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




 
                           SYSTEMIC RISK AND
                         THE FINANCIAL MARKETS

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

                                HEARING

                               BEFORE THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             SECOND SESSION

                               __________

                             JULY 24, 2008

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 110-130


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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                 BARNEY FRANK, Massachusetts, Chairman

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

        Jeanne M. Roslanowick, Staff Director and Chief Counsel


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    July 24, 2008................................................     1
Appendix:
    July 24, 2008................................................    45

                               WITNESSES
                        Thursday, July 24, 2008

Cox, Hon. Christopher, Chairman, U.S. Securities and Exchange 
  Commission.....................................................     6
Geithner, Timothy F., President and Chief Executive Officer, 
  Federal Reserve Bank of New York...............................     9

                                APPENDIX

Prepared statements:
    Cox, Hon. Christopher........................................    46
    Geithner, Timothy F..........................................    55


                           SYSTEMIC RISK AND
                         THE FINANCIAL MARKETS

                              ----------                              


                        Thursday, July 24, 2008

             U.S. House of Representatives,
                   Committee on Financial Services,
                                                   Washington, D.C.
    The committee met, pursuant to notice, at 10:06 a.m., in 
room 2128, Rayburn House Office Building, Hon. Barney Frank 
[chairman of the committee] presiding.
    Members present: Representatives Frank, Kanjorski, Waters, 
Maloney, Watt, Ackerman, Moore of Kansas, Capuano, Lynch, 
Miller of North Carolina, Scott, Green, Cleaver, Hodes, Klein, 
Wilson, Perlmutter, Murphy, Speier, Childers; Bachus, Royce, 
Manzullo, Jones, Biggert, Feeney, Hensarling, Garrett, 
Neugebauer, McHenry, Campbell, Putnam, Marchant, and Heller.
    The Chairman. The hearing will come to order.
    This is the second hearing we have had in a series that may 
continue in the fall and will certainly lead to action next 
year.
    What we are dealing with here is the action that we ought 
to be taking as a Congress and as a government to the events 
that manifested themselves in the reaction of the Department of 
the Treasury and the Federal Reserve to Bear Stearns. We are 
not here specifically to look at that, although that is 
obviously one of the subjects, given the centrality of the role 
of the New York Federal Reserve. It is a subject that was 
discussed before. But what we want to do is to look at that in 
the context of what do we do going forward?
    There is, I think, an increasing consensus that some 
extension of regulation is called for with regard to currently 
lightly-regulated aspects, lightly-regulated financial 
institutions. I say ``lightly regulated'' because we have 
represented here, our former colleague, the Chairman of the 
Securities and Exchange Commission. That institution has some 
responsibility, but I think it ought to be clear that Congress 
has never given the SEC the kind of full statutory mandate over 
systemic stability. They have a focus on investor protection 
and on keeping the markets functioning, and I don't think there 
was any basis for any criticism of the SEC's performance. Some, 
frankly, of what I have seen is based on a misunderstanding of 
their mandate. And the fact is that they have, I think, acted 
within their mandate. It is up to the Congress and the 
Executive Branch working together to decide whether that 
mandate should be expanded. And that is what we are talking 
about.
    We are talking about the extent to which regulatory 
authority over the activities of investment banks and others, 
particularly since they may now be asking for access to various 
instruments in the Federal Reserve, to what extent should we 
deal with this? I think we have shown an ability as an economy 
and as a government to deal on an ad hoc basis with crises.
    It is important, however, that we do two things: First of 
all, examine what further instruments the regulators ought to 
have in dealing with the crisis; and even more important to 
me--because I do believe we can cobble together things in the 
short term, but that is not a very satisfactory long-term 
answer--what new regulatory approaches should we be taking to 
make the crises less likely? To what extent should we be giving 
some Federal entities in the regulatory field new powers over 
institutions that are not now heavily regulated, particularly 
from the standpoint of avoiding systemic risk?
    Then the related question is, there are different functions 
here. This is investor protection. And I know that the 
gentleman from Pennsylvania and I were just telling the 
Chairman of the SEC privately, but we both will say it 
publicly, that we are very pleased with the action he has taken 
regarding short selling, and we think that has been very 
helpful from the standpoint of protecting the integrity of the 
market.
    But there is a question as to what extent actions that are 
taken to protect the integrity of the market in the individual 
instance and the investor do or don't conflict from time to 
time with questions of systemic stability? It is, in fact, we 
don't want to take individual enforcement actions that, in a 
particular context--well, we may want to take them, but it is 
conceivable that individual enforcement actions, particularly 
against a number of institutions, could have some systemic 
impacts. How do we evaluate that?
    That also leads to the question of what is the 
institutional arrangement? I congratulate the Federal Reserve 
and the Securities and Exchange Commission for the memorandum 
of understanding they signed. That was a very good example of 
how we get cooperation. And the memorandum of understanding was 
useful. It does open the question that is, should there be some 
statutorization of that memorandum of understanding? Are there 
areas that should be approached in defining the relationship of 
these two important entities that could not be reached without 
some further legislation? How do we structure it?
    This is a noncrisis hearing. It is the second in our 
efforts to ask the responsible regulators here what their 
recommendations are to us for going forward. And of course, the 
goal I think we all share is very simple. We want to continue 
to reap the benefits of financial innovation, including 
securitization and the other creative ways of financial 
institutions serving the economy, while diminishing the risks. 
And you never hit 100 percent optimality there. But I do 
believe that there is room for us to take some action that will 
diminish risks without unduly impinging on the benefits we get 
from these operations. That is the purpose of this hearing.
    Let me say, under the rules, having the Department heads 
here, particularly the head of the SEC, we will just have the 
four opening statements, the two Chairs and the two ranking 
members.
    So the gentleman from Alabama is recognized for 5 minutes.
    Mr. Bachus. I thank the chairman for holding this second 
hearing on systemic risk.
    And I welcome our two witnesses to the hearing. Chairman 
Cox and President of the New York Fed Geithner, you have 
actually been at the center of the government's response to 
recent turmoil in the financial markets. And I commend you both 
on the job you are doing. You are both very capable public 
servants, and I think the country is fortunate to have your 
expertise. We look forward to your perspectives as we go 
forward.
    Nothing I say today should be taken as a criticism of 
anything you have done, particularly in the Bear Stearns 
matter, because I realize that sometimes decisions are made, 
and we don't know at the time whether they are the best, but we 
do the best we can.
    I think we were faced with that yesterday on the Floor. We 
had a difference of opinion. But we make a decision, and then 
we all come together and hope that decision is right when it is 
collectively made.
    I would say this to Chairman Frank, before we begin a 
serious discussion of greater government involvement in our 
capital markets, we need to have a clearer understanding of 
exactly where we are and how we got to where we are. I know the 
chairman has also said that. We need to know how we arrived at 
a system in which the issuers of credit default swaps are 
allowed to provide guarantees that far exceed their capital 
reserves and that there is virtually no possibility that they 
can pay in the defaults of the underlying obligations, commit 
themselves to obligations that they cannot possibly cover in 
worst-case scenarios.
    We need a better understanding of why our regulations allow 
credit default swaps to remain essentially under-regulated when 
they have such a profound effect and are so intertwined with 
our larger financial markets and even our economy.
    And in light of the Bear Stearns episode, and I think we 
all learned from that, we need to know whether the SEC's 
current approach to the supervision of investment banks and 
their holding companies is sufficient to prevent further 
meltdowns in that sector of our financial services industry. Or 
even, you know, we need to ask ourselves, can regulators really 
prevent such meltdowns? What are our obligations? Sometimes, it 
may be to stand back and allow companies to fail.
    In this vein, and perhaps most critical of all, we need to 
know how we ended up with a financial system in which almost 
every primary dealer, at least on the surface, appears almost 
too big or too interconnected to fail or whether we have 
arrived at that point. If we accept that premise, that every 
primary dealer is too big to fail, then we also have to 
conclude that our financial markets are no longer capable of 
self-regulation and that government must exercise greater 
control, both as a regulator and as a lender, if not a buyer of 
last resort.
    As I indicated at our first hearing 2 weeks ago, that is a 
conclusion I am not prepared to accept.
    I think a far better approach is one that restores market 
discipline and discourages moral hazard. Does the Bear Stearns 
rescue and recent proposals to invest taxpayer dollars in the 
debt in equity of Fannie Mae and Freddie Mac, does that send a 
different signal to the market, that taxpayers can be counted 
on, ultimately, to indemnify risk-taking that reaches levels 
sufficient to place the entire financial system in jeopardy? 
What we ultimately need is to ensure that our regulators 
maintain a framework in which individual firms can fail while 
the system continues to function. I think it has been referred 
to as an orderly liquidation.
    We know that sudden failures like Bear Stearns, if they are 
not orderly, can definitely have systemic risk. And I think we 
all appreciate that.
    We need to ensure that our firms strike the right balance 
between risk and leverage. Capital and credit must continue to 
flow where they are most needed, but our financial institutions 
should not be taking outsized risks that require repeated 
government interventions to save the system from recurring 
crisis.
    Chairman Cox, you have taken significant steps to protect 
the integrity of our capital markets during these turbulent 
times. I think your efforts have been underappreciated.
    One of your most important initiatives has been to help 
make sure investors have access to accurate and reliable 
information. In this regard, your credit rating agency reforms, 
your firm stance against the spreading of false information, 
and your emergency order to curb abusive short-selling 
practices in the securities of 17 primary dealers and Fannie 
and Freddie were welcomed developments. And we have seen now 
that they have had a positive effect.
    On July 15th, the SEC also noted that it will undertake a 
rulemaking to address these issues across the entire market. I 
look forward to working with the Commission to ensure that a 
rulemaking recognizes the legitimate role of short selling and 
does not eliminate liquidity from the capital markets.
    I think we all appreciate that short selling is a valid, 
valuable process. It serves a useful purpose. What isn't and 
what is presently prohibited is the spreading of false 
information to drive down the price of these stocks by some 
short sellers, not most, and that, you know, puts and calls, 
all those, are a valuable part of our market and indicate a 
sophisticated financial system.
    Mr. Chairman, I want to conclude by thanking you for 
holding this hearing.
    And my thanks to Chairman Cox and Mr. Geithner for being 
with us today. We look forward to your testimony.
    The Chairman. The gentleman from Pennsylvania, the Chair of 
the Subcommittee on Capital Markets, is recognized.
    Mr. Kanjorski. Thank you very much, Mr. Chairman.
    Today we continue our review of a systemic risk in 
financial markets. Although we passed the housing reform 
package yesterday, tremendous economic anxiety and uncertainty 
remain. Finding an effective regulatory regime to keep pace 
with increasingly complex financial products and markets 
remains our goal.
    Striking an appropriate balance to enhance protection 
against systemic risk is also a difficult task. For just as the 
markets continually change and evolve, so must regulation. The 
explosive growth of complex financial instruments is well-
documented. Credit default swaps and collateralized debt 
obligations are just two examples of comparatively new exotic 
products flooding our markets.
    Warren Buffett famously labeled credit derivatives as 
``financial weapons of mass destruction.'' Some may view his 
characterization as extreme. But allowing these risky creations 
to thrive in a thinly regulated or unregulated market is a 
recipe for disaster. So, in order to better understand these 
instruments, I sent 2 days ago a request to the Government 
Accountability Office that it begin a study on structured 
financial products. This study will examine the nature of these 
instruments and the degree of transparency and market 
regulation surrounding them. From this study, we should obtain 
a clearer picture of how to improve regulation in the sector of 
our financial system.
    Another area of regulation we should consider is the 
consolidation of regulation of our securities and commodities 
markets. The Treasury's recommendation to merge the Securities 
Exchange Commission and the Commodity Futures Trading 
Commission is something that ought to be discussed today. Such 
a merger illustrates the kind of streamlined regulatory system 
to which we should aspire.
    Additionally, last week's emergency order on naked short 
selling has received much attention. This committee is due an 
explanation as to the reason for the order, the effect to date 
on the market, its possible extension, and whether it will be 
expanded to broader market segments. I dare say it is something 
that the Commission should be commended for. I have seen the 
results and they seem to be quite clear that they aid the free 
flow of the market.
    Even to those of us who view short selling as a necessary 
provider of liquidity and market efficiency, naked short 
selling is worthy of closer scrutiny. People enter into trades 
with the expectation to complete them.
    In closing, both the Commission and the New York Federal 
Reserve have played crucial roles throughout the current 
financial crisis. I very much appreciate Chairman Cox and Mr. 
Geithner being here today, and I look forward to their 
testimony.
    The Chairman. On instruction from the gentleman from 
Alabama, I now recognize the gentleman from California, Mr. 
Royce, for 1 minute.
    Mr. Royce. Thank you, Mr. Chairman.
    I would like to thank you for your continued attention on 
this issue. I think it is important to be fully vetted.
    I would also just like to briefly welcome my good friend 
and our former colleague here, Chairman Cox.
    And just to say, Chairman Cox, while your leadership and 
insight while you were a Member here are missed, we do 
appreciate your hard work at the Commission, especially on 
behalf of investors and the securities industry during these 
rather difficult and challenging times with our capital 
markets.
    And so, welcome back.
    The Chairman. In the interest of bipartisanship, we will 
start Mr. Royce's minute now. We won't charge him for being 
nice. That is not necessarily a precedent around here, but we 
will do it today.
    So, Mr. Royce.
    Mr. Royce. I will yield back, Mr. Chairman.
    The Chairman. Then we have 2 minutes for the gentleman from 
Texas, Mr. Hensarling.
    Mr. Hensarling. Thank you, Mr. Chairman.
    I find it somewhat ironic that we would be holding this 
hearing 24 hours after we gave the Secretary of Treasury a 
blank check to help bail out Fannie and Freddie. It seems that 
we took a huge step in the wrong direction with respect to 
systemic risk.
    Moral hazard leads to more systemic risk. And I fear 
yesterday a very strong message was sent to every investment 
bank in America that if you are large enough, if you get 
interconnected, if you get well-connected in the halls of 
Congress, you can indeed figure out a way to privatize your 
profits and socialize your losses.
    And just in case somebody missed the message, we are having 
a serious discussion now about giving the Federal Reserve 
increased responsibility and ultimate authority for financial 
stability in our markets. This may be a good thing. It may be a 
bad thing. But it is also a very risky thing. And I fear that 
the markets will interpret this as meaning, again, that 
potential Fed backing is around the corner if investment banks 
get in trouble.
    I fear that, as we continue to lose market discipline, we 
substantially increase the chances of having yet another Fannie 
and Freddie debacle, perhaps another S & L debacle.
    I am very concerned also about where we find the role of 
the Federal Reserve today in all the different directions they 
are pulled, starting with price stability and monetary policy, 
minimizing unemployment. On top of that, we add a healthy dose 
of consumer protection. Now we are about to add potential 
financial stability, and oh, I at least heard the chairman say 
once that he cared about taxpayer protection as well. That is 
pulling the Fed in a lot of different directions.
    I do know that some believe that the ultimate answer is 
more regulation. I certainly believe we could have better 
regulation. We may need smarter regulation. I don't know if we 
necessarily need more regulation. And I do know that an overly 
restrictive regulatory regime will kill innovation and chase 
our capital overseas, something I do not want to see.
    With that, Mr. Chairman, I thank you, and I yield back the 
balance of my time.
    The Chairman. I thank the gentleman.
    We will now proceed with the statements. And we will begin 
with the Chairman of the Securities and Exchange Commission, 
our former colleague.

