[Senate Hearing 110-1004]
[From the U.S. Government Publishing Office]



                                                       S. Hrg. 110-1004


                   THE STATE OF THE BANKING INDUSTRY:
                                PART II

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

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED TENTH CONGRESS

                             SECOND SESSION

                                   ON

             THE CURRENT STATE OF THE U.S. BANKING INDUSTRY


                               __________

                         THURSDAY, JUNE 5, 2008

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs




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                            senate05sh.html





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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware           CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey          JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii              MIKE CRAPO, Idaho
SHERROD BROWN, Ohio                  ELIZABETH DOLE, North Carolina
ROBERT P. CASEY, Pennsylvania        MEL MARTINEZ, Florida
JON TESTER, Montana                  BOB CORKER, Tennessee

                      Shawn Maher, Staff Director
        William D. Duhnke, Republican Staff Director and Counsel

                      Amy S. Friend, Chief Counsel

                    Mark Osterle, Republican Counsel

                       Dawn Ratliff, Chief Clerk
                      Shelvin Simmons, IT Director
                          Jim Crowell, Editor












                            C O N T E N T S

                              ----------                              

                         THURSDAY, JUNE 5, 2008

                                                                   Page

Opening statement of Chairman Dodd...............................     1

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     3
    Senator Reed.................................................     4
    Senator Allard...............................................     4
    Senator Dole.................................................     5
    Senator Corker...............................................     7
    Senator Bunning..............................................     7
    Senator Martinez.............................................     7

                               WITNESSES

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation..     8
    Prepared statement...........................................    33
    Response to written questions of:
        Senator Bunning..........................................   191
        Senator Dole.............................................   192
John C. Dugan, Comptroller of the Currency, United States 
  Treasury.......................................................    10
    Prepared statement...........................................    68
    Response to written questions of:
        Senator Bunning..........................................   196
        Senator Dole.............................................   198
John M. Reich, Director, Office of Thrift Supervision............    12
    Prepared statement...........................................    89
    Response to written questions of:
        Senator Bunning..........................................   199
        Senator Dole.............................................   200
        Senator Corker...........................................   210
JoAnn Johnson, Chairman, National Credit Union Administration....    14
    Prepared statement...........................................   109
    Response to written questions of:
        Senator Dole.............................................   210
Donald L. Kohn, Vice Chairman, Board of Governors, Federal 
  Reserve System.................................................    15
    Prepared statement...........................................   125
    Response to written questions of:
        Senator Bunning..........................................   211
        Senator Dole.............................................   214
        Senator Corker...........................................   221
Timothy J. Karsky, Commissioner, North Dakota Department of 
  Financial Institutions, and Chairman, Conference of State Bank 
  Supervisors....................................................    17
    Prepared statement...........................................   139

