[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]



 
                  SYSTEMIC RISK: EXAMINING REGULATORS'
                     ABILITY TO RESPOND TO THREATS
                        TO THE FINANCIAL SYSTEM

=======================================================================

                                HEARING

                               BEFORE THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

                            OCTOBER 2, 2007

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 110-65


                                     
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                 BARNEY FRANK, Massachusetts, Chairman

PAUL E. KANJORSKI, Pennsylvania      SPENCER BACHUS, Alabama
MAXINE WATERS, California            RICHARD H. BAKER, Louisiana
CAROLYN B. MALONEY, New York         DEBORAH PRYCE, Ohio
LUIS V. GUTIERREZ, Illinois          MICHAEL N. CASTLE, Delaware
NYDIA M. VELAZQUEZ, New York         PETER T. KING, New York
MELVIN L. WATT, North Carolina       EDWARD R. ROYCE, California
GARY L. ACKERMAN, New York           FRANK D. LUCAS, Oklahoma
JULIA CARSON, Indiana                RON PAUL, Texas
BRAD SHERMAN, California             PAUL E. GILLMOR, Ohio
GREGORY W. MEEKS, New York           STEVEN C. LaTOURETTE, Ohio
DENNIS MOORE, Kansas                 DONALD A. MANZULLO, Illinois
MICHAEL E. CAPUANO, Massachusetts    WALTER B. JONES, Jr., North 
RUBEN HINOJOSA, Texas                    Carolina
WM. LACY CLAY, Missouri              JUDY BIGGERT, Illinois
CAROLYN McCARTHY, New York           CHRISTOPHER SHAYS, Connecticut
JOE BACA, California                 GARY G. MILLER, California
STEPHEN F. LYNCH, Massachusetts      SHELLEY MOORE CAPITO, West 
BRAD MILLER, North Carolina              Virginia
DAVID SCOTT, Georgia                 TOM FEENEY, Florida
AL GREEN, Texas                      JEB HENSARLING, Texas
EMANUEL CLEAVER, Missouri            SCOTT GARRETT, New Jersey
MELISSA L. BEAN, Illinois            GINNY BROWN-WAITE, Florida
GWEN MOORE, Wisconsin,               J. GRESHAM BARRETT, South Carolina
LINCOLN DAVIS, Tennessee             JIM GERLACH, Pennsylvania
ALBIO SIRES, New Jersey              STEVAN PEARCE, New Mexico
PAUL W. HODES, New Hampshire         RANDY NEUGEBAUER, Texas
KEITH ELLISON, Minnesota             TOM PRICE, Georgia
RON KLEIN, Florida                   GEOFF DAVIS, Kentucky
TIM MAHONEY, Florida                 PATRICK T. McHENRY, North Carolina
CHARLES WILSON, Ohio                 JOHN CAMPBELL, California
ED PERLMUTTER, Colorado              ADAM PUTNAM, Florida
CHRISTOPHER S. MURPHY, Connecticut   MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana                PETER J. ROSKAM, Illinois
ROBERT WEXLER, Florida               KENNY MARCHANT, Texas
JIM MARSHALL, Georgia                THADDEUS G. McCOTTER, Michigan
DAN BOREN, Oklahoma

        Jeanne M. Roslanowick, Staff Director and Chief Counsel


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    October 2, 2007..............................................     1
Appendix:
    October 2, 2007..............................................    43

                               WITNESSES
                        Tuesday, October 2, 2007

Bookstaber, Richard, author, ``A Demon of our Own Design: 
  Markets, Hedge Funds, and the Perils of Financial Innovation''.     7
Kuttner, Robert, Editor, The American Prospect...................    12
Pollock, Alex J., Resident Fellow, American Enterprise Institute.    15
Schwarcz, Steven L., Stanley A. Star Professor of Law and 
  Business, Duke University School of Law........................     9

                                APPENDIX

Prepared statements:
    Waters, Hon. Maxine..........................................    44
    Bookstaber, Richard..........................................    47
    Kuttner, Robert..............................................    53
    Pollock, Alex J..............................................    66
    Schwarcz, Steven L...........................................    72

              Additional Material Submitted for the Record

Manzullo, Hon. Donald A.:
    Disclosure form, ``The Basic Facts About Your Mortgage Loan''    83


                  SYSTEMIC RISK: EXAMINING REGULATORS'
                     ABILITY TO RESPOND TO THREATS
                        TO THE FINANCIAL SYSTEM

                              ----------                              


                        Tuesday, October 2, 2007

             U.S. House of Representatives,
                   Committee on Financial Services,
                                                   Washington, D.C.
    The committee met, pursuant to notice, at 10:03 a.m., in 
room 2128, Rayburn House Office Building, Hon. Barney Frank, 
[chairman of the committee] presiding.
    Present: Representatives Frank, Waters, Maloney, Watt, 
Hinojosa, McCarthy, Miller of North Carolina, Scott, Cleaver, 
Moore of Wisconsin, Ellison, Klein, Donnelly, Marshall; Bachus, 
Castle, Manzullo, Biggert, Capito, Garrett, Brown-Waite, and 
Neugebauer.
    The Chairman. The hearing will convene. This hearing is one 
in a series we are having on the question of innovation in the 
financial system and what is the appropriate response. And I 
want to be very clear that I think overwhelmingly, probably 
unanimously, members of this committee welcome innovation in 
the financial system. And I believe in the essential 
rationality of the market system. I don't think you get 
innovation unless those innovations do some good and meet a 
need. I don't think that this is purely random.
    On the other hand, there is a tendency--and I was pleased 
to see Secretary Paulson say essentially that a week or so 
ago--for innovation to outrun regulation. That's very sensible. 
You don't regulate in the abstract and in anticipation 
generally. What we have been able to do I believe in our 
financial system over time is to create regulations that allow 
the financial system to do its work with some protections, and 
we should not lose sight of the fact that an important part of 
the regulation we talk about investor and consumer protection, 
which is important.
    We obviously have the concern about systemic risk, which 
today is the most important. And I have been saying that it 
seemed to me less important than investor protection, but here 
we have an issue, we see this in some aspects of subprime where 
investor protection becomes, at the very least, market 
enhancing, and in some cases it may be a necessity for markets. 
That is, in the current situation, we are confronted with a 
substantial lack of investor confidence. And simply talking our 
way out of it doesn't work. Sensible regulation that provides 
some degree of quality assurance is very important if you want 
to get a market going again. My view is that if we want to get 
back into a secondary market for mortgages, and I believe the 
secondary market for mortgages has had enormous benefit as well 
as causing us problems, that can only be done if the--in the 
near term, if the investors have some confidence in the quality 
of what they're being asked to buy. And that's one of the 
things we're working on. I was pleased to see that Chairman 
Bernanke acknowledged that.
    We have been focusing on the subprime issue, and it seems 
to me that's a clear case of innovation leaving regulation 
behind. And if you look at the regulated set of institutions 
that make mortgage loans--the banks and the credit unions 
subjected to State bank authorities, the FDIC, the OCC, and 
others--they did not--the problems weren't there. The problems 
arose in the unregulated sector. We had a pretty good case 
study of this. And our job in part legislative leaves the job 
which the ranking member and the gentleman from North Carolina 
who is here, Mr. Miller, the gentleman, Mr. Watt and I started 
working on 2\1/2\ years ago, and we were rudely interrupted. 
But we will restart that up to do--essentially, we know that 
there are regulations in the area of mortgages that have worked 
reasonably well. And to some extent, our job is to write those 
down and apply them to everybody who regulates mortgages.
    We also, as I said, want to put some confidence into the 
investors in the secondary market that they have some quality 
assurance, and that I think goes to the duty of the servicers, 
the active element in the packaging and selling.
    The question that is harder to answer is what do we do 
about the broader market? We should be very clear. Virtually 
everybody was surprised by the extent to which the problems in 
the subprime market spilled over into the broader market. There 
are people who tell me that they saw it coming. I have asked 
them for any copy of the correspondence in which they notified 
anybody else. So far, nothing. The Fed acknowledges it was 
surprised. The Treasury was surprised. The Financial Services 
Authority in England was surprised, the EU. No one saw the 
extent to which this was going to spill over, at least no one 
in the regulatory area.
    That raises the first question: Do they need to have more 
information? Certainly that ought to be at least a minimum 
amount that we do. I also want to be clear, we are not here 
focused on the particular entity that does the investing. It's 
not hedge funds. It's not private equity. It's not investment 
banks. It's the type of investment, particularly the great 
increase in leverage. A combination of technology and other 
factors have allowed people to do virtually a new form of 
investing. People will tell me maybe it's always been there, 
but as Marx said, in this case accurately, changes in quantity 
become changes in quality. And that's what we have to look at.
    Are there in our financial markets today--is there a degree 
of leverage that people have lost sight of? We can say that 
individuals, individual entities, know what they have. But do 
they know what everybody else has sufficient to make a 
judgment? Do they know that if they need to get out of a 
certain instrument, they won't be in a race with a lot of other 
people trying to do the same thing, devaluing what they have? 
And I am pleased to say that the regulators sense that we 
really need to take a hard look at this and think what it is we 
have to do.
    I also will note one thing, with a little satisfaction. A 
little less than a year ago when I became the chairman of this 
committee, the dominant discussion in the financial press was 
the need for us to deregulate very rapidly lest everybody with 
more than $100 go to England. There was this fear that we were 
going to be depopulated in our financial markets, and we had 
the McKenzie report from Mayor Bloomberg and Senator Schumer. 
We had the report that Secretary Paulson got out of Harvard Law 
School.
    Clearly, we have to look to our competitive situation. And 
we've done some things that we think help with that, and I've 
been a supporter of the SEC, for instance, I think this 
committee in general has, of trying to work with the European 
authorities to get joint accounting, to do other things that 
will ease transnational operations.
    But I think the tone has shifted. We are still talking 
about the international aspect, but we've shifted from a kind 
of argument that we had better deregulate more so that we catch 
down with England, to the notion that the regulators need to 
work together to create some rules. There is an understanding, 
and in fact, I don't know if there are as many enthusiasts, for 
instance, in Europe, some of them were hit pretty hard by the 
consequences of our unregulated subprime market.
    So, obviously, regulation should be diminished. This 
committee is working, for instance, with the American bankers 
and the Financial Services Roundtable to cut down the amount of 
paper that has to be sent to the Treasury, which we think is 
unnecessary. There are other regulations where we have moved to 
cut back. But on this whole question of whether or not the 
fundamental regulatory structure is today adequate to keep the 
regulators informed of what's going on in these new 
developments in the financial market, that's very much an open 
question, and that's what we are focusing on here, and I 
appreciate the witnesses joining us.
    The gentleman from Alabama is recognized for his opening 
statement.
    Mr. Bachus. Thank you, Mr. Chairman. I appreciate you 
calling this hearing on systemic risk. I thought the earlier 
hearings on systemic risks were very helpful, and how 
regulators and market participants can manage the risk that is 
really inherent in a market, if ``manage'' is a good word. I'm 
not sure it is.
    Since the implosion of Long-Term Capital Management in 
1998, which required a bailout orchestrated by the Federal 
Reserve, the Treasury Department, and other regulatory bodies, 
the subject of systemic risk posed by the operations of large, 
complex financial institutions has been a concern of financial 
regulators, and rightly so. Systemic risk is not theoretical, 
and if not properly contained and managed, could threaten the 
stability and soundness of financial markets. There's always 
the potential for massive losses at a single financial 
institution to trigger a cascading effect that could impact the 
broader financial markets, and ultimately the global economy.
    The recent instability we've seen in global capital markets 
arising primarily out of problems in subprime mortgage lending 
in the United States have renewed concerns about systemic risk. 
These concerns were underscored by the collapse of large hedge 
funds operated by Bear Stearns and Goldman Sachs in August, and 
reports that other highly leveraged hedge funds had suffered 
substantial losses from investments in residential mortgage-
backed securities.
    The fact that hedge funds and other lightly regulated 
private pools of capital operate under a less stringent 
disclosure regime than banks and other regulated entities 
helped fuel some of the concern, and in some cases, bordering 
on the panic we saw in the markets over the summer. This 
relative lack of transparency complicates the task of 
identifying and mitigating the types of losses at individual 
firms that could give rise to systemic risk. While the 
financial contagion that many predicted when credit markets 
first began experiencing disruptions 2 months ago has not 
materialized, that is certainly no cause for complacency on the 
part of either regulators or market participants. For hedge 
fund investors and counterparties, the challenge is to demand a 
level of financial transparency and market discipline that 
allows for a meaningful assessment of the risk involved in the 
complex trading strategies employed by many funds.
    As for financial regulators, they must insist that the 
institutions they oversee are well-capitalized and have the 
risk management systems in place to weather financial shocks 
and severe market downturns. At the same time, regulators must 
avoid the type of heavy-handed market intervention that could 
stifle innovation and actually harm those investors, including 
public employee and private pension funds, which have enjoyed 
strong returns from their investment in hedge funds in recent 
years.
    Finally, given the global nature of our financial markets, 
U.S. regulators must work closely with their international 
counterparts to promote cooperation, not competition, among 
regulatory bodies, and ensure that information about potential 
systemic risk is shared promptly.
    The chairman mentioned this committee and its involvement 
in subprime legislation, and I'd like to take this opportunity 
to commend Mr. Pollock. Your one-page disclosure on subprime 
lending was actually included in the bill that I introduced 
earlier this year. I always try to borrow the best approaches 
out there, and I thought it was something that very much needs 
to be done. And I think there's pretty much unanimity that it 
would be of great help to homeowners to really see what they're 
getting and what their future payments would be. So I commend 
you for that.
    Let me close by again thanking Chairman Frank for his 
continued attention to the issue of systemic risk and by 
welcoming our distinguished panel of witnesses to today's 
hearing. We look forward to hearing your insights on this 
important subject.
    Thank you.
    The Chairman. Is there any other member who wishes to make 
an opening statement? Mr. Scott.
    Mr. Scott. Thank you very much, Mr. Chairman. I want to 
thank you for having this important hearing because our 
financial system is so very precious, so very important, and we 
want to make sure we learn some things from this crisis that 
we're going through.
    I'm very interested in learning more about how the 
President's Working Group on Financial Markets is progressing, 
on its assessment regarding systemic risk in our financial 
markets as well as their processes that might be improved to 
ensure that our markets are secure. That is the important 
bottom line, that our financial markets are secure, and that's 
what the American people are looking to this Congress to make 
sure.
    Questions like, could more have been done to assess, 
anticipate, or even prevent the subprime mortgage crisis? 
Unfortunately, this is a question we can ask, but I believe 
that at this time we must more intently focus on ensuring 
regulators in the future have the necessary tools at their 
disposal to mitigate future financial market crises. Private 
equity transactions in the United States last year totaled $406 
billion, and between 1991 and 2006, private equity created more 
than $30 billion in profits for their investors. This is our 
system at work. These funds hold unmatched sway over our 
markets. Eight--I'm sorry--are responsible for more than a 
third of stock trades, control more than $2 trillion worth of 
assets, and each of the top hedge fund managers earned more 
than $1 billion in 2006. That is the state of affairs which 
faces us.
    Now I understand a growing number of market watchers wonder 
whether the system is encouraging hedge funds to take on too 
much risk, and I certainly appreciate and would appreciate 
hearing your comments on this statement and whether or not you 
believe these funds do not warrant increased attention. As a 
majority of hedge funds seek out increasingly exotic but not 
always so much marketable investments, what further action has 
the President's Working Group taken to somewhat monitor the 
potential systemic risk of these funds? Critics of the hedge 
fund industry cite investor protection and systemic risk as the 
basis of their concern about hedge funds, but the question is, 
is more regulation really the answer? And if so, what kind of 
regulation? Granted, many bankers and regulators consider this 
process to be one of the great advances in finance over the 
past 5 years. However, how dependent has this new financial 
system become on hedge funds?
    We have some very, very dynamic issues we're faced with. I 
look forward to your testimony on some of the issues that I 
have raised. I yield back the balance of my time. Thank you, 
Mr. Chairman.
    The Chairman. The gentleman from New Jersey.
    Mr. Garrett. I thank the chairman, and I also thank the 
witnesses for coming to testify. While I'm aware that much of 
today's focus is on the current troubles in the housing market 
and the concerns of hedge funds and those concerns that the 
chairman raised, I hope that some attention will be directed to 
our ongoing potential problems created by the large portfolios 
held by Fannie Mae and Freddie Mac, particularly since some of 
the suggestions that we've heard would enlarge their 
portfolios, that may be a solution.
    There are basically two options now being discussed--to 
allow the GSEs to help ease the current housing crunch. I 
believe that over the last several weeks, these two options 
have become somewhat muddled together and there's some 
confusion as to how much either will help and how much they can 
really help far in the future.
    The first option under consideration is to increase the 
conforming loan limits for Fannie and Freddie and allow them to 
securitize mortgages over 417. Now these are jumbo mortgages 
that carry a much higher spread and would be really a boon to 
Fannie and Freddie to be able to purchase. In his testimony 
before this committee on September 20th, Chairman Bernanke 
stated that, ``Raising the conforming loan limit would expand 
this implied guarantee to another portion of the mortgage 
market, reducing mortgage market discipline further. If, 
despite these considerations, the Congress were inclined to 
move in this direction, it should assess whether such actions 
could be taken in such a way that would be both explicitly 
temporary and able to be implemented sufficiently promptly to 
serve its intended purposes.''
    Now based on this testimony, the only way that raising the 
conforming loan limits can help stabilize the current market is 
if Congress moves quickly and makes it temporary. Well, we know 
how quickly Congress acts. In fact, the time for quick action 
may have already passed. I've already seen data that indicates 
jumbo mortgage rates have declined some and are expected to 
fall even more in the future. In regard to making an increase 
temporary, well, I believe that none of us are so naive as to 
think that once Fannie and Freddie get their teeth into this 
very lucrative and tasty part of the housing market, that 
they're ever going to let it go. We just passed a 15-year 
extension to the temporary TRIA program, all by making that 
temporary program permanent. So who's to say that's not going 
to occur here?
    The second question discussed for allowing the GSEs to help 
their subprime market is to raise the current caps on the size 
of the portfolios. Currently, the GSEs only participate on the 
fringes of the subprime market, only purchasing the best and 
most creditworthy subprime mortgages because of the limitations 
in their charter. So raising their portfolio limits will only 
allow them to buy and retain more prime mortgages where there's 
no really a credit problem, and further exacerbate the current 
systemic risk posed to the broader economy by the complicated 
hedging of the increased interest rates.
    When we talk about giving the GSEs expanded powers and 
larger shares of the housing market, we should ask ourselves 
this question: Are these the same GSEs that just this week had 
some of their former top executives cut a deal with the SEC in 
which they will now pay thousand dollars in fines and are 
barred from ever working there in the future? And are these the 
GSEs that are having such difficultly with their financials 
that it has taken them over 3 years to get them close to be 
accurate? Would it not really be prudent, then, to require them 
to prove themselves before giving them even more power?
    The recent actions taken by the Fed to cut interest rates 
by 50 basis points has substantially helped the overall economy 
rebound from the recent downturn. Yesterday the Dow rose by 
over 190 points; it's back over 14,000 for the first time since 
July. Also, the tightening of the underwriting standards, 
coupled with an increase in skepticism of the ratings assigned 
to the mortgage-backed securities, has allowed the market to 
basically self-correct a lot of its own problems.
    I know that foreclosures and reset data indicates that the 
worst may be yet to come, and that the problems will probably 
bottom out sometime in February or March of next year. However, 
the data also indicates the problem in the longer term is 
subsiding, and that the market is self-correcting. So by the 
time Congress would pass substantive legislation trying to 
help, in all likelihood, it will already be too late.
    I believe we should help people suffering from the housing 
crunch and exhaust all options to help keep people out of 
foreclosure. But I do not feel that we should make statutory 
changes that will have negligible positive effects in the short 
term and possible negative, long-term lasting and systemic 
consequences in the long term.
    I look forward now to working with my colleagues and the 
chairman to ensure that we examine all these options at our 
disposal and keep the U.S. housing market the strongest in the 
world.
    And, again, I thank you and the members of the committee, 
and the witnesses for coming to testify. Thank you. I yield 
back.
    The Chairman. Are there any further opening statements? If 
not, we'll go to the witnesses. I do--I wouldn't want the 
witnesses to feel that they were prepared for the wrong 
hearing. Obviously, the gentleman from New Jersey feels very 
strongly. You shouldn't feel that was the subject of the 
hearing. I mean, you may go ahead and talk about the subject of 
the hearing. I wouldn't want--none of those issues have been 
involved in this hearing. We will continue to debate those in 
other forums. The gentleman was referencing bills that have 
already passed the House.
    Mr. Bachus. Mr. Chairman?
    The Chairman. Yes?
    Mr. Bachus. I believe part of the point Mr. Garrett was 
saying is the market has corrected itself in the situation.
    The Chairman. Well, I understand that. But just there were 
references to specific legislative issues. And I don't--
sometimes witnesses wonder if they were supposed to discuss 
them.
    We will begin, if there are no further statements, with Mr. 
Bookstaber.