  STATEMENT OF THE HONORABLE CHRISTOPHER COX, CHAIRMAN, U.S. 
               SECURITIES AND EXCHANGE COMMISSION

    Mr. Cox. Thank you very much, Chairman Frank, Ranking 
Member Bachus, and members of the committee.
    It is a pleasure to appear on this panel with my regulatory 
colleague, Tim Geithner. Under his leadership at the New York 
Fed, the SEC and the New York Fed have established a very 
strong and positive working relationship.
    I want to thank this committee for inviting me to testify 
on behalf of the SEC about reform of the U.S. financial 
regulatory system.
    There is no question, as several of you have just pointed 
out, that the financial regulatory structure that was forged in 
the Great Depression has served this Nation well over the 
intervening 8 decades. Even today in the midst of current 
strains on the financial sector, the U.S. capital market is 
larger, deeper, and more liquid than any other market in the 
world. In large measure, that is due to the world-class 
protections that investors enjoy in the United States, and 
those are protections that we should secure.
    In the decade since our regulatory agencies were chartered, 
the capital markets and the broader economy have undergone 
profound changes. The regulatory system in the main has adapted 
well to some of these changes, but other changes have presented 
new challenges that are rightly the subject of this committee's 
review as you consider legislative solutions.
    I hasten to add that, given the many strengths of the 
current regulatory system, we don't need to start from scratch. 
Instead, we can build on what we know has worked. At the same 
time, we can take lessons from what has not worked and 
modernize, rather than replace, the current system.
    One thing that has worked exceptionally well is the 
regulatory concept of an agency chartered to protect investors, 
to maintain fair, orderly markets, and to promote capital 
formation. If the SEC didn't already exist, Congress would have 
to invent it.
    Each of the elements of the SEC's mission is mutually 
reinforcing of the others. The Commission's work to protect 
investors through our enforcement program has been greatly 
benefited by the expertise of the SEC staff who specialize in 
the regulation and supervision of broker dealers and investment 
advisors. The Commission's regulatory program, including our 
commitment to ensuring full disclosure of information about 
public companies, has been informed by the experience, in turn, 
of the enforcement and examination staffs.
    But I hasten to add that, given these many strengths, there 
are many problems as well in the current system. Today when 
derivatives compete with securities and futures, and insurance 
products are sold for their investment features, it is no 
longer true that we can stovepipe regulation.
    As we approach the end of the first decade of the 21st 
Century, the growing gaps and crevices in our regulatory system 
are beginning to show. We all know that the current market 
crisis began with the deterioration of mortgage origination 
standards. As a result, it could have been contained to banking 
and real estate if only our markets weren't so interconnected.
    But in today's world, these problems quickly spread 
throughout the capital markets through securitization, and at 
the same time, the explosive growth of the over-the-counter 
derivatives markets have drawn the world's major financial 
institutions into a tangled web of deeper interconnections. 
This has led to the realization that when a major commercial or 
investment bank is threatened, so, too, may be the entire 
marketplace. And it has cast a spotlight on the significant 
regulatory gap that currently exists when it comes to the 
regulation of investment banks.
    When this committee devised the Gramm-Leach-Bliley Act in 
1999, you--or perhaps I should say ``I'' because, along with 
many of you, I served on the conference committee that wrote 
the legislation--decided that the SEC would serve as the 
functional regulator with responsibility over broker dealers, 
investment advisors, and mutual funds. And we decided that the 
Federal banking regulators similarly would be functional 
regulators for banking activities. Under this approach, the 
securities-related activities would be regulated by the SEC, 
which would also continue to be responsible for regulating 
broker dealers that are the central entities in investment 
banks. The Fed would be given consolidated oversight of holding 
companies that contain broker dealers and also most types of 
insured depository institutions. And finally, the SEC would 
retain the authority to regulate that net capital of broker 
dealers within the financial holding companies.
    But no explicit arrangement was established for the regular 
sharing of information between the Fed and the SEC in order to 
take into account the need to view capital and liquidity on an 
entity-wide basis. And that is what the memorandum of 
understanding between the Federal Reserve Board and the SEC is 
accomplishing today.
    Likewise, neither the Commission nor the Fed was authorized 
to exercise mandatory consolidated supervision over investment 
bank holding companies. As a result, today there is simply no 
provision in law that requires investment bank holding 
companies to compute capital measures and maintain liquidity on 
a consolidated basis.
    In 2004, the Commission adopted our voluntary program, 
called the Consolidated Supervised Entities Program, to fill 
this regulatory gap. But now, recent events have highlighted 
the need for legislative improvements as well. We need to fill 
the Gramm-Leach-Bliley regulatory gap by amending the existing 
statutory authorization for voluntary SEC supervision of 
investment bank holding companies to make it mandatory for all 
firms that today are regulated as CSEs.
    The Commission should be given a statutory mandate to 
perform this function at the holding company level along with 
the authority to require compliance. In addition, legislation 
should prescribe explicitly how the resolution of financial 
difficulties at investment bank holding companies will be 
organized and funded. Any regulatory reform that you undertake 
should recognize the very fundamental business, accounting, and 
regulatory differences between investment banks and commercial 
banks. Rather than extend the current approach of commercial 
bank regulation to investment banks, I believe Congress and 
regulators must recognize that different regulatory structures 
are needed for oversight of these industries and, in 
particular, that investment banks should not be treated like 
commercial banks by providing them with permanent access to 
government-provided backstopped liquidity. The added regulation 
that this would necessitate, following the commercial bank 
model, would fundamentally alter the role that investment banks 
play in the economy.
    In addition, as you weigh other possible reforms, there are 
five points that should be carefully considered:
    First, were the Congress to consider addressing the 
potential for future Bear Stearns-like rescues in statute, any 
such authority should be reserved for exceptionally rare cases.
    Second, the securities and bankruptcy laws currently 
provide an explicit statutory framework for liquidating a 
failed securities brokerage firm and for protecting customer 
cash and securities. This framework generally works as well, 
even in instances of fraud. I would not recommend changing the 
system.
    Third, for banks and thrifts, the FDIC has long served as 
the receiver for failed banks. The FDIC Improvement Act, 
FDICIA, mandates a least-cost resolution analysis and imposes 
intentionally onerous restrictions on a bank's ability to 
receive lender-of-last-resort funding. This is a useful model 
for resolving investment banks as well.
    Fourth, FDICIA prescribes a detailed process involving 
super-majority approvals by the interested regulators and 
formal approval of the Secretary of the Treasury after 
consultation with the President. It also requires detailed 
findings of serious adverse effects on economic conditions or 
financial stability and a finding that the proposed action 
would mitigate any adverse effects. These, too, are important 
constraints.
    Fifth and finally, OTC derivatives receive special 
treatment in bankruptcy proceedings. In particular, in the 
event of insolvency, counterparties can immediately terminate 
their contracts and seize any collateral related to OTC 
derivatives. As a result, today, unwinding a significant 
portfolio in bankruptcy can threaten market disruptions and 
raise systemic issues. To remedy this problem, the SEC should 
be given explicit authority to control the liquidation of 
investment bank holding companies or their unregulated 
affiliates that generally hold most of the derivative 
positions.
    Mr. Chairman, I hope that these observations from the SEC 
will be of assistance to you and to the committee as you 
consider the broad questions of whether and, if so, how to 
reform the existing Federal regulatory system for financial 
services.
    Thank you, again, for this opportunity to discuss these 
important issues. I look forward to taking your questions.
    [The prepared statement of Chairman Cox can be found on 
page 46 of the appendix.]
    The Chairman. Thank you, Mr. Chairman.
    You really did engage exactly what we were hoping to 
engage.
    And now, Mr. Geithner.

