[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
FEDERAL RESPONSE TO MARKET TURMOIL: WHAT'S THE IMPACT ON THE BUDGET
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HEARING
before the
COMMITTEE ON THE BUDGET
HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
HEARING HELD IN WASHINGTON, DC, SEPTEMBER 24, 2008
__________
Serial No. 110-41
__________
Printed for the use of the Committee on the Budget
Available on the Internet:
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COMMITTEE ON THE BUDGET
JOHN M. SPRATT, Jr., South Carolina, Chairman
ROSA L. DeLAURO, Connecticut, PAUL RYAN, Wisconsin,
CHET EDWARDS, Texas Ranking Minority Member
JIM COOPER, Tennessee J. GRESHAM BARRETT, South Carolina
THOMAS H. ALLEN, Maine JO BONNER, Alabama
ALLYSON Y. SCHWARTZ, Pennsylvania SCOTT GARRETT, New Jersey
MARCY KAPTUR, Ohio MARIO DIAZ-BALART, Florida
XAVIER BECERRA, California JEB HENSARLING, Texas
LLOYD DOGGETT, Texas DANIEL E. LUNGREN, California
EARL BLUMENAUER, Oregon MICHAEL K. SIMPSON, Idaho
MARION BERRY, Arkansas PATRICK T. McHENRY, North Carolina
ALLEN BOYD, Florida CONNIE MACK, Florida
JAMES P. McGOVERN, Massachusetts K. MICHAEL CONAWAY, Texas
NIKI TSONGAS, Massachusetts JOHN CAMPBELL, California
ROBERT E. ANDREWS, New Jersey PATRICK J. TIBERI, Ohio
ROBERT C. ``BOBBY'' SCOTT, Virginia JON C. PORTER, Nevada
BOB ETHERIDGE, North Carolina RODNEY ALEXANDER, Louisiana
DARLENE HOOLEY, Oregon ADRIAN SMITH, Nebraska
BRIAN BAIRD, Washington JIM JORDAN, Ohio
DENNIS MOORE, Kansas
TIMOTHY H. BISHOP, New York
GWEN MOORE, Wisconsin
Professional Staff
Thomas S. Kahn, Staff Director and Chief Counsel
Austin Smythe, Minority Staff Director
C O N T E N T S
Page
Hearing held in Washington, DC, September 24, 2008............... 1
Statement of:
Hon. John M. Spratt, Jr., Chairman, House Committee on the
Budget..................................................... 1
Additional submission: Congressional Research Service
report................................................. 12
Hon. Paul Ryan, ranking minority member, House Committee on
the Budget................................................. 11
Peter Orszag, Director, Congressional Budget Office.......... 3
Prepared statement of.................................... 6
FEDERAL RESPONSE TO MARKET TURMOIL: WHAT'S THE IMPACT ON THE BUDGET
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WEDNESDAY, SEPTEMBER 24, 2008
House of Representatives,
Committee on the Budget,
Washington, DC.
The committee met, pursuant to call, at 10:10 a.m. in room
2103, Cannon House Office Building, Hon. John Spratt [chairman
of the committee] presiding.
Present: Representatives Spratt, DeLauro, Edwards, Cooper,
Schwartz, Kaptur, Becerra, Berry, Boyd, Scott, Etheridge,
Baird, Garrett, Hensarling, Conaway, Tiberi, and Porter,
Chairman Spratt. Mr. Ryan apparently is in a meeting and
will be here shortly. In the interest of time, I will proceed
by opening the hearing, welcoming our witness, and making my
opening statement.
Last Thursday Secretary Paulson, Chairman Bernanke and the
Chairman of the SEC, Chris Cox, came to the Capitol to brief
the leadership of the Congress on the financial crisis facing
our country and to ask for a swift, robust response by
Congress.
On Saturday they followed up that meeting with a
legislative proposal, or at least a skeletal outline of the
bookends of a proposal, with the contents to follow, along with
a dire warning that time was of the essence.
Since then, Congress has been poring over the Bush
administration proposal, making various improvements to it and
trying to find common ground for consensus. On the Budget
Committee we have a limited role in legislating the proposal
before us, even though it has major repercussions for the
budget.
Just 2 weeks ago the Congressional Budget Office released
its updated economic forecast and warned us of large,
unrelenting deficits that lie ahead of us. Economic events
since then have only worsened the outlook. The Bush
administration requested an unprecedented sum, $700 billion, to
shore up failing firms, to stop panic in the financial markets,
and to keep the economy from backsliding into a protracted
recession.
Our hearing today will examine the impact of the
President's request on the budget. The President has called for
Congress to act with dispatch, but we must also act with
diligence and deliberation as we consider his request, and that
is the purpose of today's hearing.
To that end I decided yesterday--and Mr. Ryan graciously
agreed--to move this hearing up from its scheduled time on
Friday. Although the time for full consideration has not yet
been set, I was concerned that a hearing on Friday would come
after the bill was considered on the floor. I want to commend
the staff of the Budget Committee on both sides of the aisle,
Democrats and Republicans, Tom Kahn and Austin Smythe, who have
been working in a collegial bipartisan way to analyze the
proposals that were sent to us.
We were concerned that the proposal in its original form
did not adequately account for market risk and, therefore,
understated costs. Our staff has been working with the staff at
OMB on the proposed scoring of this proposal so that it better
reflects the market risk involved.
Budget Committee staff have also helped to add to the bill
periodic requirements for the reporting of funds dispersed,
assets acquired, and the estimated recovery or repayment of
those assets.
Our witness today is Peter Orszag, the Director of the
Congressional Budget Office. I want to thank Dr. Orszag for
rearranging his schedule on short notice so that he could
testify.
I also want to thank his staff for all they have done to
help us analyze this proposal. CBO has been working overtime on
written testimony, and most of our members probably did not see
the testimony of Dr. Orszag until they arrived here this
morning. I would encourage everybody to read it because it is
an excellent statement of the situation. And I would also
encourage Dr. Orszag to take whatever time he needs to give us
a thorough, complete analysis of how CBO analyzes a request and
how it should be reflected in the budget.
Just by way of background, let me lay out the budget
question that is mainly before us. There are two conventions
for recording the President's $700 billion request, should it
be granted. Under traditional scoring, when the Federal
Government purchases an asset, the purchase payment is shown in
the budget as an outlay. But there is no corresponding entry
for the value of the asset acquired, not at least until the
asset is sold. When it is sold, the sale price is booked as an
offsetting receipt or a negative outlay. If CBO follows this
method, this convention, it needs to know various things: How
much of the $700 billion will be drawn down by the Treasury and
paid out and when that withdrawal will occur? And to complete
the transaction CBO needs to know when the asset is sold and
the receipts that are derived from the sale. Obviously these
things are difficult to know at this point in time.
If the government's disbursement takes the form of a loan,
the loan amount is not booked as an outlay and the subsequent
repayments are not booked as receipts.
Under the Federal Credit Reform Act, if the loan is deemed
likely to repay on a present-value basis less than the original
principal amount because of losses or subsidies, then CBO books
a probable shortfall does not lay in the year the loan is made.
OMB believes that the request of $700 billion should be scored
in this matter because many of the assets the government
acquires will be mortgage loans, so the government will be
stepping into the shoes of the mortgagee.
As you can see, the customary accounting conventions are
not an easy fit for the circumstances we find ourselves in. Yet
the convention used can have a major impact on how the
requested $700 billion is incorporated into the budget.
Our purpose is to explore these and other budget process
issues with Dr. Orszag. And in that connection, let me remind
all of our members that Dr. Orszag is not here to oppose or
support this proposal before us. He and his staff are here as
analysts, not advocates.
Before turning to Dr. Orszag I would normally turn to our
Ranking Member, Mr. Ryan. I understand that he will reserve his
place to make an opening statement. It is going to be a closing
statement, after Dr. Orszag has testified.
Dr. Orszag, I think the better part of wisdom is to proceed
with your testimony. Thank you for being here. And your
testimony is an excellent statement of the situation of the
choices before us, and I would encourage you to take all the
time you need to thoroughly explain it to the members of this
committee. Thank you once again for your excellent contribution
to our effort.
STATEMENT OF PETER R. ORSZAG, DIRECTOR, CONGRESSIONAL BUDGET
OFFICE
Mr. Orszag. Thank you, Mr. Chairman, members of the
committee. Since August 2007, financial markets have
experienced severe strains which emanated from the bursting of
the housing bubble and then fed into declines in mortgage-
related assets, which then fed into significant difficulties in
ascertaining the financial condition of the institutions
holding such securities. These problems contributed to a
broader collapse of confidence, with the result of financial
institutions having become increasingly unwilling to lend to
one another.
Over the past few weeks, the collapse of confidence in
financial markets has become particularly severe. I have a
chart that I would like to put up which shows one illustration
of that collapse of confidence in financial markets.
This shows, in a sense, the higher you go on that curve,
the more turmoil there is in short-term financial markets. And
that spike that you see occurred over the past couple of weeks.
So a very dramatic collapse, which is what drove the Treasury
Department to propose the act that is under consideration.
One thing that is striking is the turmoil in the financial
markets thus far has had less impact on macroeconomic activity
than one might have thought, and indeed the second quarter
showed fairly robust economic growth. A modern economy like the
United States, however, depends crucially on the effective
functioning of its financial markets in order to operate. And
there is little doubt that if the kinds of strains that are
shown in that graph were perpetuated, the effects on economic
growth, on household income, and on other things that we all
care about would be quite severe if not devastating.
To mitigate these risks the Treasury Department and others
have put forward a variety of proposals. In analyzing them it
is crucially important to keep distinct two problems. One is
that the markets for some types of assets have effectively
stopped functioning; that there is illiquidity in particular
financial markets. For that kind of issue, the Federal
Government could intervene as a market maker to reestablish
liquidity. And that need not--and I am going to return to this
later--that need not involve any significant subsidy from the
Federal Government to private market institutions.
The second problem, though, involves the potential
insolvency of specific financial institutions. By some
estimates, global commercial banks and investment banks may
need to raise hundreds of billions of dollars more to cover
their losses. Restoring solvency to insolvent institutions
requires additional capital investment, and one possible source
of such capital injections is the Federal Government.
These two problems are related in the sense that it is
difficult to know which institutions are insolvent if you can't
price their assets because of illiquidity in the markets; and,
conversely, injecting more equity into insolvent or barely
solvent financial institutions could help to restore liquidity
to some financial markets because each counterparty may be more
willing to lend to another financial institution with more
confidence that there is a greater capital cushion at that
other financial institution to which it would be lending.
Nonetheless, the problems are, even though they are
related, conceptually distinct, and much of the policy
discussion about the Treasury proposal and other recent
proposals have muddled or confused the two issues. Indeed, some
proposals appear to be aimed primarily at the illiquidity of
particular asset markets; others seem to be aimed primarily at
insolvency; and some may do a little bit of both, depending on
how they are implemented.
Given that, let me turn in particular to the troubled Asset
Relief Act of 2008 as proposed by the administration. As you
know, the act would authorize the Secretary of the Treasury to
purchase, hold, and sell a wide variety of financial
instruments, particularly those that are based on or related to
mortgages issued prior to September 2008. The legislation would
appropriate such sums as are necessary to enable the Secretary
to purchase up to $700 billion of such assets at any point
during the 2-year window of opportunity specified under the
legislation and to cover relevant administrative expenses.
At this time, given the lack of specificity regarding how
the program would be implemented and even what classes would be
purchased by the Secretary, CBO cannot provide a meaningful
estimate of the ultimate net cost of the administration's
proposal. The Secretary would have the authority to purchase
virtually any asset at any price and sell it at any future
date.
The lack of specificity regarding how that authority would
be implemented makes it impossible at this point to provide a
quantitative analysis of the net costs to the Federal
Government. Nonetheless, some observations are possible with
regard to what would influence the net cost to the Federal
Government.
And I would identify two key forces. The first is whether
the Federal Government seeks and is able to succeed in
obtaining a fair price for the assets it purchases, and in
particular whether it can avoid being saddled with the worst
credit risk without the purchase price reflecting those risks.
I am going to return to that in a moment.
The second force is whether, because of severe market
turmoil, market prices are currently lower than the underlying
value of the assets. If current prices reflect so-called fire-
sale pricing that can result from severe liquidity constraints
and impairment of credit flows, taxpayers could possibly
benefit by buying now, holding the securities, and selling them
as prices return to those underlying values.
But let me return to that first force and whether the
Federal Government will obtain a fair price for the assets that
it is purchasing. That will depend not only on the types of
assets that are purchased, but how the transactions are
conducted. The Treasury has indicated that it would conduct
reverse auctions for at least some of the purchases. And I
would note a reverse auction can work well in some cases, but
it is not magic. It only works well under certain conditions;
in particular, under a reverse auction, the sellers offer to
sell you something and someone will offer--I will sell it to
you for $100, someone else will say $90, someone else will say
$80. And instead of a regular auction where the price goes up,
the price goes down, so that you get the lowest bidder winning
the contract, thereby getting the best price possible as a
buyer. Thus, a reverse auction.
In the context of financial assets a reverse auction works
best when different sellers are offering to sell their shares
in the same asset rather than offering to sell different
assets, and also when many sellers participate. When sellers
are offering different assets, the lowest bidder may win by
offering an asset with particularly risky or poor future
prospects and the price may not reflect the degree to which the
specific asset is impaired or risky.
Consequently, the Federal Government could purchase too
many risky or impaired assets without enjoying sufficient price
discounts.
Similarly, if the number of bidders or participants is
unduly limited, the government could overpay relative to a fair
price. One focus the Treasury has identified for the program is
mortgage-backed securities, and they have indicated that they
may conduct reverse auctions on a tranche-by-tranche basis,
that is on a CUSIP-by-CUSIP basis for each individual cash flow
associated with the mortgage-backed security. Reverse auctions
on that basis. That would work relatively well.
And to the extent that the program was limited to that kind
of auction for that kind of security done in that kind of way,
you are likely to get a price that reflects the underlying
characteristics of the cash flows that the Federal Government
would be purchasing.
Reverse auctions may not obtain a fair price for the
government for many other types of assets that may be covered
under the program, though. In particular, for example, if the
Federal Government went out and bought loans themselves from
banks, you are very likely to wind up with the worst quality
within any given risk classification and to wind up overpaying
for those individual assets.
Basically the problem there is that the seller has more
information than you do about the characteristics of the asset
and there is no way that a reverse auction can ensure that you
are obtaining a sufficiently low price for the risk
characteristics of what you are purchasing. Substantial
purchases of those types of assets would make it unlikely that
the Treasury could operate the proposed new program at little
or no net cost to the taxpayer.
In other words, the more that the Treasury program
concentrates on assets that are difficult for a buyer to value,
the more likely that the government will overpay. And the more
that that occurs, the more the program moves beyond simply
reestablishing trading in illiquid financial markets, and the
more it instead subsidizes particular financial institutions
selling those assets to the government in a manner that seems
unlikely to be an efficient approach to addressing concerns
about insolvency.
The written statement includes some discussion of
alternative proposals including direct equity injections. I
would be happy to answer questions about that. But especially
since I see that Mr. Ryan is now here, I will end my oral
statement with that. Thank you very much Mr. Chairman.
[The prepared statement of Peter R. Orszag follows:]
Prepared Statement of Peter R. Orszag, Director, Congressional Budget
Office
Chairman Spratt, Ranking Member Ryan, and Members of the Committee,
thank you for inviting me to testify this morning on the budgetary and
economic implications of the recent turmoil in financial markets and
the Administration's proposal to address it.
