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



                                                        S. Hrg. 110-712
 
WALL STREET TO MAIN STREET: IS THE CREDIT CRISIS OVER AND WHAT CAN THE 
   FEDERAL GOVERNMENT DO TO PREVENT UNNECESSARY SYSTEMIC RISK IN THE 
                                FUTURE?

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

                                HEARING

                               before the

                        JOINT ECONOMIC COMMITTEE
                     CONGRESS OF THE UNITED STATES

                       ONE HUNDRED TENTH CONGRESS

                             SECOND SESSION

                               __________

                              MAY 14, 2008

                               __________

          Printed for the use of the Joint Economic Committee


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                        JOINT ECONOMIC COMMITTEE

    [Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]

SENATE                               HOUSE OF REPRESENTATIVES
Charles E. Schumer, New York,        Carolyn B. Maloney, New York, Vice 
    Chairman                             Chair
Edward M. Kennedy, Massachusetts     Maurice D. Hinchey, New York
Jeff Bingaman, New Mexico            Baron P. Hill, Indiana
Amy Klobuchar, Minnesota             Loretta Sanchez, California
Robert P. Casey, Jr., Pennsylvania   Elijah E. Cummings, Maryland
Jim Webb, Virginia                   Lloyd Doggett, Texas
Sam Brownback, Kansas                Jim Saxton, New Jersey, Ranking 
John E. Sununu, New Hampshire            Minority
Jim DeMint, South Carolina           Kevin Brady, Texas
Robert F. Bennett, Utah              Phil English, Pennsylvania
                                     Ron Paul, Texas

                  Michael Laskawy, Executive Director
            Christopher J. Frenze, Republican Staff Director


                            C O N T E N T S

                              ----------                              

                                Members

Statement of Hon. Charles E. Schumer, Chairman, a U.S. Senator 
  from New York..................................................     1
Statement of Hon. Sam Brownback, a U.S. Representative Senator 
  from Kansas....................................................     3
Statement of Hon. Kevin Brady, a U.S. Representative from Texas..     5
Statement of Hon. Carolyn B. Maloney, Vice Chair, a U.S. 
  Representative from New York...................................     6

                               Witnesses

Statement of Hon. Paul A Volcker, former Chairman of the Federal 
  Reserve Board of Governors, Washington,DC......................     8
Statement of Dr. Douglas W. Elmendorf, senior economic fellow, 
  Brookings Institution, Washington,DC...........................    33
Statement of Ellen Seidman, director, Financial Services and 
  Education Project, Asset Building Program, New America 
  Foundation, Washington, DC.....................................    35
Statement of Alex J. Pollock, resident fellow, American 
  Enterprise Institute, Washington, DC...........................    38

                       Submissions for the Record

Prepared statement of Senator Charles E. Schumer, Chairman.......    52
Prepared statement of Representative Carolyn B. Maloney, Vice 
  Chair..........................................................    54
Prepared statement of Senator Sam Brownback......................    55
Prepared statement of Hon. Paul A Volcker, former Chairman of the 
  Federal Reserve Board of Governors, Washington,DC..............    56
Prepared statement of Dr. Douglas W. Elmendorf, senior economic 
  fellow, Brookings Institution, Washington,DC...................    58
Prepared statement of Ellen Seidman, director, Financial Services 
  and Education Project, Asset Building Program, New America 
  Foundation, Washington, DC.....................................    63
Prepared statement of Alex J. Pollock, resident fellow, American 
  Enterprise Institute, Washington, DC...........................    65


WALL STREET TO MAIN STREET: IS THE CREDIT CRISIS OVER AND WHAT CAN THE 
   FEDERAL GOVERNMENT DO TO PREVENT UNNECESSARY SYSTEMIC RISK IN THE 
                                FUTURE?

                              ----------                              


                        WEDNESDAY, MAY 14, 2008

             Congress of the United States,
                          Joint Economic Committee,
                                                    Washington, DC.
    The Committee met at 9:30 a.m., in room SH-216 of the Hart 
Senate Office Building, the Honorable Charles E. Schumer 
(Chairman of the Committee) presiding.
    Senators present: Klobuchar, Webb, and Brownback.
    Representatives present: Maloney, Hinchey, Brady, and Paul.
    Staff present: Christina Baumgardner, Heather Boushey, 
Chris Frenze, Tamara Fucile, Nan Gibson, Rachel Greszler, 
Colleen Healy, Bob Keleher, Israel Klein, Tyler Kurtz, Michael 
Laskawy, David Min, Robert O'Quinn, Jeff Schlagenhauf, 
Christina Valentine, and Jeff Wrase.

OPENING STATEMENT OF HON. CHARLES E. SCHUMER, CHAIRMAN, A U.S. 
                     SENATOR FROM NEW YORK

    Chairman Schumer. Good morning, everyone. The hearing will 
come to order, and we're going to get started unusually and 
atypically, right on time here.
    First, I want to thank you, Chairman Volcker, as well as 
our other witnesses--we have a second panel today--for coming 
to this hearing about the financial system and the steps we 
need to take to reform our regulatory structure.
    Our discussion will be a broader one. We're not going to 
get into specifics. That's the real province of the Banking 
Committee--I serve on that, as well, and some of us on this 
Committee do--but rather, the broader regulatory questions that 
we face, given everything that's happening in our new financial 
world.
    I'm worried that because things do not seem as bad as they 
did a month ago, we're already starting to become complacent 
about the critical need to address the regulatory and market 
failures that have had much to do with the troubling economic 
situation we find ourselves in.
    The past year has been a stark reminder of the direct link 
between Wall Street and Main Street, between the health of 
financial markets, and the economic well-being of all 
Americans.
    A year ago, most of us had never heard of CDOs and CMOs, 
and SIVs and of option ARMs and credit default swaps and 
auction-rate securities. Now we know that those who knew about 
those complex financial instruments clearly didn't know enough 
to protect consumers, investors, and our economy from them.
    And we've learned too much about the central role these 
financial tools have played in the worst housing crisis since 
the Great Depression, the freezing of credit markets worldwide, 
and the onset of the current economic slowdown which probably 
more than half of all economists call a recession.
    Financial innovation is vital, both for the health of our 
financial system and our economy, but it's just as vital that 
financial regulation keep up with innovation. Unfortunately, it 
has not.
    In my view, this credit crisis is as much a failure of 
regulation as it is a failure of the marketplace.
    The goal of regulation should always be to encourage 
entrepreneurial vigor, while ensuring the health of the 
financial system. We have, indeed, found that balance in the 
past, but it seems to have been lost.
    We have a 21st century global financial system, but a 20th 
century national set of financial regulations, and that has to 
change.
    To begin, we have to acknowledge that consolidation has 
transformed the financial industry. We no longer have any clear 
distinctions between commercial banks, investment banks, 
broker-dealers, and insurers that we did 60 years ago, or even 
20 years ago.
    Instead, there is a large number of financial institutions 
surrounded by many, many more smaller institutions, such as 
hedge funds and private equity funds with their own 
specialties. It's as though we have a handful of large 
financial Jupiters that are becoming more and more similar, 
encircled by numerous small asteroids.
    A regulatory structure has to recognize that change, as 
large investment banks have come to act more like commercial 
banks, and especially now that they can borrow from the Fed's 
Discount Window, they need to be supervised more strictly.
    We need to think very seriously about moving toward more 
unified regulation, if not a single regulator. We have too many 
financial regulators each watching a different part of the 
financial system, while virtually no one can keep an eye on the 
greater threats of systemic risk.
    In the United Kingdom, they have a single strong regulator 
who has responsibility for the entire system and the authority 
to act when necessary.
    Maybe a regulator with that authority could have prevented 
a debacle like the collapse of Bear Stearns, by acting quickly 
and forcefully before things unravelled.
    In a certain sense, the regulator--the prime regulator of 
Bear Stearns--was the SEC. They're interested in investor 
protection and transparency, whereas the Fed, which has the 
primary jurisdiction over systemic risk, really didn't have 
much knowledge or ability to go look at Bear Stearns, so you 
had mismatched regulators for what needed to be done.
    We have to figure out how to regulate the currently 
unregulated parts of financial markets as well.
    For example, credit default swaps are a multi-trillion-
dollar industry, almost completely outside the purview of 
regulators. Recently, there's been talk about creating a 
clearinghouse for credit default swaps.
    I think this is an excellent idea and the sort of 
innovation we should be thinking about more broadly. I also 
believe we need to think about whether a unique exchange for 
these swaps might be an even more effective way to bring about 
greater transparency and limit systemic risks.
    We must have greater transparency in the financial system--
period. The credit crunch has been as much a crisis of 
confidence as it has been a real economic crisis.
    Financial markets operate on trust and on the belief that 
participants have--that they can rely on the people they are 
entering into contracts with. As long as so many black holes 
remain in the financial system, it's going to be hard for that 
trust to be restored.
    We also must involve our international partners. National 
regulations can achieve only so much in a global financial 
market. It does us no good to enact new rules here if other 
countries remain lax in their regulations or their enforcement.
    The global financial regulatory system should not be the 
arithmetical equivalent of the lowest common denominator. This 
crisis and the complexity of our system requires much more.
    And finally, we must put aside the laissez-faire, no-
government-is-good-government mantra that we too often hear 
from this Administration and from many of my friends on the 
other side of the aisle.
    Clearly, the market does not solve all problems by itself, 
and of course, neither does Government. That's why we need 
firm, forward-looking regulation to prevent the sort of crises 
we're facing now from occurring in the future.
    I share with Treasury Secretary Paulson and Chairman 
Bernanke the hope that the worst of the credit crisis is behind 
us, but I'm not convinced that it's over. Whatever calm has 
been brought to financial markets today has been the result, 
largely, of extraordinary actions taken by the Federal Reserve.
    Chairman Bernanke deserves credit, but the actions he has 
had to take are a sign of just how unprecedented and how 
troubling this credit crisis has been.
    We cannot sit back, relax, and hope for the best. The 
American people, our economy, and the global financial system 
can't afford it.
    [The prepared statement of Senator Schumer appears in the 
Submissions for the Record on page 52.]
    Chairman Schumer. I'd now like to call on Senator Brownback 
for an opening statement.

 OPENING STATEMENT OF HON. SAM BROWNBACK, A U.S. SENATOR FROM 
                             KANSAS

    Senator Brownback. Thank you very much, Mr. Chairman. 
Welcome, Chairman Volcker. Good to have you back. It's always a 
pleasure to see you.
    I was talking to some individuals the other day, who had 
had some comments or had heard a speech you had recently given, 
and I wanted to follow up in questioning, in the time period 
that I have with you, about that.
    Mr. Chairman, I appreciate the topic. It's quite a broad 
one: Is the credit crisis over and what can the Federal 
Government do to prevent unnecessary systemic risk in the 
future? It sounds suitable, I think, for a well-planned series 
of broad-based hearings.
    I certainly hope that we can take the time in the Committee 
to examine this subject in much more detail. It certainly seems 
like it's ripe for a discussion and something that we can work 
on collectively.
    Obviously, much of the current economic slowdown can be 
attributed to dysfunctional financial markets over the past 
year, caused by turmoil in markets for asset-backed debt 
securities and obligations.
    We have witnessed the collapse of a major investment 
banking firm, or near-collapse, but for the unprecedented 
action of the Federal Reserve Board.
    Well, there's been general praise for the actions of the 
Federal Reserve, which I have joined. Questions have been 
raised about how close to, or how far outside the boundaries of 
the its authority the Federal Reserves's actions were.
    I'd like to note that the Fed took onto its balance sheet, 
and therefore the taxpayers' balance sheet, risky, private-
sector assets inherited from an investment bank, over which the 
Fed did not have direct regulatory oversight as part of the 
takeover of Bear Stearns by J.P. Morgan Chase.
    Well, the Fed has the power to do so under a 1932 provision 
of the Federal Reserve Act, allowing the Fed to lend to non-
banks under, quote, ``unusual and exigent circumstances.'' It 
isn't entirely clear what constitutes such circumstances.
    The Fed's recent actions introduce serious issues of moral 
hazard by signalling to risk-takers and financial markets, that 
if the dice do not turn up favorable, the Fed, and hence 
taxpayers, will provide a backstop.
    The Federal Reserve has also created new ways of lending to 
depository institutions and to investment banks by setting up a 
new term auction facility and term securities lending facility.
    The latter allows primary dealers to exchange less liquid 
securities at an auction-determined fee for some of the Fed's 
Treasury securities.
    Recently, the Fed has allowed private-sector asset-backed 
securities as securities eligible for such transactions.
    So, the Fed has basically been conducting some of its 
monetary policy by rearranging its, and therefore, the 
taxpayers' balance sheet, trading Treasury securities for 
securities that include risky, asset-backed private securities.
    While I believe that the Fed's recent actions and 
activities have been creative and may have helped reduce 
tensions in domestic and global credit markets, I also take 
seriously the responsibility that Congress has in its oversight 
role regarding the Fed.
    I think that we need to know more than we currently do 
about recent actions. For example, to my knowledge, we don't 
have a clear accounting of the assets that the Fed took onto 
its balance sheet in the Bear Stearns J.P. Morgan Chase deal, 
or an accounting of the value of those assets.
    Given the Fed's recent emphasis on transparency, it would 
be useful to know, but interesting that we don't.
    One of our witnesses today, former Federal Reserve Bank 
Board Chairman, Paul Volcker, is certainly eminently qualified 
to offer perspectives, not only on the broad topic of avoiding 
system risk, but on the more narrow questions of whether or not 
the Federal Reserve acted appropriately.
    Mr. Chairman, I look forward to the discussion and the 
questions with our witnesses.
    [The prepared statement of Senator Brownback appears in the 
Submissions for the Record on page 55.]
    Chairman Schumer. Thank you. I think we'll call on Mr. 
Brady, Congressman Brady, before Congresswoman Maloney, so that 
Congresswoman Maloney can get settled.
    Congressman Brady is taking the place of Congressman Saxton 
today.

 OPENING STATEMENT OF HON. KEVIN BRADY, A U.S. REPRESENTATIVE 
                           FROM TEXAS

    Representative Brady. Thank you, Mr. Chairman, very much. 
It's a pleasure to join in welcoming the witnesses before us 
today.
    The recent financial turmoil and the consideration of 
appropriate responses are key concerns of policymakers, and I 
thank Chairman Schumer for calling this hearing.
    I'd like to also express my appreciation for the service of 
Paul Volcker as Federal Reserve Chairman. His perspective is 
invaluable.
    He was appointed by President Carter, in 1979, to deal with 
the serious and growing inflation problem that was wreaking 
havoc on the economy.
    The magnitude of the problem can be seen in a number of 
statistics from 1980. That year, inflation was 13.5 percent. It 
pushed interest rates up, with mortgage rates well over 10 
percent and rising.
    A recession caused the Gross Domestic Product to decline, 
while unemployment averaged over 7 percent for the year. With 
inflation and unemployment both rising, the notion that higher 
inflation could lead to lasting reduction of unemployment was 
finally discredited.
    As Fed Chairman, Mr. Volcker had the difficult task of 
sharply reducing inflation and restoring price stability, 
thereby laying a foundation for sustainable economic growth.
    The Fed has maintained the policy of price stability since 
the early 1980s, leading to an era of low inflation, low 
interest rates, and low unemployment.
    The economic growth of the last 25 years would not have 
been possible without the cornerstone of price stability laid 
down under Mr. Volcker's tenure.
    More recently, there have been concerns about whether 
inflation may be a rising threat to future economic growth. 
There have been concerns that earlier policies may have 
contributed to the housing bubble and resulting debacle in 
mortgage-backed securities and related investments.
    In addition, a variety of new financial instruments have 
been created, generating risks that were poorly understood, 
even by the most sophisticated bank executives on Wall Street. 
As a result, after the bubble burst, banks have had to make 
massive writedowns, and then in response, the Fed has loosened 
monetary policy and resorted to a series of innovations and 
extraordinary actions, including the rescue of Bear Stearns 
last March, amid serious distress in the financial markets.
    I will conclude with this: Financial innovation and the 
recent financial turmoil have made clear the need for financial 
regulatory reform. The issues are very complex, and the debate 
about regulatory reform will likely go on for many years.
    As a layman, it seems to me that our financial markets and 
their instruments tend to move with the speed and agility of 
the matrix, yet Government regulation, by nature, and 
regulators tend to move with the speed and agility of John 
Madden, whom I love by the way.
    But the point is that--my concern is that whatever 
direction we head, that our regulators not micromanage each 
instrument and each market, but put in place the transparency 
and the standards that better allow investors and the public to 
monitor and short-circuit such crises before they occur again. 
That is our challenge before us. Mr. Chairman, I yield back.
    Chairman Schumer. Thank you, Congressman Brady. Last, but 
not least, Vice Chair Maloney.

  OPENING STATEMENT OF HON. CAROLYN B. MALONEY, VICE CHAIR, A 
               U.S. REPRESENTATIVE FROM NEW YORK

    Vice Chair Maloney. Thank you so much. I first thank the 
Senior Senator from the great State of New York for his 
leadership on this issue, and New Yorkers are equally proud of 
Chairman Volcker and his distinguished service to our country.
    We are thrilled to have you here today. We all look forward 
to your advice and your statements and your wisdom.
    At the core of the ongoing liquidity crisis is the decline 
in home prices which is causing banks to readjust their balance 
sheets and to buildup capital.
    Congress is currently focusing its attention on keeping 
families in their homes and stemming the deepening decline in 
home prices. The crisis in the housing market has brought to 
light the inability of some of our most sophisticated and 
respected institutions to measure their exposure to opaque 
assets and manage the risks associated with them.
    Untangling the DNA of assets has become increasingly 
difficult for investors. We clearly need greater transparency 
for complex investment products to assure a smoothly 
functioning market.
    Our entire regulatory system is also in serious need of 
renovation because financial innovation has surpassed our 
ability to protect consumers and hold institutions accountable.
    In our rather fragmented system, financial regulators do 
not have authority to broadly address systemic risk. The 
Financial Services Committee will soon turn its attention to 
rethinking financial services regulation.
    Meanwhile, the Treasury Secretary has a sweeping proposal 
for revising the Federal regulation of all financial 
institutions. That plan would grant the Federal Reserve power 
to serve as an overreaching market stability regulator, with 
the ability to collect information and require corrective 
action across the broad spectrum of financial services.
    Our current system of multiple regulators does leave big 
holes that a super regulator could plug. For example, the 
unwillingness, up to this point, of the Federal Reserve and the 
SEC to require working capital limits has been criticized as 
adding to risk-taking.
    Only now has the SEC joined other Federal regulators in 
working with the Basel Committee to extend the capital adequacy 
standards to deal explicitly with the liquidity risks.
    The Bear Stearns rescue also exposed the lack of Federal 
regulatory authority to supervise investment bank holding 
companies with bank affiliates, as the Fed supervises 
commercial bank holding companies.
    Thus, investment bank holding companies don't have to 
maintain liquidity on a consolidated basis. In the wake of the 
Bear Stearns debacle, SEC Chairman Cox has said that investment 
banks can no longer operate outside of a statutorily 
consolidated supervision regime.
    Giving investment banks access to the Fed's discount 
window--which was created for depository institutions--creates 
challenges, since they are not regulated like depository 
institutions. In particular, they have no restrictions on how 
highly leveraged they can be.
    We need reforms, but the Treasury plan is so sweeping that 
it risks possibly being disruptive, while we are working so 
very hard to stabilize our economy. Moreover, it risks 
eliminating regulatory voices that should be heard.
    The American system of Government relies on checks and 
balances, and we can all think of instances when the lone voice 
of a Federal regulator has pushed the group to an action that 
was unpopular, but proved to be right.
    We should focus first on targeted reforms with maximum 
effect. Improving the transparency and accountability of 
trading and credit default swaps and derivatives is one 
possible example.
    A key factor that apparently pushed the Fed to rescue Bear 
Stearns was concern about a domino effect from the interlocking 
relationships between thousands of investors and banks over 
credit default swaps, which are presently traded by investment 
banks off any exchange and without any transparency.
    Requiring the use of exchanges and clearinghouses for 
credit default swaps and derivatives is possibly worth 
exploring, and I look forward to your comments on it.
    Mr. Chairman, I thank you again for holding this hearing 
and for your leadership for New York and for our economy and so 
many creative ways. And again, it is a great honor for this 
Committee to have Chairman Volcker here today.
    Everyone is asking me in New York, what does Chairman 
Volcker have to say about what is happening; so today, we get 
an opportunity to hear from you. We are delighted by your 
presence, and thank you again for your service to our Nation.
    [The prepared statement of Representative Maloney appears 
in the Submissions for the Record on Page 54.]
    Chairman Schumer. Thank you, Vice Chair Maloney. Now to our 
first witness; Paul Volcker is truly one of the most esteemed 
public servants in American recent history, a giant of 
financial regulation.
    He is a former Chairman of the Board of Governors of the 
Federal Reserve System, where he served from 1979 to 1987. 
After retiring as chairman of Wolfenson and Company, Mr. 
Volcker served as Chairman of the Board of Trustees of the 
International Accounting Standards Committee from 2000 to 2005.
    He chaired the independent inquiry into the United Nations 
Oil-For-Food Program in 2004, and he's also professor emeritus 
of international economic policy at Princeton University. 
Chairman Volcker, we're delighted you're here, and thank you 
for going out of your way to come.