STATEMENT OF TIMOTHY F. GEITHNER, PRESIDENT AND CHIEF EXECUTIVE 
           OFFICER, FEDERAL RESERVE BANK OF NEW YORK

    Mr. Geithner. Thank you, Mr. Chairman, Ranking Member 
Bachus, and other members of the committee. I appreciate the 
opportunity to be here with you today.
    We are dealing with some very consequential issues, and I 
think as a country we are going to face some very important 
questions going forward.
    I am particularly pleased to be here with Chairman Cox from 
the SEC. We are working very, very closely together in 
navigating through the present challenges. And I want to 
express appreciation for his support and cooperation.
    The U.S. and the global financial systems are going through 
a very challenging period of adjustment, an exceptionally 
challenging period of adjustment. And this process is going to 
take some time. A lot of adjustment has already happened, but 
this process will necessarily take time. And the critical 
imperative of the policymakers today is to help ease that 
process of adjustment and cushion its impact on the broader 
economy, first stability and repair and then reform.
    Looking forward though, the United States will look to 
undertake substantial reforms to our financial system. There 
was a strong case for reform before this crisis. Our system was 
designed in a different era for a different set of challenges. 
But the case for reform, of course, is stronger today. Reform 
is important, of course, because a strong and resilient 
financial system is integral to the economic performance of any 
economy.
    My written testimony outlines some of the changes to the 
financial system that motivate the case for reform. These 
changes include, of course, a dramatic decline in the share of 
financial assets held by traditional banks; a corresponding 
increase in the share of financial assets held by nonbank 
financial institutions, funds, and complex financial 
structures; a gradual blurring of the line between banks and 
nonbanks, as well as between institutions and markets; 
extensive rapid innovation in derivatives that have made it 
easier to trade and hedge credit risk; and a dramatic growth in 
the extension of credit, particularly for less creditworthy 
borrowers.
    As a consequence of these changes and other changes to our 
financial system, a larger share of financial assets ended up 
in institutions and vehicles with substantial leverage, and in 
many cases, these assets were financed with short-term 
obligations. And just as banks are vulnerable to a sudden 
withdrawal of deposits, these nonbanks and funding vehicles are 
vulnerable to an erosion in market liquidity when confidence 
deteriorates.
    The large share of financial assets held in institutions 
without direct access to the Fed's traditional lending 
facilities complicated our ability as a central bank, the 
ability of our traditional policy instruments to help contain 
the damage to the financial system and their broader economy 
presented by this crisis.
    I want to outline a core set of principles, objectives that 
I believe should guide reform. I offer these from my 
perspective at the Federal Reserve Bank of New York. The 
critical imperative is to build a system that is a financial--
that is more robust to shocks.
    This is not the only challenge facing reform. We face a 
broad set of changes in how to better protect consumers, how 
the mortgage market should evolve, the appropriate role of the 
GSEs and others, and how to think about market integrity and 
investor protection going forward.
    I want to focus on the systemic dimensions of reform and 
regulatory restructure. First on capital, the shock absorbers 
for financial institutions, the critical shock absorbers are 
about capital and reserves, about margin and collateral, about 
liquidity resources, and about the broad risk management and 
control regime. We need to ensure that, in periods of 
expansion, in periods of relative stability, financial 
institutions and the centralized infrastructure of the system 
hold adequate resources against the losses and liquidity 
pressures that can emerge in economic downturns. This is 
important both in the institutions and the infrastructure.
    And the best way I think that we know how to limit pro-
cyclicality and severity of financial crises is to try to 
ensure that those cushions are designed in a way that provides 
adequate protection against extreme events.
    A few points on regulatory simplification and 
consolidation. It is very important, I believe, that central 
banks and supervisors and market regulators together move to 
adopt a more integrated approach to the design and enforcement 
of these capital standards and other prudential regulations 
that are critical to financial stability. We need a more 
consistent set of rules, more consistently applied, that 
substantially reduce the opportunities for arbitrage that exist 
in our current very segmented, fragmented system.
    Reducing moral hazard is critical. As we change the 
framework of regulation oversight, we need to do so in a way 
that strengthens market discipline over financial institutions 
and limits the moral hazard risk that is present in any 
regulated financial system. The liquidity tools of central 
banks and, to some extent, the emergency powers of other public 
authorities were created in the recognition of the fact of the 
basic reality that individual financial institutions cannot 
protect themselves fully from an abrupt evaporation in market 
liquidity or the ability to liquify their assets.
    Now the moral hazard that is associated with these lender-
of-last-resort tools needs to be mitigated by strong 
supervisory authority over the consolidated financial entities 
that are critical to the financial system.
    On crisis management, the Congress gave the Federal Reserve 
very substantial tools, very substantial powers to mitigate the 
risk to the economy in any financial crisis. But I think, going 
forward, there are things we could put in place that would help 
strengthen the capacity of governments to respond to crises. As 
Secretary Paulson, Chairman Bernanke, and Chairman Cox have all 
recognized, we need a companion framework to what exists now in 
FDICIA for facilitating the orderly liquidation of financial 
institutions where failure may pose risks to the stability of 
the financial system or where the disorderly unwinding or the 
abrupt risk of default of an institution may pose risk to the 
stability of the financial system.
    Finally, we need a clearer structure of responsibility and 
authority over the payment systems. These payment systems, 
settlement systems, play a very important role in financial 
stability. And our current system is overseen by a patchwork of 
authorities with responsibilities diffused across several 
different agencies with significant gaps.
    It is very important to underscore that, as we move to 
adapt the U.S. framework, we have to work to bring a consensus 
among the major economies about complementary changes in the 
global framework.
    Moving forward will require a very complicated set of 
policy choices, including determining what level of 
conservatism should be built into future prudential regulations 
and capital requirements; what institutions should be subject 
to that framework of constraints or protections; which 
institutions should have access to central bank liquidity under 
what conditions; and many other questions.
    A few points, finally, about how to think about the role of 
the Federal Reserve in promoting financial stability.
    First, the Federal Reserve has a very important role today, 
working in cooperation with bank supervisors and the SEC in 
establishing the capital and other prudential safeguards that 
are applied on a consolidated basis to institutions that are 
critical to the proper functioning of markets.
    Second, the Federal Reserve, as the financial system's 
lender of last resort, should play an important role in the 
consolidated supervision of those institutions that have access 
to central bank liquidity and play a critical role in market 
functioning. The judgments we are required to make about 
liquidity and solvency of institutions in the system requires 
the knowledge that can only come from a direct, established, 
ongoing role in prudential supervision.
    Third, the Federal Reserve should be granted clear 
authority over systemically important payments or settlement 
systems.
    Fourth, the Federal Reserve Board should have an important 
consultative role in judgment about official intervention in 
crises where there is potential for systemic risk as is 
currently the case for bank resolutions under FDICIA.
    And finally, the Federal Reserve's approach to supervision 
and to market oversight will need to look beyond the stability 
just of individual banks to market developments more broadly, 
to the infrastructure that is critical to market functioning, 
and the role played by other leveraged financial institutions.
    I want to emphasize in conclusion that we are working very 
actively now today in close cooperation with the SEC and other 
bank supervisors and with our international counterparts to put 
in place steps now that offer the prospect of improving the 
capacity of the financial system to withstand stress. We are 
doing this in the derivative markets. We are doing it in secure 
funding markets, and we are doing it with respect to the 
centralized infrastructure.
    I very much look forward to working with you and your 
colleagues as we move ahead in working to build a more 
effective financial regulatory framework in this country.
    Thank you very much.
    [The prepared statement of Mr. Geithner can be found on 
page 55 of the appendix.]
    The Chairman. Thank you, Mr. Geithner, and also for 
directly addressing our--there are a couple of empty chairs 
here. We have two very well-prepared witnesses, so their 
revenues are smaller. They didn't need quite as many helpers, 
so there are a couple of empty chairs over there. People should 
fill themselves in. And there are some staff chairs; people 
shouldn't have to stand if there are chairs.
    I am going to hold off on my questions for a while. I want 
to give members a chance. So I am going to begin the 
questioning with the chairman of the Capital Markets 
Subcommittee, not the Financial Institutions Subcommittee. I 
incorrectly designated the committee.
    The gentleman from Pennsylvania.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Mr. Geithner, I am trying to discern the bottom line of 
just how thorough a reform you are talking about, or 
reorganization, of our regulatory system. It sounds to me that 
you are going down to the rudimentary rules and approach it 
perhaps even from a whole new philosophical view. Is that 
correct? Or am I overreacting to what you are saying?
    Mr. Geithner. I think you have to look at everything.
    You have to be prepared to look at everything. Our system 
has many strengths. But I think the challenges we have seen in 
this crisis justify a very broad-based fundamental look.
    Mr. Kanjorski. I agree with that proposition, and I think 
it would take a number of Congresses to succeed along those 
lines. We are particularly acutely aware of the international 
accounting standards that are going to come into play about 
2012. And it seems to me we ought to coordinate our regulatory 
reform in this country to be consistent with that.
    But then I anticipate a problem that prior to this 
immediate credit crisis that we ran into, the situation that 
people will argue that we ought to prevent the race to the 
bottom in reform shopping. And I see that as if we--you know, 
we could write great regulatory reform here and have all our 
companies go to Bermuda, if you will. So how do we prevent the 
two? And how do we get adequate and good responsible reform 
and, on the other hand, don't run into the escape psychology of 
companies that can do better in another jurisdiction?
    Mr. Geithner. I think you are absolutely right. As we think 
about what makes sense for us, we have to figure out ways to 
get the world to move with us. And I don't believe it is 
possible, given how integrated our markets are, for us moving 
alone to adequately address the challenges we face here. So a 
critical part of everything we do will be to try to improve the 
odds that we get a more resilient system in place in the United 
States and get the primary supervisors of other major global 
financial institutions and the other major financial centers to 
move with us. And we have a very active cooperative effort now 
underway, including with Chairman Cox and his colleagues today. 
I believe we have a reasonable prospect, if we identify 
sensible things here, of bringing the major financial centers 
along with us.
    Mr. Kanjorski. Do you perhaps suggest that we could use an 
international conference or a summit with all the leading 
industrial nations of the world to establish international 
standards of regulations?
    Mr. Geithner. Well, our predecessors built a very elaborate 
network of consultative bodies, the Basel Committee on Banking 
Supervision. I chaired something called the Committee on 
Payments and Settlement Systems. There is a group called the 
Financial Stability Forum, established in the late 1990's, that 
brings together central banks, market supervisors, market 
regulators, and supervisors. I believe that framework provides 
a lot of opportunity for us to build consensus.
    But I just want to underscore your point. I think you are 
exactly right that we can't achieve what we need in this 
country that is in the interest of the United States without 
achieving progress outside of the United States, at least in 
the major financial centers.
    Mr. Kanjorski. I guess--and just before I lose my time 
here--Chairman Cox, how can we get the CFTC and your 
organization merged so that we do not have this conflict? Or is 
that a hope that defies political solution?
    Mr. Cox. Well, obviously, the answer is through 
legislation. Short of that, and we are far short of that, what 
the SEC and the CFTC have undertaken under our existing 
regulatory authorities--and we administer statutory regimes 
that in some respects are significantly different--is to 
execute a memorandum of understanding so that we work together 
as closely as possible.
    In some respects, I have observed over a period of many 
years, including when I first worked in the Executive Branch in 
the 1980's, that the SEC and the CFTC can be, for turf reasons, 
natural enemies. The chairs of the CFTC with whom I have worked 
have very much wished that this was not the case. And we have 
worked, I think, in the best interests of investors in the 
marketplace to make sure that, for example, new product 
approvals are done in a consultative way, not serially by the 
CFTC and by the SEC. This kind of deepened personal and 
organizational cooperation and collaboration between regulators 
is something that I think works very well. It typifies what we 
are doing with the Fed.
    We have also had a great deal of experience in the last few 
years doing this with international regulators, I should say, 
with foreign regulators as well in the international context. 
That was necessitated by such market occurrences as the NYSE 
Euronext merger and by the NASDAQ OMX combination. We are 
working with regulators in those countries of necessity, and we 
have deepened our collaboration also on the enforcement front.
    So, in all of these ways, I think that, starting with the 
SEC and the CFTC, the question you put about collaboration 
among regulators, generally we can do a lot even if it is 
difficult to rationalize the whole thing with an entirely new 
statutory regime.
    Mr. Kanjorski. Let me ask you, on our committee right now, 
we are working on consideration providing legislation to have 
an optional Federal charter insurance. And of course, we were 
considerably along that line when the credit crisis occurred. I 
would like your honest opinion, both of you, actually, is this 
something that should be delayed on our part because of this 
tendency to confuse and complicate the existing crisis? Or is 
it something we should move forward with? Is it a tool that 
could be utilized to standardize regulatory reform within the 
system?
    Mr. Cox. Well, I think I will defer, only in part, to Tim 
on the subject of the across-the-board economic-wide systemic 
issues that you inquire about.
    I will say, on the merits, I think it is a good idea. It is 
certainly important in any case for this committee to be 
considering it in a very serious way. There are obviously some 
significant issues to be worked out with the States. The 
background of State regulation in this area is rich with 
history, and people understand it. This is an optional charter 
that we are talking about. It is not unduly intrusive in that 
sense. But that kind of very close working relationship with 
the States as you consider this legislation, I think would 
serve the subject matter well.
    Mr. Geithner. On the question of whether you need to do it 
now, I think that, in general, across the set of issues, I 
think it is going to be hard to get the ideal balance and mix 
until we are through this crisis. And so I think most of the 
big questions need to be thought of in an overall context once 
we get to the other side of this downturn.
    But I think, right now, there needs to be a spirit, and I 
think there is, a spirit of pragmatism at the State level among 
those insurance supervisors so that if capital can come into 
the parts of the system now where capital is necessary, that is 
able to happen with the necessary speed.
    The Chairman. The gentleman from Alabama.
    Mr. Bachus. Thank you, Mr. Chairman.
    Mr. Chairman, before I ask questions of these two 
witnesses, I would like to make a statement that I think is 
very important.
    There is an article in the American Banker today where 
Ralph Nader talks about the Deposit Insurance Fund. I won't 
criticize anyone. But let me say this, during the height of the 