 
               THE STATE OF THE BANKING INDUSTRY: PART II

                              ----------                              


                         THURSDAY, JUNE 5, 2008

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:07 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Christopher J. Dodd (Chairman of 
the Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. Good morning, everyone. The Committee will 
come to order.
    I thank all of our guests here this morning. I want to 
thank our witnesses for being back before the Committee.
    This morning the Committee convenes to examine the 
supervision and regulation of the banking industry, as a follow 
up hearing to the Committee hearing held on March 4th. At that 
hearing, Senator Shelby and I expressed, I think, in no 
uncertain terms our intention--indeed, our determination--to 
reconvene this panel of witnesses to assess the efforts and 
effectiveness of the agencies represented here during these 
extraordinary times for our economy and for the financial 
services sector in particular.
    I look forward, as all of us do this morning, to your 
testimony and hearing your views regarding the current 
condition of our banking industry and assessment of your 
supervision response to the recent and ongoing turmoil in the 
U.S. credit and mortgage markets, and your analysis of what 
lessons have been learned as a result.
    Perhaps most importantly, 3 months after your previous 
appearance before this Committee, I look forward to hearing 
about what each of you intend to do and hopefully have already 
begun to improve your regulatory oversight and address the 
issues of ongoing concern for the banking industry and in 
anticipation of future challenges.
    Recent history tells us that many banking officials, 
private sector CEOs, bank presidents and executives, and 
officials in the public sector including some of the regulatory 
institutions represented here this morning, expressed the 
opinion last year that the problems in the credit markets were 
contained and nearing an end. Those pronouncements were wrong, 
of course, the unjustified optimism that may have led to a 
complacency on the part of some that, at least in part, may 
have allowed problems that originated in the subprime mortgage 
market to evolve into a global credit crisis, a crisis that 
crippled the balance sheets of some of the world's largest 
banks and spread to non-mortgage related credit areas including 
student loans, credit cards, commercial real estate. And as 
Senator Reed and I were talking about recently, maybe into auto 
loans and the like.
    These concerns were not unknown. In fact, some of us had 
expressed the need for regulators to intervene to address the 
problems in the subprime market.
    A look at the transcript for the March 4th hearing reflects 
that many of you then, and I assume now, believe you could have 
and should have done more under the respective authorities of 
your agencies to address this crisis earlier on. I mention this 
not to engage in revisionist history--quite the contrary--or to 
assign blame, but rather to urge you to be vigilant and 
proactive in your regulatory and supervisory responsibilities 
moving forward.
    If my words are not enough to encourage your continued 
vigilance, then some of the data recently reported by the FDIC 
in its quarterly banking report certainly should be. The report 
includes some worrisome data suggesting that the banking 
industry continues to grapple with the fallout of the credit 
mortgage market turmoil and the effects of a weak economy.
    Among its findings are the following: ongoing problems in 
the real estate market continue to eat into bank profits. 
Commercial banks and thrifts reported a decline in profits of 
50 percent in the first quarter of 2008, compared with the 
first quarter of 2007. Over half of the insured institutions 
reported lower net income in the first quarter. Bank earnings 
in the fourth quarter of 2007 were revised downward to their 
lowest levels in 18 years. An additional $26 billion in 
outstanding loans were delinquent--90 days or more past due is 
what we describe as being delinquent--from the previous 
quarter. And while much of that increase was mortgage related, 
credit card and auto loan delinquencies also increased, further 
proof that the ongoing credit mortgage market turmoil, coupled 
with the economic slowdown is destabilizing the economic 
condition of American families.
    The number of troubled U.S. banks grew, as well, with the 
FDIC now tracking 90 problem banks, the highest number in 
nearly 4 years. This is a significant likelihood--there is a 
significant likelihood that that number will continue to grow 
and that even larger institutions may end up on the problem 
list.
    At the same time, the FDIC's reserve fund is at its lowest 
level, 1.19 percent of covered deposits, in more than a decade. 
These findings strongly suggest that our banks, their 
customers, and our economy will likely continue to grapple with 
the economic fallout of the meltdown in the credit mortgage 
markets for the foreseeable future, and perhaps well into 2009.
    So while I look forward to hearing your assessment of 
whether or not the worst is truly behind us, what is of greater 
interest to me, and I hope to my colleagues as well, and I 
imagine to other members of this Committee and others, is your 
outlook for what the future holds and what steps you have taken 
to ensure that there will be no more surprises for the members 
of this Committee and for our banking industry, which is so 
vital to our Nation's economic well-being.
    As I said in our very first hearing, the regulatory 
agencies that oversee our banking industry play an 
indispensable role, not only in the economic activities of the 
institutions that they regulate but the economic life of our 
Nation as a whole. You serve as the gatekeepers of the credit 
that fuels the world's largest and most dynamic economy. And 
through your regulation of insured institutions, which holds in 
excess of $4 trillion in deposits, you serve as the guardians 
of the interest of the American taxpayers, who are ultimately 
liable when institutions fail.
    Yours is a Herculean mission and one that I know you and 
your dedicated colleagues strive to fulfill every single day. 
So I look forward to learning from each of you this morning not 
only your views regarding the current state of our banking 
industry, but also the concrete steps that you are taking to 
address the lessons learned in the recent market failures.
    With that, I thank you and I turn to Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    There have been some significant developments in the 
banking sector since our last hearing, making this meeting I 
think both timely and very important.
    The most significant development has been the collapse of 
Bear Stearns, including the Federal Reserve's efforts to 
intervene and its willingness to open the discount window to 
the 19 primary securities dealers. While this action provided a 
source of stability for the financial system, it also raised a 
number of policy questions which we can explore further today.
    Since March, the so-called problem bank list has also 
grown. As these numbers rise, I am concerned that the Deposit 
Insurance Fund reserve ratio is at its lowest level since 1996. 
I believe that it is critical to ensure that the fund remains 
healthy as we work through this period of stress.
    Finally, there has been a large number of earnings 
restatements in the banking industry for the fourth quarter of 
2007. Earnings were originally reported at $5.8 billion but 
sizable restatements by a few large institutions caused fourth 
net income to decline significantly.
    If the credit crisis has demonstrated anything, I believe 
there is no substitute for sound risk management. In this time 
of turmoil, I think we must be confident that the Nation's 
financial institutions are operating in a safe and sound 
manner. This requires vigilance and clear guidance from you, 
the regulators.
    As the credit crisis continues to affect many of our 
Nation's financial institutions, I am also interested to hear 
today what you, as regulators, believe may be on the horizon. I 
am particularly interested to hear about the exposure of 
financial institutions to commercial real estate and the 
construction lending tied to the mortgage market.
    I would also like to hear how you are ensuring that banks 
operating in some of the most overheated markets are adequately 
prepared to deal with the stresses of the next several months 
which they will clearly face.
    As we discussed in March, banks have been well capitalized 
coming into this period of stress, which is good news. But as 
we transition to new capital standards, however, I think we 
must continue to examine how Basel II will hold up in periods 
of stress because it has not been tested yet.
    I believe it is important to look at the number of facts, 
including general liquidity, the risk weighting of securitized 
assets, as well as a host of other factors. And with the list 
of troubled financial institutions growing, there is little 
doubt that bank failures will rise.
    The question for our witnesses, among others, is how do you 
intend to mitigate the fallout?
    I welcome all of our witnesses here today and I am sure we 
are going to be spending a lot of time together in the next 
year or so.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator Shelby, very much.
    Let me ask my colleagues, Senator Reed, any opening 
comments?