Since August 2007, the Federal Reserve and the Treasury have been
attempting to address a series of severe breakdowns in financial
markets that emanated from the bursting of the housing bubble, leading
to substantial losses on mortgage-related securities and great
difficulty in accurately ascertaining the financial condition of the
institutions holding such securities. Those problems generated
significant increases in risk spreads (or the interest rates charged on
risky assets relative to Treasury securities) but, more important,
contributed to a broader collapse of confidence, with the result that
financial institutions became increasingly unwilling to lend to one
another.
Over the past several weeks, the collapse of confidence in
financial markets has become particularly severe. Short-term loans
between financial institutions have fallen off sharply. Instead, the
Treasury and the Federal Reserve have become the financial
intermediaries for them. In other words, rather than financial
institutions with excess money lending to institutions needing short-
term funding, many institutions with excess short-term money have
purchased Treasury securities, the Treasury has placed the proceeds on
deposit at the Federal Reserve, and the Federal Reserve has then lent
the money out to those institutions needing short-run funding.
Thus far, turmoil in the financial markets has had less impact on
macroeconomic activity than may have been expected, and, indeed,
economic growth was relatively strong in the second quarter of this
year--in part because of the stimulus package enacted earlier this
year. A modern economy like the United States', however, depends
crucially on the functioning of its financial markets to allocate
capital, and history suggests that the real economy typically slows
some time after a downturn in financial markets. Moreover, ominous
signs about credit difficulties are accumulating. The issuance of
corporate debt plummeted in the third quarter, and the short-term
commercial paper market has also been hit hard. Bank lending, which has
thus far remained relatively strong, will undoubtedly be severely
curtailed by the difficulties that banks are facing in raising capital.
Such a curtailment of credit means that businesses and individuals will
find it increasingly difficult to borrow money to carry out their
normal activities. In sum, the problems occurring in financial markets
raise the possibility of a severe credit crunch, which could have
devastating effects on the U.S. and world economies.
To mitigate the risks, the Department of the Treasury has proposed
the Troubled Asset Relief Act of 2008, and similar proposals have also
been put forward by the Chairman of the House Financial Services
Committee and the Chairman of the Senate Banking Committee. In an
analysis of these proposals, it is useful to identify two problems
facing financial markets: illiquidity triggered by market panic and the
potential insolvency of many financial institutions.
One problem is that the markets for some types of assets and
transactions have essentially stopped functioning. To address that
problem, the government could conceivably intervene as a ``market
maker,'' by offering to purchase assets through a competitive process
and thereby provide a price signal to other market participants. (That
type of intervention, if designed carefully to keep the government from
overpaying, might not involve any significant subsidy from the
government to financial institutions.) The second problem, though,
involves the potential insolvency of specific financial institutions.
By some estimates, global commercial banks and investment banks may
need to raise a minimum of roughly $150 billion more to cover their
losses. As of mid-September 2008, cumulative recognized losses stood at
about $520 billion, while the institutions had raised $370 billion of
additional capital.\1\ Restoring solvency to insolvent institutions
requires additional capital injections, and one possible source of such
capital is the federal government.
Those two problems are related in the sense that it is difficult to
know which institutions are insolvent without being able to value the
assets they hold (which in turn is impeded by illiquid markets).
Undisclosed losses are unlikely to be distributed uniformly throughout
the financial system, and the inability to identify which institutions
are carrying the largest losses has led to a breakdown of trust in the
entire financial sector.\2\ That loss of trust has sharply increased
the cost of raising capital and rolling over debt, which threatens the
solvency of all financial institutions. Injecting more capital into
financial institutions could help to restore liquidity to some
financial markets, because, with larger cushions of capital to protect
against default, the institutions would be more willing to lend to one
another. Another linkage between these two problems could occur if some
institutions are unwilling to sell assets at current market prices if
that then triggered the recognition of accounting losses; such
reluctance to sell can contribute to illiquid markets. With additional
equity, those institutions may be more willing to sell at current
market prices even if that required recognizing losses.
Although the problems of illiquidity and insolvency are
interrelated, they are at least conceptually distinct. Indeed, some
policy proposals appear to be aimed primarily at the illiquidity of
particular asset markets, and others appear to be aimed primarily at
the potential insolvency of specific financial institutions.
Most of this testimony examines the Troubled Asset Relief Act of
2008. That act appears to be motivated primarily by concerns about
illiquid markets. The more the government overpays for assets purchased
under that act, however, the more the proposed program would instead
provide a subsidy to specific financial institutions, in a manner that
seems unlikely to be an efficient approach to addressing concerns about
insolvency.
the troubled asset relief act of 2008
The Congressional Budget Office (CBO) has reviewed the Troubled
Asset Relief Act of 2008, as proposed by the Administration. The act
would authorize the Secretary of the Treasury to purchase, hold, and
sell a wide variety of financial instruments, particularly those that
are based on or related to residential or commercial mortgages issued
prior to September 17, 2008. The authority to enter into agreements to
purchase such financial instruments, which the proposal refers to as
troubled assets, would expire two years after its enactment.
The legislation would appropriate such sums as are necessary, for
as many years as necessary, to enable the Secretary to purchase up to
$700 billion of troubled assets at any point during the two-year window
of opportunity (though cumulative gross purchases may exceed $700
billion as previously purchased assets are sold) and to cover all
administrative expenses of purchasing, holding, and selling those
assets. The federal debt limit would be increased by $700 billion.
At this time, given the lack of specificity regarding how the
program would be implemented and even what asset classes would be
purchased, CBO cannot provide a meaningful estimate of the ultimate net
cost of the Administration's proposal. The Secretary would have the
authority to purchase virtually any asset, at any price, and sell it at
any future date; the lack of specificity regarding how that authority
would be implemented makes it impossible at this point to provide a
quantitative analysis of the net cost to the federal government.
the budgetary treatment of the proposal
The federal cost of the proposal could be reflected in the budget
either on a cash basis or on a net-expected-cost basis. The proposal
would require that the federal budget display the costs of this new
activity under the latter approach, using procedures similar to those
contained in the Federal Credit Reform Act (but adjusting for market
risk in a manner not reflected in that law). In particular, the federal
budget would not record the gross cash outlays associated with
purchases of troubled assets but, instead, would reflect the estimated
net cost to the government of such purchases (broadly speaking, the
purchase cost minus the expected value of any estimated future earnings
from holding those assets and the proceeds from the eventual sale of
them). That approach would be similar to the current budgetary
treatment of a broad array of loans and loan guarantees made by the
federal government, wherein the best measure of the cost to the
government reflects not only initial disbursements but also the
resulting cash flows in future years.
In CBO's view, that budgetary treatment best reflects the impact of
the purchases of financial assets on the federal government's
underlying financial condition. The fundamental idea is that if the
government buys a security at the going market price, it has exchanged
cash for another asset ratherthancausedadeteriorationin its underlying
fiscal position.
CBO expects that the Treasury would probably fully use its $700
billion authority in fiscal year 2009 to purchase various troubled
assets. To finance those purchases, the Treasury would have to sell
debt to the public. Federal debt held by the public would therefore
initially rise by about $700 billion. Nevertheless, CBO expects that,
over time, the net cash disbursements under the program would be
substantially less than $700 billion, because, ultimately, the
government would sell the acquired assets and thus generate income that
would offset at least much of the initial cost.
Whether those transactions ultimately resulted in a gain or loss to
the government would depend on the types of assets purchased, how they
were acquired and managed, and when and under what terms they were
sold. In addition to the future evolution of the housing prices,
interest rates, and other fundamental drivers of asset values, two key
forces would influence the net gain or loss on the assets purchased:
Whether the federal government seeks and is able to
succeed in obtaining a fair market price for the assets it purchases
and, in particular, whether it can avoid being saddled with the worst
credit risks without the purchase price reflecting those risks.
Concerns about the government's overpaying are particularly salient
when sellers offer assets with varying underlying characteristics that
are complicated to evaluate. As discussed further below, such problems
are attenuated the more that the government focuses on buying part of a
given asset from institutions that all own a share of that asset,
rather than buying different assets from different institutions. That
is, the government is more likely to pay a fair price when multiple
institutions are competing to sell identical assets than when it has to
assess competing offers for different assets with hard-to-determine
values.
Whether, because of severe market turmoil, market prices
are currently lower than the underlying value of the assets. If current
prices reflect ``fire sale'' prices that can result from severe
liquidity constraints and the impairment of credit flows, then
taxpayers could possibly benefit along with the institutions selling
the assets. Under normal circumstances, prices do not long depart from
their fundamentals because the incentive to engage in arbitrage and
profit from price discrepancies is large. But arbitrage practices work
less well when liquidity is restrained, as it is now, and many
potential arbitragers cannot get short-term financing.\3\ It is
therefore at least possible that the prices of some assets are below
their fundamental value; in that case, to the extent that the
government bought now and held such assets until their market prices
recovered to reflect that underlying value, net gains would be
possible.
In addition to any net gain or loss on the purchase of $700 billion
or more in assets, the government would also incur significant
administrative costs for the proposed program. Those costs would depend
on what kinds of assets were purchased. On the basis of the costs
incurred by private investment firms that acquire, manage, and sell
similar assets, CBO expects that the administrative costs of operating
the program could amount to a few billion dollars per year, as long as
the government held all or most of the purchased assets
The proposed program could affect other federal programs--
including, for example, the operations of Fannie Mae, Freddie Mac,
federal housing programs, and deposit insurance. The program's impact
on the future costs of other federal programs would depend on what
kinds of assets were acquired and from what types of institutions and
on how successful the program was in restoring liquidity to the
nation's financial markets.
determining a purchase price for troubled assets
The legislation would authorize the Secretary to purchase almost
any conceivable type of asset related to residential or commercial
mortgages, from individual loans to complex insurance products, and
possibly other assets not directly related to such mortgages. The
Treasury Department has indicated that it would conduct reverse
auctions for at least some of the purchases. In a reverse auction, many
potential sellers would bid on the price to be accepted by the
government, and the lowest bidders would win. Using a reverse auction
process in which multiple sellers compete to offer the Treasury the
lowest price for a set volume of similar troubled assets would help
ensure that the government was paying a fair price for those assets.
In the context of financial assets, a reverse auction works best
when (1) different sellers are offering to sell their shares in the
same asset rather than offering to sell different assets and (2) when
many sellers participate. When sellers are offering different assets,
the lowest bidder may win by offering an asset with particularly risky
or poor future prospects, and the price may not reflect the degree to
which that specific asset is risky or impaired. Consequently, the
federal government could purchase too many risky or impaired assets
without enjoying sufficient price discounts. Similarly, if the number
of participants in the reverse auction is unduly limited (either
because few institutions own the asset that the government wants to
purchase or because few owners choose to participate in the auction),
the government could overpay relative to a fair price.
One focus of the Treasury program seems likely to be mortgage-
backed securities (MBSs), which are ownership shares in large pools of
individual mortgages. Financial institutions own hundreds of thousands
of such securities, reflecting more than $7 trillion in pooled mortgage
assets; most of the hard-to-value MBS assets are likely to be in the
nearly $3 trillion not owned or insured by Fannie Mae and Freddie Mac.
The Treasury Department has indicated that the reverse auctions for MBS
assets might be conducted security by security--that is, there would be
a separate ``mini-auction'' for each tranche of the MBSs.\4\ If those
tranches were widely distributed across financial institutions and if
the government offered to purchase only a small share of each tranche,
the result should be that the government would obtain a fair price for
such purchases.\5\
Reverse auctions may not obtain a fair price for the government for
many other types of assets the Treasury may seek to purchase. In
particular, determining fair market prices using an auction is
difficult for assets that are not clearly the same or very similar in
quality--that is, when the seller has more information about the
quality of the asset than the buyer does. In such cases, each auction
participant will offer up assets with unique attributes known only to
the seller, thus increasing the likelihood that the government will pay
too much. That type of problem is likely to be particularly severe for
assets like individual home mortgages or esoteric derivative products
entirely owned by specific financial institutions.\6\ Substantial
purchases of such assets would make it unlikely that the Treasury could
operate the proposed new program at little or no net cost.
In other words, the more that the Treasury program concentrates on
assets that are difficult for a buyer to value, the more likely that
the government will overpay. The more that occurs, the more the program
moves beyond simply reestablishing trading in illiquid financial
markets and instead subsidizes the particular financial institutions
selling assets to the government, at a cost to taxpayers.
financial market and other effects of the proposal
The Treasury's proposal is aimed at stabilizing financial markets
and the economy by providing liquidity to support credit flows. One
reason that credit markets have seized up is the uncertainty about who
holds impaired assets and what they are worth, especially those related
to mortgages. The underlying losses on those assets reflect the decline
in home prices, but the mortgage loans have been repackaged as MBSs and
then again into more complex securities such as collateralized debt
obligations and credit default swaps that have spread the risk across
many financial markets.
The proposal would allow the Treasury to buy up those assets
regardless of the form in which they are held. The core problem,
though, has moved beyond the mortgage markets and has become a broader
collapse of confidence in financial markets. It therefore remains
uncertain whether the program will be sufficient to restore trust,
especially if the program is limited to the asset classes in which the
government is least likely to overpay for its purchases.
At the same time, intervention on a massive scale is not without
risks to taxpayers and to the economy.\7\ Almost by definition, the
intervention cannot solve insolvency problems without shifting costs to
the taxpayers. Ironically, the intervention could even trigger
additional failures of large institutions, because some institutions
may be carrying troubled assets on their books at inflated values.
Establishing clearer prices might reveal those institutions to be
insolvent. (To the extent such insolvencies were revealed, the net
effect might not be deleterious. Providing more transparency about the
lack of solvency at specific institutions may be necessary to restore
trust in the financial system.)
More broadly, there is an inherent tension between minimizing the
costs to taxpayers and pursuing other policy goals. For example, as the
manager of troubled mortgage assets, the government would be likely to
come under intense pressure to avoid foreclosures or to take other
steps to pursue goals for low-and moderate-income housing through
activities that would not be subject to the constraints of the normal
budget process. Those objectives may benefit specific homeowners, at
the expense of taxpayers as a whole.
alternatives to the treasury's proposal
Some analysts, in assessing the Treasury's proposal, have pointed
out that other recent actions by the Federal Reserve and the Treasury
have given taxpayers significantly more upside in the form of equity
stakes in the companies that receive assistance. Those actions have
been aimed at supporting particular troubled institutions, rather than
at enhancing the liquidity of the financial markets. Under some
alternative proposals, the government would receive shares in an
institution if it ultimately lost money on the sale of assets purchased
from the institution. That approach would reduce the risk of overpaying
for securities if the seller had more information about the value of
those securities than the Treasury did. However, institutions that gave
up equity would presumably expect to receive higher prices for their
assets, and an equity stake in the firms might not offer any better
upside to taxpayers than direct purchases of the assets on a risk-
adjusted basis. Furthermore, healthy institutions might be deterred
from participating, which could make it more likely that the federal
government would overpay for assets by limiting the potential number of
sellers--and the potential dilution for existing shareholders if asset
prices declined in the future might make it challenging for financial
institutions that issued such equity to the government to raise private
capital in the future.
An alternative approach that is more directly aimed at addressing
insolvency concerns is for the government to invest directly in
financial institutions to strengthen their capital positions, without
directly purchasing troubled assets. The injections could take the form
of preferred stock, which would effectively lower the cost of new
capital for the institutions. Such proposals could be modeled along the
lines of the Reconstruction Finance Corporation, a Depression-era
institution.