Savings and Loan debacle, there were 1,800 financial 
institutions on the trouble list, and 800 or 900 of them 
failed. People are comparing the financial services banking 
industry, that to now. And it is not a valid comparison.
    We only have 90 banks that are even on the troubled list. 
If we have a situation like Savings and Loan, as far as the 
number, then 40 percent of those may fail. And so you are 
talking 40 or 50 banks out of a large universe. Our banks are 
well capitalized. Our Deposit Insurance Fund is sound. There is 
absolutely no factual basis for saying that there is not money 
there to pay.
    There is a crisis in confidence. There are a lot of people 
saying things that may be panicking the general public. But 
factually, it is irresponsible to say that. And I wanted to say 
that because I think it is very important--we have talked about 
short sellers, people spreading mischief, and whether it is for 
sensationalism, to sell magazines, or to grab attention, it is 
just not true. And we as Americans ought to all be concerned 
about that, not to say things which cause people--
    The Chairman. Would the gentleman yield to me for just a 
second?
    Two questions that have to be kept separate. One, the 
question of how at the Federal level we would finance any need 
to respond.
    Two, are the insured deposits safe? The answer to two is, 
absolutely, completely, without question.
    We will be dealing with question number one as it comes up. 
But nobody ought to think that there is any linkage between 
those two questions. Insured deposits are 100 percent safe.
    Mr. Bachus. Thank you.
    I associate myself with those remarks. And I just hope the 
general public--I hope in our writing, we don't repeat rumors 
that are totally sensational without any basis.
    And I think the story that the American people need to hear 
is that our banking system is sound. It is well capitalized, 
and their deposit--I wouldn't say that. As a politician, the 
worst thing I could say is that there is a problem with the 
solvency of that. I would never want to say that if I didn't 
believe it 100 percent.
    Chairman Cox, in your June 19th editorial, you asked a 
question that I think this committee has to answer. And that 
is, should the extensive system of commercial banking 
supervision and regulation developed in large measure to 
counter the problem of moral hazard be extended to investment 
banks? And if so, who should be responsible?
    How would you answer your own question? And in doing so, 
are there characteristics that distinguish investment banks 
from commercial banks and argue for a different treatment, 
different regulatory treatment?
    Mr. Cox. I think that there are. And I think that the 
object of reform in this area should be to create the 
conditions in the marketplace that first give a lot of 
transparency to investors so they can see where the risk lies. 
We have had shortcomings that have been clearly identified in 
that respect of late. In addition, that can make it possible 
for interconnectedness, which can be a good thing, to be only a 
good thing and not also a bad thing with a dark side because we 
don't know where risk lies. So that when a firm is mismanaged, 
it can fail, as in a free enterprise economy it should, without 
threatening the entire financial system.
    We need to get to a better place in that respect than where 
we are. I think it is for that reason that the authorities, the 
emergency authorities, that regulators have exercised in these 
circumstances are temporary. But the object should be to let 
market discipline govern risk and investment in risk and not to 
have the Federal Government have to step in in each of these 
cases.
    Mr. Bachus. Thank you.
    And President Geithner, one of the particular, I guess, 
sources of systemic risk could be the credit default swaps. I 
know the credit default (CDS) market has grown over the past 
decade to more than $45 trillion, which is roughly twice the 
size of the stock market. And I know you have made efforts to 
create a central clearinghouse for these derivatives and to 
automate their trading and settlement. Those are welcomed 
initiatives.
    How have credit default swap issuers been able to provide 
guarantees that vastly exceed their capital reserves to the 
point where there is virtually no possibility that they can pay 
in the event of a default on the underlying obligations? And in 
answering that question, how can we contain that systemic risk 
posed by CDSs but at the same time preserve the beneficial uses 
of CDSs as a valuable risk-management tool for these firms, 
because they are a valuable financial instrument?
    Mr. Geithner. I completely agree. They do bring very 
important benefits to the financial system that we do want to 
retain, but they come with a lot of challenges.
    So I think the two really critical things are that the 
institutions, the dealers that are at the center of this 
market, carefully manage their exposures in this area relative 
to their capital. So the first most important thing is to make 
sure that these institutions--and this is largely a group of 12 
to 18 of the largest financial institutions of the world, 
banks, investment banks--carefully manage those exposures.
    The second thing, as you noted, is to try to make sure that 
the trade processing infrastructure that supports what is now a 
bilateral market is modernized to the point that it offers a 
level of automation, a reduction in operational risk, a 
capacity for dealing with defaults in the underlying, that is 
more appropriate to the centrality of these instruments and 
this market.
    You can't say another way, but that infrastructure 
substantially lagged development of that market. We are working 
very hard at trying to close that gap. And that requires not 
just moving the standardized part of this market onto a central 
clearinghouse and moving to greater automation but a range of 
other things that are critically important.
    You are going to see in the public domain in the next 
couple of weeks another set of clear objectives and targets and 
commitments from those dealers.
    Mr. Bachus. Thank you, Chairman Cox, and Mr. Geithner.
    I appreciate you both.
    The Chairman. I am now going to proceed. As I announced at 
the last hearing where we had Mr. Bernanke and Mr. Paulson, we 
are going to now go to the people who didn't get to ask 
questions there first, and then come back. The order, by the 
way, will be Mr. Ackerman, Mr. Scott, Mr. Perlmutter, and Mr. 
Wilson. And then we will get back to the regular order.
    So Mr. Ackerman will begin.
    Mr. Ackerman. Thank you. Thank you very much.
    I would like to know why, at a time when we see a lot of 
abusive and manipulative short selling, especially in an 
economic climate where people are very mistrustful and lack 
confidence, that we would not reinstate the uptick rule.
    Mr. Cox. The uptick rule--
    Mr. Ackerman. I have introduced legislation that would 
mandate that it be reinstated. It seemed to work very, very 
well when we had it for all of those years, and we seem to have 
all of these problems now.
    Mr. Cox. The uptick rule, as you know, went into effect in 
1938 when a tick was a tick. It meant something.
    We went to decimalization in relatively recent history, and 
a tick became a penny. There has never been an SEC action more 
carefully studied by economists both within and without the 
Agency. Indeed, in order to study this issue, which commenced 
under my predecessor, one third of the stocks on the Russell 
3000 Index were put into a pilot; half of them had a tick test, 
half of them didn't have a tick test, and the effects on a 
number of parameters, including volatility, were studied.
    What was discovered was that the tick test no longer had 
any effect. It wasn't effective in achieving its original 
purpose. The question that you raise, however, is a very good 
one; should there be a test that does work, should there be 
something that is meaningful? If it can't be a tick because a 
tick is now just a penny, and even when the stock is dropping 
like a stone it tends to drop with penny upticks along the way, 
is there a price test that could work with an increment of a 
nickel or dime or what have you? And the SEC is carefully 
studying this even now.
    Mr. Ackerman. Maybe a tick is just a tick, but I think we 
are suffering from Lyme disease right now. In the movie The 
Producers, and the play, which is very successful, the hustlers 
in that game would go out and sell 150 percent or 500 percent, 
1,000 percent of this play and try to make it bad enough that 
it would definitely lose so that they could make money when it 
lost.
    I think we are dealing with a market that is very, very 
rumor sensitive, especially in this day and age. And while 
betting on something going down is a legitimate game, I think 
that pounding it down and hammering it down is something that 
is disastrous, and a game that we should be protecting against, 
so that there is transparency and people understand what they 
are investing in; and at the same time, tie this in with the 
issue of naked short selling, where people can actually sell 
150 percent because they are not really borrowing the stock. If 
you combine that with the tick rule or the lack of such, I 
think we are heading for an absolute total disaster. I would 
like to know why the change in rules has basically given a 
cloak of protection and security to 19 firms instead of 
protecting all of the banking institutions on naked short 
selling. Who are we protecting if we are not protecting 
everybody?
    Mr. Cox. Well, there is a regulation recently put into 
effect and recently tightened even further called Regulation 
SHO that targets naked short selling. It applies across the 
entire market. And so the norm, that you need to borrow a stock 
or you need to have a contract to borrow that stock or you have 
to have a reasonable expectation that you can--
    Mr. Ackerman. But you have two different standards, one for 
19 companies and one for everybody else as to what the standard 
of showing is.
    Mr. Cox. The difference between Reg SHO, which applies 
across the market, and our emergency order is that one of the 
three prongs of the test has been removed, so that now you have 
to either borrow or have a contract to borrow. Having a 
reasonable expectation that you can do so is no longer 
sufficient. And the universe of entities to which this 
emergency order applies is precisely the universe that the 
Federal Reserve has drawn.
    Mr. Ackerman. And with the 19 to whom the full test 
applies, it seems to be very effective. If something is very 
effective, why not use that as a template and apply it to 
everybody, so that everybody has the same sense of confidence 
in the playing field?
    Mr. Cox. When the Commission issued its order, I made it 
very clear that is our intent; that we are going to propose a 
rulemaking that will put in operational protections for the 
entire market beyond even those in Reg SHO that presently 
exist.
    The Chairman. The gentleman from California, Mr. Royce.
    Mr. Royce. Thank you, Mr. Chairman.
    Chairman Cox, we had a previous hearing here in the 
committee on systemic risk, and we had the Chairman of the 
Federal Reserve here at that time and the Treasury Secretary. I 
mentioned a quote by former Chairman Alan Greenspan, and in 
that quote, Mr. Greenspan expressed his belief that private 
counterparty regulation or monitoring basically through market 
discipline generally has proved better at constraining 
excessive risk taking than has government regulation, in his 
view. I mention this quote again because as we look to 
potentially increase the regulatory authority of the Fed over 
investment banks and large broker dealers, I think it is 
critical that we preserve the rule of market discipline among 
these institutions. We have to keep an eye, I think, on what 
happens when we lose that market discipline.
    And I was going to ask you, Mr. Chairman, are you concerned 
that the potential increase in regulatory authority and overall 
regulation may in fact weaken the effectiveness of market 
discipline among these firms?
    Mr. Cox. Of course. I think the goal of our supervision of 
the firms and of any financial regulatory regime restructuring 
should be to eliminate the need for continued access to the 
Fed's liquidity facilities. No one more than the Federal 
Reserve appreciates the connection between the provision of 
government backstop liquidity on the one hand and moral hazard 
on the other. It gives rise in turn to the need then for more 
regulation and supervision. And ultimately, if one takes that 
to the logical extreme, the requirement would be for the 
government to have to supplant the wisdom of the entire market, 
and to do everything through regulation supervision clearly is 
not possible. So it is the wrong model. It is not what we 
should be building towards.
    These are exigencies, as Chairman Frank noted and others 
noted in your statements. We are doing a good job of dealing 
with problems as they come up. But this hearing is about 
restructuring the thing so that you don't have to do this. And 
our objective should be--whether or not mankind can be perfect 
in this respect is perhaps another question. But there is no 
question what we should be trying to build, and what we should 
be trying to build is something in which the Federal Government 
isn't in this business.
    Mr. Royce. It has been reported recently that many of the 
investment banks have scaled back their usage of the primary 
dealer credit facility that we established in March that was--
in fact I think the window has gone unused, the discount window 
has gone unused for the past 3 weeks by these institutions. 
What should we make of this pullback? If there isn't this 
borrowing going on now through the discount window, is this a 
reflection of the health now of these institutions? Or is this 
a statement to regulators and lawmakers that these investment 
banks are not prepared to trade access to the discount window 
in exchange for the burdens of increased regulation? I was just 
wondering what your take is on that.
    Mr. Cox. I think you probably want to hear from both of us 
on this.
    From the point of view of the SEC, I don't think it is the 
latter. I do think that it is a reflection of what Secretary 
Paulson has said on many occasions: It is much better to not 
use authority that people know exists, to not have to rely on 
backing that people know exists because it does its job better 
that way. I think that is a bit of what is going on here.
    Mr. Royce. Let me ask then the President of the Federal 
Reserve Bank of New York. Mr. Geithner, what is your 
observation on that?
    Mr. Geithner. It is hard to know. But my sense is that 
these facilities, all of them, are still providing a very 
important role in confidence as a backstop source of liquidity 
in extremis. And I don't think you can really judge the value 
today to the firms themselves or to the people who fund them 
from looking at use day-by-day. So my own sense is that there 
is still plenty of kind of an important role, even though use 
has declined progressively over time.
    Just to underscore one important point, we have been very 
careful from the beginning, along with the SEC, to try to make 
sure that while these facilities are in place the major 
investment banks move to adopt a more conservative mix of 
leverage and funding than they had on the eve of the Bear 
Stearns thing. And I think it is important to note, and I think 
Chairman Cox has said this, too, that they have made 
substantial progress in moving towards an appropriately more 
conservative mix, as I said, of the leverage and funding risk.
    Mr. Royce. Thank you. Thank you, Chairman Cox.
    The Chairman. The gentleman from Georgia.
    Mr. Scott. Thank you very much, Mr. Chairman.
    Let me ask, do each of you believe that the action that has 
been taken by the Fed, the Treasury, and other central banks 
has done a good job in helping reduce risk, raise capital, and 
build liquidity? How can we improve upon this? And as the Fed 
is beginning to face added pressures from some regional Federal 
bank presidents regarding starting to raise the cost of credit 
to curb expectation of higher inflation, in your minds, is 
inflation indeed of greater concern right now?
    Mr. Geithner. Congressman, it shouldn't surprise you to 
hear me say that I believe that what the Fed has done with 
other central banks to help ease the liquidity pressures in 
markets has been necessary and appropriate. And we try to be 
careful to underscore a commitment to continue to do things, as 
I said, to, ``help ease this process of adjustment.'' That is 
important, and not just because the financial institution is 
still facing some pretty substantial pressures and we want to 
mitigate the risk that those pressures increase overall 
headwinds to the economy as a whole. But it is important to 
make monetary policy more able to deal with the full range of 
challenges we face as a central banker.
    Mr. Cox. I would be happy to address your question as well. 
As you know, the SEC is not responsible for monetary policy, 
but inflation is something about which investors--whom we look 
after--care a great deal. One of the things that the SEC 
concerns itself with every day is making investors comfortable, 
taking their money and putting it into investments where it can 
be productive in our economy, what you on this committee call 
intermediation. We want to make sure that can happen. And that 
is one of the best ways for investors to protect themselves 
against inflation if they think that is a risk or if in fact it 
is a risk.
    So creating and maintaining market confidence is vitally 
important in this respect as well as in others. That is what we 
are focused upon.
    Mr. Scott. Another part of my question is yesterday, we 
made a very bold and I think a very, very, very good and 
substantial move with our housing package. And given the fact 
