municipal industry as the bond insurers carried in the risk of subprime mortgage-backed securities, the insurers' and the financial sectors' leverage of ratings on securitized debt, and failed rating agency models. Attached, please find our January 2008 report, ``MMA on Corporate Equivalent Ratings,'' and our April 2008 report, ``Second Research Note on Moody's,'' for more detail on the problem with how municipal bonds have been rated. In the last year, both Moody's and Fitch ratings strongly considered reforming their muni rating processes, but both have tabled these initiatives because of the recession. Standard and Poor's continues to deny the existence of separate rating scales for municipals and corporate bonds, but that agency has embarked on a plan of sweeping upgrades to selected municipal sectors. Finally, the U.S. House of Representatives considered the ``Municipal Bond Ratings Fairness Act of 2008,'' which MMA believes would, for little cost to taxpayers, successfully remediate much of the rating problem in our sector. We strongly recommend that Congress adopt this legislation in its current form. MMA has been a leader on the topic of ratings and the municipal sector's use of bond insurance; we welcome any opportunities to continue to educate Congress and its agents on these topics.Pricing and Evaluation Issues The events of the past 18 months have amplified the risks and challenges associated with illiquidity and limited price discovery for municipal bond investors and issuers. The municipal bond industry has been challenged with a troublesome irony. While municipal bonds have favorable low historical default risks, the securities can be illiquid. How can a safe investment not have liquidity? Inconsistency of primary market pricing, the eclectic composition and multitude of issuing entities, the penal and overly granular ratings scale, reduced number of liquidity providers, the diminished number of AAA bond insurers and the inability to manage interest rate and credit risk have contributed to the challenges for the markets transactions to provide evaluation services with sufficient price discovery. The result is that evaluations that represent the price that investors receive on their investment firm statements or the prices that comprise the net asset value of a mutual fund share may bear little resemblance to an execution price should an investor choose to buy or sell. In addition, the periodic illiquid market conditions and limited price can result in sharp volatility that can be misinterpreted as credit or default risk, either of which may not be valid. In this manner the data can misinform an investor and potentially prompt emotional and inappropriate investment decisions. These same characteristics can also increase the difficulty for municipal issuers to assess market conditions and accurately predict market demand to give context for the pricing of their primary market deal. An aggressive, investigative and knowledgeable regulator with access to all transactions and who conducted each transaction, can assist consumers--both the investor and borrower--with providing a context to ensure that the data is relied upon by consumers inspires confidence and provides an objective context in which investors and issuers can make decisions from the prices of their securities.Schedule of Additional Attachments MMA has attached the following documents, under separate Acrobat file, in support of the arguments made herein. NFMA White Paper ``Federal Securities Law Relating to Municipal Securities'' March 2008 DPC Data ``The Consequences of Poor Disclosure Enforcement in The Municipal Securities Market'' January 2009 Municipal Market Advisors ``Corporate Ratings for Munis'' January 2008 Municipal Market Advisors ``Second Research Note on Moody's'' April 2008 FOMC20081216meeting--82 80,MR. KOHN.," Thank you, Mr. Chairman. I want to join the others in thanking the staff for their work. These are very difficult issues, and I think you have brought to bear a lot of what little information we have on these subjects and have kind of kept me out of trouble for the last week. My wife thanks you as well. [Laughter] I think the questions in the first set are largely moot, as a number of people have said. We are already close to the zero bound, and because I think moving there aggressively under the current circumstances is the right thing to do, I don't have any regrets about that. Like President Yellen, I came into this situation, at least a couple of months ago, wondering why zero wasn't the right lower bound. I recognize the market issues that might obtain--sort of as President Bullard said, I wonder whether markets won't adjust as we go on--but so close to zero, the difference between 6� basis points and zero isn't going to matter very much. But I think we ought to keep our eye on how markets are functioning, whether they adjust, and where we should be. Now, once we are at a minimum--and I think we ought to get wherever we are going at this meeting, as soon as possible (a number of people have said that, and I agree)--we can't influence actual expected short-term rates with our actions. We do need to rely on other methods to change relative asset prices--longer-term rates relative to short-term rates, private rates relative to government rates, nominal rates relative to expected inflation--and that is where the communications and the size and the composition of the asset portfolio come in. Both the communications and the portfolio actions can be effective and influential, but I think we need to recognize that we are losing our most powerful policy instrument. The effects of these other aspects of our policies are uncertain, and it will require some trial and error to figure out where we are going. With respect to communications, I do think it would be useful to tell people the conditions under which we expect to keep rates low and the conditions under which we would be prepared to raise interest rates. I think we can tell them if we think it is going to be soon or if it is going to take some time. But I agree with your point at the beginning, Mr. Chairman--and President Plosser and others said this--we should emphasize the conditions rather than the time period. We shouldn't commit to a time path. I think something like this should help long-term nominal rates better reflect our expectations for the path of policy and could be especially important if markets come to anticipate a firming before we actually anticipate firming. It could come into play, particularly in the context of some massive fiscal stimulus, which seems to be coming. I don't think we want the effects of that fiscal stimulus diminished or crowded out by increases in long-term rates that are based on a false assumption about the effect of the fiscal stimulus on monetary policy. I think being clear about where we want inflation to be over the long run will probably help anchor inflation expectations a bit better--keep them from drifting down when inflation itself is very low and keep real interest rates from rising--and thereby reduce the odds of persistent deflation taking hold. We will have an important opportunity to take a step in that direction if we agree to our longer-term forecasts in January. As President Yellen noted, the Subcommittee on Communications is recommending that. I think voting on an inflation target would be a substantially bigger step. That is, we would have to reach agreement on that. It could be a more powerful signal of our intentions, and it might become necessary. I certainly think we ought to discuss it. It has a lot of implications that we need to look at, including where we will be in a couple of years. I think we need to be careful. A number of people--outside commentators, anyhow--have noted that they thought that we kept our eye too much on macro variables in the low inflation period and that gave rise to these asset-price increases. I disagree, but I think it is an open question. I have seen comments from other members of the FOMC wondering whether we should look at more than just the path for consumer prices when we are setting monetary policy. But let's not do something now without thinking about how it is going to play five or ten years down the road. I also agree with your point, Mr. Chairman, about congressional consultation. Having an inflation target won't have any effect if it is repudiated by the Congress. As soon as we make it, it could have a negative effect. I think changes in the size and composition of our portfolio can affect relative asset prices. I guess I think, President Evans, that changes are more likely to be effective at times like these, when markets are illiquid and participants have very, very strong preferences for one sector or another. When private parties seem unwilling to lend to each other, substituting Federal Reserve credit for private credit can be quite effective. Carefully designed programs can reduce the cost of credit and increase the availability of capital to households and businesses. I see where we are as a natural extension of where we have been. Really since August 2007, we have been using our balance sheet to try to stimulate credit markets. At first we sterilized that by selling Treasury securities. Then we sterilized it by the Treasury selling Treasury securities. Then that program ran out, and we thought we could sterilize it by interest on excess reserves, and it didn't work. But I don't think we have crossed a sudden barrier in the last month or two. It is true that the base has begun to rise because we have run out of the other sterilization options. But I do think it is a natural extension of where we have been for a while. That brings me to the monetary base. I find myself more skeptical about the effect of increases in the monetary base per se than what I hear around the room. Such increases I think are supposed to affect asset prices by inducing banks to substitute into higher-yielding assets. Give them a bunch of reserves, and they substitute into higher-yielding assets like loans. But I wonder how effective that is when short-term rates don't decline with the increase in the base because we are pinned at zero--that is, we are in a liquidity trap--and when banks are reluctant to expand portfolios because they are concerned about capital and their leverage ratio. So I don't really understand the channels through which an increase in the monetary base, under these circumstances, is supposed to affect economic activity. We have seen a huge increase in the base over the last couple of months and no effect on the money supply. Now, that is very short term, I agree. Your observation, Mr. Chairman, was that we saw a big increase in the base in Japan. I agree with President Lacker that they weren't as dedicated to that as they might have been, but I just don't see any evidence that the base isn't going to be absorbed in a declining money multiplier rather than an expanding money supply and increased activity. I don't understand the channels. I think the base, as we are setting this out, is determined by the people who use our credit facilities. I think that is very important, and I don't want to upset that. So I would be very, very hesitant to restructure the directive in terms of the quantity of reserves or the monetary base. I would have to understand much better what that means, and I wouldn't want to constrain the use of liquidity facilities with such a restraint. I think the situation in the 1970s and early 1980s was very different. First of all, the October 6, 1979, meeting that went to monetary targeting was a natural evolution of a lot of work that had relied more and more on the money supply as a way of communicating about policy over time. Second, it was about constraining inflation, holding it down. I do agree, Jeff, that ""too much money chasing too few goods"" is something that people kind of understand. I am not sure that they understand the opposite--too little money chasing too many goods, or whatever, as a cause for deflation. I think it would be very, very difficult to communicate what that meant and how that was supposed to work. So it is a very different situation than we had back then. I do think we can help by increasing and directing our asset expansion in particular directions. We have seen evidence, as Bill showed us in the MBS and GSE purchases and the commercial paper facility. Also I favor the consideration of purchases of long-term Treasury bonds. I think that will help to lower longer-term rates in an environment of large liquidity and term premiums. I would consider expanding our purchases of MBS and GSE debt, if it looks as though they might help bring down mortgage rates. I agree with others who have said that they would be very reluctant to specify such operations with a rate target because I don't think we can really control that. So I think that talking about quantities would be much better, as we have done with the MBS. I would also continue to look for other ways to use our discount window to help restart credit markets or substitute for private markets in which the functioning is impaired, and I would be open to a variety of possibilities. I agree that credit allocation is very uncomfortable for the central bank. We are into that. We have been into that for a while. I wish we didn't have to be there. But I don't see any evidence that the private sector is going to start lending anytime soon on its own. If I saw that some of those other markets with which we weren't involved and weren't likely to get involved--like the junk bond market that Bill showed us in that chart--were beginning to open up without our help, that would be fine. But nothing is happening out there in the markets that we are not touching. I don't think that is only because everybody is waiting for us to intervene in those particular markets, because there are a bunch of them that they know we can't or won't intervene in. So we need to remain open to possible further credit market interventions. This raises very difficult governance issues. Our inability to sterilize and the huge increase in our balance sheet raise very difficult questions about how the Board and the Reserve Banks together carry out their shared responsibility for achieving the objectives of the Federal Reserve Act. It is not so much about legalities as it is about how to reach the best decisions and how best to explain those decisions to the world at large. We have always worked in a collaborative and cooperative way, and I think we need to continue to do that. Crisis management strains the normal collaborative and deliberative mode of Federal Reserve operations. Decisions get made on short notice, often over a weekend, but as you said, Mr. Chairman, we can work at improving our collaboration. The FOMC, as a body, will continue to have the major influence on our communications about the outlook, the likely path of rates, and the acceptability of the inflation outcome. The key elements in our communications have always been and will remain under the control of this group, and that is a large part of what we will be doing. I agree that we should, when consistent with fulfilling our obligations to protect financial stability, consult more and earlier on liquidity facilities. I hope that we can emerge from this discussion and subsequent ones with an agreed-upon framework for what we are doing and what motivates it under these unusual circumstances. I think we--the Federal Reserve System, the FOMC, all of us--should consider issuing an explanatory document on these matters that we can all agree to. I wrote this before this meeting. Now that I have heard the meeting, I am not sure it is possible. But I think it might be worth the effort. Thank you, Mr. Chairman. " fcic_final_report_full--162 The other major rating agencies followed a similar approach.  Academics, in- cluding some who worked at regulatory agencies, cautioned investors that assump- tion-heavy CDO credit ratings could be dangerous. “The complexity of structured finance transactions may lead to situations where investors tend to rely more heavily on ratings than for other types of rated securities. On this basis, the transformation of risk involved in structured finance gives rise to a number of questions with important potential implications. One such question is whether tranched instruments might re- sult in unanticipated concentrations of risk in institutions’ portfolios,” a report from the Bank for International Settlements, an international financial organization spon- sored by the world’s regulators and central banks, warned in June .  CDO managers and underwriters relied on the ratings to promote the bonds. For each new CDO, they created marketing material, including a pitch book that in- vestors used to decide whether to subscribe to a new CDO. Each book described the types of assets that would make up the portfolio without providing details.  With- out exception, every pitch book examined by the FCIC staff cited an analysis from ei- ther Moody’s or S&P that contrasted the historical “stability” of these new products’ ratings with the stability of corporate bonds. Statistics that made this case included the fact that between  and ,  of these new products did not experience any rating changes over a twelve-month period while only  of corporate bonds maintained their ratings. Over a longer time period, however, structured finance rat- ings were not so stable. Between  and , only  of triple-A-rated struc- tured finance securities retained their original rating after five years.  Underwriters continued to sell CDOs using these statistics in their pitch books during  and , after mortgage defaults had started to rise but before the rating agencies had downgraded large numbers of mortgage-backed securities. Of course, each pitch book did include the disclaimer that “past performance is not a guarantee of future performance” and encouraged investors to perform their own due diligence. As Kyle Bass of Dallas-based Hayman Capital Advisors testified before the House Financial Services Committee, CDOs that purchased lower-rated tranches of mort- gage-backed securities “are arcane structured finance products that were designed specifically to make dangerous, lowly rated tranches of subprime debt deceptively at- tractive to investors. This was achieved through some alchemy and some negligence in adapting unrealistic correlation assumptions on behalf of the ratings agencies. They convinced investors that  of a collection of toxic subprime tranches were the ratings equivalent of U.S. Government bonds.”  When housing prices started to fall nationwide and defaults increased, it turned out that the mortgage-backed securities were in fact much more highly correlated than the rating agencies had estimated—that is, they stopped performing at roughly the same time. These losses led to massive downgrades in the ratings of the CDOs. In ,  of U.S. CDO securities would be downgraded. In ,  would.  CHRG-111hhrg50289--22 Mr. McGannon," I would certainly agree with Cynthia. As far as Country Club Bank goes, we have always held our SBA loans. I think that we just have never had reliance on the secondary market. If it is out of our control, I think that we feel like we need to try to take care of what we are funding. But Cynthia is right. If the secondary market does open up, it does give every bank an opportunity to re-leverage those dollars into more SBA lending. " FOMC20071211meeting--13 11,MR. DUDLEY.," Yes, I think that is correct. If you look at chart 10, which shows corporate credit spreads, you have a widening of about 50 basis points in investment-grade corporate spreads at a time that long-term—you know, ten-year—Treasury note yields have come down by I think a little larger magnitude. In contrast, in the high-yield debt market, you have a widening of spreads of 200 basis points just in the last month and a half or two months, which is much more dramatic than any decline that we have seen in Treasury rates." CHRG-109hhrg28024--272 Mr. Scott," Thank you. Thank you, Mr. Chairman. Mr. Chairman, I certainly want to welcome you to your new position, and you come with such great credentials from Harvard, MIT, Princeton. It seems like the only one you're missing is the Wharton School of Finance at the University of Pennsylvania. Of course, that's where I graduated from, but I won't hold that against you, because you have the one sterling criterion, which is you're a native of my home state of Georgia, so as a fellow Georgian, I welcome you. Let me start out by first of all reading something you said, which I think is very interesting, concerning your independence. You made a very, very good statement. You said in your hearings, you stated, ``I will be strictly independent of all political influences and will be guided solely by my mandate from Congress and the public interest''--which is very good. I want to give you this opportunity to begin that process. This deals with our tax relief package, the tax cuts, the permanency of tax cuts at a time of great uncertainty and great demands. You're looking at one here who supported the tax cuts, the earlier tax cut relief because I thought they did well in stimulating the economy, and they did so. But permanency at a time when our fiscal health is in dire straits, at a time of great uncertainty--we don't know what energy costs are going to be; we don't understand and fully grasp the meaning of what the war on terror is going to be; we've not been able to adequately even respond to natural disasters like Katrina at a time when global warming says there are going to be more of these. In order to offset these tax cuts, we're going to have to cut dire programs of the American people--Medicare, Medicaid, 45 million Americans have no health insurance at all; on top of that, we are borrowing 45 percent of our debt from foreign countries, over half of it from China, India, and Japan, at extraordinary interest rates in and of themselves, and that debt has gone, just to our foreigners, from 1 to 20 trillion dollars in just the last 2 years. My point is, if you're going to really respond to the mandate of Congress and the public interest, I urge you to speak independently. When the President asks you, ``Is this the time,'' not whether tax cuts are good, not whether making them permanent is good, but given the crisis, the situation that our financial health is in, ``This is not the time to make them permanent, Mr. President.'' Would you do that? " CHRG-111hhrg54867--60 Mr. Gutierrez," The time of the gentleman has expired. I recognize myself for 5 minutes. Secretary Geithner, a year ago, you were--Mr. Paulson and Mr. Bernanke, Lehman Brothers was about to collapse and go into bankruptcy. How much did the 30:1 leverage have to do with Lehman Brothers and its collapse? " CHRG-111hhrg54872--74 Mr. Shelton," No, not at all. The biggest problem right now is first the lack of access of capital in the communities you are talking about. Some of the biggest challenges we have are issues not clearly covered by this bill, are issues very much like payday lending, some of those concerns. Too often in the communities that we serve there are so few legitimate financial lending institutions available that they find themselves being victimized by 456 percent APR when they go to, for instance, a payday lending facility in the local community. So the idea is to make sure: one, there is capital available in those communities; two, it is done in a fair way; and three, there is oversight to make sure the same consumers you are talking about don't get taken advantage of in the process. What we saw happening as we saw the economic downturn is very well, even with the policies and oversight available to us now, there are many consumers who are actually led into products that they could not sustain. And we want to make sure there is oversight and transparency there as well. Brokers sat down with racial and ethnic minorities, sat down with the elderly and very well discussed products that they did not get full disclosure on how those products would actually function. As a result, tragedy occurred. There are many Americans who owned their own homes that went to refinance. For instance, elderly to buy new storm windows to address issues of climate change, or new roofs to address leakage of an aging house found themselves not only going into debt, but also going into debt at a rate they were not aware they would be going into because there was not full disclosure or full oversight. So we very well argue that we need the products, we need the oversight, and we need a clear agency whose primary function is to provide some protection of the consumers as we enter these very challenging products. " CHRG-111shrg52619--182 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM JOHN C. DUGANQ.1. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue? Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.1. As was discussed in Senior Deputy Comptroller Long's March 18th testimony before the Subcommittee on Securities, Insurance, and Investment, looking back on the events of the past two years, there are clearly things we may have done differently or sooner, but I do not believe our supervisory record indicates that there was a ``lack of action'' by the OCC. For example, we began alerting national banks to our concerns about increasingly liberal underwriting practices in certain loan products as early as 2003. Over the next few years, we progressively increased our scrutiny and responses, especially with regard to credit cards, residential mortgages, and commercial real estate loans even though the underlying ``fundamentals'' for these products and market segments were still robust. Throughout this period, our examiners were diligent in identifying risks and directing banks to take corrective action. Nonetheless, we and the industry initially underestimated the magnitude and severity of the disruptions that we have subsequently seen in the market and the rapidity at which these disruptions spilled over into the overall economy. In this regard, we concur with the GAO that regulators and large, complex banking institutions need to develop better stress test mechanisms that evaluate risks across the entire firm and that identify interconnected risks and potential tail events. We also agree that more transparency and capital is needed for certain off-balance sheet conduits and products that can amplify a bank's risk exposure. While changes to our regulatory system are warranted--especially in the area of systemic risk--I do not believe that fundamental changes are required to the structure for conducting banking supervision.Q.2. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms? Is this an issue that can be addressed through regulatory restructure efforts?A.2. A key issue for bankers and supervisors is determining when the accumulation of risks either within an individual firm or across the system has become too high, such that corrective or mitigating actions are needed. Knowing when and how to strike this balance is one of the most difficult jobs that supervisors face. Taking action too quickly can constrain economic growth and impede access to credit by credit-worthy borrowers. Waiting too long can result in an overhang of risk becoming embedded into banks that can lead to failure and, in the marketplace, that can lead to the types of dislocations we have seen over the past year. This need to balance supervisory actions, I believe, is fundamental to bank supervision and is not an issue that can be addressed through regulatory restructure--the same issue will face whatever entity or agency is ultimately charged with supervision. There are, however, actions that I believe we can and should take to help dampen some of the effects of business and economic cycles. First, as previously noted, I believe we need to insist that large institutions establish more rigorous and comprehensive stress tests that can identify risks that may be accumulating across various business and product lines. As we have seen, some senior bank managers thought they had avoided exposure to subprime residential mortgages by deliberately choosing not to originate such loans in the bank, only to find out after the fact that their investment banks affiliates had purchased subprime loans elsewhere. For smaller, community banks, we need to develop better screening mechanisms that we can use to help identify banks that are building up concentrations in a particular product line and where mitigating actions may be necessary. We have been doing just that for our smaller banks that may have significant commercial real estate exposures. We also need to ensure that banks have the ability to strengthen their loan loss reserves at an appropriate time in the credit cycle, as their potential future loans losses are increasing. A more forward-looking ``life of the loan'' or ``expected loss'' concept would allow provisions to incorporate losses expected over a more realistic time horizon, and would not be limited to losses incurred as of the balance sheet date, as under the current regime. Such a revision would help to dampen the decidedly pro-cyclical effect that the current rules are having today. This is an issue that I am actively engaged in through my role as Chairman of the Financial Stability Board's Working Group on Provisioning. Similarly, the Basel Committee on Bank Supervision recently announced an initiative to introduce standards that would promote the build up of capital buffers that can be drawn upon in periods of stress. Such a measure could also potentially serve as a buffer or governor to the build up of risk concentrations. There are additional measures we could consider, such as establishing absolute limits on the concentration a bank could have to a particular industry or market segment, similar to the loan limits we currently have for loans to an individual borrower. The benefits of such actions would need to be carefully weighed against the potential costs this may impose. For example, such a regime could result in a de facto regulatory allocation of credit away from various industries or markets. Such limits could also have a disproportionate affect on smaller, community banks whose portfolios by their very nature, tend to be concentrated in their local communities and, often, particular market segments such as commercial real estate.Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking?A.3. As alluded to in Governor Tarullo and Chairman Bair's testimonies, most of the prominent failures that have occurred and contributed to the current market disruption primarily involved systemically important firms that were not affiliated with an insured bank and were thus not overseen by the Federal Reserve or subject to the provisions of the Bank Holding Company Act. Although portions of these firms may have been subject to some form of oversight, they generally were not subject to the type or scope of consolidated supervision applied to banks and bank holding companies. Nonetheless, large national banking companies clearly have not been immune to the problems we have seen over the past eighteen months and several have needed active supervisory intervention or the assistance of the capital and funding programs instituted by the U.S. Treasury, Federal Reserve, and FDIC. As I noted in my previous answer, prior to the recent market disruptions our examiners had been identifying risks and risk management practices that needed corrective action and were working with bank management teams to ensure that such actions were being implemented. We were also directing our large banks to shore up their capital levels and during the eight month period from October 2007 through early June 2008, the largest national banking companies increased their capital and debt levels through public and private offerings by over $100 billion. I firmly believe that our actions that resulted in banks strengthening their underwriting standards, increasing their capital and reserves, and shoring up their liquidity were instrumental to the resilience that the national banking system as whole has shown during this period of unprecedented disruption in bank funding markets and significant credit losses. Indeed several of the largest national banks have served as a source of strength to the financial system by acquiring significant problem thrift institutions (i.e., Countrywide and Washington Mutual) and broker-dealer operations (i.e., Bear Stearns and Merrill Lynch). In addition, we worked to successfully resolve via acquisition by other national banks, two large national banks--National City and Wachovia--that faced severe funding pressures in the latter part of 2008. While both of these banks had adequate capital levels, they were unable to roll over their short term liabilities in the marketplace at a time when market perception and sentiment for many banking companies were under siege. Due to these funding pressures, both banks had to be taken over by companies with stronger capital and funding bases. As the breadth and depth of credit problems accelerated in late 2008, two other large banking companies, Citigroup and Bank of America, required additional financial assistance through Treasury's Asset Guarantee and Targeted Investment programs to help stabilize their financial condition. As part of the broader Supervisory Capital Assessment Program that the OCC, Federal Reserve, and FDIC recently conducted on the largest recipients of funds under the Treasury's Troubled Assets Relief Program, we are closely monitoring the adequacy of these firms' capital levels to withstand further adverse economic conditions and will be requiring them to submit capital plans to ensure that they have sufficient capital to weather such conditions. In almost all cases, our large national banking organizations are on track to meet any identified capital needs and have been able to raise private capital through the marketplace, a sign that investor confidence may be returning to these institutions. While the vast majority of national banks remain sound, many national banks will continue to face substantial credit losses as credit problems work through the banking system. In addition, until the capital and securitization markets are more fully restored, larger banks will continue to face potential liquidity pressures and funding constraints. As I have stated in previous testimonies, we do expect that the number of problem banks and bank failures will continue to increase for some time given current economic conditions. In problem bank situations, our efforts focus on developing a specific plan that takes into consideration the ability and willingness of management and the board to correct deficiencies in a timely manner and return the bank to a safe and sound condition. In most instances our efforts, coupled with the commitment of bank management, result in a successful rehabilitation of the bank. There will be cases, however, where the situation is of such significance that we will require the sale, merger, or liquidation of the bank, if possible. Where that is not possible, we will appoint the FDIC as receiver.Q.4. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.4. The failure of certain hedge funds, while not by themselves systemically important (in contrast to the failure of Long Term Capital Management in 1998), led to a reduction in market liquidity as leveraged investors accelerated efforts to reduce exposures by selling assets. Given significant uncertainty over asset values, reflecting sharply reduced market liquidity, this unwinding of leveraged positions has put additional strains on the financial system and contributed to lack of investor confidence in the markets.Q.5. Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.5. At the outset, it is important to be clear that bank examiners do not have authority over the nonbank companies in a holding company. These nonbank firms were the source of many of the issues confronting large banking firms. With respect to banks, as noted above, we were identifying issues and taking actions to address problems that we were seeing in loan underwriting standards and other areas. At individual banks, we were directing banks to strengthen risk management and corporate governance practices and, at some institutions, were effecting changes in key managerial positions. Nonetheless, in retrospect, it is clear that we should have been more aggressive in addressing some of the practices and risks that were building up across the banking system during this period. For example, it is clear that we and many bank managers put too much reliance on the various credit enhancements used to support certain collateralized debt obligations and not enough emphasis on the quality of, and correlations across, the underlying assets supporting those obligations. Similarly, we were not sufficiently attuned to the systemic risk implications of the significant migration by large banks to an ``originate-to-distribute model'' for commercial and leveraged loan products. Under this model, banks originated a significant volume of loans with the express purpose of packaging and selling them to institutional investors who generally were willing to accept more liberal underwriting standards than the banks themselves would accept, in return for marginally higher yields. In the fall of 2007, when the risk appetite of investors changed dramatically (and at times for reasons not directly related to the exposures they held), banks were left with significant pipelines of loans that they needed to fund, thus exacerbating their funding and capital pressures. As has been well-documented, similar pressures were leading to relaxation of underwriting standards within the residential mortgage loan markets. While the preponderance of the subprime and ``Alt-A'' loans that have been most problematic were originated outside of the national banking system, the subsequent downward spiral in housing prices that these practices triggered have clearly affected all financial institutions, including national banks. ------ CHRG-111shrg50815--105 Chairman Dodd," I appreciate the point. I mean, an annual fee, that is in terms of the pricing points, that when you pay an annual fee, you know what it is. The question then of when these additional fees kick in, how they kick in, has been the source of the contention. In too many cases, they appear to be for reasons that should be unrelated to the performance of the consumer when it comes to the credit card, and we have talked about them before, the universal default issue, the double-cycle billing. Now, some of these have been changed, I agree with the things, but clearly these fees were not ones that a consumer can price necessarily when they increase them in ways that seem not terribly relevant to the behavior by the consumer. I don't think anybody is suggesting that when a consumer behaves poorly, if you will, in this matter that there are obviously going to be charges associated when that occurs. The question is, it is not so much performing poorly but rather what appears to be, I say to you, that designs to rather get around the fact, because the annual fee wasn't producing the kind of revenues. The competition reduced it, so what other ways can we do this, to find that? And obviously, look, marketing--I know this is probably true no longer, but there was a while not long ago when the parlance of the industry, if you were someone that paid off whatever the obligations were on a monthly basis, you were called a deadbeat, because frankly, you weren't very good financially. Someone who pays that thing off every month, you are not making much money off of them. The ideal consumer is someone who is paying the minimums here each month because that person is going to pay a lot more for that service or product over an extended period of time than the person who pays it off immediately. And it seems to me that by marketing to a lot of people, in a sense, who are in that situation, obviously raises certain concerns. Again, I have got credit cards. I understand the value of them, the importance of them for people, and I want the industry to know this is not a hostile situation we are talking about. We are talking about trying to make it work right for people in a sense at a time of great difficulty, when people are feeling a tremendous pinch. And obviously we have got securitization of this industry, which is another incentive in a way. If you are able to securitize that debt and sell it off someplace, then the incentives for you to want to manage it better are reduced, much as it was in the residential mortgage market. When you can securitize that product and sell it, your interest in having underwriting standards and so forth and to demand greater accountability begin to diminish significantly, and this has been a significant problem. In fact, it is one of the problems the banks have, because they are looking down the road and they are seeing a lot of this debt coming at them, not only in commercial real estate, but also in student loans and in credit card obligations. So obviously one of the reasons they are not lending a lot, I suspect, is because they recognize they have got these obligations coming. Why are they coming? Because they market a lot of products to people who couldn't afford them, in a sense. And had they done a little more work and determined whether or not that person out there was actually going to be able to meet those obligations instead of basically giving them out to anybody and everyone, then we wouldn't be facing this situation, much as we are facing in the residential mortgage market. There are distinctions, obviously, between a mortgage and a credit card obligation, but nonetheless, a little more adherence to those principles would reduce the very problems we are looking at in real estate as well as in commercial transactions such as credit cards. So it is sort of a self-fulfilling prophecy, in a way, we are dealing with in this issue. There is less accountability, marketing to more people who can less likely afford the obligations. Obviously, a lot to be made off of it because obviously someone who has to pay every month something on that over a long period of time increases tremendously the amount they will pay for that. That is why I disagree with you, Mr. Zywicki. I know you don't--I don't disagree with your point, the point I think you were making. I think there is some legitimacy to this. If you load up a load of consumer warnings, there is a point at which no one reads any of it. It is like on prescription drugs or something, or over-the-counter stuff. You begin to read so much that you just--you can't remember any of it. But I do think the idea of saying to people, let me show you that if you purchase a product and make just the minimum monthly payment on this, how much more you are likely to pay for a product, I think that warning to a consumer has value. If you know that, I think you are going to have second thoughts that that item doesn't cost $50, but it is rather going to cost you $150 by the time you are through with it. It has a value. And I don't disagree that if you load it up with a lot of stuff, no one reads any of it, but I think it is an important point. I raised the issue on the securitization and I wonder if you--I will raise the question if any of you want to respond to it. The securitization of credit card loans permitted companies to engage in at least lending practices that are less vigilant. Mr. Clayton, what about that? " CHRG-111hhrg53238--211 Mr. Menzies," I guess your question presumes that we have some knowledge on whether this is all behind us or not; and that depends upon whether you are from Florida, California, Arizona, Nevada, Ohio, Michigan, or Atlanta, or when you are from the Eastern Shore of Maryland. You can bet I don't know the answer to that question. It also presumes that there is a need to create some regulation to deal with the problem, to deal with the collapse, if you will. And again I would repeat that it is so important to focus on what caused the problem. What caused the $7 trillion of economic loss to the American consumer? We can have all the product legislation in the world and do everything possible to protect the consumer, but the greatest damage to the consumer was the failure of a system because of concentrations and excesses across the board, of a Wall Street vehicle that gathered together substandard, subprime, weird mortgages that community banks didn't make, created a warehouse to slice and dice those entities, make huge profits selling off those items, and have very little skin in the game, very little capital at risk, and to be leveraged, leveraged in some cases, according to the Harvard Business Review this week, 70 to 1. That deserves attention. The too-big-to-fail, systemic-risk, too-big-to-manage, too-big-to-regulate issue must be dealt with. And from the perspective of the community banks, that is the crisis of the day. That is what has destroyed the free market system. " CHRG-111shrg57709--246 MANAGED MARKETS The Herbert Gold Society, February 1, 1993 By Christopher Whalen Financial markets and many foreign governments were taken by surprise in early January when New York Federal Reserve Bank President E. Gerald Corrigan suddenly resigned. In the unusual press conference called to announce his decision, Corrigan, who officially leaves the New York Fed in August, made a point of denying that there was any ``hidden agenda'' in his departure from more than 20 years of public service. Yet a good part of his career was not public and, indeed, was deliberately concealed, along with much of the logic behind many far-reaching decisions. Whether you agreed with him or not, Corrigan was responsible for making difficult choices during a period of increasing instability in the U.S. financial system and the global economy. During the Volcker era, as the Fed Chairman received the headlines, his intimate friend and latter day fishing buddy Corrigan did ``all the heavy lifting behind the scenes,'' one insider recalls. Because of his important, albeit behind-the-scenes role, Corrigan's sudden decision to step down is doubly wrapped in mystery. A Democrat politically associated with Establishment Liberal personalities, Corrigan under President Bill Clinton seemed likely to be at the head of the list of prospects to succeed Chairman Greenspan. Thus he sheds the limelight under circumstances and in such a way as will only intensify speculation about numerous pending issues, including his role in the Salomon Brothers scandal, the Iraq-Banco Nazionale del Lavoro affair, the BCCI collapse and widely rumored misconduct in the LDC debt market, to cite only part of a longer list of professional and personal concerns. One nationally known journalist who has closely followed Corrigan's career says that ``there is more to come'' on both the Salomon and BNL fronts, and also predicts that several lesser Fed officials close to Corrigan also may be implicated. In fact, it appears that the New York Fed chief decided to resign in the face of several ongoing congressional and grand jury investigations that when completed might, perhaps, embarrass the publicity shy central bank and compel Chairman Alan Greenspan and the board of directors of the New York Reserve Bank to force him out. The press statement from the Board of Governors in Washington, for example, stated that Corrigan had only just made his decision to resign, but why then the lengthy, 8-month period between the resignation and his departure? In fact, the search committee to find his replacement had begun its work days, perhaps weeks earlier. Even as Corrigan met the press, a personal emissary sent by Corrigan was completing a week-long swing through Europe to inform central bankers privately of the impending retirement, a final courtesy from the man who at first carried messages and later the weight of decisions during over 20 years surveying world financial markets. Many political observers lament the loss of the Fed's most senior crisis manager, yet there is in fact considerable relief inside much of the Federal Reserve System at Corrigan's departure. ``Break out the champagne,'' declared one former colleague. ``Stalin is dead.'' The unflattering nickname refers to Corrigan's often abrasive, dictatorial management style. But another 20-plus year Fed veteran, though no less critical of Corrigan's methods, worries that there is no financial official of real international stature at the central bank for the first time since Paul Volcker left New York to become Fed Chairman in 1979. ``Aside from the rather aloof Greenspan,'' he frets, ``there's no one in Washington or among the regional Reserve Bank presidents who is able to pick up the telephone and know which bankers to call in the event of a crisis. Greenspan knows everyone, but he is no banker.'' Who will replace Gerry Corrigan? Candidates range from Fed Vice Chairman David Mullins, an Arkansas native, to economists and bankers from around the country. Yet to appreciate the scale of the task to select his replacement, it is first necessary to review Corrigan's long career. He probably will be best remembered in his last incarnations as both head of the Cooke bank supervisory committee and the chief U.S. financial liaison to the shaky government of Boris Yeltsin in Moscow, where he and the equally hard-drinking Russian leader often stayed up all night devising schemes to stave off a debt default. The Russian effort is perhaps most interesting to students of the Fed because of the combination of luck and divine providence that brought the New York Fed chief and the Russian leader together in the first place and also because it illustrates many aspects of a two-decade long career that has been largely obscured from public view. But now the age of Corrigan is revealed, indirectly, in the vacuum his departure leaves at the top of the American financial system.The Russian Business Early in the summer of 1991, Treasury Secretary Nicholas Brady, Fed Chairman Greenspan, Corrigan, and several lesser western functionaries traveled to Russia to meet with then-Soviet President Mikhail Gorbachev. The Brady-led economic SWAT team went to Moscow to hear the besieged Soviet leader ask for an assessment of the economic reforms that would be required for eventual International Monetary Fund membership (and the release of billions of dollars in new loans from the IMF a year later). One evening during the visit, as Brady and Greenspan went off to dine with Gorbachev, an aide to Corrigan, who was not invited along for dinner, suggested that it would not be a bad idea to meet ``discreetly'' with Yeltsin. The meeting with the Russian leader was quietly arranged. Yeltsin, it should be remembered, had just completed a disastrous tour of the United States, where he was ignored by the Bush Administration, which saw him as a dangerous, often drunken irresponsible on the fringe of Soviet politics. ``Yeltsin deeply appreciated the courtesy of Corrigan's visit,'' according to one senior Fed official familiar with the details of the trip. About a month later, when the attempted military coup against Gorbachev thrust Yeltsin to the forefront, the Russian President did not forget his new-found dining companion and billiard partner, Gerald Corrigan. In November 1991, the New York Fed chief began a series of ``technical assistance'' trips, which usually included time for trips to the country and visits to such places as Stalin's country house or dacha. He made many of his Russian trips in the company of a female Fed official that one peer described as the central bank's answer to James Baker's Margaret Tutwiller. In January 1992, Corrigan hosted a dinner for 200 bankers and other close friends in Yeltsin's honor at the New York Fed's beautiful Italian-revival building at 33 Liberty Street in lower Manhattan, in the shadow of Chase Manhattan Bank and a stone's throw from the House of Morgan. The two now-intimate friends reportedly danced and tossed back shots of vodka till the wee hours of the morning in the bank's magnificent dining room. Through 1991, as the once stalwart communist Yeltsin became deeply committed to ``free market reform,'' Corrigan began to advise Russia's leader on economic matters. This role was formalized in February 1992, after the fact, when the Fed's Board of Governors in Washington effectively appointed Corrigan ``czar'' to oversee American technical assistance to Moscow. Corrigan assembled a team of high-level financial experts from the New York financial community and led them to Russia at Yeltsin's request, to study and recommend further financial reforms. In May 1992, this team became part of a formal network called the ``Russia-U.S. Forum,'' of which Corrigan is co-chair and which includes such establishment fixtures as David Rockefeller and Cyrus Vance as directors. Significantly, Vance is a two-term member of the board of directors of the New York Fed and part of the search committee to find a replacement for Corrigan. Thus the New York Fed chief, who was already the senior U.S. bank regulator, also assumed the role of financial liaison to the Yeltsin regime. Together with Corrigan's long-time mentor, former Fed Chairman Volcker, who ironically acted as adviser to the Russian government after years of steering the world through the international debt crisis, Corrigan has been perhaps the most influential Western financial expert on the scene in Russia, particularly after James Baker moved to the White House in August 1992 to direct the abortive Bush reelection effort. Yet were helping Russia move toward a market-based economy really Washington's first priority, the fate that brought Yeltsin