   STATEMENT OF HON. PAUL A. VOLCKER, FORMER CHAIRMAN OF THE 
       FEDERAL RESERVE BOARD OF GOVERNORS, WASHINGTON, DC

    Chairman Volcker. Well, thank you, Mr. Chairman, ladies and 
gentlemen. We had a couple of conversations about coming here, 
and you emphasized that you looked forward to informality in 
this hearing.
    Chairman Schumer. Correct.
    Chairman Volcker. And I appreciate that. I'll just make a 
few brief comments, if I can, which duplicate some of the 
things you've been saying, to kind of help set the stage; but I 
would emphasize at the beginning, I do not see any reason for 
complacency about recent market developments, however much, we 
can welcome a little bit more calmness at the moment.
    Now, we are in most difficult and complicated economic and 
financial circumstances, and we shouldn't doubt that.
    I would emphasize a point that we often lose sight of, 
that, in the background, this is not just a financial problem; 
it is an economic problem.
     We have had an unbalanced economy. This country has spent 
some years spending a lot more than it's been producing. It's 
carrying out a higher level of consumption, relative to GNP, 
than we could sustain, and that adjustment had to be made 
sooner or later.
    I think we're probably in the midst of making it, but it is 
a difficult question.
    That's in the background. In the foreground is the new 
financial system that a number of you commented on: less 
reliant upon banks, more reliant upon the open market, a more 
fluid system. It's certainly heavily engineered.
    You and others have said, Mr. Chairman, that you look 
toward more transparency, and it's hard to argue against 
transparency, but I have to tell you, this new financial 
system, with all its enormous complexity, gives rise to a 
certain opaqueness that it is almost impossible to penetrate, 
so I don't think we're going to find all the answers in 
transparency.
    There's kind of a symbiotic relationship between this new 
financial system and the unbalanced economy. The new financial 
system was so fluid and so effective in some ways that it 
enabled us to finance the excess in spending.
    We didn't have to save when people thought they had other 
ways of finding money. The subprime mortgage phenomenon is the 
prime example of financial engineering leading to a way to 
finance consumption.
    Well that's broken down, and to oversimplify, I think we 
are seeing a system in which the mathematicians, basically, 
have taken over--the financial engineers. Combine that 
complexity and opaqueness with a supercharged compensation 
system, and you had great incentives for risk-taking.
    And at the same time, you had a basic breakdown, I think, 
in the discipline of credit analysis: The system developed in a 
way that's trading-dominated. People didn't worry so much about 
the quality of the paper, so long as you could pass it off on 
somebody else in a hurry.
    Chairman Schumer. Right.
    Chairman Volcker. And there was a lesser sense of 
vulnerability.
    As a general, sweeping conclusion, I would have to say 
that, under stress, this new system has really failed the test 
of the marketplace. We are here because the new system has, in 
effect, broken down.
    That put the Federal Reserve front and center in dealing 
with a crisis. It's obviously reacted in unprecedented ways, as 
has been mentioned here, with considerable success, but it 
leaves us with some big unresolved issues which you have all 
already mentioned.
    What is the proper role of the lender of last resort? The 
traditional framework has been the banking system, heavily 
regulated, on the one side, has access to the lender of last 
resort, as a protection mechanism. Now we have the lender of 
last resort, rescuing sectors which are not subject to heavy 
regulation, and that's an incongruity that I think has to be 
corrected.
    A little more subtle, but also mentioned by one of you, the 
Federal Reserve has taken on its balance sheet--not just the 
Federal Reserves, it's other central banks in Europe. They have 
become, in particular, supporters of the mortgage market.
    They've done it in order to react to the current crisis, 
but we have to ask ourselves, what are the implications for a 
central bank getting involved in supporting particular sections 
of the market?
    I understand that there are demands now, that they get into 
the student loan market, which is under stress, and maybe some 
other year, it will be some other part of the market. That has 
not been in the tradition of central banks, and I think what's 
at issue here, in the long run, is the independence of the 
central bank.
    If it is going to be looked to as a rescuer or supporter of 
particular sectors of the market, that is not a strictly 
monetary function in the way it's been interpreted in the past.
    And then there is, of course, the question of the Federal 
Reserve's role, or anybody's role in supervision. I know from 
experience--it's obvious that regulation has inherent problems; 
it's awkward, arbitrary, backward-looking often. Apart from 
that, the life of a regulator is not a happy one.
    When things are going well, nobody wants to be regulated.
    Chairman Schumer. Right.
    Chairman Volcker. And the resistance of the market to being 
regulated is transmitted quite readily into the political 
process when things are going well.
    When things are going bad, everybody asks the regulator, 
where were you? Well, he wasn't there, in part because of the 
inherent difficulty of effective regulation when things are 
going well.
    There have been breakdowns in supervision and regulation 
here; I don't think there's any doubt about it.
    But beyond the Federal Reserve and beyond supervision and 
regulation, let me just make my own list. There are other 
issues involved here: Credit rating agencies; accounting; the 
role of mark-to-market and fair-value accounting.
    I wonder, in this situation, going back months ago, where 
were Fannie Mae and Freddie Mac? Here are institutions that 
have been created to support and facilitate the mortgage 
market, and in pursuit of their private property objectives, 
they strained themselves to the point that when the crisis 
comes, their ability to act is limited.
    How do we restore credit analysis? What about the 
compensation system?
    These are not very easily soluble problems, and I would 
conclude with the point that you just made, Mr. Chairman, that 
we're not going to solve these problems by domestic action 
alone. This is an international market, and we're going to have 
to work together with others.
    I don't think that's an impossible challenge. There's been 
a lot of progress in that area recently.
    This crisis clearly goes beyond the boundaries of the 
United States. It's clearly recognized in Europe; I think it's 
recognized in Japan, and there is a lot of basis for hope that 
we can get together on reasonable regulatory approaches, as we 
already do in some areas, with other major financial centers.
    [The prepared statement of Hon. Paul A. Volcker appears in 
the Submissions for the Record on page 56.]
    Chairman Schumer. Well, Mr. Chairman, thank you. I recall, 
in my House days on the Banking Committee, when you were Fed 
Chairman. There's only one thing that's changed; your acuity 
and your being able to summarize succinctly, but with just 
laser-like analysis, is still there.
    But the rules have changed and you don't have your big 
cigar, so you don't have all the smoke coming in front of you.
    Chairman Volcker. I don't even miss it, which is something 
I never thought was possible.
    Chairman Schumer. See, regulation moves onward.
    [Laughter.]
    Chairman Schumer. But, in any case, it is great to hear 
you, and I have so many different questions.
    Your analysis is troubling and sort of puts us in a 
different way. You know, when I look at this, I sometimes say 
the international aspects are the most difficult, but you're 
saying, no, we've had good progress there.
    The difficulty here is just the complexity of these markets 
and the inability of regulation to almost catch up. 
Transparency doesn't solve the problem, because, in a sense, 
the markets are fragmented and opaque in themselves.
    That's worrisome and troubling, and something we're going 
to have to think about a lot.
    Chairman Volcker. I have, just as a homely example, looked 
at a couple of annual reports of major financial institutions, 
recently. They are very thick.
    And if you can keep awake while reading them and 
understanding them, you're a better man than I am, and it 
reminds you that the executives of these companies, I think, to 
put it mildly, have great difficulty in really understanding 
the amount of risk and complexity involved in their 
organizations.
    Chairman Schumer. Right. I agree with you. First--and you 
can give a relatively quick answer here--the Federal Reserve 
did take the radical step you talked about it, to prevent the 
collapse of Bear Stearns.
    Some people have said they've overstepped their authority. 
Do you think they had any choice? Could they have done it 
differently? Do you basically agree with what Chairman Bernanke 
did, given his limited abilities ahead of time?
    Chairman Volcker. I was not there, but I can imagine that 
they were faced with a problem, and with a very short 
timeframe, worried about the contagion from the loss of Bear 
Stearns which was thrust upon their consciousness with 
suddenness, very quickly, and the interaction of a major 
investment banking firm--it's interesting that it was the 
smallest of the major investment banking firms--nonetheless 
created the possibility of a severe systemic crisis and 
difficult circumstances, so I can certainly understand why they 
felt they had to act.
    Chairman Schumer. Do you think we have to follow up now, 
and does this almost, by definition, require us to re-examine 
how regulation is done?
    Chairman Volcker. Absolutely. In a way, this crisis forced 
attention to what existed, in fact, already. The banking 
sector, which was protected and regulated, had gotten 
relatively smaller. The other sector had gotten larger and 
larger, but legislation and banking regulations had not caught 
up with that fact. Now, you're forced to look at it.
    Chairman Schumer. Right.
    Chairman Volcker. That's easy to say.
    Chairman Schumer. Hard to do.
    Chairman Volcker. What is an investment bank? Who is 
protected; who is not protected? It's put in stark contrast, 
when you think back to long-term capital management. This 
wasn't even an investment bank; it was a hedge fund.
    My God, there are 40,000 or 50,000 hedge funds in the 
world, and this was supposed to have been a very sophisticated 
one. Have we got a financial system that cannot stand the 
particular loss of one hedge fund, with a relatively 
concentrated number of creditors?
    That is a pretty sad commentary on the basic framework of 
the financial system.
    Chairman Schumer. Right, and frightening, in a certain 
sense. The interconnectedness and, as you say, the complexity 
and opaqueness, allow a small flea on a tail of a dog, to have 
the whole system sort of collapse.
    Let me ask you about two specific issues and just get your 
thoughts on them. I have been moving in the direction and 
talking about consolidating the system of regulation. When you 
have the combination that you've talked about, to have the 
regulators all chopped up in 25 different pieces, doesn't make 
much sense. What do you think of that?
    Second, these swaps and derivatives, in general, as you 
say, are as opaque as could be, and difficult, and transparency 
may not solve much, but there is a lot of talk about having 
some kind of clearinghouse, so that trades don't just occur 
among two parties, but at least a larger number of parties who 
are in the general area, get to see what's going on.
    What do you think of each of those ideas?
    Chairman Volcker. Well, let me take the second one, first, 
because I can give you a briefer answer. I'm not an expert in 
these kinds of things, but this is one of the weak points, I 
think, in the present financial system, that you do not have a 
clearinghouse where a potential loss can be absorbed over a 
large number of participants.
    Until recently, the settlement arrangements for this 
explosion in derivatives, have been very uncertain, in my 
understanding. That's been cleaned up, fortunately, to some 
extent, but by and large, there's no clearinghouse for most 
credit default swaps, in particular, which is, I think, the 
biggest point of vulnerability, so, yes, I think that is a 
priority.
    Now, I won't say much more about it, because I'm not an 
expert in that area.
    Chairman Schumer. Good enough.
    Chairman Volcker. On consolidated regulatory authority, of 
course, this is a big issue. The English thought they got it 
right some years ago. They put it all in one big agency, had 
some liaison with the Central Bank, but not apparently, close 
enough.
    As soon as it was tested, it didn't pass the test very 
vigorously, and the admiration for that system is somewhat 
diluted and leaves open the question.
    I'll illustrate the difficulty, I guess, without an answer: 
From my point of view, it's always seemed rather clear, maybe 
even obvious to me, but I'm biased, that the Federal Reserve 
ought to be the principal financial supervisor, given its broad 
responsibilities.
    Partly because of its responsibilities as lender of last 
resort, but also because of its independence, I think it's in a 
better position to resist political pressures on regulation. It 
also has a sense of continuity and the place of regulation 
within the broader economic context.
    So, I would say, yes, we need more uniformity, and it looks 
like the Federal Reserve seems to be the logical candidate.
    Chairman Schumer. So, one place you might look to is, give 
them more authority over holding companies of so-called 
investments.
    Chairman Volcker. That is one way to do it, but now I have 
a certain hesitancy. How much do you want to give to the 
Federal Reserve? If you make them, to go to the extreme, the 
sole regulator of financial stability considerations, which 
would include what you're saying, it becomes an even more 
powerful agency in the United States.
    It's getting into areas that are not typically thought to 
require the degree of independence that monetary policy does, 
so what does that mean for the structure of the Federal 
Reserve? I'm sure it means one thing, administratively--the 
Federal Reserve is not equipped to do it now.
    Chairman Schumer. Right.
    Chairman Volcker. And it would have to be reorganized and 
to the degree the Federal Reserve takes on more responsibility, 
and even without that, I would urge the Congress to make some 
arrangement where within the Federal Reserve there is an 
official, presumably subject to, I guess, Congressional 
confirmation; that is the chief supervisory regulator.
    Now, maybe he's on the Federal Reserve Board. It could be 
the Vice Chairman of the Federal Reserve Board.
    But there has to be somebody there who's accountable, more 
directly than is the case at the moment when you begin 
combining these agencies, at least in my view. You've got to 
have stronger staff, you've got to be able to pay some of these 
mathematicians and experts to get it on your side, instead of 
on the other side, or at least to match the other side.
    So, there are all kinds of interesting questions, including 
whether the Federal Reserve really needs to be the sole 
supervisor.
    There's something to be said for the Treasury outline. I 
think it was interesting.
    Chairman Schumer. Which outline?
    Chairman Volcker. The one announced by Secretary Paulson 
where they want to divide up the supervision by function. Take 
business practice, consumer protection, investor protection and 
give that to a new super SEC, I guess; create a super safety 
and stability regulator, and then have the Federal Reserve 
oversee it in some sense.
    The obvious question that many people have pointed out to 
that is, if the Federal Reserve is going to oversee it, it 
better get more involved than just coming in after a crisis.
    So I don't think that resolves the problem, but it's an 
interesting suggestion.
    Chairman Schumer. Thank you.
    Representative Brady.
    Representative Brady. Thank you, Chairman, and thank you, 
Chairman Volcker.
    I worry a bit about piling too much on the Federal 
Reserve's plate for fear that they will lose sight of their 
core mission. I know that in Federal agencies when Congress 
tends to create that mission for them, they often are 
ineffective in actually doing what we sent them up to do. 
That's a concern.
    The reason I really appreciate you being here today, is, I 
think we've really reached the point where we ought to be 
applying Noah's principle, which is, we need fewer people 
telling us it's raining and more people picking up a hammer and 
helping us build an ark.
    Your perspective is, I think, to help us identify the types 
of reforms that can help us build a regulatory environment that 
maximizes the up side of capitalism and helps prevent the 
problems we have today.
    Forgetting for a moment, who would be the regulator, or if 
it would be a consolidated regulator, in your view, what is the 
most important reform that Congress and the executive branch 
could bring to bear on this ever-changing, complex, 
international financial market? What's the most important? 
Where would you start on the regulatory side on this issue?
    Chairman Volcker. Well, I would start from the 
Congressional perspective, I think, to decide what we were just 
discussing. What should be the broad framework for that 
regulation? Should it be one agency? Should it be maybe two 
agencies along the lines of the Treasury proposal, one for 
business practices and one for safety and soundness?
    That's kind of an alluring suggestion to me, but then as we 
just discussed, you can't or should not--anyway, in my view, 
remove it all from the Federal Reserve. They have to be rather 
intimately involved.
    Whether they have to be the operating regulatory agency in 
all detail is a question that needs to be resolved. But don't 
separate them, don't insulate the regulator from the lender of 
last resort.
    I think the British experience is relevant--and it's not 
just that. There was an incident in Canada some years ago, 
where the most important regional banks in Canada, together, 
were in danger of failing. The Bank of Canada was called in for 
a rescue, and they had no supervisory authority, were obviously 
unfamiliar with the situation, but yet they were deemed 
responsible for maintaining the stability of those 
institutions.
    That is not a sensible system, in my view.
    Representative Brady. In part of the discussion of how best 
to regulate and who should do it, what is the goal we want them 
to accomplish? Where do we want them to start?
    You mentioned that the current opaqueness in the system is 
a great contributor to the problem. And you sort of inferred 
transparency is not necessarily the solution, but is it your 
point that transparency would help.
    When you've got CEOs of major financial institutions who 
don't understand the complexity of their own purchases and 
risk-taking, surely we need to have more transparency, so that 
average investors understand--and regulators and Members of 
Congress, can understand what is happening in the market at a 
given time, don't you?
    Chairman Volcker. Well, yes, but I don't know how you get 
it. Take these CDOs that have been mentioned. These are big 
packages of mortgages and other forms of debt that some 
transformer has put into a big package.
    They may or may not individually have some credit ratings, 
but a lot of them have not had much credit discrimination these 
days, because the originator doesn't take any risk, so he's not 
worried about the credit. The transformer doesn't take much 
risk because he's going to sell it.
    They're put into a huge package, turned over to a credit 
rating agency that is going to use the same mathematical 
formulas and algorithms for evaluating the package that the 
originator used.
    Representative Brady. Sure.
    Chairman Volcker. Because those are the ones that exist. 
They haven't looked at the individual credits, and then they 
sell it in the market. They may sell it to some municipality in 
Norway or whatever, to UBS in Switzerland, or obviously, to 
pension funds in California or wherever.
    And nobody's really looked at it. You know, transparency, 
all right, what's the transparency? You're going to list 6,000 
individual mortgages that are in the package? Who's going to 
look at them?
    Nobody really has, now, responsibility for them, or cares, 
in some sense, so long as you can sell it. They've been told 
that, you know, mathematical analysis says it's not likely that 
more than 5 percent are going to go bad, and another 10 percent 
will have difficulty, and the other 70 percent are going to be 
triple-A credits.
    Well, that's fine, until somebody begins questioning 
whether that's true, in the middle of a crisis, and you have a 
mess.
    Representative Brady. Thank you, Mr. Chairman. I appreciate 
it.
    Vice Chair Maloney [presiding]. Thank you. What should the 
Fed have done differently, if anything?
    Chairman Volcker. Pardon?
    Vice Chair Maloney. What should the Fed have done 
differently with the Bear Stearns situation?
    Chairman Volcker. I can't say how it could be done 
differently. They were faced with a situation to which they 
reacted, and they reacted by drawing on emergency powers and 
interpreting existing law in a way that permitted them to act, 
and act forcefully.
    The more relevant question, I suppose it seems to me, is 
could more effective supervision by the Federal Reserve, or by 
other agencies--earlier--have avoided the crisis in the first 
place? Well that is a proposition to be examined. My answer 
would be: Not entirely, because supervision and regulation is 
not always that effective.
    But I think there are lessons to be learned in supervision 
and regulation in this case, and some parts to me seem fairly 
obvious. How did these banks-- why were they permitted to set 
up these off-balance sheet entities which may or may not have 
had some formal relationship to the bank? They certainly had 
enough relationship to the bank, so when they got in trouble, 
the banks felt responsible for them, but yet they were not 
regulated and they did not hold any capital against them, or 
adequate amounts of capital against them. Why did that happen 
against the experience in another area of Enron, WorldCom, and 
all these other places that had similar off-balance sheet 
accounting entities?
    Vice Chair Maloney. Thank you.
    Chairman Volcker. There are lessons to be learned here, 
without any question.
    Vice Chair Maloney. Can you elaborate on the question that 
you posed in your testimony about whether it is wise for such 
far-reaching responsibilities--oversight of commercial and 
investment banking--to rest within a single organization like 
the Fed?
    And related to that, how do you think vesting all of these 
regulatory responsibilities at the Fed would impact its ability 
to conduct monetary policy and also maintain its independence?
    Chairman Volcker. Well let me draw a distinction; it may be 
subtle, but I think it is real--a distinction between 
regulatory and supervisory responsibility, and a willingness or 
demands to intervene in particular sectors of the credit 
markets.
    The Federal Reserve, as are other Central Banks, is 
obviously taking into its balance sheet a lot of mortgages 
these days. One of the critical elements of this crisis has 
been a freezing up of the mortgage market. So the reaction has 
been,``all right, let's try to unfreeze the market, and we'll 
buy a lot of mortgages.''
    Well the creators of the Federal Reserve System would be 
rolling over in their graves thinking that the Federal Reserve 
is buying mortgages. In those days, they couldn't do anything 
except buy short-term commercial paper. They couldn't even buy 
a Treasury Bond, much less a Mortgage Bond.
    And when I look at it I say: Look, the mortgage market was 
a problem. There is no doubt about it. But where were Fannie 
Mae and Freddie Mac? These are two Congressionally created 
agencies with the specific responsibility for encouraging the 
stability and flexibility of the mortgage market.
    A crisis comes along, and they say: Well, we are already 
over-stretched; our capital exposure is already strained; we 
can't do anything to help.
    Well what kind of a system have we got when the agencies 
who are supposed to be reflecting the public interest in the 
mortgage market are out serving the interests of their 
stockholders? As they see it, that's understandable----
    Vice Chair Maloney. That's a very good question, a very, 
very good question.
    Are we just--could you comment on our place in the world 
economy and the need for flexibility for our financial 
institutions to remain the leaders--we hope--in the world 
economy, or certainly one of the powerful voices in it, and a 
complaint that I hear sometimes that more supervision and 
regulation would stymie our creative ability to be----
    Chairman Volcker. Yes, I know.
    Vice Chair Maloney. You have heard the same thing?
    Chairman Volcker. Yes, I have heard that.
    Vice Chair Maloney. Would you comment on it, please? And 
then my time is up.
    Chairman Volcker. No, but I think you've just got to look 
at this from the other direction, that these problems are 
common to developed markets all over. The United States may 
have been in the lead in some of this market development, but 
it is not alone.
    Some would argue the principal capital of the world capital 
markets these days is in London, not in New York. I hope that's 
not true, but in any event, it's international.
    And you can't have certain types of regulation anyway, 
effectively in the United States because the business can be 
done elsewhere. It's already being done elsewhere. But I do 
think there is a common interest among developed countries with 
developed markets to approach this together. And that is not 
new.
    People told me 20 years ago when we started out uniform 
capital standards for commercial banks, it couldn't be done. 
Forget about it. Well, it got done. And you do have relatively 
uniform capital standards today.
    We now have, remarkably, the approach of uniform accounting 
standards around the world, another area where 10 years ago 
people in the United States said, ``forget about it; our 
accounting standards are good; the rest of the world can follow 
our accounting standard.''
    Well that is not the view anymore--quite correctly--and a 
lot of progress has been made in those areas. There are efforts 
toward standardizing and improving auditing standards around 
the world.
    There are other examples of this kind of cooperation. Some 
people came in to see me the other day from the European 
Parliament where they are working hard on regulation 
supervision of hedge funds and private equity funds. They are 
ahead of us in terms of eagerness to get some sensible 
regulations.
    So we have to work with these people because I think there 
is a definite common interest. And in this crisis--the biggest 
bank in Switzerland has been in an epicenter of this crisis. Do 
you think the Swiss are not going to be interested in 
developing some common standards? Well I think they are going 
to be.
    So I think you have to look at it from that direction. This 
is a global problem.
    Vice Chair Maloney. Thank you so much. My time has expired.
    Congressman Paul.
    Representative Paul. Thank you, Madam Chair.
    Welcome, Chairman Volcker. It's good to see you again. Like 
Chairman Schumer, I remember well the discussions we had back 
in the 1970s and early 1980s regarding another financial 
problem at the time. But back then, we also dealt with the 
Monetary Control Act that we debated rather vigorously, and I 
was concerned about Reserve requirements going down to zero, as 
well as the Fed being able to buy just about anything to hold 
as an asset and as collateral.
    I think the ongoing problem we have today is related to 
that attitude, because not only does the Fed now buy housing 
securities which keep going down in value, but now they are 
talking about buying credit card securities, car loan 
securities, student loan securities. I mean, that does not 
reflect a very sound economy.
    I think if we do not address that subject some day, we 
cannot just claim that all we have to do is have more 
regulations. I think we have to define some of the issues 
rather well, and how do we get in the trouble. What is the 
problem?
    One thing I don't think we ever do is define ``capital.'' 
We talk about capital, but in capitalism in the free markets, 
capital comes from savings. Well we don't have any savings. 
Capital comes out of thin air. And we have had the luxury of 
creating as much so-called capital as we want because we were 
able to issue the reserve currency of the world.
    You mentioned the problem that we have is over-consumption. 
Well that wouldn't occur if you had a commodity standard of 
money because it holds you in check. You know you have to pay 
your current-account deficit routinely. But now there hasn't 
been. And this of course, in my estimation, leads to the gross 
distortion, the gross malinvestment, and the huge amount of 
debt that we have.
    So the consensus seems to be what we need, without asking 
the question how did we get here, is we need more regulation. 
And everybody said, well, bailing out Bear Stearns was just 
wonderful.
    Well that to me is sort of like saying, you know, if you 
have a drug addict having a withdrawal symptom, you give him 
another fix and he feels good; then everything is going to be 
OK.
    So I don't think that can be that reassuring to us because 
we have so many problems that we still face. I believe in 
regulation, but I don't believe for a minute that it's the lack 
of Government regulation that is our problem. It was the fact 
that the Government had license through the Federal Reserve to 
distort the market, create capital out of thin air, distort 
interest rates, cause the malinvestment, and the excessive 
debt--and the market is a good regulator.
    The market, through interest rate changes, gives us signals 
that we should follow. But we don't have that anymore. But just 
to say, well, we need more regulation, I think it is sort of 
like saying that we need regulations for something that's 
unregulatable because the system is so artificial and has 
nothing to do with the market economy.
    So I really fear when I hear statements: Well, it's the 
free market that is the problem, and rather than asking, where 
did the bubble come from? I think it is very, very precise and 
very clear where financial bubbles come from, and we have to 
deal with that.
    But I have one very minor question. You might not want to 
comment on this, but I had read one time, many years ago, that 
you might have had some reservations about the breakdown in the 
Bretton Woods Agreement. If you can make a brief comment on 
that.
    The other question that I have is: Could you compare the 
crisis we face today to the one that you faced in 1979? Because 
you did have a huge crisis which required saving the dollar. 
That could have gotten out of hand. Interest rates were up to 
21 percent.
    In today's prices of gold, gold was like $2,500. It was 
huge. Yet today, I see some conditions that may well be worse 
when you look at our foreign indebtedness, our domestic debt. 
So are there any similarities, or are there any comparisons? 
And what kind of shape are we really in?
    Chairman Volcker. Well in your passing question about 
Bretton Woods, I did have my reservations about it. I was in 
the middle of that breakdown. It doesn't mean I was happy about 
it.
    The way it all came out didn't meet my hopes at the time, 
but changes had to be made. But I did have reservations.
    Look, supervision and regulation is not going to solve all 
these problems. You're quite right. You have to get the basic 
structure of the system right.
    One point of concern which I think touches upon what you 
are saying is you cannot lose sight of the fact that if people 
get used to the notion that financial institutions--the 
creditors of financial institutions--are going to be protected, 
that will affect their behavior, and they will take more risk 
than they otherwise will take.
    That is what is at issue in the whole question of the 
lender-of-last-resort.
    Now I can't conclude from that that because that risk 
exists, and the more you extend the lender-of-last-resort the 
greater it is that we shouldn't have a lender of last resort. 
Because the risks of the breakdown on the other side are too 
great.
    But how do you achieve a balance? That is partly where 
regulation and supervision has to help. If you are going to 
protect those institutions, they will take risks and their 
creditors will take risks that would not take place in a 
different kind of market.
    So the supervision and regulation has to come in and 
balance that by insisting that you have to keep higher capital 
than you would otherwise keep. You've got to keep more 
liquidity than you would otherwise keep. And you want to do 
this in a way that's obviously least awkward and least 
obtrusive, but you've got to do it because otherwise people 
will run to extremes.
    There's financial volatility in all these markets, whether 
they're protected or not. That's the history of financial 
capitalism. But you want to restrain as much as you can the 
excesses, and that does require if you've got protection on the 
one side you've got to have supervision on the other side.
    Representative Paul. Thank you.
    Vice Chair Maloney. Senator Klobuchar.
    Senator Klobuchar. Thank you.
    And thank you, Chairman Volcker. You were talking, at the 
beginning of your testimony, about how this isn't just a 
financial crisis, it is an economic crisis as well.
    Could you comment a little bit on the weak dollar and how 
you see that fitting in? On the one hand, it has helped with 
our export market. I've seen that in my own State of Minnesota 
where the papermills in Canada have shut down and we're going 
great guns in Minnesota.
    On the other hand, the weak dollar has been blamed for 
skyrocketing oil prices and for triggering a foreign capital 
flight and draining U.S. credit markets.
    So what do you think? And do you believe there are policies 
we should pursue?
    Chairman Volcker. It's a perfectly ambiguous situation 
because we've gotten ourselves in a situation where--I don't 
think it's going to cure it; a depreciation of the dollar 
against some currencies anyway, was probably necessary to get 
our economy rebalanced. And that is going on.
    I think underneath the surface of all this, consumption is 
being restrained, as it has to be. Exports are doing very well, 
as they must do if we're going to deal with the external 
balance. And we'd like to have an economy that can move ahead 
with a stronger external position and a more balanced 
consumption, and lay the base for a sustained recovery.
    But the dollar is important not only because of its 
inflationary implications in the United States at a time when 
there obviously are concerns about inflation, and should be, 
but because the dollar--to go back to Mr. Paul's questioning--
has been the linchpin of the world international monetary and 
financial system. And if there is a real loss of confidence in 
the dollar, I think we are in trouble in terms of sustaining 
open markets, free trade, continuing economic advance 
generally.
    So, that is something that has to be watched. We have to 
accept the fact that some depreciation has taken place, but we 
don't want it to get out of hand.
    Senator Klobuchar. We had a hearing on sovereign-wealth 
funds earlier here. Are you concerned about the foreign 
capital?
    Chairman Volcker. Well, you know Mr. Paul said we haven't 
got any savings here. Well, where is it? It's in Singapore; 
it's in China; it's in Abu Dhabi, and Dubai, and Kuwait, and we 
are in a position where we have to go to these countries and 
their sovereign wealth funds to recapitalize our financial 
system. Not a very happy circumstance, but we'll take it where 
we can get it, I guess for the moment, and that is the attitude 
of the financial institutions.
    But we don't want to be in that position, and we've got to 
restore a kind of equilibrium where we are not in that 
position.
    Senator Klobuchar. What role do you see the price of oil 
and our dependency on foreign oil, and our lack of developing 
our own energy policy, playing here?
    Chairman Volcker. Well, you know, we're dependent. I'm 
afraid there's nothing we can do about it in the short run. And 
all this talk about energy independence is pie-in-the-sky for 
the moment. We are heavily dependent upon oil imports, which 
leaves us at the mercy of whatever squeeze there is in the 
market for economic reasons or other reasons.
    Senator Klobuchar. But if we did develop a long-term policy 
like some other countries have done, do you think we could 
change that?
    Chairman Volcker. Well, I am certainly in favor of 
developing both short- and long-term policies. I would be in 
favor of developing policies. But of course, there we are. That 
is a real nice issue for the Congress and for the next 
President----