 STATEMENT OF RICHARD BOOKSTABER, AUTHOR, ``A DEMON OF OUR OWN 
   DESIGN: MARKETS, HEDGE FUNDS, AND THE PERILS OF FINANCIAL 
                          INNOVATION''

    Mr. Bookstaber. Thank you, Mr. Chairman, and members of the 
committee. I thank you for the opportunity to testify today. My 
name is Richard Bookstaber. Until June of this year, I was in 
charge of a long-short equity quantitative hedge fund at 
FrontPoint Partners. Before that, I had quite a bit of 
experience in the risk management area. I was in charge of 
market risk management at Morgan Stanley. I oversaw firm-wide 
risk management at Salomon Brothers, and was there during the 
LTCM crisis, and then I moved to the buy-side and was in charge 
of risk management at Moore Capital Management and then Ziff 
Brothers investments. I also have written a book that recently 
came out called, ``A Demon of Our Own Design: Markets, Hedge 
Funds, and the Perils of Financial Innovation.
    My comments today will take some of the themes from that 
book, which in turn is based on a number of the experiences and 
lessons that I learned over the period of time that I worked in 
risk management and before that in other capacities on Wall 
Street.
    I believe that the threats to the financial system stem 
largely from two increasingly dominant market characteristics. 
The first is the complexity of the market. Complexity basically 
means that an event can propagate in unanticipated ways. And 
for financial markets, complexity comes through derivatives and 
other innovative products. Many derivatives have nonlinear 
payoffs, which means that a small market move in some 
situations can lead to really substantial impacts on the 
derivatives.
    Also, many derivatives lead to unexpected and sometimes 
unnatural linkages between instruments and markets. We observed 
some of these unnatural linkages during the subprime problems. 
Subprimes were included in a number of CDOs, along with other 
types of mortgages and corporate bonds. And like a kid who 
brings a cold to a birthday party, the subprimes mingling with 
these other instruments led to contagion into these other 
markets.
    The second characteristic besides complexity that I think 
is critical to understanding the nature of the market and 
market crises is the tendency for markets to move rapidly into 
a crisis mode with little time or opportunity to intervene. 
Borrowing a term from engineering, refer to the second 
characteristic as tight coupling. Examples of tight coupling in 
other areas of engineering include the launching of a space 
shuttle, a nuclear power plant moving toward criticality, or 
even something as prosaic as the process for baking bread. The 
main point is that during periods in a process that has tight 
coupling, you don't have time to pull an emergency stop switch 
and convene a committee to figure out what's going on. Things 
propagate and move from one market to the other because of the 
interconnectedness across the markets.
    In financial markets, tight coupling can come from 
computer-driven strategies, which is what we saw occur during 
the portfolio insurance issues that caused the crash in 1987. 
But more commonly, tight coupling comes from the effects of 
leverage. When things go badly for a very highly-leveraged 
fund, its collateral can drop to the point that its lenders can 
force it to liquidate assets. This liquidation can lead to a 
drop in prices, which leads to the collateral dropping even 
more, and therefore forcing more sales and more liquidation. 
And the result is a downward cycle, which is the sort of thing 
that we saw with the demise of LTCM in 1998, and it also is 
what we saw with a number of hedge funds in the recent past.
    And it can get even worse than that, because just like 
complexity, leverage can lead to surprising linkages between 
markets. In fact, high leverage in one market can end up 
devastating another unrelated and perfectly healthy market. 
This happens because when a market is under stress, it becomes 
illiquid, and fund managers must look to other markets to 
liquidate. Basically, if you can't sell what you want to sell, 
you sell what you can.
    We observed this sort of unpredictable type of linkage 
again during the LTCM crisis. The trigger for LTCM's failure 
was the default of the Russian debt market. But interestingly, 
LTCM had virtually no exposure in Russia. This year, we 
observed the same sort of strange result when the equity 
quantitative funds somehow came under stress as a result of 
what occurred with the subprime mortgages, even though not only 
did they not hold subprime mortgages, but they tended to be 
very scrupulously hedged against most type of market risks.
    So I believe that the two characteristics, complexity and 
tight coupling, are at the source of market crises ranging from 
the crash in 1987 to the failure of LTCM to the current 
subprime-related crisis. That means that regulation needs to 
control level and complexity.
    If we allow leverage to mount and allow new derivatives and 
swaps to grow unfettered and then try to impose regulation on 
top of that, I believe that we will fail to stem market crises. 
I suggest instead that the regulatory system should be actively 
engaged in controlling leverage and in limiting the arms race 
of innovative products. Now this is a difficult approach to 
regulation. It's different than the approach taken now. It 
might be considered invasive to the markets. It might face 
political hurdles that would make it impractical to execute. 
However, I believe that structuring effective regulation one 
way or another will need to address these key sources of market 
crisis head on.
    Let me close, if I can have an extra minute, with an 
analogy that makes my point from the field of biology. The 
lowly cockroach, I believe, can teach us a few things about how 
to structure and regulate markets. The cockroach has existed 
for hundreds of millions of years and survived as jungles 
turned to deserts and deserts turned to cities, and it survived 
using a very simple and coarse defense mechanism. The cockroach 
doesn't hear. It doesn't see. It doesn't smell. All it does is 
it moves in the opposite direction of a gust of wind. Now in 
any particular environment, the cockroach would never win the 
best-designed insect award; but it always seems to be good 
enough to survive. Other insects might be more fine-tuned for a 
particular environment, but are incapable of surviving the 
inevitable change as one environment moves to another.
    I believe that we need to keep the cockroach in mind when 
we think about how to address systemic risk. We must rethink 
efforts that engineer and fine-tune the markets in an attempt 
to seek out every advantage in the world as we see it today. 
When faced with the inevitable march of events that we cannot 
even anticipate, simpler financial instruments and less 
leverage will create a market that is more robust and more 
survivable.
    Thank you.
    [The prepared statement of Mr. Bookstaber can be found on 
page 47 of the appendix.]
    The Chairman. Mr. Schwarcz.