A number of twists to that approach have been offered. Some
versions require that the institutions match the injection with new
private funds in the form of common stock. In addition, some require
that the underwriting risk associated with raising new capital be
mutualized by the group of participating institutions acting as a
syndicate. The syndicate would be responsible for at least half of the
underwriting burden, which would give it an incentive to limit
membership to solvent institutions only. Participating banks might also
be required to suspend dividends, which would increase their retained
earnings and thus add directly to capital. (Although institutions can
always cut their dividends, doing so usually sends a bad signal to
financial markets. A requirement could dilute the effect of that bad
signal.)
Such proposals have some advantages: \8\
They provide some upside to taxpayers in the form of
dividends and capital gains on preferred stock. Under some proposals,
the payments of dividends to the government would be deferred.
They avoid the challenge of pricing and then selling
individual assets (although they raise the issue of how to price the
equity shares the government offers to purchase).
They avoid rewarding the firms that have made the worst
investment decisions.
They keep the government as a minority shareholder. The
firms' managers would continue to run the firms on a profit-maximizing
basis, thereby mitigating the risks of the government using its equity
positions to pursue a range of public policy goals.
They could impose losses on shareholders and changes in
management. Such plans have some disadvantages though:
They fail to address directly the illiquidity problems for
some assets and the associated uncertainty.
The assistance may not be targeted to the institutions
most in need of help, and the firms that most need capital may be most
reluctant to take it.
The approach could inject additional funds into
institutions whose business model is no longer viable. Past experience
suggests that extending the operations of insolvent institutions may
increase the ultimate cost to taxpayers.
The proposals raise difficult questions about eligibility
criteria. For example, would finance companies that are part of large
diversified holding companies be eligible?
endnotes
\1\ Figures are from Bloomberg as of September 22, 2008. For
institutions located in the Americas, recognized losses are about $260
billion, while the amount of additional capital raised to date is $180
billion, which leaves a gap of about $80 billion.
\2\ Anil K. Kashyap, Raghuram G. Rajan, and Jeremy C. Stein,
``Rethinking Capital Regulation'' (paper presented at the Federal
Reserve Bank of Kansas City symposium on ``Maintaining Stability in a
Changing Financial System, Jackson Hole, Wyo., August 21--23, 2008),
available at www.kc.frb.org/publicat/sympos/2008/
KashyapRajanStein.09.15.08.pdf.
\3\. Andrei Shliefer and Robert W. Vishny, ``The Limits to
Arbitrage,'' JournalofFinance, vol. 52, no. 1 (1997), pp. 35--55.
\4\ Rights to the income from the pool of mortgages are divided up
into slices, or tranches. The senior tranches will get paid under
almost all circumstances; the most junior tranches will take the first
risk of loss of income from defaults on the underlying mortgages. Each
tranche is identified by a standard CUSIP (Committee on Uniform
Security Identification Procedure) number like any other publicly
traded security. Pieces of each tranche are likely to be held by many
institutions, some troubled, some not.
\5\ For further discussion of efficient auction designs, see
Lawrence M. Ausubel and Peter Cramton, ``Auction Design Matters for
Rescue Plan.''
\6\ Such problems could be attenuated by requiring that private
capital pools run by the asset managers hired by the government under
the program participate in some share of each purchase made by the
government.
\7\ Douglas W. Elmendorf, Concerns About the Treasury Rescue Plan
(September 19, 2008), available at www.brookings.edu/opinion/2008/
0919--treasury-plan-elmendorf.aspx.
\8\ Ibid.
Chairman Spratt. Let me now turn to Mr. Ryan for his
opening statement.
Mr. Ryan. Thank you, Mr. Chairman. I apologize for being
late. As you know, there are a lot of meetings going on in this
building right now, to which many of us are attending. This a
real serious situation. By nearly all accounts, the turmoil in
our financial markets last week was unprecedented in recent
history. Clearly, and I think rightly, Americans are genuinely
worried. And all of us here, Republicans and Democrats, are
very concerned about the situation we find ourselves in. We
know that our markets are in serious trouble.
And we also need to understand that this just isn't a
problem for Wall Street. It is also a problem with potential
harm to our entire economy. And everyone and everything from
small businesses to workers to senior retirement accounts are
at risk here. I think there will be an endless debate over the
next few months, maybe years, as to how we got to this point.
And there are certainly many contributing factors. But clearly,
two of the biggest are, number one, a monetary policy that kept
interest rates artificially low and encouraged imprudent and
often outright reckless borrowing and lending.
Number two, Fannie and Freddie's buildup of investment
portfolios to boost profits, all at the risk and unlikely
expense of the taxpayers.
For the past few months, Congress and the administration
has scrambled to address each of these episodes dealing with
whichever crisis had come to a head at the moment, but not
really doing anything to address the underlying problem and
thus prevent the next crisis from popping up.
This week, of course, we are all working with the
administration and with Treasury to deal with this crisis. The
administration has proposed an ambitious unprecedented plan to
address this problem and to stem some of the fallout to the
larger economy. The plan would provide Treasury the authority
to purchase up to $700 billion in private mortgage-backed
securities. And, yes, I have genuine concerns about giving
Treasury, or anyone, that kind of authority.
Finally--and a primary concern to this committee--what is
all of this going to mean to the Federal budget?
Dr. Orszag, I know that at this point the most accurate
answer to this question is probably we just don't know. But
that said, this is the business of this committee. We are going
to have to figure this out. And I very much appreciate, Dr.
Orszag, you doing your best today, under the circumstances, to
give this committee your best assessment of the potential
impact of the bailout legislation working its way through
Congress this week.
And Mr. Chairman I thank you for indulging me with the
opening statement. I appreciate it.
Chairman Spratt. Thank you, Mr. Ryan.
Before turning to questions for our witness, I would ask
unanimous consent that all members be allowed to submit an
opening statement for the record at this point if they so
choose. Without objection, so ordered.
[Congressional Research Service report, submitted by Mr.
Spratt, follows:]
Prepared Statement of Baird Webel, N. Eric Weiss, and Marc Labonte,
Government and Finance Division, Congressional Research Service
summary
In response to ongoing financial turmoil that began in the subprime
mortgage-backed securities market, the federal government has
intervened with private corporations on a large scale and in an ad hoc
manner three times from the beginning of 2008 through September 19,
2008. The firms affected were Bear Stearns, Fannie Mae and Freddie Mac,
and AIG. Another large investment bank, Lehman Brothers, sought
government intervention, but none was forthcoming; subsequently, the
firm sought bankruptcy protection.
These interventions have prompted questions regarding the taxpayer
costs and the sources of funding. The sources of funding are relatively
straightforward, the Federal Reserve (Fed) and the U.S. Treasury. The
costs, however, are difficult to quantify at this stage. In the most
recent interventions (Fannie Mae and Freddie Mac, and AIG), all the
lending that is possible under the interventions has yet to occur.
Also, in all the current cases, the government has received significant
debt and equity considerations from the private firms. At this point,
Fannie Mae, Freddie Mac, and AIG are essentially owned by the federal
government. Depending on the proceeds from the debt and equity
considerations, the federal government may very well end up seeing a
positive fiscal contribution from the recent interventions, as was the
case in some of the past interventions summarized in the tables at the
end of this report. The government may also suffer significant losses,
as has also occurred in the past.
This report will be updated as warranted by legislative and market
events.
where has the money come from?
In the recent interventions, there have been two primary sources of
funding: the Federal Reserve (Fed) and the U.S. Treasury. The Fed has
the general authority under its founding statute to loan money ``in
usual and exigent circumstances'' to ``any individual, partnership, or
corporation'' provided five members of the Board of Governors of the
Federal Reserve system agree.\1\ This authority has been cited in
two of the three interventions this year, Bear Stearns and AIG. The
source of money loaned under this section derives from the Fed's
general control of the money supply, which is essentially unlimited
subject to the statutory mandates of controlling inflation and
promoting economic growth.\2\ Since the profits of the Fed are
ultimately remitted to the Treasury, the indirect source of the funds
is the Treasury. In the case of Fannie Mae and Freddie Mac, the direct
source of funding is the Treasury, pursuant to the statutory authority
granted in the Housing and Economic Recovery Act of 2008.\3\
the cost of financial interventions
Determining the cost of government interventions, particularly
those currently in progress, is not straightforward. Assistance often
comes in forms other than direct monies from the Treasury, including
loan guarantees, lines of credit, or preferred stock purchases, which
may have little or no initial cost to the government. A loan guarantee,
which can be thought of as a sort of insurance, has value even if it is
never used. Many insurance policies are never used, but individuals and
companies purchase them to reduce risk of loss. In many past cases, the
value to various companies of federal guarantees was to allow them to
access the private credit markets, issuing bonds or obtaining bank
loans that they would not otherwise have been able to obtain. In other
past cases, the federal guarantee resulted in a lower interest rate on
the bonds or loans.
Depending on the conditions attached to each specific intervention
and how events proceed thereafter, the government may even see a net
inflow of funds from the actions taken, rather than a net outflow. The
summaries below address the maximal amounts promised in federal
assistance and attempt to quantify the amounts that have actually been
disbursed, although particularly in the most recent cases (Fannie Mae
and Freddie Mac, and AIG), there is little information as to the exact
amounts disbursed. There are also other, more diffuse costs that could
be weighed. For example, many would argue that the cost to the
taxpayers of any intervention should be weighed against the potential
costs of financial system instability resulting from inaction, or that
one intervention may lead to more private sector risk-taking, and thus
necessitate additional future interventions (moral hazard). Such costs,
however, are even harder to quantify than the realized cost of the
interventions. This report does not attempt to address them.
recent financial interventions
AIG
On September 16, 2008, the Fed announced that it was taking action
to support AIG, a federally chartered thrift holding company with a
broad range of businesses, primarily insurance subsidiaries, which are
state-chartered. This support took the form of a secured two-year line
of credit with a value of up to $85 billion. The interest rate on the
loan is relatively high, approximately 11.5% on the date it was
announced. In addition, the government received warrants to purchase up
to 79.9% of the equity in AIG. According to the Fed, $28 billion has
been lent to AIG as of September 18, 2008.\4\
Fannie Mae and Freddie Mac \5\
On September 7, 2008, the Federal Housing Finance Agency (FHFA)
placed Fannie Mae and Freddie Mac into conservatorship. As part of this
conservatorship, Fannie Mae and Freddie Mac have signed contracts to
issue new senior preferred stock to the Treasury, which has agreed to
purchase up to $100 billion of this stock from each of them. If
necessary, the Treasury agreed to contribute cash in the amount equal
to the difference between each company's liabilities and assets. Each
company issued the Treasury $1 billion of senior preferred stock and
warrants (options) to purchase common stock for which the Treasury did
not compensate the company. If the warrants are exercised, Treasury
would own 79.9% of each company. Treasury agreed to make open market
purchases of Fannie Mae and Freddie Mac mortgage-backed securities
(MBS). Treasury has said that it expects to profit from the spread
between the interest rate that it pays to borrow money through bonds
and the mortgage payments on the MBS. Fannie Mae and Freddie Mac will
guarantee payment of the MBS. Treasury agreed that if the companies
have difficulty borrowing money, which has apparently not been the case
to date, Treasury will create a Government Sponsored Enterprise Credit
Facility to provide liquidity to them, secured by MBS pledged as
collateral. There are no specific limits to these purchases or loans,
but they are subject to the statutory limit on the federal government's
debt. The authority for both preferred stock purchase and the credit
facility will terminate December 31, 2009. At this point, there has
been no announcement that the credit facility has been accessed, nor
that any purchase of preferred stock has occurred.
Bear Stearns
On March 16, JPMorgan Chase agreed to acquire the investment bank
Bear Stearns. As part of the agreement, the Fed lent $28.82 billion to
a Delaware limited liability corporation (LLC) that it created to
purchase financial securities from Bear Stearns. These securities are
largely mortgage-related assets. The interest and principal will be
repaid to the Fed by the LLC using the funds raised by the sale of the
assets. The Fed's loan will be made at an interest rate set equal to
the discount rate (2.5% when the terms were announced, but fluctuating
over time) for a term of 10 years, renewable by the Fed.\6\ In
addition, JPMorgan Chase extended a $1.15 billion loan to the LLC that
will have an interest rate 4.5 percentage points above the discount
rate. Thus, in order for the principal and interest to be paid off, the
assets will need to appreciate enough or generate enough income so that
the rate of return on the assets exceeds the weighted interest rate on
the loans (plus the operating costs of the LLC). The interest on the
loan will be repaid out of the asset sales, not by JPMorgan Chase.
Any difference between the proceeds and the amount of the loans is
profit or loss for the Fed, not JPMorgan Chase. Because JPMorgan
Chase's $1.15 billion loan was subordinate to the Fed's $28.8 billion
loan, if there are losses on the $29.95 billion assets, the first $1.15
billion of losses will be borne, in effect, by JPMorgan Chase, however.
Thus, if the assets appreciate in value by more than operating
expenses, the Fed will make a profit on the loan. If the assets decline
in value by less than $1.15 billion, the Fed will not suffer any loss
on the loan.\7\ Any losses beyond $1.15 billion will be borne by the
Fed. It will likely be many years until all the assets are liquidated,
and a final tally of the Fed's profit or loss can be calculated.
endnotes
\1\ 12 U.S.C. Sec. 343.
\2\ For more information on the Federal Reserve's actions, please
see CRS Report RL34437, Financial Turmoil: Federal Reserve Policy
Responses, by Marc Labonte. 3 P.L. 110-289, Title I.
\4\ See Federal Reserve Statistical Release, H.4.1, dated September
18, 2008, available at http://www.federalreserve.gov/releases/h41/
Current.
\5\ For more information see the September 7, 2008 statement by
Treasury Secretary Henry Paulson at http://ustreas.gov/press/releases/
hp1129.htm and CRS Report RL34661, Fannie Mae's and Freddie Mac's
Financial Problems: Frequently Asked Questions, by N. Eric Weiss.
\6\ Federal Reserve Bank of New York, ``Summary of Terms and
Conditions Regarding the JP Morgan Chase Facility,'' press release,
March 24, 2008.
\7\ It will only have forgone interest it could have earned on
other investments, namely U.S. Treasury securities.
Dr. Orszag, I noted in my opening statement that, broadly
speaking, there are two conventions for booking assets like
this. One is to treat it as the purchase of an asset. But oddly
enough, when you do that the asset acquisition price of a
payment is booked as an outlay, but the value of the asset
itself, the corresponding value of the asset, is not entered
anywhere on the Federal books until the asset is sold. At that
time, the proceeds of the sale are treated as offsetting
receipts or as a negative outlay.
The other is the Credit Reform Act in which case you try to
calculate the likely losses and subsidies downstream and
discount them back to present value. To the extent the present
value is less than the original amount of the loan, you have
got losses booked in the year of the loan.
Which does CBO prefer to undertake in this case?
Mr. Orszag. The latter. And in particular it is CBO's view
that the budgetary treatment, if we went out and we bought in a
liquid financial market where you would imagine that the
Federal Government would be obtaining a fair price for an
asset, we go out and we buy an asset for a dollar in a liquid
market, the best budgetary treatment of that is basically that
there is zero net gain or net loss at that point because you
have purchased something for a dollar that is worth a dollar.
And what has happened is that the government has rearranged
its portfolio, rather than caused a deterioration in its fiscal
condition. That is much different than going out and buying a
tank for a dollar, if you could buy a tank for a dollar.
So what we think is the best way of measuring these kinds
of financial transactions is the degree to which what you are
purchasing doesn't reflect liquid markets or doesn't reflect a
competitive bidding process, and it is the net subsidy that you
are providing. So if you go out and you buy something from a
financial institution for a dollar that by some fair-value
accounting basis is only worth 50 cents, the government should
show a 50-cent subsidy. And the reason is that is what causes
the deterioration in the government's physical condition. It is
the subsidization that causes the deterioration, not just
swapping assets on a fair-market basis.