    Senator Klobuchar. Good. Thank you.
    Mr. Volcker [continuing]. No question about it.
    If I may just come back to something Mr. Paul said, which I 
think is relevant: How did this compare with the crisis in the 
late 1970s?
    There the enemy, in my view, but I think in the country's 
view, was quite clear. There was an overpowering concern about 
inflation, and the country was ready to--it may not have been 
delighted, but there was a sort of acceptance of 
extraordinarily tough measures.
    We also had a financial crisis in the midst of all that, 
but that financial crisis involved--was centered in the banking 
system. And a crisis that was centered in the regulated banking 
system was frankly easier to deal with and contain than the 
present crisis, which is so diffused and involves big 
institutions not under the direct control of the Federal 
Reserve.
    Senator Klobuchar. All right. Thank you very much.
    Chairman Schumer [presiding]. And now, Representative 
Hinchey.
    Representative Hinchey. Thank you very much, Mr. Chairman.
    Chairman Volcker, thank you very much. I am a great admirer 
of yours, and I want to express my appreciation for everything 
that you have done publicly, and the work that you have done 
since you left the Federal Reserve as well, which has been very 
substantial. I very much appreciate your being here.
    I think that what you mentioned about the leading by 
example I think is very, very important. The best way to lead 
is always by example. And of course the worst way to lead is by 
example. That is what we have seen recently, leading by example 
in some of the worst ways by creating this huge national debt, 
devaluing the dollar so substantially and sort of debilitating 
our circumstances domestically, particularly with regard to the 
average family--the average person and the average family.
    The Consumer Federation of America, for example, has 
estimated recently that the average household now has about 
$7,500 in credit card debt, and that the Government 
Accountability Office has said that the top six credit card 
issuers have charged recently $1.2 billion each in penalty 
fees.
    Now that was 2\1/2\ years ago, back in 2005. That is the 
latest--the last time we have the numbers. So that is about 
$7.2 billion in penalty fees which were charged on credit cards 
to consumers around the country. And credit card debt is going 
up very, very substantially. And because credit card debt is 
going up, it is impacting on the spending of median-income 
people.
    As we know, the Gross Domestic Product of this country, 
about \2/3\ of it--more than \2/3\ of it--is driven by the 
spending of median-income people, median-income households.
    So these are the things, frankly, that concern me the most. 
One of the things that you dealt with was the issue of 
stagflation where you had a downturning economy and growing 
inflation, and I think we are in danger of seeing that come 
back.
    So these are the things really that I believe we have to 
deal with here. We have to provide some regulation. One of the 
issues I think with regard to the banking company was--banking 
industry, rather--was the repeal of Glass-Steagall back in 
1999, and the impact that that has had on the creation of 
things like these hedge funds and other forms of investment.
    Now that was done intentionally. It was done purposefully 
by the Congress back in 1999, and I think it has had disastrous 
consequences.
    So, I would appreciate it if maybe you could comment on 
those issues and perhaps give us some direction as to how we 
might proceed.
    Chairman Volcker. You've raised some, obviously, very broad 
issues. My own feeling about the repeal of Glass-Steagall was 
that the formal repeal was probably catching up to the 
realities in the marketplace. Because of technology, banks were 
able to do things they weren't traditionally able to do, and 
other institutions were able to do things the banks were doing, 
and it got increasingly hard in practice to separate the 
functions in many cases.
    So in a way you can either glory in it or regret it, but it 
was probably inevitable that the old Glass-Steagall got 
eliminated. Whether it had to go all the way, you know, you can 
debate the details, but broadly I think it was inevitable, and 
you can't turn back the clock on it.
    But some of the other comments you make, I think, are only 
specific reflections of the fact that this financial crisis is 
tied in with an underlying economic imbalance where we have 
been too dependent upon consumption supported by the kind of 
credit card debt you're talking about, and also the kind of 
mortgage debt that is in so much trouble in the market today. 
And somehow that has to change.
    You could argue--I made a speech a few years ago saying 
this is going to have to change. It could change by policy, but 
I thought it would be very unlikely that policies would be 
changed because it involved things that people don't like, like 
raising taxes to reduce budget deficits and that sort of thing, 
and it is much more likely to change in response to a financial 
crisis.
    Well that was a pretty good prediction. That's where we 
are, in a financial crisis that is forcing lower consumption, 
more restrained consumption, and I think will end up with 
increasing savings in the country. With the decline in the 
dollar increasing exports, we will make the underlying economic 
adjustments. But that's a kind of a rough ride while it's 
happening, and the whole effort is--I think whether people 
admit it or not--to have it happen, but try to avoid some of 
the more severe consequences of the financial crisis.
    Let me say--just returning to the dollar and stagflation, 
and so forth--I think there is some resemblance of where we are 
now in the inflation picture to the early 1970s--not to the 
full-blown inflation of the later 1970s when you had an 
underlying tendency for inflation to increase, and then you had 
a big increase in oil prices; you also had a big increase in 
agricultural prices for a while. The price indices went up very 
sharply and while the extremes receded, I think the policy 
response was not forceful enough; the monetary policy response 
was not forceful enough in those years.
    If we lose confidence in the ability and willingness of the 
Federal Reserve to deal with inflationary pressures and to 
sustain needed underlying confidence in the dollar, we will be 
in real trouble. And that has to be very much in the forefront 
of our thinking. If we lose that, we are back in the 1970s or 
worse.
    Representative Hinchey. Well I wish this conversation could 
go on, but my time is up, and I thank you very much for those 
answers.
    Chairman Schumer. Senator Webb.
    Senator Webb. Thank you, Mr. Chairman.
    Chairman Volcker, I appreciate your being here. Again, I 
feel like I'm a prisoner of the clock. You may feel otherwise 
having sat there for quite some time, but 5 minutes is a very 
small amount of time to be able to address these issues.
    As a quick follow-on--I have a larger question to ask you; 
I have had a number of people who work in the financial sector 
and who do this for a living say to me that the present 
Consumer Price Index dramatically understates actual inflation, 
if you look at the components which hurts people on fixed 
incomes who rely on Cost of Living adjustments, but actually 
works to the advantage of people in the financial sector.
    Is that a correct evaluation?
    Chairman Volcker. Well I don't know whether it's correct or 
not. I must confess that in my old age, I'm like the little old 
lady I used to hear about some years ago who kept saying, when 
I was in the Federal Reserve, there's a lot more inflation than 
you're telling me in those figures.
    [Laughter.]
    Chairman Volcker. I'm now the little old lady, and I think 
there's a lot more inflation than those figures are telling me. 
But I think it is kind of strange--I'm not saying it's 
dishonest; it's the way we calculate the figure--that housing 
is a big part of the Consumer Price Index, and we had this 
great increase in housing prices, and the Housing Cost Index in 
the Consumer Price Index hardly moved at all.
    You know, there are reasons for that. It is based upon a 
very small sample relative to home ownership in the United 
States of rents, and that's imputed to the whole thing. There 
were artificial reasons that rents were being held down.
    And of course this idea of excluding food and energy prices 
on the basis of volatility, which is certainly understandable 
in the short run, but when the food and energy prices are 
running high, not for a couple of months and then dropping, but 
running high for years, it doesn't sound quite right. It 
doesn't feel quite right.
    Senator Webb. Your speech at the Economic Club of New York 
on April the 8th was a true breath of fresh air, if I may say, 
and I had it sent to me by a number of people. I want to ask 
you a question that I think relates to the key concern that 
many, including myself, up here have about basic economic 
fairness in the United States.
    You said at one point that there are cross-cutting 
bureaucratic and political concerns--political concerns at a 
high level regarding the proper use and allocation of 
Government power and the low level of embedded economic 
interests.
    You said a little later, ``It is equally compelling that a 
demonstrably fragile financial system that has produced 
unimaginable wealth for some, while repeatedly risking a 
cascading breakdown of the system as a whole, needs repair and 
reform.''
    Then later on you mentioned, ``Perhaps most insidious of 
all in discouraging discipline has been pervasive compensation 
practices.''
    I have watched these numbers and spoken about them, the 
percentage of--or the multiplier of executive compensation 
versus the compensation for average workers in this country. It 
is off the charts from 20 years ago. It is off the charts from 
any other country. So it can't simply be the result of the 
globalization and internationalization of American industry.
    Obviously, Government policies can protect existing 
aristocracies. They can actually help create aristocracies in 
some form. With this vast migration of wealth to the very top 
in this country, while other people are struggling, to what 
extent could you attribute this undeniably vast migration of 
wealth to the very top to Government policies? And what would 
you suggest that we think about doing about it?
    Chairman Volcker. It strikes me as an extremely difficult 
area, and I'm not, I guess, imaginative enough to know how the 
Government can effectively deal with it.
    It is partly ingrained in what we were talking of earlier 
about the incentives to start taking risks in this new 
financial system.There is a big payoff from success in the 
short run, and not much penalty, financially, anyway, over 
time, if the risks go the other way, and how you deal with that 
basic imbalance. There are obviously things that can be done 
and should be done, in the realm of corporate governance and 
the responsibility of compensation committees.
    They seem to be overwhelmed by the argument that if we 
don't do it for our executive, some other company will do it 
and steal our executive away.
    And everybody--it's like the Lake Woebegone Syndrome; 
everybody wants to be in the top quintile. I don't know if it's 
a bill of goods, but it's been sold to business boards of 
directors in a way that, so far, has been unstoppable.
    I think it reflects a weakness in corporate governance. I 
can say that, but how to correct it?
    Senator Webb. It's one thing to take high risk and high 
reward, and we all appreciate that. In this country, we're 
built on it. But it's another thing to take a very, very 
reduced risk----
    Chairman Volcker. Obviously, there are techniques, though, 
that people with stock options or otherwise could not claim the 
great rewards immediately, but have to wait and see how things 
evolve over a period of time before they can accept the 
rewards, and some of that's being built into current 
compensation practices, but I think, a little too slowly, and 
not rigorously enough.
    Senator Webb. For instance, the margins that are allowed 
for investing in oil futures, which are very low, and as a 
result, have low risk. Senator Levin had a very revealing chart 
that he used on the Senate floor a few days ago, talking about 
the percentage of oil futures and options contracts that were 
speculative, compared to just 10 years ago.
    I think the number has gone up 12 times, when you can buy 
in for 3 or 4 percent on a margin, causing a lot of people to 
say that the price of oil is overpriced by perhaps $50.
    Chairman Volcker. I know it's very hard to make judgments 
in that area. Speculators do serve some purpose in markets, but 
if it gets to be one-sided, I suppose that, fundamentally, 
going back to the earlier problem, people think they're going 
to be rescued on the down side, they're more inclined to take 
risks on the upside.
    That's part of the problem we have. The statistic that 
often gets quoted is the number of credit default swaps 
outstanding. This is an instrument that hardly existed 5 years 
ago and the latest figure I have seen--and I don't know who 
counts this up--is $60 trillion worth of credit default swaps 
which must be 5 or 6 times the total amount of credit 
outstanding.
    How can you have more protection against defaults than if 
everything defaulted? It shows there's a lot of trading in the 
market that isn't directly the kind of basic insurance policy 
that the credit default swap is supposed to represent.
    Senator Webb. Thank you for your testimony.
    Chairman Schumer. Well, Chairman Volcker said he had to go 
at 11; since you're such a great person for us to ask questions 
of, I'm going to try to have a second round for people who want 
to ask a question or two, and I'll take the prerogative of the 
Chair.
    First, I mean, your testimony is incredible, and basically 
it says that we're in a brave new world here, and we don't 
quite know what we're doing, and that's kind of frightening, 
and that's probably one of the reasons we had such worry.
    I think that even the people who deal with these credit 
default issues, or trading or whatever else, sort of know that 
we're in this brave new world, and that's why you have a crisis 
of confidence in credit, which has been one of the big problems 
here.
    But let me ask you two quick questions related to that. 
First, we were talking about how to restructure and your worry 
about having one regulator, would be that it would have too 
much power--I understand that--and not enough independence.
     Parts of it--what about separating the central bank 
function from the overall regulatory function? Could the Fed be 
a good central banker, if it didn't have the regulatory ability 
to reach into these banks and other institutions and know 
what's going on, or have some degree of separation from that?
    Chairman Volcker. Well, this is what you've got to struggle 
with, there's no doubt about it, but you can't completely 
separate them. In my view, you can't come close to completely 
separating them. That is what the United Kingdom did.
    Now, they didn't do it completely because there was some 
liaison between the Bank of England, but suddenly they had a 
crisis in a secondary bank. This was not a major British bank; 
it was kind of something like a savings and loan.
    Chairman Schumer. Yes.
    Chairman Volcker. A sizable savings and loan. And the 
central bank suddenly felt it was faced with a crisis, in a 
sense, not of its making, and not of its observation.
    Chairman Schumer. Right.
    Chairman Volcker. And it reacted very strongly by saying--
talk about unprecedented moves--well, on behalf of the 
Government--and that gets to your political question--they 
didn't do it on their own.
    Chairman Schumer. Right.
    Chairman Volcker. They said--I don't know if it was under 
orders or in consultation with the Chancellor of the 
Exchequer--we will guarantee the deposits, guarantee the 
creditors.
    And what was really surprising then, is that the Chancellor 
of the Exchequer, not the central bank, said we will protect 
all the creditors of all the institutions in London for the 
time being if they are in a similar situation.
    Now, I don't know quite what that means, but it was a very 
sweeping statement. And I feel quite certain that the central 
bank felt a little left out or a little abused, if I may say 
so, because it didn't have a good handle on what should have 
been a relatively small problem with a savings type bank.
    Chairman Schumer. It worked once, but it may not work 
again.
    Chairman Volcker. That's right. And once you say that, I 
mean again, there is a moral hazard question. Once you say 
you're going to protect all the creditors in a crisis, they're 
going to expect you to do it the next time.
    Chairman Schumer. Exactly.
    Chairman Volcker. Look, you said there's some question 
about what the Congress can do. Let me make one appeal to you:
    Don't push all this health of particular credit markets off 
on the Federal Reserve. I mean, it's very convenient not to 
provide assistance in the budget directly; it's very convenient 
not to do it by direct executive action and instead push it off 
on the Federal Reserve.
    But that's the way to destroy the Federal Reserve in the 
long run, because it does need independence. So that's why I 
get a little concerned about, you know, Fannie Mae and Freddie 
Mac not playing their part.
    But back in the Depression--or not just in the Depression, 
but in the late 1980s, early 1990s, the savings and loan 
crisis--you had a big problem in the mortgage problem. The 
Government set up a separate institution to deal with that.
    Chairman Schumer. The RTC.
    Chairman Volcker. They didn't tell the Federal Reserve to 
go out and buy all the savings and loans.
    Chairman Schumer. That's a great point. One final question, 
and this is a more practical one. Recently, Treasury Secretary 
Paulson claimed the worst of the credit crisis is over. 
Chairman Bernanke, yesterday stated, ``While the current 
situation is far from normal, turmoil in the financial markets 
has eased.''
    It has, obviously, temporarily. On the other hand, we have 
all the issues of complexity, opacity, new instruments, 
untested. Do you agree with their basic statement?
    The worry, I guess, that everyone in the markets has is 
that another shoe will drop and then all hell will break loose.
    Chairman Volcker. Let me say, first of all, even if we're 
over the worst of it and it gradually gets better, all the 
questions that you just raised are relevant, those on capacity 
and all the other things in supervision policy.
    I think that when you look ahead, the outlook for the 
financial markets is going to be dependent upon the outlook for 
the economy. If the economy goes into a real recession, you 
could easily have another wave of defaults--you would, because 
that's the nature of it, and then all these strains and 
pressures would be reemphasized.
    If the economy somehow moves along flatly for awhile, but 
then gradually improves, you've got a different picture. But 
you can't exclude the possibility that the economy is going to 
do worse, and that would have clear repercussions for the 
financial system.
    Chairman Schumer. Congressman Brady, do you have any 
questions? Don't feel obligated, but if people have other 
questions----
    Representative Brady. Yes, if I may, two quick questions, 
Mr. Chairman.
    You expressed concern about the incentives on the top end 
from CEOs and managers dealing with risk. On the front end, 
with lenders, does securitization, in your view, adversely 
affect the incentives for lenders to screen those borrowers? In 
other words, if you're able to pass the hot potato on, clearly 
you're doing less due diligence at the outset.
    Chairman Volcker. No question. And one of the approaches 
you could take--I guess I mentioned in my earlier speech, and I 
think it should be practical--is when you get these regulated 
lenders, the banks, potentially the investment banks, if you're 
going to package this stuff and sell it to other people, you 
better keep some yourself.
    And so you're going to have to eat your own cooking, so to 
speak, at least to some degree.
    And that might make a big difference. Banks would have to 
think about strengthening their credit departments again. So 
that's at least one approach.
    Representative Brady. Second question, just on inflation. 
Because of your experience, you warned recently that we ought 
not to allow inflationary expectations to become embedded in 
prices once again.
    What's your current assessment of the inflationary outlook? 
What variables do you look at in making that assessment?
    Chairman Volcker. Look, I'm an inveterate worrier about 
inflation, so I see it all the time. Behind every silver cloud, 
there's a dark cloud of inflation.
    This situation reminds me, as I said earlier, a bit about 
the early 1970s when we had an explosion in oil prices, an 
explosion in food prices, against a background of growing 
underlying inflation.
    And it was not dealt with very forcefully because of the 
concern about the economy and it will go away and so forth. And 
I think that's a danger now.
    So, I think the Federal Reserve needs all the reinforcement 
it can get, psychologically and otherwise to deal with 
inflation.
    And the question about the price index, we have changed the 
price indexes in a way that for a given change in market 
prices, they show up less in the index. We are much more 
inclined to say there are improvements in quality, and 
therefore when the nominal price of say, an apple goes up, the 
apple orchard is better, we'll take account of the fact that a 
Fuji apple is crisper than a McIntosh or something.
    Chairman Schumer. A New York State apple is crisper than a 
Washington State apple.
    [Laughter.]
    Chairman Volcker. My mother came from upstate New York and 
I spent Mother's Day driving through Wayne County to see the 
apple orchards. And there aren't many left in New York State.
    Representative Brady. Beyond food and fuel, are there some 
variables you pay special attention to?
    Chairman Volcker. Pardon me?
    Representative Brady. Beyond food and fuel prices, are 
there other variables that you----
    Chairman Volcker. Well, I think one of the danger points 
here which is beginning to be evident--only beginning--is that 
prices or tradeables have been held down. The prices of the 
kind of thing that the consumer buys a lot--clothing, household 
materials that we import en masse now from China and Asia--have 
either held steady or, in some cases, gone down for a decade. 
But now they're beginning to go up, I don't know how much is 
yet reflected in the stores, but it's reflected in the import 
prices because of the depreciation of the dollar and the 
growing inflation in China and elsewhere.
    And so this is one point of concern. If the dollar got a 
lot weaker, that concern would increase.
    But I think the bias here clearly is toward more inflation, 
offset now by the weakness of the domestic economy at the 
moment--flatness, at least, of the domestic economy.
    Now, if the domestic economy began growing more rapidly, 
which you would like to see in time, then those inflationary 
pressures I'm referring to would become more overt.
    So I think there is a problem, and we shouldn't be relaxed 
about it.
    Representative Brady. Thank you, Chairman for your 
perspective.
    Chairman Schumer. Vice Chair Maloney.
    Vice Chair Maloney. In your testimony, you talked about 
financial engineering, and some universities are now having 
courses in financial engineering; yet engineering is a very 
precise science and financial engineering is not, and maybe we 
should not use this term. Your thoughts on that?
    And also, I'd like comments on the fact that there is no 
entity that can evaluate the safety and soundness of investment 
banks now because they don't have to report the necessary data. 
There is no single source of data on the safety and soundness 
of all of our financial institutions, and without this 
information, the regulators are less able to take proactive 
steps that might avoid the need to resort to dramatic rescue 
efforts.
    Could you elaborate a little more on the structure that we 
might look at in reorganizing and maintaining the independence 
of the Federal Reserve? What is the role of the SEC? Do you 
think we should create a new, consolidated, regulatory 
authority? If you could just expand a little more?
    And then also, your statement--which was rather 
astonishing--that we now have $60 trillion outstanding in so-
called credit default swaps----
    Chairman Volcker. For the world, not just for the United 
States.
    Vice Chair Maloney. OK, for the world, but still, the idea 
that has been given to me by some of representatives of Wall 
Street is that the use of exchanges and clearinghouses for 
credit default swaps and derivatives, as a form of getting some 
type of control on what is happening, and the risk that is out 
there, again, again, we are deeply honored----
    Chairman Volcker. The Chairman mentioned this initially, 
and I agree, that's an important area for work, and I think at 
least some preliminary work is going on now within private 
markets themselves, and it's important for the reasons you 
suggest.
    But I can't resist one comment about financial engineering, 
which is not my favorite subject. Given the problems in the 
financial system, on the one side, and given the problems with 
our infrastructure, on the other side, I think a strong case 
can be made that our universities are turning out too many 
financial engineers and too few civil engineers.
    [Laughter.]
    Chairman Volcker. And that imbalance ought to be corrected. 
The glamorous subject is financial engineering.
    Chairman Schumer. It makes the most money.
    Chairman Volcker. I have to tell you, when my oldest 
grandson told me he wanted to become a financial engineer, my 
heart sank.
    [Laughter.]
    Chairman Volcker. Anyway, on the question of consolidated 
regulatory agency, I think the issue is here. We're a big 
country; it's a big world; one consolidated financial 
regulatory agency is a very powerful instrument for good or for 
bad, and I actually would like to retain at least a little 
competition, if we could, between regulatory agencies, which is 
an argument for giving the Federal Reserve a good deal of 
authority, but somehow letting somebody else into the game, 
too.
    That's a tough balancing act. We have too much of it now, I 
think, but how can we re-jigger that a bit?
    And I think you'd have to have a certain consistency in 
regulation around the world. I don't think you have to have the 
same regulatory structure all over the world. Different 
countries will find different administrative arrangements 
suitable, and so I don't think that's a requirement, so long as 
you have some consistency in capital standards and liquidity 
standards and so forth.
    Vice Chair Maloney. Do you think the Basel Accords will 
provide that?
    Chairman Volcker. Well, the Basel Accords already--the old 
Basel Accords certainly have. That is a great--I'm a little bit 
prejudiced, but I think that was kind of a triumph of 
international regulation, because crude as it was--arbitrary as 
it was and we knew that--it did accomplish the purpose of 
getting international discipline on capital standards. I don't 
think there's any question that bank capital now is 
significantly higher than it would have been, without Basel I.
    And if we hadn't had that, we really would be in a mess, 
because for all the pressures on the market, all the losses of 
commercial banks, they have by and large, stood--``firm'' is 
the word that comes to mind, but maybe that's too strong a 
word--but the Federal Reserve did not have to rescue a 
commercial bank.
    And that was partly because of those standards.
    Chairman Schumer. It took 10 years; it took a long time. I 
worked with you on those, and it took a very long time to get 
everybody to agree.
    Chairman Volcker. People said that was impossible, but it 
wasn't impossible. And now I think that's Basel II, and the 
problem with Basel II--and I'm out of touch--is that is very 
complicated, so that's not so transparent anymore.
    Chairman Schumer. You're right. Last round of questions for 
Congressman Hinchey, and we'll be 5 minutes over the 11, if 
that's OK with you, Mr. Chairman.
    Representative Hinchey. Thank you very much, Mr. Chairman.
    Chairman Volcker, I can't help being somewhat pessimistic 
about the future of this economy, and I think that in part, 
that is because of the sort of laissez-faire attitude that the 
Fed has had with regard to the way in which the financial 
industry has been operating and the kind of manipulation that's 
been going on.
    I mean, we see countless examples of that kind of 
manipulation, and we see examples of how that manipulation has 
had a direct impact on the economic circumstances of the 
average American family, and that's the part of it that worries 
me the most.
    We've seen for example, as Senator Webb mentioned a few 
moments ago, how the rise in oil prices has been driven up, 
maybe as much as somewhere in the neighborhood of 25 percent by 
the manipulation of investments, falsification of investments, 
people not buying anything, but stipulating their investment 
and driving the price up, so that poor people have to pay more 
at the pump than they would.
    That's just one example of the declining dollar and how we 
need to deal with that. All of these things need to be 
addressed.
    There are the dire circumstances that the average family 
has now: Their consumer debt dramatically went up by $15.3 
billion back in March. It's now up by more than $2.5 trillion. 
Now that's debt outside of household debt, mortgages, things of 
that nature.
    Most of it is credit card debt. And the way in which the 
credit card companies are now manipulating this situation, 
pulling more and more money in, raising the interest rates and 
putting more penalties into effect in various sorts of ways is 
taking more and more money out of the hands of people who are 
struggling and using those credit cards for so many buying 
practices.
    That's for food; that's for gas; that's for so many things 
that the credit card is being used, and that drives up the 
price that people are paying.
    It seems to me that we're going to have to do something 
about this. And, as you say, I think the Fed doesn't have all 
the answers here, but the Fed does have some authority with 
regard to the way in which this manipulation is going on, and 
it hasn't really exercised that authority.
    Fannie Mae and Freddie Mac are coming back with regard to 
housing now, but they're still not where they used to be, and 
they're coming back from a time when they got beat up after a 
lot of sort of negligence in the way that they were overseeing.
    That, I think, has to be addressed, as well.
    Chairman Volcker. Well, one of the implications of what 
you're saying is clearly a deficiency of the present system. 
Whether the Federal Reserve did rather poorly in supervision 
and getting after some of this manipulation, it is very 
difficult to do it, if you're just looking at banks.
    But there's another set of big institutions out there that 
are not under your control, and the institutions you do have 
influence over, will say, well, how can you do that to me when 
this guy I'm competing with every day doesn't have the same 
rules?
    So that is another strong reason why this regulatory and 
supervisory tent has to be broadened.
    Let me say in terms of manipulation, one thing that doesn't 
get much attention, but I think it's true, is these big 
financial institutions are now with or without Glass-Steagall; 
they are hotbeds of conflicts of interest.
    One arm of the organization wants to create new mortgages 
and sell them to anybody, and do they sell them to their own 
investment management clients, or not? They're arranging a 
merger on the one side and financing or not financing 
participants on the other side.
    I think there's a question--it won't solve the problem, but 
should these financial institutions, whether banks or 
investment banks, should they be running hedge funds at the 
same time? Should they be running equity funds at the same 
time?
    They lead to direct collisions of conflicts of interest, 
and the bigger they get, the more complicated they get, the 
more systemic risk there is, so I think that's an area that 
deserves some looking at, too.
    Representative Hinchey. Well, I think you're absolutely 
right, and I think that which we're experiencing right now 
flows from the repeal of Glass-Steagall, back in 1999. They 
wouldn't have been able to do those things; these hedge funds 
wouldn't be able to manipulate in the same way they're 
manipulating now.
    Chairman Volcker. Well, the banks wouldn't have been able 
to do it, maybe, although the banks could have--you know, 
there's nothing in Glass-Steagall that said a bank couldn't 
have a hedge fund.
    The Federal Reserve may have interpreted it that way, and I 
say that without thinking through all the law, but I think 
that's true. So it's a matter of interpretation. You can't 
blame it all on Glass-Steagall, but they have become widely 
diversified institutions and the diversification creates more 
conflicts of interest.
    Representative Hinchey. One of the things you said earlier, 
was that what we're seeing now is the kind of thing that we saw 
in the early 1970s, the kind of situation that we're dealing 
with now.
    And that tells me that if we don't deal with this set of 
circumstances, the situation is going to get increasingly 
worse.
    And the main reason for that is the impact that it's had on 
median-income consumers, on the average household across the 
country. They find themselves in deeper and deeper debt, more 
dire circumstances, more trouble functioning on a daily basis, 
more trouble buying fuel for heating the home, or gasoline to 
get to work, or food, and a whole host of other things that, as 
you said, now are going up as a result of the situation in 
China and other places around the world.
    Our economic circumstances are negatively impacting other 
countries in a very dire way. And all of that right now is 
influencing the median-income people.
    We've got to deal with that. We've got to deal with that 
effectively, and if we fail to do so, I think that this edge of 
recession that we're experiencing now is likely to get 
progressively worse and worse and worse over the course of the 
next several years.
    Chairman Volcker. I don't know what to make of it, but the 
point you're making and the point Senator Webb made earlier 
about the distribution of income and the pressure on the median 
incomes or the lower incomes, all this bright new world of 
financial markets and financial engineering, maybe co-
incidentally, has not been accompanied by much growth in real 
income for the lower half of the economy or the lower three 
quarters of the economy, really.
    Chairman Schumer. Ninety percent.
    Chairman Volcker. And I hesitate to say that' it's cause-
and-effect, but it's an observation, anyway.
    Chairman Schumer. Well, with that, Mr. Chairman, we thank 
you very much again for your erudition, your practicality, your 
ability to sort of synthesize issues and see both sides and 
then yet still have strong views. They have never ceased to 
impress, and we've missed you and even your cigar.
    Chairman Volcker. Thank you very much.
    Chairman Schumer. We're going to take a 5-minute break and 
then we'll get the second panel.
    [Recess.]
    Chairman Schumer. OK, we will resume.
    We have lost our House colleagues because they have a vote. 
Some of them may be back. Let me introduce our panel who are 
very distinguished and we very much appreciate them all being 
here, and having a chance to listen to Chairman Volcker, which 
is a treat.
    Dr. Douglas Elmendorf is a Senior Fellow at Brookings where 
he specializes in issues of macroeconomics and fiscal policy. 
Prior to joining Brookings, Dr. Elmendorf was an Assistant 
Director and Senior Economist at the Federal Reserve. He has 
also served as a Deputy Assistant Secretary in the U.S. 
Treasury Department, and as an economist on the Council of 
Economic Advisors. He holds a Ph.D. in economics from Harvard 
University.
    Ellen Seidman is director of Financial--of the Financial 
Services and Education Project in the Asset Building Program of 
the New America Foundation. Ms. Seidman also serves as 
executive vice president in National Policy and Partnership 
Development at ShoreBank Corporation. From 1997 to 2001 she was 
the director of OTS. She was also Director of FDIC and chairman 
of the Board of the Neighborhood Reinvestment Corporation.
    Alex Pollock is currently a resident fellow at the American 
Enterprise Institute where he's been since 2004 focusing on 
financial policy issues, including Government-sponsored 
enterprises, housing finance, and corporate finance. Before 
joining AEI, he spent 35 years in banking, including 12 years 
as president and chief executive of the Chicago office of the 
Federal Home Loan Bank.
    With that, we are going to read your entire statements into 
the record. We would ask each witness to take 5 minutes and 
then we will go to questions. Thank you for being here.