and Corrigan together would have to be seen as one of those crazy events in history when the wrong person was in the right place at the wrong time. ``The oddest thing that is going on right now is that Gerry Corrigan is taking to Moscow a bunch of people from the big money center banks to tell them how to run a banking system,'' financial author Martin Mayer noted during a seminar on banking at Ohio State University last summer. ``The Russians don't need that kind of help.'' Perhaps it is just a coincidence, but Corrigan's resignation comes as Mayer is about to publish a new book later this year on the Salomon Brothers scandal that reveals the New York Fed's central role in the debacle. Yet Corrigan's willingness to tolerate Salomon's market shenanigans is not surprising. By his own admission, Corrigan has never entirely or even partially trusted in free markets, and the Fed's conduct in the Salomon affair was an illustration of this viewpoint put into practice. The New York Fed knew that something was afoot in the government bond market but turned a blind eye to Salomon's machinations rather than risk the ``stability'' of the sales of Treasury paper. Corrigan is a classic interventionist who sees the seemingly random workings of a truly free market as dangerously unpredictable. The intellectual author and sponsor of such uniquely modernist financial terms such as ``too big to fail,'' which refers to the unwritten government policy to bail out the depositors of big banks, and ``systemic risk,'' which refers to the potential for market disruption arising from inter-bank claims when a major financial institutions fails, Corrigan's career at the Fed was devoted to thwarting the extreme variations of the marketplace in order to ``manage'' various financial and political crises, a role that he learned and gradually inherited from former Chairman Volcker. At a July 1, 1991 conference on restructuring financial markets, Corrigan said that relying entirely on market forces actually posed a risk to the world financial system. ``There is a tendency to think that market forces must be good,'' he opined, and said also that the ``challenge'' for regulators will be how to ``balance free market forces'' with the ``dictates of stability in the financial structure.'' And as Salomon and a host of other examples illustrate, Corrigan worked very hard to ensure that stability, regardless of the secondary impact on markets or the long-term cost. A career of almost day-to-day crisis control stretched back to the Hunt Brothers silver debacle in 1980, but especially to the collapse of Drysdale Government Securities in 1982, the Mexican debt crisis (1982-1990) and the October 1987 market crash. Russia was Corrigan's greatest and last test, yet despite claims of fostering private sector activity in Russia or stability in domestic financial markets, in fact his first and most important priority over two decades of service was consistently bureaucratic: to help heavily indebted countries and their creditor banks navigate a financial minefield that was neither of his making nor within his power to remove. Like Volcker before him, Gerald Corrigan cleaned up the messes left behind by the big banks and politicians in Washington, and tried to keep a bad situation from getting any worse.Volcker's Apprentice Corrigan's unlikely rise to the top of the American financial system started in 1976 when as corporate secretary of the N.Y. Fed he was befriended by then-President Volcker. At the time, other senior officers of the New York Reserve Bank still were a bit stand-offish toward Volcker because of policy disagreements, most notably after America's abandonment of gold for international settlements at Camp David in August 1971, a move Volcker supported (he actually participated in the drafting of the plan). But Corrigan extended himself for the new president and quickly became his trusted adviser and friend, and the man doing the difficult jobs behind the scenes as Volcker attracted the limelight as the crisis manager. When Volcker was appointed Fed Chairman late in the summer of 1979, Corrigan followed him to Washington as the chairman's aide and hands-on situation manager (although he remained on the New York Fed's payroll and was subsequently promoted). He was quickly thrown into the crisis control fray when Bunker and Herbert Hunt's attempt to manipulate the silver market blew up into a $1.3 billion disaster the following year. Corrigan managed the unwinding of silver positions, providing the moral suasion necessary to convince reluctant banks to furnish credit to brokers who made bad loans to the Hunts to finance their silver purchases. In 1982, when Drysdale Government Securities collapsed, Corrigan was again the man on the scene to do the cleanup job, working to avoid the worst effects of one of the ugliest financial debacles in the post war period. Drysdale was the first in a series of shocks that year which included the Mexican debt default and the collapse of Penn Square Bank. Drysdale threatened not only the workings of the government securities market, but the stability of a major money center bank, Chase Manhattan, which saw its stock plummet when rumors began to fly as to the magnitude of losses. Corrigan fashioned a combination of Fed loans of cash and collateral, and other expedients, to make the crisis slowly disappear, even as Volcker again received public credit for meeting the crisis. It was about this time that Corrigan, who had never shown any inclination toward outdoor sports (although he is an avid pro-football fan), discovered a love for fly fishing, a favorite pastime of Volcker. He joined a select group of cronies such as current New York Fed foreign adviser and former Morgan Stanley partner Ed Yeo and then-IMF managing director Jacques de Larosiere, who would go on long fishing trips. We may never know what was discussed while this select group let their lines dangle into the water, but fishing no doubt took up far less than most of the time. Later in 1982 Volcker, who was by then supervising the unfolding Penn Square situation, pushed for Corrigan to take the open presidency of the Minneapolis Fed. (Volcker later admitted wanting to keep the badly insolvent Penn Square open for fear of wider market effects, but the FDIC closed down the now infamous Oklahoma bank, paying out only on insured deposits.) Significantly, as Volcker promoted Corrigan's career within the Fed, he took extraordinary measures to prevent the nomination or appointment of respected economists and free market advocates like W. Lee Hoskins and Jerry L. Jordan to head other Reserve Banks (both Hoskins and later Jordan were appointed to the Cleveland Reserve Bank's presidency after Volcker's departure in 1987). Hoskins in particular was the antithesis of Volcker, an unrepentant exponent of conservative, sound money theory who advocated making zero inflation a national goal. He left the Cleveland Fed last year to become president of the solid Huntington Bank in Columbus (which interestingly was among the last institutions to approve new bank loans for Chrysler in 1992). Hoskins and other free market exponents believe that ill-managed banks should be allowed to fail and that Federal deposit insurance hurts rather than protects the financial system by allowing banks to take excessive risks that are, in effect, subsidized by the American taxpayer. But this free market perspective, which represented mainstream American economic thought before the New Deal, is at odds with the Volcker-Corrigan view of avoiding ``systemic risk'' via public sops for large banks and other, more generalized types of government intervention in the ``private'' marketplace. Volcker moved to protect his bureaucratic flank in 1984 when he nominated Corrigan as a replacement for Anthony Solomon as president at the New York Fed, an event that required almost as much lobbying as was latter needed to block the appointment of Hoskins to head the St. Louis Fed in 1986. The cigar chomping Fed chairman got on a plane to call a rare Sunday meeting of the Reserve Bank's board, where he reportedly pounded the table and warned of being outnumbered by Reagan-era free market-zealots. The St. Louis Fed's board caved in to Volcker's demands and Hoskins was passed-over, although he would be appointed President of the Cleveland Fed in late 1987, after Volcker no longer was Federal Reserve Board Chairman. Significantly, Corrigan's impending selection in 1984 caused several more conservative line officers and research officials to flee the New York Reserve Bank. Roger Kubarych, one of the deputy heads of research in New York and a widely respected economist on Wall Street (he's Henry Kaufman's chief economist), actually resigned the day Corrigan's appointment was formally announced, fulfilling an earlier vow not to serve under Volcker's apprentice that symbolized earlier internal Fed disputes.The Neverending Crisis From the first day he took over as head of the New York Fed in 1985, Corrigan's chief priority was ``managing'' the LDC debt crisis and in particular its devastating effects on the New York money center banks. Even in the late 1980s, when most scholars and government officials admitted that loans to countries like Brazil, Argentina and Mexico would have to be written off, as J.P. Morgan did in 1989, Corrigan continued to push for new lending to indebted countries in an effort to bolster the fiction that loans made earlier could still be carried at par or book value, 100 cents on the dollar. Even today, when some analysts declare the debt crisis to be over, the secondary market bid prices for LDC debt range from 65 cents for Mexico to 45 cents for Argentina and 25 cents for Brazil. ``Anything approaching a `forced' write down of even a part of the debt--no matter how well dressed up--seems to me to run the risks of inevitably and fatally crushing the prospects for fresh money financing that is so central to growth prospects of the troubled LDCs and to the ultimate restoration of their credit standing,'' Corrigan wrote in the New York Fed quarterly review in 1988. ``A debt strategy that cannot hold out the hope of renewed debtor access to market sources of external finance is no strategy at all.'' And of course, in the case of Mexico, debt relief has been followed by massive new lending and short-term investment, albeit to finance a growing external trade imbalance ($15 billion in deficit during the first 9 months of 1992 alone) that is strikingly similar to the import surge which preceded the 1982 debt default. Likewise bankrupt Russia, which is supposedly cutoff from new Western credit, has received almost $18 billion in new western loans over the past 12 months--loans guaranteed by the taxpayers of the G-7 countries. But in addition to pressing for new loans to LDC countries, Corrigan worked hard at home to manage the debt crisis, bending accounting rules, delaying and even intervening in the closing of bank examinations, resisting regulatory initiatives such as market value accounting for banks' investment securities portfolios and initially promoting the growth of the interbank loans, swaps and other designer ``derivative'' assets now traded for short-term profit in the growing secondary market. In particular, Corrigan played a leading role in affording regulatory forbearance to a number of large banks with fatal levels of exposure to heavily indebted countries in Latin America. But no member of the New York Clearing House has received more special treatment than Citibank, the lead bank of the $216 billion total asset Citicorp organization. When former Citicorp chairman Walter Wriston said that sovereign nations don't go bankrupt, this in response to questions about his bank's extensive financial risk exposure because of lending in Latin America, his supreme confidence in the eventual outcome of the LDC debt crisis was credible because he and other financiers knew that senior Fed officials like Volcker and Corrigan would do their best to blunt the impact of bad LDC loans on the balance sheets and income statements of major banking institutions. In 1989, for example, as Wriston's successor, John Reed, was in Buenos Aires negotiating a debt-for-equity swap to reduce his bank's credit exposure in Argentina, Corrigan pressured bank examiners in New York to keep open the bank's examination for 14 months. This unprecedented intervention in a regularly scheduled audit contradicted the Fed's own policy statements in 1987 to the effect that large banks would be examined every 6 months, with a full-scope examination every year. Corrigan's decision (he and other Fed officials refuse to discuss regulatory issues as a matter of standing policy) probably was made in order to avoid charges against earnings by forcing the bank to post higher reserves against its illiquid Third World loan portfolio, an action that would later be taken anyway as Argentina slid further down the slope of inflation and political chaos. Yet in a recent internal memo, Corrigan declared the debt crisis ``resolved,'' even as LDC debt continues to grow, both in nominally and in real, inflation-adjusted terms. Public sector debt has fallen in Mexico, for example, accumulation of new private loans and short-term investment has driven total foreign debt over $120 billion, not-withstanding the abortive Brady Plan, while real wages in Mexico continue to deteriorate. This is about $30 billion more than Mexico's total debt level following the Brady Plan debt exchange in 1989. It is significant to note that while Corrigan and other officials pushed the Baker plan after 1985 (essentially a new money lending program) to help ``buy time'' for commercial banks, as Volcker did before him, there remain literally thousands of unsecured commercial creditors of Mexico, Brazil and other LDCs who have little hope of ever seeing even the meager benefits such as World Bank guarantees on interest payments accorded to commercial banks under the Brady scheme. Indeed, because of its debt reduction aspects there remains doubt as to whether Corrigan even fully endorsed the abortive Brady Plan.Systemic Risk & Fiat Money As vice chairman of the Federal Open Market Committee, a position by law held by the New York Fed chief, Corrigan consistently supported the forces pushing for easy money in recent years in order to reflate the domestic economy and eastern real estate markets, and thereby to bolster the sagging balance sheets of insolvent money center behemoths. In fairness, it must be said that Mr. Corrigan, for the most part, was merely following Chairman Greenspan's lead on those monetary policy votes. Since becoming a Reserve Bank president in 1982, he never dissented in an FOMC vote against the chairman's position under either Volcker or Greenspan. Yet as Bill Clinton seems destined to discover, embracing inflationism today in order to accommodate Federal deficits, and bail out badly managed commercial banks and real estate developers, has its price tomorrow in terms of maintaining long-term price and financial market stability. Several of the nation's largest commercial banks, which are headquartered in Corrigan's second Fed district, are or until recently have been by any rational, market-oriented measure insolvent and should have been closed or merged away years ago. Concern about the threat to the financial markets of ``systemic risk'' is used to keep big banks alive, and also as a broad justification for all types of market intervention. The reasoning behind ``systemic risk'' goes something like this: If Russia defaults on its debts, large banks (mostly in Europe) will fail, causing other banks and companies to lose money and also fail. Therefore, new money must keep flowing to countries like Russia, Mexico, Brazil and Argentina so that they may remain current on private debts to commercial lenders, essentially the old-style pyramid or Ponzi scheme on an international scale, funded by taxpayers in America, Europe and Japan via inflation and public sector debt. When Corrigan gave a speech earlier this year warning about the risks inherent in derivative, off-balance sheet instruments such as interest rate swaps, many market participants wondered aloud if the New York Fed chief really understands the market he once promoted but now so fears. ``Off-balance sheet activities have a role, but they must be managed and controlled carefully,'' he told a mystified audience at the New York State Bankers Association in February. ``And they must be understood by top management as well as traders and rocket scientists.'' Swap market mavens were right to wonder about Corrigan's grasp of derivative securities, but they might better ask whether Corrigan appreciates the connection between embracing easy money and inflation to bail out the big banks, and the expansion of derivative markets. In fact, the growth of the swaps market in particular and financial innovation generally, is fueled by paper dollars created by monetary expansion, credit growth that Corrigan has long and repeatedly advocated within the FOMC's closed councils. From $2 trillion in 1990, the derivatives market grew to $3.8 trillion at the end of last year (Citicorp is one quarter of the total swaps market) and may double again before the end of 1994. And yet in basic, purely financial terms, there is no difference between an interest rate swap with a counterparty incapable of understanding the risk, a loan to Brazil, and the commercial real estate loans that fueled the Olympia & York disaster; all are simply vehicles for marketing credit in a market awash in paper, legal tender greenbacks created by an increasingly politicized Federal Reserve Board. In addition to the exponential growth in markets such as interest rate swaps, another side effect of expansionary monetary policy has been an increase in market volatility generally. When the great mountain of dollars created by the Fed during the previous decade suddenly moved out of U.S. equities on Black Monday, October 19, 1987, the New York Fed under Corrigan reportedly urged private banks to purchase stock index futures to stabilize cash prices on the New York Stock Exchange. Corrigan bluntly told commercial banks to lend to brokers in order to help prop the market up, and dealers were even allowed to borrow collateral directly from the Fed in order to alleviate a short-squeeze. Orchestrating such a financial rescue is still intervention in the free market, albeit of an indirect nature. In October 1987, banks in Europe and Japan had refused to lend Treasury paper to counterparties in New York, many of whom had been taken short by customers and other dealers during the frenzied flight to quality that occurred, from stocks into AAA-rated U.S. Government debt. The Fed saved may dealers from grave losses by lending securities they could not otherwise obtain, but this seemingly legitimate response to a market upheaval still represents government inspired meddling in the workings of a supposedly private market. Traders who sell short a stock or bond that they cannot immediately buy back in the market at a lower price are no better than gamblers who have none to blame save themselves for such stupidity and should seek the counsel of a priest or bartender. But in an illustration of the broadly corporativist evolution of Fed policy, as manifested in the government bond market, Corrigan sought broader powers to support the dealer community. In fact, in the wake of the bond market collateral squeeze in 1987 (and again during the ``mini crash'' in October 1989), the New York Fed chief pushed for and late last year obtained authority from Congress to lend directly to broker-dealers in ``emergencies,'' thus allowing the central bank to provide direct liquidity support to the U.S. stock market the next time sellers badly outnumber buyers. When it came time to explain the 1987 debacle to the Congress and the American people, Corrigan was more than willing to help the private citizen drafted to oversee the task, former New Jersey Senator Nicholas Brady, who after being appointed to the Presidential commission created to study the crash, became Treasury Secretary in 1988 when James Baker left the government to run the Bush election campaign. Yet Corrigan assisted the work of Brady's hand-picked assistants, Harvard professor Robert Glauber, who later became under secretary of the Treasury for Finance, and David Mullins, who also joined Brady's Treasury and is now a Bush-appointee as Vice Chairman of the Fed Board of Governors. Mullins and Glauber worked on the Brady report in offices provided by the New York Fed and reportedly dined regularly with Corrigan, who offered them his informed view of how financial markets work. When the Salomon scandal erupted in the Spring and Summer of 1991, Corrigan was again the key man on the scene to manage the fallout from a debacle that has still been only partially unveiled. Following 1986, when regulatory responsibility for the government bond market had been explicitly given to the SEC, the Fed, at Corrigan's instruction, had largely curtailed its surveillance of the market for Treasury debt, particularly the informal ``when-issued'' market in Treasury paper before each auction. And yet when the Salomon scandal broke open, it was apparent that the hands-on ``management'' of markets prescribed by Corrigan had failed to prevent one of the great financial scandals of the century. ``Neither in Washington nor in New York did the Fed seem aware that the dangers of failure to supervise this market had grown exponentially in 1991,'' Mayer notes in an early draft of his upcoming book on the Salomon debacle. ``Like the Federal Home Loan Bank Board in its pursuit of making the S&Ls look solvent in 1981-82, the Fed had adopted tunnel-vision policies to save the nation's banks. And just as excessive kindness to S&Ls in the early 1980s had drawn to the trough people who should not have been in the thrift business, Fed monetary policies in the early 1990s created a carnival in the government bond business.'' The Salomon crisis was not the only bogie on the scope in 1991. During December 1990, the Federal Reserve Bank of New York, working in concert with several private institutions, fashioned a secret rescue package for Chase Manhattan Bank when markets refused to lend money to the troubled banking giant. While Chase officials vociferously deny that any bailout occurred, the pattern of discount window loans during the period and off-the-record statements by officials at the Fed and several private banks suggest very strongly that Corrigan's personal intervention prevented a major banking crisis at the end of 1990. Rational observers would agree that the collapse of a major banking institution is not a desirable outcome, but the larger, more fundamental issue is whether any private bank, large or small, should be subject to the discipline of the marketplace. In the case of Citibank, Chase and numerous other smaller institutions, Corrigan, like Volcker before him, answered this question with a resounding ``no.'' The corporativist tendencies of this extra-legal arrangement amounts to the privatization of profits and the socialization of losses.A Question Of Principles The real issue raised by Corrigan and his supporters within the Fed bureaucracy has been not what they believe, but the fact that they did not seem to have any basic core beliefs with which to guide regulatory actions and policy recommendations during years of difficult domestic and international crises. Other than seeking to avoid a market-based resolution to bank insolvencies and other random events in the marketplace, for example, there is no discernible logic to ``too big to fail.'' While this attitude may be useful to elected officials, appointed higher ups and the CEOs of large banks, it cannot help confusing an American public that still believes that concepts like free markets and the rule of law matter. There is not, for example, any explicit statutory authority supporting the doctrine of ``too big to fail,'' nor has Congress given the Fed authority to support the market for government bonds or even private equity via surreptitious purchases of stock index futures, as was alleged in 1987 and on several occasions since. In the case of the conflict between monetary accommodation for big money center banks and complaining about the explosive growth of derivative products, for example, or warning about banking capital levels while allowing regulatory forbearance and financial accommodation for brain dead money center institutions, Corrigan's positions are riven with logical inconsistencies and interventionist prescriptives that, as the Salomon scandal also illustrates, fail to address the underlying problems. But it may be unfair to place all or even part of the blame for this incongruity at his feet alone. Since beginning his work under Volcker in 1976, Corrigan has met and at least temporarily resolved each foreign and domestic crisis with various types of short-term expedients designed to maintain financial and frequently political stability. The rarefied atmosphere of crisis management leaves small time for recourse to first principles. In this respect, Corrigan must be seen as a pathetic figure, an errand boy doing difficult jobs for politicians and servile Fed Chairmen in Washington who have been unwilling to take the hard decisions needed to truly end the multiple crises that affected the American-centered world financial system since the 1960s abroad and the 1970s at home. By at once advocating new lending to LDCs while softening regulatory treatment for heavily exposed money center institutions, Corrigan was at the forefront of efforts to forestall the day of financial reckoning for the big banks, whether from Third World loans, domestic crises arising from real estate loans, or highly leveraged transactions. However, if Russia, Mexico or some other financial trouble spot boils over after next summer, Gerry Corrigan will have gone fishing. And he will leave behind a very large pair of much-traveled boots that Alan Greenspan and the Clinton Administration quickly must fill. ______ FOMC20080430meeting--216 214,MR. HILTON.," Thank you, Jim. We have identified four critical objectives for a new operating framework, which are listed on page 34 of your handout. These are (1) to reduce burdens and deadweight loss associated with the current regime, (2) to enhance monetary policy implementation, (3) to promote efficient and resilient money markets, and (4) to promote an efficient payment system. For each of the five options that Jim has just presented, I am going to describe what we see as the major advantages and disadvantages of each vis � vis these objectives. I will also highlight some important sources of uncertainty that we have about how some of these options might function in practice. Then I will close with a broad assessment of how the five options measure up against each of these four objectives. The key advantages and disadvantages of option 1--remunerate required and excess reserve balances--are listed on page 35. This option would have the advantage of being relatively easy to implement given that it would build largely on elements of the current operating framework and would simply pay interest on reserve requirements and, at a lower rate, on excess reserves. The basic framework, which consists of an interest rate corridor with reserve requirements and maintenance periods, is widely used by other central banks, and we're pretty certain how it would function in practice. For central banks that have adopted this basic framework, it has proven to be reasonably effective for controlling short-term interbank rates under a variety of circumstances. However, this option would do little to reduce the administrative burdens associated with our current regime. This framework is also somewhat rigid, particularly in the flexibility it would provide to us and to banks themselves to adjust the level of requirements in ways that would facilitate monetary policy implementation. A particular shortcoming is that many depositories active in the interbank market have a very small base of deposits against which requirements of any level could be assessed. An important source of uncertainty with this option is whether it would lead to a significant increase in total required operating balances, which would be helpful for damping interest rate fluctuations that can arise when requirements are very low. However, the Fed would have some power to influence the aggregate level of requirements by raising requirement ratios. Option 2--voluntary balance targets--(shown on page 36) would lead to some reduction of administrative costs and burdens compared with the current framework (option 1), as relative simplicity would be one of the principal design objectives for a new system of voluntary reserve targets. The basic framework is similar to that of option 1. It consists of an interest rate corridor with maintenance periods but substitutes voluntary targets for reserve requirements. As already noted, this basic framework has proven to be reasonably effective for controlling overnight interbank rates where it has been adopted. Furthermore, a new system of voluntary targets could provide all DIs with considerable flexibility for setting their own level of targets and for adjusting the size of these targets, a feature that banks might find useful during periods of heightened uncertainty or stress. With this option, there would also be the opportunity to review and totally revamp the length and mechanics of the maintenance period to make them more supportive of monetary policy implementation. However, almost any system of voluntary targets for reserves is bound to impose some administrative costs on both depositories and the Fed, and there may be some tradeoff between administrative simplicity and design flexibility. An important source of uncertainty with this option is that we have yet to identify with precision a system of voluntary reserve targets that would be workable, in the sense of being easy to administer across a large number of DIs with disparate structures, and that would be effective in yielding a total level and distribution of voluntary targets across DIs that would enhance our ability to achieve our operating objectives. Unfortunately, experiences of other central banks offer little guidance in how to design voluntary targets. A particular risk that concerned the Bank of England when it designed its voluntary target scheme was the potential for market manipulation that a new system might offer individual banks if they were entirely free to choose their level. Option 3--simple corridor--(on page 37) would go about as far as possible toward eliminating administrative burdens by doing away with all requirements and maintenance period accounting rules. This option should also keep the overnight interbank rate within a narrower range than the other options, assuming that we adopt a narrower spread between the discount rate and the interest rate paid on excess reserves. Experiences of other central banks that have adopted this kind of operating system support that belief. However, there is also reason to believe that, with removal of the ability of banks to average reserve holdings over a maintenance period, interest rate volatility within the interest rate corridor could be high. We could respond to high volatility within a corridor by further narrowing that corridor. But there is the risk that, at some point as you go in that direction, market participants could use our discount window or interest on excess reserves as a first recourse rather than as a last resort and thus affect the Fed's role as intermediary and impair normal market functioning. There are some important questions about how effectively a simple corridor system would function in our particular environment. All the options we are considering propose to use the primary credit facility to limit upward movements in market rates. To the extent that this facility might not serve as an effective brake on upward rate movements, the consequences would be greatest for this option because there are no other mechanisms for smoothing interest rates. Some central banks that have a simple corridor framework have also developed arrangements to adjust reserve levels late in the day to prevent exogenous reserve shocks from pushing market rates to either the upper or the lower end of the corridor. Option 4--floor with high balances--is shown on page 38. It would also do away with all requirements and maintenance period accounting rules and, like option 3, would go a long way toward eliminating administrative burdens. Moreover, because the rate effects of even a large aggregate reserve shock or a payment shock at an individual DI are likely to be relatively small, the need for depositories or for the Desk to manage daily reserve positions intensively is likely to be reduced, which should translate to further resource savings. Better insulation of market rates from exogeneous reserve shocks is a design objective, and it is a particularly distinctive feature of this framework. However, completely severing the link between daily reserve levels and interest rate movements can be a double-edged sword. While we may wish to better insulate market rates from reserve shocks, we may also wish to preserve some ability to influence market rates by manipulating reserve supply when other factors are distorting rates. One risk associated with this option is that it would represent a radical departure from the basic elements of our own current framework and from those of almost every other central bank, preventing us from learning from the experiences of other central banks. A particular unknown with this option is the possible implication for the functioning of the interbank market. Offering to compensate DIs for all the reserves they might choose to hold at a rate that is in line with market rates could have profound effects on their willingness to lend in the market, under both normal circumstances and during periods of market stress. The Reserve Bank of New Zealand, one central bank that has experimented with a system similar to option 4, did run into some difficulties with the hoarding of reserves by individual banks to the detriment of the interbank market. As a result, they adjusted their framework to cap holdings of excess reserves by individual banks. Option 5--voluntary daily target with clearing band--is on page 39. It has many of the same advantages and disadvantages as option 2, stemming from the fact that both feature voluntary reserve targets. Because simplicity would be one of the design principles, it should reduce current administrative burdens. It would also provide DIs with the same kind of flexibility that option 2 does for setting and adjusting their own reserve targets. On the other hand, a system of voluntary targets for reserves would still leave some administrative costs, and we have yet to specify a system of voluntary reserve targets that would be workable and effective. An additional advantage of this option is that it could allow the Fed to adjust the width of the daily clearing band around the reserve target. The final choice of clearing band width could be made after some experimentation based on what works best. Moreover, being able to make temporary adjustments to the width of this daily clearing band could be a powerful tool for dealing with exigent circumstances. Experiences of other central banks provide little guidance about how this flexibility might be best employed. But the Bank of England did widen its maintenance period clearing band during the recent financial market turmoil, and they have been happy with the results. Interestingly, the ECB, quite independently, has been examining the possibility of a new system centered on a one-day clearing band rather than a multi-day maintenance period. Let me sum up by outlining how these five options stack up against the four objectives that we have established for a new operating framework, which are summarized on pages 40 and 41. First, all the options would eliminate most of the current ""reserve tax"" associated with the nonpayment of interest on reserves, and perhaps with the exception of option 1, they would reduce the administrative burdens associated with our current framework. Option 3 (simple corridor) and option 4 (floor with high balances) would do the most to eliminate these administrative costs. Second, all the options would improve monetary policy implementation by helping set a floor on the fed funds rate. Most have additional features that could help control rate volatility, although these differ from one another in terms of their mechanics. But some of the options offer greater potential to adjust parameters in ways that could be helpful amid changing circumstances--say, during periods of market stress or heightened uncertainty about developments that could affect our balance sheet. An adjustable clearing band in option 5 could offer considerable flexibility. Adjustable reserve targets, a feature of both options 2 and 5, are another possibility. Third, all the options would rely on efficient money markets for distributing reserves between DIs. There is more uncertainty, however, about how some of the options might influence the incentive structure for trading and the allocation of liquidity in short-term financing markets and the role of the central bank in that process. This is the case with option 3 (simple corridor), should that corridor be too narrow, and with option 4 (floor with high balances), where the choices of lending excess liquidity in the market versus holding excess reserves would be nearly equivalent. Fourth, all the options are compatible with the proposed changes in payment system policies. However, there are differences among the options in the levels of reserves that would likely be in place and that could serve as a substitute for the provision of central bank daylight credit. Option 4 (floor with high balances) would provide the most reserves in the system, and option 3 (simple corridor) would provide the fewest, perhaps even lower than current levels. A system of voluntary reserve targets, a feature of both options 2 and 5, could be deliberately designed to encourage a relatively high level of reserves. " fcic_final_report_full--493 Lower-income and minority families have made major gains in access to the mortgage market in the 1990s. A variety of reasons have accounted for these gains, including improved housing affordability, enhanced enforcement of the Community Reinvestment Act, more flexible mortgage underwriting , and stepped-up enforcement of the Fair Housing Act. But most industry observers believe that one factor behind these gains has been the improved performance of Fannie Mae and Freddie Mac under HUD’s affordable lending goals. HUD’s recent increases in the goals for 2001-03 will encourage the GSEs to further step up their support for affordable lending . 62 [emphasis supplied] Or this statement in 2004, when HUD was again increasing the affordable housing goals for Fannie and Freddie: Millions of Americans with less than perfect credit or who cannot meet some of the tougher underwriting requirements of the prime market for reasons such as inadequate income documentation, limited downpayment or cash reserves, or the desire to take more cash out in a refinancing than conventional loans allow, rely on subprime lenders for access to mortgage financing. If the GSEs reach deeper into the subprime market, more borrowers will benefit from the advantages that greater stability and standardization create . 63 [emphasis supplied] Or, finally, this statement in a 2005 report commissioned by HUD: More liberal mortgage financing has contributed to the increase in demand for housing. During the 1990s, lenders have been encouraged by HUD and banking regulators to increase lending to low-income and minority households. The Community Reinvestment Act (CRA), Home Mortgage Disclosure Act (HMDA), government-sponsored enterprises (GSE) housing goals and fair lending laws have strongly encouraged mortgage brokers and lenders to market to low-income and minority borrowers. Sometimes these borrowers are higher risk, with blemished credit histories and high debt or simply little savings for a down payment. Lenders have responded with low down payment loan products and automated underwriting, which has allowed them to more carefully determine the risk of the loan. 64 [emphasis supplied] Despite the recent effort by HUD to deny its own role in fostering the growth of subprime and other high risk mortgage lending, there is strong—indeed irrefutable—evidence that, beginning in the early 1990s, HUD led an ultimately successful effort to lower underwriting standards in every area of the mortgage market where HUD had or could obtain influence. With support in congressional legislation, the policy was launched in the Clinton administration and extended almost to the end of the Bush administration. It involved FHA, which was under the direct control of HUD; Fannie Mae and Freddie Mac, which were subject to HUD’s affordable housing regulations; and the mortgage banking industry, which— while not subject to HUD’s legal jurisdiction—apparently agreed to pursue HUD’s 62 63 64 Issue Brief: HUD’s Affordable Housing Goals for Fannie Mae and Freddie Mac, p.5. Final Rule, http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf. HUD PDR, May 2005, HUD Contract C-OPC-21895, Task Order CHI-T0007, “Recent House Price Trends and Homeownership Affordability”, p.85. 489 policies out of fear that they would be brought under the Community Reinvestment Act through legislation. 65 In addition, although not subject to HUD’s jurisdiction, the new tighter CRA regulations that became effective in 1995 led to a process in which community groups could obtain commitments for substantial amounts of CRA-qualifying mortgages and other loans to subprime borrowers when banks were applying for merger approvals. 66 CHRG-111hhrg74090--55 Mr. Butterfield," Thank you, Chairman Rush, for holding this very important hearing and I especially want to thank the witnesses for their testimony today. Mr. Chairman, I hope this hearing will provide an opportunity for the subcommittee to address some concerns that we have about the proposed agency, particularly the loss of jurisdiction on the part of the Federal Trade Commission. Now, my colleagues are right, Mr. Chairman, there are many actors to blame for the current state of our economy. Unscrupulous subprime mortgage lenders and speculators and the like have all contributed to the financial meltdown. Of deep concern and rightfully so is the regulatory patchwork of federal agencies charged with regulating all aspects of financial institutions. For example, depository institutions such as banks and credit unions are overseen by many different agencies. Conversely, all non-depository institutions are overseen by one agency, and that is the FTC. The FTC has done a good job, and I think we can agree all on that, at regulating these players and I am concerned that reducing FTC oversight as part of the creation of the Consumer Financial Protection Agency may do more harm than good. While I am pleased that the Administration's proposal seeks to strengthen the FTC's rulemaking and enforcement abilities in areas unrelated to financial products, I believe that it is extremely important that the FTC maintain strong non-depository institution oversight. The Administration's proposed agency would seek to achieve four important objectives aimed at bolstering consumer confidence in financial institutions and transactions, and these objectives include ensuring consumer education and understanding of these financial products, better protecting consumers from unfair and deceptive practices and discrimination, ensuring consumer financial services operate fairly, making certain that underserved communities like my district have increased access to financial services. These are excellent objectives and I strongly support the goals of the proposed agencies but I want to be certain that the creation of a new regulatory agency will not place undue and unnecessary strains and burdens on existing federal regulatory framework that may still be capable of meeting those same goals and objectives. And so, Mr. Chairman, this hearing today is vitally important. I look forward to hearing the testimony of the witnesses and I thank you for the time. " CHRG-111hhrg51585--148 Mr. Lance," Thank you very much, Madam Chairwoman. Good morning to you all. I find this a very interesting issue, and as I view the testimony, the State of New Jersey where I live may be in a similar situation to the State of California. And I will direct my questions to Mr. Street, but certainly there are other experts on the panel as well. In the State of California, is there a requirement, constitutionally, that the State budget has to be balanced each year; and can debt be issued for the general operating portions of the State budget? Would you know that, sir? " CHRG-111hhrg55814--370 Mr. Baker," Thank you, Mr. Chairman. It is a pleasure to be here today. I shall wait to the end of the proceedings to come to a resolution thereon. MFA is the primary advocate for sound business practices in industry professionals in hedge funds, funds of funds, and managed futures, as well as industry service providers. MFA is committed to playing a constructive role in the regulatory reform discussion as it continues, as investors' funds have a shared interest with other market participants and policymakers in seeking to restore investor confidence and achieving a stable financial system. In considering the topic of a Systemic Risk and Resolution Authority, it is important to understand the nature of our industry in taking action. With an estimated $1.5 trillion under management, the industry is significantly smaller than the U.S. mutual fund industry or the $13 trillion U.S. dollar banking industry. Because many hedge funds use little or no leverage, their losses have not contributed to the systemic risk that more highly-leveraged institutions contributed. A recent study found that 26.9 percent of managers do not deploy leverage at all, while an FSA study in 2009 found that, on average over a 5-year period, leverage of funds was between 2 or 3 to 1, significantly below most public perception. The industry's relatively modest size and low leverage, coupled with the expertise of our members at managing financial risk, means we have not been a contributing cause to the current difficulties experienced by the average investor or the American taxpayer. Although funds did not cause the problems in our markets, and though we certainly agree with recent statements by Chairman Bernanke that it is unlikely that any individual hedge fund is systemically relevant, we believe that the industry has a role in being a constructive participant as policymakers develop regulatory systems with the goal of restoring stability to the marketplace. We believe the objectives of systemic risk can be met through a framework that addresses participant, product, and structural issues, which include: a central systemic regulator with oversight of the key elements of the entire system; confidential reporting by every institution, generally to its functional regulator, which would then make appropriate reports to the systemic regulator; prudential regulation of systemically relevant entities, products, and markets; and a clear, single mandate for the systemic risk regulator to take action if the failure of a relevant firm would jeopardize broad aspects of economic function. We believe these authorities are consistent with the authorities contemplated by the discussion draft. We believe the objectives of systemic risk regulation are best met not by subjecting non-banks to the Bank Holding Company Act, but by developing a framework that adopts a tailored regulatory approach that addresses the different risk concerns of the business models, activities, and risks of the systemically significant firms. For example, when firms post collateral when they borrow from counterparties, like hedge funds customarily do and as major market participants will be required to do under the OTC bill recently passed by this committee, the potential systemic risks associated with that borrowing are greatly reduced, a factor that should mitigate in determining what prudential rules should apply to various market activities. We believe that smart regulation, facilitated by the OTC, the Advisor Registration, and the Investor Protection bills recently passed by the committee also will greatly reduce the likelihood that a Resolution Authority framework will even need to be implemented. To the extent that a regulator does need to implement such authority, however, we believe that it should be done in a manner to ensure that a firm's failure does not jeopardize the financial system. However, it should be explicitly stated that this authority should not be used to save firms from failing. It is unclear at the moment whether the authority granted by the proposal would enable assistance to be extended to a firm not leading to resolution of the entity being assisted. There are other issues that have been raised by members' questions and the testimony earlier today that we would also address. But for the sake of time, I shall conclude by saying we believe that the Systemic Risk and Resolution Authority framework discussed above will address the concerns underlying the Systemic Risk and Resolution Authority bills, while minimizing unfair competitive advantages and moral hazards that can result from market participants having an implied government guarantee. It is important this framework be implemented in a manner that allows investors, lenders, and counterparties to understand the relevant rules and have confidence those rules will be applied consistently in the future. When investors do not have that confidence, they are less likely to put their capital at risk. And when market function is impaired, we all pay a price. Thank you, Mr. Chairman. [The prepared statement of Mr. Baker can be found on page 117 of the appendix.] " FOMC20080318meeting--3 1,MR. DUDLEY.,"1 Thank you, Mr. Chairman. To start, I just want to update people on what happened overnight in markets. Equities rebounded a bit in both Asia and Europe, and bond yields reversed some of the decline that they saw on Monday. The dollar was slightly weaker against the yen and the euro but still in the range that it established. It did not go back below the lows that it reached early on Monday. I would say that generally the markets' function was okay. The big issue was bank funding pressures in Europe were evident for dollar funding. The funds rate bid as high as 3� percent, which is quite surprising on the eve of a meeting in which we are likely to reduce the federal funds rate target. Term funding pressures, if you look at the onemonth or three-month LIBOR�OIS spread, are basically unchanged from Monday, when they were up quite sharply from last Friday. Before talking about what markets have been doing over the six weeks since the last FOMC meeting, I'm going to talk a bit about the Bear Stearns situation. In my view, an old-fashioned bank run is what really led to Bear Stearns's demise. But in this case it wasn't depositors lining up to make withdrawals; it was customers moving their business elsewhere and investors' unwillingness to roll over their collateralized loans to Bear. The rapidity of the Bear Stearns collapse has had significant contagion effects to the other major U.S. broker�dealers for two reasons. First, these firms also are dependent on the repo market to finance a significant portion of their balance 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). sheets. Second, the $2 per share purchase price for Bear Stearns was a shock given the firm's $70 per share price a week earlier and its stated book value of $84 per share at the end of the last fiscal year. The disparity between book value and the purchase price caused investors to question the accuracy of investment banks' financial statements more generally. The contrast in the behavior of investment bank equity prices versus credit default swap (CDS) spreads is revealing. Share prices fell sharply, but the CDS spreads narrowed a bit, indicating a lower risk of default. For example, Lehman's stock price fell 19 percent, but its CDS narrowed by 20 basis points, to 450 basis points, yesterday. This underscores the difference between the $2 per share buyout price for Bear Stearns--less value than people thought--and the introduction of the Primary Dealer Credit Facility (PDCF)--a reduction in the risk that a liquidity problem could drive a firm into insolvency. I have a few words about the PDCF, before moving to a discussion of market developments since the January FOMC meeting. The PDCF should help to restore confidence among repo investors. It essentially creates a tri-party repo customer of last resort--us. When investors have concerns about the ability of a dealer to fund itself, they are reluctant to roll over their own repo transactions. The reason is the fear that the clearing bank may not send their cash back the next morning when the overnight repos mature. This fear may not be misplaced. If the clearing bank is worried about whether investors will stay put, the clearing bank may decide to keep the cash. In that case, the investors would be stuck with the securities that collateralize the repo transactions. The PDCF should break that chain of worry by reassuring the clearing bank that the Fed will be there as a lender to fund the repo transactions. The repo investors are reassured that the clearing