Chairman Spratt. That would be the amount that would be
added to the deficit in that year?
Mr. Orszag. Under the proposed accounting treatment and
under what we think is the best way to account for these
transactions, yes.
Chairman Spratt. So in all likelihood it would be
substantially less than the requested amount, $700 billion?
Mr. Orszag. One would imagine that it should be
substantially less than $700 billion, the net cost, yes.
Chairman Spratt. Now, on page 3 of your testimony you say,
At this time, given the lack of specificity regarding how the
program would be implemented and even what asset classes would
be purchased, CBO cannot provide a meaningful estimate of the
ultimate net cost of the administration's proposal. The
Secretary would have the authority to purchase virtually any
asset at any price and sell at any future date. Lack of
specificity, of course, makes it difficult for you to do
anything.
However, on the next page you say, CBO expects the Treasury
will probably fully use its $700 billion authority, but the net
cash disbursements under the program will be substantially less
than $700 billion. Would you explain that?
Mr. Orszag. Sure. It just returns to the discussion we were
just having that the net impact on the Federal Government
presumably will be significantly less than $700 billion unless
you lose 100 percent of the value of whatever you are
purchasing.
So I can't quantify what the net gain or loss would be
without knowing whether the Federal Government is purchasing
whole loans or tranche-by-tranche reverse auctions on mortgage-
backed securities or more esoteric products. But it would seem
implausible that the Federal Government would lose 100 cents on
the dollar for every purchase that it made, which is what
justified the statement on page 4.
Chairman Spratt. Do you know and can you explain to us what
scoring approach OMB intends to take?
Mr. Orszag. My understanding is that OMB intends to
undertake--and the legislation reflects--a similar scoring
process in which, while the methodology may differ slightly,
the result is the same. Which is to say the cost that is shown
on the Federal budget will be the degree to which the Federal
Government subsidizes the purchase of particular assets.
Chairman Spratt. Would the estimate of credit cost vary
from transaction to transaction depending on the terms of the
transaction?
Mr. Orszag. I would think so, yes.
Again, returning to the basic point, if the Federal
Government said, even through an auction process we are going
to go out and buy specific loans from different banks, it is
much more likely the Federal Government will suffer some losses
on those transactions, not only because you are likely to wind
up with, even with any given FICO score or any given risk
classification, the sort of worst part of the distribution of
the asset classes, as financial institutions are selling you
the stuff that they most want to unload; but also because, as
various parts of the legislation now reflect, the Federal
Government may well be a more lenient owner of that mortgage
than the bank itself was in terms of foreclosing and other
measures.
Chairman Spratt. You give us a graphic description and a
good description of what has happened in the illiquid credit
markets. Can you give us your analytical view of what could
happen if we don't provide some substantial and extraordinary
assistance?
Mr. Orszag. Let me back up. Being able to obtain credit is
crucial for households and it is crucial for firms. Our entire
economy functions because people are able to obtain financing
for what they want to purchase, and for firms what they--you
know, new plans and equipment and investments that they want to
make. And if that system collapses, we will have severe turmoil
in the real economy, which is to say in our real lives in terms
of our jobs, our output and what have you.
So that is the fundamental problem. We have already seen
some ominous signs emanating from capital markets. Corporate
debt issuance plummeted in the third quarter. The short-term
asset-backed commercial paper markets are under severe stress;
bank lending. It is implausible to me, given the tensions in
the banking sector, that even though bank lending so far has
held up fairly well that it will not also come under severe
stress. So the various places where you can go for liquidity
are drying up and that is a huge problem to the economy.
Chairman Spratt. Dr. Orszag, thank you very much. We will
turn now to Mr. Ryan.
Mr. Ryan. Let me just pick up where the Chairman left off
because that is the kind of questioning I want to go to as
well. Using the Credit Reform Act scoring methodology, but
looking at this bill, Treasury is going to basically determine
how to set up these auctions. And since we don't really have a
price discovery mechanism right now, because we don't have a
market for these securities, given that these mortgage-backed
securities are--no one mortgage-backed security is like the
other, you are going to have to give us a rear-view mirror
score on this, correct?
I mean, typically when we pass bills here, you give us an
estimate on what it is going to cost, and that factors into our
budget and therefore we make decisions based on these cost
estimates. Is it basically not the case here that if this
passes and we give the Treasury the authority, then they go
forward, set up these auctions, a price discovery mechanism,
and based on the price they pay for these securities, then the
subsidies determine--you are not going to be able to give us a
true cost of this until after these trades occur; is that not
correct.
Mr. Orszag. Well, yes and no. I think we could provide more
information to you and at least an estimate of what the
subsidies are likely to be if we knew even before the trades
occurred what the structure of the mechanism was and what the
asset classes are. So in particular if the Treasury said we are
going to only do, again, tranche-by-tranche----
Mr. Ryan. Triple A versus mezzanine versus all this other
stuff.
Mr. Orszag. Well, and even beyond that. They are talking
about hundreds of thousands, if not millions, of mini-auctions.
So it is not that we are going to go out and buy triple A-rated
paper, sell us what you want, and we will determine a price; it
is on mortgage-backed security number 123753 which is then--a
tranche of that is then owned by 50 or 100 institutions. We are
going to go out and bid just on that tranche, and you 50 or 100
institutions, you bid for us. We are going to buy 20 percent of
the total. That is likely to obtain a fair price. So if that is
all that we were doing, I would say a fair guess is zero.
If we are going out and we are buying, again just to return
to the example of individual loans from banks, what we would
provide to you then is some analysis up front before we knew
what the individual transactions are of--if they say we are
going to conduct auctions for FICO scores with the following
ranges, we would look at what the distribution of performance
of loans for those given FICO ranges are, assume the Federal
Government is going to wind up with tilting towards the bad end
of that distribution, given incentives for financial
institutions, and give you some estimate based on that.
So in other words, if they went out and they said we are
going to put $200 billion into reverse auctions on a CUSIP-by-
CUSIP basis on mortgage-backed securities, $150 billion into
purchasing individual loans in the following way and what have
you, we could at least give you some estimate of what the net
subsidy would be across those different asset classes. But we
don't even know that.
Mr. Ryan. So once the methodology is determined by
Treasury, then you can start giving us estimates.
Mr. Orszag. Yes.
Mr. Ryan. Treasury, they have a couple of concerns, meaning
they want to pump liquidity into these firms, into these banks,
and they want to get these bad assets off the books. And we
don't want the taxpayer to have to pay for it. We want this to
be a net zero cost here. We are kind of at odds here, are we
not?
Mr. Orszag. Yeah.
Mr. Ryan. And if the goal here is to pump liquidity into
these institutions, that means they are not intending to pay
fire-sale prices for these securities. They are going to pay
above fire-sale prices. If the goal is liquidity, that means
the taxpayer is going to pay for some of this; is that not
correct?
Mr. Orszag. I think we need to be very clear about what we
are trying to accomplish here because the descriptions about
what the programs are trying to accomplish often do get
muddled. And as I mentioned before, there are two problems. One
is many financial institutions may be insolvent and we are
concerned about that. The second problem is various financial
markets like I showed on my graph are not functioning
effectively. Solving that second problem need not involve any
significant subsidy from the Federal Government; solving the
first problem does.
To the extent that we implement these programs in a way
where we overpay for assets, we are sort of in a backhand way
addressing the insolvency issue, even though the program is
framed as addressing illiquidity. And I would go beyond that
and say we are likely to be addressing the insolvency issue in
a kind of haphazard way where we are providing support to
particular financial institutions that may not be under stress,
not providing support to others that may be under stress. And
if we are going to address the insolvency issue, it may be
better to do it directly.
I would also note, by the way, one other thing. That
restoring liquidity to particular financial markets may
actually exacerbate insolvency concerns because there is lack
of clarity right now about which institutions are or are not
insolvent, in part because many financial institutions are not
fully marking to market. They are using flexibility not to
fully mark their assets to market.
Mr. Ryan. To play it out longer.
Mr. Orszag. To play it out longer. And that is also
creating some illiquidity because they don't want to sell at
current market prices, given that that would then require them
to book the losses and perhaps trigger problems.
If we establish pricing for these assets, many institutions
may be revealed to be insolvent because they would then have to
mark to market, given the rules, which may look like a bad
thing because the number of insolvencies would go up; but then
again, I would say to the extent you have these sort of hidden
insolvencies throughout the financial system, one of the
reasons that trust in the financial markets is now undermined
is precisely that concern. So if we revealed which institutions
did and didn't have problems, even if that caused some
insolvencies to be revealed, the net result may be positive in
terms of restoring confidence that the people you are dealing
with actually are solvent.
Mr. Ryan. So when we establish price discovery, that is
going to occur. If we subsidize the price discovery, we are
going to delay the inevitable insolvencies that just have to
get flushed through our system.
Mr. Orszag. Well, if you subsidize the asset purchases, you
are doing two things. You are sort of establishing some more
price transparency, but you are also then transferring
resources from taxpayers to particular financial institutions
in a way that may be haphazard.
Mr. Ryan. So if the goal here is solvency, is capital
injections, it is a pretty crude tool we are using here and we
may not be giving them to the healthiest organizations or
institutions that ought to get the capital injections, and that
is basically what you are saying. If the goal here is a
liquidity issue, that is one thing. If it is a solvency issue,
this is not the way to go about doing it correctly.
Mr. Orszag. Well, just to return, I would say if it is a
liquidity issue, then one should focus on trying to get the
best price possible for the Federal Government and avoid
overpaying. And to the extent it is a solvency issue and you
are addressing that by overpaying for particular assets, you
are kind of scattering money across lots of financial
institutions, some of which may be perfectly healthy and not
need help from a solvency perspective, and you are overpaying
them too.
Mr. Ryan. And we will simply delay inevitable bankruptcies.
I will just finish with this. Let me ask you your
professional judgment. And you are a trained economist. Do you
see our problem primarily as a liquidity problem or as a
solvency problem, meaning--and I think we just went through
this a bit--do financial institutions suffer from a lack of
short-term funding or have their assets declined to such an
extent that they need to be recapitalized? What do you think is
in essence the primary problem here?
Mr. Orszag. I think both problems.
Mr. Ryan. So you think they are twin?
Mr. Orszag. I think both markets are affecting financial
markets, yes.
Mr. Ryan. All right. Thank you.
Chairman Spratt. Ms. DeLauro.
Ms. DeLauro. Thank you, Mr. Chairman.
Dr. Orszag, thank you. I know that this is the Budget
Committee and the questions are technical with regard to the
budget. I am trying to put myself in the shoes of middle-class
Americans who are trying to understand in essence what is
happening. And, quite frankly, there hasn't been any real
explanation to middle-class Americans about what is happening
to this Nation.
And reverse auctions and liquidity and insolvency and short
selling and naked shorts and all that, they have no
understanding. They just know that they are already in a very
severe economic crisis and real economic insecurity in their
families. And what is all of this going to mean to them?
You started to say--and I would like you to address this,
because you said something in your commentary that said that
credit is stability, in essence is what you said. If you can
describe what this financial situation at this moment, in the
absence of whatever program they potentially would be looking
at in terms of trying to bring some sense out of insanity here,
how would you describe this to middle-class America and saying
this is where we are, this is what this means to you, this is
what happens if we do not act? And what are the kinds of pieces
that need to be put into place in order to safeguard your
economic security in this morass?
Mr. Orszag. And I am going to try to avoid using any big
words in doing this.
Ms. DeLauro. Thank you.
Mr. Orszag. Financial markets----
Mr. Blumenauer. Speak slowly.
Mr. Orszag. I will speak slowly and not use big words.
Financial markets--that is, banks and the institutions that
lend to--let's just take a hypothetical household. They work
for a company, Company X, Y, Z. They own a house, they own some
cars, okay. The company that they work for finances its
operations. So it makes whatever, widgets or whatever you want
it to make. And it relies on borrowing from lots of financial
markets and from banks in order to do what it does.
Right now financial markets are suffering a collapse of
confidence. The people that--the institutions that would
normally lend to your employer are reluctant to do so, in part
because of this turmoil surrounding, again, lack of confidence.
And the company itself would often sometimes issue debt to
finance its operations. It would issue a bond or something like
that so that it could have cash to pay your salary. That is
also under stress. It would borrow over, like, for short
periods of time and then pay the money back.
So let's say it had a new set of inventory coming in. It
would borrow a little bit of money to buy the inventory and
then as it sold this stuff at stores, it would pay off that
short-term loan. It is having trouble getting that, too,
because of this collapse of confidence.
Similarly, ultimately the bank from which you got your
mortgage and the bank that financed your auto purchase, they
are under stress, too. They don't have enough capital to lend
you that money. And that is in part because they are having
trouble borrowing from other banks and other financial
institutions.
So this implosion of confidence among financial market
participants ultimately will affect you, even though right now
it may seem really esoteric and kind of just out there in some
other world. It will come home in the form of your company
having trouble financing its operations, and it will come home
in the interest rates that you have to pay on mortgages and
auto loans and what have you, and those effects may be somewhat
delayed. The history does suggest that those kinds of effects
occur some period after the financial market turmoil itself
begins, but they do happen.
Ms. DeLauro. Quickly, let me ask you this. One of the main
causes of this was the subprime mortgage crisis, if you will,
the whole issue of how mortgages were issued et cetera. If that
being the case, with all of the potential relief that we are
trying to bring to the markets here, in anything that you see,
with any of the current plans that are on the table, the
conditionalities, et cetera, is there anything that is
essentially looking at restructuring, if you will, our mortgage
institutions fundamentally and in the way they do business and
the mortgage contract?
Do you see any of that in anything that we are looking at,
if that was the root cause of this problem?
Mr. Orszag. I would go broader and say we are in the middle
of a potential crisis and there are a variety of things that
seem targeted at that, although with some ambiguity about
exactly what they are targeting, as we were just discussing.
And then, secondly, there are a whole series of structural
and regulatory reforms, not only on home mortgages and
commercial mortgages, but in terms of the overall regulation of
the financial sector, that are under discussion and that are
worthy of serious consideration.
I don't see them moving at the same speed as this proposal
appears to be.
Ms. DeLauro. On what side? Where's the speed? On the
financial institutions versus the mortgage side, or is it a
regulatory problem?
Mr. Orszag. No, no. I just meant the whole question of how
to structure the regulatory apparatus, which I want to say is
in need of restructuring, but one also needs to be very
careful. We often fight the last war and create the seeds of
the next problem by making changes that seem attractive at the
time, but then create problematic incentives later on.
So as we move forward in restructuring financial
regulation, including for mortgage originators and the whole
mortgage process, one needs to be very careful to make sure we
are not just fighting the last war but also looking forward to
preventing the next one.
Ms. DeLauro. I just will get you a copy of an article in
the New York Times, September 21st, by Robert Shiller at Yale,
the professor of economics at Yale, talking about the mortgage
of the future and some ideas about how to restructure. And I
would like to get your views on that.
Mr. Orszag. Let me just briefly pause. This is a little bit
outside of the immediate hearing. But Bob Shiller and others
are emphasizing something that I think is crucially important:
that in financial markets and in the rest of public policy, we
need to be paying more attention to psychology and a little
less attention to the purely rational econ 101 version of the
world where everything is frictionless and things work
perfectly. Because in the real world that often tends to be
particularly important. And Bob Shiller is among the leaders in
advancing that field of thought.