STATEMENT OF DR. DOUGLAS W. ELMENDORF, SENIOR ECONOMIC FELLOW, 
             BROOKINGS INSTITUTION, WASHINGTON, DC

    Dr. Elmendorf. Thank you, Mr. Chairman. I appreciate the 
opportunity.
    The current financial crisis in the United States poses two 
separate challenges for economic policy.
    One, to resolve the immediate problems; the other, to 
reduce the likelihood that these problems recur.
    My testimony focuses on the latter challenge. The diagnosis 
and prescriptions I will offer come from a report I am writing 
with my Brookings colleagues Martin Baily and Bob Litan.
    The U.S. financial system remains in a perilous state. I 
share the view of other observers and some people you have 
heard today that the worst of the credit crisis is probably 
behind us, but that is hardly certain. And even if it turns out 
to be right, the return to normal financial conditions will be 
slow and uneven. Billions of dollars of mortgage-related losses 
have yet to be declared by financial institutions, and risk 
spreads remain elevated.
    Moreover, an absence of dramatic events does not imply that 
intermediation has returned to normal. Weakened bank balance 
sheets mean that banks will be reluctant to lend to households 
and businesses for some time to come.
    Meanwhile, data on spending, employment, and production 
suggest that the economy is very likely in recession. The 
ongoing drop in housing construction, further predicted 
declines in house prices, tighter lending standards and terms, 
and rising oil prices are all exerting downward pressure on 
economic activity.
    To be sure, not all the incoming data are bad and powerful 
economic stimuli have been sent in motion by the Federal 
Reserve Board and this Congress.
    Therefore, I agree with the consensus of economic 
forecasters that a mild recession is the most likely outcome. 
But a more serious downturn is quite possible.
    Thus, the experience of the past year vividly demonstrates 
the need for financial regulatory reform. Let me offer four 
principles to guide reform, and some specific recommendations 
that follow from them.
    Principle number one is that financial regulation should 
try to keep pace with financial innovation. Innovation has been 
a positive force in our economy, as several people have said 
today, extending opportunities further down the income scale, 
improving the allocation of capital and distribution of risk, 
and helping to stabilize the economy.
    Yet, innovation also creates problems. New products and 
institutions are usually more complex and less transparent. 
They generally boost leverage and risk-taking, and they tend to 
skirt existing regulation and supervision.
    Financial innovators and regulators are in a race, and the 
regulators will lose. But it matters how much they lose by. If 
regulators do not try to keep up, or if regulators are 
completely outclassed in the race, much of the benefit of 
financial innovation will be offset by the cost.
    Principle number two is that mortgage origination should 
have simpler disclosures for everyone, and some limits on 
offerings to subprime borrowers. Having more choices may not 
improve people's well-being, if they are choosing among 
complicated products without enough information and 
understanding.
    Evidence demonstrates that people do not fully understand 
the financial arrangements. An innovation that offers more 
options can make that problem worse. Martin Baily and Bob Litan 
and I recommend simpler mortgage disclosures, in fact, taking 
something put together by one of my fellow witnesses this 
morning--pre-mortgage counseling for subprime borrowers, and 
perhaps a default mortgage contract from which people could opt 
out.
    Also, further restrictions on the design of mortgage 
contracts under the HOEPA rules, and a broadening of HOEPA 
coverage along the lines proposed by the Federal Reserve. And 
Federal oversight of State regulation of mortgage originators.
    Principle number three is that financial institutions and 
instruments should be more transparent. Self-interest is a 
powerful economic force, and smart regulation harnesses that 
force. By increasing transparency, we can give investors better 
tools to monitor financial risk-taking themselves.
    The private sector is moving in this direction, and better 
regulation can help. We recommend for credit ratings agencies, 
greater clarity in presenting ratings across asset classes 
reporting of the rating agencies' track records, and disclosure 
of the limitations of ratings for newer instruments.
    For commercial banks, clearer accounting of off-
balancesheet activities. And for derivatives, a shift toward 
trading on exchanges which will encourage standardization of 
instruments.
    Principle number four is that key financial institutions 
should be less leveraged and more liquid. As Chairman Volcker 
said, clearly more transparency is not enough. Even if private 
investors had perfect information, they would take greater 
financial risks than are optimal from society's perspective. 
The reason is simply that risk-taking has spillovers, in part 
because of contagion in the financial system, and in part 
because of the Government's safety net, including deposit 
insurance and the lender-of-last-resort role of the Fed.
    To counteract this tendency toward excessive risk, we 
recommend for commercial banks capital requirements for off-
balancesheet liabilities; required issuance of uninsured 
subordinated debt; and closer supervision of risk management. 
For investment banks, we recommend closer regulation and 
supervision. And for bond insurers, higher capital requirements 
and closer supervision of underwriting standards, especially 
for new and untested products.
    Let me conclude by observing that financial markets will 
always experience swings between confidence and fear, between 
optimism and pessimism, but effective regulation and 
supervision can reduce the frequency, the magnitude, and the 
broader consequences of those swings.
    Thank you, very much.
    [The prepared statement of Dr. Elmendorf appears in the 
Submissions for the Record on page 58.]
    Chairman Schumer. Thank you, Mr. Elmendorf.
    Ms. Seidman.

 STATEMENT OF ELLEN SEIDMAN, DIRECTOR, FINANCIAL SERVICES AND 
    EDUCATION PROJECT, ASSET BUILDING PROGRAM, NEW AMERICA 
                   FOUNDATION, WASHINGTON, DC

    Ms. Seidman. Thank you, Senator Schumer, and thank you for 
giving me the opportunity to testify before you concerning the 
regulatory implications of and guidance we can take from the 
current market failures.
    As you have mentioned, I have had a variety of jobs and 
experiences recently, and all of them--my project at the New 
America Foundation, my work with ShoreBank, and my tenure as 
the director of the Office of Thrift Supervision and the seat 
on the Federal Deposit Insurance Corporation--all are what I 
draw on for many of the points and recommendations I make 
today.
    Before I get to recommendations, I want to step back for a 
minute and consider how we got here. I think there are three 
root causes, and these can be stated in a number of ways: The 
unsustainable buildup of system risk; an antiquated, uneven, 
and frequently ineffective regulatory system; and a loss of 
alignment between serving customers well and standard business 
practices.
    First, we have allowed systemic risk to build up to what 
has obviously become an intolerable level. The risks include 
those that were known, but hidden from consumers, from 
investors, from participants in the system, from regulators; 
risks that were unknown, often because firms had created such a 
degree of complexity that even the best efforts at ferreting 
out risks would have failed; and risks that were unknowable, 
the model failures that Chairman Volcker talked about in his 
Economic Club of New York speech.
    Excessive leverage and reliance on short-term funding to 
support long-term assets exacerbated the impact of these risks.
    Second, we have both tolerated and allowed to grow a 
regulatory structure that has two major failures. First, 
entities performing the same kinds of functions are regulated 
very differently, with the general effect that business 
practice has flowed downhill to the practices of the least 
regulated.
    But second, we have not focused our regulatory attention 
tightly enough on what really matters. Is finding every last 
SAR violation really more important than making sure that the 
implied recourse on SIVs is adequately capitalized, or that 
borrowers have an ability to repay?
    Our regulatory system has become simultaneously unduly 
complex, ineffective where it counts, and excessively 
burdensome on some of the least risky and most consumer-
friendly elements of the system.
    Now getting this balanced right is hard. In my tenure at 
OTS I know we sometimes got it right, as when we stepped in 
early to keep thrifts from funding payday lending; sometimes we 
got it wrong, most spectacularly in the Superior Bank failure; 
and sometimes we did things that seemed right at the time, but 
had in retrospect some unintended negative consequences, and I 
think these are the most difficult.
    An example of this is the subprime guidance that all the 
regulators issued in 2001. Sure it helped keep the banks from 
getting in even more deeply than they did, but what it also did 
was push subprime lending outside of the banks, making our 
current problem worse.
    But the fact that we sometimes get it wrong does not mean 
we are excused from trying.
    Third, we have lost incentives for financial institutions 
to provide high quality, consumer-friendly products that 
provide long-term value. This is a result with many causes:
    The originate-and-sell business model that especially when 
tied to the brokering at the front and CDOs at the back, has 
separated the interest of borrower and lender and of principal 
and agent.
    Not extending the affirmative service mandate of CRA beyond 
banks and thrifts.
    The manner in which CRA and other consumer protections 
were, or frequently were not, enforced.
    Failure of financial literacy to keep up with the fast-
paced fast-changing financial world, and not focusing our 
imagination and creativity on ways to help consumers gravitate 
to products and services that are beneficial to them while also 
profitable to providers.
    Now this is not just being nice to consumers. As should be 
obvious from the mess we are in now, the financial viability of 
institutions is inextricably linked to that of their customers, 
including consumers.
    So what do we need to do?
    In the face of the problems that families, communities, 
companies, and markets now confront, I believe the critical 
question is how can we re-establish in our financial markets 
and the companies a long-term quality-oriented culture that 
incents all parties to focus their attention on products and 
services that benefit both sides; complete and accurate 
transparent risk assessment and management; and profitability 
and growth that is sustainable over the long run.
    This is not a job solely for a regulatory system, and it is 
just as obviously not easy, but I think if we set it as a goal, 
we will have a standard to measure our thoughts and proposals 
against.
    I suggest six critical strategies:
    First, effective enforcement. The will and financial 
wherewithal to enforce laws and regulations we establish. 
Without this we are not only allowing bad things to grow, we 
are fooling ourselves into believing we have resolved problems. 
And this is an issue not only at the Federal level, but also at 
the State level where regulatory agencies are frequently 
starved for resources.
    Second, risk assessment. Namely, concentration on enhanced 
risk knowledge and transparency within organizations, among 
organizations, for the public, and to and among regulators both 
domestically and internationally. We can no longer afford to 
have institutions that do not know their own level of risk and 
that of their counterparties and regulators who are also in the 
dark.
    Third, capital adequacy, with increased capital all around. 
This has three critical effects. First, capital is the 
penultimate guard against institutional collapse. Second, 
because capital is at risk it serves to mitigate against 
excessive and foolhardy risk taking of the heads-I-win/tails-
you-lose variety. And third, if all entities in the system are 
required to hold a greater amount of capital, demand for 
returns based on financial leverage should diminish. And I 
think it is time to recognize that in an uncertain world, loan 
reserves are in practice part of the capital structure, and to 
allow them to serve a counter-cyclical function by building up 
during good times so they can be drawn down in the bad that 
will inevitably follow.
    Fourth, enhanced responsibility. A system where all players 
have skin in the game. Realigning the interests of borrowers, 
lenders, and all those in the chain between money provided and 
money used. For institutions, in part it is capital. But an 
explicit continuing residual interest in sold assets whose 
value depends on future performance should also be considered. 
And certainly we need to do something about compensation 
systems, both individual and institutional that do not 
recognize back-end risk. In this connection, I urge Congress to 
move ahead with consideration of the two sets of bills related 
to the mortgage crisis that are pending, those dealing with the 
regulation of the market and those dealing with the response to 
the crisis for homeowners, communities, and markets.
    Fifth, regulatory consistency across entities that are 
performing the same tasks, such as providing consumer credit or 
brokering significant financial services for consumers, and/or 
have access to the same kinds of benefits.
    At the same time, we need to be cognizant of actual risk 
and relate it to actual burden. Regulation is a fixed and a 
hidden cost and smaller institutions both have fewer options 
for dealing effectively with regulators, and smaller budgets 
within which to absorb the costs.
    Finally, aligning incentives with practices that treat 
customers fairly and equitably before, during, and after their 
purchase of financial services. There are many ways to do this, 
including not only consumer protection legislation and 
regulation, but also the establishment of a suitability 
standard for those selling or brokering significant consumer 
credit products; enhancing and making more broadly applicable 
the Community Reinvestment Act; public disclosure systems that 
extend beyond the Home Mortgage Disclosure Act to enable the 
public and the media to see who is being served, who is doing 
it well, and who is doing it badly; improving financial 
literacy; and barrier removals and incentives to help consumers 
do the right things, such as the opt-out provisions that were 
incorporated into the Pension Protection Act of 2006.
    As markets begin to stabilize, or we reach what I suspect 
will be temporary lulls in foreclosures or house price 
declines, it will be easy to fall back into believing that the 
status quo is acceptable; that changing it is too hard; or that 
enhanced regulation of consumer products will hurt consumers by 
limiting choice.
    Such a result would be not only dangerous and a mistake, 
but also a waste of the trauma and turmoil we have been 
through. We instead need to use this experience to learn, to 
think creatively, and to act.
    Thank you, very much.
    [The prepared statement of Ms. Seidman appears in the 
Submissons for the Record on page 63.]
    Chairman Schumer. Thank you, Ms. Seidman.
    Mr. Pollock.