that now we have addressed our housing package, let me ask you, 
do you believe that a second round of stimulus package is 
necessary? Would you support a second round of stimulus in the 
face of what people are saying and economists, that we still 
expect sustained economic weakness to last, many say, for the 
next 2 or 3 years?
    So my point is, given the housing package, given the 
earlier stimulus, do you foresee down the road a necessity to 
move with a second stimulus package? And what do you think the 
first stimulus package has done?
    Mr. Cox. I think economists will have to tell us what are 
the actual effects based on empirical data that even now they 
are collecting of the stimulus package that has already been 
put into effect.
    Complementary to the SEC's role in instilling and 
maintaining market confidence is the policy that the Federal 
Government and that the Congress enacts, including fiscal 
policy, that stimulates economic activity and that promotes 
economic growth.
    I would say, as the investors advocate, that investors 
rather obviously look for after-tax rates of return. And that 
when they are facing, as they are now, scheduled increases in 
taxes on dividends, capital gains, ordinary income, that there 
is probably a lot of room there to create positive incentives 
for people to put their money in the market that will also be 
consistent with promoting growth in the economy, and that for 
Congress to be examining those things.
    Mr. Scott. My time is about up. So what you are saying then 
is that you believe that we have moved sufficiently with the 
housing, we have moved sufficiently with the economic stimulus 
package. Is that enough right now? Or where do you see us in 
terms of calming the jitters within the markets?
    Mr. Cox. I think we are far from achieving our potential as 
an economy, as a Nation, and that there is a great deal more 
that sound policy, promoting economic growth, can accomplish.
    Mr. Scott. Thank you, Mr. Chairman.
    The Chairman. The gentlewoman from Illinois.
    Mrs. Biggert. Thank you, Mr. Chairman. And I would like to 
welcome you to this hearing. My first year here was 1999, which 
was a very interesting year, of course, when Gramm-Leach-Bliley 
passed. And I thought that we did it rather quickly, until I 
realized that most of my colleagues on this committee had spent 
their entire congressional career working on that. I guess I 
was fortunate just to have 1 year of hearings.
    But in looking at what you both have presented as outlines 
in what should be accomplished, and I know that the centerpiece 
of the Treasury Blueprint is the reorganization of regulators 
and the regulatory authorities along functional lines, is what 
you are proposing in line with that? They say it says to do a 
consumer protection regulator and insured institutions 
regulator and a systems risk regulator. And I must say, I 
haven't had time to really study what you both have proposed. 
But is this in keeping with the Treasury? Or is this a 
different way to do this? And most of all I am concerned about, 
how long will this take, what has to be legislated, and what 
can be done now?
    Mr. Geithner or Chairman Cox, whomever would like to go 
first.
    Mr. Geithner. The Secretary of the Treasury, I think, 
deserves a lot of credit for putting out a very comprehensive 
set of reforms with a very, I think, sensible set of objectives 
for those reforms.
    I did not address in my written testimony the full range of 
issues that will be raised by that, including those that affect 
the specific rules of the Fed. But I think the basic idea of 
modernizing the framework, of having a more clearly 
established, appropriately assigned set of rules more 
consistently applied is very important. I think the call for 
very substantial consolidation simplification is very 
important. I think the emphasis in trying to make sure that 
there is authority commensurate with the responsibility where 
that rests for financial stability, I think those are all 
absolutely sensible objectives, and probably should guide any 
framework of reforms going forward.
    There are a lot of complicated things about how to do that 
that have to be thought through carefully, but I think at that 
basic level it is a very well-designed, comprehensive set of 
proposals.
    Mrs. Biggert. Thank you. Chairman Cox?
    Mr. Cox. The Treasury Blueprint was a ``big think'' 
exercise going way outside the box and the boxes. We had a 
brief exchange here during this hearing about just what would 
be involved if one were to consider only the piece involving 
the CFTC and the SEC. Obviously, we would have to get the 
Agriculture Committee in this room and likewise on the Senate 
side.
    While I think those exercises, those big think exercises 
are useful in many respects to challenge orthodoxy and to get 
us imagining all the possibilities, what I am here to testify 
about today is very focused and very different and, I think, 
much more tractable in real time even if real time is measured 
as next year or the year after. We are asking first that we 
plug the Gramm-Leach-Bliley regulatory hole concerning the lack 
of consolidated supervision for investment bank holding 
companies, and we are saying that the SEC should be given 
explicit authority to control liquidation of investment bank 
holding companies or their unregulated affiliates that 
generally hold most of the derivative positions.
    I think those are things that this committee could do in 
something like real time.
    Mrs. Biggert. So do you think then that you will be working 
with the Treasury after the real-time considerations that you 
have and then move on? Is there a move to really look at that, 
or was it just a think exercise?
    Mr. Cox. No, I don't think that this is merely an exercise. 
It is certainly big think. But I think the Treasury in issuing 
it, and you should all be aware as I am sure you are, that this 
was a Treasury product, not a Fed product, not an SEC product. 
It was meant by being purposefully nonconsultative to be 
internally logically consistent. And it is that. Whether or not 
it has the approval of every other regulator in every other 
respect, I think you can imagine it does not. But the Treasury 
acknowledged when they issued it that this wasn't going to 
happen right away. It might not ever happen, that this is a 
process that is getting underway.
    We then had Bear Stearns. We had other events in the 
marketplace that have accelerated the pace of the people's 
thinking here. I think that has focused us much more on what 
can be done realistically, measured in terms of months. The 
Treasury, the SEC, the Federal Reserve, and the CFTC, through 
the President's Working Group are very focused on these and 
related questions on a regular basis. There will obviously be a 
change of Administrations before I think any thorough 
legislation is passed. So these are institutional questions. It 
is not so much a question of whether Chris Cox is working with 
Hank Paulson or Tim Geithner or Ben Bernanke as it is that 
Congress is focused institutionally on these things and has a 
path and a way forward. I think this hearing is a wonderful way 
to institutionalize that process here in the House.
    The Chairman. The gentleman from Colorado. The order now 
will be the gentleman from Colorado, the gentleman from 
Connecticut, and the gentleman from Ohio. Then, we will go back 
to the regular order. The gentleman from Colorado.
    Mr. Perlmutter. Thank you, Mr. Chairman. Just a quick 
question back on that uptick rule. And the reason I am 
interested in it is that I am walking precincts on Saturday. As 
Chairman, you have had to walk plenty of precincts. A guy says, 
why did they eliminate the uptick rule? And you said it is 
because of the decimalization and the fact that a penny isn't 
worth very much anymore. But shouldn't there be some sort of 
stop in this system? Because when you look at Bear Stearns, 
when you take a look at what I think happened to Freddie Mac 
and Fannie Mae 2 or 3 weeks ago, these guys are betting against 
the house; they are betting in a big way. I think you used the 
words ``distort'' and ``short.'' And something isn't right 
about all of that. So shouldn't there be an automatic stop?
    Mr. Cox. There are several questions I think that you have 
touched on in your comment, and I will try and address each of 
them.
    First, the most virulent combination from a regulator's 
standpoint is intentionally false information being inserted 
into the marketplace by people who are then manipulating the 
stock and using short selling as a means to turbo charge the 
effect of it. It is that combination that we really need to be 
worried about, because that goes directly towards the 
credibility and integrity of the information in the marketplace 
that everybody depends upon. And particularly when markets are 
moving as fast as they do today, there is not a lot of time to 
get it right a week later. We want information to be right in 
real time, and we are focused a lot on real-time disclosure for 
public companies.
    Second, the uptick rule itself was the subject of, as I 
mentioned earlier, a very elaborate pilot study in which 
essentially the provisions of the rule were suspended for one 
group of stocks and they were comparable stocks, so within the 
Russell 3000 they were studied not only by the Office of 
Economic Analysis within the SEC over a period of a year, but 
also by academics outside who replicated this and got similar 
results. And the findings were that there was no significant 
effect on market quality or on volatility.
    We were then able in the subsequent more volatile markets 
to compare the effects on volatility, on the U.S. economy, with 
effects and changes in volatility in other countries, some of 
which had an uptick rule, some of which didn't. And there was 
found to be no correlation. So if one is focused on empirical 
results, we have a lot of them here, and that is generally the 
basis on which you want your regulators to make decisions.
    But then the third question that you raised is whether or 
not you want something that does work. And I think that is very 
much under Commission consideration right now. The trade-off 
there, rather obviously, is a circuit breaker or something that 
can protect investors from things running away on the one hand, 
and making sure that you don't interfere with liquidity and 
efficiency on the other hand.
    Mr. Perlmutter. I appreciate that. And I guess I am more 
for putting a stop in there, because information does flow so 
quickly that for you to be able to catch up even a day or two 
later may be too late. And so we have seen huge swings in these 
organizations and their stock prices. And I think in one of 
your articles we talk about if you pump the stock up based on 
false information, you get jail time. And hopefully the same 
thing applies, if you drive the stock down based on false 
information, you get jail time. That is what I am feeling. 
Because a lot of people lost a heck of a lot of money in the 
last 3 or 4 weeks in some very significant stocks to this 
country, and we had to take some emergency steps yesterday to 
remedy that.
    Now, I do want to get to the bigger question, which is 
Gramm-Leach-Bliley and Glass-Steagall. In my opinion, 
investment banks and commercial banks are very different 
animals and have very different purposes, equity side, debt 
side. And in one of your comments in your paper, you say: 
``Rather than extend the current approach of commercial bank 
regulation to investment banks, I believe Congress and 
regulators must recognize that different regulatory structures 
are needed for oversight of these industries.''
    My question is, shouldn't we separate these things again? 
There was an erosion of the separation between the two types of 
banks, the investment banks and the commercial banks, from 1980 
to today. Has that been good for us? And shouldn't we separate 
them again?
    And then I am done. Thank you.
    Mr. Cox. I think that the Gramm-Leach-Bliley essence of 
eliminating the Glass-Steagall in a wall of separation was a 
good thing and can be distinguished from what I am trying to 
point out here, which are the essential differences even in 
today's world that characterize investment banks on the one 
hand and commercial banks on the other. Some of those 
differences are regulatory, some of them are accounting, some 
of them are the nature of the business. The approach to 
leverage and risk is very different in investment banks than it 
is for commercial banks. For accounting reasons, investment 
banks have to daily mark to market everything they have. 
Commercial banks don't often have to do that.
    If we don't appreciate these distinctions and appreciate 
the different roles that these institutions play, then I think 
we will find that applying the commercial bank model of 
regulation to investment banks will so restrain the role that 
they play in the economy that somebody else then in the 
marketplace is going to rush in to do that, likely an 
unregulated entity, hedge funds and others private pools of 
capital. Then we will have the same set of questions to ask all 
over again but now with a new set of entities, and we haven't 
really solved that problem.
    The Chairman. I want to say to my friend from Colorado, I 
did a quick survey of some of my colleagues here, and we want 
to congratulate you on the financial sophistication of your 
district. None of us going door-to-door have ever been asked 
about the uptick rule. So we did want to either congratulate or 
console you on that.
    The gentleman from Texas.
    Mr. Hensarling. Thank you, Mr. Chairman.
    Mr. Geithner, in my opening comments I asked a rhetorical 
question; now I would like to ask a direct question. And that 
is, just how will the Federal Reserve think about the balance 
between price stability, financial stability, consumer 
protection, full employment, and taxpayer protection? I am 
curious about how you, as head of at least the New York Fed, 
would think about this balance. And what would be the risk 
associated with increasing the charge to the Fed with more 
responsibilities, particularly at a time when at least many of 
our constituents, when they look at price stability, might not 
give you an A-plus?
    Mr. Geithner. I think you are raising exactly the right 
question. I think that it is very important that we are not 
given responsibilities for which we do not have authority, and 
it is very important we are not given responsibilities which 
would conflict fundamentally with the basic obligations that 
the Congress gave us in the Federal Reserve Act.
    It is important, though, to recognize that all central 
banks in any serious economy are given a set of mandates that 
require a balance between price stability and some mix of 
sustainable long-term growth objectives. That mix differs. But 
also financial stability. And in any central bank, the basic 
lender of last resort instruments that are given to prevent 
liquidity problems from becoming solvency problems along with 
some broader financial stability are inherent to the functions 
of modern central banks.
    It is very important, though, to recognize that those 
instruments' responsibilities come with and have implications 
for moral hazard; and, therefore, it is very important they be 
complemented by a set of constraints on risk-taking and a 
framework for dealing with problems that can help limit and 
offset that moral hazard risk. But that basic framework of 
responsibilities, from price stability to financial stability, 
are integral to what all central banks live with every day, and 
those objectives do not need to conflict.
    Mr. Hensarling. As we seemingly have the Fed go down this 
road of taking on increasing responsibilities for financial 
stability, I believe it is now twice in 60 years that the Fed 
has chosen to open a discount window to nondepository 
institutions, those two occasions being within the last 4 
months. I asked Chairman Bernanke the same question. I didn't 
leave with an answer that I felt necessarily was the model of 
clarity, and maybe that was on purpose. But I would like to 
know, in your opinion, who is this window open to? What is the 
criteria? Who is eligible? Why are they eligible? Is it simply 
bigness? Is it simply interconnectedness? What is the criteria? 
Who qualifies? And if that is difficult to answer, who doesn't 
qualify?
    Mr. Geithner. Today, under the current facilities, two 
types of institutions qualify: Institutions that are what we 
call depository institutions, institutions that take deposits 
like banks; and institutions that we call primary dealers. 
Primary dealers come now in essentially two forms. They are 
affiliated with banks and those that are independent. The four 
large investment banks are examples of the latter.
    The reason why they have access to those facilities now is 
because those institutions play critical and unique roles in 
market functioning. And in order to help facilitate this 
adjustment the economy is going through, they need to have the 
ability to finance less liquid assets with the central bank, 
but those are the institutions and that is where the line now 
exists.
    Now, the Federal Reserve Act did give us the ability to go 
broader if we believe circumstances require that, but at the 
moment we have drawn the line there, I think appropriately.
    Mr. Hensarling. I see I am soon to run out of time. From 
the perspective of just dealing with systemic risk, 
notwithstanding what took place on the House Floor yesterday 
vis-a-vis Fannie and Freddie, but looking forward and not 
looking backwards since I assume ultimately the bill will 
become law, if in an orderly fashion, and your one goal was to 
reduce systemic risk, would you believe that a system where you 
had broken up Fannie and Freddie into a more atomistic market, 
lowered their conforming loan limits, and minimized their 
portfolio holdings, or, in the alternative, totally privatized 