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Mr. Chairman, you and Senator Shelby have 
articulated very well the continuing challenge in the credit 
markets. Just yesterday Moody's announced that MBIA and Ambac 
have been placed on the negative watch list. And after the 
Federal Reserve's timely intervention with respect to Bear 
Stearns, they have now securities which I presume are rated by 
Ambac and MBIA. That goes to the question of the Federal 
Reserve's position with respect to these securities.
    That is just one indication of the continuing significant 
difficulties in the credit markets.
    The housing market continues to deteriorate, as you have 
illustrated and indicated. Credit card problems, Sheila Bair 
has pointed out the correlation between housing problems and 
credit card defaults and delinquencies.
    All of this requires continued observation and scrutiny and 
I think this hearing is timely and extremely important.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Thank you, Mr. Chairman. I want to thank 
you and Ranking Member Shelby again for convening this hearing. 
I think it is important that we have a thorough understanding 
of the dynamics that are going on out there in the banking and 
the various money markets and everything. And this will help.
    Also, today we continue to examine the state of the banking 
industry and the wide effects of housing and mortgage problems, 
what they have had on our entire financial system, and the 
continued deterioration in real estate and construction loans 
has put a persistent strain on the banking industry and there 
is a reason why industry earnings declined 49 percent from the 
previous year.
    There is also a contraction of the credit markets, and this 
has caused problems for consumers. I think it has had an impact 
on home loans. It has had an impact on auto loans and what not, 
and I would like to hear some of your views as we move forward 
with that. So it has become much harder to borrow and obtain 
credit in many of these areas.
    If these lenders are not able to continue to lend or are 
unwilling to lend, it could have a huge impact on our economy 
and its ability to grow. So in time of record gas prices and 
higher food prices, the American consumer needs to be kept in 
mind, I think, as we move forward on these tough times.
    Now we are continuing to see a number of banks added to the 
problem list, which has been mentioned by my colleagues. But we 
also--I do not believe we have seen an increase in or 
experienced a spike in failed institutions. So I would like to 
have you comment a little bit about how that is happening and 
how we are moving forward and maybe we are not seeing a spike 
in failed institutions--I think in past times perhaps we would 
have seen a spike--and what we put in there that is acting as a 
cushion.
    So finally, I just think in this time of economic 
uncertainty we need to remain confident that our banking 
industry and economy as a whole will rebound and continue to 
foster growth, and so we are all eager to hear your assessment 
of the state of the banking industry and your insights, which I 
think will be helpful as we consider the various policy issues.
    Thank you.
    Chairman Dodd. Thank you, Senator.
    Senator Dole, any comments?