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

    Mr. Pollock. Thank you, Mr. Chairman, and thank you for the 
chance to be here today.
    Well, here we are, as we know, in the deflation of a 
classic asset bubble, this time of houses and condominiums. We 
keep having these financial adventures no matter how great our 
technological advance, our theoretical advance, or our 
regulatory reorganizations. We keep having them because the 
human nature behind the bubbles and busts doesn't change.
    So the bust continues. Large losses of the housing bust are 
now being recognized in the general Main Street banking system. 
I think it is quite important in this context that 48 percent 
of the total loans of insured depositories are based on real 
estate and for the vast majority of banks--those which have 
assets of less than $1 billion--67 percent of the loans are 
based on real estate.
    From this, we know that a real estate bust is a serious 
matter for the old-fashioned banking system, just like it is 
for the new-fashioned banking system.
    Now political actions also played a role in the housing 
bubble. Politicians of both parties cheered increasing home 
ownership rates and expanding so-called access to lower quality 
credit.
    On top of this, bubbles are notoriously hard to control 
because so many people of all kinds make money from the bubble 
while it lasts, and everybody likes the bubble while it is 
still expanding. But of course, all bubbles come to a sad end, 
and I can't resist this story: Retreating eastward after the 
collapse of the bubble in Kansas land prices of the 1880s, 
financed by mortgage money from the East Coast, defaulted farm 
mortgage borrowers who had abandoned their farms to the lenders 
had the sign on their wagons: ``In God we trusted, in Kansas we 
busted.''
    Today we can say: In house price appreciation we trusted, 
with house price depreciation we busted.
    Some current discussions give the impression, Mr. Chairman, 
that there used to be a time when highly regulated banks 
dominated the credit system and so we didn't have any problems 
because we had all these regulated entities. This we could 
think of as the ``old financial system.''
    Well, as the discussion of earlier this morning made clear, 
there never was such a time. There never was such a golden era 
of regulation.
    In my written testimony I go through in some detail the 
severe credit crunches of the 1960s, the financial disasters of 
the 1970s, the giant bust of the 1980s, all of these taking 
place in the old financial system when all of the assets were 
on the balance sheets, of banks and thrifts.
    The old financial system was also utterly opaque. Nobody 
knows less about the actual risk being undertaken than a 
depositor in a bank, at least a typical depositor.
    So following the 1980s bust, the Secretary of the Treasury 
said about the reforms of 1989 and the early 1990s, they have 
the motto of ``Never again.'' And those are the mottos of every 
reform, ``Never again.'' Yet, Mr. Chairman, here we are again.
    We even had the enormously expensive Sarbanes-Oxley Act to 
manage and limit corporate risk, and it was so successful we've 
nearly had a global financial collapse. And as Chairman Volcker 
said, we watched the consolidated British regulator, the FHA, 
separated from the Bank of England, be involved in great 
troubles trying to deal with the Northern Rock situation.
    In sum, we have to be realistic about the limitations of 
all interventions. I am against utopian hopes for what 
financial regulation can achieve, but I am for sensible 
improvements.
    My written testimony makes eight suggestions for such 
improvements, of which I will discuss the first three and the 
last one briefly.
    First thank you very much, Dr. Elmendorf, for mentioning 
the one-page disclosure. I have previously testified to you and 
this Committee that we should have a clear, straightforward 
one-page disclosure.
    And, Mr. Chairman, you introduced--and thank you very 
much--S. 2296----
    Chairman Schumer. As a result of your testimony, Mr. 
Pollock.
    Mr. Pollock. Thank you, sir--which would implement this 
idea. Everybody should be able to agree on this idea, and I 
certainly hope it will be included in any final mortgage 
legislation coming out of the Congress.
    Second, we have the issue of rating agencies, which we all 
know are an issue. Rating agencies are, they say, in the 
business of publishing opinions about the future. I think 
they're right about this. One implication of that is of course, 
such opinions will inevitably prove to be mistaken some of the 
time, and even disastrously mistaken.
    More opinions and more competition are likely to uncover 
new insights into credit risks and methods of analysis, and as 
many people have said, a particularly desirable form of this 
competition would be from rating agencies solely paid by 
investors.
    But here is a larger question I would like to pose today.
    Since all opinions about the future are liable to error, 
and opinions based on financial engineering and models--as we 
have learned to our sorrow--are liable to disastrous error, why 
should the U.S. Government want to enshrine certain opinions as 
having preferred, preferential, indeed mandatory status among 
others?
    I think it should not. And I suggest that all regulatory 
requirements to use the ratings of certain preferred agencies 
should be eliminated.
    Third is the topic of encouraging credit risk retention by 
mortgage originators. As some other speakers have touched on, I 
think this is a key idea.
    One of the lessons of the savings and loan collapse was 
that for the depository institutions to keep long-term fixed-
rate mortgages on their own balance sheet was extremely 
dangerous in terms of interest-rate risk.
    You have to smile, Mr. Chairman, when you hear certain 
people say, well, those were the good old days. The savings and 
loans made the loan and kept it--as if they couldn't remember 
that by doing that, they put themselves out of business.
    So the answer was to sell the loans to bond investors 
through securitization and divest the interest-rate risk to 
those better able to hold it.
    As a side effect, not really intended, the credit risk was 
also divested. Well, now we've learned in the wake of the 
mortgage bubble and bust that it has problems of its own when 
you split the incentives of those making the credit decision 
and the ultimate investor which actually bears the credit risk.
    So I think the right synthesis of the historical lessons is 
for securitization to continue to address interest-rate risk, 
while encouraging at the same time the retention of significant 
credit risk by the original mortgage lenders.
    Now there are numerous regulatory and accounting obstacles 
to getting this done, but it seems to me that the obvious 
superiority of the structure makes it worthwhile to try to 
overcome them. I suggest that Congress ought to give, as an 
assignment to an appropriate group of financial regulators, 
figuring out how we could make the synthesis happen and remove 
the obstacles.
    Finally, Mr. Chairman, as the great financial writer, 
Walter Bagehot said, ``the mistakes of a sanguine manager are 
far more to be dreaded than the theft of a dishonest manager.'' 
In other words, nothing is more destructive than confidence and 
optimism. The best protection against excessively sanguine 
beliefs is the study of financial history with its many 
examples of how easy it is to be plausible but wrong, both as 
financial actors and as policymakers. We all ought to be 
studying the recurring bubbles, busts, foibles, and disasters 
of financial history to gain perspective, and with luck, even 
wisdom.
    Thank you for the chance to be here.
    [The prepared statement of Mr. Pollock appears in the 
Submissions for the Record on page 65.]
    Chairman Schumer. Well thank you. I want to thank all three 
of you. These were outstanding testimony, and I just hope--I 
would like all my colleagues to be able to see it as we begin 
to enter this brave new world. There is a brave new world out 
there in the financial markets, and now there is a brave new 
world in terms of regulation, because nobody says the present 
system works.
    First a quick question for Mr. Elmendorf. You talked about 
false dawns we have already seen in the credit crisis. Can you 
elaborate? Where do you see other weaknesses that might creep 
up on us?
    Dr. Elmendorf. The false dawns I mentioned are last 
October, and then again earlier this year when it appeared that 
conditions had stabilized--or were stabilizing.
    Chairman Schumer. Right.
    Dr. Elmendorf. Much as it does today. So I am hopeful, as 
I've said, that this is really the dawn. But I think the 
biggest risk is that there are losses out there that have not 
been declared.
    We don't know how big the total losses in the world on 
mortgage-related securities will be. We don't know how much is 
held by U.S. institutions, but the best estimates I have seen 
suggest that there are tens if not hundreds of billions of 
dollars of mortgage losses that have not been declared. And 
until they are declared, we don't know who bears them and who 
will suffer.
    Chairman Schumer. So in the mortgage area itself, not a 
separate or not----
    Dr. Elmendorf. That's right. Not only do we not know, but 
the other institutions who would do transactions with them 
don't know, and that uncertainty is what keeps the risk spreads 
high and creates other problems.
    Chairman Schumer. I see. Mr. Pollock, just on credit rating 
agencies, which you touched on, as you know now, there are two 
companies that do get involved in--or use the model that you 
suggest, which is investor-rated.
    You don't think that competition is enough now to spur 
things on?
    Mr. Pollock. I think that competition is excellent, 
particularly to have the competition, as you and I have 
discussed before, between the models, between the issue-pay 
model and the investor-pay model, is a definite step forward.
    As I suggested in my testimony, there is another step I 
would take.
    Chairman Schumer. Which is just to get rid of the 
Government imprimatur----
    Mr. Pollock. Yes.
    Chairman Schumer And let it rip. What do you folks think of 
that? Dr. Elmendorf, Ms. Seidman? Ms. Seidman, you've had the 
expertise in that area.
    Ms. Seidman. Right. I must say that as we were working on 
what has become Basel II, and this question came up, front I 
was very uneasy about enshrining the rating agencies in the 
regulations concerning the capital system.
    I think the problem that we face is the famous ``compared 
to what?'' problem. Because the response was always, well, if 
it's not the rating agencies, then you've got essentially two 
other potential players. One is the regulators themselves, 
which I think is the most desirable solution. But as we've 
discussed earlier today, given that the regulators are almost 
always behind the innovations, and in good times can never 
compete for sufficient talent, that is extraordinarily 
difficult.
    And the other is the option that has in fact been enshrined 
in Basel II, which is to let the institutions themselves make 
the decisions.
    So I think my preference would be strongly for a much more 
competitive, more broadly based transparency out of ratings 
agencies, but I am not sure that that is in fact the answer. I 
do know that what we've got now is very troublesome.
    Chairman Schumer. Right.
    Dr. Elmendorf
    Dr. Elmendorf. I would just add two quick points.
    I am also intrigued by the idea. I think one thing is we 
would need to be sure if that happens that people who take 
these ratings seriously understand that then they are dealing 
with a much larger set of raters with very different capacities 
perhaps. It is very important that they realize that that then 
puts them back on their own judgment. It doesn't just 
proliferate the number of institutions getting a gold star that 
should be taken for granted.
    Chairman Schumer. That's happening anyway.
    Dr. Elmendorf. I think that is happening.
    Chairman Schumer. They relied on these agencies to their 
detriment, and I am sure they are not going to rely as much now 
as they did a year ago.
    Dr. Elmendorf. I think that's right.
    I think the second thing is just to echo the importance of 
deciding how we are going to measure risk and control risk in 
these institutions, and what we do in the absence of the 
ratings.
    Chairman Schumer. You didn't, Mr. Pollock, talk about the 
Super Fed idea, but you heard my interchange with Paul Volcker. 
Do you want to just comment on that? I mean, again I think 
having--Paul brings up two very good points. Too much power. 
And independence.
    Both are important--well, why don't you comment. But on the 
other hand he agrees we have to do some degree of consolidation 
here.
    Mr. Pollock. I did touch on what people are calling, and I 
called, the Super Fed in my written testimony----
    Chairman Schumer. Yes, you did.
    Mr. Pollock [continuing]. And that is the one thing in the 
Treasury Plan, Secretary Paulson's plan, that I think is likely 
to happen, as well being as a good idea.
    Making bureaucratic agencies go out of existence, as we all 
know, is not easy. But I think if you look at the idea of an 
overall financial market risk overseer, that's actually pretty 
sensible. As I say in my written testimony, in my view it is 
consistent with the original idea of the Fed in 1913.
    We didn't have Glass-Steagall in 1913, not for 20 more 
years.
    Chairman Schumer. Right.
    Mr. Pollock. And we don't have Glass-Steagall now. So the 
debates, which in my mind reflect the 1933-1999 period, which 
is over, really miss the point.
    Then the next question becomes though, about oversight. 
Well then, how much information do you have to have? How much 
authority do you have to have? And you clearly have to have 
some.
    On the other hand, I must say I am not at all drawn to the 
other part of the consolidated regulator idea. With 
consolidated regulators you have missed the checks and balances 
that Chairman Volcker talked about. Also, as we've seen with 
the rating agencies, you might get some things right, but you 
might get some things enormously wrong with a single point of 
view, and in general, I am a fan of checks and balances in 
every area of Government.
    Chairman Schumer. Although a lot of the times now we don't 
have checks and balances, we just have sort of little islands 
each unto themselves, each issuing regulations. They're not 
checking one another.
    First, they miss large chunks altogether. And then 
sometimes they send out conflicting and not necessarily one 
checking the other kind of thing. It is sort of a mismatch 
right now.
    Mr. Pollock. It's a problem, but in my view, whatever we 
may design we would have a good Madisonian focus on ensuring 
checks and balances.
    Chairman Schumer. Well, the American Enterprise Institute 
would very much like your reference to Madison. Any 
Hamiltonians here? Dr. Elmendorf?
    [Laughter.]
    Dr. Elmendorf. I am a Hamiltonian. I guess I would----
    Chairman Schumer. From New York.
    Dr. Elmendorf. Yes.
    Mr. Pollock. That's what I was going to say.
    [Laughter.]
    Dr. Elmendorf. I think I would not put too much emphasis in 
thinking about regulatory reform on who is doing it. I think 
the higher priority is to focus on what the regulation is 
doing.
    Chairman Schumer. Exactly, yes.
    Dr. Elmendorf. So I think for example that the Treasury 
blueprint has a lot of interesting ideas, and I commend them 
for putting it out, but it focuses mostly on the boxes on the 
organization chart, which I think is a legacy of starting the 
study at a time when the biggest concern was competitiveness 
and consistency and not so much how to deal with the excessive 
leverage that we've seen.
    I think it is better to focus on how we are regulating 
people. And many of the specific changes that all of us have 
talked about would be enhanced by some coordination across the 
regulatory agencies as exists.
    It's not that I am an enthusiast for the current 
hodgepodge, but I think given the complexity of the issues, it 
is important to prioritize and tackle the issues that are 
highest priority first.
    Chairman Schumer. Take my example of Bear Stearns, which I 
mentioned early on. That wasn't a question of having better 
regulation; it was a question of which box governed which. And 
you had the wrong box governing the wrong place. So that wasn't 
a question of coming up with a new way of regulating, or a new 
model.
    My guess is--I don't know, but had the Fed had jurisdiction 
over Bear Stearns on safety and soundness issues, there's a 
real chance they would have forced them to do the things that 
the SEC was unable to, and certainly it wasn't even in their 
sphere of thinking.
    Dr. Elmendorf. I think that's exactly right. The investment 
banks are a particular example where there is no box that is 
responsible for the aspects of their behavior that have turned 
out to be very important. And in that case, I do support--and 
we talk in our paper about giving more authority to the Federal 
Reserve.
    If they are going to be lending to these institutions as 
the lender of last resort, they should be regulating and 
supervising them as well.
    Chairman Schumer. Ms. Seidman.
    Ms. Seidman. I basically agree with what Doug has said, but 
let me point out a couple of things that I think are important.
    When we talk about the current crisis and the current 
market crisis, and focus in on Bear Stearns, I think we, very 
correctly, are thinkng about the top tier of institutions.
    And yet when we say ``consolidated regulator,'' all of a 
sudden we're bringing into play insurance companies, community 
banks, pay-day lenders.
    I totally agree with Doug, that figuring out what we're 
doing is more important than figuring out the boxes.
    Chairman Schumer. And you'd be sort of for functional 
regulation? You'd change the boxes to more conform--I mean, 
pay-day lender and somebody who's looking at a hedge fund----
    Ms. Seidman. Are very different.
    Chairman Schumer [continuing]. For systemic risk----
    Ms. Seidman. Are totally different.
    Chairman Schumer. Are totally different and probably should 
be in the same agency.
    Ms. Seidman. That's my basic point; that I think that 
functionality at the level of institutions that can in fact 
create systemic problems, may not be the best way to organize.
    It may be that with systemic-risk entities you organize 
across functions. Maybe this is where the Fed really should 
have its focus.
    But that requires us to change our language.
    Chairman Schumer. Yes.
    Ms. Seidman. And to make sure that we don't sweep all these 
other institutions that really still need to be considered 
under that.
    One other thing I'd like to say about the British situation 
is I can remember visiting the FSA, while I was at OTS, and 
talking to them about how they were setting up. It was right 
after they started what they were doing.
    And I'd say that there were two things that we need to be 
cognizant about with the British system: One, they rely very, 
very, very heavily on CPAs and the public accountng system in a 
way that is much greater than we do in terms of examination. 
They have a much smaller exmaination corps.
    The second thing is that in England, name and shame still 
counts for something, and I'm not sure it does in the United 
States.
    Chairman Schumer. So you might disagree with Volcker's 
analysis that Northern Rock was a failure of the FSA and is 
much more a--well, go ahead. Do you?
    Ms. Seidman. I mean, I don't know what Northern Rock was 
primarily a failure of. I think that certainly, the issue of 
swooping in and announcing that you're going to back up all the 
creditors is a troublesome way to run a system.
    Chairman Schumer. That wasn't the FSA.
    Ms. Seidman. The FSA should have figured out that there was 
a problem earlier.
    Chairman Schumer. Got it. Do you both agree?
    Dr. Elmendorf. Yes.
    Mr. Pollock. I think the problem, as I understand it--
although I'm not a close student of it--in dealing with Black 
Rock----
    Chairman Schumer. I'm sorry. I don't want to create any 
problems.
    Mr. Pollock [continuing]. With the Northern Rock----
    [Laughter.]
    Mr. Pollock [continuing]. Was the dependence on short-term 
market funding, funding longer-term assets. At least some 
people say the longer-term assets were of good quality. I don't 
know.
    There is a general characteristic of all financial bubbles, 
as the confidence builds. Here, I will cite a different 
authority, Hyman P. Minsky, an old friend of mine who wrote 
with great insight, I think, into the makings of financial 
busts which he called ``financial fragility.'' As the 
confidence builds, it becomes viewed subjectively as normal and 
proper to engage in greater and greater degrees of short-term 
financing.
    Chairman Schumer. Right. So that leads to something that I 
think has been touched on here, but I haven't heard much 
discussion of on this side of the table, which is your 
suggestion, Mr. Pollock, which I think either Dr. Elmendorf or 
Ms. Seidman talks about, which is encouraging risk retention by 
the mortgage originators.
    It sounds great, but how the heck do you do it?
    Ms. Seidman. Oh, I mean, we used to do it.
    Chairman Schumer. OK, tell me.
    Ms. Seidman. Even after securitization really got going, it 
was very traditional for the securitizer, the originating bank, 
to hold a significant piece of the bond.
    Chairman Schumer. They were required to.
    Ms. Seidman. Well, no one would take it from them is really 
what was going on, and the rating agencies required--it was a 
combination of no one would buy it from them and the rating 
agencies saying you've got to hold it in order to be able to 
get the kind of rating you want.
    Chairman Schumer. And no one would buy it from them 
because, if they weren't holding a piece--got it. It wasn't 
that sophisticated where they were chopping up different types 
of pieces with different amounts of risk.
    Ms. Seidman. This one is not as hard as people have a 
tendency to make it.
    Mr. Pollock. Mr. Chairman, this one, financially speaking, 
is really easy. The problems are regulatory capital and 
accounting problems.
    Chairman Schumer. I mean, yes, and what if you either 
required, or probably more likely, required different retention 
of capital by how much you retained. You know, different----
    Ms. Seidman. Well, that's one of the big issues, because 
the question becomes, OK, so I've retained 5 percent of this 
pool. Have I therefore----
    Chairman Schumer. Just 1 second. These days, the pool isn't 
uniform the way it used to be. It's chopped up in different 
pieces with different levels of risk.
    Ms. Seidman. Right, but let's start with the simple one.
    Chairman Schumer. OK.
    Ms. Seidman. And even in the old days, the pools were 
always, for example, geographically diversified, except when 
they were CRA pools. They were geographicaly diversified 
because there was the benefit of geographical diversification, 
particularly in real estate.
    So, if I'm holding onto 5 percent of the pool, the question 
is have I nevertheless held onto a 100 percent of the risk.
    Chairman Schumer. Right.
    Ms. Seidman. And if I've held onto a 100 percent of the 
risk, then proper capitalization should require me to 
capitalize it as if I'd held onto the whole pool.
    Chairman Schumer. Right.
    Ms. Seidman. And that obviously obviates the benefits of 
securitization.
    Chairman Schumer. Right.
    Ms. Seidman. That's why, as Alex points out, it's easy to 
figure out the finance; it's hard to figure out the capital and 
accounting.
    Chairman Schumer. What do you think?
    Dr. Elmendorf. I think this is a case where a private 
response can be very helpful. As Ellen says, people couldn't 
sell those before because the other side of the transaction 
wouldn't buy.
    Chairman Schumer. Wouldn't buy.
    Dr. Elmendorf. And I was on a panel recently with a former 
president of an important bank, and the president said that he 
thought the real problem was that people let Countrywide, which 
was the example, issue a bunch of mortgages they shouldn't have 
been allowed to issue. So I'm inclined to think that there 
should have been restrictions, mostly to protect the mortgage 
borrowers.
    But the fair question I put to him was also, but you 
shouldn't have bought these mortgages from Countrywide. And if 
his bank had not been putting up the money, then Countrywide 
would not have been making loans of that sort, because they 
would not have been able to get the funding for them.
    Chairman Schumer. Right.
    Dr. Elmendorf. So, a lot of it comes back to these 
institutions, and this was a heavily regulated and supervised 
bank, but I think they need to take this lesson to heart. I 
think some of them have learned.
    Also, I think the supervisors need to learn that if some 
bank is buying a lot of mortgages and they know nothing about 
the origination of those mortgages, or the underwriting 
standards that were applied, then they need to know doing this 
is very, very risky.
    Chairman Schumer. We don't just have two levels here. It 
could be four or five levels, and that bank that bought them 
would probably, just like Coutrywide, have no intention of 
keeping any of it even, right?
    Dr. Elmendorf. That's right. I think some more----
    Chairman Schumer. That doesn't----
    Dr. Elmendorf. [continuing]. More askance the internal risk 
manangement systems and the more askance the supervisors need 
to look at it.
    Chairman Schumer. Somehow, it seems to me, there's got to 
be a way to give both more information and more responsibility 
to the ultimate investor, as opposed to looking at it, as you 
go through the plan, I mean, which is sort of the opposite, in 
a certain sense, of what people are saying, although it relates 
to credit rating agencies, it relates to----
    I mean, I guess you have two models here. They're not 
necessarily conflicting, but having the risk, having the 
ultimate investor have greater knowledge and ability to assess 
the risk--and maybe that's just a market force--or having the 
originator have some of the risk, based on, you know, based on 
credit.
    Mr. Pollock. Mr. Chairman, could I add something?
    Chairman Schumer. Yes.
    Mr. Pollock. One of the key things in this idea of 
retention of credit risk by the originator is to distinguish 
between kinds of risks.
    Chairman Schumer. Yes.
    Mr. Pollock. You might----
    Chairman Schumer. As opposed to--yeah.
    Mr. Pollock. That is to say, you could be retaining credit 
risk, but fully, or at least very largely, divesting yourself 
of the interest rate risk and the liquidity risk, and that's 
where I think, Ellen, the rules have to adjust themselves.
    For prime mortgages, most of the risk is interest rate 
risk.
    Chairman Schumer. Yes.
    Mr. Pollock. And that's where I think we could really do 
some fruitful work on distinguishing the types of risk and 
allowing this structure to emerge.
    And also, as you say, Mr. Chairman, we don't want the 
buyers to be able to go to their trustees and say, nothing to 
worry about, I've got a Government-approved triple-A. You want 
them to say, wait a mimute, what is this?
    Ms. Seidman. This is another place where--and Alex 
mentioned it a little bit in his testimony--where I think we 
have to be careful about our language because thinking that the 
ultimate investor, me buying a share in a mutual fund, wouldn't 
be able to have any idea of risk, is--I mean, we'd be fooling 
ourselves. That's why we have deposit insurance.
    Chairman Schumer. Well, in these instruments, you didn't 
have----
    Ms. Seidman. I understand.
    Chairman Schumer. The answer there would be that's why we 
have credit rating agencies.
    Ms. Seidman. No, I understand, Alex's point was that 
there's nothing as opaque as a bank.
    Chairman Schumer. Right.
    Ms. Seidman. But we have deposit insurance, so we can put a 
deposit in. I do think that it is with the large intermediaries 
that eventually enable the little guys to buy, where we have to 
put this responsibility for knowing what you're buying and not 
buying it, if it's risky, and having your regulator tell you 
not to buy it, or that you have to capitalize heavily against 
it, if you have.
    I think you just have to get the level right.
    Chairman Schumer. A lot of people--and tell me if I'm wrong 
here--a lot of the people who ultimately bought this, were not 
little guys. They were very big guys.
    Ms. Seidman. A lot of people were very big guys, but you 
know, there's the apocryphal----
    Chairman Schumer. I'll bet the vast bulk of all of these 
chopped up pieces ended up not in--I mean, the only way they'd 
end up in the little guy's pockets was through pension funds 
and whatever else.
    Ms. Seidman. That's exactly my point, right.
    Chairman Schumer. But not--the actual purchaser who 
ultimately parked the stuff, was not a little guy.
    Ms. Seidman. Right. There are pieces of information that 
simply weren't there. So, for example, on the first round of a 
securitization of mortgages, if you are a Lou Ranieri, you can 
get the information and run it through your computers.
    Even Lou Ranieri could not do that through their CDOs 
because the information was not available.
    Chairman Schumer. Right. But he, Lou Ranieri, fact in 
point, was a friend of mine, and he was warning about this 
stuff long before anybody else.
    Ms. Seidman. He absolutely was. If people had paid 
attention to what Lou was saying in early 2006, we might be in 
a different place.
    Chairman Schumer. Right. Dr. Elmendorf, you get the last 
word here on all this.
    Dr. Elmendorf. That's a lot. I would just make a small 
point, which is that I think the extent to which these risky 
assets found their way back onto the balance sheets, or right 
next to the balance sheets of the large institutions, was one 
of the very surprising features for many people.
    The idea had been that the risk was going to be 
disseminated, and certainly some was sent around the world. 
That's why UBS was in trouble and other foreign institutions.
    But the fact that such a large share ended up right back on 
the balance sheets or in the structured investment vehicles 
that we pretended weren't on the balance sheets of these large 
financial institutions was shocking, and that's really----
    Chairman Schumer. And they relied on the credit rating. I 
mean, I guess they ultimately--these very sophisticated 
institutions--I was not there. I don't do this for a living, 
but I'm sure somebody said, well, it's triple-A.
    Dr. Elmendorf. Yes.
    Chairman Schumer. And we can leverage it, and we can make a 
lot of money on a triple-A investment.
    Dr. Elmendorf. I think that the extent to which the risk 
was correlated across the underlying mortgages was not 
recognized. There was a sense that you have a pool of a hundred 
thousand mortgages, then you can guess pretty well what share 
of the people will lose their jobs or get sick----
    Chairman Schumer. Right.
    Dr. Elmendorf. [continuing]. Or have other reasons for not 
paying. The extent to which the whole pool and all of the 
mortgages were only good if house prices continued to go up and 
didn't go down--which was a very highly correlated risk across 
them--was not understood, and it's hard to see, in retrospect, 
how that could have been missed, but it does seem to have been 
missed.
    Chairman Schumer. I'm still totally befuddled by the fact 
that all these sophisticated people from the credit--would buy 
no-doc loans, and it's only no-doc loans--no-doc loans. And a 
lot of these--and it's only related to the, I guess, idea that 
everything will always go up and all you have to do, Mr. 
Pollock, is study financial history. Everything doesn't always 
go up, but that's what they were doing.
    Dr. Elmendorf. Yes.
    Chairman Schumer. Hey, this was great. Thank you all very 
much for your concern and erudition. The hearing is finished.
    [Whereupon, at 12:04 p.m., the hearing was adjourned.]