Ms. DeLauro. And he talks about continuous work-out
mortgages and us investing. Thank you very much, Mr. Chairman,
I appreciate your bearing with me.
Chairman Spratt. Mr. Hensarling.
Mr. Hensarling. Thank you, Mr. Chairman. And thank you for
calling this hearing. It is clearly one of the most important
hearings I have attended in my congressional career. For many
of us, I think, we feel like we are being faced with a
financial panic and crisis on the one hand and potential
taxpayer bankruptcy in a fundamental change in the role of
government in a free enterprise economy on the other.
For those who may think that Congress will choose between
those two options in 72 hours, that is a rather naive thought.
So I appreciate, Mr. Chairman, you holding this hearing.
I think I understand the short-term gain to be had by the
Paulson plan or some permutation thereof. But clearly this
committee also needs to focus on potential long-term pain,
long-term pain to the taxpayer.
Although we reviewed it before Dr. Orszag, simply the
Federal Government that we have today left on automatic pilot,
isn't it more or less the consensus of CBO, OMB, GAO, that
without any fundamental changes in the programs we have today,
that if we wanted to balance the budget through tax increases
only, that we would essentially have to double taxes on the
next generation? Is that not the glide path that we are
essentially on?
Mr. Orszag. Very substantial increases in revenue would be
required. We have substantial increases in spending driven, as
you know, mostly by our health programs under current policy.
Mr. Hensarling. So we are coming off, I believe, the single
largest 1-year increase in the Federal debt, the single largest
unfunded obligations we have ever had, at roughly $57 trillion,
and the long-term prospect is not good today. So on top of
that, we are looking at perhaps a $700 billion program.
Some say, and I believe you opine, that maybe there is a
possibility the taxpayer actually made money out of this. But
first let's look at history as our guide. And you have greater
expertise on this than I do. But the closest incident I can
find is the S&L bailout of the early 1980s. My reading, in real
dollars, is that cost the taxpayer roughly $150 billion to $200
billion. Do you have a different reading of that?
Mr. Orszag. That is roughly the same range. I agree with
that range.
Mr. Hensarling. So it is certainly not axiomatic that
somehow the taxpayer is going to make money if they buy a bunch
of troubled assets. There is certainly the potential for great
loss.
Mr. Orszag. But let me just clarify. And there have been
parallels drawn to the Resolution Trust Corporation and what
have you. It is a much different situation. That loss occurred
mostly because the Federal Government had insured deposits at
institutions that then failed. And the assets, the Resolution
Trust Corporation, the asset part of that was when the
institution failed, we took over the asset side of their
balance sheet in addition to the liabilities, and then we sold
off the assets. That is a much different thing than going out
and buying assets, seeing what price you can get for them, and
then later selling them.
Mr. Hensarling. But they are still illiquid assets in many
places without a functioning market.
Let me also ask you this question. There is certainly a
cost in allowing financial institutions to fail. And as you
well point out, there is a huge psychological component to the
capital markets. But isn't there also a cost to keeping some
institutions open that perhaps should be forced to realize
their losses?
Is there a parallel to the lost decade in Japan where
essentially by trying to keep failed financial institutions
open, they enjoyed a decade of stagflation and negative
economic growth? Might that be a potential cost to this plan?
Mr. Orszag. Yes. In particular, perpetuating--so I think
the lesson of history suggests that especially in banking
crises, that perpetuating insolvent institutions just raises
costs. And it is better to address the problem up front, take
the problem assets off the books somehow, or address the
problem directly. And I think the Treasury folks would say they
are trying to do that.
Mr. Hensarling. In looking--a number of Members of
Congress, Dr. Orszag, as you probably know, are looking at a
lot of options. And clearly there are many lousy options on the
table, and to some extent it is having to choose among lousy
options. Some wish to explore a secured loan program versus
Uncle Sam walking in to try to buy up troubled assets from
institutions that may not deserve it and may not deserve--and
may pose longer term systemic risk to the economy by staying
open.
How would, under CBO scoring--and maybe the answer is the
same--are we essentially trading asset for asset if
conceptually the program was structured as a secured loan
program as opposed to an asset purchase program?
Mr. Orszag. I have heard some discussion of similar
proposals, and the scoring would be the same. The question is--
so you are extending a loan secured by some underlying asset to
a financial institution or someone else--and the question is
what are the loan terms and are you subsidizing that facility
or not? And if you are not, the net cost in expected value is
zero.
Mr. Hensarling. Thank you, Mr. Chairman.
Chairman Spratt. Mr. Edwards.
Mr. Edwards. Dr. Orszag, I will leave the debate for
another day on how we got into this mess and to what extent
unpaid for tax cuts and the deregulatory philosophy were major
contributors to all of this. And I think we all recognize we
are facing a serious crisis.
My first question to you is, is this potential crisis so
severe and so imminent that the difference between Congress
acting by Friday of this week or Friday a week later could make
a difference in the economy?
Mr. Orszag. I can't answer that. What I can say is that if
there is no action taken and Congress departs and there is just
nothing, that you are running a very substantial risk of utter
financial crisis. Whether it has to happen over the next 72
hours or the next week or 10 days is impossible for me to say,
and I don't think anyone can say.
It comes back to the role of confidence in psychology. That
is at heart what we are dealing with here is the confidence of
financial markets.
Mr. Edwards. Would it be your best judgment--and I realize
it is subjective judgment--but would it be your best judgment
if the congressional leaders, Republicans and Democrats alike,
say we are going to have a rescue plan, it will be significant,
but we are going to take an extra week to get it right, rather
than to push it to the President's desk under a gun?
Mr. Orszag. Again, my perception is the key thing that
financial markets are looking for now is the existence of a
significant package. And I suppose that coming out with a
statement of principles or agreement that there will be a
package, and that we are going to make sure that we reach
agreement on that within some period of time, would fulfill
that purpose.
Mr. Edwards. My next question is, what would be your
expected projection on the impact on short-term or long-term
interest rates when the United States Government goes out in
the markets and borrows $700 billion?
Mr. Orszag. That is a great question. It depends on the
degree to which--two things--the degree to which we actually
wind up subsidizing things; and, secondly, the degree to which
the financial markets perceptions and psychology matter.
So let me just in a purely rational, you know--everything
works like a textbook suggests--any effect on interest rates
and the exchange rates should only reflect the degree to which
the Nation's underlying fiscal condition is deteriorated as a
result of these interventions. And again, if we are getting a
fair price and there is no net subsidy, that is just a wash.
That should be you are just trading one asset for another. It
shouldn't cause any--at least in a purely textbook kind of
rational way--shouldn't cause any financial market effect,
including on interest rates.
But to the extent we do subsidize the purchases, that
should show up in interest rates and the exchange rate; and,
secondly, to the extent that financial markets don't have
clarity about whether we are providing a subsidy or not and are
guessing about that, there can also be effects on interest
rates and exchange rates from that.
Mr. Edwards. Okay. My final question is this. Give me the
best-case scenario, the worst-case scenario and what you think
is the most likely scenario of Congress taking no action. And
when I say ``best case'' and ``worst case,'' I mean in terms of
impact on GDP, I mean in terms of unemployment rates, I mean in
length of a recession or potential depression, if you are
talking about the worst-case scenario.
Mr. Orszag. You are asking me if Congress does not act what
the effects would be?
Mr. Edwards. I am asking you if Congress takes no action--
make that assumption--what is the worst-case scenario, what
will happen to our economy in terms of GDP growth, in terms of
unemployment rates, length of a recession or potential
depression, and what would be the best-case scenario if
Congress takes no action? And then if you still have time, what
you think the most likely scenario would be.
Mr. Orszag. I will just come back to saying that if having
created the expectation in financial markets that there will be
a package, and given the stresses that we saw last week in
financial markets, if there is no package whatsoever, there is
a very significant risk of utter financial market chaos, which
will then have significant effects on the real economy in a way
that I think isn't particularly helpful for me to lay out in
its full gory details. But it would be a very bad situation.
Mr. Edwards. Let me focus on that because I want to make it
clear. I am talking about the worst-case scenario, not your
most likely projection. But we need to understand in looking at
the cost and benefits of taking action or no action, and one of
the costs of taking no action is the worst-case scenario, is it
possible that the worst-case scenario--if Congress takes no
action--is something similar to the market crash of 1929?
Mr. Orszag. Again, I don't want to start speculating on the
precise quantitative magnitudes other than to say you would, in
that case I think, have a financial market meltdown which would
cause very severe economic dislocations, which may be on the
order of magnitude of Great Depression-type effects, but
exactly how it plays out--one of the things about crises is
they can play out in such a terribly diverse array of ways that
speculating in exactly the specific way that a crisis plays out
doesn't seem productive to me, other than to say it would be
very serious.
Mr. Edwards. Thank you.
Chairman Spratt. Mr. Conaway.
Mr. Conaway. Thank you, Mr. Chairman. And I appreciate my
good colleague from Texas not wanting to debate how we got
here, because I too would like to defer that, and whether it
goes back as far as the Community Reinvestment Act and the
seeds of that causing it, we can have that debate at a
different day.
You cut off your analysis of the family impacts. Talk to us
a little bit about the impact that that reduction in business,
slowdown for that particular business, would have on the
family's 401(k) to the extent it might be invested in company
stock and the impact that that had? And then also visit with us
about the risks that this could severely damage the overall
U.S. economy and kind of give us a magnitude.
We had a guy the other day give us kind of a back-of-the-
envelope guess as to what Federal revenues might be impacted if
we had a 1 percent increase in the economy or a 1 percent
decrease in the economy.
So flesh out the impact on the family. In addition to jobs
and those kinds of things, one of them said they were 401(k)
and retirement planning.
Mr. Orszag. Well, again, to the extent that as the prices
decline, their 401(k)s and IRAs and any other assets they have
would decline also. To the extent that you are causing further
disruption to the housing market and shutting down any
additional mortgage lending or making that much more expensive,
you are also curtailing or reducing their house price perhaps
even further, raising difficulties for them to finance any new
purchases, even if they would want to, given the threat to
their employment and income because their employer is having
difficulty.
So all of these things become a self-reinforcing negative
spiral. And the fact that they are then less confident about
their future and not going out and buying the new refrigerator
means that the seller of the refrigerators has lower sales.
That is the kind of scenario in which you can have a very
substantial downward spiral that affects the macro economy.
You are then also right, if we were to enter a severe
recession, Federal revenue would be significantly adversely
affected. And in addition to that, various kinds of spending
would go up, including things on food stamps and unemployment
insurance and what have you, the net result of which would be
to take the deficit figures that have already been spoken about
and raise them significantly.
Mr. Conaway. Give your thoughts on, as I look at the
circumstances, the most immediate issue to me is a seizing up
or a freezing of this overnight credit market that is really
below most people's radar screens.
I was in a bank and used to run the bank's long- and short-
term portfolio, and all extra cash every night was invested and
you just assumed it was coming back the next day. To me, that
is the crisis of confidence and the risk to the system.
How does dealing with the housing, the subprime mortgages,
and all these other kinds of things, fixing that, how do you
see that instilling the confidence or restoring the confidence
that these individuals across the United States who are making
those overnight decisions will have that the money is going to
come back the next day?
Mr. Orszag. They are related. Let me pause on this for a
second, with the Chairman's indulgence, because I think this is
crucial. This is what one of the most salient aspects of the
crisis has been, which is, to a first approximation, financial
institutions are no longer lending to each other on an
overnight or short-term basis. Instead, it is being
intermediated through the Treasury and the Fed. So instead of
financial institution A that has extra money lending directly
to financial institution B that needs the money for the day or
for the night, the financial institution that has extra money
is lending money to the Treasury, which is selling additional
debt. The Treasury is taking the cash and putting it in the
Federal Reserve. The Federal Reserve is taking that money and
lending it out to financial institution B, because financial
institution A is unwilling to extend the credit to the other
financial institution, given the risk of not being repaid,
whereas they are confident that the Treasury Department will
repay--you know, is good for the money or that that will all
work out well. And the Federal Reserve is willing to lend to
financial institution B.
It is not a healthy development for the Federal Government
to be intermediating overnight in short-term transactions in
that way and to that degree, and that reflects the collapse of
confidence.
So then the question becomes, what jump-starts that
confidence again? And the two approaches, broadly speaking, are
to restore liquidity to various asset classes that are
currently illiquid. I am not lending to you because you have
got $200 billion of mortgage-backed security stuff on your
books, and I am not really sure what it is worth. So that is
one way of approaching it.
The other is, I am not worried you have enough capital--
even if I knew what the $200 billion was worth--that you have
enough capital cushion, if housing prices and mortgage-backed
security prices decline, that you would be able to repay me,
given the difficulty you may have in raising capital yourself.
So I want you to have a bigger capital cushion.
And that leads to the equity injection or more solvency
prism or perspective on the problem. Either approach could help
significantly, and in fact in some sense that is the driver of
the crisis. Having that overnight lending collapse, as that
chart showed you, is a very unhealthy development. And putting
the Federal Government in the middle of all those transactions
is not a salubrious way of running a financial system.
Mr. Conaway. As part of your telling us you weren't going
to use long big words, ``salubrious'' is a big one. Thank you,
Mr. Chairman, I yield back.
Chairman Spratt. Mr. Cooper.
Mr. Cooper. Thank you, Mr. Chairman. Thank you, Dr. Orszag,
for your very helpful testimony. I would like to divide the
problem into three levels: Number one is fighting individual
fires; number two, fire control policy of systemic solution;
and number three, talking about the fire department. First,
talk about fighting individual fires, financial fires. How much
capacity does the Treasury Department or the Fed have to take
on an individual case today like an AIG or a Lehman Brothers or
a Bear Stearns?
Mr. Orszag. The Federal Government has substantial capacity
to take those on. The question is whether that is the most
efficient way of doing it. And the concern is that financial
markets, without a more systematic approach, get concerned
about a particular institution, AIG, and then we step in on
that, and then they become concerned about some other
institution, we have to step in there, and then it is like the
whack-a-mole game where something keeps popping up and it is
very difficult to keep up.
Mr. Cooper. I share those concerns, and I want an efficient
solution. We are going to have a substantial debate over the
efficient solution of fire control policy, so it is no longer
just whack-a-mole. But your answer did seem to indicate that
the Federal Government has still substantial capacity to take
on the moles as they need to get whacked.
Mr. Orszag. At some cost to the American taxpayer and at
some cost, ultimately, to our outstanding reputation with
regard to our debt and risk characteristics. But, yes, we do
have--we can issue a lot more Treasury debt if we need to.
Mr. Cooper. The second level, fire control policy. Your
distinction between the liquidity problem and the insolvency
problem is very helpful, and I wish that more discussion could
take place on that. As I break that down, it seems like if the
taxpayer invests in solving the liquidity problem, we have a
substantial opportunity by buying assets at fire-sale prices to
possibly even make money, because some bailouts in the past
have in fact produced revenue to the taxpayer; for example, the
Chrysler bailout when we got warrants.
But to the extent we try to bail out insolvent
institutions, on the other hand, we can face a substantial risk
of not only losing money but keeping debt institutions alive
artificially that probably should be taken out in the market.
So we face two different types of choices here that can
conflict.
But my main question is on the integrity of the fire
department. That is the Federal Government. If we lose the
capacity to fight fires, then we are really in trouble. And
that is my ultimate concern because, as was discussed earlier,
the fiscal gap, the huge unbudgeted, untold liabilities of this
country, are at least $57 trillion; and if you throw in
Medicaid, it is probably $70 trillion or $80 trillion.