              STATEMENT OF SENATOR ELIZABETH DOLE

    Senator Dole. Yes. And again, I want to thank you for 
holding this hearing this morning, you and Ranking Member 
Shelby.
    First, there is no question, as you have already 
underscored, that the credit and housing crisis continues in 
earnest to this day. While this Committee has been active in 
looking into a number of the problems associated with the 
current crisis, for many Americans this issue came to the 
forefront after the near collapse of Bear Stearns, closely 
followed by the unprecedented Government-assisted sale of that 
firm to JPMorgan, an event that continues to be widely 
scrutinized.
    I believe that without the prompt action from the Federal 
Reserve and Treasury Department over those few days in March, 
our financial markets could have been exposed to systemic risk. 
While I remain concerned about the precedent this action sets 
for future crises, as well as the perceived exposure to the 
U.S. taxpayer as the ultimate backstop as part of the Federal 
Reserve/Treasury negotiated agreement, it appears that the 
regulators on the ground made the most of the situation at 
hand.
    Recently, there have been some encouraging signs. 
Confidence in the credit markets appears to have improved 
somewhat over the past 2 months, represented by the fact that 
the so-called yield spreads between bonds issued by securities 
firms and U.S. Treasuries have narrowed, which some economists 
would point to as a positive indicator.
    In addition, the IPO market appears to be showing some 
signs of life. As of the end of May, the Renaissance IPO Index 
had gained nearly 17 percent over the past 3 months, albeit 
still well below comparable activity levels from 2007.
    Clearly, we are not out of the woods yet. Consumer 
confidence, as calculated by the University of Michigan, sank 
to a 28-year low last month. This comes on top of the widely 
followed Case-Shiller Housing Index which showed that home 
prices nationwide plunged 14 percent in the first quarter.
    Finally, as the events of this week have already 
demonstrated, with the major investment banks slated to begin 
reporting second quarter earnings in the next few weeks, there 
is an ever-increasing likelihood that there will be additional 
losses and further asset write-downs at these institutions.
    Mr. Chairman, when this Committee examined the Government's 
facilitated buy-out of Bear Stearns in early April, I brought 
up the issue of credit defaults swaps and the role they could 
have played in its demise. As I mentioned, as I understand it, 
this market has exploded in size, from an estimated $1 trillion 
in 2000 to $62 trillion in market exposure this year. This 
dwarfs the size of the underlying bond issuances and has the 
potential to unwind the credit markets by exposing counterparty 
risk.
    While the regulator aspect of credit default swaps might 
seem like an esoteric issue for some, although $62 trillion can 
hardly be considered esoteric, I think it underscores an 
important point. These instruments, like so many other 
structured products and derivatives, operate in an environment 
where there is no formal clearing process or minimal public 
reporting regarding the true value of these assets.
    While I do not question that the creation of these 
structured products has delivered a measurable benefit to the 
American consumer by lowering borrowing costs, it is becoming 
clear that a lack of transparency in the pricing and trading of 
these instruments has contributed to the credit crisis.
    I challenge Federal regulators to begin more closely 
monitoring these effects and to seek ways to improve 
transparency regarding the pricing and trading of these 
instruments across the financial marketplace.
    Last week, the FDIC published its quarterly banking profile 
for the first quarter of 2008, which provides insight about the 
stability of the U.S. banking industry. Several items caught my 
eye. Industry earnings declined 46 percent from last year. Loan 
loss reserves now absorb a higher share of revenues, which 
eclipsed $37.1 billion in the first quarter. And problem loans 
continue to rise across many banks' real estate portfolios.
    In addition, the FDIC reported that the number of so-called 
troubled institutions increased from 76 to 90 in the first 
quarter, with no end in sight. This marks the sixth consecutive 
quarter that the number of problem institutions has increased 
and reflects the largest number of institutions on this list 
since the 3rd quarter of 2004. Clearly, these are not promising 
developments and I hope that Congress has empowered the FDIC--
which I believe is responding to this crisis to the best of--
its ability, with the necessary tools and resources to handle 
the new realities facing the banking industry.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator, very much.
    Senator Corker, any comments?