                       Submissions for the Record

[GRAPHIC] [TIFF OMITTED] T2773.001

       Prepared Statement of Senator Charles E. Schumer, Chairman

    I want to thank you, Chairman Volcker, as well the other witnesses 
who will join us on the second panel, for coming to this hearing today 
about the financial system, and the steps we need to take to reform our 
regulatory structures.
    I'm worried that, because things do not seem as bad as they were a 
month or so ago, we're already starting to become complacent about the 
critical need to address the regulatory and market failures that have 
had much to do with the troubling economic situation we find ourselves 
in.
    The past year has been a stark reminder of the direct link between 
Wall Street and Main Street, between the health of the financial 
markets and the economic well-being of all Americans.
    A year ago, most of us had never heard of CDO's and CMG's and 
SIV's, of option ARM's and credit default swaps and auction rate 
securities. Now, we know that those who knew about these complex 
financial instruments clearly didn't know enough to protect consumers, 
investors, and our economy from them. And we've learned too much about 
the central role these financial tools have played in the worst housing 
crisis since the Great Depression, the freezing of credit markets 
worldwide, and the onset of our current recession.
    Financial innovation is vital, both for the health of our financial 
system and our economy, but it is just as vital that financial 
regulation keep up with innovation. It has not.
    In my view, this credit crisis is as much a failure of regulation 
as it is a failure of the marketplace. The goal of regulation should 
always be to encourage entrepreneurial vigor while ensuring the health 
of the financial system. We found that balance in the past, but it 
seems to have been lost. We have a 21st century global financial 
system, but a 20th century national set of financial regulations. That 
needs to change soon.
    To begin, we need to acknowledge that consolidation has transformed 
the financial industry. We no longer have the clear distinctions 
between commercial banks, investment banks, broker-dealers and insurers 
that we did sixty years ago, or even twenty years ago. Instead, there 
are a large number of financial institutions surrounded by many smaller 
institutions--such as hedge funds and private equity funds--with their 
own specialties. It's as though we have a handful of large financial 
Jupiters that are becoming more and more similar encircled by numerous 
small asteroids. Our regulatory structure has to recognize that change. 
As large investment banks have come to act more and more like 
commercial banks--especially now that they can borrow from the Fed's 
discount window--then they need to be supervised more strictly.
    We need to think very seriously about moving toward more unified 
regulation, if not a single regulator. We have too many regulators, 
each watching a different part of the financial system, while no one 
keeps an eye on the greater threats of systemic risk. In the U.K., they 
have a single, strong regulator who has responsibility for the entire 
system and the authority to act when necessary. Maybe a regulator with 
that authority could have prevented a debacle like the collapse of Bear 
Stearns by acting quickly and forcefully before things began to 
unravel.
    We must figure out how to regulate the currently unregulated parts 
of financial markets. For example, credit default swaps are a multi-
trillion dollar industry almost completely outside the purview of 
regulators. Recently, there's has been talk about creating a 
clearinghouse for credit default swaps. I think this an excellent idea, 
and the sort of innovation we should be thinking about more broadly. I 
also believe we need to think about whether a unique exchange for these 
swaps might be an even more effective way to bring about greater 
transparency and limit systemic risk.
    We must have greater transparency in the financial system. The 
credit crunch has been as much a crisis of confidence as it has been a 
real economic crisis. Financial markets operate on trust, on the belief 
participants have that they can rely on the people they are entering 
into contracts with. As long as so many black holes remain in the 
financial system, it will be hard for that trust to be restored.
    We must involve our international partners. National regulations 
can only achieve so much in a global financial market. It does us no 
good to enact new rules if other countries remain lax in their 
regulations or their enforcement. The global financial regulatory 
system should not be the arithmetical equivalent of the lowest common 
denominator. This crisis and the complexity of our system requires much 
more.
    And finally, we must put aside the `laissez-faire', no Government 
is good government, mantra that we hear from this administration and 
the other side of the aisle. The market does not solve all problems by 
itself and neither does the Government. That's why we need firm, 
forward looking regulation, to prevent the sort of crises we're facing 
now from recurring in the future.
    I share with Treasury Secretary Paulson and Chairman Bernanke the 
hope that the worst of the credit crisis is behind us. But I am not 
convinced that it is over. Whatever calm has been brought to financial 
markets today has been the result largely of extraordinary actions 
taken by the Federal Reserve. Chairman Bernanke deserves credit, but 
the actions he has had to take are sign of just how unprecedented, and 
how troubling, this credit crisis has been.
    We cannot sit back, relax and hope for the best. The American 
people, our economy and the global financial system cannot afford it.

[GRAPHIC] [TIFF OMITTED] T2773.001

  Prepared Statement of Representative Carolyn B. Maloney, Vice Chair
    Good morning. I would like to thank Chairman Schumer for holding 
this hearing to examine the risks in the U.S. financial system and 
potential solutions. I want to welcome former Chairman Volcker and our 
other witnesses and thank you all for your testimony today.
    At the core of the ongoing liquidity crisis is the decline in home 
prices, which is causing banks to readjust their balance sheets and to 
buildup capital. Congress is currently focusing its attention on 
keeping families in their homes and stemming the deepening decline in 
home prices.
    The crisis in the housing market has brought to light the inability 
of our most sophisticated and respected institutions to measure their 
exposure to opaque assets and manage the risks associated with them. 
Detangling the DNA of assets has become increasingly difficult for 
investors. We clearly need greater transparency for complex investment 
products to assure smoothly functioning markets.
    Our entire regulatory system is also in serious need of renovation 
because financial innovation has surpassed our ability to protect 
consumers and hold institutions accountable. In our rather fragmented 
system, financial regulators do not have authority to broadly address 
systemic risk.
    The Financial Services Committee will soon turn its attention to 
rethinking financial services regulation. Meanwhile, the Treasury 
Secretary has a sweeping proposal for revising the Federal regulation 
of all financial institutions. That plan would grant the Federal 
Reserve power to serve as an overarching ``market stability'' 
regulator, with the ability to collect information and require 
corrective action across the broad spectrum of financial services.
    Our current system of multiple regulators leaves big holes that a 
``super regulator'' could plug. For example, the unwillingness up to 
this point of the Federal Reserve and the S.E.C. to require working 
capital limits has been criticized as exacerbating risk-taking. Only 
now has the S.E.C. joined other Federal regulators in working with the 
Basel Committee to extend the capital adequacy standards to deal 
explicitly with liquidity risk.
    The Bear Stearns rescue also exposed the lack of Federal regulatory 
authority to supervise investment bank holding companies with bank 
affiliates, as the Fed supervises commercial bank holding companies. 
Thus, investment bank holding companies don't have to maintain 
liquidity on a consolidated basis.
    In the wake of the Bear Stearns debacle, S.E.C. Chairman Cox has 
said that investment banks can no longer operate outside on a statutory 
consolidated supervision regime. Giving investment banks access to the 
Fed's discount window, which was created for depository institutions, 
creates problems since they are not regulated like depository 
institutions. In particular, they have no restrictions on how highly 
leveraged they can be.
    We need reform, but the Treasury plan is so sweeping that it risks 
being disruptive while we are working hard to stabilize our economy. 
Moreover, it risks eliminating regulatory voices that should be heard. 
The American system of Government relies on checks and balances, and we 
can all think of instances when the lone voice of the multiple Federal 
regulators has pushed the group to an action that was unpopular but 
proved to be right.
    We should focus first on targeted reforms with maximum effect. 
Improving the transparency and accountability of trading in credit 
default swaps and derivatives is an example. A key factor that 
apparently pushed the Fed to rescue Bear Stearns was concerns about a 
domino effect from the interlocking relationships between thousands of 
investors and banks over credit default swaps, which are presently 
traded by investment banks off any exchange and without any 
transparency. Requiring the use of exchanges and clearing houses for 
credit default swaps and derivatives is worth exploring.
    Mr. Chairman, thank you for holding this hearing and I look forward 
to our witnesses views on correcting the imbalances in our financial 
markets.

[GRAPHIC] [TIFF OMITTED] T2773.003

              Prepared Statement of Senator Sam Brownback

    Thank you Mr. Chairman. I appreciate you scheduling today's 
hearing. Our topic is quite broad, Mr. Chairman. ``Is the Credit Crisis 
Over and What Can the Federal Government Do to Prevent Unnecessary 
Systemic Risk in the Future?'' sounds suitable for a series of well-
planned and broad-based hearings. I certainly hope that we will take 
the time as a committee to examine this subject in much more detail.
    Obviously, much of the current economic slowdown can be attributed 
to dysfunctional financial markets over the past year caused by turmoil 
in markets for asset-backed debt securities and obligations. We have 
witnessed the collapse of a major investment banking firm--or near 
collapse, but for the unprecedented action of the Federal Reserve 
Board. While there has been general praise for the actions of the 
Federal Reserve, questions have been raised about how close to or how 
far outside the boundaries of its authority the Federal Reserve actions 
were.
    Mr. Chairman, I must say that one aspect of our hearing title 
causes me some concern--``prevent unnecessary systemic risk.'' I think 
we need to determine what level of systemic risk is acceptable before 
we can even venture into a discussion of whether it's necessary or not. 
I also believe that a related issue to define and sort out is the 
definition of the ``lender of last resort'' function of the Federal 
Reserve and what that actually means the Fed can and cannot do in 
pursuing that function.
    I would like to note that the Fed took onto its balance sheet, and 
therefore the taxpayers' balance sheet, risky private-sector assets, 
inherited from an investment bank over which the Fed did not have 
direct regulatory oversight, in its part of the takeover of Bear 
Stearns by JPMorgan Chase. While the Fed has the power to do so, under 
a 1932 provision of the Federal Reserve Act allowing the Fed to lend to 
non-banks under ``unusual and exigent circumstances,'' it isn't 
entirely clear what constitutes such circumstances. The Fed's recent 
actions introduce serious issues of moral hazard by signaling to risk-
takers in financial markets that if the dice do not turn up favorable, 
the Fed and, hence, taxpayers will provide a backstop.
    The Federal Reserve has also created new ways of lending to 
depository institutions and to investment banks by setting up a new 
Term Auction Facility and Term Securities Lending Facility. The latter 
allows primary dealers to exchange less-liquid securities at an 
auction-determined fee for some of the Fed's Treasury securities. 
Recently, the Fed has allowed private-sector asset-backed securities as 
securities eligible for such transactions. So, the Fed has basically 
been conducting some of its monetary policy by rearranging its, and 
therefore the taxpayers', balance sheet--trading Treasury securities 
for securities that include risky asset-backed private securities.
    While I believe that the Fed's recent activities have been creative 
and may have helped reduce tensions in domestic and global credit 
markets, I also take seriously the responsibility that Congress has in 
its oversight role regarding the Fed. I think that we need to know more 
than we currently do about recent actions. For example, to my 
knowledge, we don't have a clear accounting of the assets or that the 
Fed took onto its balance sheet in the Bear Stearns-JPMorgan Chase deal 
or an accounting of the value of those assets. Given the Fed's recent 
emphasis on transparency, it would be useful to know, but interesting 
that we don't.
    One of our witnesses today, former Federal Reserve Board Chairman 
Paul Volcker, is eminently qualified to offer perspectives not only on 
the broad topic of avoiding systemic risk, but on the more narrow 
question of whether or not the Federal Reserve acted appropriately.
    Chairman Volcker served our nation at another time of crisis when 
the Federal Reserve's dual mandate was severely strained. Inflation 
raged in double digits and the unemployment rate was a full percent 
higher than it is today. Through Chairman Volcker's leadership, 
inflation was brought under control. That did not come without a steep 
price in terms of a recession that saw the unemployment rate rise to 
10.8 percent.
    It was also during his tenure that the Federal Reserve, over 
Chairman Volcker's objection, used it regulatory powers to grant banks 
expanded powers in the investment banking arena despite the provisions 
of the Glass-Steagall Act. It may be a useful time to revisit that 
decision and debate whether we need a clearer, Glass-Steagall-like 
delineation between where investors have a safety net under them, 
subject to certain restrictions, and where investors should not expect 
any Government backing of their private risk taking.
    It may be that part of our recent problem stems from an absence of 
such a clear delineation, because if you are a big enough private 
financial risk taker, and are intertwined enough with a large number of 
counterparties in important markets, then you evidently have access to 
the Fed's discount window and a taxpayer-funded safety net. Taxpayers 
are being exposed to risks without, perhaps, the benefit of adequate 
oversight regarding institutions that are being backed by the Fed. I am 
concerned that recent actions by the Fed could introduce too much moral 
hazard and signals that have been sent by recent Federal Reserve 
actions.
    Before closing, I would like to take exception to the portrayal by 
many on the other side of the aisle of a recent financial crisis 
somehow caused by an Administration that is somehow antagonistic toward 
financial regulation and an Administration that shuns regulation of 
financial activity. I would ask: What actions identify such an attitude 
by the Administration? We clearly have now, and have had for some time, 
regulations against much of the freewheeling mortgage activities that 
led us to a lot of our recent problems. And a lot of those regulations 
are housed at the Federal Reserve, under the Home Ownership Equity 
Protection Act of 1994 for example. The current Administration did 
nothing to prevent the Fed from using its supervision and regulation 
staff to take action regarding what was clear to anyone with a pulse 
was risky mortgage lending in recent years. Nor did the Administration 
encourage any regulatory agency to act loosely in enforcing existing 
regulations. To paint the recent strains in mortgage and financial 
markets as somehow being caused by the Administration is plain and 
simply an exercise in groundless political positioning.
    I am interested to hear Chairman Volcker's views and those of our 
other witnesses, on our present situation, changes to our regulatory 
system, and what other actions we should take to avoid another crisis 
within the next decade.
                               __________
  Prepared Statement of Hon. Paul A. Volcker, Former Chairman of the 
           Federal Reserve Board of Governors, Washington, DC