 STATEMENT OF STEVEN L. SCHWARCZ, STANLEY A. STAR PROFESSOR OF 
        LAW AND BUSINESS, DUKE UNIVERSITY SCHOOL OF LAW

    Mr. Schwarcz. Thank you, Mr. Chairman, and members of the 
committee. My name is Steven Schwarcz, and I am the Stanley A. 
Star professor of law and business at Duke University and the 
founding director of Duke's Global Capital Markets Center. My 
testimony today is based on the results of my research over the 
past year on systemic risk, but the research is set forth more 
fully in my paper, ``Systemic Risk,'' which is a forthcoming 
draft.
    Today I will first describe a conceptual framework based on 
my research in which to think about systemic risk, and then 
using that framework, I'll try to answer the questions that the 
committee specifically asks.
    In terms of the framework, the classic example of systemic 
risk, of course, is a bank run. Companies today, though, are 
able to obtain most of their financing through the capita 
markets without the use of intermediaries. As a result, capital 
markets are increasingly central to any examination of systemic 
risk.
    Whether systemic risk should be regulated can be viewed as 
a subset of the question of whether it's appropriate to 
regulate financial risk. Now the primary justification for 
doing that is to maximize economic efficiency. Without 
regulation, the externalities-- the third-party harmful 
effects--caused by systemic risk would not be prevented or 
internalized.
    Now this reflects, I believe, a type of what is called a 
tragedy of the commons. This is an event in which the benefits 
of exploiting finite capital resources accrue to individual 
market participants, each of which is motivated to maximize use 
of the resource, whereas the costs of the exploitation are 
distributed among an even wider class of persons, in this case 
ordinary people who are harmed by unemployment and poverty.
    I considered a number of regulatory approaches, of which 
I'll discuss a few today. One approach is disclosure. 
Disclosure, of course, has been viewed traditionally as the 
primary market regulatory mechanism. However, I argue that 
because of the tragedy of the commons, requiring additional 
disclosure would do little to deter systemic risk. Investors 
already can negotiate the type of disclosure they need when 
they deal with hedge funds or so forth who act as 
counterparties, but in terms of disclosing risk that affects 
third parties, investors may not care.
    Further commentators, including Mr. Bookstaber, have argued 
that imposing additional disclosure requirements may even 
backfire. The efficacy of disclosure also is limited, and Mr. 
Bookstaber also said this, by the increasing complexity of 
transactions in markets. And I have researched and written an 
article called, ``Rethinking the Disclosure Paradigm in a World 
of Complexity,'' in which I look at the increasing complexity 
of financial instruments, and what it means in terms of the 
ability to achieve transparency. So I conclude that disclosure 
at least itself is a weak regulatory approach.
    Another approach I look at is ensuring liquidity, and the 
most practical way to do this is through a lender or market 
maker of last resort. A market maker or lender of last resort 
could be an expensive proposition because you have two costs. 
You have moral hazard, and you have the potential shift of cost 
to taxpayers. I show in my research that these costs are 
controllable.
    Another approach is market discipline. Under this approach, 
the regulators' job is to ensure that market participants 
exercise the type of diligence that enables the market to work 
efficiently, and this is the approach presently taken by the 
Executive Branch. This approach, though, I argue is inherently 
suspect. Again, you have the problem of the tragedy of the 
commons that no firm has sufficient incentive to limit its own 
risk to avoid risk to third parties, and also regulators have a 
mixed track record of ensuring that participants in fact 
maintain market discipline, and I argue that this is a 
behavioral psychology effect. So I look at market discipline as 
a potential supplement to other regulatory approaches.
    In terms of recommendations, I propose that there be 
created a lender/market-maker of last resort, that to minimize 
moral hazard, the market-maker/lender of last resort could 
adopt a policy of constructive ambiguity; that is that no third 
party would know when the lending or the market making would 
occur. And also, I show how this can be done in a way that only 
minimally transfers risk--transfers cost, I should say--to 
taxpayers. And this approach should be supplemented by market 
discipline approach. And to the extent none of those works, 
then you always have potential for ad hoc approaches.
    Now let me address the committee's specific questions. One 
is, what are the major challenges facing the U.S. financial 
regulators? And the immediate challenge of course is to instill 
additional investor confidence in the financial markets. I 
argue that the recent monetary policy actions by the Fed are 
helpful, but they primarily impact banks, not financial 
markets, and that one, to the extent necessary, there should be 
a lender of last resort set up to deal with the situation with 
the markets' collapse, similar to the tight coupling suggested 
by Mr. Bookstaber.
    Two, what challenges will regulators face going forward? I 
believe regulators need to come to grips with changing market 
realities in at least two ways. They should shift their focus 
from banks more to financial markets, to address the reality of 
financial disintermediation, the shifting from bank finance to 
capital market finance. And second, they should begin thinking 
more seriously about the increasing problem of complexity.
    The third question is, do regulators have the tools they 
need to meet these challenges? And I propose that the Fed or 
some other governmental entity be given the power to act as, or 
at least to arrange for, a market-maker/lender of last resort 
along the lines discussed. And also because financial markets 
and institutions increasingly cross sovereign borders, that the 
Federal Reserve be given any necessary authority to work with 
regulators outside the United States, including the possibility 
of establishing an international lender or market-maker of last 
resort.
    The next question the committee asked is what changes, if 
any, should be contemplated to our regulatory system? And 
again, I repeat what I said before, that the Fed be given that 
authority to work both domestically and internationally, 
including as a lender of last resort.
    And the fifth question is what powers or information could 
have allowed regulators to anticipate and prevent the current 
subprime mortgage crisis and its impact on the broader 
financial system? I believe it would have been possible through 
a lender/market-maker of last resort to mitigate the impact of 
that crisis on the broader financial system. And, furthermore, 
I think that if the collapse were more severe, a lender or 
market-maker of last resort would have been even more 
important.
    I am less than certain, however, what powers or information 
could have allowed regulators to anticipate and prevent the 
current subprime mortgage-related crisis. Now Alan Blinder in 
his Sunday Op Ed in the Sunday Times tries to identify what 
caused the mortgage crisis. But I believe that even if one 
could identify that, there are infinite other ways that crises 
could occur in the future, and trying to regulate all of them 
would dampen the economy. I will give you an example. The 
underlying cause of the subprime mortgage crisis was that 
mortgage loans turned out in retrospect to be 
undercollateralized, given the drop in home prices. One could 
consider, for example, imposing going forward a restriction on 
these types of loans, akin perhaps to what the Fed did in 
response to the problems you had in the 1920's and 1930's, the 
Great Depression. And that is the margin regulations, G, U, T, 
and X. This would basically require for mortgage lenders 
additional collateral so that you didn't have a collateral 
shortage. For example, in a securities context of those 
regulations, you have two-to-one collateral coverage of margin 
stock to margin loans. You could say, for example, that you 
would have additional collateral coverage of home mortgage 
loans.
    The problem I have with something like that, although I 
think it would be very effective to limit the risk going 
forward, is that you impede homeownership, basically, and you 
would also impose a high administrative cost. So one has to be 
very circumspect as to any regulation.
    And finally, it is easy to rush to incorrect conclusions. 
Also on Sunday, Blinder criticized the rating agencies being 
paid by the issuers, a supposed conflict of interest, and 
arguing that if students paid him directly for grading their 
work, his dean would be outraged. But that's misleading. 
Because for rating agencies, the rating is universally 
independent of the fee, and so one needs to be very careful not 
to make false analogies.
    Thank you.
    [The prepared statement of Professor Schwarcz can be found 
on page 72 of the appendix.]
    The Chairman. Thank you.
    And Mr. Kuttner.

   STATEMENT OF ROBERT KUTTNER, EDITOR, THE AMERICAN PROSPECT

    Mr. Kuttner. Thank you, Mr. Chairman, for this invitation. 
My name is Robert Kuttner. I'm an economics journalist, editor, 
author, former investigator for the Senate Banking Committee, 
and I have a book coming out in a few weeks that addresses the 
systemic risks of financial innovation coupled with 
deregulation and the hazards of periodic bailouts.
    In my research, I reviewed the abuses of the 1920's, and 
the efforts in the 1930's to create a stable financial system. 
The Senate Banking Committee in the celebrated Pecora hearings 
of 1933 and 1934 laid bare the abuses of the 1920's and devised 
the groundwork for modern financial regulation. If you revisit 
the Pecora hearing records, I think you will be startled by the 
sense of deja vu and the parallels to today's excesses.
    Although the particulars are different and some of today's 
innovations are highly technical, financial history suggests 
that the risks and abuses are enduring. They are variations on 
a few hearty perennials: Excess leverage, conflicts of 
interest, nontransparency, misrepresentation, and engineered 
euphoria. In the 1920's, such practices as stock pools, margin 
lending, pyramiding of holding companies, and the repackaging 
of dubious loans and bonds all promoted by middlemen with 
conflicts of interest, created asset bubbles and ultimately 
lead to the great crashes.
    In the 1930's, Congress barred these abuses through 
regulations that required transparency, eliminated excess 
leverage, abolished holding company pyramids, limited margin 
accounts and prohibited insider self-dealing out of the 
conflicts of interests. But thanks to deregulation, many of 
these abuses were repeated in the scandals of the 1990's where 
the malfactors were auditors and accountants and stock 
analysts, and it remains to be seen what role the bond rating 
agencies have played in the current crisis.
    Securitized credit. Some people think this is an innovation 
of the past 30 years. In fact, it was absolutely central to the 
abuses of the 1920's, and those abuses led Congress to separate 
investment banking from commercial banking in the Glass-
Steagall Act. Since repeal of Glass-Steagall in 1999, trillion-
dollar superbanks have been able to reenact the same kind of 
structural conflicts of interest.
    Though these entities are only partly government-guaranteed 
and supervised, they are nonetheless treated as too big to 
fail. And anybody familiar with derivatives or hedge funds 
knows that margin limits, although they're still on the books, 
are for little people. Private equity, which might be better 
named private debt, gets its astronomically high rate of return 
on equity through the use of borrowed money. As in the 1920's, 
the game continues only as long as assets continue to inflate.
    Now there's one enormous difference. The economy did not 
crash with the stock market collapse of 1989 or of 2000, 2001. 
And while there are other differences, the primary difference 
is that in the late 1920's, the Federal Reserve had neither the 
tools nor the expertise nor the self-confidence to act 
decisively in a credit crunch. Today when speculative meltdowns 
risk hurting the larger economy, the Fed floods the market with 
cash and lowers target short-term rates.
    This was the case in the Third World loan losses of the 
1980's, the currency speculation losses of 1997, and of course 
the collapse of long-term capital management in 1998. Even 
though Chairman Greenspan had expressed worry 2 years and 
several thousand points earlier that irrational exuberance was 
creating a stock market bubble, the big losses led Greenspan to 
keep cutting rates despite his foreboding that the cheaper 
money would only pump up asset bubbles and invite still more 
speculation.
    I just read Chairman Greenspan's fascinating memoir in 
which he confirms both this rescue philosophy and his strong 
support for free markets and deep antipathy to regulation. But 
I don't see how you can have it both ways. If you believe that 
markets are self-regulating and self-correcting, then you 
should logically let markets live with the consequences. On the 
other hand, if you were going to let markets--if you're going 
to rescue markets from their excesses on the very reasonable 
ground that a crash threatens the larger system, then you have 
an obligation, I think, to act prophylactically to head off the 
wildly speculative behavior in the first place. Otherwise, the 
Fed is just an enabler.
    The point is not that the Fed should let the whole economy 
collapse in order to teach speculators a lesson. The point is 
that the Fed needs to remember its other role as regulator. 
Financial regulation is too often understood as merely 
protecting investors. If investors are consenting adults, who 
needs regulators? But of course the other purpose is to protect 
the system from moral hazard and catastrophic risk.
    As these hearings proceed, here are the issues that I think 
require further exploration. First, which innovations of 
financial engineering truly enhance economic efficiency and 
which ones mainly enrich middlemen, strip assets, reallocate 
wealth, and increase system risk?
    Secondly, which techniques and strategies of regulation do 
we need to moderate these new systemic risks that were at the 
heart of the financial crisis of the 1920's, the 1990's, and 
the zeroes? Again, there are recurring abuses: Lack of 
transparency, excessive leverage, and conflicts of interest. 
Those in turn suggest remedies: Greater disclosure, either to 
regulators or to the public; requirement of increased reserves 
in direct proportion to how opaque and difficult to value are 
the assets held by banks; some restoration of the laws against 
conflicts of interest once provided by Glass-Steagall; and tax 
policies to discourage dangerously high leverage ratios in 
whatever form.
    Finally, a third big question to be addressed is the 
relationship of financial engineering to corporate governance. 
Ever since Berle and Means, it has been conventional to point 
out that corporate management is not adequately responsible to 
shareholders. Since the first leveraged buyout boom, advocates 
of hostile takeovers have proposed a radically libertarian 
solution to the Berle Means problem. Let a market for corporate 
control hold managers accountable by buying, selling, and 
recombining entire companies. There have to be better 
strategies to hold managers accountable.
    One last parallel. I am chilled, as I'm sure you are, Mr. 
Chairman, every time I hear a public official or a Wall Street 
eminence utter the reassuring words, ``the economic 
fundamentals are sound.'' Those same words were used by 
President Hoover and the captains of finance in the cold winter 
of 1929. They didn't restore confidence.
    The fact is, the economic fundamentals are sound if you 
look at the real economy. It is the financial economy that is 
dangerously unsound. And as every student of economy history 
knows, depressions, ever since the South Sea bubble, originate 
in excesses in the financial economy and go on to ruin the real 
economy. Not all innovations are constructive.
    It remains to be seen whether we have dodged the bullet for 
now. If markets do calm down, then we have bought precious 
time. The worst thing of all would be to conclude that markets 
have self-corrected once again. The Fed has really ridden to 
the rescue once again, and the worst thing of all would be to 
take no action and let the bubble economy continue to fester.
    Thank you very much.
    [The prepared statement of Mr. Kuttner can be found on page 
53 of the appendix.]
    The Chairman. Thank you, Mr. Kuttner.
    Mr. Pollock.

    STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW, AMERICAN 
                      ENTERPRISE INSTITUTE

    Mr. Pollock. Mr. Chairman, Ranking Member Bachus, and 
members of the committee, thank you for your kind comments on 
my proposal in your opening remarks. My own career has included 
many credit cycles which involved issues of systemic risk, 
starting in my case with the credit crunch of 1969, the 
commercial paper panic of 1970, the real estate investment 
trust collapse of 1975, and so on to the current subprime 
mortgage and housing bust, with numerous others in between. I 
have also studied the long history of such events.
    I expect, Mr. Kuttner, that you and I disagree on many 
things, but we agree on the importance of looking at these 
historical patterns. Systemic risk always makes me think of a 
memorable saying of John Maynard Keynes, that a prudent banker 
is one who goes broke when everybody else goes broke. As Keynes 
suggests, prudence means doing what everybody else is doing, 
and that's a key component in financial booms and busts.
    To put these in context, maximum, long-term growth and the 
greatest economic wellbeing for ordinary people depends on 
market innovation and experimentation. But these, of course, 
make the future more uncertain. Markets for financial 
instruments by definition place a current price on future, thus 
inherently uncertain, events. That much is obvious, but it's 
easy to forget this when addressing the results of a bust with 
the benefit of hindsight, when it seems like you would have had 
to be stupid to make the mistakes that smart people actually 
did make.
    In the boom, many people succeed, just as many people 
succeeded in the long housing boom just past. This success gets 
extrapolated and makes lenders and investors and regulators 
confident of the ``new era.'' Investor confidence leads to 
underestimation of future uncertainties, notably in a leveraged 
sector, and there comes to be a lot of investing long and 
borrowing short. Risky, illiquid assets get to be financed by 
very risk-averse, short-term lenders, like commercial paper 
buyers and repo dealers, and in a previous day, unsecured bank 
depositors.
    These short-term lenders are likely to behave like the 
depositors of Britain's Northern Rock, that is to say, in the 
manner of the Plank Curve. I hope you can see this, ladies and 
gentleman. This is the Plank Curve. It is the pattern of credit 
available in a panic. You can see it goes like this and then it 
drops off the end. It's called the Plank Curve because it is 
the pattern of a man walking the plank.
    We know for certain that markets will create both long-term 
economic growth and cyclical booms and busts. Markets are 
recursive. Regulations change the market. Models of financial 
behavior themselves change the market, and thereby become less 
effective or obsolete, as did the subprime credit models of 
both investors and the rating agencies.
    One way to go broke when everyone else does is to use 
models with the same assumptions that everyone else has. This 
should make us skeptical of the model-based regulatory approach 
currently popular as Basel II.
    The great economic historian, Charles Kindleberger, 
surveying several centuries of financial history, observed that 
financial crises and scandals occur on average about once every 
10 years regardless of what legislators or regulators do. The 
lessons are all learned after the fact.
    Every bust is followed by hopes that the reforms have 
solved the problem. For example, in 1914, the then-Comptroller 
of the Currency announced that with the creation of the new 
Federal Reserve, ``financial and commercial crises or panics 
seem to be mathematically impossible.'' Of course in time, the 
next bust arrives nonetheless.
    Although this should make us skeptical of excessive claims 
about what regulation can do, it doesn't mean that we shouldn't 
have reforms. Greater disclosure certainly makes sense. The 
subprime mortgage bust suffered from inadequate disclosures all 
the way from the consumer, as was mentioned a little bit ago, 
to the ultimate investor levels and at a good many places in 
between. The role of the credit rating agencies is part of this 
issue. I think we should be working on ways to make investor-
paid rating agencies a greater force in this key information 
providing sector.
    A particular disclosure reform pertinent to private pools 
of capital would be to require symmetrical disclosure of short 
and long equity concentrations. Concentrated short positions in 
a company's stock should be disclosed publicly in exactly the 
same way as long positions are.
    And it would certainly be a good idea to make whatever deal 
with the Senate is necessary to enact regulatory reform of the 
housing GSEs.
    Good times, a long period of profits, and an expansionary 
economy induce financial actors, regulators, and observers to 
take readily tradable markets, otherwise called ``liquidity,'' 
too much for granted, so liquidity comes to be thought of as 
how much you can borrow. When the crisis comes, it's found that 
liquidity is about what happens when you can't borrow, except 
from some government instrumentality.
    At this point, we have arrived at why central banks exist. 
The power of the government with its ability to compel, borrow, 
tax, print money, and credibly guarantee the payment of claims 
can intervene to break the everybody-stops-taking-risk-at-once 
psychology of systemic risk. The key is to assure that this 
intervention is temporary, as are credit panics by nature.
    As historically recent examples of government interventions 
in housing busts, since 1970, we've had the Emergency Home 
Finance Act of 1970, the Emergency Housing Act of 1975, the 
Emergency Housing Assistance Act of 1983, and the Emergency 
Housing Assistance Act of 1988. And I don't count the Hurricane 
Katrina Emergency Housing Act of 2005, since that's a special 
case.
    As Walter Bagehot wrote, ``Every great crisis reveals the 
excessive speculations of many houses which no one before 
suspected.'' The current bust is true to type, and we are 
seeing and will continue to see large losses revealed. As 
everybody gets used to the idea that these losses have 
happened, I think liquidity will return reasonably quickly to 
markets for prime instruments. I agree with Congressman Garrett 
that we don't need Fannie and Freddie in the prime jumbo 
market.
    One insightful observer has predicted that the panic about 
credit markets will be a memory by Thanksgiving. For prime 
markets, I believe he's right. However, the severe problems 
with subprime mortgages and securities made out of them related 
defaults and foreclosures, and most importantly, falling house 
prices, will continue past then. The interesting times we're 
experiencing in the wake of the bursting of the housing bubble 
does have a good way yet to run.
    Thank you for the opportunity to share these views.
    [The prepared statement of Mr. Pollock can be found on page 
66 of the appendix.]
    The Chairman. Thank you, Mr. Pollock. Let me begin with 
you. You say of your 90 percent, 10 percent policy mix, and you 
say when the system hits its inevitable periodic crisis, about 
10 percent of the time the intervention is necessary. What 
kinds of intervention? For instance, I assume, as you 
acknowledge--not acknowledge, as you note, this is one of those 
times. What sorts of intervention have been and are appropriate 
now since you say we are in one of those 10 percent times?
    Mr. Pollock. Thank you very much, Mr. Chairman, for reading 
my testimony about what I call the Cincinnatian Doctrine, which 
is this 90 percent/10 percent.
    The Chairman. Why Cincinnatian?
    Mr. Pollock. If I may have a minute to explain.
    The Chairman. Sure.
    Mr. Pollock. Cincinnatus--
    The Chairman. Yes.
    Mr. Pollock. --the great Roman hero, left the plough to 
save the state--became temporary dictator of Rome.
    The Chairman. Right.
    Mr. Pollock. And after he saved the state by expelling the 
barbarians, he resigned his dictatorship and went back to his 
farm.
    The Chairman. Why 90/10?
    Mr. Pollock. Excuse me?
    The Chairman. Was that like 10 percent of his life? I just 
didn't understand the 90/10.
    Mr. Pollock. No, no.
    The Chairman. I thought maybe because he was a farmer, he 
was getting 90 percent parity.
    Mr. Pollock. There are, of course, agricultural busts as 
well, Mr. Chairman.
    The Chairman. All right. Why Cincinnatus? I just didn't get 
the name.
    Mr. Pollock. That is why Cincinnatus.
    The Chairman. All right.
    Mr. Pollock. Of course, George Washington, who also could 
have been king and instead went back to his farm, had 
Cincinnatus as--
    The Chairman. Well, he was more of a politician than 
Cincinnatus. He stayed a while.
    Mr. Pollock. Well, then he came back, of course. Anyway, 
90/10 is because about once every 10 years is the time of the 
bust. Appropriate actions--
    The Chairman. I've always found that the more remote people 
are in time, the easier it is to impute total purity to their 
motives. But let's get back--
    Mr. Pollock. That's very true. The less well we know them, 
Mr. Chairman.
    The Chairman. What kinds of interventions would you say 
should have been, and are now, relevant to this 10 percent 
crisis?
    Mr. Pollock. We are clearly with the subprime bust in this 
10 percent period. We've had the central bank intervening, as 
it did with discount--
    The Chairman. What forms of intervention do you think are 
appropriate, the ones that have happened? Are there things that 
happened that shouldn't have, or has everything been done 
correctly?
    Mr. Pollock. I think the actions of the Fed were quite 
appropriate and seemed to have been successful in returning the 
prime markets to much more normal functioning, which we're 
seeing. I do think, as we discussed in the previous hearing, 
that in the current subprime bust, the ways to refinance 
subprime ARMs in particular are appropriate interventions, 
using the FHA, for example.
    I had the honor of proposing to you when I was last here 
that Fannie and Freddie might be used to acquire in segregated 
special portfolios refinanced subprime ARMs. I think that would 
be an appropriate intervention in this 10 percent period.
    My point with the 90/10 is that all of these things should 
be temporary. The lessons will be learned by all, government 
and market, and when we get past the--
    The Chairman. Let me just say, on that, I appreciate with 
regard to the Fed, obviously those are temporary. And a special 
Fannie/Freddie subprime would be. The FHA proposal from the 
Administration and what we've done would be permanent. Should 
that be--I mean, that is letting the FHA from now on deal with 
people with weaker credit. Is there any reason to limit that, 
going forward?
    Mr. Pollock. If you look at subprime delinquencies and FHA 
delinquencies, Mr. Chairman, they are quite similar in the 
fixed-rate area--almost half of subprime loans are fixed-rate 
loans. And fixed-rate subprime delinquencies actually are not 
that much more than FHA delinquencies. And of course, total FHA 
delinquencies are well up into double digits. So I wouldn't 
support lowering the credit standards of the FHA by a lot. But 
I would support their temporary ability to refinance subprime--
    The Chairman. Okay. I understand that. What the 
Administration asked for was a permanent change, so I 
appreciate your noting a difference there.
    Let me just say to Mr. Kuttner that I think he--I was glad 
to see he hit on what I think is a central point, and that is 
Mr. Greenspan has been criticized by some who say that he 
should have acted with regard to the stock market exuberance 
and also subprime by deflating the entire economy. And when he 
said he shouldn't have done that, you and I agree, and that of 
course would have exacerbated what is America's number one 
economic problem now, which is the increasing inequality where 
wage earners are falling further and further behind.
    But as you note, implicitly, when you get into that debate, 
that assumes that the choices are either deflating the entire 
economy or letting problems happen, that there is only a macro 
response, and that is of course the case for sensible 
regulation, that among the arguments for regulation is that it 
gives you a third choice, and that you don't have to choose 
between this bringing about a recession or tolerating abuses. 
And because of Mr. Greenspan's role, and I think, frankly, some 
of my friends on the liberal side were so eager to criticize 
him, that they fell into that trap without realizing what the 
consequences were, and there was an alternative.
    Let me just, finally, to Mr. Schwarcz and Mr. Bookstaber, I 
note what seem to be some similarity between your argument 
about the government as a provider of funding for last resort. 
Is that accurate? The question is, is it just lending? Mr. 
Bookstaber, you talked about maybe buying up the assets. Mr. 
Schwarcz, are there differences--I mean, there's a good degree 
of congruence there, and I think that's--I welcome that, 
because we don't always get a lot of specific suggestions from 
people, and I thank you.
    Will you both talk about that, that area of whether there 
is congruence or maybe some shading of difference?
    Mr. Bookstaber. I look at it a little differently. I call 
it a liquidity provider of last resort, but I think we're 
thinking along the same lines.
    The Chairman. By the way, leave the label aside. We'll come 
up with the most perfumed name possible though. You just 
describe the substance.
    Mr. Bookstaber. The reason this happens is if you look at 
the dynamics of what occurs in most crises, LTCM is sort of the 
poster child for it, but we see it with other crises, 
especially when it's hedge-fund oriented. There's a market 
shock that occurs, and a highly levered hedge fund, because of 
that market shock, now has to essentially sell assets because 
it's collateral is below the margin or haircut required by the 
lender.
    The selling of the assets drops the market even more, which 
requires even more liquidation, and you just get this cycle. 
People who are astute in the business, for example, Citadel, 
then recognize that the reason this market is down 50 percent--
    The Chairman. I don't want to--I mean that was the thrust 
of your testimony. I guess the shading--is whether it's all 
loans or would you have purchases as well. And I'd be 
interested in Mr. Schwarcz's view.
    Mr. Schwarcz. Let me respond. I think that what Mr. 
Bookstaber is saying is you would potentially have both, which 
is what I'm saying as well. I referred to a lender/market-maker 
of last resort, which--I could have said liquidity provider.
    The Chairman. You're lending, knowing full well that this 
loan may never be repaid and you're in effect going to be 
buying it.
    Mr. Schwarcz. Well, it would be repaid, and let me give an 
example. Presently you do have a lender of last resort in 
international context, the IMF. And the IMF, of course, makes 
loans in a country debt crisis situation.
    The argument, I know, of former Treasury Secretary Rubin is 
that governments do not lose money on this. And generally 
that's true because those loans are ultimately repaid. And I 
think it would be true as well that the--
    The Chairman. Just a final question from me, and I 
appreciate the indulgence. Is there a difference when the 
lender of last resort, the provider of liquidity, whatever, is 
it the Fed in both cases, let me ask you, or are we talking 
about a new entity to do that?
    Mr. Schwarcz. Well, I think that the Fed--in my research I 
look at possibilities. I think the Fed is the most logical--
    The Chairman. Okay. That's good. ``Yes'' is a good answer 
sometimes.
    Mr. Schwarcz. Yes.
    The Chairman. And the question then would be when the Fed 
or whomever is doing this, do they have--I mean do they start 
out constantly saying, ``Well, am I going to lend or am I going 
to buy,'' or is it kind of they go into it and play it by ear 
as they go into it?
    Mr. Schwarcz. I think it will depend on the situation. If 
there is an institution that is failing, say LTCM, and if 
there's not a private arrangement it would probably be a loan 
if the private market--
    The Chairman. And let me ask the both of you, what about 
the--one of the arguments we'll get is what about moral hazards 
being created by this. Go ahead, Mr. Bookstaber.
    Mr. Bookstaber. What I'm thinking is in a fairly limited 
context where you're looking at hedge funds. And there will be 
no moral hazard because in that case you're actually buying up 
the assets of the firm--