                STATEMENT OF SENATOR BOB CORKER

    Senator Corker. Mr. Chairman, as usual, I look forward to 
hearing from the witnesses.
    Thank you.
    Chairman Dodd. Thank you very much, Senator.
    I do not know whether Senator Martinez or Senator Bunning, 
I am not sure what order they came in. I apologize.
    Senator Martinez. Mr. Chairman, I will defer to my senior 
colleague from Kentucky.
    [Laughter.]
    Senator Bunning. Senior colleague, thank you very much.
    Chairman Dodd. It is been amazing how you have grown, Mel, 
in understanding.
    Senator Bunning. I deeply appreciate that, and I think 
Senator----
    Chairman Dodd. He offered his--he did not defer to Senator 
Hagel, who is leaving, of course. He is deferring to you.
    Senator Bunning. I know, because I got here just a little 
ahead of Senator Hagel.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Mr. Chairman, I want to thank you for 
holding this second hearing on this critical issue.
    After all the problems in the financial system over the 
last year, we would all like to think our banks are out of the 
woods, but they are not. Hopefully, we are getting closer to 
the end than we are to the beginning.
    Home prices are continuing to fall and problems still exist 
in the credit markets. Unfortunately, it appears that troubles 
at banks around the country are on the rise. The FDIC problem 
list is getting longer. Four banks have already been closed 
this year, and it seems like there is speculation every day 
about the health of the major banks. I think we are all worried 
about that.
    I hope to hear from our regulators today that they are 
closely monitoring the health of the banks and are ready and 
able to respond even if a major bank fails. I also hope to hear 
that they do not expect that to happen.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator Bunning.
    Senator Hagel? Senator Martinez?