    I appreciate the opportunity to discuss informally some 
implications of the systemic risks in the financial system as revealed 
in the current crisis. This statement will simply point out some of the 
more important and unresolved issues as I see them. The complications 
are evident. There are no quick and facile answers. Your deliberations 
can, however, help lay the groundwork for legislation that will, I 
believe, be necessary, if not now in the midst of crisis and an 
election campaign, then in 2009.
    The background for the crisis and for any official and legislative 
response is the rather profound change in the locus and nature of 
financial intermediation over the past couple of decades. We have moved 
from a heavily regulated and protected commercial bank dominated world 
to a more open market system, with individual credits packaged and 
repackaged and traded in impersonal markets. Large commercial banks 
have themselves taken on important characteristics of investment banks, 
but the investment banks and hedge funds that have come to dominate the 
trading, if regulated at all, have not been closely supervised with 
respect to their safety and soundness.
    The new ``system'' has, indeed, been heavily ``engineered'', with 
highly talented, well paid, and mathematically sophisticated 
individuals dissecting and combining credits in a manner designed to 
diffuse risk and to encourage an allocation of those risks to those 
most able to handle them.
    The result in practice has been enormous complexity, and with the 
complexity has come an opaqueness. In the process, close examination of 
particular credits with respect to risk has too often been lost; the 
sub-prime mortgage is only the leading case at point.
    The complexity has also made it more difficult to assess risk for 
the managers of particular large institutions, for supervisors and for 
credit rating agencies alike. The new system seemed to work effectively 
in fair financial weather, with great confidence in its efficiency and 
presumed benefits. However, I believe there is no escape from the 
conclusion that, faced with the kind of recurrent strains and pressures 
typical of free financial markets, the new system has failed the test 
of maintaining reasonable stability and fluidity.
    One broad lesson, it seems to me, is the limitations of financial 
engineering, involving presumably sophisticated modeling of past market 
behavior and probabilities of default. It's not simply a matter of 
inexperience or technical failures in data selection or the choice of 
relevant time periods for analysis. The underlying problem, I believe, 
is that mathematic modeling, imbued with the concept of normal 
frequency distributions found in physical phenomena, cannot easily take 
account of the human element of markets--the episodes of contagious 
``irrational exuberance'' or conversely ``unreasoned despair'' that 
characterize extreme financial disturbance.
    It is recognition of those extreme and unsettling market 
disturbances that conceptually has justified official intervention in 
free markets. That intervention has taken the form of regulation and 
supervision and of providing an official ``safety net'' for 
systemically important institutions, in the past almost entirely 
limited to commercial banks and traditional thrift institutions.
    Faced with the evident threat of a potential cascading breakdown of 
an already heavily strained financial institution, the Federal Reserve, 
drawing upon long dormant emergency powers, recently felt it necessary 
to extend that safety net, first by providing direct support for one 
important investment bank experiencing a devastating run, and then 
potentially extending such support to other investment banks that 
appeared vulnerable speculative attack.
    Whatever claims might be made about the uniqueness of current 
circumstances, it seems inevitable that the nature of the Fed's 
response will be taken into account and be anticipated, by officials 
and market participants alike, in similar future circumstances. Hence, 
the natural corollary is that systemically important investment banking 
institutions should be regulated and supervised along at least the 
basic lines appropriate for commercial banks that they closely resemble 
in key respects.
    Several issues now need to be resolved by legislation or otherwise.
    Just how far should the logic of regulation and supervision be 
extended? To all ``investment banks'' and what is an accepted 
definition of an investment bank? What about to ``hedge funds'' of 
which I am told there are some fifty thousand around the world? 
Presumably very few of them could reasonably meet the test of systemic 
importance. However, a few years ago, a single large, widely admired, 
heavily ``engineered'' hedge fund suddenly came under market pressure 
and was judged to require assistance by the Federal Reserve in the 
form, not of overt official financial assistance, but of moral suasion 
among its creditors.
    Recent events raise another significant question for central 
banking. Given the strong pressures and the immobility of the mortgage 
markets--pressures spreading well beyond the sub-prime sector--central 
banks in the United States and elsewhere have directly or indirectly 
intervened in a large scale in those markets. That approach departs 
from time-honored central bank practices of limiting lending or direct 
purchases of securities to Government obligations or to strong highly 
rated commercial loans. Apart from any consequent risk of loss, 
intervention in a broad range of credit market instruments may imply 
official support for a particular sector of the market or of the 
economy. Questions of appropriate public policy may in turn be raised, 
going beyond the usual remit of central banks, which are typically 
provided a high degree of insulation from political pressures.
    That independence is integral to the central responsibility of the 
Federal Reserve (and other central banks) for the conduct of monetary 
policy.
    The Federal Reserve also has in practice, and enshrined in is 
founding mandate, certain responsibilities for commercial banking 
supervision. In practice, it has in my mind been properly considered as 
``primus inter pares'' among the various financial regulators.
    In my view, a continuing strong role in banking regulation and 
supervision by the Fed has been important for at least three reasons. 
First, as the ``lender of last resort'' and the ultimate provider of 
financial liquidity, if should be intimately aware of conditions in the 
banking system generally and of particular institutions within it, a 
precondition for decisions with respect to financial or other 
assistance.
    Second, the widely understood and accepted independence of the 
central bank provides strong protection from the narrow political 
pressures that may be brought to bear in the exercise of regulatory 
responsibilities.
    Third, the broad responsibilities of the Federal Reserve to 
encourage orderly growth seem to me to encourage an even-handedness 
over time in its approach toward regulation.
    I have long thought the Federal Reserve lead role in banking (and 
financial) supervision should be recognized more clearly than in 
present law. Experience over time, reinforced by recent events, also 
strongly suggests that if that Federal Reserve role is to be maintained 
and strengthened, important changes will be necessary in its internal 
organization. Specifically, direct and clear administrative 
responsibility should lie with a senior official, designated by law. 
Stronger staff resources, adequately compensated, will be necessary.
    I recognize that, if supervisory and regulatory responsibilities 
are to extend well beyond the world of commercial banking and its 
holding companies, then a more fundamental question will need to be 
faced. Should such a large responsibility be vested in a single 
organization, and should that organization reasonably be in the Federal 
Reserve without risking dilution of its independence and central bank 
monetary responsibilities?
    Clearly, other large questions are exposed by the present financial 
crisis. The role and organization of credit rating agencies, the use 
and mis-use of mark-tomarket and ``fair value'' accounting, the 
oversight of hedge funds, and somewhat removed but nonetheless 
important, the growing role of sovereign wealth funds, all need 
consideration.
    More generally, I must emphasize that little of the needed changes 
and reforms can proceed independently, without consideration of, and a 
high degree of cooperation with, other leading financial powers, 
especially the European Union and Japan. In a world of globalized 
finance, recent experience demonstrates we are all in this together. 
Idiosyncratic national approaches simply cannot be fully effective, and 
can easily be counter-productive of needed discipline.
    Recent years have brought encouraging progress in a number of 
important areas: bank capital requirements, common accounting 
standards, growing consistency in auditing and settlement procedures 
and elsewhere. It is those areas of intergovernmental, private, and 
public--private initiative upon which we need to build. The critical 
pressures on our financial markets are not unique; nor can an approach 
to dealing with those pressures be successful in isolation. We have a 
lot upon which to build, and we should not miss the opportunity to 
extend the areas of cooperation.
                               __________
    Prepared Statement of Dr. Douglas W. Elmendorf, Senior Fellow, 
                 Brookings Institution, Washington, DC

    Chairman Schumer, Ranking Member Saxton, and Members of the 
Committee, I appreciate the opportunity to appear before you today.
    The current financial crisis in the United States poses two 
separate challenges for economic policy: one, to resolve the immediate 
problems; the other, to reduce the likelihood that these problems 
recur. My testimony will focus on the second of these challenges. The 
diagnosis and prescriptions I will offer are based on a report I am 
writing with my Brookings Institution colleagues Martin Baily and Bob 
Litan, of which a preliminary draft will be released this Friday. 
However, I alone am responsible for any errors or inadequacies in my 
comments.
    The U.S. financial system remains in a perilous state. I share the 
view of some other observers that the worst of the credit crisis is 
probably behind us. But that is by no means certain, and, even if it 
turns out to be right, the return to normal financial conditions will 
be a slow and uneven process.
    Indeed, we have already seen two false dawns during this crisis. 
Last October and again this January, financial conditions appeared to 
be stabilizing--only to be followed by renewed widening of risk 
spreads, further declines in asset values, and struggles for survival 
by some financial intermediaries. The Federal Reserve has responded to 
this turmoil vigorously and, in my view, appropriately by reducing the 
Federal funds rate 3\1/4\ percentage points and by providing 
significant liquidity as the so-called ``lender of last resort.'' 
Through these actions, the Fed has so far prevented what might have 
been a cascade of defaults and institutional failures. Hopefully, the 
relative calm since the sale of Bear Stearns in March is a precursor of 
further stabilization.
    Still, estimates suggest that billions of dollars of mortgage-
related losses have yet to be declared by U.S. financial institutions. 
Interbank loan rates remain elevated as banks hoard liquidity and 
continue to be concerned about the creditworthiness of other 
institutions. The slowing of the economy is depressing loan repayment 
rates. Thus, the risk of a large institutional collapse has been 
reduced but not eliminated. More important, an absence of dramatic 
events going forward will not imply that financial intermediation is 
back to normal. The weakened state of banks' balance sheets will make 
them less willing to lend to households and businesses for some time to 
come. For example, the Fed reported recently that a large fraction of 
banks tightened lending standards and terms across a broad range of 
loan categories in the first quarter of the year. Many banks have 
raised additional capital to bolster their balance sheets, but much 
more needs to be raised. If that does not occur in a timely way, we 
could face a constriction of lending to households and businesses 
analogous to the Japanese experience in the 1990s.
    The turmoil in the financial system is important primarily because 
of its impact on the overall economy. The latest data on spending, 
employment, and production suggest that the economy is very likely in 
recession, and several forces are exerting further downward pressure on 
economic activity:
      Housing construction continues to fall sharply, and the 
large supply of unoccupied homes offers no comfort that construction 
will recover soon.
      House-price futures and analysts' estimates of 
sustainable house prices point to further declines, and the resulting 
loss in household wealth will depress consumption to a growing extent 
over the next year.
      The tightening in lending that I just mentioned will 
further restrain spending, as will the weak level of consumer 
confidence and the rising trend of home foreclosures.
      And this year's further rise in oil prices amounts to a 
tax on households whose full effect on spending has probably not been 
apparent yet.
    I do not mean to suggest that all of the economic news is bad. Data 
for the first quarter of the year were more favorable than many had 
feared, and the decline in the value of the dollar is buoying net 
exports. Moreover, powerful economic stimulus has been set in motion 
through the actions of the Federal Reserve and the tax-cut legislation 
passed by Congress in February. Therefore, I share the consensus view 
among forecasters that a mild recession is the most likely outcome. But 
I would caution that a more serious economic downturn is entirely 
possible.
    The experience of the U.S. financial system and economy during the 
past year vividly demonstrate the need for reform of our financial 
regulation and supervision. Let me offer four principles to guide 
reform and the specific recommendations that follow from them:

    PRINCIPLE #1: FINANCIAL REGULATION SHOULD TRY TO KEEP PACE WITH 
                          FINANCIAL INNOVATION

    This principle may seem self-evident, but it is worth stating 
explicitly because it is so important. Financial innovation has been a 
very positive force in our economy, but it also creates problems. New 
products, new markets, and new institutions are usually more complex 
and less transparent than their predecessors; they tend to boost 
leverage and risk-taking; and they tend to skirt existing regulations 
and supervisory attention. In recent years, regulation and supervision 
of financial institutions did not fully recognize the problems that 
were building and did not adapt enough to put effective limits on these 
problems. Going forward, we need to be sure that regulation evolves 
along with the financial system so that we can reap the greatest 
benefits of innovation.
    Financial innovation has benefited our economy in at least three 
important ways:
      Innovation in recent decades has extended good 
opportunities for borrowing and saving to people further down the 
income scale. The late Ned Gramlich, a former Governor of the Federal 
Reserve, emphasized last year that the needed reforms of subprime 
mortgage lending should preserve the good aspects of such lending. He 
explained that the subprime expansion had enabled many households with 
low income and poor credit histories to move out of undesirable rental 
housing, so that even with the current problems, many households will 
have benefited from this home-owning opportunity. On balance, the 
democratization of our financial system has been a good thing.
      Innovation has improved the allocation of capital and the 
distribution of risk in our economy, thereby spurring long-term growth 
and raising people's well-being. Economists who have systematically 
compared the experiences of different countries have found that 
financial development has a significant positive effect on growth 
rates.\1\ In our country, we know that improved access to credit for 
smaller and riskier businesses--for example, through the expansion of 
venture capital and the so-called ``junk bond'' market--has provided 
critical funds for new industries.
---------------------------------------------------------------------------
    \1\ For example, see Aubhik Khan, ``The Finance and Growth Nexus,'' 
Federal Reserve Bank of Philadelphia Business Review, January/February 
2000, and Ross Levine, ``More on Finance and Growth: More Finance, More 
Growth?,'' Federal Reserve Bank of St. Louis Review, July/August 2003.
---------------------------------------------------------------------------
      Innovation has probably helped to stabilize the economy. 
This statement may be surprising as we stand on the brink of a 
recession that was caused, at least in part, by innovation run amok. 
However, I wrote a paper several years ago with Karen Dynan and Dan 
Sichel in which we tried to catalog the channels through which 
financial innovation affects economic volatility. We identified myriad 
channels, with different aspects of innovation pushing volatility in 
different directions. On balance, we concluded that innovation likely 
contributed to the mid-1980's stabilization of the U.S. economy known 
as the ``Great Moderation.''\2\
---------------------------------------------------------------------------
    \2\ See Karen E. Dynan, Douglas W. Elmendorf, and Daniel E. Sichel, 
``Can Financial Innovation Help to Explain the Reduced Volatility of 
Economic Activity?,'' Journal of Monetary Economics, January 2006, and 
Federal Reserve Board Working Paper, November 2005, http://
www.Federalreserve.gov/pubs/feds/2005/200554/200554abs.html.
---------------------------------------------------------------------------
    Along with these benefits, however, financial innovation also 
creates problems:
      One key problem with innovation in recent years is the 
high degree of complexity and low degree of transparency. 
Nontraditional mortgages--including interest-only mortgages, negative 
amortization mortgages, and mortgages with teaser rates--were 
apparently not well understood by many who borrowed this way or lent 
this way. Unconventional credit-market instruments--such as derivatives 
on asset-backed securities--were intrinsically complicated and 
unfamiliar even to sophisticated investors, and they had a very short 
track record that was exclusively from a period of rapidly rising house 
prices. Transparency was further reduced by arrangements that purported 
to insulate investors from risk, such as credit default swaps, bond 
insurance, and shifting liabilities off balance sheets.
      Another key problem is the increasing divergence of 
incentives between the ultimate investors and the people guiding 
financial decisions. These ``principal-agent problems,'' as economists 
call them, are endemic in financial markets, but recent innovation has 
exacerbated them. One example is mortgage brokers who were compensated 
for the volume of transactions they initiated and had little incentive 
to monitor the quality of loans they made. Another example is credit 
ratings agencies that are paid by the sellers of securities rather than 
the buyers; as securities became more complicated, investors' reliance 
on the agencies' judgment increased.
    These problems diluted the potential benefits of the innovation. 
Democratization of credit is counterproductive if many people end up 
with loans that are inappropriate for them. Capital is not allocated to 
its highest-value uses if everyone thinks that the risks of investment 
are borne by someone else. Lack of transparency and divergent 
incentives caused a run-up in financial risk-taking, both in the assets 
purchased and the degree of leverage used to finance those assets. 
These forces helped to fuel the housing bubble, and they greatly 
worsened the consequences when the bubble deflated.
    In sum, financial innovators and regulators are in a race, and the 
regulators will always lose that race. But it matters how much they 
lose by. If regulators do not try to keep up, or are completely 
outclassed in the race, then much of the benefit of financial 
innovation will be offset by the cost.

PRINCIPLE #2: MORTGAGE ORIGINATION SHOULD HAVE SIMPLER DISCLOSURES FOR 
         EVERYONE AND LIMITS ON OFFERINGS TO SUBPRIME BORROWERS

    Economists and others sometimes assume that having more choices 
improves people's well-being. Clearly, that is true in many cases. 
However, it is not necessarily true if people are choosing among 
complicated products without sufficient information or understanding.
    A growing body of evidence demonstrates that people do not fully 
understand their financial arrangements. For example, researchers have 
found that younger adults and older adults tend to pay significantly 
higher interest rates than middle-aged adults, even after controlling 
for various personal characteristics.\3\ This finding suggests 
different degrees of sophistication across households of different 
ages. Researchers have also found that households with low income and 
little education are less likely than other households to know their 
mortgage terms--for example, the extent to which their interest rates 
can change.\4\
---------------------------------------------------------------------------
    \3\ See Sumit Agarwal, John C. Driscoll, Xavier Gabaix, and David 
Laibson, ``The Age of Reason: Financial Decisions Over the Lifecycle,'' 
Harvard University, March 2007.
    \4\ See Brian Bucks and Karen Pence, ``Do Homeowners Know Their 
House Values and Mortgage Terms?,'' Federal Reserve Board Working 
Paper, January 2006, http://www.Federalreserve.gov/PUBS/FEDS/2006/
200603/index.html.
---------------------------------------------------------------------------
    Financial innovation that gives people more choices can make these 
problems worse. Newly designed mortgages are generally more complicated 
than older ones, and people have little experience with new mortgages--
in their own lives or the lives of their friends and family members--to 
use in making decisions. More generally, the ability to borrow more is 
also the ability to borrow too much. Even in 2004, prior to the worst 
of the deterioration in lending standards, households with the highest 
ratios of debt to assets were more likely to be insolvent than in 
previous decades and more likely to face financial strain.\5\
---------------------------------------------------------------------------
    \5\ See Karen E. Dynan and Donald L. Kohn, ``The Rise in U.S. 
Household Indebtedness: Causes and Consequences'' in The Structure and 
Resilience of the Financial System, Reserve Bank of Australia, 2007, 
and Federal Reserve Board Working Paper, August 2007, http://
www.Federalreserve.gov/pubs/feds/2007/200737/200737abs.html.
---------------------------------------------------------------------------
    Of course, protecting people from unwise choices is easier said 
than done. Financial arrangements that are unwise for some people in 
some circumstances are quite sensible for other people in different 
circumstances. Thus, public policy should improve financial literacy 
and provide information needed for making informed financial choices. 
However, these steps are not enough in my view, and some limitations on 
mortgage offerings are also appropriate. Moreover, protecting people 
also reduces risks for the financial system as a whole, because people 
who understand their mortgages are more likely to be able to repay 
them.
    Specifically, Martin Baily and Bob Litan and I recommend:
      Simpler mortgage disclosures, pre-mortgage counseling for 
subprime borrowers, and perhaps a default mortgage contract from which 
people could opt out.
      Further restrictions on the design of mortgage contracts 
under the HOEPA rules and a broadening of HOEPA coverage, both along 
the lines proposed by the Federal Reserve.
      Federal oversight of state regulation for all mortgage 
originators.

  PRINCIPLE #3: FINANCIAL INSTRUMENTS AND INSTITUTIONS SHOULD BE MORE 
                              TRANSPARENT

    As we know from many examples, self-interest is a powerful economic 
force. Good regulation harnesses that force. I have already explained 
that one important problem with the new financial products and markets 
of recent years is their very low degree of transparency. By increasing 
transparency, we can give investors better tools to monitor financial 
risk-taking themselves.
    The private sector is already moving in this direction. Many 
financial intermediaries recognize that they need to be more diligent 
in learning about assets before buying them instead of placing blind 
confidence in other people's evaluations. Going forward, investors will 
put less weight on the judgment of the credit ratings agencies. They 
will be more skeptical of assertions that certain complicated financial 
strategies have no risk. They will be more concerned about the 
underwriting standards that had been applied to loans underlying asset-
backed securities. And they will be less likely to buy derivatives 
whose payoff structure they do not fully grasp. Warren Buffett has been 
quoted as saying that he only buys things he understands, and more 
investors will adopt that mantra.
    Appropriate changes in regulation can aid investors in this 
process. Specifically, Martin Baily and Bob Litan and I recommend:
      Increased transparency in the mortgage origination 
process, as I have already described.
      For asset-backed securities, public reporting on 
characteristics of the underlying assets.
      For credit ratings agencies, greater clarity in 
presenting ratings across asset classes, reporting of the ratings 
agencies' track records, and disclosure of the limitations of ratings 
for newer instruments.
      For commercial banks, clearer accounting of off-balance-
sheet activities.
      For derivatives, a shift toward trading on exchanges, 
which will encourage standardization of instruments.

 PRINCIPLE #4. KEY FINANCIAL INSTITUTIONS SHOULD BE LESS LEVERAGED AND 
                              MORE LIQUID

    Even if private investors had perfect information, they would tend 
to take greater financial risks than are optimal from society's 
perspective. The reason is that taking risks in a financial transaction 
can have negative consequences for people not directly involved in that 
transaction. These spillover effects arise in part because of the risk 
of contagion in the financial system, and they arise in part because of 
the Government safety net including bank deposit insurance and the role 
of the Federal Reserve as lender of last resort. The parties to a 
transaction have no reason to take account of these externalities, as 
economists label them, and this provides the traditional rationale for 
Government financial regulation and supervision.
    To be sure, the financial system is already moving to reduce 
leverage and increase liquidity. Those institutions with larger capital 
cushions are weathering this crisis far better than their less-
conservative competitors, and they now find themselves in a position to 
purchase assets at favorable prices. Those institutions with greater 
amounts of liquid assets have been less subject to ``runs'' in which 
their investors scramble to get their money out first. These examples 
provide strong lessons for future institutional strategies. To 
highlight one example, the future will see less borrowing on a short-
term basis to finance long-term commitments. That approach ended up 
hurting families who could not afford their adjustable-rate mortgage 
payments after the rates reset; it hurt so-called ``structured 
investment vehicles'' (SIVs) that were not viable when short-term 
funding costs increased; it hurt municipalities that borrowed in the 
auction-rate market and were suddenly unable to roll over their debts 
at previous rates; and it hurt investment banks that financed 
themselves heavily through overnight repurchase agreements. In the 
future, more borrowers will pay higher rates to lock in longer-term 
financing.
    Still, these private responses should be accompanied by changes in 
regulation and supervision.\6\ Specifically, Martin Baily and Bob Litan 
and I recommend:
---------------------------------------------------------------------------
    \6\ Some analysts have argued that excessive leverage should also 
be thwarted by restrictive monetary policy. In the words of the IMF's 
recent World Economic Outlook, there may be ``benefits to be derived 
from `leaning against the wind,' that is increasing interest rates to 
stem the growth of house price bubbles and help restrain the buildup of 
financial imbalances.'' I disagree with this view, principally because 
monetary policy is a very blunt tool for preventing increases in 
leverage. More restrictive policy earlier this decade might have 
diminished the housing and financial bubbles, but only at the cost of 
significantly higher unemployment and lower inflation at a time when 
resource utilization was already depressed and inflation was falling 
toward the bottom of the Federal Reserve's comfort zone. See Douglas W. 
Elmendorf, ``Financial Innovation and Housing: Implications for 
Monetary Policy,'' Brookings Institution, April 2008, http://
www.brookings.edu/papers/2008/0421_monetary_policy_elmendorf.aspx.
---------------------------------------------------------------------------
      For commercial banks, capital requirements for off-
balance-sheet liabilities, required issuance of uninsured subordinated 
debt, and closer public supervision of risk-management practices.
      For investment banks, regulation and supervision of 
capital, liquidity, and risk management.
      For bond insurers, higher capital requirements and closer 
supervision of underwriting standards for new products.