    The Chairman. And putting them out of business?
    Mr. Bookstaber. And they're out of business, but you stop 
the dominoes from propagating out.
    Mr. Schwarcz. And there could be moral hazard certainly in 
terms of markets, but the idea would be to purchase assets in 
the market to prevent the collapse but still do so at a 
sufficient discount to impose pain on those--
    The Chairman. I think that's very important, a little 
bottom feeding by the Fed.
    Mr. Kuttner, quickly.
    Mr. Kuttner. I would just put more emphasis on prevention 
rather than on--
    The Chairman. Well, I understand that--I'm all for 
prevention--but that doesn't mean I don't go to the doctor when 
I need an operation. The gentleman from Alabama.
    Mr. Bachus. Thank you. First I'd like the record to show 
that Chairman Frank and I, neither one of us have farms--unlike 
George Washington or Cincinnatus--so I don't suppose we'll be 
leaving any time soon.
    Mr. Pollock, there are persistent rumors that there is 
going to be--in the Judiciary Committee this week or next week, 
there is going to be an emergency mortgage bankruptcy bill, and 
one of the provisions in that bill will allow bankruptcy judges 
to reduce loan principals, reduce interest rates, and extend 
loan terms.
    Do you believe this would disrupt the market for mortgage-
backed securities, any fear of that? Would it discourage 
lenders in the future from making loans? Would it--the 
liquidity crisis seems to be passing. Would that not just bring 
it back?
    Mr. Pollock. Congressman, since the chairman has said yes 
is a good answer, yes, I think it would hurt the market, and 
yes, it would cut future access to home finance because the 
house itself and the ability to pledge it is the principal 
thing that a mortgage borrower brings to the transaction.
    Mr. Bachus. Thank you. Professor Schwarcz, this 
international lender of last resort, discuss--one of the 
questions I was going to ask about is moral hazard, but you've 
sort of explained that away by saying that these assets, you 
could turn around and sell them for more money. But if that 
were the case, wouldn't private parties also come in and buy 
those? Why would you need a quasi-government agency?
    Mr. Schwarcz. In a perfect market you are correct, the 
third parties would come in and buy them. I guess you have two 
problems. Problem number one is that people or institutions or 
third-party buyers are going to be very hesitant to come in, 
and that is both a psychological thing and it also goes to the 
institutional structure.
    Institutions are worked by people, and a person who is 
going to make a decision is going to be unlikely to want to 
have the institution buy into a market when the market is 
dropping and everyone is saying, ``Let's abandon the market.'' 
People tend to go with the herd. You have a certain herd 
mentality and this could deter buying. Individuals in 
institutions also may find it safer to conform to the herd view 
even if they believe there is value there.
    So a lender of last resort would take a more objective 
position. That would be the argument.
    Mr. Bachus. Mr. Bookstaber, is that how you pronounce your 
name?
    Mr. Bookstaber. Bookstaber.
    Mr. Bachus. Bookstaber, I'm sorry.
    Both of you have talked about this lender of last resort. 
Do you subscribe to an international lender of last resort like 
the professor or does that create some problems?
    Mr. Bookstaber. Well, I haven't thought of it in an 
international context.
    Mr. Bachus. You what?
    Mr. Bookstaber. I haven't thought of it in an international 
context, so I couldn't really say. The cases I've looked at 
have tended to be domestic. The examples I use are Citadel's 
purchase of Sowood and Amaranth.
    Mr. Bachus. Let me ask you this. Professor Schwarcz, you 
actually said it wouldn't be predictable, you'd do it 
sometimes, you wouldn't do it other times. You know, allowing a 
governmental or quasi-governmental agency to bail some folks 
out, intervene in some cases and not in others, doesn't that--
couldn't that breed favoritism or unequal treatment?
    You're a law school professor. Does it bother you that you 
might be picking winners and losers?
    Mr. Schwarcz. I think if you picked winners and losers on a 
basis as to who they were, that would bother me.
    Mr. Bachus. You'd obviously know who you were bailing out.
    Mr. Schwarcz. Right, but I mean in terms of saying we're 
going to decide to bail out these types of entities but not 
those types of entities. I think one needs to decide it on an 
ad hoc basis to see what the effect is going to be of a failure 
on the markets and then to make a case-by-case determination.
    I agree with you that it's not a perfect solution. These 
are all second best solutions here.
    Mr. Bachus. Mr. Bookstaber.
    Mr. Bookstaber. Yes, the way I would see it occurring in 
most circumstances, it would be a bailout of the market in the 
sense that it would prevent the market from cascading into 
crisis, but it wouldn't be a bailout of the firm.
    Mr. Bachus. But you do it sometimes, you don't do it other 
times? You know, you were with Goldman Sachs.
    Mr. Bookstaber. Yes, I agree that there would always be 
some judgment. And as Professor Schwarcz is saying it wouldn't 
be so much an issue of the failure of the firm, it would be the 
question of whether there's a fear that the firm's failure 
would propagate out to affect other markets.
    Mr. Bachus. Professor Schwarcz, you mentioned that the IMF, 
I think you seemed to imply they always get paid back, that the 
World Bank--I mean I actually have had the debt relief bill, I 
sponsored that bill, and the reason it was debt relief is 
because a lot of those countries were not paying it back. And a 
lot of the loans didn't go to the benefit of the country, they 
went to what I would term insiders with the World Bank or the 
IMF or a lot of times corporations, you know, which--it was 
really a subsidy to the corporation. The country or the 
citizens didn't receive any benefits.
    I wish you'd kind of look at that whole history of debt 
relief. I think you might--you know, the idea that they always 
get paid back.
    Mr. Schwarcz. Sir, I was trying to quote Secretary Rubin, 
former Secretary Rubin on that. My view, and I have said this 
in writing, is that the IMF, the way it does its lending of 
last resort is not a way to be necessarily modeled because it 
does a number of things wrong, including it charges a lower 
interest rate than its own cost of funds, but I propose a 
situation that solves that.
    Mr. Bachus. In fact, a lot of the poverty in a lot of these 
third world countries is the result of the massive debt that 
they owe, and it really caused tremendous long-term problems, a 
real headache.
    Mr. Schwarcz. That is correct.
    Mr. Bachus. May I just close by saying this international 
lender of last resort, how do we go to the taxpayers of the 
United States and ask them to finance this? Wouldn't they 
rather sort of finance a road in front of their house or the 
school down the block as opposed to funding loans by some 
international agency?
    Mr. Schwarcz. I agree with that, that other things being 
equal they might. But the question is going to be--the funding 
would occur only in those situations where the potential for 
market collapse would be so severe that it would really 
outweigh other uses of the money. And that would have to be 
determined, again, on a case-by-case basis.
    But the rationale for having a lender or international 
lender of last resort in place is because the collapse of 
markets can be so quick, the so-called tight coupling that Mr. 
Bookstaber mentioned, that you may be faced with a sudden 
collapse no matter what you've done to try to prevent the 
problem from arising.
    And in that case I think the lender of last resort is 
probably the best solution.
    Mr. Bachus. Yes, I guess what I'm thinking about, we talked 
about Russia, which didn't have disclosure, so all of a sudden 
we bail out a country because they didn't have disclosure or 
because they didn't have sound practices. So the countries that 
have done a better job end up bailing out those countries who 
haven't.
    Mr. Bookstaber. When I think of this, I'm thinking of it 
not so much in an IMF, country bailout or loan mode. I think 
the best example of this is to look back at LTCM, and we went a 
different route. But remember, Warren Buffett almost bought all 
the assets of LTCM, and if he had done so, the crisis would 
have ended right then because he could have held those assets, 
which clearly were priced very low because of this liquidity 
event.
    So, what if Warren Buffett isn't around to do it, and as 
Professor Schwarcz has mentioned, in these situations often 
everybody scurries for the sidelines. If the government can 
say, here's a fund that is close enough to cause a systemic 
problem that, rather than allowing it to cascade, we'll walk in 
and buy the assets for pennies on the dollar, you now are out 
of business. We have assets that probably, once you adjust for 
liquidity, are under their true value.
    For the same reason that Citadel bailed out, so to speak, 
Amaranth, and hopefully turned a profit from it, I think more 
often than not if the government had a liquidity provider of 
last resort, at the end of the day, the taxpayers would end up 
making money from it.
    Mr. Bachus. Of course, you know, the government usually 
doesn't turn a profit. Thank you.
    Mr. Bookstaber. Thank you.
    Ms. Waters. [presiding] Thank you very much. I'll recognize 
myself for 5 minutes. I'd like to thank all of our panelists 
for being here today.
    We have spent quite a bit of time in this committee dealing 
with the home foreclosure disaster, and I suppose I could ask 
you a lot of questions about our regulatory agency and why they 
have not been stronger and more aggressive in monitoring what 
was going on with our financial institutions, or I could talk 
about our attempts to do something about predatory lending in 
this committee and do away with prepayment penalties, and I 
could talk about these exotic products that were advanced, the 
interest-only, the no-doc loans and all of that, but I really 
do know the answers already, and I know that we don't have a 
lot of regulations.
    There is a resistance to regulations. The financial 
institution is extremely powerful, and I had an opportunity to 
serve on another subcommittee of this committee, the 
Subcommittee on Financial Institutions and Consumer Credit, but 
I declined. I declined, and I'm chairing the Subcommittee on 
Housing and Community Opportunity, because I thought I could 
get something done there. I did not think that I could get 
anything done on Financial Institutions. They are just so 
powerful, so influential, and the regulatory agencies are not 
at all willing to cross them and to come up with strong 
regulations, so I'm not going to bother you with that.
    I want to talk to Mr. Kuttner. I have long been a fan of 
yours, and I'd like to ask you what we can do to prevent the 
impending crisis, the collapse of the market. What can be done 
at this point?
    Mr. Kuttner. Thank you very much, Madam Chairwoman. I think 
the Fed did what it had to do, but I think going forward the 
proverbial ounce of prevention is where we ought to be 
emphasizing our public policy.
    That is to say, without the benefit of hindsight, because 
people were criticizing it at the time, you can say that the 
underwriting practices of these subprime lenders never should 
have been permitted.
    Had the Fed not stonewalled in the issuance of regulations 
under the 1994 Homeownership Equity Opportunity Protection Act, 
there would have been underwriting standards in place. Just the 
fact that some consenting adult can be found to buy the paper 
is not a good justification to allow predatory lending 
practices.
    And by the same token, the most unscrupulous lender's 
willingness to make a loan is not a substitute for a low-income 
housing policy. It just creates heartbreak later on. So I think 
a lot of these mortgages ought to be refinanced.
    It is up to Congress to decide whether that is done through 
FHA or the GSEs or some other entity. I think someone needs to 
decide which of these borrowers were innocent victims of 
predators and which of them were a bit predatory themselves, 
which of them were speculators themselves.
    The ones who are innocent victims ought to be permitted to 
get refinancings that save their homes, and going forward, the 
predators should be put out of business. We have had the 
homeownership rate in this country trickle upwards, but we need 
a real housing policy to encourage first-time homeownership and 
not one based on speculation.
    Ms. Waters. If I may interrupt you for a moment, I've been 
trying to focus on the servicers. Those entities that are 
collecting the money, doing the foreclosing, the late payments, 
all of that, I supposes some are independent, some are owned 
by--I don't know if Countrywide, for example, did their own 
servicing.
    Oh, and as I have asked about the ability for the servicers 
to renegotiate these loans, rearrange them in some way, I am 
being told that some of the servicers are saying, but we are 
liable. We are liable, and if we make arrangements that fail, 
we can be held liable by the company that we are working for.
    Do you know anything about these servicers and what 
potential we have to enter there in order to readjust these 
loans?
    Mr. Kuttner. Well, I think there are some bad actors in 
this industry, but I think there is a structural problem with 
the way securitized mortgage credit creates an incentive 
against workouts.
    If the lender is the originator and also the holder of the 
paper, the lender is more inclined to do a workout. If there's 
a whole chain with middlemen each extracting a fee at each link 
in the chain they actually make more money by letting the 
foreclosure go forward.
    I did some research on whether securitization of mortgage 
credit actually helps lenders, and I think by the time you look 
at the fee extracted by the mortgage broker, the fee extracted 
by the mortgage banker, the fee extracted by the investment 
bank that packages the loans into securities, and the fee 
extracted by the bond rating agency, the borrower is no better 
off, and the borrower may, in fact, be at a higher risk.
    So I think the whole system of securitized credit and the 
role played by these middlemen and the greater hazard that it 
creates in the event of foreclosure is ripe for broader 
investigation.
    Ms. Waters. Thank you very much. I will now recognize Mr. 
Garrett for 5 minutes.
    Mr. Garrett. Thank you. I think I'll take up where the 
ranking member was finishing off, and that goes back to the 
issue of the lender of last resort. Maybe I'll start on the 
other end of the table there, since I don't think Mr. Pollock 
has weighed in on that.
    In a sense, don't we already have a couple of lenders of 
last resort in existence now? And one, correct me if my analogy 
is wrong, but one would be the Fed, by doing what it did that, 
in essence, facilitated that? And although the chairman thinks 
that this was an inappropriate word to bring up during this 
discussion, GSEs, aren't they also a--if they're doing their 
job or, I should say, if they're doing what they proclaim to 
do, although the evidence would say that they actually don't do 
this after times of trouble like this?
    And after 9/11, the evidence would show to the contrary 
that they do not get actually into the market but they're 
supposed to. Aren't they the other lender of last resort that 
we actually have right now?
    Mr. Pollock. Congressman, I agree with that. Certainly to 
be a completely capable lender of last resort, you have to be 
able to print money; the Fed is the only one that can do that. 
That is to say, just write in your books, ``this is money,'' 
and it is the definition of the Fed.
    But it also is very helpful if you can sell debt, which is 
treated as a government liability, which is what the GSEs, 
Fannie and Freddie and the Federal Home Loan Banks do. This was 
the pattern if you look historically in the times of crisis 
when various organizations were set up to finance the bust and 
try to stop debt deflation, such as the Reconstruction Finance 
Corporation or the Homeowner's Loan Corporation.
    All of these things were set up to be able to sell debt, 
which was taken by the market actually as government debt. Once 
you have that, then you can fulfill this role.
    I'd say, Congressman, in my view we do not want any such 
organization buying assets, at least unless we get into a real 