               STATEMENT OF SENATOR MEL MARTINEZ

    Senator Martinez. I will be very brief. Thank you, Mr. 
Chairman.
    I appreciate this hearing and I am glad that we are keeping 
a close eye on our banking industry, which is so important to 
our Nation.
    Chairman Bernanke, in speaking to the International 
Monetary Conference yesterday, noted that although we may see 
somewhat better economic conditions during the second half of 
2008, until the housing market--and particularly housing 
prices--show clear signs of stabilization, downward growth risk 
will remain.
    On that note, I would like to sound a note of cautious 
optimism that in the real estate market in Florida, it appears 
that we are heading in a better direction. Florida Realtors 
recently reported an upswing in existing home and condominium 
sales from March to April of 2008. And Realtors around my State 
are reporting an increase in phone calls, home showings, and 
buyer activity. The market appears to be stabilizing and we are 
working through the huge backlog of inventory that exists.
    Economists at the National Association of Realtors predict 
that home sales and prices throughout most of the Nation will 
improve in the second half of the year, especially if access to 
mortgage backed by the Federal Housing Administration, Fannie 
Mae, and Freddie Mac increases.
    So I believe we are witnessing, in many ways, the market's 
reaction to various steps Congress has taken to help alleviate 
the current housing crisis. Congress has much to finish on this 
front, including finalizing the pending legislation. As we work 
toward that end, we should be moving simultaneously to ensure 
we do not ever find ourselves back in the kind of situation we 
are in today to the extent possible.
    I continue to be concerned about the availability of credit 
and the condition of our banking system as we work through the 
crisis. Some of my friends in the industry in Florida complain 
about excessive regulation, the increase in reserves to a point 
where they now are constraining their ability to continue to be 
a resource to those who would create the conditions for the 
market to come back.
    So I hope we will continue to shed light on this situation 
through today's hearing and look forward to hearing from the 
witnesses.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator.
    And again, welcome to our witnesses this morning. We have 
six very distinguished witnesses this morning, and I am going 
to ask all of you, if you would, to try and keep your remarks 
to around 5 to 6 or 7 minutes, if you could. Obviously, all of 
your full statements and any supporting documentation you think 
would be valuable for the Committee will be included in the 
record.
    I will ask you to proceed in the order that you are 
sitting, Sheila beginning with you and ending up here at the 
other end of the table. Good to have you with us here this 
morning, as well. Mr. Karsky, is that how you pronounce it?
    Mr. Karsky. Sure.
    Chairman Dodd. And we will proceed along those lines, and 
then we will get to some questions. But we thank all of you for 
being here and coming back to the Committee.
    Sheila Bair.