them over, say, a 5- to 7-year basis, would you believe that 
would lead to less systemic risk in the economy?
    Mr. Geithner. I believe that there is going to have to be 
some very fundamental rethinking of the future of these 
institutions going forward. It is hard, though, to say today 
with confidence what the optimal role will be in the future. 
But for the reasons you have said and many others, the current 
balance is probably untenable over the longer term.
    Mr. Hensarling. Thank you.
    The Chairman. The gentleman from Connecticut, Mr. Murphy.
    Mr. Murphy. Thank you, Mr. Chairman.
    Mr. Cox, I wanted to get specifically at the emergency 
order relevant to pre-borrow requirements for short selling. 
And I for one appreciate the SEC's action in this regard, but I 
have maybe a twofold question.
    You have limited the order to 19 specific stocks. There are 
those of us in correspondence with your office who have been 
advocating for a pre-borrow requirement industrywide, and I 
appreciate the fact that you have recognized that at least for 
these particular companies, this is an immediate problem that 
necessitated the emergency order.
    But I guess the two parts to my question are: First, why 
not apply this industrywide? You have had a regulatory process 
that has been ongoing for some time looking at this issue which 
has now been I think going forward for about a year, and I am 
interested to know why, if it makes sense for these 19 
companies, it doesn't make sense for the entire industry? And 
second, what hazard do you potentially see with selecting only 
these companies and not others? We have seen just in the 2 days 
after the emergency order was put into effect, I think for all 
but two or three of those companies, a double digit percentage 
increase in the value of their stocks. I think across-the-
board, I am looking at a 21 percent increase in their value in 
the 2 days after that order was put into place.
    So the twofold question is: First, why not do it for the 
entirety of the industry? And, second, do you foresee any 
problems in picking only these 19, and leaving other companies 
then potentially with even greater exposure to short sales?
    Mr. Cox. Well, thank you for the opportunity to expand on 
this, because I think it is an important and a good question.
    Our emergency authority is limited, as you can imagine. Our 
rulemakings are generally governed by the Administrative 
Procedure Act, which requires an elaborate process of notice 
and comment; it requires economic justification; it requires a 
fair amount of empirical analysis, historical analysis, and so 
on.
    Our emergency order was tailored precisely to the emergency 
orders that the Federal Reserve had issued. We issued it in 
close consultation with the Treasury and the Fed as an 
ancillary, as a support for those actions. And so the universe 
of firms that are covered by the emergency extension of credit 
facilities by the Federal Reserve is the same universe of firms 
that the SEC order covers. And I think because of the nature of 
our emergency authority we are constrained in that respect.
    However, it is vitally important for us to look after fraud 
in the entire market, and we are doing so in real time. This 
isn't the only initiative that we have announced. As you know, 
we have a sweep examination that we have undertaken with FINRA 
and also with other regulators, and that covers the intentional 
spread of false information in the marketplace that is 
generally part of this witch's brew of distort and short, to 
which you alluded.
    In addition, beyond that we have immediately pivoted to a 
broader rulemaking so that we can use the APA process to extend 
this kind of procedural protection to the entire marketplace. I 
think that very soon we will be in a position to issue a 
proposal on that.
    Mr. Murphy. And let me ask again the second part of that 
question: Do you have concerns? And Mr. Geithner, you can 
answer this as well. Do you have concerns as has been 
expressed, for instance, by some of the banking organizations 
in letters to your office, that by limiting this order to a 
small set of stocks, you are creating greater exposure for 
those that weren't included in this order? And, again, I think 
this has been expressed to you at the very least by some 
community banking organizations that believe this might be the 
case.
    Mr. Cox. I think the concerns in the marketplace are 
chiefly focused on the potential for illegal manipulation 
through the insertion in the marketplace of false information. 
And that is something that we are policing across the entire 
market.
    I think it is important to note that our emergency order 
concerning naked short selling was not based on an analysis of 
a big problem in this area that exists currently. It is 
prophylactic. It is preventative. It is designed to shore up 
confidence. But because there was not an epidemic in the first 
place, I don't think that there is a risk that the epidemic 
that didn't exist is going to be moved to somewhere else.
    We also have Reg SHO. We have the opportunity because of 
the step-up in enforcement that we are doing in this area, we 
have the opportunity to enforce it across-the-board. So I think 
any financial institution, and indeed any public company, can 
expect much greater protection and confidence for their 
investors that the marketplace is operating on the level as a 
result.
    The Chairman. The gentleman from New Jersey.
    Mr. Garrett. Thank you, Mr. Chairman. And good morning, 
gentlemen.
    We are here for a hearing on systemic risk in the financial 
markets. And I guess it is typical of the way government and 
Congress works that we are doing this today, only the day after 
we voted in Congress on perhaps one of the most significant 
changes to our financial marketplace and the taxpayers with the 
potential for a $5 trillion impact upon the taxpayer and 
extension of authority to the Treasury Secretary. But perhaps 
that is just the way Congress works; we do the hearings 
following the action. But I do appreciate your coming here 
today to talk about some of these actions, and I will begin 
with what we did yesterday with regard to the GSEs and Fannie 
Mae and Freddie Mac.
    Secretary Paulson, prior to us taking this action, was sort 
of in the marketplace trying to calm it down, if you will, 
trying to facilitate the debt sales and that sort of thing. But 
Chairman Cox, during that period of time, if you were a trader 
in Fannie or Freddie, in their equities, if you were long on 
their positions, was everyone's ability still in margin 
accounts? Or were there some of the brokers requiring cash 
accounts basically for Fannie or Freddie during that period of 
time and even today as well?
    Mr. Cox. I am not sure--
    Mr. Garrett. Were the brokers requiring marginal--raising 
the margin requirements on the trades?
    Mr. Cox. No.
    Mr. Garrett. So there were none of them out there asking 
for, basically treating it as a cash transaction, to your 
knowledge?
    Mr. Cox. I think the answer to that is ``no.''
    Mr. Garrett. My understanding is that perhaps that is not 
the case, and that some of them were looking at it, trading it 
as a cash requirement. Maybe I am wrong. I will ask you to get 
back to me to clarify to assure me that is not the case.
    If that was the case, that they were in essence raising the 
margin requirements at the same time that the Secretary was out 
there trying to smooth things over, calm the marketplace, then 
that would be going exactly in the opposite direction. Wouldn't 
that be?
    Mr. Cox. I think that is right.
    Mr. Garrett. And is that the SEC's responsibility to be 
looking at that sort of thing?
    Mr. Cox. Obviously our concern is that, first, the 
information in the marketplace on which investment decisions 
are being made is accurate. And then, second, in terms of 
maintaining orderly markets, to make sure that the trading 
itself is disciplined.
    Mr. Garrett. The other thing, this is a general question, 
this is a step back, is looking for stability in the 
marketplace, is stability with all you folks. Where are you 
guys going to be? I know where I hope to be a year from now if 
everything works out well in November. Where will you both be a 
year from now?
    Mr. Cox. A fascinating question.
    The Chairman. Chairman, your wife may be watching 
television.
    Mr. Cox. I hope that at least the market environment in 
which I am operating at that time will be a positive one and a 
strong one. That is what we are working on building here.
    Mr. Garrett. And you will still be with the Bank?
    Mr. Geithner. Life is uncertain, but I certainly expect to 
be.
    Mr. Garrett. I say that in jest in some sense, but also in 
the sense that it is reassuring that the players who are here 
today will be the players who will be here a year from now, all 
present company included up here on the panel as well.
    Back with the SEC and the Bear Stearns situation, was it 
your responsibility or were you engaged in the process of 
looking at Bear Stearns, their situation, their liquidity, and 
their management at the time prior to the ``collapse?'' If you 
were, what were your findings? And did you feel that there were 
any shortcomings in what you were doing?
    Mr. Cox. The SEC through our consolidated and supervised 
entity program was monitoring capital and liquidity at Bear 
Stearns. And in fact, on a daily basis in January, February, 
and March, the liquidity position of Bear Stearns as a result 
of that interaction more than doubled between January and 
February. They were in a position of, going into March, having 
between $18 billion and $20 billion of liquidity. The CSE 
program, managed rigorously against the standards that it had 
been set up with for liquidity to ensure that--
    Mr. Garrett. I only have about 10 seconds, sir. I will put 
my question out again, sir. Should there have been any other 
red flags that you should have seen going up to that time? 
Because other people on the street were not seeing them as 
well, should the SEC have seen the red flags prior to obviously 
what just happened?
    Mr. Cox. Beginning with the failure of Bear Stearns hedge 
funds, there were market rumors in Europe about loss of secured 
funding sources that caused us to take a look at all of their 
secured funding sources. We found out, in fact, that their 
secured funding had increased.
    Using the capital and liquidity standards that the SEC 
program put in place, including the Basel II standards, 
including liquidity standards that require that you be able to 
go a full year without access to unsecured funding, the capital 
and liquidity cushions for Bear Stearns going into the week of 
March 10th were above regulatory requirements. But what we 
discovered during that week, and what banking regulators of all 
kinds in the United States and in other countries have not seen 
up to that point was that there could be this run on the bank 
phenomenon, where customers withdraw their free cash balances, 
where people novate their contracts and so on. The result in 
the Bear Stearns case was that it lost 89 percent of its 
liquidity in 3 days.
    Mr. Garrett. Thank you.
    The Chairman. The gentleman from Ohio.
    Mr. Wilson. Thank you, Mr. Chairman.
    Gentlemen, I would like to address my question to both of 
you, if I may. One of the concerns I have had through this 
whole process has been the oversight and the lack of connection 
or the not having connection among the oversight groups. So I 
have two questions. One is, how important is it that the 
central banks, governments, and supervisors look more carefully 
at the interaction between accounting, tax, and disclosure, and 
capital requirements and their effect on the overall leverage 
and risks across the financial system?
    Mr. Geithner. Very important. There has not been enough 
attention paid to that interaction in the past, largely set by 
entities with independent authority and responsibility. And so 
I think it is a central imperative going forward.
    Mr. Wilson. Mr. Cox?
    Mr. Cox. I strongly agree with that. And because of the 
nature of these different responsibilities, the fact that they 
of necessity fall in the hands of different regulators, some of 
what in the past has been ad hoc'ery and is now increasingly 
formalized, the cooperation through a memorandum of 
understanding, for example, is absolutely vital.
    Mr. Wilson. As we look and move forward to work on this, I 
think it is very important that be one of the primary goals 
that we have. And sometimes it surprises me how much we get off 
of the real issue we are trying to accomplish.
    As Congress considers the Fed's bid to expand authority 
over the financial services industry, what do you believe is 
fair regarding additional powers for what you will do to help 
with the oversight and the stability of the financial services 
market?
    Mr. Cox. I am sorry, is your question directed to the SEC?
    Mr. Wilson. I was basically addressing it to both of you. I 
can specifically make it to you, Mr. Cox.
    Mr. Cox. All right. To begin with, the SEC. First, the SEC 
already has in statute the authority to run a voluntary program 
of consolidated supervision with respect to an oddly defined 
category of investment bank holding companies. We need to 
strengthen that legislation so that the program is not 
voluntary, it is mandatory, so that the SEC has the authority 
to mandate compliance, and also so that each of the CSE firms 
that presently today are regulated under that program are 
covered.
    Second, we have asked to be given explicit authority to 
control the liquidation of investment bank holding companies 
and their unregulated affiliates, particularly with respect to 
derivative positions that they hold.
    Mr. Wilson. Mr. Geithner.
    Mr. Geithner. I don't believe that we need a dramatic 
expansion or redefinition or change of our rule. As I laid out 
in my testimony, I think there are some areas which represent 
continuity where there are additional responsibilities, where I 
think you need to tighten up responsibility and authority and 
give us a better balance of ability to compensate for the moral 
hazard that is created by things we have to do in crisis.
    So I would say, just to repeat them, it is very important 
that we have, as we do now, a rule in thinking about and 
setting the capital requirements and other prudential 
requirements that apply to core institutions. It is very 
important that we have a rule in consolidated supervision of 
those institutions, because you will not have good judgments 
made by this Bank, this Federal Reserve in the future unless we 
have the direct knowledge that comes with supervision.
    It is very important in crises that central banks are able 
to move with force and speed when circumstances require it, and 
that won't happen unless you have a tighter match between that 
responsibility for lender of last resort functions and the 
knowledge that can only come for some role going forward. It is 
very important in the payments area, where we have substantial 
responsibilities now, that you have a little more clarity about 
who is accountable for a level playing field and a broader 
systemic stability. And it is very important in crises that 
have systemic implications that we have a consolidated 
framework.
    That basic framework is very consistent with the 
responsibilities we have now, but our system has changed a lot 
since that was designed, and so we just need to look at how to 
make sure we get a better match between responsibility and 
authority.
    Mr. Wilson. Thank you. We will certainly try to do that.
    Thank you, Mr. Chairman.
    Mr. Cox. Mr. Chairman, if I might, just before this next 
round of questions, clarify my response to Congressman Garrett. 
I was not sure in his question whether he was asking about 
brokers' individual or required margins. The question that I 
answered concerned required margins. Required margins did not 
change. But it is also the case that brokers can raise their 
own marginal requirements. We don't have data about that at 
this hearing, but if Congressman Garrett would like that for 
the record, we would be happy to provide it.
    The Chairman. Thank you.
    Mr. McHenry.
    Mr. McHenry. Thank you, Mr. Chairman. This question is to 
Chairman Cox.
    There is wide agreement that the credit rating agencies 
need to be reformed, and there needs to be reform instituted by 
them as well. Your rulemaking goes a long way towards that end 
to resolve some conflicts of interest and create some greater 
transparency within the credit rating agencies so the market 
can truly know what is happening. And I believe we need to 
ensure that issuers and originators are providing credit rating 
agencies with adequate information on assets underlying a 
structured security.
    So does the SEC currently have the authority to ensure that 
originators and issuers are providing NRSROs the information 
they need to rate structured securities?
    Mr. Cox. Our authority under the Credit Rating Agency 
Reform Act runs to the rating agencies. But we certainly have 
authority concerning their disclosure of the information upon 
which they rely and their internal procedures for using that 
information. We don't have the authority in statute to regulate 
precisely how they come up with their ratings, nor do I think 
that you want the Federal Government to regulate that. We want 
to deal with that through competition and disclosure. But the 
net result of this, which will be covered amply in our very 
sweeping set of rule proposals, is that we will get directly at 
this problem.
    Mr. McHenry. Can the SEC intervene when NRSROs, basically 
if the credit rating agency fails to advise the investing 
public of material information?
    Mr. Cox. Absolutely. That authority is clearly given to the 
SEC under the credit rating agency format. By the way, these 
authorities just kicked in last fall. We have been aggressively 
using them since that time. But there has been a great deal of 