bank will send back their cash the next day and thus are willing to roll over their repo transactions. At least that's the theory. As noted, the PDCF should provide some comfort to the counterparties of these firms that these firms will, in fact, be able to fund their obligations. Yesterday, the major money market mutual fund complexes did roll their outstanding repos with the major investment banks. However, the jury is still out on whether the PDCF will be sufficient to stabilize confidence. High use of the PDCF would result in a large increase in the amount of reserves added to the banking system. I think it is important to go on record on that because, if that were to occur, over the short run the New York Desk might not be able to drain reserves sufficiently quickly to keep the federal funds rate from trading extremely soft to the target. We will make all efforts to make the ""short run"" as short as possible. But realistically, there is a good chance that the federal funds rate could trade soft relative to the target, especially through the end of the current reserve maintenance period. In fact, yesterday we saw that, although it started the day quite firm, the funds rate crashed at the end of the day, and the effective fed funds rate for the day was 2.69 percent. It depends, in large part, on the volume of use of the PDCF. Stepping back from developments of the past few days, recent weeks have been marked by rapid and, at times, disorderly deleveraging of financial holdings within the global financial system. As I discussed last week, the most pernicious part of this unwinding has been the dynamic of higher haircuts, missed margin calls, forced selling, lower prices, higher volatility, and still higher haircuts, with this dynamic particularly evident in the mortgage-backed securities market. I'll be referring to the handout from here. Over the past six weeks, we have surveyed a number of hedge funds and one REIT about the haircuts they face for financing different types of collateral. As shown in exhibit 1, the rise in haircuts has been most pronounced in non-agency mortgage-backed securities. But even agency MBS have seen a significant widening of haircuts in recent weeks. The collateral funding pressures have been particularly evident for residential-mortgage-backed securities collateral. This is due to several factors including very unfavorable fundamentals for housing, a high level of uncertainty about the ultimate level of losses, and an overhang of product for sale, both currently and prospectively. In our discussions with market participants, unleveraged players have been unwilling to step in to buy ""cheap"" assets for several reasons. First, there are few signs that housing is close to a bottom. Second, a significant amount of product sits in weak hands and, thus, could be dumped on the market. Third, this particular asset class has characteristics that exacerbate price volatility and, therefore, risk. For example, when spreads widen and yields climb, prepayment speeds slow. This extends duration. When the yield curve is upward sloping for longer maturities, the rise in duration generates an increase in yields. The rise in yields also reduces housing affordability, which puts further downward pressure on home prices, increasing prospective losses on the mortgage loans that underpin the securities. Signs of distress in this market include the following. First, a sharp widening in option-adjusted mortgage spreads--as shown in exhibit 2, option-adjusted spreads for conforming fixed-rate mortgages have widened considerably since the January 30-31 FOMC meeting, though they have come in quite a bit over the past couple of days. That's good news. Second, jumbo mortgage spreads relative to conforming mortgages rates remain very wide. As shown in exhibit 3, this spread has averaged more than 100 basis points this year. The current yield on prime jumbo loans is around 7 percent, a margin of about 3� percentage points over ten-year Treasury note yields. Third, mortgage securities prices continue to fall. For example, as shown in exhibit 4, the prices for AAA-rated tranches of the ABX 07-01 vintage continue to decline. Fourth, Fannie Mae and Freddie Mac reported large fourth-quarter losses, and their stock prices and CDS spreads have performed accordingly (exhibit 5). The sharp decline in the equity prices has made the companies reluctant to raise new capital, despite the prospects of higher-margin new business, because additional share issuance at the current share prices would lead to massive dilution for existing shareholders. Fifth, the yield levels on many mortgage-backed securities have climbed significantly above the yield on the underlying mortgages that underpin the securities. This is the opposite of how securitization is supposed to work. This phenomenon reflects the glut of supply of such securities on the market and the added risk premium attached to assets that are typically held on a mark-to-market basis. Although the residential mortgage market is the epicenter of the crisis, distress has been evident much more broadly--with the municipal market fully implicated in the period since the January meeting. The deleveraging process evident among financial intermediaries operating outside the commercial banking system has led to a widespread repricing of financial assets. When available leverage drops, riskadjusted spreads have to rise for leveraged investors to earn the same targeted rate of return as before. This helps explain why the problems in the residential mortgage market have infected financial markets more generally, leading to wider credit spreads (exhibits 6 and 7) and lower equity prices (exhibit 8) both in the United States and abroad. As leverage is reduced and spreads widen, financial arbitrage implies that all assets should reprice. The risk-adjusted returns from holding different asset types should converge--recognizing that the degree of leverage that is available in markets may differ across asset classes in accordance with divergences in price volatility, liquidity, transparency, and other characteristics. Of course, the notion of convergence to equivalent risk-adjusted returns is an equilibrium concept, and we are not in equilibrium. The events of the past week underscore that point. But there are plenty of other examples of disequilibrium at work. For example, for mortgage-backed securities, the losses implied by the prices of the AAA-rated ABX index tranches appear to be high even relative to the darkest macroeconomic scenarios. The municipal bond market is also a good example of how market valuations can become unusually depressed when supply increases rapidly. Then the value inherent in the securities becomes broadly known, this mobilizes new money, and risk-adjusted returns come back down relatively quickly. Term funding spreads also indicate greater stress within the financial system. As shown in exhibits 9 and 10, the spreads between one-month and three-month LIBOR� OIS spreads have widened sharply in recent weeks, even before Bear Stearns's demise. We are sitting today at 56 basis points for the one-month LIBOR�OIS spread and 77 basis points for the three-month LIBOR�OIS spread, about the same as yesterday morning. As you are all aware, we have been active in responding to the growing market illiquidity. Exhibit 11 illustrates the results of the TAF auctions. Note how propositions and the number of bidders have increased recently and the spread between the stop-out rate and the OIS rate has risen over the past few weeks. Even before the Primary Dealer Credit Facility was implemented this weekend, we were in the middle of a historic transformation in the Federal Reserve System's balance sheet. We are increasing the supply of Treasuries held by the public (either outright or borrowed) and reducing the supply of more-illiquid collateral held by the private sector. Even excluding the uncertain impact of PDCF borrowing, this shift will speed up noticeably over the next month or two. Our current plans are to increase the size of the TAF to $100 billion, scale up the single-tranche RP book to $100 billion, renew and increase the size of the foreign currency swaps with the ECB and the SNB to $36 billion outstanding (if fully subscribed), and implement a $200 billion TSLF program. Exhibit 12 shows how these programs are likely to change the composition of the Federal Reserve's SOMA portfolio. As can be seen, when all the current programs are fully phased in by May, Treasury holdings will have shrunk to about 45 percent of the total portfolio, down from about 97 percent last July. At the same time that financial markets have been under severe stress and the macroeconomic growth outlook has deteriorated, the inflation news has also been disturbing. Several market-based indicators are adding to investors' concerns about the inflation outlook. First, commodity prices have increased sharply. As shown in exhibit 13, the increases have been concentrated in both energy and agricultural prices. Of course, subsidies to stimulate the production of ethanol from corn have been an important factor. By diverting corn production to this purpose, the linkage between energy and grain prices has been significantly strengthened. Second, the dollar, after a period of stability that lasted from mid-December into February, has begun to weaken anew (exhibit 14). This has gotten considerable attention in the press and abroad as the dollar has hit new lows against the euro and has fallen below 100 against the yen. Up to now, the decline has generally been orderly, and the downward slope of the broad real trade-weighted dollar trajectory shown in exhibit 14 has not changed much. The foreign exchange markets are clearly very skittish. In particular, there has been considerable focus on China and the Gulf Cooperation Council (GCC) countries and their willingness to maintain their pegs against the dollar. For China, investors expect its crawling peg to move faster. As shown in exhibit 15, the Chinese yuan is now expected to appreciate about 11 percent against the dollar over the next year, up from an 8 percent pace at the beginning of the year. For the GCC countries, there is speculation that some of these countries might decouple from the dollar. However, on a one-year-forward basis, market participants are currently building in only a couple of percentage points of expected appreciation. Breakeven rates of inflation have continued to widen. As shown in exhibit 16, both the Board staff's and the Barclays measures have broken out above the ranges evident in recent years. It is difficult to differentiate how much this widening reflects a higher risk premium due to greater uncertainty about the inflation outlook versus higher expected inflation. But either way, it is probably fair to say that inflation expectations have become less well anchored over the intermeeting period. I will say, however, that yesterday breakeven rates of inflation came down very sharply--the move was 15 to 20 basis points. Today, we are back in the range we were in, but that is only today. Short-term rate expectations continue to move lower. As shown in exhibit 17, federal funds rate futures now anticipate a trough in yields a bit below 1.5 percent. The yields implied by Eurodollar futures prices have also shifted sharply lower, as shown in exhibit 18. The trough in yields is expected to be reached in late summer or early fall. Our formal survey of primary dealers, which we normally show you, was conducted more than a week ago, and it is clearly out of date (these exhibits are included in the appendix to the handout). So let me focus on what the dealers' expectations were as of yesterday. They changed quite a bit over the past week. Most dealers expect either a cut of 75 or 100 basis points: There are eight for 100 basis points, ten for 75 basis points, and two for 50 basis points. This compares with the slightly more than 100 basis points built into the April federal funds rate contract (yesterday the April fed funds contract implied a 1.95 percent effective fed funds rate for the month). 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 January 30-31 FOMC meeting. Of course, I am very happy to take questions. " CHRG-109shrg21981--204 PREPARED STATEMENT OF ALAN GREENSPAN Chairman, Board of Governors of the Federal Reserve System February 16, 2005 Mr. Chairman and Members of the Committee, I am pleased to be here today to present the Federal Reserve's Monetary Policy Report to the Congress. In the 7 months since I last testified before this Committee, the U.S. economic expansion has firmed, overall inflation has subsided, and core inflation has remained low. Over the first half of 2004, the available information increasingly suggested that the economic expansion was becoming less fragile and that the risk of an undesirable decline in inflation had greatly diminished. Toward mid-year, the Federal Reserve came to the judgment that the extraordinary degree of policy accommodation that had been in place since the middle of 2003 was no longer warranted and, in the announcement released at the conclusion of our May meeting, signaled that a firming of policy was likely. The Federal Open Market Committee began to raise the Federal funds rate at its June meeting, and the announcement following that meeting indicated the need for further, albeit gradual, withdrawal of monetary policy stimulus. Around the same time, incoming data suggested a lull in activity as the economy absorbed the impact of higher energy prices. Much as had been expected, this soft patch proved to be short-lived. Accordingly, the Federal Reserve has followed the June policy move with similar actions at each meeting since then, including our most recent meeting earlier this month. The cumulative removal of policy accommodation to date has significantly raised measures of the real Federal funds rate, but by most measures, it remains fairly low. The evidence broadly supports the view that economic fundamentals have steadied. Consumer spending has been well-maintained over recent months, buoyed by continued growth in disposable personal income, gains in net worth, and accommodative conditions in credit markets. Households have recorded a modest improvement in their financial position over this period, to the betterment of many indicators of credit quality. Low interest rates and rising incomes have contributed to a decline in the aggregate household financial obligation ratio, and delinquency and charge-off rates on various categories of consumer loans have stayed at low levels. The sizable gains in consumer spending of recent years have been accompanied by a drop in the personal saving rate to an average of only 1 percent over 2004--a very low figure relative to the nearly 7 percent rate averaged over the previous three decades. Among the factors contributing to the strength of spending and the decline in saving have been developments in housing markets and home finance that have spurred rising household wealth and allowed greater access to that wealth. The rapid rise in home prices over the past several years has provided households with considerable capital gains. Moreover, a significant increase in the rate of single-family home turnover has meant that many consumers have been able to realize gains from the sale of their homes. To be sure, such capital gains, largely realized through an increase in mortgage debt on the home, do not increase the pool of national savings available to finance new capital investment. But from the perspective of a! n individual household, cash realized from capital gains has the same spending power as cash from any other source. More broadly, rising home prices along with higher equity prices have outpaced the rise in household, largely mortgage, debt and have pushed up household net worth to about 5\1/2\ times disposable income by the end of last year. Although the ratio of net worth to income is well below the peak attained in 1999, it remains above the long-term historical average. These gains in net worth help to explain why households in the aggregate do not appear uncomfortable with their financial position even though their reported personal saving rate is negligible. Of course, household net worth may not continue to rise relative to income, and some reversal in that ratio is not out of the question. If that were to occur, households would probably perceive the need to save more out of current income; the personal saving rate would accordingly rise, and consumer spending would slow. But while household spending may well play a smaller role in the expansion going forward, business executives apparently have become somewhat more optimistic in recent months. Capital spending and corporate borrowing have firmed noticeably, but some of the latter may have been directed to finance the recent backup in inventories. Mergers and acquisitions, though, have clearly perked up. Even in the current much-improved environment, however, some caution among business executives remains. Although capital investment has been advancing at a reasonably good pace, it has nonetheless lagged the exceptional rise in profits and internal cashflow. This is most unusual; it took a deep recession to produce the last such configuration in 1975. The lingering caution evident in capital spending decisions has also been manifest in less-aggressive hiring by businesses. In contrast to the typical pattern early in previous business-cycle recoveries, firms have appeared reluctant to take on new workers and have remained focused on cost containment. As opposed to the lingering hesitancy among business executives, participants in financial markets seem very confident about the future and, judging by the exceptionally low level of risk spreads in credit markets, quite willing to bear risk. This apparent disparity in sentiment between business people and market participants could reflect the heightened additional concerns of business executives about potential legal liabilities rather than a fundamentally different assessment of macroeconomic risks. Turning to the outlook for costs and prices, productivity developments will likely play a key role. The growth of output per hour slowed over the past half year, giving a boost to unit labor costs after 2 years of declines. Going forward, the implications for inflation will be influenced by the extent and persistence of any slowdown in productivity. A lower rate of productivity growth in the context of relatively stable increases in average hourly compensation has led to slightly more rapid growth in unit labor costs. Whether inflation actually rises in the wake of slowing productivity growth, however, will depend on the rate of growth of labor compensation and the ability and willingness of firms to pass on higher costs to their customers. That, in turn, will depend on the degree of utilization of resources and how monetary policymakers respond. To date, with profit margins already high, competitive pressures have tended to limit the extent to which cost pressures have ! been reflected in higher prices. Productivity is notoriously difficult to predict. Neither the large surge in output per hour from the first quarter of 2003 to the second quarter of 2004, nor the more recent moderation was easy to anticipate. It seems likely that these swings reflected delayed efficiency gains from the capital goods boom of the 1990's. Throughout the first half of last year, businesses were able to meet increasing orders with management efficiencies rather than new hires. But conceivably the backlog of untapped total efficiencies has run low, requiring new hires. Indeed, new hires as a percent of employment rose in the fourth quarter of last year to the highest level since the second quarter of 2001. There is little question that the potential remains for large advances in productivity from further applications of existing knowledge, and insights into applications not even now contemplated doubtless will emerge in the years ahead. However, we have scant ability to infer the pace at which such gains will play out and, therefore, their implications for the growth of productivity over the longer-run. It is, of course, the rate of change of productivity over time, and not its level, that influences the persistent changes in unit labor costs and hence the rate of inflation. The inflation outlook will also be shaped by developments affecting the exchange value of the dollar and oil prices. Although the dollar has been declining since early 2002, exporters to the United States apparently have held dollar prices relatively steady to preserve their market share, effectively choosing to absorb the decline in the dollar by accepting a reduction in their profit margins. However, the recent somewhat quickened pace of increases in U.S. import prices suggests that profit margins of exporters to the United States have contracted to the point where the foreign shippers may exhibit only limited tolerance for additional reductions in margins should the dollar decline further. The sharp rise in oil prices over the past year has no doubt boosted firms' costs and may have weighed on production, particularly given the sizable permanent component of oil price increases suggested by distant-horizon oil futures contracts. However, the share of total business expenses attributable to energy costs has declined appreciably over the past 30 years, which has helped to buffer profits and the economy more generally from the adverse effect of high oil and natural gas prices. Still, although the aggregate effect may be modest, we must recognize that some sectors of the economy and regions of the country have been hit hard by the increase in energy costs, especially over the past year. Despite the combination of somewhat slower growth of productivity in recent quarters, higher energy prices, and a decline in the exchange rate for the dollar, core measures of consumer prices have registered only modest increases. The core PCE and CPI measures, for example, climbed about 1\1/4\ and 2 percent, respectively, at an annual rate over the second half of last year. All told, the economy seems to have entered 2005 expanding at a reasonably good pace, with inflation and inflation expectations well anchored. On the whole, financial markets appear to share this view. In particular, a broad array of financial indicators convey a pervasive sense of confidence among investors and an associated greater willingness to bear risk than is yet evident among business managers. Both realized and option-implied measures of uncertainty in equity and fixed-income markets have declined markedly over recent months to quite low levels. Credit spreads, read from corporate bond yields and credit default swap premiums, have continued to narrow amid widespread signs of an improvement in corporate credit quality, including notable drops in corporate bond defaults and debt ratings downgrades. Moreover, recent surveys suggest that bank lending officers have further eased standards and terms on business loans, and anecdotal reports suggest that securities dealers and other market-makers appear quite willing to commit capital in providing market liquidity. In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target Federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of 10 consecutive 1 year forward rates. A rise in the first-year forward rate, which correlates closely with the Federal funds rate, would increase the yield on 10-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening. In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the tenth-year tranche, which yielded 6\1/2\ percent last June, is now at about 5\1/4\ percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations. Some analysts have worried that the dip in forward real interest rates since last June may indicate that market participants have marked down their view of economic growth going forward, perhaps because of the rise in oil prices. But this interpretation does not mesh seamlessly with the rise in stock prices and the narrowing of credit spreads observed over the same interval. Others have emphasized the subdued overall business demand for credit in the United States and the apparent eagerness of lenders, including foreign investors, to provide financing. In particular, heavy purchases of longer-term Treasury securities by foreign central banks have often been cited as a factor boosting bond prices and pulling down longer-term yields. Thirty-year, fixed-rate mortgage rates have dropped to a level only a little higher than the record lows touched in 2003 and, as a consequence, the estimated average duration of outstanding mortgage-backed securities has shortened appreciably ! over recent months. Attempts by mortgage investors to offset this decline in duration by purchasing longer-term securities may be yet another contributor to the recent downward pressure on longer-term yields. But we should be careful in endeavoring to account for the decline in long-term interest rates by adverting to technical factors in the United States alone because yields and risk spreads have narrowed globally. The German 10-year Bund rate, for example, has declined from 4\1/4\ percent last June to current levels of 3\1/2\ percent. And spreads of yields on bonds issued by emerging-market nations over U.S. Treasury yields have declined to very low levels. There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services, and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last 9 months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but ! it will be some time before we are able to better judge the forces underlying recent experience. This is but one of many uncertainties that will confront world policymakers. Over the past two decades, the industrial world has fended off two severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and, of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. In the United States, only five quarters in the past 20 years exhibited declines in GDP, and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward. Yet history cautions that people experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency, especially since several important economic challenges confront policymakers in the years ahead. Prominent among these challenges in the United States is the pressing need to maintain the flexibility of our economic and financial system. This will be essential if we are to address our current account deficit without significant disruption. Besides market pressures, which appear poised to stabilize and over the longer-run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction. Central to that adjustment must be an increase in net national saving. This serves to underscore the imperative to restore fiscal discipline. Beyond the near-term, benefits promised to a burgeoning retirement-age population under mandatory entitlement programs, most notably Social Security and Medicare, threaten to strain the resources of the working-age population in the years ahead. Real progress on these issues will unavoidably entail many difficult choices. But the demographics are inexorable, and call for action before the leading edge of baby boomer retirement becomes evident in 2008. This is especially the case because longer-term problems, if not addressed, could begin to affect longer-dated debt issues, the value of which is based partly on expectations of developments many years in the future. Another critical long-run economic challenge facing the United States is the need to ensure that our workforce is equipped with the requisite skills to compete effectively in an environment of rapid technological progress and global competition. Technological advance is continually altering the shape, nature, and complexity of our economic processes. But technology and, more recently, competition from abroad have grown to a point at which demand for the least-skilled workers in the United States and other developed countries is diminishing, placing downward pressure on their wages. These workers will need to acquire the skills required to compete effectively for the new jobs that our economy will create. At the risk of some oversimplification, if the skill composition of our workforce meshed fully with the needs of our increasingly complex capital stock, wage-skill differentials would be stable, and percentage changes in wage rates would be the same for all job grades. But for the past 20 years, the supply of skilled, particularly highly skilled, workers has failed to keep up with a persistent rise in the demand for such skills. Conversely, the demand for lesser-skilled workers has declined, especially in response to growing international competition. The failure of our society to enhance the skills of a significant segment of our workforce has left a disproportionate share with lesser skills. The effect, of course, is to widen the wage gap between the skilled and the lesser skilled. In a democratic society, such a stark bifurcation of wealth and income trends among large segments of the population can fuel resentment and political polarization. These social developments can lead to political clashes and misguided economic policies that work to the detriment of the economy and society as a whole. As I have noted on previous occasions, strengthening elementary and secondary schooling in the United States--especially in the core disciplines of math, science, and written and verbal communications--is one crucial element in avoiding such outcomes. We need to reduce the relative excess of lesser-skilled workers and enhance the number of skilled workers by expediting the acquisition of skills by all students, both through formal education and on-the-job training. Although the long-run challenges confronting the U.S. economy are significant, I fully anticipate that they will ultimately be met and resolved. In recent decades our Nation has demonstrated remarkable resilience and flexibility when tested by events, and we have every reason to be confident that it will weather future challenges as well. For our part, the Federal Reserve will pursue its statutory objectives of price stability and maximum sustainable employment--the latter of which we have learned can best be achieved in the long-run by maintaining price stability. This is the surest contribution that the Federal Reserve can make in fostering the economic prosperity and well-being of our Nation and its people. CHRG-111hhrg53246--67 Mr. Gensler," I thank you, and I thank you for the support in last year's farm bill for the additional authorities. The CFTC, under a statute that had been in place for some 70 years, sets limits in the agricultural space--corn, wheat, soy, and so forth--and has the authority, in fact, it says that we shall set them in other markets. And so what we have raised as a question is, we do it in the agricultural stock, we don't do it in the energy markets. The philosophy really is to protect against the burdens that may come from excess speculation. Speculators are good, they provide the other side for hedgers to hedge their transactions. But conceptually, it is that we have at least a minimum number of participants in a market place. If there is a diversity, if you had that 10 percent limit, then you would have at least 10 participants in a marketplace and lower the risk that there are dislocations. If they have to liquidate those positions, it actually lowers the risk in clearinghouses that we have been talking about today. So we are going to have hearings starting next week--I see Commissioner Dunn from the CFTC is here also today--and we will be looking at this over the next several weeks and then trying, if appropriate, to move on it during the fall. " CHRG-111hhrg56847--7 Mr. Bernanke," Chairman Spratt, Ranking Member Ryan and other members of the committee, I am pleased to have this opportunity to offer my views on current economic and financial conditions and on issues pertaining to the Federal budget. The recovery and economic activity that began in the second half of last year has continued at a moderate pace so far this year. Moreover, the economy, supported by stimulative monetary policy and a concerted effort of policymakers to stabilize the financial system, appears to be on track to continue to expand through this year and next. The latest economic projections of Federal Reserve Governors and Reserve Bank presidents, which were made near the end of April, anticipate that real gross domestic product will grow in the neighborhood of 3-\1/2\ percent over the course of 2010 as a whole and at a somewhat faster pace next year. If this pace of growth were to be realized, it would probably be associated with only a slow reduction in the unemployment rate over time. In this environment, inflation is likely to remain subdued. Although the support to economic growth and fiscal policy is likely to diminish in the coming year, the incoming data suggests that gains in private final demand will sustain the recovery in economic activity. Real consumer spending has risen at an annual rate of nearly 3\1/2\ percent so far this year, with particular strength in the highly cyclical category or durable goods. Consumer spending is likely to increase at a moderate pace going forward, supported by a gradual pickup in employment and income, greater consumer confidence, and some improvement in credit conditions. In the business sector, real outlays for equipment and software posted another solid gain in the first quarter and the increases were more broadly based than in late 2009. The available indicators point to continued strength in the second quarter. Looking forward, investment in new equipment and software is expected to be supported by healthy corporate balance sheets, relatively low cost of financing of new projects, increased confidence in the durability of the recovery, and the need of many businesses to replace aging equipment and expand capacity as sales prospects brighten. More generally, U.S. manufacturing output, which has benefited from strong export demand, rose at an annual rate of 9 percent over the first 4 months of this year. At the same time, significant restraints on the pace of the recovery remain. In the housing market, sales and construction have been temporarily boosted lately by the home buyer tax credit. But looking through these temporary movements, underlying housing activity appears to have firmed only a little since mid-2009, with activity being weighed down in part by a large inventory of distressed or vacant and existing houses and by the difficulties of many builders in obtaining credit. Spending on nonresidential buildings also is being held back by high vacancy rates, low property prices, and strained credit conditions. Meanwhile, pressures on State and local budgets, though tempered somewhat by ongoing Federal support, have led these governments to make further cuts in employment and construction spending. As you know, the labor market was hit particularly hard by the recession, but we have begun to see some modest improvement recently in employment, hours of work, and labor income. Payroll employment rose by 431,000 in May, but that figure importantly reflected an increase of 411,000 in hiring for the decennial consensus. Private payroll employment has risen an average of 140,000 per month for the past 3 months and expectations of both businesses and households about hiring prospects have improved since the beginning of the year. In all likelihood, however, a significant amount of time will be required to restore the nearly 8\1/2\ million jobs that were lost over 2008 and 2009. On the inflation front, recent data continue to show a subdued rate of increases in consumer prices. For the 3 months ending in April, the price index for personal consumption expenditures rose at an annual rate of just \1/2\ percent, as energy prices declined and the index excluding food and energy rose at an annual rate of about 1 percent. Over the past 2 years, overall consumer prices have fluctuated in response to large swings in energy and food prices. But aside from these volatile components, a moderation in inflation has been clear and broadly based over this period. To date, long-run inflation expectations have been stable, with most survey-based measures remaining within the narrow range that have prevailed for the past few years. Measures based on nominal index Treasury yields have decreased somewhat of late, but at least part of these declines reflect market responses to changes in the financial situation in Europe, to which I now turn. Since late last year, market concerns have mounted over the ability of Greece and a number of other euro-area countries to manage their sizeable budget deficits and high levels of public debt. By early May, financial strains had increased significantly as investors focused on several interrelated issues, including whether the fiscally stronger euro-area governments would provide financial support to the weakest members, the extent to which euro-area growth would be slowed by efforts of fiscal consolidation, and the extent of exposure of major European financial institutions to vulnerable countries. U.S. financial markets have been roiled in recent weeks by these developments, which have triggered a reduction in demand for risky assets. Broad equity market indexes have declined and implied volatility has risen considerably. Treasury yields have fallen as much as 50 basis points since late April, primarily as a result of safe-haven flows that boosted the demand for Treasury securities. Corporate spreads have widened over the same period and some issuance of corporate bonds have been postponed, especially by speculative grade issuers. In response to these concerns, European leaders have put in place a number of strong measures. Countries under stress have committed to address their fiscal problems. A major assistance package has been established jointly by the European Union and the International Monetary Fund for Greece. To backstop near-term financing needs of its members more generally, the EU has established a European financial stabilization mechanism with up to 500 billion euros in funding, which could be used in tandem with significant bilateral support from the IMF. EU leaders are also discussing proposals to tighten surveillance of members' fiscal performance and improve the design of the EU's fiscal support mechanisms. In addition, to address strains in European financial markets, the European Central Bank has begun purchasing debt securities in markets that it sees as malfunctioning. It has resumed auctions of 3 and 6-month loans of euros in unlimited quantities to borrowers with appropriate collateral. To help ease strains in U.S. dollar funding markets, the Federal Reserve has reestablished temporary U.S. dollar liquidity swap lines with the ECB and other major central banks. To date, drawings under these swap lines remain quite limited and far below their peaks reached at the height of the financial crisis in late 2008, but they are nevertheless providing an important backstop for the functioning of dollar funding markets. More generally, our ongoing international cooperation sends an important signal to global financial markets that we will take the actions necessary to ensure stability and continued economic recovery. The actions taken by European leaders represent a firm commitment to resolve the prevailing stresses and restore market confidence and stability. If markets continue to stabilize, then the effects of the crisis on economic growth in the United States seem likely to be modest. Although the recent fall in equity prices and weaker economic prospects in Europe will leave some imprint on the U.S. economy, offsetting factors include declines in interest rates and Treasury bonds and home mortgages, as well as lower prices for oil and some other globally traded commodities. The Federal Reserve will remain highly attentive to developments abroad and to their potential effects on the U.S. economy. Ongoing developments in Europe point to the importance of maintaining sound government finances. In many ways, the United States enjoys a uniquely favored position. Our economy is large, diversified, and flexible; our financial markets are deep and liquid; and as I have mentioned, in the midst of financial turmoil, global investors have viewed Treasury securities as a safe haven. Nevertheless, history makes clear that failure to achieve fiscal sustainability will over time sap the Nation's economic vitality, reduce our living standards, and greatly increase the risk of economic and financial instability. Our Nation's fiscal position has deteriorated appreciably since the onset of the financial crisis and the recession. The exceptional increase in the deficit has in large part reflected the effects of the weak economy on tax revenues and spending, along with the necessary policy actions taken to ease the recession and steady financial markets. As the economy and financial markets continue to recover and as the actions taken to provide economic stimulus and promote financial stability are phased out, the budget deficit should narrow over the next few years. Even after economic and financial conditions have returned to normal, however, in the absence of further policy actions, the Federal budget appears to be on an unsustainable path. A variety of projections that extrapolate current policies and make plausible assumptions about the future evolution of the economy show a structural budget gap that is both large relative to the size of the economy and increasing over time. Among the primary forces putting upward pressure on the deficit is the aging of the U.S. population, as the number of people expected to be working and paying taxes into various programs is rising more slowly than the number of people projected to receive benefits. Notably this year, about 5 individuals are between the ages of 20 and 64 for each person age 65 or older. By the time most of the baby boomers have retired in 2030, this ratio is projected to have declined to around 3. In addition, government expenditures in health care for both retirees and non-retirees have continued to rise rapidly as increases in the cost of care have exceeded increases in incomes. To avoid sharp disruptive shifts in spending programs and tax policies in the future and to retain the confidence of the public in the markets, we should be planning now how we will be meeting these looming budgetary challenges. Achieving long-term fiscal sustainability will be difficult, but unless we as a nation make a strong commitment to fiscal responsibility in the longer run, we will have neither financial stability nor healthy economic growth. Thank you, Mr. Chairman. I am happy to take your questions. [The prepared statement of Ben Bernanke follows:] Prepared Statement of Hon. Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System Chairman Spratt, Ranking Member Ryan, and other members of the Committee, I am pleased to have this opportunity to offer my views on current economic and financial conditions and on issues pertaining to the federal budget. the economic outlook The recovery in economic activity that began in the second half of last year has continued at a moderate pace so far this year. Moreover, the economy--supported by stimulative monetary policy and the concerted efforts of policymakers to stabilize the financial system--appears to be on track to continue to expand through this year and next. The latest economic projections of Federal Reserve Governors and Reserve Bank presidents, which were made near the end of April, anticipate that real gross domestic product (GDP) will grow in the neighborhood of 3\1/2\ percent over the course of 2010 as a whole and at a somewhat faster pace next year.\1\ This pace of growth, were it to be realized, would probably be associated with only a slow reduction in the unemployment rate over time. In this environment, inflation is likely to remain subdued.--------------------------------------------------------------------------- \1\ See ``Summary of Economic Projections,'' an addendum to the April Federal Open Market Committee minutes, available at Board of Governors of the Federal Reserve System (2010), ``Minutes of the Federal Open Market Committee, April 27-28, 2010,'' press release, May 19, www.federalreserve.gov/newsevents/press/monetary/20100519a.htm.--------------------------------------------------------------------------- Although the support to economic growth from fiscal policy is likely to diminish in the coming year, the incoming data suggest that gains in private final demand will sustain the recovery in economic activity. Real consumer spending has risen at an annual rate of nearly 3\1/2\ percent so far this year, with particular strength in the highly cyclical category of durable goods. Consumer spending is likely to increase at a moderate pace going forward, supported by a gradual pickup in employment and income, greater consumer confidence, and some improvement in credit conditions. In the business sector, real outlays for equipment and software posted another solid gain in the first quarter, and the increases were more broadly based than in late 2009; the available indicators point to continued strength in the second quarter. Looking forward, investment in new equipment and software is expected to be supported by healthy corporate balance sheets, relatively low costs of financing of new projects, increased confidence in the durability of the recovery, and the need of many businesses to replace aging equipment and expand capacity as sales prospects brighten. More generally, U.S. manufacturing output, which has benefited from strong export demand, rose at an annual rate of 9 percent over the first four months of the year. At the same time, significant restraints on the pace of the recovery remain. In the housing market, sales and construction have been temporarily boosted lately by the homebuyer tax credit. But looking through these temporary movements, underlying housing activity appears to have firmed only a little since mid-2009, with activity being weighed down, in part, by a large inventory of distressed or vacant existing houses and by the difficulties of many builders in obtaining credit. Spending on nonresidential buildings also is being held back by high vacancy rates, low property prices, and strained credit conditions. Meanwhile, pressures on state and local budgets, though tempered somewhat by ongoing federal support, have led these governments to make further cuts in employment and construction spending. As you know, the labor market was hit particularly hard by the recession, but we have begun to see some modest improvement recently in employment, hours of work, and labor income. Payroll employment rose by 431,000 in May, but that figure importantly reflected an increase of 411,000 in hiring for the decennial census. Private payroll employment has risen an average of 140,000 per month for the past three months, and expectations of both businesses and households about hiring prospects have improved since the beginning of the year. In all likelihood, however, a significant amount of time will be required to restore the nearly 8\1/2\ million jobs that were lost over 2008 and 2009. On the inflation front, recent data continue to show a subdued rate of increase in consumer prices. For the three months ended in April, the price index for personal consumption expenditures rose at an annual rate of just \1/2\ percent, as energy prices declined and the index excluding food and energy rose at an annual rate of about 1 percent. Over the past two years, overall consumer prices have fluctuated in response to large swings in energy and food prices. But aside from these volatile components, a moderation in inflation has been clear and broadly based over this period. To date, long-run inflation expectations have been stable, with most survey-based measures remaining within the narrow ranges that have prevailed for the past few years. Measures based on nominal and indexed Treasury yields have decreased somewhat of late, but at least part of these declines reflect market responses to changes in the financial situation in Europe, to which I now turn. developments in europe Since late last year, market concerns have mounted over the ability of Greece and a number of other euro-area countries to manage their sizable budget deficits and high levels of public debt. By early May, financial strains had increased significantly as investors focused on several interrelated issues, including whether the fiscally stronger euro-area governments would provide financial support to the weakest members, the extent to which euro-area growth would be slowed by efforts at fiscal consolidation, and the extent of exposure of major European financial institutions to vulnerable countries. U.S. financial markets have been roiled in recent weeks by these developments, which have triggered a reduction in demand for risky assets: Broad equity market indexes have declined, and implied volatility has risen considerably. Treasury yields have fallen as much as 50 basis points since late April, primarily as a result of safe-haven flows that boosted the demand for Treasury securities. Corporate spreads have widened over the same period, and some issuance of corporate bonds has been postponed, especially by speculative-grade issuers. In response to these concerns, European leaders have put in place a number of strong measures. Countries under stress have committed to address their fiscal problems. A major assistance package has been established jointly by the European Union (EU) and the International Monetary Fund (IMF) for Greece. To backstop near-term financing needs of its members more generally, the EU has established a European Financial Stabilization Mechanism with up to 500 billion euros in funding, which could be used in tandem with significant bilateral support from the IMF. EU leaders are also discussing proposals to tighten surveillance of members' fiscal performance and improve the design of the EU's fiscal support mechanisms. In addition, to address strains in European financial markets, the European Central Bank (ECB) has begun purchasing debt securities in markets that it sees as malfunctioning, and has resumed auctions of three- and six-month loans of euros in unlimited quantities to borrowers with appropriate collateral. To help ease strains in U.S. dollar funding markets, the Federal Reserve has reestablished temporary U.S. dollar liquidity swap lines with the ECB and other major central banks. To date, drawings under these swap lines remain quite limited and far below their peaks reached at the height of the financial crisis in late 2008, but they are nevertheless providing an important backstop for the functioning of dollar funding markets. More generally, our ongoing international cooperation sends an important signal to global financial markets that we will take the actions necessary to ensure stability and continued economic recovery. The actions taken by European leaders represent a firm commitment to resolve the prevailing stresses and restore market confidence and stability. If markets continue to stabilize, then the effects of the crisis on economic growth in the United States seem likely to be modest. Although the recent fall in equity prices and weaker economic prospects in Europe will leave some imprint on the U.S. economy, offsetting factors include declines in interest rates on Treasury bonds and home mortgages as well as lower prices for oil and some other globally traded commodities. The Federal Reserve will remain highly attentive to developments abroad and to their potential effects on the U.S. economy. fiscal sustainability Ongoing developments in Europe point to the importance of maintaining sound government finances. In many ways, the United States enjoys a uniquely favored position. Our economy is large, diversified, and flexible; our financial markets are deep and liquid; and, as I have mentioned, in the midst of financial turmoil, global investors have viewed Treasury securities as a safe haven. Nevertheless, history makes clear that failure to achieve fiscal sustainability will, over time, sap the nation's economic vitality, reduce our living standards, and greatly increase the risk of economic and financial instability. Our nation's fiscal position has deteriorated appreciably since the onset of the financial crisis and the recession. The exceptional increase in the deficit has in large part reflected the effects of the weak economy on tax revenues and spending, along with the necessary policy actions taken to ease the recession and steady financial markets. As the economy and financial markets continue to recover, and as the actions taken to provide economic stimulus and promote financial stability are phased out, the budget deficit should narrow over the next few years. Even after economic and financial conditions have returned to normal, however, in the absence of further policy actions, the federal budget appears to be on an unsustainable path. A variety of projections that extrapolate current policies and make plausible assumptions about the future evolution of the economy show a structural budget gap that is both large relative to the size of the economy and increasing over time. Among the primary forces putting upward pressure on the deficit is the aging of the U.S. population, as the number of persons expected to be working and paying taxes into various programs is rising more slowly than the number of persons projected to receive benefits. Notably, this year about 5 individuals are between the ages of 20 and 64 for each person aged 65 or older. By the time most of the baby boomers have retired in 2030, this ratio is projected to have declined to around 3. In addition, government expenditures on health care for both retirees and non-retirees have continued to rise rapidly as increases in the costs of care have exceeded increases in incomes. To avoid sharp, disruptive shifts in spending programs and tax policies in the future, and to retain the confidence of the public and the markets, we should be planning now how we will meet these looming budgetary challenges. Achieving long-term fiscal sustainability will be difficult. But unless we as a nation make a strong commitment to fiscal responsibility, in the longer run, we will have neither financial stability nor healthy economic growth. " CHRG-111shrg382--9 Mr. Sobel," The way I see the answer to that question, Mr. Chairman, we are going to work together really hard with---- Senator Bayh. And I had currency manipulation in mind, not--when they have loaned money to countries, they do have leverage there. But in some other areas--and they can make pronouncements, but moral suasion doesn't seem to be enough in some cases. " CHRG-111hhrg51698--473 Mr. Brickell," Mr. Chairman, I am very glad that you asked that question. I heard statements made from the prior panel, and I have certainly seen comments in the newspaper that suggest there are people who believe that swaps allow unlimited leverage or unlimited speculation. " CHRG-111hhrg54867--291 Secretary Geithner," You can't have a fixed list. It is going to have to evolve over time. It is going to require a careful judgment of who poses the most risk to the system. But the most important thing, I think, as you said, is they need to live under appropriately conservative constraints on leverage. And they are going to have to know what those constraints are. " CHRG-111hhrg48875--151 Secretary Geithner," And so what we have to do is to make sure that those institutions are subject to a more effective set of constraints on leverage and risk-taking. I don't see any other way to do it, because market discipline alone is not going to protect a system from that. But you're exactly right that you can do this in ways that will make the problem worse. " FOMC20081216meeting--479 477,MR. DUDLEY., May I add just one thing to that? It's also not clear to me that the private sector won't be clever enough to take these things and package them into securities that have the equity and the leverage embedded in them and sell them to people who want to get high rates of return. It might be a pretty interesting proposition. FOMC20050920meeting--90 88,MR. STERN.," Thank you, Mr. Chairman. Let me start with a few pertinent facts about the District economy, both pre- and post-Katrina. Overall, the District economy remains healthy. Employment is continuing to advance modestly; and in at least a few geographic areas, it seems likely that employment gains are being constrained by a lack of available labor. Construction activity, both residential and nonresidential, is strong and/or improving. And one of the large credit card issuers in our District has reported—and I think this is reflective of national conditions—that repayments on credit card debt are up and charge-offs are at a 10-year low. Higher fuel prices so far have not led to production cutbacks or plant closings in the District. Where possible, firms are switching to less expensive sources of energy, and surcharges are, of course, common. Higher energy prices do, though, seem to be particularly adverse for local governments and for farmers, who are also adversely affected by the infrastructure destruction and disruption in the Gulf area. As for the effects of Katrina on the national economy, at the qualitative level I think we actually have considerable experience in analyzing these kinds of shocks, and in my view the Greenbook at that level has it essentially right. It seems to me, as others have commented, that in the short term we will get a disruption to growth followed by a rebound and presumably ultimately a resumption of trend growth. And, as far as inflation is concerned, I think we will get an acceleration ultimately followed by a return to trend, assuming that policy adheres more or less to the path that it would have followed. At the quantitative level, though, it seems to me difficult to say anything precise with a lot of confidence. But I would venture that in these circumstances—because of the concentration September 20, 2005 65 of 117 relative to the energy and transportation infrastructure—the amplitude of the swings, both in terms of growth and inflation, and perhaps the duration of the adjustment, would be extended. There’s a temptation, I suppose, to exaggerate this. After all, a relatively small part of the economy is affected. But it seems to me that, in any event, uncertainty has increased. And if this overall description is roughly appropriate, then I find thinking about monetary policy more complicated than it was formerly. Moreover, I don’t think the situation is going to get clarified in the near term, because the incoming data, of course, will be difficult to read, given that they will be affected in one way or another by both the disruption and the recovery efforts as they proceed. In these circumstances, I feel most comfortable falling back on fundamentals—namely, the flexibility and strength of the underlying economy, which I don’t think are affected by this. So I come out with a view that it’s appropriate to continue on our path of removing policy accommodation, and I would favor a ¼ point increase in the fed funds rate. Having said that, I think we are getting to the point where we’ve removed a lot of accommodation. And one of these days we need to consider that and also think about how that ought to affect the language in the statement." fcic_final_report_full--142 Collateralized Debt Obligations Collateralized debt obligations (CDOs) are structured financial instruments that purchase and pool financial assets such as the riskier tranches of various mortgage-backed securities. 