 STATEMENT OF SHEILA BAIR, CHAIRMAN, FEDERAL DEPOSIT INSURANCE 
                          CORPORATION

    Ms. Bair. Thank you, Chairman Dodd, Senator Shelby, and 
members of the Committee.
    I appreciate the opportunity to testify on behalf of the 
FDIC regarding the condition of the banking industry.
    Uncertainties in today's economic environment continue to 
pose significant challenges for banks, households, and bank 
regulators. As I said before, I believe that the distress in 
the housing market is the key to our broader economic problems. 
In order to return stability to the credit markets, we must 
ensure that future mortgage lending is properly underwritten 
and results in loans that are sustainable over the long term 
for borrowers.
    In addition, we must deploy multiple tools to combat 
unnecessary foreclosures that create a self-reinforcing 
downward spiral for housing prices.
    Last week, the FDIC released its quarterly banking profile, 
a comprehensive summary of financial results for all FDIC-
insured institutions for the first quarter of 2008. Although 
the industry reported earnings of $19.3 billion, the data 
showed financial performance that was significantly lower than 
in past years. The economic slowdown brought on by the 
disruptions in credit availability is expected to exert 
continuing downward pressure on industry earnings over the 
coming quarters.
    The construction and development segment of commercial real 
estate lending stands out as the most important short-term 
credit quality issue. Loss rates have risen dramatically on C&D 
loans through the first quarter of 2008 and likely will 
increase because of the current oversupply of new housing 
units.
    The FDIC is taking aggressive steps to work with our 
supervised institutions. Examiners have conducted targeted 
visits in institutions with C&D lending concentrations in 
former high growth markets and determined that a rapid increase 
in problem loans may translate into significant further losses 
this year. As a result, we are intensifying our supervision of 
these institutions and we are accelerating onsite reviews and 
expanding examination tools to deal with these developments.
    In addition, we are taking steps to improve our capability 
to handle future bank failures. So far this year, four 
institutions have failed, with total assets of $2.2 billion and 
estimated losses of $225 million to the Deposit Insurance Fund. 
The number of failures in recent years has been unusually low 
by historic standards and we expect that bank failure activity 
in the near term will be higher.
    As we reported last week, there were 90 institutions with 
total assets of $26.3 billion on the FDIC's problem bank list 
at the end of the first quarter, up from 76 with total assets 
of $22.2 billion at the end of 2007. Nevertheless, about 99 
percent of all insured institutions, representing over 99 
percent of industry assets, met or exceeded the minimum 
regulatory capital standard for well capitalized status under 
PCA.
    As of March 31st, the balance in the Deposit Insurance Fund 
stood at $52.8 billion. The strong growth in insured deposits, 
together with the increase in loss provisions, pushed down the 
DIF reserve ratio to 1.19 percent from 1.22 percent at year-end 
2007. As insurance losses increase due to failures, combined 
with strong deposit growth, the fund could drop below the 1.15 
percent minimum of the statutory range. I can assure this 
Committee that the FDIC Board will act as necessary under the 
statutory requirements of the Reform Act to maintain the 
integrity of the DIF.
    Because the rate of bank failures is expected to return to 
a level above that of recent years, and with the current 
uncertainties in the banking industry, the FDIC is actively 
ensuring that we have the capacity and appropriate skills to 
address the resolution of failed institutions. With the 
significant consolidation in the banking industry, we are 
focusing particularly on unique issues associated with large 
financial institutions.
    Even though the probability of such a failure is extremely 
unlikely, the development of mega-institutions means that the 
FDIC must ensure that its processes and systems are capable of 
handling the complex issues such a failure would pose. For 
example, some institutions may have millions of deposit 
accounts. The ability to determine their insured status quickly 
is essential to a successful resolution of a large failed bank.
    After 2 years of study and public input, the FDIC Board 
will be considering at our next meeting a new regulation to 
require certain large banks to modify their deposit systems to 
facilitate deposit insurance determinations.
    The FDIC also is working to improve our ability to respond 
effectively to larger and more complex portfolios of qualified 
financial contracts held by banks. The new rule will ensure 
that critical information about these complex financial 
relationships is available to the FDIC under the very tight 
timeframes necessary to achieve an orderly resolution of a 
failed bank.
    As part of our contingency planning for increased bank 
failures, we have beefed up our resolution and receivership 
staff and cross-trained over 1,200 existing staff who can help 
with various aspects of the resolution process. We have also 
been running bank failure readiness exercises to test our 
preparedness for the resolution of larger, more complex 
institutions. We are taking these measures as a precaution. We 
feel we must be prepared for any contingency.
    Finally and most importantly, I commend the Committee on 
passing legislation to expand eligibility for loans guaranteed 
by the FHA, combined with GSE modernization and regulatory 
reform. This legislation is laudable and will help many 
borrowers.
    We have also welcomed the opportunity to discuss with 
Committee members individually our suggestions for additional 
tools to combat escalating foreclosures. My written statement 
includes a description of the Home Ownership Preservation loan 
proposal that would provide loans to pay down distressed 
mortgages to an affordable level with repayment costs shared by 
borrowers and mortgage investors. We believe this proposal 
could be a valuable compliment to the current FHA proposals 
recently approved by this Committee.
    This concludes my testimony. Thank you very much.
    Chairman Dodd. Thank you very much, Ms. Bair.
    John Dugan, thank you.