bust like the 1930's, in which you are willing to do things you 
might not do otherwise. I think that such operations should be 
limited to lending and should be accompanied by, as was pointed 
out by some of my colleagues on the panel, a replacement of the 
management which got the organizations into the trouble where 
they needed the lender of last resort financing.
    Mr. Garrett. And if Mr. Schwarcz or others want to chime in 
on this point, I think you made the comment, correct me if I'm 
quoting you wrong, that in this frame of the discussion--
whereas, well, we may not actually want to have the choice for 
the tax dollars, and the example was fixing the hole in front 
of my street. I think it was the example somebody said in there 
before as far as the lender of last resort, where the dollars 
go to.
    Of course, whether it's that little project or the bigger 
picture, when it is the Fed, that is--as I'm describing it, as 
the lender of last resort stepping in, and when they do what 
they do and which then theoretically or in actuality has a 
downward pressure on the dollar, so now our dollars are less, 
doesn't that actually also have a hit-it-home impact upon those 
other tax dollar expenses as well because now we actually--the 
dollar is less?
    So in order to fix that hole at home in front of my street, 
for the government to do that, there's actually less of an 
ability for the government to provide those other functions 
because of the actions over here by the Fed acting on that 
matter? Is that clear?
    Mr. Schwarcz. Well, I'm--let me, I guess, respond in two 
ways. First, your question, your original question was, don't 
we already have a lender of last resort in terms of the Fed, 
and we could. I don't think the Fed has the powers presently to 
act in the role as I envision it and as I think Mr. Bookstaber, 
although I shouldn't speak for him, but I believe he envisions 
it.
    What they've done in terms of their so-called liquidity 
injections really are--that's a misnomer. They have of course, 
you know, lowered the discount rate and the Fed funds rate, and 
these are rates in terms of bank borrowings.
    All I'm suggesting is that the Fed be given the authority, 
and they have to decide when to use it, so they can do things 
like purchase securities in markets that are collapsing. And 
that of course, that power would be used with a great deal of 
discretion because you'd want to--I think Mr. Pollock said 
this--use it only when the market was truly collapsing.
    Whether it would, in fact, have been used in these 
circumstances now I'm not 100 percent sure whether it would 
have done that.
    Mr. Garrett. I don't have much time. I guess I'll close on 
this. I'll take one of your comments home with me tonight. I 
think you said that everything we do is--these proposals are 
second best.
    Mr. Schwarcz. That is correct.
    Mr. Garrett. And I'll take the other comment as well in 
this area from Mr. Pollock in that we've had these things since 
the statement in 1914 that the Fed is going to resolve these 
problems into the future. Every decade we have them and 
sometimes more than once in a decade. And that, despite the 
fact of all the work that Congress has done.
    And I don't see that, from the examples or the testimony 
here--Mr. Kuttner gave the example, the only differences, I 
think, in the last period of time would be expiration and 
repealing of Glass-Steagall and involvement of the Fed more 
recently. But that was really the most significant difference 
that we saw in the last cycle. So other than that, Congress has 
repeatedly gotten into the action, tried to resolve their 
issue, and regardless, 10 years later or within the next decade 
we still get into this.
    So maybe the best thing is to really go slow before we pick 
up one of these second bests because we may just be picking 
something that is going to even exacerbate the problem ever 
forward because we know--I think everyone will agree on this, 
we will have another, we will have another crisis within the 
next 10 years or so. Does everybody agree on that one?
    Mr. Schwarcz. Mr. Garrett, may I just quickly respond? One 
of the things about the lender of last resort is that it's--the 
potential is out there. It could solve any problem, 
irrespective of its cause. Trying to address, I think, the 
cause, is almost like fighting the last war because the next 
problem will be different.
    Mr. Garrett. Mr. Kuttner is shaking his head, ``no.''
    Mr. Kuttner. I really disagree, and I think if we have more 
hazard with the Fed bailing out the systemic effects of 
speculation as it has done with the 50-basis-point cut, I think 
to allow the Fed to buy individual securities issued by private 
actors would be even more inducing of moral hazard, and I would 
rather see more preventive regulation going in.
    Mr. Pollock. Mr. Kuttner and I certainly agree on the Fed 
not buying assets. You know, Congressman, I agree with your 
statement.
    Mr. Garrett. Thank you.
    Mr. Bookstaber. Again, I think there may be--again, I can't 
speak for Mr. Schwarcz completely, but I think although we 
hadn't talked before this, we're on the same wavelength. And 
there is a distinction between being a liquidity provider of 
last resort and the traditional role of the Fed or the IMF in 
being a lender of last resort.
    If essentially you see a market that's in crisis and the 
reason it's in crisis is because there's huge liquidity 
demands, somebody is forced to sell. And you can walk in and 
say, ``You need to sell those assets, and I'll buy them from 
you, for pennies on the dollar,'' and that stops the crisis 
from then cascading out.
    The person who caused the problem is still out of business, 
therefore there's not a moral hazard problem, but you've done 
what the market with its particular temperament and risk 
aversion in times of crisis wouldn't do, unless you happen to 
have a Citadel around or a Buffett around that has the deep 
pockets and is willing to walk in and do it.
    Mr. Schwarcz. And may I just--
    The Chairman. No, you may not. We have gone over time.
    Mr. Miller.
    Mr. Miller of North Carolina. Thank you, Mr. Chairman.
    Mr. Pollock, it is good to see you again.
    In answer to Mr. Bachus's question about whether a 
bankruptcy court should be able to modify the terms of a home 
mortgage you said--and his question was wouldn't that make 
things worse, your short answer was yes.
    Every other form of secured debt is subject to modification 
and bankruptcy; only home mortgages are not. That went into the 
bankruptcy code in 1978. I have looked to try to find what the 
rationale was. Near as I can tell, it was just a sloppy 
compromise on the Senate side, which isn't to say that we 
don't--excuse me, in the other body, which isn't to say we 
don't have sloppy compromises also.
    But the lending industry opposed any kind of modification 
in bankruptcy. Consumer advocate supporters of the bankruptcy 
bill at that time wanted everything to be modified in 
bankruptcy. Can you explain to me the rationale, if you see 
one, between home mortgages and mortgages on investment 
properties or any other kind of secure debt?
    Mr. Pollock. Congressman, this is obviously a question that 
has been debated quite a bit, and reasonable men can disagree.
    I think the difference is that the home loan is far and 
away the biggest and the most important form of debt, and you 
want to give people the right truly to hypothecate the house if 
people are able to borrow as they are, in the mortgage system 
as it is, extremely large amounts to become homeowners. That 
seems to be a valuable right to have.
    Mr. Miller of North Carolina. Why is the right different 
from that of an investment property where people also borrow 
substantial amounts of money? Why should a bankruptcy court--in 
a hearing in the Judiciary Committee a couple of weeks ago the 
head of the Financial Services Roundtable said, ``You're 
right.''
    It wasn't me asking the question. It may have been Mr. Watt 
asking the question--said that none of those should be 
rewritten.
    Mr. Pollock. I would go that way on investment properties, 
Congressman. Indeed, as you suggest, I don't think investment 
properties in particular should be modified.
    Mr. Miller of North Carolina. You don't think any sort of 
secure debt should be modified in a bankruptcy court?
    Mr. Pollock. In bankruptcy. However, I do think that we 
ought to have ways, as we've previously discussed, of 
refinancing mortgages where we're in the negotiating space in 
which the haircut taken by the lender is less than the cost 
would be to proceed through foreclosure. You can create a win-
win refinancing. That I do favor.
    Mr. Miller of North Carolina. Mr. Kuttner, you were a 
student of history in this area. In 1934, Congress allowed for 
modification of mortgages on family farms. The Depression began 
on the farm before it began in the factory.
    When farm prices collapsed in the 1920's, farmers borrowed 
to try to get through, and when farm prices did not improve 
they had no way to pay the mortgages. And Congress enacted 
legislation. It's called the Frasier-Lenke Act of 1934 that 
allowed the bankruptcy court to limit the amount secured by a 
family farm to the value of the farm and then set an interest 
rate that reasonably reflected what the risk was of that 
borrower.
    Did credit collapse for farm mortgages? Did grass grow in 
the street? Well, actually, at that point grass was growing in 
the streets, but what was the result of that and do you see a 
rationale for a distinction?
    Mr. Kuttner. Yes, I do. Of course, that wasn't all that 
Congress did. Congress enacted the Homeowner's Loan Act. 
Congress invented the modern long-term self-amortizing 
mortgage. Congress intervened in the free market in a number of 
ways to get mortgage markets functioning again and to prevent 
millions of people from losing their homes. And that's what it 
took to get normal markets functioning again.
    So I think there is a role both for modification of 
bankruptcy law and for refinancings that allow folks to keep 
their homes. And if it can be a win-win situation, that's fine. 
If it simply requires the private mortgage lender to be taken 
out of the picture and the Federal Government to use the 
Federal borrowing rate to underwrite some of these 
refinancings, that's okay too because I think the mortgage 
lending industry, particularly the predatory part of it, 
deserves more than a haircut; it deserves a scalping, and we 
should act so that this doesn't happen again anytime soon.
    Mr. Miller of North Carolina. Mr. Chairman, I'm not sure I 
have the time to begin another line of questioning.
    The Chairman. Go ahead.
    Mr. Miller of North Carolina. Mr. Pollock, when we last 
spoke--I guess it was last week or the week before, we talked 
about the duties or whether there should be a duty by broker or 
loan originator, a loan officer. And I told you of rate sheets 
that we had seen that showed a grid. Down one side was loan to 
value, down the other side was a credit score for the borrower, 
and you followed it across and you found the interest rate that 
borrower qualified for. And then there was a footnote, and it 
said for every point above that that the borrower paid that the 
loan provided for, if there was also a prepayment penalty that 
the broker would get an additional half-point payment from the 
lender, called a yield spread premium.
    I viewed that as a conflict of interest. Mr. Kuttner spoke 
of conflicts of interest as being part of the problem. You seem 
to be less offended by it and used the analogy of a used car 
salesman. Do you think a mortgage broker is simply a used car 
salesman?
    Mr. Pollock. I think a mortgage broker is a salesman, and 
that should be understood by the borrower.
    Mr. Miller of North Carolina. And so the borrower was 
simply a chump to have believed what the broker told them?
    Mr. Pollock. Congressman, my view is that borrowers and 
ordinary people deal successfully all the time with salesmen of 
all varieties. But as you know, I think they need to be told 
the truth about the deal being offered.
    Mr. Miller of North Carolina. There are actually other 
relationships. Not every relationship we have in society is a 
``buyer beware.'' The law has long recognized that there are 
certain kinds of relationships where we are entitled to trust 
the person we're dealing with, for instance, a lawyer.
    And usually what marks those relationships is that there is 
a disparity in knowledge and power. And one way that you 
create, you put that burden on yourself, a fiduciary, is you 
tell the person you're dealing with, ``Look, I'm on your side; 
this is complicated; I know it, you don't know it; I'll be on 
your side; I'll do what's best for you.'' If you say that you 
have created a greater obligation than what a used car salesman 
has, which everyone knows is a buyer-beware relationship.
    Why is there not a greater expectation, given the disparity 
of knowledge, given the disparity in power, given what brokers 
hold themselves out to be, for a broker than there is for a 
used car salesman?
    Mr. Pollock. Congressman, I think it actually would be a 
very good idea for a set of mortgage brokers, and I think there 
is such a set, to create themselves as fiduciaries.
    There is a very interesting organization called Upfront 
Brokers organized by a friend of mine, where these brokers say 
to the customers exactly what you're suggesting and pledge to 
act that way, as agents for the customer, not agents for the 
lender.
    I think that's a very healthy thing to have in the market. 
I hope it expands.
    The Chairman. The gentlewoman from Illinois.
    Mrs. Biggert. Thank you, Mr. Chairman. Just to go back to 
the securitization, which I think is the next step in the chain 
here, it has been an important tool in providing liquidity to 
the mortgage market and has really led to an explosion, I 
think, for residential mortgage-backed securities.
    As with any investment, there is a potential to make money 
or to lose money. And I think as many of the investors are now 
finding out the hard way, they can lose money.
    But some have suggested that third parties such as the 
investors should be held liable for contributing to the 
problems in the subprime market. Shouldn't the market determine 
who is rewarded and who should be punished? Isn't that enough 
when the investors lose money on the investments?
    And I'd like to know what you see as the short- and long-
term implications of imposing such liability. Mr. Pollock, I 
will start with you.
    Mr. Pollock. I don't think we should impose liability on 
the investors in mortgage-backed securities for the very 
reasons you mentioned, Congresswoman.
    Clearly the market has punished a lot of people already. 
The danger point is when the flight of short term creditors 
happens on my Plank Curve shape and then it takes some kind of 
stabilizing intervention. Past that, I think the market 
discipline is in fact working right now.
    A lot of jobs are being lost. A lot of loss is being taken 
and companies closing, as you say.
    Mrs. Biggert. Thank you. Mr. Kuttner.
    Mr. Kuttner. Well, I think this is not a case where the 
market self-corrected. This is a case where the Fed came in 
with a 50-basis-point bailout that it would not have otherwise 
done, which may be having really hazardous effects on the 
dollar, that was necessitated by a credit crunch that could 
have been prevented had the Fed issued regulations under 
existing law.
    And I think the toleration of speculative underwriting 
standards based on a kind of black hole in the rating process 
and the assumption that someone is going to be induced to buy 
the paper because they think mistakenly that the reward 
justifies the risk has created a whole climate of moral hazard 
that is not worth the candle.
    So I think if you believe, and I don't mean you personally, 
I mean if one believes that this is the market self-correcting, 
one has to first define the Federal Reserve as something other 
than part of the government. The market did not self-correct. 
That's why the Fed had to make heroic interventions.
    Mrs. Biggert. Well, there has been a lot of criticism that 
the regulators didn't do enough and should have acted sooner.
    Mr. Kuttner. Yes.
    Mrs. Biggert. How would they know? I mean looking back it's 
easy to say, well, we saw that the signs were there.
    Mr. Kuttner. You know, there were all kinds of serious 
people warning that this was a disaster waiting to happen, and 
when Congress legislated on this in 1994 it wasn't just to 
protect consumers. It was also a lot of concern for systemic 
risks.