1. Purchase The CDO manager and securities firm select and purchase assets, such as some of the lower-rated tranches of mortgage-backed securities. 3. CDO tranches Similar to mortgage-backed securities, the CDO issues securities in tranches that vary based on their place in the cash flow waterfall. Low risk, low yield First claim to cash flow from principal & interest payments… New pool of RMBS and other securities AAA AAA next claim… 2. Pool The CDO manager and securities firm pool various assets in an attempt to next… etc. AA A AA A BBB BB get diversification benefits. BBB BB EQUITY High risk, high yield Figure . The securities firms argued—and the rating agencies agreed—that if they pooled many BBB-rated mortgage-backed securities, they would create additional diversifi- cation benefits. The rating agencies believed that those diversification benefits were significant—that if one security went bad, the second had only a very small chance of going bad at the same time. And as long as losses were limited, only those investors at the bottom would lose money. They would absorb the blow, and the other investors would continue to get paid. Relying on that logic, the CDO machine gobbled up the BBB and other lower-rated tranches of mortgage-backed securities, growing from a bit player to a multi-hundred- billion-dollar industry. Between  and , as house prices rose  nationally and  trillion in mortgage-backed securities were created, Wall Street issued nearly  billion in CDOs that included mortgage-backed securities as collateral.  With ready buyers for their own product, mortgage securitizers continued to demand loans for their pools, and hundreds of billions of dollars flooded the mortgage world. In ef- fect, the CDO became the engine that powered the mortgage supply chain. “There is a machine going,” Scott Eichel, a senior managing director at Bear Stearns, told a finan- cial journalist in May . “There is a lot of brain power to keep this going.”  Everyone involved in keeping this machine humming—the CDO managers and underwriters who packaged and sold the securities, the rating agencies that gave most of them sterling ratings, and the guarantors who wrote protection against their defaulting—collected fees based on the dollar volume of securities sold. For the bankers who had put these deals together, as for the executives of their companies, volume equaled fees equaled bonuses. And those fees were in the billions of dollars across the market. CHRG-110shrg50420--339 Mr. Gettelfinger," And what I would respond to that, Senator, is that we have brought in two professional groups to help us. We took action yesterday to delay or to defer the payments that are due on January the first of 2010. Senator Corker. But I am not going to get the payments if they go bankrupt, so again, I would like to ask--it is a serious question. Are you willing to take to your membership that type of proposal, which is the only way these guys--you have got to look at the fact they have X-debt today. They need to do away with at least two-thirds of their bond indebtedness. They have got to do away with at least half of their VEBA obligations in order to survive. And I am just asking if you are willing to do that, because otherwise, there is really no reason for us to be contemplating all these things. " fcic_final_report_full--250 Broderick was right about the impact of Goldman’s marks on clients and counter- parties. The first significant dispute about these marks began in May : it con- cerned the two high-flying, mortgage-focused hedge funds run by Bear Stearns Asset Management (BSAM). BEAR STEARNS ’S HEDGE FUNDS: “LOOKS PRETTY DAMN UGLY ” In , Ralph Cioffi and Matthew Tannin, who had structured CDOs at Bear Stearns, were busy managing BSAM’s High-Grade Structured Credit Strategies Fund. When they added the higher-leveraged, higher-risk Enhanced Fund in  they be- came even busier. By April , internal BSAM risk exposure reports showed about  of the High-Grade fund’s collateral to be subprime mortgage–backed CDOs, assets that were beginning to lose market value.  In a diary kept in his personal email account because he “didn’t want to use [his] work email anymore,” Tannin recounted that in  “a wave of fear set over [him]” when he realized that the Enhanced Fund “was going to subject investors to ‘blow up risk’” and “we could not run the leverage as high as I had thought we could.”  This “blow up risk,” coupled with bad timing, proved fatal for the Enhanced Fund. Shortly after the fund opened, the ABX BBB- index started to falter, falling  in the last three months of ; then another  in January and  in February. The market’s confidence fell with the ABX. Investors began to bail out of both Enhanced and High-Grade. Cioffi and Tannin stepped up their marketing. On March , , Tannin said in an email to investors, “we see an opportunity here—not crazy oppor- tunity—but prudent opportunity—I am putting in additional capital—I think you should as well.”  On a March  conference call, Tannin and Cioffi assured investors that both funds “have plenty of liquidity,” and they continued to use the investment of their own money as evidence of their confidence.  Tannin even said he was in- creasing his personal investment, although, according to the SEC, he never did.  Despite their avowals of confidence, Cioffi and Tannin were in full red-alert mode. In April, Cioffi redeemed  million of his own . million investment in En- hanced Leverage and transferred the funds to a third hedge fund he managed.  They tried to sell the toxic CDO securities held by the hedge funds. They had little success selling them directly on the market,  but there was another way. In late May, BSAM put together a CDO-squared deal that would take  billion of CDO assets off the hedge funds’ books. The senior-most tranches, worth . billion, were sold as commercial paper to short-term investors such as money market mutual funds.  CHRG-111hhrg56776--239 Mr. Foster," Thank you both for waiting around to the end here. In the Wall Street Journal's list of the recommendations for what should be done to reform the financial system, the number one recommendation was to improve capital standards, including the incorporation of contingent capital, into the capital structure of large financial firms. I was the author of the amendment that passed out of this committee, authorizing contingent capital requirements. And I understand it's being dealt favorably in the Senate proposal, as well. So, what I was interested in was what--do you view the role of the Fed in administering standards for contingent capital, and possibly administering the stress test that's often talked about as the trigger mechanism for the debt conversion? Do you think that's an appropriate Federal--one that's likely to happen? " FOMC20080805meeting--3 1,MR. DUDLEY.," 1 Thank you, Mr. Chairman. I am going to be referring to the handout in front of you. It seems to be getting thicker at every meeting. Since the June FOMC meeting, financial markets have been characterized by two distinct phases. Until the middle of July, share prices weakened substantially, and credit spreads widened. The financial sector's difficulties were at the forefront as housingprice declines continued to pressure this sector. The IndyMac failure led to uninsured depositors taking losses, and this roiled the regional banking sector. The equity prices of Fannie Mae and Freddie Mac plummeted, and their ongoing viability was called into question. The passage of housing legislation that provided support to the GSEs then led to an improvement in investor sentiment and a modest recovery in share prices. As shown in exhibit 1, financial sector shares led the recovery. However, the overall improvement in the broad market indexes was very modest, both in the United States and abroad (exhibit 2). Moreover, no meaningful improvement was evident in the corporate debt or CDS markets. CDS spreads have not changed much, and spreads of asset-backed securities have begun to widen again (exhibits 3 and 4). Despite intermeeting news that I would characterize on balance as more bad than good, this news did not trigger the type of risk-reduction spasms by investors that have sporadically plagued financial markets over the past year. Exhibits 5 and 6 compare the correlation of daily asset price changes across a broad array of asset classes in July to the corresponding period in March. The blue boxes denote correlations with absolute values of more than 0.5. As can be seen, asset price movements have become much less correlated. Although the mood is slightly improved today compared with a few weeks ago, the underlying news, especially from the financial sector, remains quite bleak in most respects. In particular, there is little conviction that financial shares have reached a bottom. This can be seen in the unusually high volatility of financial share prices (exhibit 7) and the positive skew in options prices for financial firms, in which the price of a put has been much higher than an equivalent out-of-the money call (exhibit 8). Financial market participants are paying more to protect the downside than to participate on the upside. Merrill Lynch's recent experience is reflective of the challenging environment faced by financial firms. Merrill Lynch raised new equity capital and announced that it had sharply reduced its net ABS CDO exposure. Investors were initially pleased that the company had bitten the bullet, and the share price rallied in response. But further consideration tempered the initial enthusiasm--and there are more articles on this in the Wall Street Journal today. A closer look revealed some troubling aspects of the transactions. First, Merrill Lynch took an additional $4.4 billion of CDO writedowns from the June quarter-end valuation date. Merrill Lynch sold CDO exposures with a par value of $30.6 billion to Lone Star for $6.7 billion. At quarter-end, these positions had been carried on the books for $11.1 billion. Second, this transaction resulted in a drop in net CDO exposure of only $1.7 billion because Merrill Lynch 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). provided 75 percent nonrecourse financing to Lone Star. Merrill Lynch gave away all the upside on these assets in exchange for a payment equal to 6 percent of their par value. Third, Merrill Lynch's equity issuance reportedly resulted in 38 percent dilution to existing shareholders. The dilution was exacerbated by the terms of an earlier share issuance agreement with Temasek, a Singapore sovereign wealth fund. This agreement granted Temasek a ""make whole"" provision if, within 12 months, common stock was issued at a price below Temasek's $48 per share investment. This resulted in Merrill Lynch's paying $2.5 billion to Temasek, which Temasek then rolled into a new $3.4 billion share investment. Over the past month, the troubles of Fannie Mae and Freddie Mac have taken center stage. Rising loan delinquencies for prime single-family mortgages caused share prices to plunge. This eroded confidence that the firms would be able to raise new equity capital and raised concerns about the viability of these firms. This, in turn, intensified the downward pressure on share prices. As a result, investors began to lose their enthusiasm for the firms' debt. Investors in short-term discount notes were uninterested in taking on any potential credit risk. As a result, issuance volumes fell, and discount note rates climbed (exhibits 9 and 10). Some investors in the firms' longer-term debt obligations--including some major foreign central banks--became unwilling to add to their long-term agency debt and agency MBS positions, and one or two of the central banks actually cut their positions somewhat. However, longerterm debt spreads did not change much because the loss of central bank demand was offset by buying from U.S. fixed-income asset managers, who believed that the implicit Treasury support of GSE debt was likely to be hardened (exhibit 11). Fannie and Freddie responded by issuing less debt. To husband their liquidity, the two firms have backed away from purchasing agency mortgage-backed securities for their own portfolios. The removal of this bid was one factor that caused the mortgage basis-- the spreads between the option-adjusted yield on agency MBS and other benchmark yields, such as Treasuries and interest rate swaps--to widen significantly (exhibit 12). The Congress responded by enacting housing legislation that included provisions that hardened the implicit government guarantee and, thus, reduced debt rollover risk. The Treasury now has authority to lend the GSEs an unlimited amount of funds, the magnitude being constrained only by the debt-limit ceiling. In response, discount note issuance costs have fallen in the most recent auctions. However, enactment of the legislation has not generated any comparable narrowing in the mortgage basis or resolved the longer-term outlook for the GSEs. The mortgage basis remains wide in part because Fannie Mae and Freddie Mac have few incentives to expand their balance sheets. Although their regulatory capital is still well above minimum levels, these capital standards are under review. Moreover, because further losses are likely in coming quarters, it is unclear how long this excess capital will be available to support portfolio growth. Of course, the two firms could respond by issuing new equity. However, the low level of these companies' share prices makes this option unattractive. To raise sufficient funds to ensure long-term viability would cause massive dilution for existing shareholders. To put this in perspective, the current market capitalization of Freddie Mac is only about $5 billion. This compares with a book of business in terms of its portfolio and guaranteed book of $2.2 trillion. Because the GSEs will likely remain reluctant to expand their balance sheets in the near term, the mortgage basis will probably remain elevated, keeping mortgage rates high. This will intensify the downward pressure on housing activity and prices, which in turn will lead to greater loan delinquencies and losses. The consequence will likely put further pressure on Fannie's and Freddie's capital positions. So what's the bottom line? In my view, the legislation has helped to avert--at least for now--a meltdown in the agency debt and agency MBS markets. But the passage is no panacea for ensuring the viability of Fannie Mae and Freddie Mac or in enabling the two firms to provide significant support to the U.S. housing market. One consequence of the GSE-related turbulence was a temporary pickup in demand in the most recent schedule 1 TSLF auction, on July 25 (exhibit 13). As term mortgage agency repo spreads widened relative to term Treasury repo rates, the cost of borrowing via the TSLF became more attractive. This illustrates how the TSLF program can act as a shock absorber and reduce volatility in term repo rates. With the exception of the July 25 auction, the TSLF auctions continue to be undersubscribed with relatively stable bid-to-cover ratios. In contrast to the turbulence evident in the financial sector, the bank term funding markets have been relatively stable since the June FOMC meeting. As shown in exhibits 14 and 15, the spreads of one-month LIBOR and three-month LIBOR to OIS remain elevated in the United States, Europe, and the United Kingdom. However, this masks the fact that forward funding rates appear to have risen significantly. As shown in exhibit 16, the forward three-month LIBOR�OIS spread has risen about 20 basis points over the past three months. This spread is now anticipated to remain elevated at around 50 basis points on a one-to-two-year time horizon, indicating that market participants expect term funding pressures to persist for the foreseeable future. Before the crisis, the spread was about 10 basis points. The U.S. TAF auctions also show a stable trend. As shown in exhibit 17, the bidto-cover ratio remains around 1.2 to 1, and the stop-out rate has been quite steady over the past five auctions. In contrast, as shown in exhibit 18, the bid-to-cover ratio for the ECB dollar auction continues to climb. As I noted in an earlier briefing, part of this rise reflects the fact that the ECB auction is noncompetitive. The bids are prorated, and the banks pay the U.S stop-out rate. Larger bids by European banks in the ECB auction do not affect the interest rate they pay for such funding, and that encourages more-aggressive bidding. Conversations with the ECB staff indicate that they are concerned that the outcome could be a bidding spiral. Individual banks could keep raising the size of their bid submissions to ensure a stable amount of dollar funding. It is possible that these pressures could eventually encourage the ECB to switch to a Swiss National Bank type of multiple-price auction. This would eliminate the incentives to bid more and more aggressively on the part of the European banks. However, such a change probably would result in a higher stop-out rate in the ECB auctions compared with the United States or Switzerland. ECB officials might not be fully comfortable with such an outcome. Early reactions by primary dealers and depository institutions to the two refinements to our liquidity facilities--the $50 billion program of options on the TSLF and the introduction of the longer, 84-day, maturity TAF auctions--have been favorable. We recently--last Friday and this Monday--completed an extensive set of interviews with the primary dealer community about the TSLF options program and will be proposing final terms, within the set of parameters approved by the FOMC on July 24, by the end of this week. Of course, we will keep you fully apprised as we go forward on this. As you know, our liquidity facilities have placed significant demands on the Federal Reserve's balance sheet, as the Chairman mentioned. As the liquidity facilities have been expanded, we have reduced the size of our Treasury portfolio. We do this to drain the reserves added by our liquidity programs. The use of our balance sheet to sterilize these reserve additions has raised questions about whether sufficient capacity is still available to meet prospective demand--especially a large unanticipated rise in PDCF or PCF borrowing. Exhibit 19 illustrates the transformation of the Federal Reserve System's balance sheet over the past year, out of Treasuries into non-Treasury lending. As shown in exhibit 20, the non-Treasury portion consists mainly of $150 billion of TAF loans, the $62 billion (in steady state) of foreign exchange swaps executed with the ECB and the SNB, and our $80 billion 28-day maturity, single-tranche repo program. Although the amount of Treasuries held in the SOMA portfolio still totals $479 billion, a majority of these securities are encumbered in one way or another. As shown in exhibit 21, from that $479 billion we need to allocate $45 billion of Treasuries to collateralize the foreign central bank repo pool, retain $35 billion of on-the-run Treasury securities to keep available for our traditional Treasury securities lending program, and set aside $175 billion for the TSLF program and now an additional $50 billion for the TSLF options program (TOP). When the options program is included, we have about $174 billion of unencumbered Treasuries available to offset additional PCF and PDCF borrowing or to fund further expansion of our liquidity programs. Obviously, further expansion of our TAF or TSLF auctions or single-tranche repo operations would be at our discretion and, thus, does not pose a meaningful problem in terms of reserve management. We wouldn't expand these programs if we didn't have the ability to conduct offsetting reserve draining operations. However, what would we do if faced with a huge rise in PCF or PDCF borrowing? An inability to drain the reserves added by such lending would cause the federal funds rate to collapse below the target. Fortunately, we have a number of alternatives that would enable us to offset very large demands for PCF or PDCF borrowing. First, we could sell our remaining unencumbered Treasury holdings or use them to engage in reverse repo operations with the primary dealer community. This could be augmented by the $35 billion of on-the-run Treasury securities currently set aside for securities lending. Together, these two sources could be used to drain more than $200 billion of reserves. Second, we have made arrangements with the Treasury so that, if the need arises, the Treasury would issue special Treasury bills into the market on our behalf and take the proceeds and deposit them at the Federal Reserve. Putting the proceeds of such T-bill sales on the Fed's balance sheet would drain reserves from the banking system. The potential scope here is large. The housing legislation raised the debt limit substantially. There is now about $1.2 trillion of headroom under the debt limit compared with only about $400 billion previously. Third, we continue to press for legislation that would accelerate the timing of the Federal Reserve's authority to pay interest on reserves. Being able to pay interest on reserves would put a floor under the federal funds rate. In this case, an inability to drain additional reserves from the banking system would not result in the federal funds rate collapsing toward zero. Finally, we continue to explore the legal and operational feasibility of expanding our balance sheet in other ways. For example, could we engage in reverse repurchase transactions using the collateral obtained from our single-tranche repo and from our TSLF operations? I wouldn't say I am confident that we can handle any eventuality--after all, the triparty repo system provides trillions of dollars of funding to the primary dealers. In the unlikely event that it all came to us, we wouldn't have the capacity to fully offset it at present. But we could accommodate hundreds of billions of dollars of demand if that proved to be necessary. That said, I want to go on record that any very large unanticipated demand for funding from the Federal Reserve by dealers or depository institutions might take a few days or more to offset by reserve-draining operations. Thus, in such a circumstance, the federal funds rate could temporarily trade below its target. Turning now to interest rate expectations, monetary policy expectations have reverted back to the very slow path toward tightening that was evident before the April FOMC meeting. As shown in exhibits 22 and 23, the federal funds rate and Eurodollar futures curves have shifted down sharply since the June FOMC meeting. Our current survey of the primary dealers shows an even slower anticipated pace of tightening. As shown in exhibit 24, the average of the dealer forecasts in our most recent survey anticipates no tightening until the second quarter of 2009. But the change in the dealers' forecasts since the June FOMC meeting is more modest than the shift in market expectations (compare exhibits 24 and 25). Looking at the probabilities of different rate outcomes implied by options on federal funds rate futures in exhibits 26 and 27, one sees that there has been a steady trend upward in the probability that the FOMC will keep its policy target rate unchanged at both the August and the September FOMC meetings. Note also that the probability assigned by market participants to further easing is lower than the probability assigned to tightening. The past month has been marked by a significant decline in commodity prices. As shown in exhibit 28, although the energy complex has led the way down, agriculture and industrial metals prices have also declined significantly. These declines have spurred a large decline in breakeven rates of inflation measured by the spread of nominal Treasury and TIPS yields (exhibit 29). As shown in exhibit 30, longer-term market-based indicators of inflation expectations have increased a bit. Both the Barclays' and the Board staff's measures of five-year, five-year-forward inflation implied by nominal Treasury versus TIPS yields have drifted upward since the June FOMC meeting. However, both measures remain well below the peaks reached in early March. 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 June FOMC meeting. As always, I am very happy to take any questions. " CHRG-111shrg50815--7 STATEMENT OF SENATOR SCHUMER Senator Schumer. I also have a moderately brief statement, like my colleague from across the Hudson River, but I thank you for calling on me. It is an issue that I have been involved with and care about for a long time. We know how important this is. Average credit card debt for the average--the average American family has $8,500 in credit card debt on a yearly income of $52,000. That ought to make you stop and think right then and there. I have been working on this issue for a long time. When I started in the 1980s, there were two schools. Some said disclosure is enough and competition would take hold. Others said, let us put limits. I was in the former school. I said, free market, let disclosure work. I worked long and hard on legislation and the Fed and the result was something that became known as the ``Schumer Box,'' clear, concise disclosures of important credit card terms in an easy-to-read table, and it worked. Before the Schumer Box, credit card interest rates were at 19.8 percent. Every company somehow came up with the conclusion that was the exact right rate. There was no competition. The box came in and rates came down. Good old fashioned American competition did the job. So it worked. Disclosures at that point seemed to be a good balance between consumer protection and fostering business and innovation. But now, credit card companies have become so clever at inducing consumers to buy and use cards and trapping them with high interest rates and fees that I believe disclosure is no longer enough. Over the past few years, we have seen explosion of debt. The card industry began using many of the same sales tactics as mortgage brokers, below-market fees or interest rates that shoot up for the most minor of infractions, and fine print, as Senator Menendez mentioned, containing dozens of fees that a consumer has to pay. Now, recently, the Federal Reserve updated the Schumer Box. I was glad to see that. But more has to be done. Consumers are trapped in a business model that is designed to induce mistakes and jack up fees. That sums it up. And then the fees go from 7 percent to 19 percent for some minor infraction on all the debt, something is very wrong and disclosure is not enough. The type of trip-wire pricing is predatory. It has to end. One issuer went so far as to provide its customers with incorrectly addressed return envelopes to ensure that consumer payments wouldn't arrive on time and allowed the company then to charge late payment fees. That is outrageous. Other companies charge fees so often, so many fees so often, borrowers end up paying over the limit fees because their credit has been maxed out by the previous round of fees, a vicious treadmill cycle. So as I said, the Fed has made a good step, but the rule, which doesn't go into effect until July 2010, that is too far from now. Too many families are struggling to make their minimum payment. And while the Fed's intentions are now good, we cannot be too shortsighted. There is going to come another time when credit will be loose and issuers will seek to roll back some of the important protections the Fed has implemented. That is why we must legislate. I have introduced the bill on the Senate side along with my friend, Senator Udall, that Congresswoman Maloney, my colleague, has introduced and successfully passed on the House side. And I know that Senator Dodd is considering many of the points in that legislation, as many of my other colleagues' legislation, when he puts together a bill, and I hope we will move one quickly, Mr. Chairman. Senator Johnson. Does anyone else feel absolutely compelled to make a comment? Senator Reed. Can I make a very, very, very brief comment? Senator Johnson. Senator Reed. FinancialCrisisReport--363 Many investors would likely have found the negative views of Mr. Lippmann, Deutsche Bank’s top CDO trader, important to their decision as to whether or not to buy Gemstone 7, but his views, as described above, were not disclosed to them. At the time, the traders on his desk as well as other Deutsche Bank CDO personnel knew that many clients valued and relied on Mr. Lippmann’s opinion when making investment decisions, yet did not disclose his views of the specific assets included in Gemstone 7. 1428 M&T Bank told the Subcommittee that had it known about Mr. Lippmann’s views, it might have “thought twice” before purchasing Gemstone 7 securities. 1429 (d) Gemstone Sales Effort Deutsche Bank began aggressively marketing Gemstone 7 to investors beginning in January 2007. 1430 The bank communicated with potential investors about Gemstone 7 in a variety of ways, including through emails, telephone calls, face to face meetings, and at conferences. Deutsche Bank personnel also went on what they called “road shows” to cities around the world, to meet investors and pitch the CDO to them. 1431 Sean Whelan, co-head of the Deutsche Bank CDO sales force, and Ilinca Bogza, a vice president in the Deutsche Bank syndicate group, worked to market Gemstone 7 to investors, including by scheduling road shows and personal meetings with potential investors. Investors were typically shown a “Debt Investor Presentation” that had been prepared by HBK and Deutsche Bank. 1432 That presentation provided an overview of the transaction, a description of HBK’s organization, and its investment strategy. The presentation highlighted investment considerations, including HBK’s expertise in the capital markets, how its structured products exhibit relatively stable performance, and their low default history. The presentation also contained a description of HBK’s analytical systems and surveillance capabilities, and included an appendix describing the risk factors for the deal. HBK told the Subcommittee that its employees attended investor meetings, and were at times called upon to answer questions, but did not always participate in the Gemstone 7 sales efforts which were led by Deutsche Bank. 1433 1426 11/29/2006 email from Larry Pike to Eleanny Pichardo and others, DB_PSI_01731794. 1427 11/30/2006 email from Jason Lowry at HBK to Abhayad Kamat and others, GEM7-00005480. See also Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33. 1428 See 7/6/2006 email from Axel Kunde to Greg Lippmann, DBSI_PSI_EMAIL01374694 (“If you tell the sales guy the bond is really bad his investor will use that as an argument against us and demand we buy back his note, because he trusted DB [Deutsche Bank] to pick a good portfolio etc, etc.”). 1429 Subcommittee Interview of M&T (9/20/2010). 1430 See, e.g., 1/25/2007 Deutsche Bank internal email chain, DB_PSI_00346491-99, at 99. 1431 Subcommittee interview of Sean Whelan (9/22/2010). 1432 See, e.g., 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 and 2/8/2007 Gemstone 7 Debt Investor Presentation, GEM7-00001687-1747. 1433 Subcommittee interview of Kevin Jenks (10/13/2010). CHRG-111shrg52966--57 Mr. Sirri," We had escalation procedures, and we used them. I do not want to come here and tell you that every time we did it perfectly. But I personally met with audit committee members when I felt that there was an issue that was not being resolved properly. But I do not want to overstate and say in each way we escalated as far as we should have looking back. We probably should have done more at times. Senator Reed. Mr. Polakoff, same general line of questions about the reliance upon internal models, the data of the company, sort of captive of what they are doing versus being--having the resources to leverage appropriately behavior. " CHRG-111hhrg67816--140 Mr. Leibowitz," I would say certainly if we had a little more leverage in our unfairness standard, we might be able to bring unfairness cases more often. We had a much broader standard in the 1960s and 1970s, and through the late 1970s, and then Congress asked us to modify first of our own volition and then it put it in the statute, I think, in 1992, our unfairness authority. So this has been the subject of some debate going back and forth about whether we should have a little more flexibility here. We would love to work with you on this. " CHRG-111hhrg51592--121 Mr. Bachus," That pretty much sums it up. I ask the panel, do any of you plan to rely on Congressman Ackerman's Cousin Sheldon for risk assessment? Probably not, right? Let me ask you this. Mr. Joynt, first of all, let me say this: I admire you for being here. It's my understanding that S&P and Moody's were not invited, but you were. That sort of leaves you out on the point. I want to ask you, just ask you some questions, just to try to understand where we go from here, as you said. If the debt issuers don't pay for these risk assessments--I mean, individual investors can't pay for them, so who would pay for them? Is there a practical--and I know people have talked about conflicts of interest. But who would fill that gap if the issuers did not? " CHRG-111shrg56415--80 PREPARED STATEMENT OF SHEILA C. BAIR Chairman, Federal Deposit Insurance Corporation October 14, 2009 Chairman Johnson, Ranking Member Crapo and members of the Subcommittee, I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) regarding the condition of FDIC-insured institutions and the deposit insurance fund (DIF). While challenges remain, evidence is building that financial markets are stabilizing and the American economy is starting to grow again. As promising as these developments are, the fact is that bank performance typically lags behind economic recovery and this cycle is no exception. Regardless of whatever challenges still lie ahead, the FDIC will continue protecting insured depositors as we have for over 75 years. The FDIC released its comprehensive summary of second quarter 2009 financial results for all FDIC-insured institutions on August 27. The FDIC's Quarterly Banking Profile provided evidence that the difficult and necessary process of recognizing loan losses and cleaning up balance sheets continues to be reflected in the industry's bottom line. As a result, the number of problem institutions increased significantly during the quarter. We expect the numbers of problem institutions to increase and bank failures to remain high for the next several quarters. My testimony today will review the financial performance of FDIC-insured institutions and highlight some of the most significant risks that the industry faces. In addition, I will discuss the steps that we are taking through supervisory and resolutions processes to address risks and to reduce costs from failures. Finally, I will summarize the condition of the DIF and the recent steps that we have taken to strengthen the FDIC's cash position.Economy In the wake of the financial crisis of last Fall and the longest and deepest recession since the 1930s, the U.S. economy appears to be growing once again. Through August, the index of leading economic indicators had risen for five consecutive months. Consensus forecasts call for the economy to grow at a rate of 2.4 percent or higher in both the third and fourth quarters. While this relative improvement in economic conditions appears to represent a turning point in the business cycle, the road to full recovery will be a long one that poses additional challenges for FDIC-insured institutions. While we are encouraged by recent indications of the beginnings of an economic recovery, growth may still lag behind historical norms. There are several reasons why the recovery may be less robust than was the case in the past. Most important are the dislocations that have occurred in the balance sheets of the household sector and the financial sector, which will take time to repair. Households have experienced a net loss of over $12 trillion in net worth during the past 7 quarters, which amounts to almost 19 percent of their net worth at the beginning of the period. Not only is the size of this wealth loss unprecedented in our modern history, but it also has been spread widely among households to the extent that it involves declines in home values. By some measures, the average price of a U.S. home has declined by more than 30 percent since mid-2006. Home price declines have left an estimated 16 million mortgage borrowers ``underwater'' and have contributed to an historic rise in the number of foreclosures, which reached almost 1.5 million in just the first half of 2009.\1\--------------------------------------------------------------------------- \1\ Sources: Moody's Economy.com (borrowers ``underwater'') and FDIC estimate based upon Mortgage Bankers Association, National Delinquency Survey, second quarter 2009 (number of foreclosures).--------------------------------------------------------------------------- Household financial distress has been exacerbated by high unemployment. Employers have cut some 7.2 million jobs since the start of the recession, leaving over 15 million people unemployed and pushing even more people out of the official labor force. The unemployment rate now stands at a 26-year high of 9.8 percent, and may go higher, even in an expanding economy, while discouraged workers re-enter the labor force. In response to these disruptions to wealth and income, U.S. households have begun to save more out of current income. The personal savings rate, which had dipped to as low as 1.2 percent in the third quarter of 2005, rose to 4.9 percent as of second quarter 2009 and could go even higher over the next few years as households continue to repair their balance sheets. Other things being equal, this trend is likely to restrain growth in consumer spending, which currently makes up more than 70 percent of net GDP. Financial sector balance sheets also have undergone historic distress in the recent financial crisis and recession. Most notably, we have seen extraordinary government interventions necessary to stabilize several large financial institutions, and now as the credit crisis takes its toll on the real economy, a marked increase in the failure rate of smaller FDIC-insured institutions. Following a 5-year period during which only ten FDIC-insured institutions failed, there were 25 failures in 2008 and another 98 failures so far in 2009. In all, FDIC-insured institutions have set aside just over $338 billion in provisions for loan losses during the past six quarters, an amount that is about four times larger than their provisions during the prior six quarter period. While banks and thrifts are now well along in the process of loss recognition and balance sheet repair, the process will continue well into next year, especially for commercial real estate (CRE). Recent evidence points toward a gradual normalization of credit market conditions amid still-elevated levels of problem loans. We meet today just 1 year after the historic liquidity crisis in global financial markets that prompted an unprecedented response on the part of governments around the world. In part as a result of the Treasury's Troubled Asset Relief Program (TARP), the Federal Reserve's extensive lending programs, and the FDIC's Temporary Liquidity Guarantee Program (TLGP), financial market interest rate spreads have retreated from highs established at the height of the crisis last Fall and activity in interbank lending and corporate bond markets has increased. However, while these programs have played an important role in mitigating the liquidity crisis that emerged at that time, it is important that they be rolled back in a timely manner once financial market activity returns to normal. The FDIC Board recently proposed a plan to phaseout the debt guarantee component of the Temporary Liquidity Guarantee Program (TLGP) on October 31st. This will represent an important step toward putting our financial markets and institutions back on a self-sustaining basis. And even while we seek to end the various programs that were effective in addressing the liquidity crisis, we also recognize that we may need to redirect our efforts to help meet the credit needs of household and small business borrowers. For now, securitization markets for government-guaranteed debt are functioning normally, but private securitization markets remain largely shut down. During the first 7 months of 2009, $1.2 trillion in agency mortgage-backed securities were issued in comparison to just $9 billion in private mortgage-backed securities. Issuance of other types of private asset-backed securities (ABS) also remains weak. ABS issuance totaled only $118 billion during the first 9 months of 2009 in comparison to $136 billion during the first 9 months of 2008 and peak annual issuance of $754 billion in 2006. Significant credit distress persists in the wake of the recession, and has now spread well beyond nonprime mortgages. U.S. mortgage delinquency and foreclosure rates also reached new historic highs in second quarter of 2009 when almost 8 percent of all mortgages were seriously delinquent. In addition, during the same period, foreclosure actions were started on over 1 percent of loans outstanding.\2\ Consumer loan defaults continue to rise, both in number and as a percent of outstanding loans, although the number of new delinquencies now appears to be tapering off. Commercial loan portfolios are also experiencing elevated levels of problem loans which industry analysts suggest will peak in late 2009 or early 2010.--------------------------------------------------------------------------- \2\ Source: Mortgage Bankers Association, National Delinquency Survey, Second Quarter 2009.---------------------------------------------------------------------------Recent Financial Performance of FDIC-Insured Institutions The high level of distressed assets is reflected in the weak financial performance of FDIC-insured institutions. FDIC-insured institutions reported an aggregate net loss of $3.7 billion in second quarter 2009. The loss was primarily due to increased expenses for bad loans, higher noninterest expenses and a one-time loss related to revaluation of assets that were previously reported off-balance sheet. Commercial banks and savings institutions added $67 billion to their reserves against loan losses during the quarter. As the industry has taken loss provisions at a rapid pace, the industry's allowance for loan and lease losses has risen to 2.77 percent of total loans and leases, the highest level for this ratio since at least 1984. However, noncurrent loans have been growing at a faster rate than loan loss reserves, and the industry's coverage ratio (the allowance for loan and lease losses divided by total noncurrent loans) has fallen to its lowest level since the third quarter of 1991.\3\--------------------------------------------------------------------------- \3\ Noncurrent loans are loans 90 or more days past due or in nonaccrual status.--------------------------------------------------------------------------- Insured institutions saw some improvement in net interest margins in the quarter. Funding costs fell more rapidly than asset yields in the current low interest rate environment, and margins improved in the quarter for all size groups. Nevertheless, second quarter interest income was 2.3 percent lower than in the first quarter and 15.9 percent lower than a year ago, as the volume of earning assets fell for the second consecutive quarter. Industry noninterest income fell by 1.8 percent compared to the first quarter. Credit quality worsened in the second quarter by almost all measures. The share of loans and leases that were noncurrent rose to 4.35 percent, the highest it has been since the data were first reported. Increases in noncurrent loans were led by 1-to-4 family residential mortgages, real estate construction and development loans, and loans secured by nonfarm nonresidential real estate loans. However, the rate of increase in noncurrent loans may be slowing, as the second-quarter increase in noncurrent loans was about one-third smaller than the volume of noncurrent loans added in first quarter. The amount of loans past-due 30-89 days was also smaller at the end of the second quarter than in the first quarter. Net charge-off rates rose to record highs in the second quarter, as FDIC-insured institutions continued to recognize losses in the loan portfolios. Other real estate owned (ORE) increased 79.7 percent from a year ago. Many insured institutions have responded to stresses in the economy by raising and conserving capital, some as a result of regulatory reviews. Equity capital increased by $32.5 billion (2.4 percent) in the quarter. Treasury invested a total of $4.4 billion in 117 independent banks and bank and thrift holding companies during the second quarter, and nearly all of these were community banks. This compares to a total of more than $200 billion invested since the program began. Average regulatory capital ratios increased in the quarter as well. The leverage capital ratio increased to 8.25 percent, while the average total risk-based capital ratio rose to 13.76 percent. However, while the average ratios increased, fewer than half of all institutions reported increases in their regulatory capital ratios. The nation's nearly 7,500 community banks--those with less than $1 billion in total assets--hold approximately 11 percent of total industry assets. They posted an average return on assets of negative 0.06 percent, which was slightly better than the industry as a whole. As larger banks often have more diverse sources of noninterest income, community banks typically get a much greater share of their operating income from net interest income. In general, community banks have higher capital ratios than their larger competitors and are much more reliant on deposits as a source of funding. Average ratios of noncurrent loans and charge-offs are lower for community banks than the industry averages. In part, this illustrates the differing loan mix between the two groups. The larger banks' loan performance reflects record high loss rates on credit card loans and record delinquencies on mortgage loans. Community banks are important sources of credit for the nation's small businesses and small farmers. As of June 30, community banks held 38 percent of the industry's small business and small farm loans.\4\ However, the greatest exposures faced by community banks may relate to construction loans and other CRE loans. These loans made up over 43 percent of community bank portfolios, and the average ratio of CRE loans to total capital was above 280 percent.--------------------------------------------------------------------------- \4\ Defined as commercial and industrial loans or commercial real estate loans under $1 million or farm loans less than $500,000.