And we do know that when this administration went into
office, the total national debt accumulated over 230 years was,
like, $5 trillion. But now, with the latest administration
request, that will be up to $11.3 trillion, greater than a
doubling in just 8 years.
To some extent, I am worried that we could lose our
capacity to fight fires. And that is the ultimate concern. And
that is why Congressman Frank Wolf and I have proposed an
entitlement reform commission, so that this Congress and future
Congresses can get advice from experts on how best to tackle
these gargantuan problems. Because I love Medicare, I love
Medicaid, I love Social Security, I want to keep them alive,
but the best way to keep them alive is to prepare for their
needs.
Mr. Orszag. Let me say two things about that.
One, as this committee has heard over and over again, and I
don't want to sound like the boy crying wolf, but it is a fact
that, given the path that we are on, two things: One is we will
ultimately wind up with a financial crisis that is
substantially more severe that even what we are facing today if
we don't alter the path of Federal spending; and secondly, that
if we were on that path in the future and something like we are
experiencing today occurred, we would have much less
maneuvering room to fight those fires, because we will have
already depleted the fire truck.
Mr. Cooper. Thank you, Mr. Chairman. My time has expired.
Chairman Spratt. Thank you.
Mr. Garrett?
Mr. Garrett. Thank you, Doctor. And let me, too, compliment
your presentation. For an economist, you are extremely
understandable. I appreciate that.
And just a couple points I would like to go over with you.
When I just walked in, I came in after your presentation,
but one of the answers to Paul's question was how you put this
on the books. And I thought I heard you say something to the
effect of the dollar-for-dollar example, and I thought you made
some sort of comment as far as the element of the fact that the
Treasury, you don't know right now--A, you don't know the plan
specifics, but, B, you don't know right now how long they are
going to hold these assets; they may hold them for a day, a
week, a month or a year.
The question is, does that element of uncertainty go to the
issue? I don't think it does, but does it go to the uncertainty
for you being able to come up with a figure on the balance
sheet?
Mr. Orszag. We know basically nothing about how this
program is going to be implemented with regard to even what
assets will be purchased, how they will be purchased, how the
structure of incentives for the asset managers that will be
acting on behalf of the Federal Government will be structured.
So, in that context, what I said was, at this point, we
can't give you a quantitative estimate because there aren't any
details on which to base a quantitative estimate.
Mr. Garrett. But the question, though, is, if you had most
of the information, whether they sell them a day or 6 years
later, shouldn't--if I understood you correctly, the dollar-
for-dollar exchange, because whether you would sell them the
next day or 6 years later----
Mr. Orszag. Yeah, that wouldn't be at the top of the list
of characteristics that I would be looking for to evaluate the
net subsidy.
Mr. Garrett. Thank you.
On a broader issue but on the sale aspect, we have heard
various things as to what their plan would be. I thought I
heard Chairman Bernanke say in the Senate committee the other
day that he would think probably what they would want to do is
to hold the securities for their life, their duration, even
though they may be 30-year notes or what have you. In reality,
if they are home mortgages, most people move in 7 years, so
they are probably going to hold them for 7 years.
Assume that is the case, that they hold them out, as
opposed to the RTC arrangement, which, as you already
discussed, is not as comparable but, in that case, it was more
of a fire sale, ``let's get rid of these things so we can move
on.'' The fact that you would hold them out for that period of
time would, A, I presume get you potentially a better price for
them, but, B, does that affect the bottom-line impact that it
has on the economy overall as potentially dragging out, if you
will, the negative downward pressure on the economy over time?
Is there an uncertainty of anybody else getting to that market?
Mr. Orszag. You know, I think there has been a lot of
confusion about exactly what those remarks meant. It is not
clear to me that they were intended to mean that the Federal
Government would hold the asset to maturity, as opposed to
perhaps drive pricing closer to the valuation that would be
consistent with holding it to maturity.
But, again, I think there has been a lot of ambiguity about
precisely what those comments did or did not mean.
Mr. Garrett. Can you just give a hypothetical, though, does
the impact, were the Feds to say, ``This is our policy, to hold
them out,'' how does that impact upon the economy recovering
during that period of time?
Mr. Orszag. Again, I would go back to it is not actually
whether the Federal Government holds it to maturity, because
that goes back to the length of--whether you are selling
something tomorrow or next year or 2 years later. Primarily, I
think a more important aspect of this is, are you trying to
reveal what market pricing is today, or are you trying to come
up with some concept of what you think that underlying value on
a hold-to-maturity basis is, which, if you are not doing it
through a competitive process, could wind up being very
complicated and could wind up having the Federal Government pay
substantially more than current market pricing suggests.
Mr. Garrett. Okay. The proposal that you have been talking
about today, the general proposal, the major bailout, one
comment is budgetary treatment of the proposal. But could you
go back a little bit to one of the last sections that we did,
and we talked about this, and that is the GSE situation, and
just give your comment on--not the dollar figure, I am not
trying to put a dollar figure on it, but whether or not and how
it should be budgeted?
Mr. Orszag. CBO has suggested that, given that these
entities are no longer plausibly arm's length from the Federal
Government, in our view, their operation should be combined
with the Federal Government's operations in the budget. And
that is the way we are going to be reflecting their activities
in our baseline early next year.
And, by the way, a recent development, I think, underscores
the wisdom of that approach, which is, I believe it was last
week, the Secretary of the Treasury said, ``We, the Treasury,
are going to go out and purchase additional mortgage-backed
securities, and we are also directing Fannie Mae and Freddie
Mac to do the same thing.''
I don't think that those two things should be reflected
differently in the Federal budget given that they are based on
the sovereign power of the Federal Government in terms of
ultimate direction. And our approach will reflect those in
similar ways.
Mr. Garrett. So is that potentially like a $6 trillion or
$7 trillion item that you add to the budget or----
Mr. Orszag. Exactly how it is done is a little bit
complicated, and it is unlikely to be anything close to those
numbers.
Mr. Garrett. I would be curious sometime just to----
Mr. Orszag. Sure.
Chairman Spratt. Mr. Becerra?
Mr. Becerra. Dr. Orszag, thank you very much, once again,
for your testimony.
Let me move back for a moment. For many years, we have been
concerned about the size of the budget deficits that the Bush
administration has been running. The Bush administration came
in in 2001. We were told that there would be budget surpluses
totaling something close to $6 trillion, about $5.6 trillion,
over the next 10 years. And, instead, we have seen nothing but
deficits, record deficits, over the last several years, to the
point where we have seen over $3.5 trillion in deficit spending
under this administration, some $3.5 trillion added to the
national debt, if that is about right?
Mr. Orszag. I don't have the number off the top of my head.
Mr. Becerra. It is something over $3 trillion.
Mr. Orszag. I will take your word for it.
Mr. Becerra. If we didn't have a deficit of over $400
billion that we are looking at for this coming fiscal year, and
had we not spent hundreds of billions of dollars each year over
what we had over the last 7 years of the Bush presidency, would
we be in better shape as a Nation to try to help address this
financial mess that we are confronting today?
Mr. Orszag. I would say that the lower the public debt is
relative to the size of the economy and the smaller the budget
deficit is as you go into a crisis, the better off you are in
terms of dealing with a crisis.
Mr. Becerra. It sounds like an economist's way of saying
``yes.''
Mr. Orszag. Yes, it is.
Mr. Becerra. Now, part of that massive debt that we have
incurred over the last 7 years went to help pay for the
President's tax cuts, the Bush tax cuts of 2001 and 2003. We
were told that these tax cuts would help provide economic
growth and increase prosperity for Americans. And today what we
know is that deficit spending to cover the costs of those tax
cuts has left this country in a more difficult predicament, as
we just indicated from the previous question about the size of
the national debts and how it leaves us now in a more difficult
posture to try to deal with this financial crisis.
After 7 years of the 10-year Bush tax cuts, do you see any
near-term positive outlook for the economy?
Mr. Orszag. Well, CBO, even before this most recent
collapse of confidence in the financial markets, issued an
economic and budget outlook in which we projected very
significant weakness in the economy for the rest of this year
and into the early part of next year, and then, thereafter,
some recovery back to normal conditions. If anything, the
financial market turmoil should only make that outlook somewhat
more dire.
Mr. Becerra. Yeah. So, even now, close to the end of the
10-year Bush tax cuts, we still haven't seen that rosy garden
that we were supposed to find after devoting trillions of
dollars to these Bush tax cuts that went mostly to very wealthy
folks, many of the same folks who probably got us into this
mess that we are in right now in the financial markets.
Middle-class American families are doing today what they
did yesterday, what they did 3 years ago, and they are probably
going to continue doing the same thing a year or 2 years or
more from now. That is, they get up in the morning, they go to
work, they send their kids to school, they try to save a little
money. Most working-class Americans, whether they are in the
middle class or not, are doing the same thing they did before,
they did today, and they will do tomorrow.
Now, lenders in this country aren't doing what they did
yesterday, may not be able to do the same thing tomorrow. Many
of the traders on Wall Street aren't doing what they did
yesterday, are doing things differently today, and may do
things differently tomorrow.
But it is the guys on Main Street, that middle-class
family, that working-class family, is the one that is being
asked to do something differently, even though they kept doing
the same thing they did year-in, year-out: work hard and
provide for their family.
Is there a quick way that you can explain why that family
that didn't do anything that he or she or that family knows
about to cause this financial mess should now, all of a sudden,
be asked to give dumb money, in other words, to have no say?
They are the Mikeys in this mess, if you can remember the
commercials 20 years ago. The brothers would always give the
littlest brother, Mikey, the new cereal that----
Mr. Orszag. Mikey likes it, yes.
Mr. Becerra. I don't know if Mikey would like this one.
But is there any reason why we should treat the American
middle class as Mikey without knowing what we are going to get
in coming up with any $700 billion bailout?
Mr. Orszag. Well, again, I think those kinds of questions
are really for you rather than for me. But I would come back to
saying that, even if it is not any of their doing, that family
ultimately, if we perpetuated this kind of financial market
turmoil, will be hit in some unfortunate way, even if it is not
their fault or has no direct connection between what they were
doing and the current turmoil. That is unfortunately the case.
Mr. Becerra. So, unlike the Bush tax cuts that went
principally to very wealthy folks, not to middle class; unlike
the unpaid-for expenditures in Iraq, which probably gave
America's families, in many cases, a smaller family because of
the death of a soldier; perhaps, in this case, we could try to
ensure that if the American family is going to be asked to bail
out people that they don't deal with on a day-to-day basis,
that we make sure it is an investment for the American family.
So if we are going to give any amount of taxpayer money, we
have to make sure there is a return for the American taxpayer
before we move forward. And, certainly, at this stage, we
haven't seen the administration come up with a proposal that
does that for the American family.
And you don't need to comment. That is more a rhetorical
question. But I thank you for your time here.
And, Mr. Chairman, I yield back the balance of my time.
Chairman Spratt. Mr. Porter?
Mr. Porter. Thank you, Mr. Chairman.
And, Doctor, I appreciate working with you the last 2
years. We appreciate your professionalism, and it has been
truly a pleasure to work with you, so thank you very much.
I will probably be less kind to the administration than
even some of my colleagues here this morning. But, first, this
is actually more of a comment than a question.
I think you know that in the great State of Nevada we have
one of the highest foreclosure rates in the country; in my
district, about one out of 45 homes. It is a tragedy that is
happening. Plus, add to that the lack of an energy policy for
our country has caused great economic hardship for our
community of Nevada, the resort industry. Visitation is down;
we are laying off employees. So not only in Nevada is the price
at the pump a problem of getting to work, it is also preventing
people from coming to visit our community.
But I tell you that there are families that are hurting.
And what Wall Street has done is morally reprehensible. And it
appears to me that in Las Vegas we have more regulations and
enforcement than we have had on Wall Street. I am appalled that
we have a crisis of this magnitude, that has risen to this
level, without oversight and without the proper enforcement.
And, again, this is more of a comment, Doctor, because you are
here to try to help us find a solution; I am here to talk about
the problem for a moment.
I think the administration should have known about it, and
I think they should have known sooner. If they didn't know
about it, that is even a bigger problem. But I am extremely
troubled that Congress now, in the final hours of a session, is
having to find solutions to a problem that didn't just happen
overnight.
I think we are going to see, Mr. Chairman, a lot of
possible solutions that are presented. And I am convinced that
we need to take some pretty decisive action and do it as
quickly as possible.
But I want to make sure that there aren't individuals
somewhere sitting on a yacht, eating shrimp and drinking
champagne, that have taken advantage of the American people.
And I know that it is troubling. The overall majority of the
calls I receive from my district are opposed to a bailout. But
we have to, of course, look at the ramifications you presented
this morning.
So I want to say thank you for your diligence, Doctor. I,
again, share my frustration, anger with what Wall Street has
done and what I think the administration should have seen
coming. In fact, a year ago, when we were looking at the
mortgage crisis as it was escalating, we should have taken a
timeout and looked at the ramifications.
As my friends have mentioned, you know, the fire
department, I think that Wall Street, I think the SEC, I think
the administration, and even many Members of Congress have not
taken the steps that they needed to take to prevent this from
happening.
So, again, that is not a question, Doctor. I appreciate you
being here and being part of the solution. Thank you.
Mr. Orszag. Actually, if I could just take this
opportunity, since there were compliments about the testimony,
to compliment the CBO staff that has been doing a fantastic job
under trying conditions.
Chairman Spratt. Thanks very much.
Mr. Blumenauer?
Mr. Blumenauer. Thank you, Mr. Chairman.
Frustrating, because we have had some conversations in this
hearing room about this slow-motion train wreck that has been
occurring for years now, dealing with a subprime mortgage
market out of control, failure to exercise oversight and rein
things in. There aren't very many people who I suppose are
shocked or should be. There may be some surprise about the
rapidity, but the fundamentals, I think, are not much in
dispute.
I have just two questions, Doctor, that I would offer up.
One, in a practical matter, how long would it take for the
relief, the stabilization, the practical application of a
modified proposal, similar to what you have heard the
administration's plan morph into, how long would it take for
that to actually make a difference on the ground? Not talking
about restoring confidence, but in terms of actual operation.
Are we talking about 6 weeks? Six months?
Mr. Orszag. You mean make an effect, operations in
financial markets or out to that household we were discussing?
Mr. Blumenauer. In terms of actually administering a
program that would take advantage of the authority that we are
giving and go in and start the reverse auction if it could be
done in a thoughtful way. If you could put the administration
in place, if you had the oversight, if you had the workout, are
we talking 6 months?
Mr. Orszag. I sure hope not. Again, the more that it is
focused on, you use the example reverse action for the
mortgage-backed securities, the easier it is going to be to
design things and get them in place quickly. The more the
Federal Government is going to be purchasing individual loans
and you are going to have to have a more elaborate process for
making sure that you are not overpaying for those loans, the
longer it may take.
I would say, in the best-case scenario, you are talking
about weeks, not many months. You have to go out and hire the
asset managers and then start doing the auctions.
Mr. Blumenauer. Yes, but I am seeking an order of
magnitude. Are we talking 6 or 8 weeks under best
circumstances? Are we talking about 6, 8, 10, 12 weeks?
Mr. Orszag. That is going to depend on how stringent the
regulations are with regard to, for example, hiring the asset
managers. So, if given the current draft the Treasury
Department submitted where it is very open-ended, I think they
could go out and contract with asset managers very quickly; it
would be a low number of weeks. If there are lots of boxes that
have to be checked, it may take somewhat longer. So there is a
tradeoff between getting oversight and protection and
timeliness.