    We had a member of the Board of Governors, recently 
deceased, playing the role of Cassandra on this, and he wasn't 
listened to. So it's not like Monday morning quarterbacking. 
There were people who saw this coming, and we should have acted 
before it happened.
    Mrs. Biggert. Thank you. Anyone else? Mr. Schwarcz?
    Mr. Schwarcz. I don't--I think your question was whether 
investors should be punished in some way.
    Mrs. Biggert. Or be held--is there any liability?
    Mr. Schwarcz. Right. I think I agree with Mr. Pollock that 
their liability already is the loss of a portion of their 
investment, and I don't see anything inherently wrong or 
inappropriate in what the investors do.
    Part of the problem of course is that our system thrives on 
innovation and change, and innovation and change always creates 
a potential for problems, and I would be very hesitant to 
create negative incentives.
    Mrs. Biggert. Do you think--and I agree with you that we 
really need the creativity and the innovation, and particularly 
with the hedge funds it really is a competitive issue for the 
United States. Do you think if we attempt to regulate and 
perhaps over-regulate, would you expect to see the hedge funds 
leave for Europe or other friendly confines?
    Mr. Schwarcz. I have looked at it in terms of regulating 
disclosure, increasing disclosure. I have indicated that 
because of the tragedy of the commons I'm not sure that more 
disclosure would really change how parties would behave vis-a-
vis systemic risk because counterparties who--people who deal 
with hedge funds as counterparties already will get the 
information they need to make their investment decision.
    To the extent they find information that could create harm 
to third parties and not to them necessarily or not directly to 
them, they will ignore that information. So I'm not sure how 
much is to be gained by regulating hedge funds.
    Mrs. Biggert. Thank you. I yield back.
    The Chairman. The gentlewoman from New York.
    Mrs. Maloney. Thank you, Mr. Chairman, and I thank all of 
the participants for their testimony. It is very good to see 
you again, Mr. Pollock
    Mr. Bookstaber, I was interested in your comments on the 
reducing leverage and market complexity in your statement at 
the end, suggesting that the regulatory system actively engage 
in controlling leverage. I'd like you to elaborate on that.
    And related to that, I am concerned about reports of major 
institutions that not only have exposure to direct loses in 
credit and asset-backed products but which also may have 
significant credit-derivative exposure, meaning that they have 
to pay out to the investors in the event of a downgrade or of a 
negative event affecting credit.
    And the Fed acted in a way you would like them, and in 2005 
they expressed concern about a lack of transparency in this 
market due to flaws in the mechanics of processing the 
transactions. I guess that means that no one knows what anyone 
is owing to whom or what the product is really worth.
    In your view can regulators ascertain the true risk 
exposures from credit derivatives of the institutions they 
supervise? And what information would they need to do that?
    It ties into your overall theme, how do we bring in knowing 
what's out there? There's a sense that no one knows what the 
credit is, and you see that in the LIBOR rates that remain so 
high.
    Mr. Bookstaber. I think this is a central issue.
    From somebody who has been in the risk-management area, it 
is extremely troubling that some of the key data, the sort that 
is Risk Management 101 type of data, are simply not available.
    We don't know the web of counterparties for swaps or credit 
default swaps, who owes what to whom. And if some entity goes 
bankrupt how will that filter out to affect others? We don't 
even know by hedge fund type the amount of leverage hedge funds 
have and whether the leverage is going up or not.
    So again, I don't know the issues of how this information 
is garnered, but certainly as a starting point you would want 
to know that. You would want to know--
    Mrs. Maloney. But what information should we be asking for 
in order to be able to answer these questions?
    Mr. Bookstaber. I think in the ideal world what you would 
want to know from all the banks and investment banks, you would 
want to know what the counterparties are for all the 
transactions they are in and similarly for hedge funds.
    And for hedge funds you'd want to know the degree of 
leverage that they have and be able to look at it historically, 
just as a starting point.
    Mrs. Maloney. I'd like to go back to the LIBOR rates, which 
is the global rate at which banks lend to each other. It's 
remained very high, despite the cuts by the central banks like 
the Fed.
    One interpretation of this high LIBOR rate might be that 
while banks may be perfectly happy to borrow at discounted 
rates from central banks, they are reluctant to lend to each 
other because of just what you said. They don't really know, 
and I would like to know, do you agree? Is that why that is 
happening, and does this reluctance, in your opinion, mean that 
banks see something disturbing in each other's credit quality? 
And are the banks concerned that the fallout from the current 
credit squeeze is still not being fully reflected on the 
balance sheets of credit quality of their fellow banks? Why 
does it remain so high when all of this is happening, in your 
interpretation?
    And I invite Mr. Pollock and the others to join in.
    Mr. Bookstaber. I agree with the statements that you're 
making, that the banks understand the fragility of the ratings 
and the fragility basically of the counterparty system. And 
that would be one of any number of different causes for what 
we're observing right now in the LIBOR rate and the general 
disinterest in providing credit.
    Mrs. Maloney. I'd also like to ask you, do you think that 
depositories and investment banks should be required to market 
their own securities and holdings as aggressively as they value 
the collateral against loans and credit of their customers?
    Mr. Bookstaber. You are hitting a lot of critical points. I 
think the mark-to-market is--there are basically different 
levels of mark-to-market, the most extreme being what some 
people have termed ``mark to make-believe,'' and I think mark-
to-market based on ratings is not too far behind that.
    So at a minimum, getting back to the sort of information 
you'd want, you would like to know, both for hedge funds and 
investment banks, when profits and returns are mentioned how 
much of it is realized versus unrealized, and if it's 
unrealized, what is the marking convention that's been used, 
and is it being applied consistently.
    Mrs. Maloney. Mr. Pollock.
    Mr. Pollock. Thank you, Congresswoman.
    I mentioned in my testimony, coming back to the point on 
the LIBOR rate, that one of the characteristics of credit busts 
generally is that we get a lot of what's effectively lending 
long and borrowing short, and the short money is typically 
provided by lenders who are highly risk averse.
    Operators who are running short-term money desks are not in 
the business of taking much risk. So when the crisis comes and 
no one is sure who is broke and who isn't, which is the 
uncertainty and the penumbra of fear in a crisis, you see the 
short-term money pull back very fast. That's a regularity.
    We're seeing instances of that, as you suggest, in the 
LIBOR rate. As the losses come out and are reported, as the 
market sorts out who is broke and who isn't, we'll see that 
correct. I think that will correct fairly quickly.
    The Chairman. The gentleman from Illinois.
    Mr. Manzullo. Well, thank you. I'm sorry that I missed the 
testimony. I've been trying to catch snippets back in the 
office, and I've been able to read through some of this right 
here. I guess I have more of a theoretical question, knowing 
that you gentlemen don't get involved in theories, that 
everything is absolute and that you can predict with great 
experience how people are going to react in the world, but it 
appears that we have--every 10 years we have a problem like 
this. And I guess the first question is if we know we're going 
to have a problem like this every 10 years, Mr. Pollock, why do 
we have to repeat it again 10 years from now, which means that 
I would need the wisdom of all four of you to let us know what 
we could do now so it doesn't reoccur, if any of you want to 
try to answer that question.
    Mr. Pollock. Congressman, I'll try, since you have called 
on me.
    Mr. Manzullo. All right. Okay.
    Mr. Pollock. That is the great paradox or conundrum, that 
not only over decades, but over centuries, these patterns 
repeat. Every time we have a problem we enact reforms and do 
controls and then problems emerge yet again. The reason for 
that is precisely that finance is really about human behavior 
and human behavior is not predictable, as you suggest, 
Congressman. And it is not mechanistic. It's organic and 
recursive, to use a technical term. And we're always finding 
new ways to become very confident investors, to run up leverage 
and short-term debt and then be surprised when it doesn't work 
out the way that the optimistic players thought. That seems to 
be a regularity of human nature when enmeshed in financial 
systems.
    Mr. Manzullo. Well, Mr. Greenspan says that the housing 
problem is over, so maybe we could take his wisdom. Who is 
shaking their head over there? Yes, sir. Anybody want to--go 
ahead.
    Mr. Kuttner. I'm not sure it's quite accurate to say we 
have a problem every 10 years no matter what we do. I mean the 
regulatory schema that was invented in the 1930's really was 
quite solid for 40 or 50 years, and that was in the era when 
there was bipartisan support for the premise that finance 
should be regulated and well-disciplined so that the real 
economy could flourish.
    And it wasn't until we started dismantling some of that and 
not keeping up with the innovations that we started having the 
big time problems. And I think as we have deregulated more and 
not kept up with the innovations, the problems are occurring at 
a rate more frequent than every 10 years.
    The late 1990's was a period of multiple problems, currency 
speculation, long-term capital management. We had the dot com 
bust. It's only 7 years later and now we're having a big 
problem again. I think that correlates with the fact that we've 
deregulated. So I don't accept the premise that we should just 
say, ``Well, this is going to occur every 10 years no matter 
what we do.'' I do think even though mistakes are made, 
Congress does have the ability to head off the worst.
    Mr. Pollock. The regulation will change the form. We should 
be precise about the 1930's. As far as housing finance goes, 
the extremely heavily regulated housing finance system created 
in the 1930's was in trouble already by the mid-1960's and of 
course collapsed utterly in the 1980's.
    Mr. Kuttner. But 50 years as these things go, and this was 
a period where the rate of homeownership expanded from 40 
percent on the even of World War II to 64 percent by the mid-
1960's, that's a stunning, unrivaled record. If I could bet on 
a system that would last 30 or 40 years, I would take the bet.
    Mr. Pollock. We'll have fun talking about the history 
another time.
    Mr. Schwarcz. I would respond that there's a pattern based 
in human behavior, which I described in my testimony as 
alternating optimism and skittishness, which reflects the 
availability bias, the tendency of a recent crisis to be the 
most--the one that people really see. And so part of the 
pattern is that once the crisis fades people start getting more 
risk prone, and once the crisis occurs, they become overly risk 
averse and then the markets fail.
    It is very hard to prevent this human behavior, and one of 
the reasons why a liquidity provider of last resort is needed 
is that it can stand there and be available irrespective of 
what the cause of the problem is.
    Mr. Bookstaber. I would say that things are even worse than 
what you're suggesting because I believe that the number of 
crises has accelerated over the course of the last decade or 
two, even at the same time that actual underlying economic 
risk, the exogenous risk, has reduced, which means that more 
and more of the crises that we're seeing are really endogenous 
to the financial market.
    I'd also say that one of the problems that we have with 
financial crises is that they're inherently unpredictable 
because what causes the crisis depends on who owns what, who's 
under pressure and what else they happen to own when they are 
under pressure.
    So it changes, the likely candidates for market crisis 
change every time somebody changes their positions.
    The Chairman. The gentleman from Georgia, but I would ask 
the gentleman to give me just 45 seconds. I did want to 
comment.
    There was reference to the analogy between the mortgage 
broker and the used car salesman, which frankly baffles me. 
Used car salesmen work for used car agencies. Brokers are 
freelancers. The difference between walking into an 
establishment and talking to an employee of that establishment 
and hiring an independent contractor who presumably is picking 
and choosing certainly ought to be big enough to say they're 
different
    Now there may or may not be other arguments that apply, but 
the notion that you should assume that the consumer thinks he's 
in the same relationship with an employee of a business he 
walks into and an independent contractor just baffles me. That 
has to be the worst analogy I've ever heard.
    Mr. Pollock, did you want to respond?
    Mr. Pollock. I do, Mr. Chairman, thank you.
    My analogy was to salesmen in general.
    The Chairman. Okay. I thought you said used car salesman. 
Then it had nothing to do with you.
    Mr. Pollock. That was mentioned by the Member.
    The Chairman. Okay. Well, if you were talking about a free-
floating salesman, if there was a profession of used car sales 
agent who held herself out as someone who would help you get 
the best used car anywhere, that would be different, but I have 
heard the used car analogy from other people, and I would say, 
yes, there is a difference between a sales person whom you know 
works for a particular company and someone who holds him or 
herself out as an agent to get you the best deal.
    The gentleman from Georgia. I appreciate it.
    Mr. Cleaver. To any of you and each of you, if you could 
comment on this, you would say that investor protection and 
systemic risk really form the basis of the concerns that we 
have with hedge funds, is that correct? Pretty much? And with 
that being the case, I think the question has to be, is more 
regulation the answer. And how far down does the impact go?
    My specific question is, what impact, for example, would 
taxing private equity firms have on some of our smaller firms, 
minority owned, black owned firms, firms owned by women, many 
of whom are backed by these private equity firms? Would there 
be an undesired consequence on some of these smaller firms if 
we move with a form of taxing carried interest, for example, 
which is being bandied about?
    But I think I would like to get some thorough discussion on 
what might we do or not do? But let's put these smaller 
businesses, African American owned businesses, many of these 
businesses who are in real estate who invest in lower income 
areas, can you give me some answer to the concerns that many of 
these smaller businesses have?
    That in our quest to hit these folks and put these kinds 
of--and also, if you would, kind of let us examine the impact 
of what we are doing in regulating hedge funds and specifically 
taxing them and specifically the carried interest, and what 
impact this has on African American owned businesses, minority 
and small owned businesses, many of whom are backed heavily by 
these private equity firms.
    Mr. Kuttner.
    Mr. Kuttner. Well, let's take these separately. I think 
with hedge funds, there is a regulatory problem of a lot of 
this being a kind of a black box and regulators not being able 
to know what the balance sheet risk is for the banks and the 
investment banks that are funding these folks. I think there, 
the remedy is one part disclosure and one part a limitation on 
leverage.
    I think the tax issue is a separate issue. It's an equity 
question, is it reasonable that a billionaire, who makes his 
money from so-called carried interest, which simply means that 
his income is treated as capital gains, even though the man on 
the street would view it as ordinary income, is it reasonable 