--------------------------------------------------------------------------- As insured institutions work through their troubled assets, the list of ``problem institutions''--those rated CAMELS 4 or 5--will grow. Over a hundred institutions were added to the FDIC's ``problem list'' in the second quarter. The combined assets of the 416 banks and thrifts on the problem list now total almost $300 billion. However, the number of problem institutions is still well below the more than 1,400 identified in 1991, during the last banking crisis on both a nominal and a percentage basis. Institutions on the problem list are monitored closely, and most do not fail. Still, the rising number of problem institutions and the high number of failures reflect the challenges that FDIC-insured institutions continue to face.Risks to FDIC-Insured Institutions Troubled loans at FDIC-insured institutions have been concentrated thus far in three main areas--residential mortgage loans, construction loans, and credit cards. The credit quality problems in 1-to-4 family mortgage loans and the coincident declines in U.S. home prices are well known to this Committee. Net chargeoffs of 1- to 4-famly mortgages and home equity lines of credit by FDIC-insured institutions over the past 2 years have totaled more than $65 billion. Declining home prices have also impacted construction loan portfolios, on which many small and mid-sized banks heavily depend. There has been a tenfold increase in the ratio of noncurrent construction loans since mid-year 2007, and this ratio now stands at a near-record 13.5 percent. Net charge-offs for construction loans over the past 2 years have totaled about $32 billion, and almost 40 percent of these were for one-to-four family construction. With the longest and deepest recession since the 1930s has come a new round of credit problems in consumer and commercial loans. The net charge-off rate for credit card loans on bank portfolios rose to record-high 9.95 percent in the second quarter. While stronger underwriting standards and deleveraging by households should eventually help bring loss rates down, ongoing labor market distress threatens to keep loss rates elevated for an extended period. By contrast, loans to businesses, i.e., commercial and industrial (C&I) loans, have performed reasonably well given the severity of the recession in part because corporate balance sheets were comparatively strong coming into the recession. The noncurrent loan ratio of 2.79 percent for C&I loans stands more than four times higher than the record low seen in 2007, but remains still well below the record high of 5.14 percent in 1987. The most prominent area of risk for rising credit losses at FDIC-insured institutions during the next several quarters is in CRE lending. While financing vehicles such as commercial mortgage-backed securities (CMBS) have emerged as significant CRE funding sources in recent years, FDIC-insured institutions still hold the largest share of commercial mortgage debt outstanding, and their exposure to CRE loans stands at an historic high. As of June, CRE loans backed by nonfarm, nonresidential properties totaled almost $1.1 trillion, or 14.2 percent of total loans and leases. The deep recession, in combination with ongoing credit market disruptions for market-based CRE financing, has made this a particularly challenging environment for commercial real estate. The loss of more than 7 million jobs since the onset of the recession has reduced demand for office space and other CRE property types, leading to deterioration in fundamental factors such as rental rates and vacancy rates. Amid weak fundamentals, investors have been re-evaluating their required rate of return on commercial properties, leading to a sharp rise in ``cap rates'' and lower market valuations for commercial properties. Finally, the virtual shutdown of CMBS issuance in the wake of last year's financial crisis has made financing harder to obtain. Large volumes of CRE loans are scheduled to roll over in coming quarters, and falling property prices will make it more difficult for some borrowers to renew their financing. Outside of construction portfolios, losses on loans backed by CRE properties have been modest to this point. Net charge-offs on loans backed by nonfarm, nonresidential properties have been just $6.2 billion over the past 2 years. Over this period, however, the noncurrent loan ratio in this category has quadrupled, and we expect it to rise further as more CRE loans come due over the next few years. The ultimate scale of losses in the CRE loan portfolio will very much depend on the pace of recovery in the U.S. economy and financial markets during that time.FDIC Response to Industry Risks and ChallengesSupervisory Response to Problems in Banking Industry The FDIC has maintained a balanced supervisory approach that focuses on vigilant oversight but remains sensitive to the economic and real estate market conditions. Deteriorating credit quality has caused a reduction in earnings and capital at a number of institutions we supervise which has resulted in a rise in problem banks and the increased issuance of corrective programs. We have been strongly advocating increased capital and loan loss allowance levels to cushion the impact of rising non-performing assets. Appropriate allowance levels are a fundamental tenet of sound banking, and we expect that banks will add to their loss reserves as credit conditions warrant--and in accordance with generally accepted accounting principles. We have also been emphasizing the importance of a strong workout infrastructure in the current environment. Given the rising level of non-performing assets, and difficulties in refinancing loans coming due because of decreased collateral values and lack of a securitization market, banks need to have the right resources in place to restructure weakened credit relationships and dispose of other real estate holdings in a timely, orderly fashion. We have been using a combination of offsite monitoring and onsite examination work to keep abreast of emerging issues at FDIC-supervised institutions and are accelerating full-scope examinations when necessary. Bankers understand that FDIC examiners will perform a thorough, yet balanced asset review during our examinations, with a particular focus on concentrations of credit risk. Over the past several years, we have emphasized the risks in real estate lending through examination and industry guidance, training, and targeted analysis and supervisory activities. Our efforts have focused on underwriting, loan administration, concentrations, portfolio management and stress testing, proper accounting, and the use of interest reserves. CRE loans and construction and development loans are a significant examination focus right now and have been for some time. Our examiners in the field have been sampling banks' CRE loan exposures during regular exams as well as special visitations and ensuring that credit grading systems, loan policies, and risk management processes have kept pace with market conditions. We have been scrutinizing for some time construction and development lending relationships that are supported by interest reserves to ensure that they are prudently administrated and accurately portray the borrower's repayment capacity. In 2008, we issued guidance and produced a journal article on the use of interest reserves,\5\ as well as internal review procedures for examiners.--------------------------------------------------------------------------- \5\ FDIC, Supervisory Insights, http://www.fdic.gov/regulations/examinations/supervisory/insights/sisum08/article01_Primer.html.--------------------------------------------------------------------------- We strive to learn from those instances where the bank's failure led to a material loss to the DIF, and we have made revisions to our examination procedures when warranted. This self-assessment process is intended to make our procedures more forward-looking, timely and risk-focused. In addition, due to increased demands on examination staff, we have been working diligently to hire additional examiners since 2007. During 2009, we hired 440 mid career employees with financial services skills as examiners and almost another 200 examiner trainees. We are also conducting training to reinforce important skills that are relevant in today's rapidly changing environment. The FDIC continues to have a well-trained and capable supervisory workforce that provides vigilant oversight of state nonmember institutions.Measures to Ensure Examination Programs Don't Interfere with Credit Availability Large and small businesses are contending with extremely challenging economic conditions which have been exacerbated by turmoil in the credit markets over the past 18 months. These conditions, coupled with a more risk-averse posture by lenders, have diminished the availability of credit. We have heard concerns expressed by Members of Congress and industry representatives that banking regulators are somehow instructing banks to curtail lending, making it more difficult for consumers and businesses to obtain credit or roll over otherwise performing loans. This is not the case. The FDIC provides banks with considerable flexibility in dealing with customer relationships and managing loan portfolios. I can assure you that we do not instruct banks to curtail prudently managed lending activities, restrict lines of credit to strong borrowers, or require appraisals on performing loans unless an advance of new funds is being contemplated. It has also been suggested that regulators are expecting banks to shut off lines of credit or not roll-over maturing loans because of depreciating collateral values. To be clear, the FDIC focuses on borrowers' repayment sources, particularly their cash-flow, as a means of paying off loans. Collateral is a secondary source of repayment and should not be the primary determinant in extending or refinancing loans. Accordingly, we have not encouraged banks to close down credit lines or deny a refinance request solely because of weakened collateral value. The FDIC has been vocal in its support of bank lending to small businesses in a variety of industry forums and in the interagency statement on making loans to creditworthy borrowers that was issued last November. I would like to emphasize that the FDIC wants banks to make prudent small business loans as they are an engine of growth in our economy and can help to create jobs at this critical juncture. In addition, the Federal banking agencies will soon issue guidance on CRE loan workouts. The agencies recognize that lenders and borrowers face challenging credit conditions due to the economic downturn, and are frequently dealing with diminished cash-flows and depreciating collateral values. Prudent loan workouts are often in the best interest of financial institutions and borrowers, particularly during difficult economic circumstances and constrained credit availability. This guidance reflects that reality, and supports prudent and pragmatic credit and business decisionmaking within the framework of financial accuracy, transparency, and timely loss recognition.Innovative resolution structures The FDIC has made several changes to its resolution strategies in response to this crisis, and we will continue to re-evaluate our methods going forward. The most important change is an increased emphasis on partnership arrangements. The FDIC and RTC used partnership arrangements in the past--specifically loss sharing and structured transactions. In the early 1990s, the FDIC introduced and used loss sharing. During the same time period, the RTC introduced and used structured transactions as a significant part of their asset sales strategy. As in the past, the FDIC has begun using these types of structures in order to lower resolution costs and simplify the FDIC's resolution workload. Also, the loss share agreements reduce the FDIC's liquidity needs, further enhancing the FDIC's ability to meet the statutory least cost test requirement. The loss share agreements enable banks to acquire an entire failed bank franchise without taking on too much risk, while the structured transactions allow the FDIC to market and sell assets to both banks and non-banks without undertaking the tasks and responsibilities of managing those assets. Both types of agreements are partnerships where the private sector partner manages the assets and the FDIC monitors the partner. An important characteristic of these agreements is the alignment of interests: both parties benefit financially when the value of the assets is maximized. For the most part, after the end of the savings and loan and banking crisis of the late 1980s and early 1990s, the FDIC shifted away from these types of agreements to more traditional methods since the affected asset markets became stronger and more liquid. The main reason why we now are returning to these methods is that in the past several months investor interest has been low and asset values have been uncertain. If we tried to sell the assets of failed banks into today's markets, the prices would likely be well below their intrinsic value--that is, their value if they were held and actively managed until markets recover. The partnerships allow the FDIC to sell the assets today but still benefit from future market improvements. During 2009, the FDIC has used loss share for 58 out of 98 resolutions. We estimate that the cost savings have been substantial: the estimated loss rate for loss share failures averaged 25 percent; for all other transactions, it was 38 percent. Through September 30, 2009, the FDIC has entered into seven structured transactions, with about $8 billion in assets. To address the unique nature of today's crisis, we have made several changes to the earlier agreements. The earlier loss share agreements covered only commercial assets. We have updated the agreements to include single family assets and to require the application of a systematic loan modification program for troubled mortgage loans. We strongly encourage our loss share partners to adopt the Administration's Home Affordable Modification Program (HAMP) for managing single family assets. If they do not adopt the HAMP, we require them to use the FDIC loan modification program which was the model for the HAMP modification protocol. Both are designed to ensure that acquirers offer sustainable and affordable loan modifications to troubled homeowners whenever it is cost-effective. This serves to lower costs and minimize foreclosures. We have also encouraged our loss share partners to deploy forbearance programs when homeowners struggle with mortgage payments due to life events (unemployment, illness, divorce, etc.). We also invite our loss share partners to propose other innovative strategies that will help keep homeowners in their homes and reduce the FDIC's costs. In addition, the FDIC has explored funding changes to our structured transactions to make them more appealing in today's environment. To attract more bidders and hopefully higher pricing, the FDIC has offered various forms of leverage. In recent transactions where the leverage was provided to the investors, the highest bids with the leverage option substantially improved the overall economics of the transactions. The overall feedback on the structure from both investors and market participants was very positive.The Condition of the Deposit Insurance FundCurrent Conditions and Projections As of June 30, 2009, the balance (or net worth) of the DIF (the fund) was approximately $10 billion. The fund reserve ratio--the fund balance divided by estimated insured deposits in the banking system--was 0.22 percent. In contrast, on December 31, 2007, the fund balance was almost $52 billion and the reserve ratio was 1.22 percent. Losses from institution failures have caused much of the decline in the fund balance, but increases in the contingent loss reserve--the amount set aside for losses expected during the next 12 months--has contributed significantly to the decline. The contingent loss reserve on June 30 was approximately $32 billion. The FDIC estimates that as of September 30, 2009, both the fund balance and the reserve ratio were negative after reserving for projected losses over the next 12 months, though our cash position remained positive. This is not the first time that a fund balance has been negative. The FDIC reported a negative fund balance during the last banking crisis in the late 1980s and early 1990s.\6\ Because the FDIC has many potential sources of cash, a negative fund balance does not affect the FDIC's ability to protect insured depositors or promptly resolve failed institutions.--------------------------------------------------------------------------- \6\ The FDIC reported a negative fund balance as of December 31, 1991 of approximately -$7.0 billion due to setting aside a large ($16.3 billion) reserve for future failures. The fund remained negative for five quarters, until March 31, 1993, when the fund balance was approximately $1.2 billion.--------------------------------------------------------------------------- The negative fund balance reflects, in part, an increase in provisioning for anticipated failures. The FDIC projects that, over the period 2009 through 2013, the fund could incur approximately $100 billion in failure costs. The FDIC projects that most of these costs will occur in 2009 and 2010. In fact, well over half of this amount will already be reflected in the September 2009 fund balance. Assessment revenue is projected to be about $63 billion over this 5-year period, which exceeds the remaining loss amount. The problem we are facing is one of timing. Losses are occurring in the near term and revenue is spread out into future years. At present, cash and marketable securities available to resolve failed institutions remain positive, although they have also declined. At the beginning of the current banking crisis, in June 2008, total assets held by the fund were approximately $55 billion, and consisted almost entirely of cash and marketable securities (i.e., liquid assets). As the crisis has unfolded, the liquid assets of the fund have been expended to protect depositors of failed institutions and have been exchanged for less liquid claims against the assets of failed institutions. As of June 30, 2009, while total assets of the fund had increased to almost $65 billion, cash and marketable securities had fallen to about $22 billion. The pace of resolutions continues to put downward pressure on cash balances. While the less liquid assets in the fund have value that will eventually be converted to cash when sold, the FDIC's immediate need is for more liquid assets to fund near-term failures. If the FDIC took no action under its existing authority to increase its liquidity, the FDIC projects that its liquidity needs would exceed its liquid assets next year.The FDIC's Response The FDIC has taken several steps to ensure that the fund reserve ratio returns to its statutorily mandated minimum level of 1.15 percent within the time prescribed by Congress and that it has sufficient cash to promptly resolve failing institutions. For the first quarter of 2009, the FDIC raised rates by 7 basis points. The FDIC also imposed a special assessment as of June 30, 2009 of 5 basis points of each institution's assets minus Tier 1 capital, with a cap of 10 basis points of an institution's regular assessment base. On September 22, the FDIC again took action to increase assessment rates--the board decided that effective January 1, 2011, rates will uniformly increase by 3 basis points. The FDIC projects that bank and thrift failures will peak in 2009 and 2010 and that industry earnings will have recovered sufficiently by 2011 to absorb a 3 basis point increase in deposit insurance assessments. We project that these steps should return the fund to a positive balance in 2012 and the reserve ratio to 1.15 percent by the first quarter of 2017. While the final rule imposing the special assessment in June permitted the FDIC to impose additional special assessments of the same size this year without further notice and comment rulemaking, the FDIC decided not to impose any additional special assessments this year. Any additional special assessment would impose a burden on an industry that is struggling to achieve positive earnings overall. In general, an assessment system that charges institutions less when credit is restricted and more when it is not is more conducive to economic stability and sustained growth than a system that does the opposite. To meet the FDIC's liquidity needs, on September 29 the FDIC authorized publication of a Notice of Proposed Rulemaking (NPR) to require insured depository institutions to prepay about 3 years of their estimated risk-based assessments. The FDIC estimates that prepayment would bring in approximately $45 billion in cash. Unlike a special assessment, prepaid assessments would not immediately affect the DIF balance or depository institutions' earnings. An institution would record the entire amount of its prepaid assessment as a prepaid expense (asset) as of December 30, 2009. As of December 31, 2009, and each quarter thereafter, the institution would record an expense (charge to earnings) for its regular quarterly assessment for the quarter and an offsetting credit to the prepaid assessment until the asset is exhausted. Once the asset is exhausted, the institution would record an expense and an accrued expense payable each quarter for its regular assessment, which would be paid in arrears to the FDIC at the end of the following quarter. On the FDIC side, prepaid assessments would have no effect on the DIF balance, but would provide us with the cash needed for future resolutions. The proposed rule would allow the FDIC to exercise its discretion as supervisor and insurer to exempt an institution from the prepayment requirement if the FDIC determines that the prepayment would adversely affect the safety and soundness of the institution. The FDIC believes that using prepaid assessments as a means of collecting enough cash to meet upcoming liquidity needs to fund future resolutions has significant advantages compared to imposing additional or higher special assessments. Additional or higher special assessments could severely reduce industry earnings and capital at a time when the industry is under stress. Prepayment would not materially impair the capital or earnings of insured institutions. In addition, the FDIC believes that most of the prepaid assessment would be drawn from available cash and excess reserves, which should not significantly affect depository institutions' current lending activities. As of June 30, FDIC-insured institutions held more than $1.3 trillion in liquid balances, or 22 percent more than they did a year ago.\7\--------------------------------------------------------------------------- \7\ Liquid balances include balances due from Federal Reserve Banks, depository institutions and others, Federal funds sold, and securities purchased under agreements to resell.--------------------------------------------------------------------------- In the FDIC's view, requiring that institutions prepay assessments is also preferable to borrowing from the U.S. Treasury. Prepayment of assessments ensures that the deposit insurance system remains directly industry-funded and it preserves Treasury borrowing for emergency situations. Additionally, the FDIC believes that, unlike borrowing from the Treasury or the FFB, requiring prepaid assessments would not count toward the public debt limit. Finally, collecting prepaid assessments would be the least costly option to the fund for raising liquidity as there would be no interest cost. However, the FDIC is seeking comment on these and other options in the NPR. The FDIC's proposal requiring prepayment of assessments is really about how and when the industry fulfills its obligation to the insurance fund. It is not about whether insured deposits are safe or whether the FDIC will be able to promptly resolve failing institutions. Deposits remain safe; the FDIC has ample resources available to promptly resolve failing institutions. We thank the Congress for raising our borrowing limit, which was important from a public confidence standpoint and essential to assure that the FDIC is prepared for all contingencies in these difficult times.Conclusion FDIC-insured banks and thrifts continue to face many challenges. However, there is no question that the FDIC will continue to ensure the safety and soundness of FDIC-insured financial institutions, and, when necessary, resolve failed financial institutions. Regarding the state of the DIF and the FDIC Board's recent proposal to have banks pay a prepaid assessment, the most important thing for everyone to remember is that the outcome of this proposal is a non-event for insured depositors. Their deposits are safe no matter what the Board decides to do in this matter. Everyone knows that the FDIC has immediate access to a $100 billion credit line at Treasury that can be expanded to $500 billion with the concurrence of the Federal Reserve and the Treasury. We also have authority to borrow additional working capital up to 90 percent of the value of assets we own. The FDIC's commitment to depositors is absolute, and we have more than enough resources at our disposal to make good on that commitment. I would be pleased to answer any questions from the members of the Subcommittee. ______ CHRG-109shrg26643--87 Chairman Bernanke," Senator, this actually ties back to the questions raised about the current account, for example. The reason we have a current account deficit is that we invest more, including housing, than we save, and we have to make up the difference by borrowing abroad, so our national saving is not sufficient to fund our domestic investment opportunities. It is a good thing in a sense that we are able to go to the international capital markets and find funding for good domestic investment opportunities, but we would be better off in some sense if we ourselves could fund those investment opportunities creating more wealth for Americans and greater capacity in the future for us to deal with the long-term challenges associated with demographic changes and the like. So, I think it is desirable for us to try to raise our national saving. There are various dimensions to that. One is on the fiscal side. We are looking in the next 5, 10, 15 years to increasing obligations and entitlement spending, for example, and increasing challenges in the Government's budget. Congress is going to have to make some very tough decisions about controlling the deficit, and by doing so, to the extent that the deficit can be reduced, that is a direct contribution to national saving and would be constructive. In addition, Americans, in part because of the increased wealth they have gained through increased home values and through other asset price increases, have not saved too much out of current income. In fact, the current saving out of disposable income is a negative rate. Senator Carper. Say that one more time. " CHRG-109shrg30354--93 Chairman Bernanke," We could try to do an evaluation with our models and the like. I am not sure how accurate it would be. In addition, the interesting thing about the energy price increases is that if you go back for 3 or 4 years and you look at each month at what the futures market was expecting, it was always expecting these things. We have had these increases, the energy prices are going to finally stabilize. And every single month it has been wrong. And so this increase in energy prices and commodity prices certainly has been a significant contributor. And I think that we would not really be talking about this now if energy prices were still $30 or $40 a barrel. Senator Sununu. Thank you, Mr. Chairman. " CHRG-110shrg50417--35 LEADERSHIP CONFERENCE ON CIVIL RIGHTS Ms. Zirkin. Thank you, Senator Dodd and other Members of the Committee. Again, I am Nancy Zirkin, Executive Vice President of the Leadership Conference on Civil Rights, our Nation's oldest and largest civil and human rights coalition. Let me begin by saying why the foreclosure crisis is so important to LCCR. Homeownership has always been one of the most important goals of the civil rights movement. It is the way most Americans build wealth and improve their lives, and it is essential to stable communities. For decades, LCCR has worked to break down barriers to fair housing, as well as the barriers from redlining and predatory lending, to the credit that most people need to own a house. For these reasons, we have argued for a number of years that the modern mortgage system was terribly flawed, that countless irresponsible and abusive loans were being made, often in a discriminatory way, and that without better regulations things would not end well. Now, after years of denial, I think it is quite obvious that the mortgage crisis is definitely not contained. But to date--and despite the best efforts of you, Mr. Chairman, and others--the whole collective response, based on voluntary efforts, has not done much to actually turn the tide. At the same time, there are helpful ideas out there now such as the FDIC proposal and the efforts of Bank of America and others. However, LCCR remains convinced that the best way to quickly reduce foreclosures is to let desperate homeowners modify their loans in Chapter 13. It would give borrowers leverage to actually negotiate with servicers and give them a last resort when the negotiations do not work. It does not use public funds, and more importantly, it would quickly help other homeowners and our economy by keeping the value of the surrounding homes from being eroded, stopping a vicious cycle that can only lead to more foreclosures. We recognize that the bankruptcy relief has faced intensive opposition from industry, which is ironic to us given the number of lenders that have obtained bankruptcy relief themselves. Opponents say that allowing bankruptcy would make investors hesitant, limiting ``access to credit'' for underserved populations. Well, the fact is right now, because of the years of irresponsible lending, there is no access to credit for most of the people, anyway. We are glad that since your last hearing several banks and the GSEs have planned to drastically increase their loan modification programs, following what the FDIC is doing with IndyMac. We are all for voluntary efforts. Every home that is saved is a step in the right direction. However, industry efforts have not provided enough affordable, lasting solutions for the borrowers. This obviously has a lot to do with securitization and second mortgages. Until these obstacles can be overcome, industry efforts cannot be a substitute for actually helping homeowners directly. The stakes are simply too high because the credit drought will not be mitigated until foreclosures are controlled. While LCCR is disappointed that the bankruptcy relief that was blocked earlier this year, we are encouraged by some of the recent discussions with FDIC about a new mortgage guarantee program. As we understand it, the plan would give new incentives for loan servicers to reduce payments to 30 percent debt-to-income ratio in return for Government guarantees. If the plan can be implemented quickly, and just as importantly, if it is quickly used by the servicers, we believe it will be a great improvement over existing efforts, including Hope for Homeowners Act, moratorium, or even the existing IndyMac plan. It also aims directly at the cause of the economic crisis--foreclosures. So it is a wise investment, especially with the latest controversies over how Wall Street has been using our tax dollars. For all of these reasons, while we have a few reservations, we strongly believe that the FDIC plan is well worth a try, and it should be adopted as quickly as possible. Before I conclude, I would be remiss, especially because this is the 40th anniversary of the Fair Housing Act, if I did not note that any measure to implement the financial rescue law must be done in a way that is fully consistent with all applicable civil rights laws--something I discuss in greater detail in my written testimony. Again, Mr. Chairman, thank you for the opportunity of testifying, and I look forward to answering questions. " FOMC20080109confcall--3 1,MR. DUDLEY.," 1 Thank you, Mr. Chairman. I'll be referring to the chart package that I hope you have in front of you. Market function has improved somewhat since the December FOMC meeting. This can be seen most notably in the term funding, foreign-exchange swap, and asset-backed commercial paper markets. In addition, some of the risks of contagion--for example, from troubled SIVs and from financial guarantors to money market mutual funds or the municipal securities market--appear to have lessened slightly. However, while market function has improved and contagion risks have diminished somewhat, the underlying strains on financial markets remain severe and may even have intensified. This can be seen in a number of areas, including (1) the wide spread of jumbo mortgage rates relative to conforming mortgages, (2) the equity prices and credit default swap spreads of a broad range of financial institutions, (3) developments in the commercial mortgagebacked securities market, and (4) corporate credit spreads and credit default swap spreads. Put simply, market participants believe that the macroeconomic outlook has deteriorated significantly and financial asset price movements broadly reflect that shift in expectations. Turning first to the better news, term funding pressures have moderated considerably over the past few weeks. As can be seen on the first page of the handout 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). in exhibits 1, 2, and 3, term funding spreads have fallen sharply for dollar, euro and sterling rates. For example, the one-month LIBOR�OIS spread is now 31 basis points, down from a peak of more than 100 basis points in December. However, the narrowing in three-month term spreads has been much more modest, and neither spread is back to where it was in late October or early November. Much of the recent improvement is undoubtedly due to the passage of year-end. But coordinated central bank term funding actions, including the term auction facility (TAF) and the dollar term funding auctions conducted by the ECB and the SNB, appear also to have been helpful. The first two TAF auctions went well, with bid-to-cover ratios of around 3 to 1 and stop-out rates below the 4.75 percent primary credit rate. Interestingly, term funding spreads narrowed notably on the two days when these auctions settled. This supports the notion that the TAF auctions did contribute to a lessening of term funding pressures. Moreover, market participants have generally reacted favorably to the news that the TAF auctions would continue and that the size of the January auctions would increase to $30 billion per auction. As hoped and anticipated, stigma appears to have been less of a factor for the TAF compared with the primary credit facility. The stop-out rate rose slightly in the second auction relative to the first, and some less healthy institutions bid more aggressively in the second auction. This suggests that, as depository institutions gain experience with the TAF, that might lead to an even further diminution of stigma. As term funding markets have improved, the foreign exchange swap market has also improved in terms of function. Bid-asked spreads have narrowed, and transaction sizes have increased. The all-in cost of funding via foreign exchange swaps has fallen back down to approximate the cost of straight dollar LIBOR financing. Improvement in market tone is also visible in the interest rate swap market. As can be seen in exhibit 4, swap spreads have fallen notably from the peaks reached in the fourth quarter. Another positive development has been the improvement in the asset-backed commercial paper market. The volume of ABCP outstanding has stabilized, and the spread between the thirty-day ABCP rate and the one-month OIS rate has narrowed sharply. The spread relative to one-month LIBOR is about back to what it was before the financial market turbulence began in August (exhibit 5). Bank sponsors have generally stepped forward to take problem SIV assets back on their balance sheets, and this has reduced the risk of asset fire sales. Also, the roll-up of SIV assets onto bank balance sheets has reduced the risk of further contagion to the money market mutual fund industry. Finally on the positive side of the ledger, although the financial guarantors remain under significant stress (as shown in exhibits 6 and 7, there has been no recovery in the share prices or CDS spreads for the two major financial guarantors--MBIA and Ambac), this has had only a modest effect on the municipal securities market. Apparently, investors have decided that the quality of the underlying municipal securities is quite good--the historical default experience after all has been very low--and therefore have not been that troubled by the decline in the quality of the insurance on these instruments. That said, any actual downgrade of the financial guarantors' credit ratings could still disturb the municipal market, in part, through its potential impact on insured municipal bond funds, which use the AAA ratings obtained from the insurance as a selling point to retail investors. Despite these positive developments in terms of market function, financial conditions have tightened as balance sheet pressures on commercial and investment banks remain intense and as the macroeconomic outlook has deteriorated. This can be seen in a number of respects. First, large writedowns and larger loan-loss provisions are cutting into bank and thrift capital and pushing down equity prices. For commercial and investment banks, the willingness of sovereign wealth funds and other investors to replenish capital has kept bank CDS spreads from widening back to the peaks reached a few months earlier. In contrast, major thrift institutions face greater difficulties in attracting new capital because their core business has soured. As a result, their CDS spreads have soared. The spread between fixed-rate jumbo mortgages and fixed-rate conforming mortgages has climbed again (see exhibit 8). This reflects the impairment of the mortgage securitization market and the lack of spare balance sheet capacity for commercial banks and thrift institutions. Second, corporate credit spreads and credit default indexes have widened sharply in the past few months, with a significant rise registered since year-end. As shown in exhibit 9, for investment-grade debt, the widening in spreads has roughly offset the fall in Treasury yields. As a result, investment-grade corporate bond yields have been relatively steady. In contrast, for non-investment-grade corporate debt, the widening in credit spreads has dwarfed the decline in Treasury yields. As a result, noninvestment-grade corporate debt yields have climbed sharply. Although actual corporate default rates have remained unusually low, forecasts of prospective default rates have become much more pessimistic. For example, Moody's announced yesterday that it had raised its speculative corporate debt default estimate for 2008 to 5.3 percent from 4.7 percent earlier. Exhibit 10 illustrates that, since mid-October, credit default swap spreads have been rising in both the United States and Europe. Third, equity markets are under pressure. For example, as illustrated in exhibit 11, the S&P 500 index declined in the fourth quarter and, up through yesterday, has fallen about 5 percent so far this year. Moreover, the equity market weakness has broadened out beyond the financial sector. For example, as of yesterday's close, the Nasdaq index, which has little weight in financials, had fallen 8 percent this year. Global stock market indexes have also generally weakened. Interestingly, the dollar has been relatively unaffected by the deterioration in the macroeconomic outlook. After rallying into year-end, the dollar has given back much of these gains over the past week. But over the past few months, the dollar has mainly been range-bound as opposed to being in the downward channel that applied for much of 2007 (exhibit 12 illustrates what the dollar has done lately against the yen and the euro). As the economic outlook has deteriorated, market participants' expectations of monetary policy easing have increased markedly. As shown in exhibit 13, the federal funds rate futures market now anticipates about 100 basis points of additional easing by midyear. As shown in exhibit 14, the Eurodollar futures market anticipates a bit more than 125 basis points of further easing by year-end 2008. Currently, as shown in exhibit 15, options prices on federal funds futures imply a probability of about 50 percent of a 50 basis point move through the January 29-30 FOMC meeting. Interestingly, market expectations for an intermeeting move appear to be relatively low. Although it is difficult to be precise about this, my best guesstimate is that the market has priced in about a 1-in-4 chance of a 25 basis point intermeeting rate cut. Although that means that a rate cut today would be a big surprise to market participants, it probably would be well understood in hindsight. The sharp downward skew in rate cut expectations that has been evident in recent months persists. As shown in exhibit 16, which looks at the expected distribution of Eurodollar futures rates 300 days ahead, the mode is 3.25 percent, well above the mean of the distribution. This likely reflects market participants' collective judgment that there are two distinct scenarios. The first (and more likely) scenario is one of an economic slowdown and a modest rise in the unemployment rate. This scenario is associated with perhaps 100 basis points of additional easing. The second scenario is a much darker one of a full-fledged recession. In this scenario, the unemployment rate would move up more sharply, and the magnitude of cumulative rate reductions would be much larger. Finally, despite the rise in headline consumer price inflation, the uptick in core consumer price inflation, and the atmospherics created by firmer gold and oil prices, market-based measures of inflation expectations remain very well behaved. As shown in exhibit 17, both the Barclays market-based measure of five-year, five-yearforward breakeven inflation and the Board's measure have narrowed since early November. Thank you. Of course, I'm happy to take any questions now or after David's presentation. " FOMC20080121confcall--19 17,MR. ROSENGREN.," I, too, strongly support reducing the federal funds rate 75 basis points. I am very concerned about financial market conditions detailed earlier by Bill. It is widely viewed in the business community that we are slipping into a recession. Problems with consumer debt are growing. I am concerned not only that we might be in, or about to be in, a recession. I am concerned also how severe a recession could be. It is time to take decisive and aggressive action, and I agree that, even with this cut, downside risks remain. Thank you. " CHRG-111hhrg53244--345 Mr. Grayson," Well, look at the next page. The very next page has the U.S. dollar nominal exchange rate, which shows a 20 percent increase in the U.S. dollar nominal exchange rate at exactly the same time that you were handing out half a trillion dollars to foreigners. Do you think that is a coincidence? " CHRG-111hhrg54873--29 Mr. Gallagher," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, my name is Dan Gallagher, and I am a Co-Acting Director at the Division of Trading and Markets at the Securities and Exchange Commission. Thank you for the opportunity to testify today regarding the oversight of credit rating agencies. I note at the outset that my written testimony today was approved by the Commission, but any remarks I make today, in particular on the draft bill, will be my own and may not reflect the views of the Commission. The poor performance of highly-rated securities over the last few years has resulted in substantial investor losses and increased market turmoil. As we work to restore the health of the markets, it is vital that we take further steps to improve the integrity and the transparency of the ratings process to promote competition among rating agencies and give investors the appropriate context for evaluating ratings. The proposed legislation Chairman Kanjorski recently released for discussion contains a number of measures that could enhance the Commission's oversight program, including provisions designed to address conflicts of interest, a lack of transparency and limited accountability in the credit rating industry. I would note that over the last few years, the Commission has been addressing a number of these issues and we welcome the opportunity to discuss these efforts. As you know, Congress provided the Commission with authority to register and oversee nationally recognized statistical rating organizations, NRSROs, in the Credit Rate Agency Reform Act of 2006. In the summer of 2007, using our new oversight authority and in response to gradually worsening marketing conditions, the Commission staff began examination of the three largest NRSROs--Fitch, Moody's, and Standard & Poor's--to look into their policies and practices relating to ratings of structured finance products linked to aggressively underwritten mortgages. To put it bluntly, the examinations revealed a number of serious problems. In particular, the examinations raised serious questions about the NRSROs' management of conflicts of interest, internal audit processes, and due diligence activities. Findings from these initial examinations informed a second round of rule amendments which the Commission proposed in June of 2008 and adopted in February of 2009. Earlier this month, on September 17th, the Commission embarked on further rulemaking designed to promote greater accountability, foster competition, decrease the level of undue reliance on NRSROs, and empower investors to make more informed decisions. The Commission adopted rule amendments designed to create a mechanism for NRSROs not hired to rate structured finance products to nonetheless determine and monitor credit ratings for these instruments. The goal of this rule is to make it possible for nonhired NRSROs to provide unsolicited ratings in the structured finance market just like they can in the corporate debt market. The Commission also adopted a requirement that NRSROs must disclose ratings history information for all outstanding ratings initially determined on or after June 26, 2007. This new disclosure requirement is designed to promote greater transparency of ratings, quality and increased accountability among NRSROs. The Commission also published for comment three sets of new requirements for NRSROs. The first proposal would increase accountability by requiring NRSROs to furnish the Commission with an annual compliance report describing actions taken to ensure compliance with the securities laws. The goal of this proposal is to increase accountability by strengthening the compliance function at the NRSROs and to alert the Commission to issues that may need to be examined. The second and third proposals would increase the information NRSROs must disclose to the public about the conflict of being paid for determining credit ratings and other services. These disclosures which would include a consolidated annual report are designed to provide investors with additional information on the source and magnitude of revenue, including revenues from non-rating services that an NRSRO receives from its clients. Notably, in its recent rulemaking, the Commission also proposed rating disclosure requirements for issuers of securities. For example, the Commission proposed amendments that would require certain detailed disclosures regarding credit ratings and registration statements. The Commission also proposed requiring the disclosure of preliminary ratings, as well as final ratings not used by an issuer so that investors would be informed when an issuer may have engaged in rating shopping. The Commission also took action to eliminate references to NRSRO credit ratings in certain of its rules and forms. This is designed to address concerns that references to NRSRO ratings and Commission rules may have contributed to an undue reliance on those ratings by market participants and the Commission found that the removal of references either improved the rules or had no effect on them. Finally, the Commission issued a concept release seeking comment on whether it should propose rescinding a rule that exempts NRSROs from expert liability under Section 11 of the Securities Act. Rescinding Rule 436(g), coupled with the proposal to require disclosure of credit ratings in a registration statement if a rating is used in connection with a registered offering, could cause NRSROs to be included in the liability scheme for experts set forth in Section 11. The Commission appreciates Congress' interest in this issue, and we stand ready to provide any assistance the subcommittee might need in its consideration of measures to reform the financial markets. I would be happy to answer any questions you may have. Thank you. [The prepared statement of Mr. Gallagher can be found on page 60 of the appendix.] " CHRG-110hhrg46593--271 Mr. Bartlett," We support the program as outlined by Mr. Findlay; and I put it, actually, in my written testimony. So we think that now that the capital infusion has been put in place, then the Treasury should be looking at other alternatives of additional ways to provide liquidity back in the market of which the asset guaranteed program, the asset purchase perhaps and perhaps the asset guarantee and the insurance program is a better, more leveraged way of providing the same thing. It is important to note that all the money that is needed for liquidity in the market cannot come from the government, not even a small fraction of it. So the government money has to be used to cause the private money to come to the table; and I think that is the basis of this insurance program, which is the right approach. " CHRG-110shrg50420--452 Chairman Dodd," People are watching. That is good. [Laughter.] Senator Corker. He, in essence, sent your applications back asking for more information, OK. So I take that as a rejection. Maybe I was a little bit too harsh. But the fact is that under 136, to receive funds, which you have all said are important to you, you have to be going entities. The Secretary has to certify, and this is pretty important, that each of you are going entities. Well, so I will go back to GM, which is why we are here, and again, I think you put forth a thoughtful plan, is you meet with people who follow you and invest in you. There are three things that basically cause you not to be a viable entity. As a matter of fact, we just got a quote while we were talking. In a 5-year credit default swap right now in your companies, basically, it is predicting that GM will default on its loans, 96 percent chance, OK, and Ford will default, 91 percent chance, and the large suppliers at 80 percent. So, I mean, you are really close to the end in most people's minds. There are three things that have kept GM, according to, I think, you and others, from being competitive. One is you have an unsustainable debt level. That has just occurred over time, and I realize we have had a pretty big peak to trough drop in cars sold, that it is unsustainable. And the fact is that all of you have got to be companies, in order to be successful, that whenever we get through doing whatever it is we might do, people are going to want to invest in you, right? I mean, that is the measure of a going concern. Will somebody else invest dollars in you? So reorganization is an interesting thing, because we know that going through that process, as painful as it is, you guys would come out without all the legacy stuff. To the dealers--I have had a lot of them calling in--probably a lot less dealers, and I am certainly not advocating that. That is just probably a fact of what would occur after bankruptcy. And the fact is, your cost structure would be far different. So I am going to try one more time, and I am going to ask Mr. Wagoner, if we put language in, and I know that we are somewhat paying attention here more so than we did I know the others, and probably because we didn't with the others, we are paying more attention with you--if we put something in--here is what is going to happen. If we put government dollars into General Motors, immediately, immediately, the day that money is deposited, your bond holders all of a sudden, instead of being willing to take 19 to 21 cents on the dollar, it is going to go way up because all of a sudden, we are in the game. And as Senator Bennett mentioned, we are patient and we print money here. I mean, there is no end to it, unfortunately. So that is a problem. That is a real problem. The bond holders, on the other hand, as I mentioned, are not going to take the kind of haircut they would unless Mr. Gettelfinger at UAW takes a bigger haircut, and Mr. Gettelfinger, you and I--I have to tell you, you have been an honest broker in this, too, in the way that you have talked with us and you have done a lot of things in the past, but the past is the past. We have got companies here that are about to go bankrupt and all of the contracts that you have negotiated, if they go bankrupt, are out the window, toast. It is over. All these VEBA arrangements, they are gone. So let me just ask of this as a reasonable thing to sort of put in place a bankruptcy-type situation where we would say that your bond holders would have to take 30 cents on the dollar, which is a 50 percent premium over where they are trading today, by March 31; that the UAW, and there are two representatives here that represent the folks in Tennessee and I have found them great to work with. The problem is that the rest of the citizens in our State and in Montana and in Connecticut and Utah, they have a tough time thinking about us loaning money to companies that are paying way, way above industry standard to workers while they are not getting paid that money. So in essence, they are subsidizing that through their taxpayer dollars. So my question would be, would it be reasonable to ask that the UAW by that time have agreed to pay scales that are equivalent to the transplants, and would it be reasonable that the UAW not just do away with the jobs bank, which is a situation where you continue to pay people whether