                               CONCLUSION

    Let me conclude with three final observations.
    First, my comments have focused on what should be regulated rather 
than who should do the regulating. That is not because I am 
enthusiastic about the existing hodgepodge of regulation. Rather, I 
think that regulatory reform needs to set priorities, and the highest 
priority in my view is not to change boxes on the organization chart 
but to change what happens inside each box. Insisting on a grand 
redesign of financial regulation may simply bog down the legislative 
process and ultimately accomplish very little. To be sure, the 
seriousness of the current situation and the impact on the housing and 
mortgage markets that directly affect so many people should provide 
political support for change. However, regulation of the financial 
system is substantively complex and will still feel remote to many 
citizens, and I expect that reform will be difficult to achieve.\7\
---------------------------------------------------------------------------
    \7\ On a related note, I think that regulatory reform should focus 
on key financial institutions. Economists generally advocate a ``level 
playing field'' in which Government rules are neutral across 
economically identical activities and thus do not distort private 
behavior. Yet, creating a completely level field for risk-taking and 
leverage is both impractical and unnecessary. It is impractical because 
individuals will always find ways to make risky investments and some 
will undoubtedly lose their wealth doing so. It is unnecessary because 
these phenomena create larger problems in some circumstances than 
others. Although mortgage-backed securities and their derivatives 
spread risks around the global financial system to some extent, 
significant exposures remained on the balance sheets of key U.S. 
institutions. It is their losses that have done the most damage to the 
functioning of the system and created the greatest concerns about 
future credit supply. Moreover, the Federal Reserve's recent actions 
show a clear benefit of doing business with key institutions. Tighter 
regulation can balance the effect of providing that safety net.
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    Second, the private and regulatory changes that I have discussed 
will raise the price of risk and therefore the cost of borrowing by 
risky borrowers. They will also reduce the demand for complex financial 
transactions, which in turn will diminish the rewards for undertaking 
this sort of financial engineering. These outcomes are appropriate in 
my view. During the past fifty years, the value added by the finance 
and insurance industry has surged from about 3 percent of GDP to about 
8 percent. Much of that increase, and the financial innovation it 
reflects, were beneficial for the reasons I described earlier. But the 
events of the past year have shown that the latest steps in financial 
complexity and risk-taking, without appropriate advances in regulation, 
had smaller benefits and larger costs than many people initially 
understood. Some step-back in the upward trend of financial engineering 
should be sought and not feared.
    Lastly, financial markets will always experience swings between 
confidence and fear, and between optimism and pessimism. However, 
effective regulation and supervision can reduce the frequency, the 
magnitude, and the broader consequences of these swings.
    Thank you very much.
 Prepared Statement of Ellen Seidman, Director, Financial Services and 
       Education Project, New America Foundation, Washington, DC
    Senator Schumer, Representative Maloney and members of the 
Committee, thank you very much for this opportunity to testify before 
you concerning the regulatory implications of and guidance we can take 
from the current market failures. My name is Ellen Seidman, and I am 
the Director of the Financial Services and Education Project in the 
Assets and Ownership Program at the New America Foundation. Our project 
is focused on the development and implementation of policies that will 
encourage responsible consumer financial services, enabling consumers 
to use our powerful financial system to build, rather than destroy, 
their assets.
    I also continue to serve as Executive Vice President, National 
Program and Partnership Development, at ShoreBank Corporation, the 
Chicago-based bank that is the nation's first and largest community 
development bank holding company and its largest community development 
financial institution. I also serve on the Boards of two other large 
and well respected community development financial institutions, the 
Low Income Investment Fund and Coastal Enterprises, Inc. Each of these 
companies is both devoted to and in fact provides responsible financial 
services for lower income communities, businesses and individuals in 
the parts of the country they serve.
    From 1997 through most of 2001, I was the Director of the Office of 
Thrift Supervision, the Federal agency that regulates the savings and 
loan industry. I draw on all these experiences for many of the points 
and recommendations I make today.
    Before I get to recommendations, let me step back a moment and 
consider how we got here. I think there are three root causes: the 
unsustainable buildup of systemic risk; an antiquated, uneven and 
frequently ineffective regulatory system; and a loss of alignment 
between serving customers well and standard business practices.
    First, we have allowed systemic risk to buildup to what has 
obviously become an intolerable level. The risks include those that 
were known but hidden--from consumers, from investors, from 
participants in the system, from regulators; risks that were unknown, 
often because firms had created such a degree of complexity that even 
the best efforts at ferreting out risk would have failed; and risks 
that were unknowable--the model failures that Chairman Volcker talked 
about in his Economic Club of New York speech. Excessive leverage and 
reliance on short-term funding to support long-term assets exacerbated 
the impact of these risks.
    Second, we have both tolerated and allowed to grow a regulatory 
structure that has two major failures. First, entities performing the 
same kinds of functions are regulated very differently, with the 
general effect that business practice flowed downhill to the practices 
of the least regulated. But second, we have not focused our regulatory 
attention tightly enough on what really matters. Is finding every last 
SAR violation really more important than making sure that the recourse 
on SIVs is adequately capitalized? Or that borrowers have an ability to 
repay? Our regulatory system has become simultaneously unduly complex, 
ineffective where it counts, and excessively burdensome on some of the 
least risky and most consumer-friendly elements of the system.
    Getting this balance right is hard. In my tenure at OTS, I know we 
sometimes got it right, as when we stepped in early to keep thrifts 
from engaging in payday lending. Sometimes we got it wrong, most 
spectacularly in the Superior Bank failure. And sometimes we did things 
that seemed right at the time but had, in retrospect, some negative 
unintended consequences. An example of this is the sub-prime guidance 
all the regulators issued in 2001 that to my mind was in part 
responsible for pushing sub-prime lending out of banks and into less 
regulated affiliates. But the fact that it's hard means that we'll 
sometimes get it wrong, not that we are excused from trying.
    Third, we have lost incentives for financial institutions to 
provide high quality, consumer friendly products that provide long-term 
value. This is a result with many causes: the originate-and-sell 
business model that, especially when tied to brokering at the front and 
CDOs on the back, has separated the interests of borrower and lender 
and of principal and agent; not extending the affirmative service 
mandate of CRA beyond banks and thrifts; the manner in which CRA and 
other consumer protections were--or weren't--enforced; failure of 
financial literacy to keep up with a fast-changing financial world; and 
not focusing our imagination and creativity on ways to help consumers 
gravitate to products and services that are beneficial to them while 
also profitable to providers.
    This is not just being nice to consumers. As should be obvious from 
the mess we're in now, the financial viability of institutions is 
inextricably linked to that of their customers--including consumers. To 
give just one example, with the advent of the secondary market, the 
long-term fixed-rate fully amortizing mortgage should have been a 
dynamite product: lenders get to charge for long-term use of money that 
is likely to be used for a much shorter period and borrowers get a 
steady, predictable payment schedule that builds equity. Somehow that's 
not what happened.
    So what do we need to do? In the face of the mess families, 
communities, companies and markets now confront, I believe the critical 
question is how can we reestablish in our financial markets and 
companies a long-term, quality-oriented culture that incents all 
parties to focus their attention on:
      products and services that benefit both lender and 
borrower;
      complete, accurate and transparent risk assessment and 
management; and
      profitability and growth that is sustainable over the 
long term?
    Obviously this is not a job solely for a regulatory system, and it 
is just as obviously not easy. But I think if we set this as a goal, we 
will have a standard to measure our thoughts and proposals against.
    I suggest six critical strategies:
      First, Effective Enforcement: the will and financial 
wherewithal to enforce the laws and regulations we establish. Without 
this, we are not only allowing bad things to continue to grow, we are 
fooling ourselves into believing we've resolved problems. And this is 
not only an issue at the Federal level, but also at the state level, 
where regulatory agencies are frequently starved for resources.
      Second, Risk Assessment, namely concentration on enhanced 
risk knowledge and transparency: within organizations, among 
organizations, for the public, and to and among regulators, both 
domestically and internationally. We can no longer afford to have 
institutions that do not know their own level of risk and that of their 
counterparties--and regulators who are also in the dark. As noted, this 
will not be perfect; there will always be unknown and unknowable risks, 
but let's at least get rid of the hiding.
      Third, Capital Adequacy, with increased capital all 
around. This has three critical effects. First, capital serves as the 
penultimate guard against institutional collapse. Second, because 
capital is at risk, it serves to mitigate against excessive and foolish 
risk-taking, of the ``heads I win, tails you lose'' variety. Third, if 
all entities in the system are required to hold a greater amount of 
capital, demand for returns based on financial leverage should 
diminish. And by the way, it's time to recognize that in an uncertain 
world, loss reserves are in practice part of the capital structure and 
to allow them to serve a counter-cyclical function by building up 
during good times so they can be drawn down during the bad that will 
inevitably follow.
      Fourth, Enhanced Responsibility, a system where all 
players have skin in the game, realigning the interests of borrowers, 
lenders and all those in the chain between money provided and money 
used. For institutions, it's capital in part, but an explicit 
continuing residual interest in sold assets whose value depends on 
future performance should also be considered. And certainly we need to 
do something about compensation systems--both individual and 
institutional--that do not recognize back-end risk. What if deferred 
compensation for executive officers were required to be haircut if the 
bank received a CAMELS rating of 3 or lower within the following 2 
years--with equivalent sanctions for non-banks? And certainly the days 
of paying mortgage brokers up-front fees with no hold-back for 
performance should be over. In this connection, I urge Congress to move 
ahead with consideration of the two sets of bills related to the 
mortgage crisis that are pending: those dealing with regulation of the 
market and those responding to the crisis for homeowners, communities 
and the markets.
      Fifth, Regulatory Consistency across entities that are 
performing the same tasks, such as providing consumer credit or 
brokering significant financial services for consumers, and/or have 
access to the same kinds of benefits, such as the discount window. At 
the same time, we need to be cognizant of actual risk and relate it to 
actual burden. Regulation is a fixed and a hidden cost, and smaller 
institutions both have fewer options for dealing effectively with 
regulators and smaller budgets within which to absorb the costs. Again, 
this is tough, but in enhancing regulation, as I believe we need to do, 
especially with respect to risk management and consumer protection, 
it's essential that we not destroy the financial viability of the 
smaller institutions closest to the people, including community 
development financial institutions, credit unions and community banks 
and thrifts.
      Finally, Aligning Incentives with Practices that treat 
customers fairly and equitably, before, during and after their purchase 
of financial services. There are many ways to do this, including not 
only consumer protection legislation and regulation--and let me voice 
my support here for the regulators to stay strong as they move toward 
final rules under HOEPA, TILA and the Federal Trade Commission Act and 
for Congress to move forward on pending legislation--but also 
establishment of a suitability standard for those selling or brokering 
significant consumer credit products; an enhanced and more broadly 
applicable Community Reinvestment Act; public information systems that 
extend beyond the Home Mortgage Disclosure Act to enable the public and 
the media to see who's being served, who's doing it well and who's 
doing it badly; improving financial literacy; and barrier removal and 
incentives to help consumers do the right things, such as the pension 
opt-out provisions that were incorporated into the Pension Protection 
Act of 2006.
    As markets begin to stabilize or we reach what I suspect will be 
temporary lulls in foreclosures or house price declines, it will be 
easy to fall back into believing that the status quo is acceptable, 
that changing it is too hard, or that enhanced regulation of consumer 
products will hurt consumers by limiting choice. Such a result would be 
not only dangerous and a mistake, but also a waste of the trauma and 
turmoil we've been through. Let's instead use this experience to learn, 
think creatively, and act.
                               __________
   Prepared Statement of Alex J. Pollock, Resident Fellow, American 
                  Enterprise Institute, Washington, DC

  REGULATORY IMPLICATIONS OF THE HOUSING AND MORTGAGE BUBBLE AND BUST

    Mr. Chairman, Ranking Member Saxton, Vice Chair Maloney and members 
of the Committee, thank you for the opportunity to be here today. I am 
Alex Pollock, a Resident Fellow at the American Enterprise Institute, 
and these are my personal views. Before joining AEI in 2004, I spent 35 
years in banking, including 12 years as President and CEO of the 
Federal Home Loan Bank of Chicago. I am a director of three financial 
services companies and a Past President of the International Union for 
Housing Finance. I have both experienced and studied many credit 
cycles, of which our 21st century housing and mortgage cycle is the 
latest example.
The Human Foundations of Financial Risk
    The severe housing and mortgage bust we are experiencing can best 
be understood as the inevitable deflation of a classic asset bubble. 
Historically speaking, why do we keep having these financial 
adventures, no matter what our technological and theoretical progress 
or regulatory reorganizations? Why is ``a prudent banker one who goes 
broke when everybody else goes broke''? This witty line of Keynes 
points us to the eternal human elements behind the credit overexpansion 
that our sophisticated, globalized, computerized, and leveraged markets 
produced between 2003 and 2006, the subsequent debt panics of 2007 and 
2008, and the continuing bust.
    The losses of the bust are now being recognized in the general, 
``Main Street'' banking system. Note in this context that 48 percent of 
the total loans of insured depositories are based on real estate. For 
the vast majority of banks, those with total assets of less than $1 
billion, this number is 67 percent.
    The human nature behind the bubbles and busts does not change, 
whether the calculations of boundless future profit from increased 
leverage are made with quill pens or advanced computers. Credit 
overexpansions are always based on a belief--the first optimistic, and 
then euphoric, belief in the rising price of some asset class.
    The belief in the ever-rising price of the favored asset seems to 
be confirmed on all sides as the bubble expands. As long as the 
underlying price, of houses in our current case, keeps rising, 
everybody wins--borrowers and lenders, brokers and investors, 
speculators and flippers, home builders and home buyers, rating 
agencies and bond salesmen, realtors and municipalities, and many 
others. Bubbles are notoriously hard to control because so many people 
are making money from them while they last.
    Political actions also play a role. In the housing bubble, 
politicians of both parties also thought they were winning as all sides 
cheered increasing home ownership ratios and expanding ``access'' to 
mortgage credit with lower credit quality loans. The government has 
been an effective promoter of higher loan to value lending and smaller 
down payments--such as recent proposals to move the FHA to 100 percent 
LTV loans--riskier lending, and the use of government guarantees. A 
1994 ``National Homeownership Strategy,'' for example, advocated 
``financing strategies, fueled by creativity'' for those to become home 
buyers who lack the cash or income to buy a home. A good deal of 
``creativity'' was indeed subsequently applied.
    Of course, bubbles always come to a sad end. Retreating eastward 
after the collapse of the bubble in Kansas land prices in the 1880s, 
defaulted farm mortgage borrowers put on their wagons: ``In God we 
trusted, in Kansas we busted.''
    This time expectations of house price increases entered the models 
analyzing subprime mortgage pools as ``HPA,'' or house price 
appreciation. What ultimately emerged was naturally HPD: house price 
depreciation. So we can update the Kansas motto of 120 years ago to: 
``In HPA we trusted, with HPD we busted.''
    Can regulation avoid these cycles?
Was There a Regulatory Golden Age?
    Some current discussions give the impression that there used to be 
a time when highly regulated banks dominated the credit system, so 
regulators prevented problems. Was there such a ``golden age'' of 
regulation? No, there wasn't.
    In the 1960s, Federal regulation of deposit interest rates (the 
infamous ``Regulation Q''), which can be viewed as having created a 
Government-sponsored deposit cartel, caused two severe credit 
crunches--those of 1966 and 1969, in which mortgage credit would get 
rationed out.
    Consider the mid-1970s, when commercial bank lending created a 
bubble and massive bust in loans to real estate investment trusts 
(``REITs''). The Senate Banking Committee held hearings wondering 
whether the entire commercial banking system was insolvent on a mark-
to-market basis. (Needless to say, the banks did not mark their assets 
to market.)
    Savings and loans were then the most intensely regulated of 
financial institutions. The result? By 1979, by following their fixed 
rate lending regulatory instructions, in the aggregate they were 
insolvent on a mark-to-market basis. The insolvency of the savings and 
loans laid the foundation for the move to mortgage securitization.
    How about the 1980s? Well, more than a thousand commercial banks 
failed in this decade. There were massive credit busts in loans to 
developing counties (``LDCs'' in the jargon of the time), in energy 
finance, and again in commercial real estate loans. In all cases, we 
are speaking of loans on the balance sheets of the banks. The 
insolvency of the saving and loans grew much greater, causing the 
insolvency of their Federal deposit insurer, ``FSLIC,'' and of course 
ending in collapse and bailout in 1989, along with regulatory reforms 
and restructuring.
    In 1993, in the wake of these reforms, the financial historian 
Bernard Shull insightfully wrote:

        Comprehensive banking reform, traditionally including augmented 
        and improved supervision, has typically evoked a transcendent, 
        and in retrospect, unwarranted optimism. The Comptroller of the 
        Currency announced in 1914 that, with the new Federal Reserve 
        Act, ``financial and commercial crises or panics. . . seem to 
        be mathematically impossible.'' Seventy-five years later, 
        confronting the S&L disaster with yet another comprehensive 
        reform. . . The Secretary of the Treasury proclaimed ``two 
        watchwords guided us as we undertook to solve this problem: 
        Never Again.''

    Yet here we are again. In the meantime Congress also imposed the 
expensive Sarbanes-Oxley Act to manage corporate risk. It was so 
successful that we have nearly had a global financial collapse.
    The British formed a consolidated financial regulator, the ``FSA,'' 
and separated its role from the Bank of England. But when the Northern 
Rock funding panic and crisis hit, this structure did not work well. No 
matter how you organize any government activity (or company or 
anything), as time goes by, you will have to reorganize it. The perfect 
answer does not exist. However you try to engineer a regulated market 
or industry, the reactions and adaptations to the regulatory 
engineering require another reform, and another, and so on ad 
infinitum.
    My point is not that no action should ever be taken, but that we 
have to be realistic about the adaptations to and unforeseeable effects 
of all interventions. I am against utopian hopes for what financial 
regulation can achieve, but I am for sensible improvements.
    Here are a number suggestions for such improvements:
      Simple and straightforward disclosure in one page
      Remove government support for rating agencies
      Encourage credit risk retention by mortgage originators
      Countercyclical management of LTV ratios
      The ``Super Fed''
      Increased GSE responsibility for refinancing the bust
      Controlling ``fair value'' accounting
      The study of financial history
    I will discuss each briefly.
Simple and Straightforward Disclosure in One Page
    I have previously testified to this Committee that we should 
require a clear, straightforward, one-page disclosure to borrowers of 
the essential information about prospective mortgage loans. The 
information, in regular-sized type, should focus on what commitments 
the borrowers are making and how much of their household income these 
will require, so they can ``underwrite themselves'' for the credit. 
This would be a major improvement in the American mortgage finance 
system.
    Mr. Chairman, thank you for introducing S. 2296, which would 
implement this idea, which everybody should be able to agree on. I hope 
it will be included in any final mortgage legislation.
    And thank you, Vice Chair Maloney, for your interest in the 
possibility of using the one-page approach in another area, overdraft 
disclosures.
Remove Government Support for Rating Agencies
    The credit rating agencies say that they are in the business of 
publishing opinions about the future. In this I believe they are right, 
and I have a good deal of sympathy with the thought that in the course 
of financial events, some such opinions will prove to have been 
mistaken, even disastrously mistaken. So when it comes to opinions 
about the future, more opinions and competition is likely to uncover 
new insights into credit risks and new methods of analysis.
    A particularly desirable form of increased competition would be 
from ratings agencies paid solely by investors, as opposed to those 
paid for by the issuers of securities, as many commentators have 
suggested.
    But here is a larger question: Since all opinions are liable to 
error, and opinions based on models are liable to systemic error of 
vast proportions--as the subprime bust makes apparent--why should the 
U.S. Government want to enshrine certain opinions as having preferred, 
preferential, indeed mandatory, status? It shouldn't.
    I suggest that all regulatory requirements to use the ratings of 
certain preferred rating agencies be eliminated. Banks and other 
regulated investors should instead be responsible for developing their 
own prudent standards, which would probably entail the use of credit 
ratings as part of a credit management system--but without government 
sponsorship of the dominant firms.
Encourage Credit Risk Retention by Mortgage Originators
    One of the lessons of the savings and loan collapse was that for 
depository institutions to keep long-term fixed rate mortgages on their 
own balance sheet, while funding them with short-term deposits, was 
extremely dangerous in terms of interest rate risk, although it was no 
problem in terms of credit risk. The answer was to sell the loans to 
bond investors through securitization and divest the interest rate risk 
to those better able to bear it. As a side effect, the credit risk was 
also divested.
    In the wake of the mortgage bubble and bust, we now realize that 
divesting the credit risk created big problems on its own, breaking the 
alignment of incentives between the lender making the credit decision 
and the ultimate investor actually bearing the credit risk. Some 
commentators have referred to the good old days when the savings and 
loans kept the loans themselves--how short the memories are of the 
disaster that caused.
    The right synthesis of the historical lessons is for securitization 
to continue to address interest rate risk, while encouraging the 
retention of significant credit risk by the original mortgage lender. 
There are numerous regulatory and accounting obstacles to this 
approach, but its obvious superiority makes it worth while to try to 
overcome them. This is an assignment which should be given to an 
appropriate group of financial regulators.
Countercyclical Management of LTV Ratios
    As asset prices rise in a bubble, more debt and leverage always 
seems better. The credit experience of loans financing the inflating 
asset will be good, with delinquencies, defaults, and losses all low. 
Thus, the risk of the loans seems to be decreasing, even while the risk 
is in fact increasing.
    The low delinquencies and defaults seem to confirm the success of 
the credit expansion and the accuracy of the lending models. Loan-to-
value (LTV) ratios rise, even while they should be being reduced. 
``Innovative'' no-down-payment mortgages are promoted. This inflates 
the price and credit bubble further, and insures that the ensuing bust 
will be worse.
    A rational, countercyclical management of LTV behavior would reduce 
LTV ratios as the price of the asset inflates beyond its trend--this is 
the opposite of what in fact occurs. How one might make this happen 
should be the subject of another study.
The ``Super Fed''
    I believe the ``Super Fed'' idea contained in the Treasury 
Department's restructuring proposal is consistent with the original 
situation in 1913, the year of the Federal Reserve Act, as well as the 
current financial world. This idea would have the Fed serve as 
stability, systemic risk overseer and lender of last resort to the 
financial markets in general.
    Much has been made of the Fed's extending discount window lending 
to investment banks, rather than only to commercial banks. But 
separation of banking into these two parts did not occur until the 
Glass-Steagall Act of 1933. In 1913, for example, J.P. Morgan and Co. 
was still both an investment bank and a commercial bank; it did not 
divide into Morgan the commercial bank and Morgan Stanley the 
investment bank until forced to in 1935.
    Today Morgan is again both a commercial bank and an investment 
bank, after the repeal of Glass-Steagall in 1999, and will be even more 
so with its pending acquisition of Bear Stearns, as arranged by the 
Fed. The ``Super Fed'' proposals seems sensibly to deal with the 
financial structures of the present and the future, as opposed to those 
of 1933-1999.
Increased GSE Responsibility for Refinancing the Bust
    As I have previously testified to this Committee, it seems to me 
that in exchange for the manifold advantages Fannie Mae and Freddie Mac 
receive from the government, they should be assigned a larger role in 
refinancing the troubled loans of the mortgage bust.
Controlling ``Fair Value'' Accounting
    I know Congress does not like to get involved in the theoretical--
one could say the metaphysical--disputes of accounting. Still, the 
current accounting fashion of ``fair value'' accounting has played an 
important role in the financial problems of the last 10 months. There 
is no doubt in my mind that ``fair value'' accounting is pro-cyclical, 
that it accentuates reported losses in times of financial panic and 
helps encourage the boom in times of optimism. Is there some way to 
control its perverse effects?
    Among the key questions which must be addressed are:
      What does a ``market price'' mean when there is no 
market?
      Should panicked levels of fear and uncertainty determine 
accounting results?
      Should accounting be about the recording of cash-flows 
over time or the theoretical buying and selling of assets and 
liabilities?
    I don't suggest that it is easy to answer such questions, only that 
they are in fact legitimate policy issues.
The Study of Financial History
    ``The mistakes of a sanguine manager are far more to be dreaded 
than the theft of a dishonest manager,'' wrote Walter Bagehot. The best 
protection against excessively sanguine beliefs is the study of 
financial history, with its many examples of how easy it is to be 
plausible, but wrong, both as financial actors and as policymakers. 
Perhaps we need a required course in the recurring bubbles, busts, 
foibles and disasters of financial history for anyone to qualify as a 
government financial official. I have the same recommendation for 
management development in every financial firm.
    Thank you again for the opportunity to share these ideas.
  

                                  
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