change in that industry in just a few months.
    Mr. McHenry. I have legislation, H.R. 6230, which would 
clarify the intent of Congress that the SEC has this authority 
and the prudential steps thereafter to take action here to 
further clarify that.
    Mr. Cox. I have not reviewed that legislation, but I think 
we would welcome that authority, because it is consistent with 
the authority I believe that Congress meant us to have.
    Mr. McHenry. Because in terms of material information, I 
think that has to be clarified so that you can take those 
actions and steps necessary. Because, after all, part of the 
credit challenges that we are facing currently are because the 
credit rating agencies did not accurately detail the risks in 
the marketplace and actually rate products effectively.
    And another question for both of you, but starting with 
you, Chairman Cox, is the SEC--and to you, Mr. Geither. Are you 
all studying the implications of the FASB fast tracking and 
elimination of the qualified special purpose entities? 
Basically, what allows for securitization in the marketplace. 
Are you studying the effects that this rulemaking--because they 
are trying to push it and have it implemented by the end of the 
year--could have in the marketplace?
    After all, in my opinion, the Federal Reserve, but more 
importantly the Treasury, stepped in on Fannie Mae and Freddie 
Mac because of a report, a Lehman Brothers report, that 
explained the risks going forward with the FASB rule the 
possibility that they might need $75 billion in capital. And 
that was just based on an assumption that the rule would go 
into place.
    So this FASB rule about qualified special purpose entities, 
if you could discuss that.
    Mr. Cox. I think it is wrong to say that this is being fast 
tracked. I think the likely scenario is that there will be a 
period for public comment, consideration, and that--
    Mr. McHenry. They have said publicly they want to have it 
done by the end of the year.
    Mr. Cox. And in terms of effective dates that they are 
considering in their proposals, we are talking years into the 
future.
    Mr. Geithner. Could I have--
    Mr. McHenry. So is that, no, you are not studying it?
    Mr. Cox. Well, the answer to your--I am sorry, if you asked 
a yes or no question, the answer is yes. We are not just 
studying it, but we have discussed it extensively with the 
FASB. We have also discussed it with the Federal Reserve Bank 
of New York. And just yesterday I discussed this with Chairman 
Bernanke. So we are very, very focused on this, and we 
understand precisely the environment in which we are operating.
    So on the one hand we have the important question of 
reforming accounting in this area, something the President's 
Working Group asked the FASB to do in March of this year. On 
the other hand, we want to make sure that the discussion of 
this and the implementation of this is conducted in such a 
fashion that the market can absorb it and it doesn't create any 
unnecessary shocks.
    Mr. McHenry. Mr. Geithner.
    Mr. Geithner. I just want to reinforce exactly what 
Chairman Cox said. Of course we are studying this carefully. 
And you are right to point out this has very substantial 
implications to the dynamics of this crisis.
    There are a range of issues in the accounting area, not 
just the treatment about balance sheet commitments, 
enterprises, that need to be thought through. And there are 
implication with changes in the capital regime, too. I think it 
is important that those be done thoughtfully and carefully, and 
be done in a way that doesn't add to uncertainty and risk, 
amplifying what is still a pretty special set of tensions in 
the markets today. And I welcome Chris's careful attention to 
those issues and willingness to consult more broadly with the 
Fed and others about those implications.
    The Chairman. I will recognize myself.
    First, there was a reference previously to one of the great 
fantasy figures that is now circulating, and that was the $5 
trillion obligation that theoretically just passed the vote 
yesterday. Nonsense rarely gets so graphic--$5 trillion is the 
total value of all the mortgages held by Fannie Mae and Freddie 
Mac. If none of them ever paid a penny, presumably there would 
be a $5 trillion loss. No one thinks that is remotely realistic 
in any case. Nothing that the House did yesterday or that the 
Senate will do or that the President will sign, misguided 
though some consider him to be in this regard, will obligate us 
to anything if those mortgages don't pay.
    But, again, we ought to be clear about the $5 trillion 
figure. It is based on an assumption apparently that there 
would be a liability because all of the mortgages they hold 
would fall to zero, that none of the houses behind them would 
be worth anything. Not a serious figure.
    I want to talk about one potential conflict we have had and 
it affects both of your organizations. We have to think about 
this going forward. Between actions that protect investors and 
the integrity of the market and systemic stability, and there 
are times when those two could theoretically fall in different 
directions, and we obviously want to make sure we can reconcile 
those. And then that has implications for, are there two 
organizations or one organization? In terms of one specific 
example, mark to market; clearly investors are entitled to know 
what is the real value of whatever it is they are asked to buy 
into. It is also the case--and I thought Mr. Cox's phrase, 
warning us against hard wiring consequences, here was a useful 
one.
    It is also the case that going not simply to a mark to 
market requirement, but insisting that various consequences 
immediately follow on the mark to market could have a 
procyclical effect, and that our interest in fully informing 
the investor by mark to market, if we are not careful, could 
generate negative consequences. No one is, I think, suggesting 
or should expect to be able to suggest that we back off mark to 
market. But I thought Mr. Cox would take some unusual steps. 
This is an example of how we could combine investor protection, 
which is part of what mark to market is, but also with some 
concern for the stability of the system by having some 
flexibility in the consequences as to how much capital has to 
be raised and how quickly, as to whether or not other entities 
have to divest.
    There is a question about mark to market. I will take my 
own case, my investment is largely in Massachusetts municipal 
bonds because that is the only investment I can make without 
members of the media harassing me any more than they already 
do, because I presume people would think it is in my interest 
as a Member of Congress to support the financial structure of 
Massachusetts even though I wasn't helping. In fact, I work 
against interest because I think the municipalities pay an 
unfairly high-risk premium from which I benefit. And I wish 
that I was getting less interest because I wish people weren't 
being overcharged.
    But the point I want to make is this: I don't plan to trade 
those things. I plan to hold them for my retirement. Marking 
them to market is really irrelevant to me to some extent 
because I am looking at the interest going forward. So I 
guess--let me just put the question now: Generally, what 
guidance can you give us and will you be giving us on how you 
reconcile those two, and particularly if you take sort of 
investor protection actions at a time like now when there is 
weakness, can you avoid procyclicality and is mark to market an 
example of this? How can we handle it? Let me begin with Mr. 
Geithner.
    Mr. Geithner. Those are deep existential fundamental 
theological questions for people involved in the central bank 
and supervision. And I personally don't know how we get a 
better balance between the accounting regimes that now apply, 
particularly to those institutions that exist to quota the 
system. But I would just say one basic point is that what you 
want to assist is have a system where you have a level of 
cushion in terms of capital reserves, liquidity, etc., in the 
good times that you can allow so that when things change, 
confidence erodes, risk goes up, that those cushions are 
stabilizing rather than destabilizing.
    If you run a system where people hold cushions that are too 
thin against plausible states of the world because they expect 
to be able to catch up and raise those in extremis, then you 
risk amplifying the crisis. And what you need to do is make 
sure you look at the interaction between the incentives we 
create for capital and those created through accounting regimes 
to make sure that they reinforce that basic objective. But this 
basic issue of procyclicality, very complicated, and you have 
very thoughtful people spend a lifetime advocating the benefits 
of both those regimes, and we live now in a somewhat 
uncomfortable middle.
    The Chairman. Mr. Cox.
    Mr. Cox. I think, first of all, you are absolutely right 
about the general perspective of investors when it comes to 
fair value accounting. Investors appreciate it. On July 9th of 
this year, the SEC hosted a roundtable, it is what we call our 
hearings, on this topic; and we heard from a wide variety of 
participants in the marketplace. The general consensus was that 
fair value has been a help to investors in these difficult 
circumstances. They want more of it, not less of it, and that 
it has not been the cause of volatility in the markets or other 
problems that we have seen in the current market turmoil.
    We, also at that same roundtable, got into the kinds of 
issues that Tim is talking about. There are, particularly in 
Europe as they consider fair value, existential questions about 
fair value or not. I don't think we are having that debate just 
now in the United States. The real question is, you know, at 
the margin when you are away from instruments that the market 
generates prices for and you have a model that is trying to 
generate your price, but at the same time that asset is 
throwing off some cash, do you have to value it at zero? There 
are practical questions that people want answers to, and we are 
hoping that we can provide those answers in something like real 
time in the form of guidance. I don't think that there is, when 
it comes to fair value, necessarily a conflict between the 
investor protection mission and the systemic risk mission. I 
think fair value, properly used, can be very helpful.
    The Chairman. Let me ask you, you did talk though, about 
the danger of hard wiring, when you say--and I agree, I don't 
think anybody should be backing away from the fair value. And 
it is a good way to call it that. But there has been a set of 
rules in place that have had some consequences automatically 
flow from a downward valuation. And the question is whether we 
should explore flexibility there.
    Mr. Cox. I think there is a lot of need for people to be 
able to understand what fair value accounting is all about. And 
depending on which investors you are talking about and in which 
country, sometimes those questions are very acute. There are 
some significantly counterintuitive results from fair value 
accounting that can startle some investors. For example, when 
fair value accounting is applied to your own debt on your own 
balance sheet when your debt becomes less valuable, it runs--in 
other words, your firm is doing worse, that generates income 
that you then run through the income statement.
    So I think there is a lot of work that we can do in terms 
of investor education so that people understand how to use 
these accounting tools. And those are all legitimate questions 
when it comes to fair value.
    The Chairman. We are going to have votes soon. We can say 
stay until the votes come. Let me ask my colleagues to each ask 
one question, the three who remain. Would that be fair? The 
gentlewoman from New York.
    Mrs. Maloney. First, I want to welcome all of our 
witnesses, particularly Tim Geithner from New York. So I have 
to put that in.
    Chairman Cox, in your recent op-ed in The Wall Street 
Journal, you wrote that for financial institutions whose 
lifeblood is trading, not lending, there is yet no agreement 
upon apples to apples, comparison of balance sheets and 
leverage metrics. Regulators must determine whether the 
different kinds of risks both types of institutions bear within 
the context of their business models are appropriate for our 
financial system as a whole.
    And one of the concerns that I have had that many people 
have expressed since the collapse of Bear Stearns is that 
certain entities have become overleveraged. How much is 
overleveraged? How do you determine to balance that in the 
future? And as you pointed out in your comments, it is hard to 
have an apples-to-apples comparison of balance sheets and 
leverage metrics. Do you think that we need to have a mechanism 
that allows for an apples-to-apples comparison? And if so, how 
would you suggest that we do this?
    Another question connected to this is, as we move forward 
with reorganization, many of my constituents have expressed 
concerns of putting too much power into the Federal Reserve, 
whose primary focus is monetary policy. Will that diminish 
their ability to be effective on monetary policy and are we 
putting too much in one area? Thank you.
    Mr. Cox. The apples to apples comparison is emerging day by 
day. It is really one of the things that we are focused on in 
our collaboration, the SEC's collaboration with the New York 
Fed, and with the Federal Reserve Board. Obviously, for some of 
the very accounting reasons we were just discussing, there are 
significant differences between the way commercial banks, 
investment banks report for financial reporting purposes. There 
are, though, sometimes translate into differences in the way 
regulatory capital is computed. But as we are now getting 
information from the Federal Reserve about financial holding 
companies so that we can look at what had been, you know, 
treated as banking regulatory beasts for regulatory purposes up 
until now in a more holistic way and they are getting from us 
investment bank holding company information so that they can 
take a look at things in a more systematic way as well.
    That is generating the need to be able to compare all this 
and analyze it under some if not common metrics then at least 
common principles. So this is a work in progress and we are 
very, very busy at it. Ultimately what accounting regulators do 
also matters here.
    The Chairman. Mr. Geithner.
    Mr. Geithner. Just two quick things. The Federal Reserve 
cannot bear the sole responsibility for responding to the kind 
of challenges that the United States is going through. I think 
that the Fed has an important role but I think as the Congress 
has recognized, the Administration has recognized and it is 
truly in all financial crises. You need a set of policy 
measures to be responsive to these challenges. And monetary 
policy cannot bear the sole burden of responding to those 
challenges. We have been very careful to make that line there.
    On the broad question about scope of authority, what I want 
to underscore again is how important it is not to give us 
broader responsibility without authority, that we cannot 
compensate for--without basic authority. If you gave us more 
responsibility, that would probably come with a broader 
increase in moral hazard, with less capacity to mitigate that 
risk. And getting that balance right is very important.
    Mrs. Maloney. Thank you.
    The Chairman. The gentleman from North Carolina.
    Mr. Watt. Thank you, Mr. Chairman. Let me start with the 
assumption that we are not going to do anything else this year 
after yesterday. It took us forever to get the Senate to do 
what we did yesterday. So in this discussion, I am really more 
looking at the longer-term reform issues. And it seems to me 
that the only person who has really done any creative proposals 
and suggestions about that has been Secretary Paulson.
    I was pretty aggressive with him because he left some gaps 
in what he proposed. But at least he came out with a proposal 
that is a real reform proposal under which he suggested a 
regulator that deals with market stability across the entire 
financial sector, a second regulator that focused on safety and 
soundness of institutions supported by Federal guarantee, and a 
third regulator focused on protecting consumers and investors. 
Everybody else who has been here, including, with all due 
respect, all of you today, has been tinkering around the edges 
of the existing structure rather than looking creatively at a 
more comprehensive reform of the regulatory structure.
    And it is the third of those really that captures my 
attention more than anything else, which is the protecting 
consumers and investors regulator, which I think the markets, 
the economy, everything you all have talked about will always 
get taken care of based on my experiences. It is the consumers 
and the investors that I always worry about.
    The proposal that I have heard that--not in this room but 
off the record--is that since most of what consumers and 
investors are buying now are products, financial products, that 
we ought to be creating something like a consumer protection 
agency or an Environmental Protection Agency or some kind of 
agency that protects people against bad toys or you know that 
kind of thing. And so I want to ask your opinion about two 
things, and you probably won't be able to do it in answers. 
Just give me the--and particularly, Chairman Cox, give me 
your--if you would--your suggestions about responses to 
Secretary Paulson's overall proposal, these three different 
areas of regulation.
    And number two, what is your reaction to a really robust 
protector of consumer and investor interest patterned on 
somebody who is really going to look out for how do you give 
them the authority they need to do that? I know they can't do 
that.
    The Chairman. Let him start with the second because they 