they are working or not, but they also do away with the sub piece? Now, it is interesting sitting where I sit, because when labor comes in, they say, by the way, will you ask the companies this and make sure that they do that. And when the companies come in, they send me e-mails back saying, by the way, will you make sure that labor does away with these sub payments because they are worse by far than the job banks. They make us very, very uncompetitive. So again, if money goes out the door, we lose that leverage. It is over. The concern that Dr. Zandi has becomes real. It is never going to happen. There is no way the bond holders will do the things they need to do if they know the spigot is unlimited, and there is no way you can survive without a vastly changed capital structure. So if the Senate and the House were to say, we will forward the money to get you through March 31, period, and potentially more will come with a trustee, if your bond holders have gotten rid of their debt at 30 cents on the dollar, because if you bankrupt, it is toast, and if the UAW will get their wages rationalized to where we are paying exactly the same, not a penny more, to what the transplants are making, would that be something that you think would cause your companies to be where they need to be for the long haul? And by the way, I would add to that the VEBA payment of $21 billion is no small deal. That is a big deal. You can't pay that right now. That is not possible. So I would add to that that at least half of that would have to be equitized into the company to get the capital structure where almost every analyst in the world is looking at your company says you have to be to be that kind of going entity that would actually allow people to invest in you in the future, which is what you have got to have to be a successful company. Is that something that would be reasonable? " CHRG-111hhrg54869--167 Mr. Neugebauer," I thank the gentleman for accommodating me. One of the things that I hope that we all agree on, and I think I hear, is that there are no more bailouts. That is bad for market discipline, that companies that make bad decisions have to suffer the consequences of that. And one of the elements of the Republican alternative is that we believe there are ways to do that. One is making sure that entities are adequately capitalized. But secondly, not having someone choose which companies are systemically risky to the marketplace and thereby giving them a free pass on their market activities. But I want to go to the resolution issue because I think it is probably as equally important in restoring market discipline. One of the things that I am very concerned about in the current bill is that it is a wheel of fortune, as I call it, when you get to the bankruptcy or to the dissolution of that entity. Because if someone is arbitrarily going to just choose which people get made whole and which aren't and which people get a certain percentage and not follow some orderly discharge of those obligations, how am I going to estimate what my risk is when I am either buying equity or I am buying security or buying debt or I am buying subordinated debt or taking an unsecured position or secured position if somebody else is going to determine what my position is? So the Republican plan quite honestly has designed about, as I think Mr. Cochrane was talking about, is that if there are--we actually set up a special chapter in the Bankruptcy Code, and if there are special powers or additional expertise that are needed to make that discharge, but that way everybody that is making an investment in an organization knows that if this investment does go south, they understand what their position is and not relying on the wheel of fortune in some cases where if the wheel turns in my direction, I went from an unsecured to a more preferential position. Your comments, Mr. Cochrane? I will start with you and kind of just go down the line there. " FOMC20080310confcall--3 1,MR. DUDLEY.," Thank you, Mr. Chairman. Financial conditions have worsened considerably in recent days. Credit spreads have widened, equity prices have declined, and market functioning has deteriorated sharply. Although there are many factors that can be cited to explain what we are seeing--including the acute weakness in the U.S. housing sector, a deteriorating macroeconomic outlook, and the loss of faith in credit ratings and structured-finance products--we may have entered a new, dangerous phase of the crisis. Major financial intermediaries are pulling back more sharply and along more margins than previously--shrinking their collateral lending books and raising the haircuts they assess against repo collateral. For a time, this adjustment was occurring in a relatively orderly way, but we appear to have passed that point about ten days ago. The failure of Peloton--a major hedge fund--and the well-publicized problems of Thornburg Mortgage and Carlyle Capital Corporation in meeting margin calls have triggered a dangerous dynamic. That dynamic goes something like this: Asset price declines--say, triggered by deterioration in the outlook--lead to margin calls. Some highly leveraged firms are unable to meet these calls. Dealers respond by liquidating collateral. This puts downward pressure on asset prices and increases price volatility. Dealers raise haircuts further to compensate for the heightened volatility and the reduced liquidity in the market. This, in turn, puts more pressure on other leveraged investors. A vicious circle ensues of higher haircuts, fire sales, lower prices, higher volatility, and still lower prices, and financial intermediaries start to break as a liquidity crisis potentially leads to insolvency when assets are sold at fire sale prices. This dynamic poses significant risks. First, it impairs the monetary policy transmission mechanism. We have seen that in recent weeks in the sharp widening between mortgage rates on an option-adjusted basis and Treasury bond rates. Second, as hinted at above, there is a systemic issue. If the vicious circle were to continue unabated, the liquidity issues could become solvency issues, and major financial intermediaries could conceivably fail. I don't want to be alarmist, but even today we saw double-digit stock price declines for Fannie Mae and Freddie Mac. There were rumors today that Bear Stearns was having funding difficulties: At one point today, its stock was down 14 percent before recovering a bit. Third, the problems in one financial market disturb others. We have seen the problems move from subprime to alt-A mortgages to jumbo prime mortgages and now even agency mortgage-backed securities. Commercial-mortgage-backed security spreads and corporate credit spreads have also widened, and we have seen considerable distortions in the municipal market. The deterioration in market function can be seen in a number of ways. First, term funding spreads have widened back out. For example, the one-month LIBOR�OIS spread today is 56 basis points, up from its low point in 2008 of 16 basis points, which was reached in January. Second, haircuts for residential MBS have increased sharply, and if anything, the rate of deterioration in terms of haircuts has accelerated markedly in the last week. Third, bid-asked spreads for transactions on many types of financial instruments have widened, indicating a growing liquidity problem in the market. To address these issues, the Federal Reserve has responded by increasing the size of the TAF program and by implementing a large, term, single-tranche RP program. Together, these two programs will likely cumulate to total outstandings of about $200 billion. In addition, as the Chairman mentioned, the ECB and the SNB today have submitted requests to increase their foreign exchange swap draws and restart their term funding auctions. But there are limits to what these programs can do. The TAF provides liquidity only to depository institutions--this liquidity is not necessarily passed on readily to primary dealers and to other financial institutions. Although term RPs do provide some assistance to primary dealers, these operations are limited to the highest quality collateral--Treasuries, agencies, and agency mortgage-backed securities. Moreover, as both programs are scaled up, there is a large impact on reserves that must be offset by Treasury redemptions, sales, or reverse repurchase operations. Frankly, there are limits to our ability to adjust our portfolio quickly without our actions becoming a source of disruption to financial markets. For this reason, the staff has proposed a new facility, the term securities lending facility, or TSLF. A memo from the New York Fed staff and a term sheet were circulated to the FOMC earlier today, and these documents discuss in some detail this proposal. Let me give a summary of what I see as the most important points. In brief, this facility would expand the Federal Reserve's securities lending program for primary dealers by lending securities secured for a term of 28 days, rather than overnight, by a pledge of other securities--Treasuries, agencies, agency mortgagebacked securities, or AAA-rated private-label mortgage-backed securities. The last category is not currently eligible for open market operations (OMO). Currently, our securities lending program is overnight and exchanges only Treasuries for Treasuries. The purpose of this facility is to help alleviate the rapidly escalating pressures evident in term collateral funding markets. So how would this facility help to accomplish this? By providing the ability to swap illiquid mortgage-backed collateral for Treasury securities, the program would reduce the uncertainty among dealers about their ability to finance such collateral. The expanded supply of Treasuries obtained in the collateral swaps would improve the ability of primary dealers to finance the positions on their balance sheets. This should, in turn, increase the willingness of dealers to make markets across a range of securities. Better market-making, in turn, should lead to greater liquidity for these securities. This, then, should reduce price volatility and obviate the need for dealers to assess higher haircuts against such securities. The liquidity option provided by the TSLF should reduce liquidity risk more generally. The program should help slow, or even reverse, the dynamic process of reduced liquidity, greater price volatility, higher haircuts, margin calls, and forced liquidation. Why does the staff recommend that the scope of collateral be broader than OMOeligible collateral? The staff believes that a program based only on OMO collateral could help improve liquidity in those markets. An improvement in liquidity in these core markets could help other related markets. Despite this, the staff recommends that the TSLF go one step further and also accept AAA-rated private-label residentialmortgage-backed securities in this program. The staff believes that it is important to take this additional step because the level of dysfunction in the non-agency mortgagebacked securities market is pronounced, this market is large, and steps to improve market function in this asset class are likely to have positive consequences for the availability and the cost of mortgage finance. In other words, improvement in this area would make monetary policy more effective and would likely generate significant macroeconomic benefits. To limit the credit risk exposure of the Federal Reserve, the facility for nonOMO-eligible collateral would be limited to AAA-rated residential-mortgage-backed securities assets not on review for downgrade. In addition, the securities would be repriced daily, and appropriate haircuts would be applied against such securities. Why not go further? Although the SOMA lending facility could be extended to include other asset classes such as commercial-mortgage-backed securities, corporates, and municipals, the staff recommends against such a broader extension for two reasons. First, these markets are not under the same degree of duress as the residential-mortgage-backed securities market. Second, adding additional asset classes would increase the operational complexity and risk of the program--for example, by requiring additional auction cycles. What are the risks of such a program? We think there are several risks that are particularly noteworthy. First, we cannot be sure that the program will have its intended impact. Experience with the TAF suggests that it will, but there is no guarantee of this. Second, the TSLF could increase moral hazard. If the program is successful in preventing losses that would have arisen from an inability to obtain funding, the TSLF would be a form of insurance that could conceivably induce broker�dealers to run smaller liquidity cushions during normal times. Third, Federal Reserve credit risk would increase as the SOMA portfolio accepted lower-quality collateral from primary dealers. On the first point--Will it work?--the TSLF would be quite large, perhaps cumulating to $200 billion, the same size as the TAF and the term RP program combined. We can make it even bigger if we desire. So we think we have the muscle here to have an impact on term funding markets. On the second point--the moral hazard issue--the staff believes that the TSLF will increase moral hazard somewhat. Ideally, this type of program would also be accompanied by prudential regulation to ensure that primary dealers hold adequate liquidity buffers across the typical business cycle. On the third point--the issue of credit risk to the Federal Reserve--we conclude that there will inevitably be some increase in credit risk. But this risk should be controllable. We know our counterparties, we are not accepting securities that are on watch for downgrades, and the non-agency MBS securities will be AAArated. Moreover, we plan to limit the exposure to the more robust AAA-rated MBS by not accepting private-label MBS with CDO-type structures and characteristics. And if securities are put on watch, we can demand substitution. Fully cognizant of these risks and others--which are outlined in more detail in the memorandum circulated to the FOMC earlier today--we conclude that the benefits are likely to significantly exceed the costs of the program. The staff believes it is important to take those steps necessary to restore the monetary policy transmission mechanism to working order and to short-circuit the vicious dynamic now evident in financial markets. Debby Perelmuter will now describe the TSLF program in more detail, focusing on how it will operate in practice, now that I've outlined the theory. Debby. " CHRG-110shrg50410--28 Secretary Paulson," Then I will just say the third thing, because you asked for all three, and I think this is important here, because we have all been working--and you, Senator, have been a champion in this area. We have been working to get reform with a world-class regulator. And I think that when that regulator is in place and that regulator is up and going, I think there will be a real opportunity to have the discussion for what is the right size, what are the risk characteristics, capital requirements, business activities. And so I think you are going to be able to address the longer term. and this also addresses the short term. Senator Shelby. Secretary, what is the trigger, at what point, in other words, would Treasury exercise this new authority? And what if, for example, the equity price falls below a dollar? We know the consequences of that, I think. Or if debt cannot be issued, or is it at the--is it too wide a spread over the Treasurys? In other words, a lot of these events--you just want to reserve that---- " CHRG-111shrg56376--148 Mr. Ludwig," Well, Mr. Chairman, I think that it is important for the new regulatory agency to have departments that are specialized in dealing with institutions of a particular size. The Comptroller's office currently has three segments: one deals with small banks, one midsized, one large. I think that there are specialized techniques, ability to simplify supervision for community banks, and I think it is important. In that regard, I think the same kind of sensitivity to small bank supervision can be found both at the Federal Reserve and the FDIC. Remember, the only thing that one would do in terms of this new agency would be to move the Federal component of the supervisory authority to the new agency. It would not change the component. But I think one can have a separate division that focuses on simplifying it. I think that Congress, in writing these rules itself, ought to mandate that simplified treatment--that one of the responsibilities of the new agency is to reduce burden wherever possible, particularly in terms of community and regional financial institutions. " FOMC20080916meeting--140 138,MR. HOENIG.," Mr. Chairman, I have thought about this considerably because I think we have come to a time in our history when we have institutions that clearly ought to be and may in fact be too big to fail. I think we tend to react ad hoc during the crisis, and we have no choice at this point. But as you look at the situation, we ought, instead of having a decade of denying too big to fail, to acknowledge it and have a receivership and intervention program that extends some of the concepts of the FDIC but goes beyond that. That is, if you are insolvent, it is not a central bank issue--we are a liquidity provider--and therefore the government comes in. But unlike the GSEs, everyone has to take some hit--the equity holders, certainly the preferred stockholders, also the subordinated-debt holders, and perhaps the senior ones--by assuming a certain amount of loss. They would have immediate access to--pick a number--80 percent. The research would help us pick that number, and they can have access, but the rest becomes a subordinate-subordinate position after the liquidation so that you have still a sense of market discipline in play and you don't get the system gaming it in that, if you know there's a bailout coming, you buy the debt and sell the equity short to make a bundle. I think therein lie the distortions that are absolutely detrimental to the longrun health of the economy. Regarding how we go forward, I think we are going to have many lessons from this. Part of the problem has been very lax lending and, obviously now, weaknesses in some of the oversight. Also a history of our reacting from a monetary policy point of view to ease quickly to try to take care of the problem and, therefore, to create a sense in the market of our support has raised some real moral hazard issues that we now need to begin to remedy as we look forward in dealing with future receiverships. We are in a world of too big to fail, and as things have become more concentrated in this episode, it will become even more so. " CHRG-111shrg56376--33 Chairman Dodd," Thank you very much. Senator Brown. Senator Brown. Thank you. I was a little surprised by Senator Shelby's question, considering the positions that you have all taken. Let me look at this in kind of a different way. The public has a general understanding. The investing public and the victims of this financial disaster, which is my whole State and most of this country, has a general understanding that regulation of financial institutions, putting it mildly, fell far short. Some have the belief that the most, I think the most egregious institutions found an agency that was too easy on them. In Washington, we call that regulator shopping. They just think that the Government, for whatever reason, was too easy on Wall Street greed. And I hear each of you. There may be some turf issues, and that may be a cynical way to look at it and I apologize if that is the way you take it, but I hear the--I see the President's plan, the President's proposed bank supervision framework. I hear each of you disputing major parts of it. How would you explain to the American public what the next step is? How do we fill the financial gaps in our financial regulatory system if consolidation of regulators is not the best move? How do you explain to the public why four very smart people playing very important roles in our financial institution regulatory system and an Administration that, I think, has equally smart people that understand this, why is there not more agreement? How do you explain in understandable terms, if you were talking directly to the American people now, not to this Committee, what we should do to fill these gaps so these kinds of egregious, awful things don't happen again? I will start with you, Ms. Bair. Ms. Bair. Well, I think there was arbitrage, but it was between the bank and the nonbank sectors. It was excess leverage with investment banks and hedge funds and other types of vehicles versus the higher leverage in risk-based capital requirements that we had for commercial banks. On consumer protection, it was third-party mortgage originators that were not affiliated with insured depository institutions originating loans being funded by Wall Street funding vehicles. The third-party mortgage originators were pretty much outside of any type of prudential or consumer protection standards that were within the purview of the banking regulators. So I think it is unfortunate the word ``bank'' is used for just about every institution, but in my world, a bank is an FDIC-insured institution. While we all made mistakes, the insured depository institution sector has held up pretty well. This is why you saw in December so many financial companies fleeing to become bank holding companies and trying to grow their insured institutions, because that was the sector that was left standing, which is hard for the FDIC because our exposure has increased significantly. We have tried to do the things we need to do to stabilize the system. But, this has increased our exposure significantly. As I have testified before, the arbitrage is between the banks and the nonbanks. Having a consumer agency with a focus especially on examination and enforcement of the nonbank sector and having a Systemic Risk Council that would have the authority to define systemic issues or systemic institutions, whether or not they voluntarily want to come in under the more stringent regulatory regime we have for banks and bank holding companies. The arbitrage was between the bank and the nonbank sectors. It was not among different types of bank charters, and certainly not between the choice of a State or Federal charter. There are 8,000 community banks in this country. Most of them have a State charter, so consequently, we regulate about 5,000 banks. I don't think they contributed to this, but you have seen traditional resistance among community banks to regulatory consolidation for fear, frankly, which I share, that inevitably there would be a regulatory viewpoint that would be dominated by the larger institutions if everyone was lumped in together. There is a valid reason for State charters. The community banks and State-chartered community banks tend to be more local in their interest and how they conduct their lending. To try to draw that issue into the much larger problems we had with arbitrage between banks and nonbanks and then the lack of regulation of derivatives, I think, is misguided and is not where you should be focusing your efforts or the American public should be focusing its efforts. Senator Brown. Mr. Dugan, your thoughts? " FOMC20061025meeting--26 24,MR. STOCKTON.," As you know, those increases were very substantial in the spring. We had projected them to slow some. They have slowed some. Whether that is noise in the data or an actual response to developments on the ground in housing such as—as I think Governor Bies has mentioned—the possibility that some of this flow of excess housing may turn back into the rental market, and that could help put a lid on rents. We’re expecting a little further slowing going forward. As I noted in my remarks, I see some upside risk, so we’re taking comfort from the fact that those 0.4 and 0.5 percent increases that we saw in the spring have now been running more like 0.3 and 0.4 percent increases. But it’s too soon to conclude that that whole process is over—that it’s all worked out and that things are going to slow down. There’s enough volatility in those rents that we could experience a return to the increases that we saw in the spring. We’re not forecasting that, but I don’t think that outcome should be out of your probability distribution. Obviously, our reason for expecting some slowdown is that, in fact, there will be some adjustments in the housing market and especially that people’s expectations for price appreciation on owner-occupied dwellings have shifted down significantly. That downshift is going to make homeownership look less attractive and the rental market look stronger. That’s why we get some slowing but not so much as to go back to the rates that we had a year or two ago, when they were increasing more like 2 and 2½ percent." CHRG-110shrg50416--110 Chairman Dodd," I think the reason was raised--and, again, you have spent your adulthood working on these issues. But the old idea, in the auction process you are getting a dollar one for in, you buy an asset for one dollar, you get a dollar value out of it--or hopefully you do; whereas in the equity side you put that dollar in, you may leverage $10 or $100 off that. And so it seems like a more attractive idea if the goal is here to excite the capital markets to begin moving. And as between the two--and I understand the value of having the option of dealing with the auction process. But in terms of the overall goal to provide that kind of--that shock, the electro-shock to the system, to get that circulatory process working, the auction--excuse me, the equity position seems to be more designed to do that than the auction process. " CHRG-111shrg53085--132 Mr. Whalen," With healthy institutions, no. As it was, I think, alluded to before, the industry can't shoulder the burden of the losses that are coming toward us. The Treasury is going to have to be involved. So if you go to a strong institution that is well managed and you say, we are going to give you more capital. We want you to eat everything that Sheila is cooking coming out of the resolution process with the FDIC. I think that makes sense, but I wouldn't allow any further combinations for the top 15, 20 banks. Why? Until we know how they are. Call me in 18 months and then maybe we will revisit this issue. But I don't want to see any more large bank mergers until we know what their loss rates are going to look like and we know what their capital needs are. I think that is a reasonable position on large banks. Small banks, it is case by case because you have a lot of strong entities. You want them to buy troubled institutions to help the public. You want there to be continuity. I mean, the FDIC does this every Friday and they are expanding their capacity so they can do more resolutions. It is a beautiful thing. When they close a bank on a Friday, there is a new owner over the weekend and on Monday morning they open and the public is served. Senator Menendez. That, I understand. I was talking about large institutions purchasing other---- " FinancialCrisisInquiry--301 WALLISON: OK. Thank you. And Mr. Mack, would you answer the same question? And that is, at least there have been reports that the investment banks became much more highly leveraged after the SEC took over regulation in about 2004, and imposed Basel II regulations. Could you respond to that—why that happened? Or if it didn’t happen, see if you can explain why these allegations are out there? CHRG-111hhrg51591--108 Mr. Foster," My next question is, Alan Greenspan and others have this interesting suggestion of dealing with too-big-to-fail by simply imposing increasingly stringent capital requirements so that they would increase non-linearly as you increase in size, and that eventually there would be a motivation for a company that as it grew bigger, to split in two to get higher returns for its investors. And I was wondering if you have a reaction, if that would be appropriate for the insurance company. Yes, Mr. Harrington? " CHRG-111shrg56376--227 PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD This afternoon, we will examine how best to ensure the strength and security of our banking system. I would like to thank our witnesses for returning to share your expertise after the last hearing was postponed. Today, we have a convoluted system of bank regulators created by historical accident. Experts agree that nobody would have designed a system that worked like this. For over 60 years, Administrations of both parties, members of Congress, commissions, and scholars have proposed streamlining this irrational system. Last week I suggested further consolidation of bank regulators would make a lot of sense. We could combine the Office of the Comptroller of the Currency and the Office of Thrift Supervision while transferring bank supervision authorities from the Federal Deposit Insurance Corporation and the Federal Reserve, leaving them to focus on their core functions. Since that time, I have heard from many who have argued that I should not push for a single bank regulator. The most common argument is not that it's a bad idea--it's that consolidation is too politically difficult. That argument doesn't work for me. Just look what the status quo has given us. In the last year some of our biggest banks needed billions of dollars of taxpayer money to prop them up, and dozens of smaller banks have failed outright. It's clear that we need to end charter shopping, where institutions look around for the regulator that will go easiest on them. It's clear that we must eliminate the overlaps, redundancies, and additional red tape created by the current alphabet soup of regulators. We don't need a super-regulator with many missions, but a single Federal bank regulator whose sole focus is the safe and sound operation of the Nation's banks. A single operator would ensure accountability and end the frustrating pass the buck excuses we've been faced with. We need to preserve our dual banking system. State banks have been a source of innovation and a source of strength in their communities. A single Federal bank regulator can work with the 50 State bank regulators. Any plan to consolidate bank regulators would have to ensure community banks are treated appropriately. Community banks did not cause this crisis and they should not have to bear the cost or burden of increased regulation necessitated by others. Regulation should be based on risk--community banks do not present the same type of supervisory challenges their large counterparts do. But we need to get this right, which is why you are all here today. I am working with Senator Shelby and my colleagues on the Committee to find consensus as we craft this incredibly important bill. ______ FOMC20071031meeting--6 4,MR. DUDLEY.,"1 Thank you, Mr. Chairman. I am going to miss Karen as my fellow scribe at the BIS. She also was the person who identified who was actually speaking. [Laughter] Two crosscurrents have dominated financial markets since the September 18 FOMC meeting: (1) greater discrimination by investors with respect to credit quality across asset classes versus (2) ongoing deterioration in credit quality within the class of mortgage-related assets. On the one hand, underlying market function has generally improved. In particular, investors have shown greater ability to differentiate between the corporate and the mortgage sectors and between different types of products such as collateralized loan obligations (CLOs) versus collateralized debt obligations (CDOs). Most of the asset-backed commercial paper market is no longer under duress, bank funding pressures have abated somewhat, and the issuance of CLOs and high-yield debt has increased. On the other hand, those areas more closely linked to the U.S. housing sector remain under pressure. This includes the subprime mortgage market, the mortgage-backed securities market, and financial entities—such as mortgage and financial guarantors—that have significant exposures to these asset classes. The tension between the improved ability of investors to discriminate among risky assets versus the deteriorating fundamentals is illustrated in the performance of the ABX indexes. These indexes measure the cost of buying protection on different tranches of particular vintages of mortgage-backed securities that hold subprime mortgage loan assets. I will be referring to the handout in front of you. Exhibit 1 shows the performance for the 07-01 vintage—that is, mortgage-backed securities originated mainly during the second half of 2006. As can be seen, the prices of the lower-rated tranches have continued to plunge in response to rising delinquency rates for subprime loans and the virtual shutdown of the subprime mortgage market. In contrast, the performance of the AAA-rated tranche has held up better, especially until very recently. This suggests that investors are more carefully distinguishing between the implications of widespread subprime losses for those tranches, such as AAA, that are in a senior position in the structure versus lower-rated tranches, where the losses may well be large enough to wipe out their value altogether. Similarly, investors appear to be doing a better job of discriminating between the different types of asset-backed commercial paper programs. Those with high-quality, diversified 1 Materials used by Mr. Dudley are appended to this transcript (appendix 1). collateral or strong bank support or both are performing well. In contrast, those programs with less solid support—mainly SIV and extendible programs—in which the commercial paper holders are more vulnerable to loss continue to hit liquidity and capital triggers and are gradually being wound down. As shown in exhibit 2, the overall asset-backed commercial paper market has been contracting recently at a much slower pace than earlier in the summer. Moreover, secured commercial paper rates have narrowed significantly relative to the overnight index swap rate and relative to top-quality unsecured commercial paper (exhibit 3). The ability of banks to securitize assets also appears to have improved. In particular, as shown in exhibits 4 and 5, CLO and high-yield debt issuance has picked up. However, CDO issuance remains very depressed relative to the level of issuance earlier in the year. Investors have lost confidence in this product as market prices have plunged and the rating agencies have begun to cut their ratings, often very sharply, on many outstanding CDOs. Market participants are more willing to buy corporate debt for three reasons. First, the underlying fundamentals in the corporate sector remain good. Second, the underlying assets are much easier to value. Third, investors are more willing to trust the credit ratings in this area. The rating agency models have been battle-tested over a much longer period and have been shown to be robust across a broad range of environments. In contrast, the ability of banks to securitize nonconforming mortgage loans remains impaired. Nevertheless, spreads between jumbo and conforming mortgage loan rates have come in a bit (see exhibit 6). This may reflect diminished pressure on bank balance sheets from other sources. Overall, term funding pressures for banks have diminished as banks have gained greater clarity about their future funding needs and the need for excess liquidity has diminished. Nevertheless, term funding pressures still persist. As can be seen in exhibit 7, although the spreads between one-month LIBOR and the one-month overnight index swap rate and three-month LIBOR and the three-month overnight index swap rate have narrowed, these spreads remain high relative to the level of spreads evident at the beginning of the summer. Exhibit 8 shows the same spreads for Europe—they have also come in but remain higher than normal. Although the credit default swap (CDS) spreads for the large investment banks and the large commercial banks narrowed following the last FOMC meeting, much of this improvement has been reversed over the past two weeks as the housing outlook has deteriorated further and as the earnings announcements for several major financial institutions have disappointed investors. Similarly, the CDS spreads for mortgage insurers and financial guarantors have widened. These CDS spreads are shown in exhibit 9. The broader bond and equity markets have generally shown improvement. In the fixed income market, credit default swap spreads have fallen somewhat for the high- yield debt market (see exhibit 10), and the U.S. equity market has largely recovered over the past couple of months (see exhibit 11). Interestingly, despite the poor earnings of the financial sector and the outlook for slower U.S. growth, earnings expectations of equity analysts for 2007 have declined only slightly, and the decline in 2007 has been offset by an upward revision to 2008 earnings estimates (see exhibit 12). Moreover, the demand for downside protection in the equity market has diminished. Exhibit 13 examines the relative cost of buying a put versus a call. A positive skew is consistent with a greater cost of downside protection. Although a significant positive skew persists, it is now much lower than it was immediately before the September 18 FOMC meeting. Exhibits 14 and 15 summarize the incomplete transition away from risk-reduction behavior by financial market participants. Exhibit 14 shows the correlation of daily price movements and yield changes across the different asset classes for the time interval between the August and the September FOMC meetings. As can be seen, the correlations were very high— indicating that risk aversion was the dominant impulse among investors—with most of the correlations over this period exceeding an absolute value of 0.5. These are shaded in blue in the exhibit. In contrast, the same correlations since the September 18 FOMC meeting, shown in exhibit 15, have come down but remain much higher than during the first half of the year. Two other market developments deserve a brief mention before I turn to dealer expectations concerning monetary policy and a brief look at inflation expectations. First, crude oil prices have shot higher. There is considerable disagreement among market participants about how long the higher prices will last and the factors behind the price surge. Although some argue that it is speculative, others point to more- fundamental drivers such as inventory drawdowns, geopolitical uncertainties, and dollar weakness. Regardless of the cause, the effect on the macroeconomy has been modest up to now because higher crude oil prices have not fed through meaningfully into product prices. That is because the so-called crack spread—the margin between the value of the refined products produced from that crude oil and the cost of crude oil supply—has come down sharply, as shown in exhibit 16. The narrowness of the crack spread implies that further increases in crude oil prices, if forthcoming, would likely feed through into product prices. Second, the dollar continues on its gradual downward course. Although the dollar has reached new lows against the euro and the Canadian dollar, the overall pace of the decline as measured by the broad trade- weighted index has not changed much from the trend exhibited earlier in the year (see exhibit 17). The dollar’s trajectory still appears to be driven mainly by interest rate differentials. This can be seen in exhibit 18, which shows the dollar versus the euro relative to the Eurodollar–EURIBOR interest rate differential. Moreover, there is little evidence that the dollar’s slide has made investors less willing to participate in the long end of the U.S. bond market. You can see that by the fact that U.S. 10-year Treasury note yields are still fairly low, trading around 4.4 percent. Market expectations about monetary policy have shown considerable variability since the last FOMC meeting. Exhibit 19 tracks the implied probability of different target rate outcomes at this meeting calculated from the option prices on federal funds futures contracts. As can be seen in the exhibit, the probability of a 25 basis point cut has fluctuated in a wide range. The most recent survey of primary dealers, conducted ten days ago, shows a slight tilt toward a 25 basis point cut at the current meeting, with eleven dealers expecting a 25 basis point cut, nine expecting no change, and one expecting a 50 basis point reduction. Since that time a number of dealers have shifted camp. Currently, a more informal survey by the Desk indicates that nineteen out of twenty-one dealers expect a 25 basis point rate cut at this meeting. Exhibits 20 and 21 show the primary dealer forecasts for the federal funds rate before the September and the current FOMC meetings. As can be seen, the dealers’ forecasts for the federal funds rate path are currently a bit lower than before the September 18 meeting—partially reflecting the fact that the FOMC easing of 50 basis points at the September meeting was of greater magnitude than the cut embodied in the average dealer forecast. Also, the gap between the dealers’ forecasts and the expectations embodied in market rates has narrowed over the past six weeks. As can be seen, considerable disagreement about the rate path remains. One year out, the dispersion of the modal dealer forecasts remains very wide. Inflation expectations increased following the 50 basis point rate cut in September. However, the degree of widening is sensitive to how the forward breakeven inflation rate is calculated. Exhibit 22 shows the five-year, five-year- forward implied inflation rate as estimated by the Board staff versus the five-year, five-year-forward breakeven inflation rate as estimated by Barclays Bank, a major participant in the TIPS market. As can be seen in the exhibit, typically these two measures move together. More recently, however, they have diverged a bit, with the Board staff measure showing a more persistent increase following the September FOMC meeting. The two measures differ in the securities that they use to compare nominal versus inflation-adjusted yields—with the Board staff using a smoothed yield curve based on off-the-run nominal Treasuries and the Barclays measure using the on-the-run nominal five-year and ten-year Treasury notes to compare with the five- year and ten-year TIPS notes. However, liquidity differences among Treasury securities are hard to model. As a result, it is difficult to be confident of the accuracy of such adjustments. This argues that one should not completely dismiss the Barclays measure when the two measures are behaving differently. This might especially be true when no rise in long-term inflation expectations is evident in other measures, such as the University of the Michigan’s survey of consumer sentiment or the Desk’s own primary dealer survey. Finally, I want to discuss briefly the Desk’s performance in implementing the FOMC’s directive from the last meeting for a 4.75 percent federal funds rate target. In this respect, let me make two observations. First, in contrast to the previous intermeeting period, in which the effective rate traded below the target for much of the period, the average effective rate has been extremely close to the target since the September 18 meeting. Exhibit 23 shows the cumulative effective rate relative to the target since the last meeting. Second, as shown in exhibit 24, there has still been more day-to-day volatility in the federal funds rate than earlier in the year. This pattern likely reflects several factors, including the demand by European banks for funds early in the day and the reduced spread between the discount rate and the target federal funds rate, which has altered the banks’ demand for reserve balances. 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 September 18 FOMC meeting. Of course, I am very happy to take questions." fcic_final_report_full--50 Then, beginning in , the Federal Reserve accommodated a series of requests from the banks to undertake activities forbidden under Glass-Steagall and its modifi- cations. The new rules permitted nonbank subsidiaries of bank holding companies to engage in “bank-ineligible” activities, including selling or holding certain kinds of se- curities that were not permissible for national banks to invest in or underwrite. At first, the Fed strictly limited these bank-ineligible securities activities to no more than  of the assets or revenue of any subsidiary. Over time, however, the Fed re- laxed these restrictions. By , bank-ineligible securities could represent up to  of assets or revenues of a securities subsidiary, and the Fed also weakened or elimi- nated other firewalls between traditional banking subsidiaries and the new securities subsidiaries of bank holding companies.  Meanwhile, the OCC, the regulator of banks with national charters, was expand- ing the permissible activities of national banks to include those that were “function- ally equivalent to, or a logical outgrowth of, a recognized bank power.”  Among these new activities were underwriting as well as trading bets and hedges, known as derivatives, on the prices of certain assets. Between  and , the OCC broad- ened the derivatives in which banks might deal to include those related to debt secu- rities (), interest and currency exchange rates (), stock indices (), precious metals such as gold and silver (), and equity stocks (). Fed Chairman Greenspan and many other regulators and legislators supported and encouraged this shift toward deregulated financial markets. They argued that fi- nancial institutions had strong incentives to protect their shareholders and would therefore regulate themselves through improved risk management. Likewise, finan- cial markets would exert strong and effective discipline through analysts, credit rat- ing agencies, and investors. Greenspan argued that the urgent question about government regulation was whether it strengthened or weakened private regulation. Testifying before Congress in , he framed the issue this way: financial “modern- ization” was needed to “remove outdated restrictions that serve no useful purpose, that decrease economic efficiency, and that . . . limit choices and options for the con- sumer of financial services.” Removing the barriers “would permit banking organiza- tions to compete more effectively in their natural markets. The result would be a more efficient financial system providing better services to the public.”  During the s and early s, banks and thrifts expanded into higher-risk loans with higher interest payments. They made loans to oil and gas producers, fi- nanced leveraged buyouts of corporations, and funded developers of residential and commercial real estate. The largest commercial banks advanced money to companies and governments in “emerging markets,” such as countries in Asia and Latin Amer- ica. Those markets offered potentially higher profits, but were much riskier than the banks’ traditional lending. The consequences appeared almost immediately—espe- cially in the real estate markets, with a bubble and massive overbuilding in residential and commercial sectors in certain regions. For example, house prices rose  per year in Texas from  to .  In California, prices rose  annually from  to .  The bubble burst first in Texas in  and , but the trouble rapidly spread across the Southeast to the mid-Atlantic states and New England, then swept back across the country to California and Arizona. Before the crisis ended, house prices had declined nationally by . from July  to February   —the first such fall since the Depression—driven by steep drops in regional markets.  In the s, with the mortgages in their portfolios paying considerably less than current interest rates, spiraling defaults on the thrifts’ residential and commercial real estate loans, and losses on energy-related, leveraged-buyout, and overseas loans, the indus- try was shattered.  