that that person should pay income tax at a lower rate than the 
janitor who cleans out his office?
    Now, on the question of whether this hurts small 
businesses, my study of this field suggests to me that there 
are a couple of different kinds of animals here, both parading 
under the name of private equity. You have the kind of firm 
that does provide equity sometimes to small businesses, and 
that's a very valued player in our financial system.
    You have other players who also call themselves private 
equity, who are mainly borrowing money to buy and sell assets 
and extract as much fee income and as much asset income as they 
can.
    I think those very short term round trips should be heavily 
taxed. I think someone who is mainly in the business of 
extracting wealth should be treated as different from someone 
who is investing long and benefitting the community. And it's 
always the case that the small business person, the minority 
businessman, the low-income homeowner is used as the poster 
child for practices that may be unsavory, and I think we really 
need to distinguish different kinds of financial players who 
merit different treatment.
    Mr. Cleaver. I want to just get--and Mr. Schwarcz, we'll 
get to you, but I want to make sure in my time that I really 
get on the record a good response to this.
    I want to just share something which was brought to my 
attention in my office but also from Financial Week, which says 
that a coalition of minority and women businesses have come out 
against efforts to tax private equity. The Access to Capital 
Coalition comprises a number of private equity and real estate 
firms, including smaller firms which focus on investing in low- 
and moderate-income areas.
    And as one who is very interested in building wealth in the 
minority communities, can you give me a response? Is this 
something they should not be concerned about? Or is this a 
legitimate concern that this group has that we should be 
concerned about?
    Yes, sir, Mr. Pollock?
    Mr. Pollock. Congressman, my view, and here perhaps Mr. 
Kuttner and I agree, is that carried interest is, in fact, a 
bonus and it ought to be taxed the way other bonuses are taxed.
    Mr. Cleaver. Excuse me, you said what should be taxed?
    Mr. Pollock. Carried interest is, in fact, a management 
bonus.
    Mr. Cleaver. Could you tell us exactly what that is?
    Mr. Pollock. It means that in exchange for the performance 
of your managerial responsibilities, as measured by some 
criteria you are given by your employer a payment. So I think 
it should be taxed the same way managers' bonuses are taxed. 
And I don't think you really have to worry at all about the 
impact on smaller businesses and so on. I don't think there 
will be any.
    Mr. Cleaver. So the worry is unfounded?
    Mr. Pollock. That is my belief, yes, sir.
    Mr. Bookstaber. One way to think of it is that my incentive 
is still to maximize return. If somebody is paying me 20 
percent of the return versus 10 percent of the return that I 
can get through the funds, the private equity fund or the hedge 
fund, I am still going to do the same thing. It is just that I 
won't make as much money.
    So the effect, really, of the carried interest incurred as 
ordinary income is that now my bonus is taxed so effectively I 
am only getting 10 percent, say, rather than 20 percent of the 
return that I generate for the fund.
    Mr. Cleaver. So everyone here supports the tax on carried 
interest?
    Mr. Schwarcz. Well, I would say that I have not studied 
that issue sufficiently to come to a view. And the issue is 
consequences. Any regulation can have potential undesired 
consequences.
    Part of this also goes to the issue of reducing leverage. I 
think that was implicit in your question. Let me simply say 
that I have looked at the issue of reducing leverage, and it is 
a very complex issue. I would urge that if there is any 
consideration given to reducing leverage by regulation that it 
be carefully studied, because I think it could be a very 
expensive and potentially negative proposition, which could 
limit, you know, economic ingenuity and innovation.
    Mr. Cleaver. In conclusion, my final point, gentlemen, is 
do you believe that our financial system now has become overly 
dependent on hedge funds?
    Mr. Schwarcz. Hedge funds, of course, have a bad rap. 
Perhaps some of it is deserved. But they do have the potential 
to spread risk, and I think they have been spreading the risk, 
reducing the risk to any given player, and that actually 
reduces systemic risk.
    Mr. Kuttner. I disagree. I think hedge funds increase 
systemic risk to a far greater degree than is often recognized. 
The bets are often in the same direction and I think further 
disclosure would not be a bad thing.
    Britain is not known as a nation that is hostile to hedge 
funds, but the largest hedge funds in Britain are required to 
make disclosures to their regulatory authority that our hedge 
funds are not.
    And the economy got along very, very well in the boom years 
of the last century without hedge funds.
    Mr. Cleaver. Thank you. I understand my time is up.
    Thank you, Mr. Chairman.
    The Chairman. The gentlewoman from Wisconsin.
    Ms. Bean. Thank you, Mr. Chairman, and I thank the 
distinguished panel for coming here. I have been very 
fascinated by your testimony, and very confused. But thank you 
for trying to present in sort of layman's terms that some of us 
can really understand. Your engineering analogies and certainly 
your cockroaches have been very, very informative.
    And what I am hearing really is a wide range, and I just 
want to get some clarity here. You know, we hear everything 
from Mr. Pollock, you know, where trying to re-regulate or 
trying to regulate too much, you know, it is not possible, as 
you say, to design society. And no matter what regulatory 
system we may implement, we are not going to avoid these 
financial booms and busts.
    And I hear from another of our speakers, from Mr. Kuttner, 
that perhaps the lack of transparency and the excesses of 
leverage and conflicts of interest, things that would in fact 
speak to our re-regulating, as it creates these moral hazards 
that we need to do.
    And then in between, I am listening to folks like Mr. 
Bookstaber, who gave us the engineering and cockroach--gave me 
the creeps analysis, that I am confused when you say, sort of 
in between, I get more mixed up when you say that regulation 
may add to the complexity of this and we may have unintended 
consequences.
    And then when we talk about the lender of last resort, we 
talk about some sort of shell game where you have these funds 
but, you know, it is put together in a constructive ambiguity 
where people don't know whether you are going to bail them out 
or not. And so my question is, after reiterating all of your 
testimony, my question really is, do you think that it is 
really possible to mix some of these things that you have said 
and not over-regulate to the point that we harm our ability to 
be competitive and put good products together, but do some 
common sense kinds of things?
    You know, this notion that we have some idea of what is 
going to happen, that we have stuff that is so highly leveraged 
that I think you might all agree that investors don't 
necessarily care about the systematic impact that they are 
making; they only care about whether they are right up to the 
margin and whether they are going to get the highest return 
possible. Would it be possible to price this risk and make them 
pay premiums into this fund of last resort?
    I heard you, Mr. Pollock, say that only people who could 
print money could be the lender of last resort. But would it be 
possible, number one, to make people who want to be high 
rollers pay a huge premium for these risks, as one thing to do? 
Disclosure is not enough, but what is wrong with some 
disclosure? Is it possible to put a package together that sort 
of meets all of the essentials? And certainly ends some of the 
conflicts of interest like--like the waiting agency being paid 
by the investors?
    Mr. Pollock. Shall we just go in--
    Ms. Bean. Yes, go for it.
    Mr. Bookstaber. I don't know the complexities of enacting 
regulation. But it seems to me that of the various proposals 
that were put forward, and I think some of my colleagues would 
share, the one that seems almost immediate to me is trying to 
get more data. I think we truly do face substantial risk of a 
crisis through credit default swaps and through the interweaved 
counter-parties. And we don't know who is who.
    I think we have seen what would happen with the 
quantitative funds in August. We don't know how levered people 
are, and therefore how susceptible they are to crisis. So if I 
were going to start from the top and go down the list, the one 
that I would think is the easiest to start with is identify and 
try to get the critical data.
    Ms. Bean. Okay, Mr. Schwarcz?
    Mr. Schwarcz. I think your suggestion is a good one. And on 
page 6 of my photocopied testimony, I say that any shifting of 
costs to taxpayers could be controlled. Rather than using 
taxation to establish a pool of funds from which a lender of 
last resort can make advances or investments, the pool can be 
funded, for example, by charging premiums to market 
participants, not unlike insurance. I assume deposit insurance, 
for example, is financed this way. So I agree with you.
    Ms. Bean. All Right, thank you. Mr. Kuttner.
    Mr. Kuttner. Yes. I think we should certainly start with a 
great deal more required disclosure, so that we can find out 
just how serious these problems are. So the extent that some of 
this information is proprietary and competitive, it could be 
disclosed to the SEC or the Federal Reserve.
    But I think at the end of the day, we are going to have to 
act to make certain practices illegal because the benefit 
doesn't outweigh the risk.
    Ms. Bean. Okay, Mr. Pollock, last but not least.
    Mr. Pollock. Okay, thank you Congresswoman. First of all, 
let me say, if I may, I really enjoyed your summary of our 
various positions. The essential framework, we are talking 
about today the relationship between systemic risk and 
regulation, is a long-debated question.
    In my testimony, I did suggest several things which could 
be done, including promotion of investor paid rating agencies, 
one of the things you mentioned. And, of course, as you know, 
on the simplest and post commonsensical level, I have suggested 
a much better disclosure for the consumer, which I hope you 
have seen and like.
    The Chairman. The gentleman from Illinois has a 
supplemental question, then I will have one comment, and we 
will be out of here.
    Mr. Manzullo. Thank you. My question dealt with the Pollock 
two-page disclosure.
    I practiced law from 1970 until I was sworn in as a Member 
of Congress in January of 1993, and I closed probably 1,500 
real estate transactions. And we could close them in a 
relatively short period of time, then along came RESPA in 1975 
or 1976. Of course, out in the country, it took 3 years for 
news to get there, and the real estate transaction should have 
closed 3 days before we were meeting so people would have the 
opportunity to shop.
    And now you go to a real estate closing and it has to be a 
stack this thick. People have no idea what is going on. They go 
through--
    The Chairman. This is a supplemental question.
    Mr. Manzullo. Absolutely. My question is, Mr. Pollock, you 
have a two-page disclosure, and I think the Washington Post 
commended you on that. Will that make that much of a 
difference? Will people read it? Will they understand it?
    Mr. Pollock. I think they will. We have done a good bit of 
discussions and trying this out on people. It is the only thing 
that really speaks to the consumer's problem, that problem 
itself, what does this mean for me? So I think it will. Not for 
everybody, but for a very large number of people, Congressman.
    Mr. Manzullo. Chairman, with your permission, could I have 
included as part of the record the two-page disclosure?
    The Chairman. Certainly.
    Mr. Manzullo. Thank you.
    The Chairman. It has been in before, but we will append it 
to that question. I just want to make two quick comments.
    One, I noticed, Mr. Pollock, you talked about the housing 
every 10 years or so. We are 19 years into your 10-year cycle, 
I just would note. And people might say, well, that is because 
the Republicans were in power. Well, they were during one of 
those cycles, at least in part, in 1983, and ascended to the 
presidency. But no one that I know of has proposed one of those 
housing bills.
    We have talked about some of us getting back into the 
affordable housing business. But there has been no emergency 
housing bill of that sort proposed for 19 years and none 
pending even now.
    Mr. Pollock. Thank you, Mr. Chairman, for your detailed 
attention to my comments. It was 10 years on average over time.
    The Chairman. If you look back, it was 1983, 1988, there 
were less than 10 years, there were four between 1970 and 1988. 
And we have gone 19 years. One thing, if we do run into it, and 
we have made things different, we still think we need to 
improve the supply on a general basis.
    The other thing I would say is this with regard to you pass 
these things and they don't make any difference, sometimes they 
do. In 1988 and 1989, we had the terrible crisis, 1987, 1989, 
in the S&L. We passed legislation that included bailing out the 
depositors, not on the whole but the stockholders or the bond 
holders. We did make good our promise to depositors.
    And since that time, that bill was passed, I think, in 
1989, we have not had a serious problem with the S&Ls. And not 
only that, we were worried about a potential domino effect in 
the commercial banks and we passed FIDICIA, I believe was the 
name of it, in 1990, and we had in the period since then great 
success, and there has in fact been a far lower incidence of 
bank failures since then.
    So that package of legislation, and Chairman Gonzales was 
presiding at the time in cooperation with the Treasury 
Department, which was then under Republicans, so the notion 
that it never works when you have these things and you try, I 
would point to the S&L and commercial bank twin bills of the 
late 1980's and early 1990's as a very successful response. And 
the record since then has really been very good.
    Mr. Pollock. Mr. Chairman, I would never wish to be 
understood as saying that legislation never makes a difference. 
Of course it can make a difference--
    The Chairman. That would be the thrust I would take from 
your testimony--
    Mr. Pollock. But the point I was trying to make is the 
busts and the systemic risks come along anyway. They tend to 
come--
    The Chairman. Well, they did not in the banking area--
    Mr. Pollock. Oh, no, I understand. But in the market in 
general, they tend to come from different directions.
    The Chairman. I will re-read your testimony, but I would 
say the thrust of it predating your refinement of it right now 
would suggest that it was a futile operation. I think it was 
unduly pessimistic paced on the record, to be honest.
    The gentlewoman from Wisconsin had something to say?
    Ms. Bean. Thank you so much, Mr. Chairman.
    I forgot which one it was in your testimony that I read 
that talked about the risks and costs of systemic failure as it 
filters down to people, loss of jobs and so on. I know that my 
sister worked for TWA and folks committed suicide and so on 
when they lost jobs. Is there a way to price this kind of risk? 
That's my question.
    Mr. Schwarcz. I have certainly spoken to that issue in my 
testimony and in the paper. In the paper itself, I attempt to 
do some calculations which attempt to price that. But I admit 
very much it's highly speculative and I conclude that I am--I 
simply look at it and say, if one looks at this, one could come 
to certain views. It is a way of thinking about it. But I 
couldn't find a clear way of pricing it.
    The Chairman. I thank the panel. It has been very useful. 
And luckily, a lot of members left. It seems like the fewer 
members we have, the better, sometimes, the conversation.
    I am reminded of Washington Irving and the Knickerbocker 
history when he said, the ship sailed around the bend and 
crashed and we will never know what happened because there were 
too many survivors.
    As we have fewer people, we can sometimes focus better. 
Thank you.
    [Whereupon, at 12:26 p.m., the hearing was adjourned.]


                            A P P E N D I X



                            October 2, 2007


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