did touch, to some extent, on the first before. I would ask 
that they hit the consumer product safety piece, because we did 
get some response earlier on the broader plan. But if we could 
get that.
    Mr. Cox. In financial services, consumers are investors 
indeed. And the investors' advocate is the Securities and 
Exchange Commission. I think when one looks at the Treasury 
Blueprint, it is a little bit difficult to find precisely where 
existing regulatory functions fall, in which box, and whether--
some people have inferred from this report that it would 
enlarge the responsibilities of the SEC, and others that it 
would substantially diminish them. The point of my testimony 
today is that we don't need to remake the world. We have a lot 
that works and what works in particular is the idea of a 
regulator whose foremost responsibilities are investor 
protection, making sure that we have orderly markets and making 
sure that we promote capital formation. The mutual reinforcing 
aspects of the different responsibilities of what the SEC does, 
for example, understanding the business of investment advisors, 
understanding the business of mutual funds, understanding the 
business of investment banks and broker dealers, regulating 
public companies, and getting honest disclosure to the market, 
all of that is vitally important to our enforcement function 
and vice versa.
    And so to have a strong consumer protection regulator, you 
need these supporting buttresses. I don't think one can imagine 
a design, a mission for a regulatory agency that has investor 
protection more clearly at heart than does the existing charge 
for the SEC. So I don't think that we need to remake that in 
any respect.
    Mr. Geithner. Could I just add one thing?
    The Chairman. Yes.
    Mr. Geithner. It is very important to focus not just on the 
standards and the rules, but also on improving the consistency 
and enforcement of those rules. Because you can very carefully 
design rules with appropriate protection for consumers, but if 
you allow vast disparities in how they are enforced across 
different institutions, what you have just created is incentive 
for that to move where enforcement is weaker.
    So as part of thinking through this, you want to make sure 
not just that you get the broth standards right with the 
appropriate balance between consumer protection and other 
objectives, but that you have oversight enforcement incentives 
for complying that are more even. And that is a complicated 
thing to do in a country designed as ours is with a Federal 
structure and a lot of competing authorities.
    The Chairman. The gentleman from Massachusetts.
    Mr. Lynch. Thank you, Mr. Chairman. Let me go one step 
further, and this is sort of related to the chairman's question 
about investor protection.
    I agree that we need a strong regulator. But I also believe 
that some of these instruments, as you said in your opening 
statement, Mr. Geithner, that our current laws and regulations 
were put in place when we had a much different market. And they 
don't necessarily address the situation we have today.
    I think one of the fundamental needs of our reform system, 
and I wish it was in one of your lists, is basic understanding 
within the market, by the market, by the individual investor. 
And it is great to have a policeman in the background of a 
strong regulator. But the best protection would be allowing the 
investor to protect themselves. And I have to tell you, I think 
Warren Buffett was right. He calls some of these complex 
derivatives the financial weapons of mass destruction, and he 
predicted this whole fallout.
    These complex instruments, the CDOs, the credit default 
swaps, these complex derivatives, based on models are so 
complex, our own rating agencies couldn't figure out who owned 
what or how to value them. And when I asked Mr. Bernanke at our 
most recent hearing who was addressing this, he indicated that 
you were, Mr. Geithner. So I hope he wasn't throwing you under 
the bus. Can you tell me what we are doing to just equip the 
investor with the ability to make those smart determinations on 
their own?
    Mr. Geithner. I wish we had the power to do that. I 
completely agree with you, that people who take risks should 
understand the risks they are taking and make sure they are not 
taking risks they cannot handle and absorb. That is a very hard 
thing to do with regulation. What you want to do is to design a 
system that doesn't prevent people from losing money and making 
mistakes because that is inevitable. What you want to do is 
make sure you run a system where the consequences of those 
mistakes are less damaging and consequential for the more 
prudent and for the economy as a whole. And that balance is 
very hard. I think, again, the fundamental objective is to try 
to make sure that the institutions at the center of this system 
are run with a set of shock absorbers against all the risks 
they assume, in derivatives and elsewhere, so they can 
withstand pretty bad outcomes. And you want to make sure that 
the infrastructure is able to better deal with the consequences 
of default by major institutions.
    Mr. Lynch. I am talking something much more basic. I am 
just talking about price, putting the right price on this 
product, how do you do that?
    Mr. Geithner. I think you can't do that with regulation 
because fundamentally that price is set by the people who are 
on both sides of that--
    Mr. Lynch. What about a clearinghouse or something of that 
nature that could vet some of these derivatives?
    Mr. Geithner. Absolutely. So for the standardized part of 
the credit default market, which is very large now, there is a 
very broad basis support in the dealer community to move that 
into a central clearinghouse over the next 6, 12, 18 months. 
And they are likely, I believe, to move quite quickly to take 
the standardized piece into that structure with appropriate 
risk management framework so the system stays safer. That is a 
very valuable thing. There are other things you can do in terms 
of disclosure that would also help that broad outcome which we 
are, along with Chris Cox and a whole bunch of others, are 
working very hard to advance.
    And I completely agree with you. Fundamentally what you 
want is people to better understand the risks they are taking 
and not take risks that are going to threaten their viability 
if that is going to have consequences for the system as a 
whole.
    Mr. Lynch. I yield back, thank you.
    The Chairman. The gentleman from Missouri.
    Mr. Cleaver. Thank you, Mr. Chairman. Mr. Cox, during my 
term as Mayor of Kansas City, there was a vicious rumor put out 
about our police chief and what he did was--I didn't think it 
was possible--he put some detectives on it. And they just went 
from person to person to person, who told you, who told you, 
who told you? It eventually landed on the desk of a secretary 
who confessed that she was just joking. Of course she wasn't. 
And she was fired. And so I know it is possible to track down a 
rumor. And the rumors that caused the collapse of Bear Stearns 
is more than just some little harmless rumor about sex. It is a 
rumor that has done devastation to our economy.
    I know that you have said that you are interested in this 
rumor-mongering. But does the SEC investigating unit deal with 
this? Or is there a financial purgatory section existing out 
here where we have no one that deals with that? Or do we need a 
rumor-mongering monitor with some teeth so that when people 
spread these rumors, they pay? Bear Stearns was the smallest, 
most vulnerable of the big five. Now Lehman Brothers is. I 
mean, what can you say that would cause the people who do this 
on Wall Street to tremble?
    Mr. Cox. Well, first of all, you are right, that in the 
circumstance that you outlined or in any market circumstance, 
it is possible for people to believe false information and make 
decisions based upon it. We have to make sure that this variant 
of false or misleading information, which is really what our 
whole honest public disclosure mission is all about, gets 
interdicted as early as possible. Prevented if at all possible, 
which we can do through the public example of our ongoing 
enforcement examinations.
    That is why this year we have been very high profile in 
what we have been doing in this area. As you know, we brought 
the first-ever case in the Agency's history this April where 
because of technology, we were able to do what you did in a 
different environment, in the market context. The individual 
who had manufactured very specific information about price, 
time and so on, board action of a prospective merger and put it 
in the marketplace so that he could trade on the false 
information was tracked down through his instant messages.
    So the same technology that is spreading these rumors 
around the world faster than ever is also now the friend of law 
enforcement. We have also announced a very significant sweep 
examination. The former case that I talked to you about was 
from our division enforcement. But our Office of Compliance 
Inspection Examination has also now joined with FINRA, the New 
York Stock Exchange regulation, to do a sweep examination of 
broker deals and hedge fund advisors to make sure that the 
existing rules, because there are rules, very specific rules 
against spreading these kinds of rumors, are being enforced, 
that there are programs in place so that there has to be 
compliance. Because sometimes it can be someone who is just 
working at a desk. And the firms that employ these people have 
to be responsible for implementing compliance control. So we 
are going at it that way as well. Enforcement and examination.
    Mr. Cleaver. We don't need any new laws?
    Mr. Cox. I think we have a lot of laws. We also have a lot 
of law enforcement and regulatory attention. Best of all, we 
have some technology now that is helping us in an area that in 
the past has been very difficult. Because what you described 
was parsing the difference between the person who started it 
and then mere intermediaries who were passing it along. Passing 
around what you heard is not a problem. Markets thrive on 
information. Markets have to evaluate whether it is true or 
false. But the people who are deliberately putting false into 
information into the mix, those are the people you want to go 
after.
    Mr. Cleaver. Thank you, Mr. Chairman. I yield back the 
balance of my time.
    The Chairman. The gentlewoman from California will finish.
    Ms. Waters. Thank you very much, Mr. Chairman. I came in at 
a time when Congressman Watt was raising some questions about 
protection for consumers. And my staff had talked with me about 
the notion of suitability in the lending and broader financial 
services industry. It gets down to a discussion that was, I 
guess, led by Harvard law professor Elizabeth Warren's notion 
of the financial product safety commission as analogous to the 
Consumer Product Safety Commission.
    Have you been involved in any extended discussion or given 
any thought to this idea of a Consumer Product Safety 
Commission that would be for either--well let's start with 
Chairman Cox.
    Mr. Cox. I think the idea of taking a look at insurance 
products, at derivatives products, at securities, at all 
financial products, which presently fall within the rubric of--
and the jurisdiction of a variety of regulators has a certain 
appeal. It also has a certain danger, and that is, that it 
might be so ambitious as to fail of its own weight. Because, as 
you know--I was just talking with Secretary Chertoff about this 
because during my 4 years chairing the Homeland Security 
Committee and the work we have spent here in Congress trying to 
do something similar in the homeland security area caused me to 
ask the basic question, what is the line, where are you better 
off merging things? And where are you better off sharing with 
existing structures? That is an issue that Secretary Chertoff 
is still managing within the Department and outside of it.
    I think it is vitally important to recognize the connection 
between the sophistication of law enforcement. President 
Geithner was talking about the enforcement piece and how 
important it is. The sophistication of that enforcement is 
really what makes the difference. If it weren't necessary, we 
would just have the NYPD or the Los Angeles Police Department 
go after this as a matter of routine law enforcement. But the 
cops on the beat really have to understand these markets. The 
products are very sophisticated. The trading techniques are 
very sophisticated. They are global markets. There is a lot of 
complexity here. Indeed I would go so far as to say that in all 
the major market disruptions and frauds that we have had, 
complexity has been a significant ally of the fraudsters 
because they kick a lot of dust up in the air, and they get 
away with things because people don't understand at first what 
they are doing.
    So there is a trade-off that has to be made. I like the 
idea of knitting this together as much as we possibly can. The 
question of whether you actually try and merge functions all 
into one agency gets a little harder because, you know, mergers 
present management difficulties. There are other organic 
statutes that are administered that might not fit together. 
There are a lot of complexities there as well.
    Ms. Waters. President Geithner, I am very concerned about 
what we are experiencing in the subprime meltdown. What 
disturbs me is, there were so many products that were 
introduced into the market. And it appears that there was no 
oversight responsibility for the no doc loans. They are not 
sophisticated ARMs. They are just trickery ARMs. The ARMs that 
have the teaser rates at the beginning, that are very low and 
then the resets quadruple. I mean, there is nothing 
sophisticated about that. Rather, it is organized in such a way 
that it entices, it encourages, and it supports people getting 
into situations that they cannot control and they cannot 
afford. And there are those who say, well, the consumer should 
know better. It is their responsibility. I take a little bit 
different approach.
    The average working man or woman who goes to work every 
day, who may be very well-educated, who is raising their 
family, who is trying to make the best use of their dollar, 
paying their bills, they don't know about these trickery 
products. Most of the Members of Congress didn't know about 
these products. Nobody reviewed these products and said to the 
initiators, I don't know. This looks a little bit difficult. I 
think this is going to create some problems in the market. And 
that is what I am talking about. I am talking about a kind of 
consumer protection that does not assume that the consumer is 
just a little bit too dumb, a little bit too stupid to 
understand these sophisticated products. What do you think 
about this Consumer Product Safety Commission idea?
    Mr. Geithner. I haven't looked at that specific proposal, 
but I want to underscore the point that the Federal Reserve 
Board did put out for public comment some pretty comprehensive 
changes to underwriting standards last week, I believe. And I 
think they would go some direction to meeting many of the 
concerns you laid out. The challenge, of course, is to make 
sure that they are evenly enforced. And you want to really make 
sure you are careful not to make sure that working family you 
described is unable to borrow, to meet the needs of health care 
or to finance education or to help create a business.
    And finally getting that balance right is important. I 
don't think we have that balance right today. I don't think 
anybody can say that. And it is going to require things like 
what the Federal Reserve Board laid out last week as well as a 
broader improvement in the sophistication and quality of 
supervision oversight and enforcement of the full range of 
institutions that are engaged in making those kind of loans.
    Ms. Waters. Thank you. If I may, there is just one other 
question that I have. I have gotten a partial answer from some 
of the staff members back here. I had an opportunity to meet 
with minority bankers. Some of them were from the Gulf Coast 
area, New Orleans in particular, who had experienced 
considerable destruction during Hurricane Katrina. And they 
were complaining about not getting a lot of support, a lot of 
help from anybody. Of course, they brought up Bear Stearns, 
look at what happens when Bear Stearns gets in trouble, but 
nobody is there for us. I don't know a lot about the use of the 
Federal Reserve discount window. Is this available to these 
bankers?
    Mr. Geithner. If they are banks, they have access to that 
window.
    Ms. Waters. How does it work?
    Mr. Geithner. You have the ability to come and borrow from 
the Fed under a set of conditions. And that privilege existed 
before Katrina, before Bear Stearns. It exists today.
    Ms. Waters. Did any of the banks who had been impacted by 
Katrina take advantage of the opportunity to borrow from the 
discount window?
    Mr. Geithner. I would have to consult with my colleagues in 
the Fed and get back with you in writing on that specific 
question.
    Ms. Waters. But you don't remember any discussion that you 
were involved with anyone?
    Mr. Geithner. Well, I am responsible for the institutions 
of New York and can't speak to the others.
    Ms. Waters. Okay.
    Mr. Geithner. What we do disclose once a week is broad use 
of our facilities. We never disclose individual institutions 
for a bunch of understandable reasons. But yes, they have 
access to those facilities today and have had for some time.
    Ms. Waters. Thank you very much. I think I am the only one 
left, so there can't be any other questions. I was not given 
permission, but I am going to adjourn this hearing. Such is the 
order. Thank you.
    [Whereupon, at 12:39 p.m., the hearing was adjourned.]


                            A P P E N D I X



                             July 24, 2008


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