Mr. Blumenauer. I guess, Mr. Chairman, I would request--
and, again, I don't want--but being able to have some of the
certified smart people you work with, just to talk about some
of the applications here. You are talking about getting asset
managers qualified, how you----
Mr. Orszag. Avoid incentive problems for them. There are
all sorts of things that are--their compensation.
Mr. Blumenauer. Yeah. But getting a sense of what the
timing is for things that haven't been filled in. That would be
helpful.
Mr. Orszag. Okay.
Mr. Blumenauer. And I have a suspicion that something we
could get in a day or 2 or 3 would still be relevant.
Mr. Orszag. Okay.
Mr. Blumenauer. My second question deals with what is
potentially next, not that it will happen, but recall a few
months ago, the furor is over the GSEs and Freddie and Fannie
and all of a sudden we are moving in. Then we have AIG
exploding and putting hundreds of thousands, millions of
annuities at risk. And now, in a matter of hours, we pivot and
we have the latest iteration.
I would like, not your saying that it will, but just give
us a sense of what are some of the other contingencies that
could potentially require a boost in confidence? Hedge fund
black holes and instability? We are talking about the auto
industry. What are the other contingencies that you think
about?
Mr. Orszag. That is a frightening prospect to consider. We
could walk through all of the financial assets, the trillions
and trillions of dollars of financial assets that are held by
American households and businesses and that trade on financial
markets and potentially raise concerns about the functioning of
all those markets.
I can't pinpoint, and I don't think anyone can, you know,
out 2 or 3 weeks or 4 weeks or 5 weeks, where the problems may
arise without the kind of detailed knowledge--for example, the
Federal Reserve does have more information about banks than we
at CBO have, because they can go in and examine the underlying
books and the trades that they are conducting. We don't have
that information.
So, as a little bit of an outsider looking in, it is very
difficult to predict what would collapse next. And even the
people who have that kind of specialized information have,
obviously, had a lot of difficulty doing the same thing.
Mr. Blumenauer. But you don't have, for instance,
specialized information about what is in large hedge funds, for
instance----
Mr. Orszag. No, I do not.
Mr. Blumenauer [continuing]. That might be heavily
leveraged.
Mr. Orszag. I do not. I do not.
Mr. Blumenauer. But that could be a potential pivot point,
theoretically.
Mr. Orszag. That is a concern that has often been
expressed, yes.
Mr. Blumenauer. Mr. Chairman, I would hope that we--and,
again, I am not trying to pin down Dr. Orszag necessarily, but
it would be helpful to identify the sorts of things that could
capture our attention next month or 2 months from now, after we
navigate this. And I would respectfully request that----
Chairman Spratt. We have reporting requirements built in to
the bill, which this committee staff, bipartisan, was
instrumental in securing in the bill. And it gives us a record
of the assets being acquired and an estimate, if I'm not
mistaken, of the likely recovery of that asset when it is
disposed of.
Mr. Blumenauer. Thank you.
Chairman Spratt. Mr. Tiberi?
Mr. Tiberi. Thank you, Mr. Chairman.
I am sorry I am late. I had another hearing that I was
attending. And I apologize if I ask a question that has already
been asked or if you have already addressed this issue.
But, from your perspective at CBO, from where you sit, how
do we know that $700 billion is the right number?
Mr. Orszag. Frankly, we don't. I mean, the bottom line here
is that there is a collapse of confidence in financial markets,
and the question is what will restore that. In the judgment of
the Secretary of the Treasury and the Federal Reserve Chair,
$700 billion was the right number. I don't think there is an
analytical basis for saying that is the right number versus a
trillion or versus $500 billion.
The thing about a collapse of confidence is you never
exactly know what restores it. And it is not just the number
itself, but lots of other things, including how it is
communicated and how it is implemented and what have you that
contribute to its success or lack thereof.
Mr. Tiberi. What are the risks for this legislative body to
miss the target, either giving too much or giving not enough to
that confidence?
Mr. Orszag. I would say, at this point, given that we don't
exactly know what the right level is and that it is in no small
part a confidence game, unless there were some, again, serious
justification for altering that number, given that that number
is out there, you probably are running a bigger risk by dialing
it in either direction than by restructuring the way in which
it is implemented.
Mr. Tiberi. What is the risk, from your perspective, of
adding to our debt that much more money?
Mr. Orszag. It depends crucially on how much the $700
billion goes to overpaying for assets versus paying for them on
a fair-value basis. If we simply take the $700 billion and
spend it in a way that we are getting roughly $700 billion
worth of assets in exchange and on a fair-value basis, then I
am much less concerned about the increase in debt, Treasury
debt, that is required to finance those purchases because it is
basically a swap.
However, if we go out and we buy $700 billion worth of
stuff that is actually worth $200 billion and there is reason
to think ahead of time that we are overpaying for the assets,
that is a much different thing. And that component would cause
a deterioration in the Nation's fiscal condition and is similar
to regular deficit spending.
Mr. Tiberi. So, if you were the king of the legislature,
which obviously you are not, but you are the king at CBO, how
do we in the legislative body try to make sure that doesn't
happen? How do we protect that from happening, from your
perspective?
Mr. Orszag. Well, if one wanted to make sure you were
getting fair value for what you are purchasing, there are ways,
for example, restricting the program to reverse auctions on a
tranche-by-tranche basis for mortgage-backed securities and
other things that we could lay out, that are more likely to get
you fair value.
And then there are asset categories and ways of conducting
these transactions that are more likely to make you overpay.
For example, buying individual loans from banks is likely to
result in the Federal Government overpaying for those loans if
it is done through a reverse auction. Because you are going to
likely wind up with the riskiest part of the loan portfolios
and not getting sufficiently low prices for bearing those
risks.
Mr. Tiberi. Particularly if you are buying----
Mr. Orszag. Taking those risks, I should say.
Mr. Tiberi. Particularly if you are just buying the bad
loans and the junk, right?
Mr. Orszag. And not getting a sufficient discount for doing
that, yes.
Mr. Tiberi. Okay. Thank you.
I yield back.
Chairman Spratt. Mr. Scott of Virginia?
Mr. Scott. Thank you, Mr. Chairman.
And thank you, Dr. Orszag.
You have indicated in your testimony that CBO cannot
provide a meaningful estimate of the ultimate net cost of the
administration's proposal, and in response to the latest
questions, within a couple of hundred billion dollars one way
or the other, it seems.
Now, we have been told that the public ought to be scared
if we do nothing. It seems to me we ought to ascertain how
scared they ought to be if we spend $700 billion without a
meaningful estimate of the ultimate net cost.
So let me ask you a question. If enough work has been done
on a loan portfolio, billions of dollars' worth of home
mortgages for example, it seems to me we can take a
statistically significant sample of that to find out the value
of that portfolio by looking first at the face value of the
mortgages, the interest rate, the creditworthiness of the
borrowers, the real value of the collateral, and you can
estimate the payments to maturity even after defaults are
considered. You can apply a reasonable discount rate to get a
yield to maturity.
If you had that information, could you provide a meaningful
estimate of the net cost to the administration's proposal?
Mr. Orszag. Well, yes, although--and that is what private
purchasers of a mortgage-backed security do. They try to
project out the cash flow and whether the current pricing is
above and below.
But here is the key thing: If an asset manager is hired by
the Federal Government to purchase that thing for us and
doesn't bear its own risk from making that purchase, I think
the question is do they have the same incentives as if they
were purchasing it for their own books and whether the same
standards will be applied.
And, furthermore, if you do it through a reverse auction,
that kind of same scrutiny isn't necessarily applied to each
mortgage-backed security.
Mr. Scott. Well, it seems to me, if we did some perfunctory
due diligence, we could figure out a good idea of what these
things are worth. And without the information--because we don't
know the collateral behind these things. We do know that the
collateral may not be sufficient on a lot of these loans. We do
know that the borrower's creditworthiness wasn't checked. And
we are trying to figure out what these things are worth without
the perfunctory information.
I mean, doesn't that insult your intelligence to be asked
to comment on a plan where you don't know what you are getting
or how much you are going to pay for it?
Mr. Orszag. I don't know that I would frame it as insulting
my intelligence, but I can't do it.
Mr. Scott. Well, let me ask you another way--well, yeah,
you can't do it.
Mr. Orszag. Yeah. There is not enough specificity to do
this right now.
Mr. Scott. Now, if we don't know what we are doing for
mortgage-backed securities, for which you can really get a good
value--I understand the first plan had limited us to mortgage-
backed securities; the next is anything he wants to buy.
Is there any reason to go past mortgage-backed securities?
Mr. Orszag. Well, the first plan didn't quite limit it to
mortgage-backed securities. It limited it to mortgage-related
assets, which can be a whole array of different things.
Mr. Scott. Is there any reason to go past that?
Mr. Orszag. I think the argument to go past that would come
back to the question Mr. Blumenauer asked, which is we don't
know what will implode next. And if you want to do this on a
one-off, kind of, give the Secretary authority to go fight
fires wherever they may occur, the fires may occur outside of
mortgage-related assets.
Mr. Scott. Generally accepted accounting principles on book
value, should the book value on the corporate books have good
face value purchase price or what?
Mr. Orszag. I think, in general--and there is some
controversy over this--but, in general, there are benefits to
marking to market. Book value doesn't always reflect market
values. There have been concerns that have been raised about
marking to market during particularly volatile financial market
times like we are experiencing today.
Mr. Scott. Okay. So it is not always--it is kind of
artistic, is what you are saying.
You indicated that if liquidity alone is the problem, those
companies that have good assets for their liabilities, if that
is all we are solving, we could do this, we could solve the
liquidity problem without much net cost to the Government. But
solving people's insolvency problem, where they are actually
bankrupt, ought to be a separate question.
Mr. Orszag. That is correct.
Mr. Scott. Okay. On this reverse auction, it seems to me
that if nobody knows down deep what is behind these things, if
the seller did a little due diligence and figured it out, we
would be buying blind, they would be selling with knowledge.
Isn't that a recipe for getting ripped off?
Mr. Orszag. Yes, if what the sellers are offering you are
different things. And if instead--and this is what at least
part of the Treasury program is likely to entail--if instead
you have different owners of the same thing, so you have some
given cash flow that is split among 100 different institutions,
if they are the ones bidding, you are only bidding on their
shares, then you don't have that problem.
Mr. Scott. Well, you only have the problem to the extent
that they know what they have and you are trusting them to try
to bid against each other to try to get a fair value, and you
hope they know what it is worth, and you would come out.
But isn't a due diligence, reasonable yield to maturity,
isn't knowing that number essential to know what you are
buying?
Mr. Orszag. Again, it depends on the context. More
confidence in the scenario we just discussed of the competitive
bidding process would give you the best guess of what that
underlying value is.
In other cases, where they are offering different things,
then, yeah, you have this problem that you have to, in a sense,
value each individual asset that people are offering to sell
you.
Mr. Scott. So you know what you are buying.
Mr. Orszag. So you know what you are buying.
Mr. Scott. Isn't that a good idea, to know what you are
buying?
Mr. Orszag. In general, it is a good idea to know what you
are buying, if you want to avoid overpaying.
Mr. Scott. Your whole analysis is such that, if you don't
overpay, you will have, at most, a wash and, at best, a profit.
If you overpay, you could be getting ripped off. And we are
going to spend $700 billion without knowing what we are doing.
Mr. Orszag. And I think one concern is it is not clear to
the degree to which we are trying to address--you know, we are
trying to overpay. And, in fact, some of the comments that were
made yesterday suggest perhaps we want to overpay, to provide
support to financial institutions, versus just simply trying to
restore liquidity to markets, which need not imply any
significant overpayment. And I think it is important to figure
out which one we are trying to do.
Mr. Scott. And it would be nice to know what we are doing
before we spend $700 billion doing it.
Chairman Spratt. Thank you, Mr. Scott.
Mr. Etheridge?
We have about 10 minutes until votes, and I want to see
that everybody gets a chance.
Mr. Etheridge?
Mr. Etheridge. Thank you, Mr. Chairman, and let me thank
you for holding this hearing.
Mr. Orszag, thank you for being here.
Let me go back to a little more personal, on Main Street on
this, with the budget implications. Friday night I was at a
Boosters Club banquet with a bunch of folks. Talked to a
builder. He is down to two people from 30. Talked to bankers
over the last several days with regional banks. They are no
longer making any loans, because they are concerned they are
not moving money, as you said earlier, from bank to bank.
And I guess the other part of it is many of us feel like we
are riding the back of the tiger and we are not sure where the
tiger is headed. And we don't want to hop off, but we are
afraid to--you know, we just feel like we are riding without a
roadmap.
So my question is, I was in business for 19 years--and you
touched on it earlier. I wanted to go back to that, because I
think what we are doing, the effects or where we get to,
businesses not only borrow money for raw materials, they have
to borrow money for inventory, for storage in some cases, for
that equipment or product that is moving. And that hasn't come
back to pay their salaries.
It is now September, mid-September. A lot of businesses
have already booked their purchases for the holiday season or
are in the process of it, needing money to pay for that
inventory with anticipation of the holidays. Talk to us, if you
will, about the impact on the budget on this issue.
If that seizes up, the inventory doesn't move, they can't
get it, some of it may be there, but the consumer has a problem
with their personal finances, and then all of a sudden we have
a horrible holiday season that bleeds into a new budget year.
Mr. Orszag. That is exactly the scenario that is of most
concern, in terms of, you know, real people and the downward
spiral that would follow.
I would note one small silver lining, which is not to
downplay the seriousness of the problems that we face, but it
is the case that corporations as a whole have built up their
cash reserves in part because they are coming off of many years
of relatively high profits and in part because there were
indications that credit markets may start experiencing
difficulty.
So that does provide them a bit of wiggle room for some
period of time to draw down those cash reserves while other
sources of liquidity are drying up. But, ultimately, if the
financial market problems are perpetuated, they will become a
very severe constraint and cause problems not just for the
Federal budget but for the economy as a whole.
Mr. Etheridge. Well, let me go a step farther, because you
are talking about the large corporate entity.
Mr. Orszag. Yeah.
Mr. Etheridge. In a lot of parts of this country, it is the
small businesses that----
Mr. Orszag. They tend not to be sitting on as much cash.
Mr. Etheridge. Yeah, and they are going to the banks
monthly, bimonthly and, in some cases, even weekly to move it
through. And that is affecting Main Street big time. When that
gets tied up, then the whole process affects the big
corporations. They may be sitting on cash, but they don't buy
their product, and it doesn't move.
And now we have counties and cities going through tax re-
evaluations with the housing market going down. That is going
to have a significant impact on the ability of the local
institutions of government to provide the services that they
need to provide. And that ultimately will impact our budget
again, correct?
Mr. Orszag. Yes. Again, we will--it is highly desirable to
avoid the downward spiral that could follow from failing to
address this crisis of confidence in financial markets.
Mr. Etheridge. It seems to me, Mr. Chairman, the challenge
we face is trying to get something right, you know, and
understanding where we are.
I thank you very much, and I yield back.
Chairman Spratt. We are going to try to give everybody a
chance, but I need to get one thing on the record.
Mr. Orszag, would you like to take 30 seconds and explain
why you need additional funding for your responsibilities?
Mr. Orszag. Yeah. The legislation requires that CBO would
report to the Congress on a quarterly basis on the net cost of
this program to the Federal Government. For us to do that well,
given the wide array of assets that are likely to be involved
in the program and the kind of modeling that was discussed
earlier, we need some more people who are expert at that. And
we may also be given a huge array of data on all of the
individual assets, and we need some capacity to be able to
process that data, which we currently lack.