CHRG-111hhrg56241--86 Mr. Stiglitz," I would like to emphasize two things that we did not do when we turned over money to these banks. First, we didn't relate giving them money to their behavior, not just with respect to the issue of compensation schemes, but also with respect to lending, which was the reason we were giving them money. That relates to the issue of jobs that has come up here a number of times. The fact that compensation went out meant there was less money inside the banks and therefore less ability or willingness to lend. The second point is that the U.S. taxpayer was not, when it gave the banks money, compensated for the risk that they bore. In some cases, we got repaid. But we ought to look at the transaction that Warren Buffet had with Goldman Sachs, which was an arm's-length transaction. If we wanted what would have been a fair compensation to the taxpayer, the bailouts would have reflected the same terms, and we would have gotten back a lot more. Mr. Moore of Kansas. Thank you, sir. I am interested in better understanding how the culture of excessive lending, abusive leverage, and excessive compensation contributed to the financial crisis. This applies across-the-board for consumers who are in over their head with maxed-out credit cards and homes they couldn't afford, to major financial firms leveraged 35 to 1. Is there anything the government can and should do in the future to prevent a similar carefree and irresponsible mindset from taking hold and exposing our financial system to another financial crisis? Professor Bebchuk? " CHRG-111shrg56262--80 Mr. Miller," I think that it would, and just building on what Mr. Davidson just indicated, I think also the representations and warranties and enhancements there are really, I think, very consistent with what he was stating in terms of creating an ongoing economic responsibility. His proposal is a bit of a variation on that theme. I think the unique loan identifier, which ASF has recently announced, will broadly assist the process of being able to drill down to the individual level of the mortgage loan as that makes its way into the secondary and debt capital market so that no matter what type of securities structure--it could be a whole loan sale, it could be a mortgage-backed securitization, it could be another type of instrument down the road--investors and other parties would be able to identify the specific loans underlying that instrument and coupled with the other data, standardization enhancements through Project Restart, be able to perform analytics at a very deep level of detail, providing investors and other market participants with a much better window into the performance characteristics and risk profiles of those loans and, thus, the securities that they are a part of. " CHRG-111hhrg55814--227 Mr. Hensarling," Thank you, Mr. Chairman. Mr. Secretary, welcome. Chairman Frank and I will continue to debate the effectiveness of the GSE legislation that he brought to the Congress. What the facts are today, we have essentially 80 percent government control of Fannie and Freddie, their conforming loan limits have increased, increasing their exposure. Their market share has increased precipitously. Taxpayers, between the Treasury and the Federal Reserve now have roughly $1 trillion exposure out of a potential of $2 trillion. Does the Administration plan to offer GSE reform legislation before year's end? " CHRG-111shrg57322--411 Mr. Sparks," Can I just, Dr. Coburn, I thought you said we were changing our positions. We were oftentimes changing our positions. I thought you meant did---- Senator Coburn. I understand, but there has never been a position change like what took place in the last 4 years in this country in the mortgage markets. There has never been anything like that. Maybe when we shut off exports of commodities to the Russians during the Afghanistan invasion, but there has never been a change like that before in this country. So I understand you change positions all the time, but there has never been anything to compare to what happened in terms of the collateralized debt obligations and the residential mortgage-backed securities in this country. Would you agree with that? Do you know anything in your history? I am 62 years old. I have never seen anything like it. " 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-109hhrg22160--234 Mr. Price," I appreciate your response, and I am so pleased to hear you talk about the consumption tax, because, as you identified, you have got to have increased income in order--relative to consumption. If the money never gets to your back pocket, it isn't income. So if I heard you correctly, I understood you to say that, if we were to be able to move to a consumption tax, to a national retail sales tax, that that would in fact have a byproduct of increasing national savings as you increase the amount of money in individual's pocket. " CHRG-111hhrg48874--61 Mr. Sherman," Thank you, Mr. Chairman. You know, we're all looking back nostalgically at this mythical 2007, when all worthy people got the credit they needed to realize their dreams. And we all are asking, why can't we return to that Shangri-La? I think we have to remember that back in 2007, I was getting plenty of complaints from people who weren't getting the loans they wanted. They didn't ask me to do anything about it, because back in 2007, we had a capitalist economic system. But also in 2007, the living standards were too loose, even though the banks were in relatively, or thought they were in reactively good shape. Today the banks are in bad shape, and every borrower is in worse shape than they were back in 2007. The solution, or one of the solutions is to allow banks to make loans even when the good bank examiner, a conservative bank examiner, says you need a 10 or 20 percent reserve against that loan by having the banks have more capital. I hope that you are pressing your banks to sell more stock, even though at today's depressed prices, they may not want to do it. I want to address the mark-to-market rule, which I think is depressing bank capital in just a second. But I also want to mention the credit unions, who aren't represented here. We as a Congress have prohibited almost all credit unions from issuing subordinated debt. That is the way they could have capital, where private investors could give the credit union money, and then if the credit union made a few risky loans and it didn't work out so well, the investors would lose money, instead of the taxpayer or the insurance system. But we have prohibited issuing that subordinated debt, and I think we should revisit that, maybe not as a permanent change in the way that credit unions are run, but for the life of this economic crisis. Because for every time somebody has to say no to a businessperson on a loan, hopefully there will be a credit union that's able to say yes, if it's a good loan. Governor Duke, I would like to ask you a question that's identical to the question I asked Chairman Bernanke yesterday, because I liked his answer and I'm hoping that you give me the same answer. You may be familiar with Section 13-3 of the Federal Reserve Act. That's the one that says the Federal Reserve can loan money in a time of economic exigency, but only on a fully secured basis. And your Chairman yesterday said that he figures that means no risk or as little risk as is possible in a financial situation, that was equivalent to triple-A paper, not double-A, not single-A--Triple-A--and that he would stand by that interpretation even if Wall Street came to you a year from now and said, ``My God, we need another trillion or the sky is going to fall, and those idiots and populists in Congress won't pass the bill. So you have to step forward, avoid all that democracy stuff, change your interpretation of Section 13-3, and give us the money Congress won't.'' Under that kind of pressure, would you give me the same answer as Chairman Bernanke, and say, ``13-3 is for triple-A paper?'' Ms. Duke. Yes, sir, I would. " CHRG-111shrg53822--73 Mr. Rajan," Yes. The one comment I will make is it seems to me that the one concern is that a number of institutions, and the way they structure their activities, essentially make themselves ``too big to fail.'' And that is why I think you want to give them incentives not to become that way. Let me give an example. One of the reasons we worried about these large banks is the destruction of the payment and settlement system that happens when we fail these banks. Well, there are intricate ways in which the liability system of these banks is tied to the payment and settlement system. Right? One example is derivative contracts, which come due and have to be replaced if, in fact, the bank cannot make good on its debt. When you reduce the value of the debt, immediately, there is a consequence to the derivative contracts that the bank is involved in. These kinds of connections, interconnections, actually make the bank essentially too complicated, ``too big to fail.'' And my suggestion of forcing them to think about their own demise and proving to regulators that they could be closed in a relatively short time period--a weekend was just a number out of the box; but in a week, I think the rationale for that is you want to give these banks an incentive to think about not making themselves excessively complicated. And one way to do it is to put the onus on them to make their structures more simple, their liability structures, their organizational structures, so that when the regulator actually comes to unwind this bank, they have a less complicated entity to deal with. It is not going to be the answer by itself, and I think we need a lot of proposals on the table to do it, but it could be one piece of what we need. Senator Akaka. Thank you. This next question is for the panel, again, and has to do with about setting standards. A lot of commentators criticize our capital standards as being pro-cyclical, demanding that financial companies raise expensive capital at the worst possible times and too little capital in good times. What are your views on having regulators set standards that require banks and other financial companies to build capital when the economy is strong as a cushion to weather the downturns? Mr. Wallison? " CHRG-111shrg51303--16 Mr. Dinallo," Thank you, Chairman Dodd, Ranking Member Shelby, and other Senators. I think that to some extent, AIG is a microcosm of our regulatory regime, love it or hate it, and I want to try to explain what I think were the roles of at least the State insurance regulators here and try to clear up any confusion about responsibility that I know existed a couple of days ago, although it sounds like a lot of that has been clarified. I think the State regulators did a very good job on what their main assignment is, which is solvency and policy holder protection. I think that the operating companies of AIG, particularly the property companies, are in excellent condition. The life insurance companies are experiencing a lot of the same stresses that other life insurance companies are experiencing across the country and the world. I think that it is important to put some of these numbers in context, because I disagree with the concept that the securities lending program had much of anything to do with the problems at AIG. We calculate that without the Federal intervention, the life insurance companies are approximately $10 billion solvent, so they were solvent prior to the intervention. The amount that was written, on Senator Shelby's numbers, the amount that was written and put into the securities lending pool wasn't a leveraging, it was a direct undertaking, would be, say, I think $40 billion was invested in RMBS. That would be against $400 billion of assets in the life insurance company. So there was 10 percent invested in AAA-rated RMBS. The loss, as you say, we will adopt the number of $17 billion. So that is less than 5 percent of the losses of the assets at the life insurance companies could be laid at the door of securities lending investing in RMBS, which I submit $17 billion is a big number, but as a percentage basis, I think it is not an overwhelming number. I would say that the securities lending business was used to expose itself to RMBS businesses. But if you look at the entirety of the assets as invested by life insurance companies, it was a modest percentage. I think the Financial Products division had a huge causation on this. I think that Chairman Bernanke was correct a couple days ago when he described that causation. And the amounts of money are staggering. The securities lending business, as I said, you would put somewhere in the $75 billion range. The Financial Products division had notional exposure through CDSs and derivatives of $2.7 trillion. That is larger than the gross national debt of Germany, Great Britain, or Italy. I do agree with both of your statements that what they essentially did was they wrote a form of insurance without anywhere near the capitalization that you would have for such an activity if you were in a regulated insurance company. They are the ones that created the systemic risk, and that systemic risk rolled through the operating companies, including causing the run that you described, Senator, on the securities lending business. The securities lending business, which is something that I am happy to discuss with you, although New York only had about 8 percent exposure to it, is not the purpose or the reason for the Federal bailout. If there had been no Financial Products division involvement, I don't think there would have been any bailout of AIG's operating companies, certainly not the securities lending business. I think it was caused by, A, the run on the bank, and also, of course, the Federal Government had to detangle it in order to sell the operating companies. So they essentially removed the remaining securities from the operating companies in the securities lending business in order to sell the assets. Those assets are the ones that are going to go to pay off the loan. So it is the solvency in the operating companies that are going to go to pay off the Federal loan that is necessary because of what Chairman Bernanke described as essentially a bolted-on hedge fund of Financial Products division. When we came into the department, we did begin to take seriously some of the issues around securities lending, and I can detail that during question and answer. But we began to work it down starting in the beginning of 2007 by 25 percent. We got the holding company to guarantee $5 billion of the losses. And in July, we sent a circular letter to all of our companies saying this is something that you need to start to examine. It does have exposure to the mortgage underwritings and securitization. And indeed, I will just tell you that we have subsequently sent out 25 letters to our regulated entities to look into securities lending businesses. Frankly, they have actually performed pretty well across the board. AIG is the lone securities lending business that has had this kind of problem of the 25 that we looked at, and I would hypothesize that it is because of the run on it and the run on it came directly because of the need for massive collateral and the run on Financial Products division. I think that there are some lessons that we can discuss. I certainly think that one of them is a revisitation of Gramm-Leach-Bliley. We did not completely abrogate Glass-Steagall, thank God, or you would have the operating dollars of policy holders being used for the hedge fund activities. But we have, I think, seen for the first time that the creation of financial supermarkets can have a, what I would almost call a knock-on effect on the operating companies to which they are related. The portions of the company that involves itself in leverage, which securities lending did not do any leverage, has the potential to commit itself so heavily that when there is a financial downturn and there is a need for liquidity which they simply didn't have, the operating companies are looked to as an opportunity for that liquidity, but because they are regulated, fortunately, against that, they can't put up the liquidity and you have a downgrade. You have people asking for collateral which doesn't exist at the holding company level, which the State regulators do not regulate. And you have the systemic effects of basically some of these companies' future being questioned, whereas actually the underlying solvency of them and the quality of them as operating companies, as Chairman Bernanke said 2 days ago, I think are actually--should be unquestioned. Thank you. " CHRG-111hhrg53244--61 Mr. Bernanke," Well, Congressman Paul, at some point, as you know, we are going to have to start raising interest rates to avoid inflation. And people have talked about the politics of that and whether the Fed will be able to do that without intervention or interference. If we were to raise interest rates at a meeting and someone in the Congress didn't like it and said, I want the GAO to audit that decision, wouldn't that be viewed as an interference or at least an ex post-- Dr. Paul. I wouldn't think so. This is just reviewing it. And you can do what you want. What about today? Interest rates are artificially low. Could there be any political pressure to keep interest rates artificially low? Historically, that has been well known. It has been documented and written about how other Federal Reserve chairmen, you know, they are on the verge of reappointment, and they know the President, and all of a sudden--so it is not like it is not politicized now. Just the fact that they can issue a lot of loans and special privileges to banks and corporations, that is political. But this idea that it would be political because we know what happened afterwards just doesn't seem to add up. Since time is short, I want to go on to the next quote, which I find fascinating, because hopefully I can agree with you on this one. This is an actual quote. It says, ``We absolutely will not monetize the debt.'' Well, that is one of the major reforms sometime in the distant future that would be beautiful, because that would stop all this chaotic monetary policy, inflations and depressions and recessions and all the mess that we have. But you say you will not. At the same time, you know, I quoted the $38 billion that was bought last week and the plan to buy $300 billion of U.S. securities. These securities are bought by dollars you create. And if you are buying U.S. securities, what is that if it is not--and besides, if the markets really believed that, that you would absolutely not monetize debt, I think the markets would get hysterical. So it seems to me like--I would like to understand exactly what you mean by that. " CHRG-111shrg61513--53 Mr. Bernanke," So in terms of the financial industry, you know, I think markets should be allowed to work, but they should be allowed to work in an environment where regulation is appropriate and where there is an appropriate level playing field. So you would, I suppose, agree that financial services were not appropriately regulated or appropriately supervised. If we strengthen that regulation and allow appropriate changes to take place, that ought to bring down the size of the financial services industry to a size which is more appropriate for our economy. Manufacturing is another issue. I think there are lots of things that mostly Congress--I do not think the Federal Reserve has a lot of direct influence on any particular sector. But there are a lot of things that Congress can do. There is tax policy, there is immigration policy, trade policy. There is the issue of picking winners and losers. I think that is difficult to do. But you gave the example of solar panels. Solar panels are a viable industry with Government support if the Congress determines that, for example, for global warming purposes that carbon-reducing technologies or capital is socially desirable and, therefore, supports that activity, then that will--the private sector will, therefore, come out and produce that. So that is a determination of Congress whether it needs a public subsidy. I do not think that many of those alternative energy sources would survive by themselves in a marketplace because whatever value they have in reducing carbon, for example, is not captured in their price in the market. So I guess what I am saying is that we need, first of all, better regulation in finance to bring finance down to an appropriate size and an appropriate set of functions. And there are a set of things that Congress can do to try to improve our trade balance, for example, to improve the tax policy. I think, frankly--and this is a topic that I never could get much traction on. I think that our immigration policy which restricts severely the number of highly trained, skilled immigrants is a problem because bringing those sorts of folks in helps our high-tech industries develop more competitive--become more competitive. So there are things I think you can do to strengthen manufacturing. I would also just note that while it has been a very severe recession in the manufacturing sector, manufacturing is, in fact, leading this recovery, as you pointed out. Industrial production has been very strong, and we are seeing, in fact, growth in manufacturing employment. So it has been important in that respect. Senator Brown. One real quick closing statement. If manufacturing were even close to the same percentage of GDP as it was, think how much stronger--how much quicker we would come out of this recession in terms of recovery, just as a point of reference perhaps. Thank you, Mr. Chairman. Senator Johnson. Senator Vitter. Senator Vitter. Thank you, Mr. Chairman. Thank you, Mr. Chairman, for being here and for your work. Thank you for your monetary report. Mr. Chairman, when I go around my State and have town hall meetings and other things, obviously folks are real concerned about jobs and the recession. But I get just as many questions and expressions of concern about what they consider the next looming crisis caused by spending and debt. Now, obviously, you gave us a monetary report focused on things you can control. Federal spending and debt is not something you can directly control. What is your general projection and outlook, once we are out of this current recession, for the impact on the current levels of what are, in my view, unsustainable Federal spending and debt and the impact on the economy? " CHRG-111hhrg55811--329 Mr. Johnson," I believe that the subprime market was the catalyst, the trigger in this episode and the opacity that was associated with the collateralized debt obligations. The funny ratings from the rating agencies played a very large role. But I do not think that is the exclusive source of opacity in this very large scale derivatives markets. Nor, by the way, do I think that derivatives are--I think they play a meaningful role, but they have to be structured so that as the gentleman speaking before me said, counterparties can assess each other and not become afraid and not withdraw credit in times of crisis or shock that emanates from any source, domestic or foreign. " CHRG-111hhrg48875--71 Mr. Marchant," My concern is that given the ratios of leverage involved here, my concern is that the actual investors have more skin in the game than is proposed here, because if they in fact just take their hedge fund partners out in America and put all of their money in, and then they pull management fees off of that, then they--they don't have, in my opinion, don't have adequate incentive to make sure that those funds--they don't have enough skin in the game if you absolutely follow the hedge fund model and putting this money in. I'm very concerned about that. " CHRG-111hhrg54867--62 Mr. Gutierrez," And when the Securities and Exchange Commission was visited by the Wall Street heads from many of the same companies you just referred to, and I think it was in 2005, and they said, listen, we really like not to leverage 5:1 and 6:1, but 30:1, how significant was the decision by the Securities and Exchange Commission to allow that practice? " CHRG-111shrg56415--37 Mr. Tarullo," Senator, I think leverage on the expectation of rising asset prices was at the heart of the subprime problem, and indeed, it is at the heart of some of the other problems that we see, to some degree, in commercial real estate, as well. So, I would try to reinforce any instinct you have to push people toward better underwriting standards, and we, as the Chairman noted, are trying to do that ourselves. " CHRG-111shrg53176--65 Mr. Breeden," It worked pretty darn well. There is similarity in the public-private partnership, that the Treasury is trying to establish for the troubled assets, and the RTC. RTC was an entity that just stripped all the assets out of everything that failed and then repackaged them and tried to sell them back out to the market as quickly as you possibly can. These assets do not get better when they are owned by the government; get them back in private hands where they can be managed effectively. I think that is what Treasury's public-private partnership is trying to do without creating an agency, if you will, to do it. And I think it will work. They are on the right path. I have not looked at all the details of it. It is critical that you have price exposure, that you let people bid on these packages, that they not be directed to individual purchasers. It is important that you have transparency. And the key to all of it is that--and the big difference between the current plan is we were dealing with debt institutions. They were closed, and then we took the assets out and repackaged them. " CHRG-109hhrg23738--131 Mr. Shays," Thank you, Chairman Greenspan. I think that you, frankly, are one of the most important powerful individuals in the world and one of the most outstanding public servants, and I thank you for using your power well and for being such an outstanding public servant. I have a number of questions, and if the answers could be as brief as possible, I might get to a few. I look at the budget deficits, the trade deficits, the unfunded liability that the federal government has in Social Security and Medicare, I look at state budget deficits and their debt and their liabilities and pension funds and so on, and it seems pretty significant to me. And then I look at the low level of savings that Americans have, and I am wondering why--I am amazed that the economy does so well in spite of that. I would like the short version of why it does so well in spite of that. " CHRG-111hhrg53021--189 Secretary Geithner," Congressman, again, I am not sure that I can be responsive now. But, again, my principal concern--our principal concern has to be by making sure that financial intermediaries provide the basic economic function that Chairman Frank outlined at the beginning of the hearing. Those intermediaries, because of the leverage they take on, should hold adequate capital against risk. That is the centerpiece of our proposals. But I have heard your concerns, and would be happy to work with you to make sure we address those concerns. " CHRG-111hhrg53021Oth--189 Secretary Geithner," Congressman, again, I am not sure that I can be responsive now. But, again, my principal concern--our principal concern has to be by making sure that financial intermediaries provide the basic economic function that Chairman Frank outlined at the beginning of the hearing. Those intermediaries, because of the leverage they take on, should hold adequate capital against risk. That is the centerpiece of our proposals. But I have heard your concerns, and would be happy to work with you to make sure we address those concerns. " CHRG-111shrg56376--67 Mr. Dugan," Senator, traditionally the leverage ratio follows GAAP completely. The risk-based ratio has some variations, and at times has been more restrictive than GAAP. There also is some flexibility to look at this and phase it in over some time. This is an issue all the regulators are looking at now to try to address some of the issues that Chairman Bair just raised. The bottom line is this stuff is coming back on the balance sheet. Banks are going to have to hold capital against it. It is really a matter of timing and how it gets phased in. Senator Vitter. Well, I do not think anybody is arguing about the fundamental issue, but I am concerned with timing and phase-in because it could have negative consequences if it were, you know, here tomorrow overnight. So what is the current thinking about how that should be handled? " CHRG-111shrg56262--93 PREPARED STATEMENT OF GEORGE P. MILLER Executive Director, American Securitization Forum October 7, 2009 On behalf of the American Securitization Forum, I appreciate the opportunity to testify before this Subcommittee as it explores problems and solutions associated with the securitization process. The American Securitization Forum (ASF) is a broad-based professional forum through which participants in the U.S. securitization market advocate their common interests on important legal, regulatory and market practice issues. ASF members include over 350 firms, including investors, mortgage and consumer credit lenders and securitization issuers, financial intermediaries, legal and accounting firms, and other professional organizations involved in the securitization markets. The ASF also provides information, education, and training on a range of securitization market issues and topics through industry conferences, seminars and similar initiatives. ASF is an affiliate of the Securities Industry and Financial Markets Association. \1\--------------------------------------------------------------------------- \1\ For more information on ASF, please visit our Web site: http://www.americansecuritization.com. For more information on the Securities Industry and Financial Markets Association, please see: http://www.sifma.org.--------------------------------------------------------------------------- My testimony today will address the following topics: 1. The role and importance of securitization to the financial system and U.S. economy; 2. Current conditions in the securitization market; 3. Limitations and deficiencies in securitization revealed by the recent financial market crisis; and 4. Views on certain securitization policy and market reform initiatives now underway or under consideration.I. The Role and Importance of Securitization to the Financial System and U.S. Economy Securitization--generally speaking, the process of pooling and financing consumer and business assets in the capital markets by issuing securities, the payment on which depends primarily on the performance of those underlying assets--plays an essential role in the financial system and the broader U.S. economy. Over the past 25 years, securitization has grown from a relatively small and unknown segment of the financial markets to a mainstream source of credit and financing for individuals and businesses alike. In recent years, the role that securitization has assumed in providing both consumers and businesses with credit is striking: currently, there is over $12 trillion of outstanding securitized assets, \2\ including mortgage-backed securities (MBS), asset-backed securities (ABS), and asset-backed commercial paper. This represents a market nearly double the size of all outstanding marketable U.S. Treasury securities--bonds, bills, notes, and TIPS combined. \3\ Between 1990 and 2006, issuance of mortgage-backed securities grew at an annually compounded rate of 13 percent, from $259 billion to $2 trillion a year. \4\ In the same time period, issuance of asset-backed securities secured by auto loans, credit cards, home equity loans, equipment loans, student loans and other assets, grew from $43 billion to $753 billion. \5\ In 2006, just before the downturn, nearly $2.9 trillion in mortgage- and asset-backed securities were issued. As these data demonstrate, securitization is clearly an important sector of today's financial markets.--------------------------------------------------------------------------- \2\ SIFMA, ``Asset-Backed Securities Outstanding'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USABSOutstanding.pdf . \3\ U.S. Department of the Treasury, ``Monthly Statement of the Public Debt of the United States: August 31, 2009'', (August 2009). http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds082009.pdf. \4\ National Economic Research Associates, Inc. (NERA), ``Study of the Impact of Securitization on Consumers, Investors, Financial Institutions and the Capital Markets'', p. 16 (June 2009). http://www.americansecuritization.com/uploadedFiles/ASF_NERA_Report.pdf . \5\ SIFMA, ``U.S. ABS Issuance'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf.--------------------------------------------------------------------------- The importance of securitization becomes more evident by observing the significant proportion of consumer credit it has financed in the U.S. It is estimated that securitization has funded between 30 and 75 percent of lending in various markets, including an estimated 59 percent of outstanding home mortgages. \6\ Securitization plays a critical role in nonmortgage consumer credit as well. Historically, most banks have securitized 50-60 percent of their credit card assets. \7\ Meanwhile, in the auto industry, a substantial portion of automobile sales are financed through auto ABS. \8\ Overall, recent data collected by the Federal Reserve Board show that securitization has provided over 25 percent of outstanding U.S. consumer credit. \9\ In the first half of 2009 alone, securitization financed over $9.5 billion in student loans. \10\ Securitization also provides an important source of commercial mortgage loan financing throughout the U.S., through the issuance of commercial mortgage-backed securities.--------------------------------------------------------------------------- \6\ Citigroup, ``Does the World Need Securitization?'' pp. 10-11 (Dec. 2008).http://www.americansecuritization.com/uploadedFiles/Citi121208_restart_securitization.pdf. \7\ Ibid., p. 10. \8\ Ibid., p. 10. \9\ Federal Reserve Board of Governors, ``G19: Consumer Credit'', (September 2009). http://www.federalreserve.gov/releases/g19/current/g19.htm. \10\ SIFMA, ``U.S. ABS Issuance'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf.--------------------------------------------------------------------------- Over the years, securitization has grown in large measure because of the benefits and value it delivers to transaction participants and to the financial system. Among these benefits and value are the following: 1. Efficiency and Cost of Financing. By linking financing terms to the performance of a discrete asset or pool of assets, rather than to the future profitability or claims-paying potential of an operating company, securitization often provides a cheaper and more efficient form of financing than other types of equity or debt financing. 2. Incremental Credit Creation. By enabling capital to be recycled via securitization, lenders can obtain additional funding from the capital markets that can be used to support incremental credit creation. In contrast, loans that are made and held in a financial institution's portfolio occupy that capital until the loans are repaid. 3. Credit Cost Reduction. The economic efficiencies and increased liquidity available from securitization can serve to lower the cost of credit to consumers. Several academic studies have demonstrated this result. A recent study by National Economic Research Associates, Inc., concluded that securitization lowers the cost of consumer credit, reducing yield spreads across a range of products including residential mortgages, credit card receivables and automobile loans. \11\ \11\ National Economic Research Associates, Inc. (NERA), ``Study of the Impact of Securitization on Consumers, Investors, Financial Institutions and the Capital Markets'', (June 2009), p. 16. http://www.americansecuritization.com/uploadedFiles/ASF_NERA_Report.pdf.--------------------------------------------------------------------------- 4. Liquidity Creation. Securitization often offers issuers an alternative and cheaper form of financing than is available from traditional bank lending, or debt or equity financing. As a result, securitization serves as an alternative and complementary form of liquidity creation within the capital markets and primary lending markets. 5. Risk Transfer. Securitization allows entities that originate credit risk to transfer that risk to other parties throughout the financial markets, thereby allocating that risk to parties willing to assume it. 6. Customized Financing and Investment Products. Securitization technology allows for precise and customized creation of financing and investment products tailored to the specific needs of issuers and investors. For example, issuers can tailor securitization structures to meet their capital needs and preferences and diversify their sources of financing and liquidity. Investors can tailor securitized products to meet their specific credit, duration, diversification and other investment objectives. \12\--------------------------------------------------------------------------- \12\ The vast majority of investors in the securitization market are institutional investors, including banks, insurance companies, mutual funds, money market funds, pension funds, hedge funds and other large pools of capital. Although these direct market participants are institutions, many of them--pension funds, mutual funds and insurance companies, in particular--invest on behalf of individuals, in addition to other account holders. Recognizing these and other benefits, policymakers globally have taken steps to help encourage and facilitate the recovery of securitization activity. The G-7 finance ministers, representing the world's largest economies, declared that ``the current situation calls for urgent and exceptional action . . . to restart the secondary markets for mortgages and other securitized assets.'' \13\ The Department of the Treasury stated in March that ``while the intricacies of secondary markets and securitization . . . may be complex, these loans account for almost half of the credit going to Main Street,'' \14\ underscoring the critical nature of securitization in today's economy. The Chairman of the Federal Reserve Board recently noted that securitization ``provides originators much wider sources of funding than they could obtain through conventional sources, such as retail deposits'' and also that ``it substantially reduces the originator's exposure to interest rate, credit, prepayment, and other risks.'' \15\ Echoing that statement, Federal Reserve Board Governor Elizabeth Duke recently stated that the ``financial system has become dependent upon securitization as an important intermediation tool,'' \16\ and last week the International Monetary Fund (IMF) noted in its Global Financial Stability Report that ``restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis and to the withdrawal of central bank and Government interventions.'' \17\ There is clear recognition in the official sector of the importance of the securitization process and the access to financing that it provides lenders, and of its importance to the availability of credit that ultimately flows to consumers, businesses and the real economy.--------------------------------------------------------------------------- \13\ G-7 Finance Ministers and Central Bank Governors Plan of Action (Oct. 10, 2008). http://www.treas.gov/press/releases/hp1195.htm. \14\ U.S. Department of the Treasury, ``Road to Stability: Consumer & Business Lending Initiative'', (March 2009). http://www.financialstability.gov/roadtostability/lendinginitiative.html. \15\ Bernanke, Ben S., ``Speech at the UC Berkeley/UCLA Symposium: The Mortgage Meltdown, the Economy, and Public Policy, Berkeley, California'', Board of Governors of the Federal Reserve System (Oct. 2008). http://www.federalreserve.gov/newsevents/speech/bernanke20081031a.htm. \16\ Duke, Elizabeth A., ``Speech at the AICPA National Conference on Banks and Savings Institutions, Washington, DC'', Board of Governors of the Federal Reserve System (Sept. 2009). http://www.federalreserve.gov/newsevents/speech/duke20090914a.htm. \17\ International Monetary Fund, ``Restarting Securitization Markets: Policy Proposals and Pitfalls'', Global Financial Stability Report: Navigating the Financial Challenges Ahead (Oct. 2009), p. 33. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.--------------------------------------------------------------------------- Restoration of function and confidence to the securitization markets is a particularly urgent need, in light of capital and liquidity constraints currently confronting financial institutions and markets globally. As mentioned above, at present nearly $12 trillion in U.S. assets are funded via securitization. With the process of bank de-leveraging and balance sheet reduction still underway, and with increased bank capital requirements on the horizon, the funding capacity provided by securitization cannot be replaced with deposit-based financing alone in the current or foreseeable economic environment. Just last week, the IMF estimated that a financing ``gap'' of $440 billion will exist between total U.S. credit capacity available for the nonfinancial sector and U.S. total credit demand from that sector for the year 2009. \18\ Moreover, nonbank finance companies, who have played an important role in providing financing to consumers and small businesses, are particularly reliant on securitization to fund their lending activities, since they do not have access to deposit-based funding. Small businesses, who employ approximately 50 percent of the Nation's workforce, depend on securitization to supply credit that is used to pay employees, finance inventory and investment, and other business purposes. Furthermore, many jobs are made possible by securitization. For example, a lack of financing for mortgages hampers the housing industry; likewise, constriction of trade receivable financing can adversely affect employment opportunities in the manufacturing sector. To jump start the engine of growth and jobs, securitization is needed to help restore credit availability.--------------------------------------------------------------------------- \18\ International Monetary Fund, ``The Road to Recovery'', Global Financial Stability Report: Navigating the Financial Challenges Ahead (Oct. 2009), p. 29. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.--------------------------------------------------------------------------- Simply put, the absence of a properly functioning securitization market, and the funding and liquidity this market has historically provided, adversely impacts consumers, businesses, financial markets, and the broader economy. The recovery and restoration of confidence in securitization is therefore a necessary ingredient for economic growth to resume, and for that growth to continue on a sustained basis into the future.II. Current Conditions in the Securitization Market The U.S. securitization markets experienced substantial dislocation during the recent financial market turmoil, with a virtual collapse of both supply and demand in the new-issue market, very substantial reductions in liquidity, widespread declines in securities prices and valuations, and increases in risk premiums throughout the secondary market. While there have been signs of recovery in certain parts of the securitization market throughout the first three calendar quarters of 2009, some market segments--most notably, private-label residential mortgage backed securities--remain dormant, with other securitization asset classes and market sectors remaining significantly challenged. In the asset-backed securities market, total issuance volume remains at a relatively low level, with 2009 issuance projected to reach $130 billion, roughly in line with the $140 billion issued in 2008 but sharply down from the $750 billion issued in 2006. \19\ Although issuance rates in nearly all major asset classes, including credit cards, auto and equipment loans, and student loans, picked up in the second quarter of 2009, a recent ASF survey showed that market participants expect securitization issuance rates to return to only half of their predownturn levels over the next 2 to 3 years. For residential mortgage-backed securities, 2009 to date has seen over $1.2 trillion in issuance, compared with a yearlong total of $1.3 trillion in 2008 and $2.1 trillion in 2006. However, in 2009, less than 1 percent of this has been issued without a Government or GSE guarantee (i.e., private-label MBS); this is compared with private-label MBS comprising over 23 percent of all issuance during the time period from 1996 to 2006. \20\ Furthermore, private-label MBS transactions that have occurred in 2009 involved pools of seasoned, conforming loans--no major private-label residential mortgage-backed securities deal of which we are aware has directly financed new mortgage loan origination this year.--------------------------------------------------------------------------- \19\ SIFMA, ``U.S. ABS Issuance'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf. \20\ SIFMA, ``U.S. Mortgage-Related Issuance'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USMortgageRelatedIssuance.pdf.--------------------------------------------------------------------------- Part of the reason for this involves a broad retreat from risk by many investors. The events of 2007 and 2008, especially in the RMBS markets, resulted in significant losses for many investors. While it seems unlikely that some types of investors, such as those who purchased securitized instruments issued by structured investment vehicles (SIVs) or certain types of collateralized debt obligations (CDOs), will play a significant role in the future MBS and ABS markets, the number of traditional securitization investors has also diminished, and along with it, the liquidity they have provided to both senior and subordinate parts of the market. Replacing at least a portion of this investor base is a significant challenge faced by participants in today's market. Certain programs sponsored by the Federal Government--in particular, the TALF program--have been successful in stimulating parts of the new-issue securitization market. President Obama described TALF as the Government's ``largest effort ever to help provide auto loans, college loans, and small business loans to the consumers and entrepreneurs who keep this economy running,'' \21\ and in many ways, TALF is among the most successful of the Government's efforts to bolster the consumer economy. As of September 2009, TALF has directly financed $46 billion \22\ of ABS issuances out of the approximately $80 billion of ABS eligible for TALF that has been issued since March. \23\ Due in significant measure to TALF, credit costs on consumer ABS have, across the board, returned to levels more in line with their historical trends than the extremely high levels that were seen in late 2008 and early 2009. For example, 3-year AAA credit card spreads to benchmark rates had ballooned to more than 500 basis points, or 5 percent, above LIBOR by January 2009, but have retracted to a level less than 1 percent above LIBOR. \24\ While this is not quite back to the spread levels seen over the years leading up to the crisis, it represents a more stable and economical level for issuers that translates into more affordable rates for borrowers. In recent months a number of issuers have been able to sell, at economical levels, transactions without the support of TALF. \25\ Clearly there are other factors at play in this recovery, including a generally more benign credit market, but one cannot dismiss the considerable and positive impact of TALF.--------------------------------------------------------------------------- \21\ Obama, Barack, ``Remarks of President Barack Obama--Address to Joint Session of Congress'', (Feb. 24, 2009). http://www.whitehouse.gov/the_press_office/remarks-of-President-Barack-Obama-address-to-joint-session-of-congress. \22\ SIFMA, ``TALF'', http://www.sifma.org/research/research.aspx?ID=10256#TALF. \23\ Allison, Herbert M., ``Written Testimony: Senate Committee on Banking, Housing and Urban Affairs'', (Sept. 2009). http://www.ustreas.gov/press/releases/tg298.htm. \24\ JPMorgan Securitized Products Weekly, September 18, 2009, pp. 22-23. \25\ See, for example: ``AmeriCredit's $725 Million Auto ABS transaction'', (July 2009) http://www.reuters.com/article/pressRelease/idUS140529+31-Aug-2009+BW20090831; JPMorgan's $2.53 billion credit card ABS deal, (Sept. 2009) http://online.wsj.com/article/SB125311472402316179.html.--------------------------------------------------------------------------- TALF has helped somewhat to bring investors back to the parts of consumer ABS markets that are not directly eligible for the program, although the markets for debt rated lower than AAA are still struggling. For example, 5-year single-A rated credit card ABS, which are not TALF eligible, saw an even more severe spread widening than that of AAA during the height of the disruption in late 2008. By January 2009 spreads had ballooned to more than 15 percent above LIBOR, but have since come back in to lower levels. \26\ The subordinate ABS markets are still relatively dormant, and unless banks are able to finance a greater portion of the capital structure, credit origination via securitization cannot be fully restored.--------------------------------------------------------------------------- \26\ ``JPMorgan Securitized Products Weekly'', September 18, 2009, pp. 22-23.--------------------------------------------------------------------------- Notwithstanding the success of the TALF program and the restoration of a modest degree of securitization financing and liquidity in some market segments, significant challenges remain, including establishing a stable, sustainable, and broad-based platform for future securitization market issuance and investment activity that is less reliant on direct Government support.III. Limitations and Deficiencies in Securitization Revealed by the Recent Financial Market Crisis The recent financial market crisis revealed several limitations and weaknesses in securitization market activity. Among the multiple (and, in many cases, interrelated) deficiencies revealed were the following: 1. Risk management failures, including the excessive or imprudent use of leverage and mismanagement of liquidity risk. Many market participants--including financial intermediaries, investors, and others--established large, leveraged risk positions in securitized instruments. A significant number of these market positions were, in effect, highly levered triggers which, when tripped by an adverse rating action or downward price movement, caused widespread deleveraging and further price reductions. At the same time, large parts of the securitization market became reliant on cheap, short term liquidity to finance long-term assets. When this liquidity disappeared and financing was either repriced or withdrawn completely, a more systematic deleveraging and unwinding process ensued. 2. Credit ratings methodologies and assessments that proved to be overly optimistic, and excessive reliance on credit ratings. Especially in parts of the residential mortgage market, a favorable economic environment and persistent increase in housing prices masked gaps in credit rating agency models and methodologies that did not sufficiently factor in the risk of nationwide housing price declines and a high correlation in the performance of the assets underlying certain mortgage and asset-backed securities. At the same time, market participants became overly reliant on credit ratings, and many failed to perform or to act upon their own assessment of the risks created by certain securitized transaction structures. 3. Deteriorating underwriting standards and loan quality. Underwriting standards declined precipitously throughout various segments of the credit markets, including but not limited to subprime mortgages, with housing prices rising steeply and credit and liquidity in plentiful supply. As loan demand and competition among lending institutions intensified, asset quality declined, leaving securitized instruments vulnerable to credit-related performance impairments. 4. Gaps in data integrity, reliability and standardization. Especially in parts of the residential mortgage market, a combination of explosive lending growth, operational weaknesses, the absence of standardized and comparable loan- level data, an increasing prevalence of fraud and other factors caused investors broadly to question the accuracy and integrity of performance data relating to the assets underlying securitizations. This led to a massive loss of confidence and widespread aversion to securitized risk, including asset classes and transaction structures that were far removed from the direct source of these concerns. 5. A breakdown in checks and balances and lack of shared responsibility for the system as a whole. While many within the securitization industry were aware of the general deterioration in credit underwriting standards and the other factors outlined above, no single party or group of market participants enforced sufficient discipline across all parts of the interdependent securitization value chain. Weaknesses and deficiencies in one part of the chain thus impaired the function of the chain in its entirety. It is important to note that the weaknesses outlined above are not inherent in securitization per se. Instead, they relate to the manner in which securitization was used in some settings by some market participants. In general, the amount of risk inherent in a securitization is equal to the risk that is embedded in the securitized assets themselves. However, in retrospect it is clear that securitization technology can be used in ways that can reduce and distribute risk (i.e., can be beneficial to the financial system), or that increase and concentrate that risk (i.e., can be detrimental to the financial system). Ancillary practices and strategies employed in some securitization transactions by some market participants--for example, the use of additional leverage; reliance on short-term funding for long-term liabilities; or the absence of effective risk management controls--can amplify and concentrate those risks. This is especially true when such practices and strategies relate to large dollar volumes of transactions and risk positions held by multiple participants throughout the financial system. It is also important to recognize that many of the deficiencies outlined above were prevalent, or at least more heavily concentrated, in certain securitization market products and sectors, rather than characterizing conditions or practices in the securitization market as a whole. In fact, the most consequential deficiencies were concentrated in portions of the residential mortgage market--and the subprime mortgage market, in particular--and in certain types of CDOs, SIVs and similar securities arbitrage structures. These transactions--many of which relied on high degrees of leverage--generated significant incremental demand for underlying securitization products. However, much of that demand was ``artificial,'' in the sense that production of underlying securitization products (e.g., subordinated risk tranches of subprime RMBS) was driven by demand from CDOs and SIVs, rather than by the financing needs of lenders or borrowing needs of consumers. In other parts of the securitization market, including prime RMBS, credit card, auto and student loan ABS, and asset-backed commercial paper conduits, among others, securitization activity largely remained focused on its historical role of financing the credit extension activities of lenders, and the credit needs of their consumer and business customers.IV. Views on Securitization Policy and Market Reform Initiatives Numerous policy and market reforms aimed at the securitization market have been advanced in response to the broader financial market crisis. Global policymaking bodies have proposed a series of securitization reforms as part of their broader response to financial market turmoil, and in the United States, both legislative and regulatory responses are under active consideration. At the same time, industry participants and their representative organizations are moving forward with important reforms to securitization market practices and to retool key parts of the market's operational infrastructure. Overall, we believe that a targeted combination of thoughtful policy reforms, coupled with industry initiatives to improve the securitization market infrastructure, will help to establish a more stable and lasting platform for future securitization market activity. In general, we believe that these policy and industry reform measures should facilitate the ability to originate and fund of a wide range of consumer and business credit via securitization. However, this activity must be supported by improved data and transparency that enables securitized risk to be evaluated and priced efficiently by market participants, and by enhanced operational controls (including but not limited to asset origination practices, due diligence and quality review practices, standardized and more effective representations and warranties, standardization of key documentation provisions and rating agency methodologies, among others) that provide necessary assurances to investors and other market participants regarding the accuracy, integrity and reliability of securitization data and transaction structures. At the same time, we believe that it is important, as a recent IMF report noted, to consider the individual and combined effects of various reform measures under consideration, to ensure that they do not inadvertently stifle otherwise sound and desirable securitization activity. \27\--------------------------------------------------------------------------- \27\ The exact language used by the IMF in its Global Financial Stability Report states: ``While most of the current proposals are unambiguously positive for securitization markets and financial stability, some proposals--such as those designed to improve the alignment of securitizer and investor interests and accounting changes that will result in more securitized assets remaining on balance sheets--may be combined in ways that could halt, not restart, securitization, by inadvertently making it too costly for securitizers.'' See, ``The Road to Recovery'', (Oct. 2009), p. 29. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.--------------------------------------------------------------------------- In the United States, a primary policy focus is on legislative proposals advanced by the Obama Administration, which in turn reflect many of the reform themes and initiatives under consideration globally. Together with other reforms being pursued by Federal regulatory agencies and accounting standards setters, these securitization reform initiatives may be broadly categorized as follows: 1. Increased Data Transparency, Disclosure, and Standardization; and Improvements to the Securitization Infrastructure. Initiatives designed to increase the type and amount of information and data (including loan-level data) that is captured and disclosed with respect to securitized instruments, and to improve and standardize that information and data as well as key documentation provisions, market practices and procedures employed in securitization transactions. 