Or another way of putting is, it is obviously up to you in
terms of whether you want us to play this role. But if you want
that kind of reporting, regular reporting, from us on this
complicated program, we don't currently have the resources to
do it.
Chairman Spratt. We think we do want that role fulfilled,
and particularly by CBO because we have the closest
relationship with you. So thank you for putting that on the
record.
Now Mr. Baird.
Mr. Baird. I want to thank Mr. Orszag. He is all on the
mark, tells us what he knows, what he doesn't know, and is
tremendously informative.
My friend, Mr. Blumenauer, from Oregon raised the issue of
what might be on the horizon. For some time, I have personally
been greatly concerned about the ARM reset issue. A great
number of Americans took out ARMs or other devices and, instead
of lowering their debt-to-equity ratio, increased it. And ads
were come-ons to do that.
Is anybody giving some thought to what happens as millions
of Americans who, at current, have a net negative savings rate
suddenly see an ARM kick in from $500 to a $1,000 a month more
than their current mortgage, and what that has? Is that the
next wave? We seem to be always behind the waves. Are people
looking at that? And how can we get ahead of that?
Mr. Orszag. As you may know, and I am sure you do, that was
a significant concern a year or 2 years ago, as we were looking
into the eye of this. Those concerns, while they are still
there to some degree, have attenuated somewhat, in part because
the Federal Reserve has acted so aggressively to reduce
interest rates that the resets aren't as severe as many people
feared, you know, let's say, 2 years ago.
So it is still there, but I think it doesn't loom as large
as a concern as it did a couple years ago, in part because
overall interest rates, especially on the short-term end of
things, have declined so dramatically.
Mr. Baird. Okay.
My second question is, if you look at how we got into this,
it is because, in a nutshell, many firms vastly overleveraged.
They had much more outstanding debt than they had collateral to
cover it.
To some extent, that is analogous to what the Federal
Government is doing. We have $9.4 trillion debt, rapidly
heading to $9.5 trillion, it looks like, and maybe more. Some
of us feel we ought to pay for this.
During the last 8 years, the administration has not once
come to this Congress and said, ``This is how we are going to
pay for something.'' And some of us feel that the people who
got vast wealth and income out of creating the conditions that
now are plaguing our country ought to be the ones who pay for
it, not the average guy on Main Street and back home who has
been paying his taxes, paying his mortgage, going to work every
day, but the guys who are pulling in $25 million golden
parachutes.
Can you give us a ballpark estimate of how much revenue
could be generated if we just put a modest tax increase on
people with, let's say, $2-million-a-year-plus income?
I seem to remember, a few months back, we were looking at
funding the GI bill. My recollection was a one-half of 1
percent tax increase on people with incomes over a million or
so a year. Beyond the million generated $50 billion over 5
years, ballpark. My memory may be wrong.
How much can we generate from even a modest increase on the
people who are most well-to-do, so we don't pass this burden on
the average taxpayer?
Mr. Orszag. Let me say two things.
First, again, to the extent that you are purchasing assets
at fair prices, in a sense that pays for itself, or there is no
net expected cost. When you are subsidizing the purchases, when
you are overpaying and thereby providing a subsidy to financial
institutions, that is where the expected costs come in.
There are a variety of ways that, if you wanted to pay for
it, you could. High-end income taxation is one possibility. I
don't remember the exact numbers which came from the Joint
Committee on Taxation, but we can get them to you.
Mr. Baird. The problem some of us have, as you read the
articles, and it says the plan from Treasury is to rescue these
companies by buying their bad debt. A guy comes up to me and
says, ``Hey, buddy, want to buy some bad debt?'' I am going to
say, ``No, I would rather buy some good debt, thank you very
much.''
So, on the one hand, we are told, oh, this won't cost very
much because you are buying real assets. On the other hand, we
are told, but you are buying the bad real assets.
Mr. Orszag. And the key thing is, what is the price at
which you are buying that bad debt? If someone comes up to you
and says, I have this bad loan and I am going to give you a
huge discount, it might be worth it to you.
And so that is why I was emphasizing so much are we
overpaying or not, how are those prices being determined. It is
not necessarily the bad debt itself but, rather, the price that
you are paying for the bad debt that becomes the issue.
Mr. Baird. The other two key questions are, who is going to
benefit from me buying it, and why should I buy something to
help somebody out? They are not just coming to say, buy the bad
debt; they are saying, buy the bad debt so all these CEOs who
made so much money driving these companies into the dirt--and
they justified these big incomes on, well, we have a lot of
responsibility. Well, they botched their responsibility, and
the average taxpayer says to me, why should I bail them out?
I thank the gentleman.
Chairman Spratt. Ms. Kaptur?
Ms. Kaptur. Thank you, Mr. Chairman, very much. Thank you
for allowing me to meet my responsibilities as a member of this
committee in Congress.
Dr. Orszag, thank you so much for coming today.
My goal is prosperity and jobs on Main Streets across this
country, with a power shift, an economic power shift, from Wall
Street and this city of Washington back to Main Street. I am
asking myself how to do it as we face this situation.
The very best book that I have read that puts this into
perspective is by Kevin Phillips, chapters 8 and 9 of his book,
``American Theocracy.'' I am going to ask the chairman to place
chapters 8 and 9 in the record, the first called ``Borrowed
Prosperity and the Financialization of the U.S. Economy,'' and
chapter 9, ``Debt.''
I believe we find ourselves in the predicament that we do
because there has been a tremendous power shift from Main
Street to Wall Street and to this city of Washington. It is too
concentrated, and it is too intangible.
I support reform of our financial structure, reform, before
any taxpayer support goes out the door, to especially the
financial services sector. FDR figured it out; we should too.
And my feeling is we shouldn't adjourn and go home to campaign
until we meet our responsibilities to the American people.
Now, let me put this in some perspective. About a century
ago, Britain, as it continued to decline in power, its colonial
secretary said, ``Banking is not the creator of our prosperity,
but the creation of it.'' He understood the difference between
money and wealth, and that trading abstract financial
instruments was different than the production of real, tangible
goods and services that create real, tangible wealth.
Now, Phillips, on page 266 of this excellent book, states,
``By 2004, financial firms in our country boasted nearly 40
percent of all U.S. profits, up from just 6 percent in 1980 and
11 percent in 1990, while the manufacturing sector fell from
over 60 percent of profits down to less than 10.''
Part of that is because this very financial sector has been
outsourcing our jobs all over creation and outsourcing the
purchase of our bonds to foreign countries. So we are losing
control as our economy is being globalized.
My question is whether propping up paper money is the best
expenditure of our Nation if our goal is prosperity, jobs and
tangible, real wealth on every Main Street across our country.
My purpose is to create wealth, not just paper money.
And let me just finally say that, if we look at the 1980s--
and I served here back then--after the Resolution Trust
Corporation was set up after the imprudent behavior of the
banking sector, rather than tightening controls and returning
power to Main Street, we did exactly the reverse. The imprudent
institutions were actually allowed to become more imprudent.
Investment houses created money without underlying assets. And
the old, time-honored principles of character and
collectability and collateral at the local level, where we had
had local savings banks with deposits, with passbooks that paid
interest, and then they made loans, we totally reversed that
and we changed loans to bonds and securitized them into this
highly debt-structured market.
And we saw this huge power shift from Main Street to Wall
Street. And now they are coming to us and saying, ``Oh, bail us
out,'' when, in fact, I am saying I am not sure the financial
sector is the sector I want to bail out. I want to produce real
money.
We did interstate banking; I voted ``no'' on that. Again,
to create these mega-giants that move power and money elsewhere
and decision-making elsewhere with imprudent standards. In
1994, they took the name ``Banking Committee'' off the
committee in this very House, and they changed it to
``Financial Services'' to empower the very folks that did this
to us. In 1999--I have many examples--Glass-Steagall was
removed; the historic separation between banking, commerce and
insurance was removed.
And my question really is, as we do this, how do we
restructure the bigger picture to return financial power and
responsibility to Main Street and to recreate the institutions
Franklin Delano Roosevelt understood well--local community
banks with prudent lending standards? He had the Homeownership
Loan Corporation to restructure the bad debt, which is what
they are asking us to do now.
Why can't we do that? Why do we have to bail out those who
created phony money?
Mr. Orszag. I think, again, there are two issues. One is
the immediate problems that the crisis of confidence in
financial market seems to entail, and the second is the
regulatory structure on a going-forward basis.
In my opinion, for whatever it is worth, I am not sure that
we have the time to make the underlying regulatory changes,
whether they are of the kind that you favor or others of your
colleagues favor, before addressing the concerns surrounding
the collapse of confidence in the financial markets. And, by
the way, especially----
Ms. Kaptur. May I just say this, Mr. Chairman? And that is
what troubles me about this whole discussion, because I hear
these pundits on TV, these guys who come up over to the Senate
from the administration, they always say, ``We want the money
before the reform.'' I say, the reverse. Roosevelt figured it
out under much more difficult conditions. So should we.
I thank you, Dr. Orszag.
Chairman Spratt. Thank you, Ms. Kaptur.
Mr. Boyd, I am prepared to miss the vote so that, Mr. Boyd,
you can go ahead and put your questions in. I think it is a
procedural vote. And if you would like to do the same, we will
proceed.
Mr. Boyd. All right. I would like to proceed, Mr. Chairman.
Thank you.
Chairman Spratt. Mr. Boyd, you are recognized.
Mr. Boyd. Dr. Orszag, thank you for your service. And I
apologize for being late, too. So if I ask something that you
have already answered, please indulge me and forgive me.
And I want to start by saying that I am, to sort of spin
off what Ms. Kaptur said, I am extremely skeptical about
whether this is the right thing to do. That skepticism I think
comes from the fact that I am concerned that we may be treating
the symptom and not the underlying cause for the problem.
But I want your counsel and advice in one specific area,
and I want to talk about the devaluation of the dollar and the
role that has played in all of this. I don't think it is
complicated that most economists would tell you that the
devaluation of the dollar, the primary cause is government
deficit spending.
In this proposal, what role--or what will that do, in terms
of the value of the dollar worldwide?
Mr. Orszag. Well, again, let's back up. The dollar has
been--actually, frankly, even though this may sound ironic, one
of the silver linings or one of the things that has been going
relatively well during the economic challenges we have been
facing over the past year or 2 is that the depreciation of the
dollar, which had to occur, has been going relatively smoothly.
In other words, the foreign exchange markets have not
experienced the same kind of crisis that some of our overnight
lending markets are now experiencing.
So that decline in the dollar, which has had to occur
because we have been borrowing an unsustainable amount of funds
from abroad, has occurred relatively smoothly. And everything
is a relative statement.
What will happen from this kind of legislation, it depends
on, again, the degree to which market participants believe we
are overpaying for the assets that we are obtaining.
To the degree that we are overpaying, that is a
deterioration in the underlying condition, fiscal condition, of
the Federal Government. And the same forces that then can lead
to concerns about both national saving and all the other things
that feed into the normal dynamic of potential depreciation
could apply.
To the extent we are just simply purchasing assets that are
worth what we are paying for them, at least in a purely
rational way, that really shouldn't have any significant effect
on the U.S. dollar. Whether financial markets, because of
psychological reasons or others, perceive it that way is an
entirely different question. That is sort of a textbook answer.
Mr. Boyd. With the existing underlying reasons for this--
and a lot of folks have talked about--Ms. Kaptur talked about
the abstract financial instruments, the derivatives and all of
that, which obviously play a role in all of this. With the
infusion of $700 billion of money, I assume most of it will be
borrowed, and that gets rolled numerous times, does that
exacerbate the devaluation-of-the-dollar problem around the
world?
Mr. Orszag. Well, what I would say is we have not
experienced, and I don't anticipate experiencing, any problems
raising the $700 billion or rolling it over regularly. But just
like financial market institutions that had gotten in the habit
and gotten used to regularly rolling over their short-term
obligation, one problem with a higher outstanding stock of
government debt, which does have to get rolled over, is if in
the future, for whatever reason, there were confidence problems
or other difficulties in the Treasury market, having a higher
outstanding stock of government debt that has to be rolled over
would exacerbate the problems that we would face.
Mr. Boyd. Okay. All right. Can you help me with my extreme
skepticism about whether this is the right thing to do?
I mean, you know, John Spratt, Marcy Kaptur and myself,
others, have certainly lived with parents who came out of the
Depression, and our lives were shaped at a very young age,
obviously, by that experience, their experience. And it is
something that we thought we had put tools in place to keep
from happening again.
So can you calm my extreme skepticism about what we should
do?
Mr. Orszag. Yeah, let me say two things.
One important contributor to the Great Depression was
policymakers who not only failed to act but actually, in some
sense, often did counterproductive things. And I think,
luckily, there is at least a mentality now that will avoid some
of the worst problems associated with policy in the late 1920s
and early 1930s. So that is the first thing.
The second thing is fundamentally you are asking will the
$700 billion work. And I don't know the answer to that,
because, again, it comes back to this question that a
fundamental driver of what is happening is a collapse of
confidence. Whether the $700 billion restores confidence or
not, I don't know.
And, by the way, it is hard to know even without knowing--
again, we don't know how the program will be implemented with
any granularity. So I think it is an open question.
But I also think that is a separate question from whether
or not you should do it. It may not work, but if you do
nothing, it definitely won't work.
So what you do is up to you. But I think, at this point,
unfortunately, especially having created the expectation in
financial markets that you will do something, doing nothing
would likely be a very serious mistake.
Mr. Boyd. Mr. Chairman, may I ask one last short question?
The great debate here about $700 billion infusion versus the
regulatory reforms, oversight reforms, those kinds of things,
if you were sitting in Congress would you vote to extend the
money without doing the other first.
Mr. Orszag. Am I allowed to say thank goodness I am not
sitting in Congress? Look, I mean, you face a difficult
situation in the sense that time is of the essence here. And I
think it has to be correct that it would be nice to be able to
do--you know, not give desert before you have eaten your
vegetables.
But the question is whether you have the time to do that.
And that is obviously an internal dynamic that I shouldn't
comment.
Ms. Kaptur. Would the gentleman yield on that?
Mr. Boyd. Certainly.
Ms. Kaptur. Mr. Chairman, I don't know if this is in the
purview of our committee, but Dr. Orszag is so excellent and
his staff and your staff, Tom, would it be possible for us just
to have a brown-bag lunch sometime and look back at the 1930s;
what was done quickly in order to stem the hemorrhage?
Chairman Spratt. Sure we can do that. We can look back to
the 1980s and what was done with Lockheed, Chrysler, Penn
Central and all of those cases that are somewhat success
stories because the loans and the guarantees were ultimately
paid and warranties, and the warrants at least in the case of
Chrysler resulted in profits.
Ms. Kaptur. Thank you, Mr. Chairman. One of the
characteristics of the three that you mentioned is they all had
tangible hard assets. What we are dealing with here is phony
money.
Chairman Spratt. That is a very good point.
Ms. Kaptur. That discussion is one I would love to have in
more depth, and I have the highest respect for you. Thank you.
Chairman Spratt. If we stop now and hustle to the floor, we
may still make the vote.
Mr. Boyd. I have one quick question. Did I understand you
to say you were advocating for a reverse auction process if we
go through this?
Mr. Orszag. I don't advocate for anything. But if you want
to obtain a fair price for what you are buying, limiting things
to reverse auctions on a given cash flow that is distributed
across many potential owners accomplishes that objective. Other
asset classes and other ways of doing it doesn't.
Chairman Spratt. Dr. Orszag, as always, thank you very
much. In particular in this case, your testimony was excellent
help to the committee. We very much appreciate it.
[Whereupon, at 12:12 p.m., the committee was adjourned.]