2. Required Risk Retention and Other Incentive Alignment Mechanisms. Mandated requirements for asset originators and/or securitizers to retain an economic interest in securitization transactions, and other mechanisms designed to produce a closer alignment of economic risks and incentives of originators, securitizers, and end investors. 3. Increased Regulatory Capital Requirements and Limitations on Off- Balance Sheet Accounting. Increases in regulatory capital required to be held against securitized exposures by regulated financial institutions, as a means of creating an additional safety and soundness buffer against potential losses associated with those exposures, and revisions to generally accepted accounting standards that restrict off-balance sheet accounting for securitized transactions and produce more widespread accounting consolidation of the assets and liabilities of securitization special purpose entities. 4. Credit Rating Agency Reforms. Various reforms intended to eliminate or minimize conflicts of interest, and to promote the accuracy, integrity and transparency of methodologies and processes that credit rating agencies apply to securitization transactions. A summary of ASF's views on each of these reform directions and initiatives are set forth below.A. Increased Transparency, Disclosure, Standardization; and Improvements to the Securitization Market Infrastructure ASF supports increased transparency and standardization in the securitization markets, and related improvements to the securitization market infrastructure. We believe that such efforts should be focused on those areas and products where preexisting practices have been determined to be deficient, and where improvements can help to restore confidence and function to the related market segment(s). Our principal focus in this area is ASF's Project on Residential Securitization Transparency and Reporting (Project RESTART), which is initially directed at addressing transparency and standardization deficiencies in the residential mortgage-backed securities (RMBS) market. Prior studies and market surveys conducted by ASF have clearly identified the RMBS market as most in need of these types of reform. Overall, Project RESTART seeks to address transparency and standardization needs in the RMBS market via the substantial injection of new disclosures and reporting by issuers and servicers on new transactions as well as on the trillions of dollars of outstanding private-label RMBS. Project RESTART would create a uniform set of data standards for such disclosure and reporting, including at the loan level. This will create a more level playing field where issuers provide the same information at the initiation of a securitization transaction and on an ongoing basis throughout the life of that transaction. With these standards in place, information provided by different issuers will be more comparable and capable of meaningful evaluation by investors and other market participants. In addition to supporting investment analysis, these data and standardization improvements will also support more robust and reliable rating agency, due diligence, quality review and valuation processes, and other downstream applications that will benefit from more robust, reliable and comparable underlying data. Project RESTART for RMBS transactions consists of the following phases: (i) the Disclosure Package, which will provide substantially more loan-level data than is currently available to investors, rating agencies and other parties, and standardize the presentation of transaction-level and loan-level data to allow for a more ready comparison of transactions and loans across issuers; (ii) the Reporting Package, which will provide for monthly updating of critical loan-level information that will enable improvements in the ability of investors, rating agencies and other market participants to analyze the performance of outstanding securities; (iii) Model RMBS Representations and Warranties, which will provide assurances to investors in RMBS transactions regarding the allocation and assumption of risk associated with loan origination and underwriting practices; (iv) Model Repurchase Procedures, which will be used to enforce the Model Representations and Warranties and to clearly delineate the roles and responsibilities of transaction parties in the repurchase process; (v) Model Pre-Securitization Due Diligence Standards, which will buttress due diligence and quality review practices relating to mortgage underwriting and origination practices and the data supplied to market participants through the Disclosure Package; and (vi) Model Servicing Provisions for Pooling and Servicing Agreements, which will create more standardized documentation provisions and work rules in key areas, such as loss mitigation procedures that servicers may employ in dealing with delinquent or defaulting loans. Final versions of the Disclosure and Reporting Packages were released by ASF in July 2009, with industry implementation beginning in 2010. Work continues on the other Project RESTART workstreams identified above, with an immediate focus on the development of Model RMBS Representations and Warranties, which are used to act as a ``return policy'' to guard against the risk of defective mortgage loans being sold into a securitization trust. Much like a defective product is returned to the store from which it was sold, a defective mortgage loan will be ``returned'' to the issuer through its removal from a securitization trust for cash. A mortgage loan is ``defective'' if it materially breaches one of the representations and warranties. Examples of defects range from a general fraud in a loan's origination to a failure to properly verify a borrower's income or employ an independent appraiser. The ASF supports 100 percent risk retention for defective loans that result from an originator's failure to meet specified underwriting criteria. Although Project RESTART has initially been focused on the RMBS market, members of the ASF have begun development of the ASF Credit Card ABS Disclosure Package, which seeks to provide increased transparency and standardization to the Credit Card ABS market. Finally, ASF believes that every mortgage loan should be assigned a unique identification number at origination, which would facilitate the identification and tracking of individual loans as they are sold or financed in the secondary market, including via RMBS securitization. ASF recently selected a vendor who will work with us to provide this unique Loan ID, which is called the ASF LINCTM. Implementation of the ASF LINC will enable market participants to access Project RESTART's valuable loan-level information without violating privacy laws by removing personal nonpublic information and other protected information from the process.B. Required Risk Retention ASF supports initiatives to align the economic interests of asset originators and securitization sponsors with investors. As suggested above, we believe that the principal goal of these efforts should be to establish and reinforce commercial incentives for originators and sponsors to create and fund assets that conform to stated underwriting standards and securitization eligibility criteria, thereby making those parties economically responsible for the stated attributes and underwriting quality of securitized loans. The creation and maintenance of effective mechanisms of this type will facilitate responsible lending, as well as a more disciplined and efficient funding of consumer assets via securitization (i.e., where the varying credit and performance risks presented by different types of securitized assets can be properly evaluated and priced in the capital markets). Securitization risk retention proposals currently under consideration, including legislation advanced by the Obama Administration, call for securitization sponsors and/or asset originators to retain an economic interest in a material portion of the credit risk that the sponsor and/or asset originator conveys to a third party via a securitization transaction. As noted above, we support the concept of requiring retention of a meaningful economic interest in securitized loans as a means of creating a better alignment of incentives among transaction participants. Many securitizations already embed this concept through various structuring mechanisms, including via the retention of subordinated or equity risk in the securitization, holding portfolio assets bearing credit exposure that is similar or identical to that of securitized assets, and representations and warranties that require originators or sponsors to repurchase assets that fail to meet stated securitization eligibility requirements, among others. However, we do not believe that mandated retention of specific portions of credit risk--one such form of economic interest--necessarily constitutes the sole or most effective means of achieving this alignment in all cases. There are numerous valid and competing policy goals that stand in opposition to requiring the retention of credit risk in securitized assets and exposures. Among others, these include the proper isolation of transferred assets (i.e., meeting legal criteria necessary to effect a ``true sale''); reduction and management of risk on financial institutions' balance sheets; balance sheet management; and the redeployment of capital to enable financial institutions to originate more credit than their limited capital resources would otherwise allow. Balancing these competing and worthwhile policy goals suggests that retention and incentive alignment mechanisms other than universal credit risk retention requirements should be considered. This viewpoint was echoed by the IMF last week in its Global Financial Stability Report, which expressed strong concerns about the potential unintended negative consequences of implementing suggested credit risk retention requirements and instead indicated that regulatory authorities ``should consider other mechanisms that incentivize due diligence and may be able to produce results comparable to a retention requirement, including, perhaps, representations and warranties.'' \28\--------------------------------------------------------------------------- \28\ International Monetary Fund, ``Restarting Securitization Markets: Policy Proposals and Pitfalls.'' Global Financial Stability Report: Navigating the Financial Challenges Ahead (Oct. 2009), p. 31. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.--------------------------------------------------------------------------- We believe that the risk or ``skin in the game'' traditionally retained by originators of RMBS is embodied in the representations and warranties that issuers provide with respect to the mortgage loans sold into the securitization trust. These representations and warranties are designed to ensure that the loans are free from undisclosed origination risks, leaving the investor primarily with normal risks of loan ownership, such as the deterioration of the borrower's credit due to loss of employment, disability or other ``life events.'' However, many market participants have indicated that the traditional representations and warranties and their related remedy provisions have not sufficiently provided a means to return defective loans to the originator. Because of this, the ASF has sought to enhance and standardize these items through the previously discussed Project RESTART Model RMBS Representations and Warranties and Model Repurchase Provisions. We therefore believe that to the extent legislation is adopted to require risk retention, regulators should have flexibility to develop and apply alternative retention mechanisms. This flexibility should include the ability for regulators to specify permissible forms and amounts of retention, how retention requirements may be calculated and measured, the duration of retention requirements, whether and to what extent hedging or risk management of retained positions is permissible, and other implementation details. Finally, we believe that it is imperative to achieve global harmonization and consistency of policy approaches to securitization risk retention. Different approaches are being considered and/or have been adopted in different jurisdictions. \29\ Given the global nature of securitization activity and the mobility of global capital among jurisdictions, significant competitive disparities and inefficiencies may be produced by introducing substantively different retention standards throughout the world's financial markets. We believe that is essential for policymakers to coordinate their approaches in this area.--------------------------------------------------------------------------- \29\ One such approach was adopted by the European Parliament in May 2009. Article 122a to the Capital Requirements Directive prohibits EU banks from investing in securitizations unless the originator retains on an ongoing basis at least 5 percent of the material net economic interest of the securities securitized. The article proposes four ways the 5 percent retention requirement may be applied. The article's requirement is scheduled to go into effect on December 31, 2010, for new issues, and December 31, 2014, for existing securitizations where new underlying exposures are added or subtracted after that date. For more information, see: http://www.europarl.europa.eu/sides/getDoc.do?type=TA&reference=P6-TA-2009-0367&language=EN&ring=A6-2009-0139#BKMD-35.---------------------------------------------------------------------------C. Increased Regulatory Capital and Limitations on Off-Balance Sheet Financing The Obama Administration has advocated that risk-based regulatory capital requirements should appropriately reflect the risk of structured credit products, including the concentrated risk of senior tranches and resecuritizations and the risk of exposures held in highly leveraged off-balance sheet vehicles. Global policymakers have also advocated for minimizing opportunities for financial institutions to use securitization to reduce their regulatory capital requirements without a commensurate reduction in risk. Consistent with the above views, the Basel Committee on Banking Supervision has amended the Basel II risk-based capital framework to require additional regulatory capital to be held against certain resecuritizations (such as CDOs), on the basis that previous rules underestimated the risks inherent in such structures. In the U.S., the combined bank regulatory agencies recently issued proposals that would continue to link risk-based capital requirements to whether an accounting sale has occurred under U.S. GAAP. Given that recent accounting changes (which will generally take effect in January 2010) will make it very difficult to achieve GAAP sales in many securitizations, including both term asset-backed securities and asset-backed commercial paper vehicles, these proposed rules will likely materially increase the capital that financial institutions will be required to hold in against securitizations, since many securitized assets will remain on or return to those institutions' balance sheets. ASF supports efforts to addresses weaknesses in the risk-based capital framework that have been revealed in certain securitization products by the recent financial market dislocation, and agrees that regulatory capital levels should adequately reflect the risks of different types of securitization transactions. Furthermore, ASF supports efforts to reduce or eliminate opportunities for regulatory capital arbitrage that are unrelated to differences in the risk profiles of securitization instruments. We therefore believe that increases in regulatory capital requirements for certain securitizations may be appropriate, based on the conclusion that they present more risk than had been previously understood (for example, because of their use of leverage or where underlying risk positions are more highly correlated than they were assumed to be, as in the case of certain CDOs and SIVs). However, a broader increase in capital requirements for securitization across the board, that is not tied to the differing risk profiles of different transactions, may produce very negative consequences for the economic viability of securitization. In turn, this outcome could unduly constrain the ability of financial institutions to originate and fund consumer and business credit demand, particularly as the broader economy begins to recover. ASF is particularly concerned that linking risk-based capital requirements to accounting outcomes--particularly when those outcomes are produced by the application of accounting standards that are not themselves risk-based--is an inappropriate policy response. We believe that the resulting increase in regulatory capital required to be held against securitized assets held on financial institutions' balance sheets will grossly misrepresent the actual, incremental risk inherent in those assets. We believe that a more targeted approach to revising the securitization risk-based capital framework is warranted. Last week ASF asked the U.S. bank regulatory agencies for a 6-month moratorium relating to any changes in bank regulatory capital requirements resulting from the implementation of FASB's Statements 166 and 167. We believe that this action is necessary to avoid a potentially severe capital and credit shock to the financial system as of January 1st, when the new accounting rules generally take effect. We will be providing detailed input and recommendations to bank regulatory agencies and other policymakers on this important topic by the October 15th deadline.D. Rating Agency Reforms ASF supports credit rating reform in the securitization markets, focusing on steps designed to increase the quality, accuracy and integrity of credit ratings and the transparency of the ratings process. Credit ratings have occupied a central role in the securitization markets, providing investors and other market participants with expert views on the credit performance and risks associated with a wide range of securitization products. As an outgrowth of the financial market crisis, confidence in rating agencies and the ratings process for securitization have been significantly impaired. We believe that a restoration of such confidence is a necessary step in restoring broader confidence and function to the securitization markets. Various credit rating reform measures targeting the securitization markets have been advanced by policymakers, and a number of proposals have been adopted or remain under consideration by the Securities Exchange Commission. Our views on some of the more significant proposals affecting the securitization market are summarized below: \30\--------------------------------------------------------------------------- \30\ For more detail on ASF's views on these and other credit rating agency reform proposals, see the series of letters submitted to the SEC by ASF between May and September of 2008. These letters may be found at: http://www.americansecuritization.com/uploadedFiles/ASFpercent20CRA percent20-percent20ratings percent20scale.pdf (May 2008); http://www.americansecuritization.com/uploadedFiles/Release_34-57967_ASF_Comment_Letter_.pdf (July 2008); and http://www.americansecuritization.com/uploadedFiles/ASF_Final_SEC_CRA--Letter_9_5_08.pdf (Sept. 2008). 1. Conflicts of Interest. We support measures aimed at developing and enhancing strong conflict of interest policies and rules governing the operations of credit rating agencies. We believe that effective management and disclosure of actual and potential conflicts is a necessary component for ensuring --------------------------------------------------------------------------- transparency and integrity in the rating process. 2. Differentiation of Structured Finance Ratings. ASF supports full and transparent disclosure of the basis for structured finance ratings, so that the risk of securitizations can be understood and differentiated from risks presented by other types of credit instruments. However, we strongly oppose proposals advocating that a special ratings designation or modifier be required for structured finance ratings. We believe that such a designation or modifier would not convey any meaningful information about the rating, and would require significant revisions to private investment guidelines that incorporate ratings requirements. 3. Ratings Performance Disclosure. We support the publication in a format reasonably accessible to investors of a record of all ratings actions for securitization instruments for which ratings are published. We believe that publication of these data will enable investors and other market participants to evaluate and compare the performance, stability, and quality of ratings judgments over time. 4. Disclosure of Ratings Methods and Processes. ASF strongly supports enhanced disclosure of securitization ratings methods and processes, including information relating to the use of ratings models and key assumptions utilized by those models. 5. Reliance on Ratings. We believe that investors and other market participants, including regulators, should not place an undue reliance on credit ratings, and should employ other mechanisms for performing an independent credit analysis. However, ASF believes that credit ratings are an important part of existing regulatory regimes, and that steps aimed at reducing or eliminating the use of ratings in regulation should be considered carefully, to avoid undue disruption to market function and efficiency.Conclusion The securitization market is an essential mechanism for supporting credit creation and capital formation throughout the consumer and business economy. Its role is even more important today, when other sources of credit and financing are limited, due to balance sheet, capital, and liquidity constraints facing financial institutions. Securitization activity was significantly impaired as a consequence of the financial market crisis. While portions of the securitization market have recovered to some extent throughout 2009, other market segments remain significantly challenged. The financial market crisis revealed weaknesses in several key areas of securitization market activity. Targeted reforms are needed, and a number are being pursued through both public- and private-sector responses. In pursuing market reforms and redressing these weaknesses, care should be taken to avoid imposing undue impediments to the restoration of securitization activity that could adversely impact credit availability and retard economic recovery and growth. Thank you for the opportunity to share these views, and I look forward to answering any questions that Members of the Subcommittee may have. ______ CHRG-111shrg53822--78 Mr. Rajan," I agree that they could have some effect. But my point is when you set capital requirements at 20 percent of bank assets, they are going to do a lot of things, which you will be surprised about in bad times because those SIVs, they have created the conduits. It will all come back on balance sheets at that point, and you will find that even the 20 percent is not enough. That is one. The second is we also have to worry about costs. When you ask banks, which are naturally funded with debt, to take on a lot of capital, intermediation is also going to suffer. I mean, I agree with you. You could have some benefits, but maybe not that much. Senator Akaka. Thank you. Speaking about capital and ensuring adequate capital, Mr. Rajan raises the idea of having large, complex financial companies buy capital insurance plans or issue bonds that will convert to equity if capital deteriorates as a way to guard against the failure of these institutions. Mr. Rajan, can you elaborate on this idea? " CHRG-110shrg50414--109 Secretary Paulson," We are not just recommending a reverse auction. That would be one way of handling it. Senator Enzi. OK, but just on the reverse auction part of this, I mean, we are going to have questions on all parts of it, but I think it will help the big banks to sell their toxic debt. But what about the smaller banks? How are they going to be able to compete with the Citigroups in the world to sell their assets? Economies of scale suggest to me that the plan will bail out the big banks, and our community institutions might be left holding the bag. What kind of consideration has been given to that? " CHRG-111hhrg48674--46 Mr. Bernanke," So, first of all, a couple of points. One is that even though foreign investments in U.S. securities have gone down, the investments have gone down on the private sector side, and investments in Treasuries have gone up because Treasuries are very safe, so there is still plenty of funding for Treasuries. But I think it is very important that, even as we run a large deficit this year and next year, and the President has said the same, that we work very hard to make sure that we restore a fiscal balance as soon as possible. So I think that is very important, and if we do that, that will make it possible for us to finance our way through this emergency. On the Federal Reserve's balance sheet of $2 trillion, as you point out, there is no government debt involved there. There is no borrowing that is not Treasury. And also we have nothing to do with the GSEs. We are not lending anything to the GSEs. You are correct in pointing out that we have a fourth loss position for both Citi and Bank of America which under extraordinarily severe, unprecedented conditions could cause us to lose some money. But, right now, I feel very comfortable that we are not on the watch list, that we have plenty of capital, that our likely losses are quite small. In fact, while I haven't put together numbers, I would guess that the profits we make on our lending programs would be a very substantial offset to any losses that we might make. " CHRG-111hhrg51698--36 Mr. Greenberger," If I could address the question, I would urge you to keep the provision in the statute. Mr. Gooch talks about CDS buying protection. We are talking about naked CDS. With naked CDS, there is no need to protect. It is a bet that, in the case of subprime mortgages, that the homeowner will not pay his mortgage or her mortgage. These get paid off if the collateralized debt obligations fail. The collateralized debt obligations are a security interest in homeowners paying their mortgages. These are people who don't have the security interest in that. John Paulson, in 2007, took out these naked credit default swaps; and because there were so many forfeitures of your constituents, he was able to take home $4 billion that year. Now, he was lucky, because he got to the window when the people who were issuing the guarantees still had money. AIG ran out of money. And, by the way, you and I and your constituents are now sending money in the front door of AIG and Citigroup and others, so it will go out the back door to pay people who took a naked bet that homeowners would not pay their mortgages. Because you are having bets out there that have no reflection of the real economic debt, as Eric Dinallo told you, it is magnifying the problems by threefold, somebody says eight-fold. In other words, more people are betting the mortgages won't be paid than there are mortgages. With regard to your correlation between the SEC short and this, I believe that Chairman Cox, a former Member of the House of Representatives and President Bush's Chair of the SEC, wants to ban naked credit default swaps because it is a way to get around the regulated equity markets. In other words, if you think GM is going to fail, you buy a naked credit default swap on GM, even if you don't own a bond in GM. And then what do some of those people do? It is reported they go out and take every action they can take to encourage the failure of GM. In the case of insuring subprime loans, Barney Frank has made the point that when banks have gone in and tried to renegotiate to leave people in their houses, that hurts the people who have guarantees for the failure. So they are bringing lawsuits to prevent that renegotiation. These naked credit default swaps create the grossest form of moral hazard. From 1789, when this Republic was founded, to the mid-1990s we didn't have credit default swaps or naked credit default swaps. I ask you, are your constituents, when you go home, saying, please, please, please allow us to have naked credit default swaps? No. It is the bankers who got us into this problem who want these naked credit default swaps. They should be banned; and I believe if this Committee doesn't do it, it will be done by the SEC. And it will be the first step in the pillar to say the CFTC is not doing the job, let's get rid of it and put it in the SEC. " FOMC20080318meeting--15 13,VICE CHAIRMAN GEITHNER.," Mr. Chairman, could I just add one thing on this? I think the delicacy of the whole tri-party repo thing is hard to overstate. For better or worse, mostly for worse, the full tri-party repo market generally has spread over the last few years well beyond Fedeligible securities, and until we get to the other side of this, there is a lot of risk in that stuff on repo that goes further out the eligible collateral quality spectrum. Even in a world where confidence comes back around the primary dealers as counterparties, the thing is there's just some natural risk that that stuff is going to have to be financed in some other form. The hardest thing in this balance now is to try to do something that doesn't increase the incentives so that we become the counterparty to everybody. We're trying to make sure that it's a backstop, but not a backstop that's so attractive that they come, and that's going to be a very hard line to walk. I say that, Bill, because, just to lower expectations, the necessary cost of the choice we've made is that we're going to take the risk that we end up funding a bunch of stuff like that, and the commitment to do that is the only way this helps. It is very hard to know. Again, even if confidence holds, there is a reasonable probability that some of that stuff is just going to have to move into different forms and other hands, and that could be a delicate transition, particularly if people read into that a broader loss of confidence in this stuff. The other thing that's important to point out is that it is just not realistic to expect, even with the force of the things that we announced on Sunday night, that we don't still have a wave of deleveraging ahead of us. There is still just a huge part of the world that knows they are really long on risk in a fragile environment and have not yet gotten to that point. With everything that's happened in markets, their leverage is going up as the world goes against them, and they're going to want to keep bringing it down. That really is going to work against the effect of all the things we're doing. So just be prepared under the best of circumstances for a sustained period of substantial fragility. But to underscore your point, Jeff, we agree with your point and had been discussing in what we thought was a slightly calmer world over the past two weeks exactly that mix of things, and we'll be on it together and consulting. " CHRG-111hhrg52406--231 Mr. Hughes," Well, I think, if insurance were exempted and we were not part of it and if there were other aspects of the bill, for example, and if the Office of National Insurance were part of it, then perhaps, yes, we would. On the new agency specifically, if we are not part of it, we will not have any interest in it, but if there are other aspects of the Administration's proposal that we do favor and if we were not part of the agency, then, in fact, we would be inclined to be supportive, yes. Ms. Speier. Ms. Weatherford? Ms. Weatherford. Our association represents financial security products, which are very different from the debt instruments that have been discussed by most of the panelists today, and we are already under the oversight of State insurance regulators--the SEC and FINRA--and fully believe that we should be exempted. Ms. Speier. I understand that, but would you support the bill if you were exempted? Ms. Weatherford. If the Office of National Insurance were included, if Representative Kanjorski's language for his bill possibly had some of that in there where we could enjoy having some Federal knowledge of insurance and insurance regulation, I think it would be most helpful to us. Ms. Speier. Wait. Are you saying that, if there were a national charter for insurers, then you would want to be exempted from this insurance being part of it? Ms. Weatherford. No. We could support it if there were the inclusion of the Office of National Insurance or of the Office of National Insurance Information where more knowledge was held at the Federal level about insurance regulation. Ms. Speier. So, if it were just the Office of Insurance Regulation and not the preemption of States relative to international treaties and agreements, you would support this bill? Ms. Weatherford. I suppose, yes, we would, other than the fact that many of the aspects of the bill are about debt instruments and apply to other entities that have nothing to do with insurance. Ms. Speier. All right. Finally. " FOMC20051213meeting--3 1,MR. KOS.,"1 Thank you, Mr. Chairman. I’ll be referring to the handout that is in front of you. With the year-end approaching, I thought I’d look back at 2005 a bit. One of the more surprising market developments has been the steady—if low-key— appreciation of the U.S. dollar. That strength is all the more surprising after the dollar’s depreciation in 2004 when it appeared that the current account imbalance had hit a threshold that was impacting exchange markets. But, as shown on the top of page 1 of your handout, the trade-weighted dollar has appreciated by 8 percent since the start of 2005. The dollar’s strength was broad-based against all major currencies. As shown in the middle left panel, the dollar rallied from below 105 yen to 120 yen. That last 10 yen—from 110 to 120—came in a nearly straight line and was coincident with Prime Minister Koizumi’s victory in the September elections and the ongoing improved sentiment about the Japanese economy. Risk appetite among Japanese investors seems to have risen and capital outflows have accelerated, as investors look to pick up yield in fixed income markets not only in the United States but also in markets such as the U.K., Australia, and New Zealand. As shown in the middle right panel, the dollar has also risen against the euro. At the start of 2005 the euro was trading at about $1.35. Today it is below $1.20. Sentiment toward the euro has been poor, given lackluster growth and the widening interest rate differentials with the dollar—but I’ll comment more on that later. Among the few currencies that the dollar depreciated against were the Mexican peso and the Brazilian real. Both countries have substantially higher nominal and real interest rates, and both central banks in recent months have been easing policy. At this point, you might be asking yourself: Whatever happened to the issue of the current account deficit? Weren’t the imbalances supposed to lead to a weaker dollar? Certainly, that explanation appeared to work last year when the dollar was falling. The bottom panel of the first page graphs the trade-weighted dollar—the red line—and the current account balance for the United States as a percent of GDP since 1980—the blue bars. Ideally, this should show that when the deficit is high, a weak dollar follows. While there have been a couple of periods when growing current account imbalances were followed by a subsequent bout of dollar weakness (for example, in the period after 1985), there are examples of just the opposite as well. The dollar strengthened in the early 1980s and also the late 1990s in the face of high and rising current account deficits. When looked at quantitatively, the correlation between the current account and the next year’s exchange rate is weak. December 13, 2005 4 of 100 What, then, explains the dollar’s strength? The most compelling explanation— and this is tentative, I should say—appears to center around the economy’s strength relative to other major economies. That difference in performance is, in turn, reflected in interest rate differentials, as shown on page 2. This page graphs the sovereign G-7 yield curve in green, the U.S. Treasury curve in blue, and the G-7 curve excluding the United States in red. The composite yield curves are based on GDP weights for each country. At the beginning of 2004, U.S. short-term rates were lower than those of other major countries and the U.S. curve was steeper. By the beginning of 2005, and with the tightening cycle here already well along, the entire U.S. yield curve had shifted above the others, as shown in the middle panel. That interest rate differential continued to widen during 2005, with the prospect for further widening if futures markets in the G-7 are to be believed. Of course, all that tells us nothing about the future course of exchange rates. Perhaps growth and interest rate differentials will continue to drive exchange markets. Or perhaps the current account will finally hit some threshold where a sharp depreciation is triggered. Unfortunately, reviewing past relationships does not help answer that key question. Turning to page 3 for a closer look at recent monetary policy expectations in the G-3, the top panel graphs the 3-month cash rate for the dollar and euro—in the solid blue and red lines, respectively—and 3-, 6-, and 9-month forward rates in the dashed lines. This graph depicts the widening of differentials between dollar and euro interest rates during the year. But it also shows the recent uptrend in rates in the euro area, as the ECB finally tightened by 25 basis points earlier this month—although that uptrend was contained by the ECB’s deliberate attempts to signal that this was not the first of a string of moves along the lines of the U.S. cycle. Short-term rates from forward-rate agreements for Japan, shown in the middle panel, suggest some backing off from earlier expectations about how quickly the Bank of Japan [BOJ] would enter a new tightening cycle, with 9-month forward rates falling about 10 basis points over the intermeeting period. Although the BOJ has signaled an intention to exit its quantitative easing policy in the second quarter of 2006, there has been substantial push-back from politicians. Furthermore, the BOJ itself has said explicitly that even after the exit from quantitative targeting, short-term rates would stay at or close to zero for some time afterward. December 13, 2005 5 of 100 currency terms. And for specific markets such as Brazil and Mexico—whose currencies have appreciated— returns expressed in dollars have been turbocharged. Turning to page 4 and continuing on the theme of healthy risk appetites, the top panel graphs the high yield and EMBI+ [Emerging Market Bond Index Plus] spreads for the year to date. High yield spreads have stabilized at around 380 basis points— higher than levels observed last spring but still low by historical standards. In contrast, since the last FOMC meeting, emerging-market debt spreads—the green line—have continued to tighten to all-time lows. Investment grade spreads—in the middle left panel—show a similar pattern. Excluding the troubled auto and airline industries, corporate financial health remains strong. Earnings and cash levels are both high, and leverage is relatively low. That said, a bit of re-leveraging is in the pipeline, judging by the increasing flows in LBO deals and announced stock buybacks. The big credit story in November, of course, was the worsened outlook for GM. CDS [credit default swap] spreads for GM, shown in the middle right panel, are now trading about 1200 basis points over Libor, compared to just over 300 basis points for the high yield CDX index. Near-term prospects for GM have deteriorated significantly, so much so that the credit yield curve for GM has inverted. In other words, it is more expensive to buy credit protection against a GM default in the next 12 months, than it is to buy credit protection against a GM default over the next 5 years. In addition, sellers of CDS protection on GM have started to demand up-front payment from buyers of protection. They are “front loading” their coupon payments of the swap because of fears that GM will default before they have received any payments from protection buyers. The worries about GM were likely reinforced by yesterday’s announcement from Standard and Poor’s that it had downgraded GM to single B. Recent declines in volatility in both equity and debt markets reinforce this low risk concept and are consistent with the strong risk appetite in markets. While the VIX has shown some periodic spikes this year, the movements this year are very small compared to historical changes. Fixed income volatility is also low, as shown in the bottom right panel. December 13, 2005 6 of 100 Looking at shorter periods, the bottom left panel graphs for 2005 the year-on­ year growth rate for currency. Currency growth has decelerated from a 5.5 percent growth rate at the beginning of the year to about 3.5 percent. The noisy panel on the bottom right shows the growth of currency in the year-end period for each of the past four years as well as this year through last week, with projections for the remainder of this year in the burgundy dots. During the 2001 year-end—the blue line at the top— currency grew about 4 percent from November to the peak in late December before the reflows began. The following year the year-end seasonal bulge was less pronounced, and that pattern has continued in each year since. Again, it’s not clear what is driving this process, but greater use of alternative forms of payment sounds reasonable. In any case, the smaller hump in seasonal demand will, if it persists, make the management of reserves more straightforward in the future. Mr. Chairman, there were no foreign operations by the Desk. I will need a vote to approve domestic operations." CHRG-111hhrg55811--72 Mr. Lucas," Since we are talking about, in many cases, some substantial increase in enforcement authority, I think it would be fascinating to know how many have been brought under existing rules in a very complicated time, so I look forward to that, very much, to that response. Now, I address this to both of you. Looking at the way this draft proposal is crafted, tell me what kind of resource increases, both personnel and dollars, would you expect from an administrative perspective you will have to have to implement the language, assuming we ultimately come up with a bill very similar to this draft. " CHRG-111hhrg54867--253 Secretary Geithner," Exactly. How you are funded is as important to how much risk you take. In fact, they are totally and completely related. And it is this mismatch between very short-term liabilities that can run and long-term assets that are liquid that allow the risk in them that creates the inherent vulnerability to crisis. So you need to both constrain leverage and make sure there is more conservative funding. " CHRG-111shrg57322--547 Mr. Birnbaum," Well, I think taking publicly available information and trading a publicly traded equity is perfectly fine---- Senator Coburn. But that is counter to what you were promoting yourself and your own deal, that you were going to expand the use and leverage the use of the knowledge within the firm. All I am asking you is you did not use any of the knowledge anywhere else in the firm to advantage your ability to make a better return as a risk management? " CHRG-111shrg55117--126 PREPARED STATEMENT OF SENATOR TIM JOHNSON Thank you, Chairman Bernanke for being here today. As the economy continues to undergo a period of stress and volatility, I look forward to hearing the Fed's economic forecast for the rest of 2009 and into 2010. The Fed continues to have a full plate as it looks for ways to address the problems plaguing our economy. I applaud your efforts to date to achieve economic stability. Unfortunately, I suspect we are not yet at the end of the road in terms the challenges facing our economy. I am committed to our Nation's economic recovery and to ensuring the safety and soundness of the financial sector without placing unnecessary burdens on the taxpayer. In the long run, the best way to protect taxpayers is to fashion a functional regulatory system that prevents situations like the ones we are currently experiencing from arising again. As the Banking Committee tackles financial regulatory restructuring in coming weeks, we will continue to look to your expertise. As many others have noted, the status quo is no longer an option. It is my hope that Members of this Committee from both sides of the aisle can construct a proposal that reflects the needs of our Nation's taxpayers, consumers and investors, and financial markets and institutions to achieve economic recovery and needed reform. ______ FinancialCrisisReport--77 Effective implementation of the High Risk Lending Strategy also required robust risk management. But while WaMu was incurring significantly more credit risk than it had in the past, risk managers were marginalized, undermined, and subordinated to WaMu’s business units. As a result, when credit risk management was most needed, WaMu found itself lacking in effective risk management and oversight. D. Shoddy Lending Practices At the same time they increased their higher risk lending, WaMu and Long Beach engaged in a host of poor lending practices that produced billions of dollars in poor quality loans. Those practices included offering high risk borrowers large loans; steering borrowers to higher risk loans; accepting loan applications without verifying the borrower’s income; using loans with low teaser rates to entice borrowers to take out larger loans; promoting negative amortization loans which led to many borrowers increasing rather than paying down their debt over time; and authorizing loans with multiple layers of risk. WaMu and Long Beach also exercised weak oversight over their loan personnel and third party mortgage brokers, and tolerated the issuance of loans with fraudulent or erroneous borrower information. (1) Long Beach Throughout the period reviewed by the Subcommittee, from 2004 until its demise in September 2007, Long Beach was plagued with problems. Long Beach was one of the largest subprime lenders in the United States, 206 but it did not have any of its own loan officers. Long Beach operated exclusively as a “wholesale lender,” meaning all of the loans it issued were obtained from third party mortgage brokers who had brought loans to the company to be financed. Long Beach “account executives” solicited and originated the mortgages that were initiated by mortgage brokers working directly with borrowers. Long Beach account executives were paid according to the volume of loans they originated, with little heed paid to loan quality. Throughout the period reviewed by the Subcommittee, Long Beach’s subprime home loans and mortgage backed securities were among the worst performing in the subprime industry. Its loans repeatedly experienced early payment defaults, its securities had among the highest delinquencies in the market, and its unexpected losses and repurchase demands damaged its parent corporation’s financial results. Internal documentation from WaMu shows that senior management at the bank was fully aware of Long Beach’s shoddy lending practices, but failed to correct them. 2003 Halt in Securitizations. For a brief period in 2003, Long Beach was required by WaMu lawyers to stop all securitizations until significant performance problems were remedied. While the problems were addressed and securitizations later resumed, many of the issues returned and lingered for several years. 206 See 1/2007 Washington Mutual Presentation, “Subprime Mortgage Program,” Hearing Exhibit 4/13-5 (slide showing Long Beach Annual Origination Volume). CHRG-109shrg26643--7 STATEMENT OF SENATOR ROBERT MENENDEZ Senator Menendez. Thank you, Mr. Chairman. Mr. Chairman, welcome, congratulations. We are pleased to welcome you, as a fellow New Jersian, and we know that you will do an exceptional job in this regard. I certainly look forward to your testimony today and to some of the challenges I think we face: The cooling off of the housing market and what that may mean, rising energy prices, consequences of deficit and debt, a variety of global influences, and a dynamic, modern economy that we have. Those are all the challenges that you face before you and so we look forward to your stewardship in meeting, having a steady hand in the midst of all of the dynamic realities that we face, so we look forward to hearing your testimony, and once again congratulations on your appointment, Mr. Chairman. " CHRG-111shrg62643--93 Mr. Bernanke," Policy uncertainties are no doubt part of it, but there is also economic uncertainties, just uncertainty about how labor markets will evolve, how consumer spending will evolve, how the global economy will evolve and so on. So there is a lot of uncertainty, and that is certainly an issue. Senator Gregg. If you were doing a formula, I think the percentage that would be assigned to Federal fiscal policy would be fairly high for creating uncertainty as a result of our unwillingness to face the long-term debt problems we have, the tax policies which are coming at us which will penalize capital formation, and the uncertainty about what sort of capital you have to have on your books in order to make loans in the financial institutions for at least the next 6 months to 2 years. " fcic_final_report_full--289 In early November, the SEC called the growing concern about Merrill’s use of the monolines for hedging “a concern that we also share.”  The large Wall Street firms attempted to minimize their exposure to the monolines, particularly ACA. On De- cember , S&P downgraded ACA to junk status, rating the company CCC, which was fatal for a company whose CEO said that its “rating is the franchise.”  Firms like Merrill Lynch would get virtually nothing for the guarantees they had purchased from ACA. Despite the stresses in the market, the SEC saw the monoline problems as largely confined to ACA. A January  internal SEC document said, “While there is a clear sentiment that capital raising will need to continue, the fact that the guarantors (with the exception of ACA) are relatively insulated from liquidity driven failures provides hope that event[s] in this sector will unfold in a manageable manner.”  Still, the rating agencies told the monolines that if they wanted to retain their stel- lar ratings, they would have to raise capital. MBIA and Ambac ultimately did raise . billion and . billion, respectively. Nonetheless, S&P downgraded both to AA in June . As the crisis unfolded, most of the monolines stopped writing new coverage. The subprime contagion spread through the monolines and into a previously unimpaired market: municipal bonds. The path of these falling dominoes is easy to follow: in anticipation of the monoline downgrades, investors devalued the protec- tion the monolines provided for other securities—even those that had nothing to do with the mortgage-backed markets, including a set of investments known as auction rate securities, or ARS. An ARS is a long-term bond whose interest rate is reset at regularly scheduled auctions held every one to seven weeks.  Existing investors can choose to rebid for the bonds and new investors can come in. The debt is frequently municipal bonds. As of December , , state and local governments had issued  billion in ARS, accounting for half of the  billion market. The other half were primarily bundles of student loans and debt of nonprofits such as museums and hospitals. The key point: these entities wanted to borrow long-term but get the benefit of lower short-term rates, and investors wanted to get the safety of investing in these se- curities without tying up their money for a long time. Unlike commercial paper, this market had no explicit liquidity backstop from a bank, but there was an implicit backstop: often, if there were not enough new buyers to replace the previous in- vestors, the dealers running these auctions, including firms like UBS, Citigroup, and Merrill Lynch, would step in and pick up the shortfall. Because of these interven- tions, there were only  failures between  and early  in more than , auctions. Dealers highlighted those minuscule failure rates to convince clients that ARS were very liquid, short-term instruments, even in times of stress.  However, if an auction did fail, the previous ARS investors would be obligated to retain their investments. In compensation, the interest rates on the debt would reset, often much higher, but investors’ funds would be trapped until new investors or the dealer stepped up or the borrower paid off the loan. ARS investors were typically very risk averse and valued liquidity, and so they were willing to pay a premium for guarantees on the ARS investments from monolines. It necessarily followed that the monolines’ growing problems in the latter half of  affected the ARS market. Fearing that the monolines would not be able to perform on their guarantees, in- vestors fled. The dealers’ interventions were all that kept the market going, but the stress became too great. With their own problems to contend with, the dealers were unable to step in and ensure successful auctions. In February, en masse, they pulled up stakes. The market collapsed almost instantaneously. On February , in one of the starkest market dislocations of the financial crisis,  of the ARS auctions failed; the following week,  failed.