STATEMENT OF JOHN C. DUGAN, COMPTROLLER OF THE CURRENCY, UNITED 
                        STATES TREASURY

    Mr. Dugan. Chairman Dodd, Senator Shelby, and Members of 
the Committee, I am pleased to be here today to update the 
Committee on recent events in the financial markets and the 
condition of the national banking system.
    When I testified before this Committee in March, I reported 
that two powerful and related forces were exerting real stress 
on banks of all sizes and in many different parts of the 
country. One was the unprecedented series of credit market 
disruptions precipitated by declining house prices and severe 
problems with subprime mortgages. The other was the slowdown in 
the economy which had begun to generate a noticeable decline in 
credit quality in a number of asset classes.
    As we assess the impact of these forces today, I would say 
this: Credit markets are somewhat better, while credit quality, 
meaning the performance of loans and other credit extensions to 
which banks are exposed, is worse.
    On the first point, we are beginning to see improvements in 
several key segments of the credit markets. In particular, 
there is significantly more liquidity in money markets, and 
spreads on credit default swaps have narrowed. Financial 
institutions have raised unprecedented amounts of capital since 
October 1st of last year, over $100 billion by national banking 
organizations alone. And this shoring up of their balance 
sheets has helped restore confidence and liquidity in the 
interbank market. In addition, the pipeline of hung leveraged 
loan deals has slowly begun the clearing process.
    While these are all good signs of progress, we clearly are 
not out of the woods. There continues to be considerable 
uncertainty among market participants about the underlying 
strength of the economy and the ongoing effects the recent 
market disruption and economic downturn are having on financial 
counterparties, consumers, and commercial borrowers. This 
uncertainty may lead to continued volatility in the financial 
markets that we and the institutions that we supervise will 
need to monitor carefully. Moreover, securitization channels 
for residential mortgages remain largely closed, except for 
conforming mortgages sold to the GSEs and FHA. Although banks 
and other portfolio lenders have taken up some of this slack, 
they cannot provide the same level of credit to this important 
part of the mortgage market as was previously provided by 
securitization markets.
    In addition, the number of homes in foreclosure continues 
to rise. In this regard, we support the significant new options 
provided in this Committee's recent legislation that would help 
borrowers refinance their homes rather than face foreclosure.
    On the second point, credit quality, the downturn in 
housing and the broader economy is indeed continuing to have an 
adverse effect on national banks' loan portfolios. The level of 
nonperforming and past-due loans is increasing. Not 
surprisingly, housing-related credit is of particular concern, 
including home equity loans, lower-quality first mortgages, and 
commercial real estate related to residential construction.
    But credit quality is also declining in credit card loans, 
auto loans, small business loans, and, to a lesser extent, 
commercial and industrial loans and commercial real estate 
unrelated to housing. There are, however, two important 
caveats:
    First, this upward trend in losses starts from a very low 
base of exceptionally benign credit conditions.
    Second, banks in some parts of the country where regional 
economies are stronger have simply not experienced the same 
increases in problem loans.
    Nevertheless, given the clear trend lines in most banks, 
responding to deteriorating credit quality will continue to be 
a major focal point for supervisors and bankers in the months 
ahead. In light of these conditions, we believe the substantial 
increases that banks have made both to loan loss reserves and 
to capital in recent quarters are both prudent and warranted. 
Indeed, should credit performance continue to worsen, as we 
expect, additional loan loss reserves will be needed and, in 
some cases, additional capital. As always, we support 
maintaining strong conservative reserves, and we will continue 
to underscore this message to bankers, the accounting standards 
setters, and bank auditors.
    Likewise, both on our own and in cooperation with other 
supervisors, we continue to identify and implement lessons 
learned from the recent market turmoil, especially for our 
larger institutions. These efforts focus on improvements to 
risk management, including addressing new types of liquidity 
risk, appropriately identifying and managing off-balance-sheet 
exposures, managing concentrations, and significantly enhanced 
metrics for aggregating risks to particular counterparties. 
Each of these areas is described in more detail in my written 
statement, and I would be pleased to address questions about 
any of them.
    Thank you very much.
    Chairman Dodd. Thank you very much.
    John Reich, thank you for being here.

    STATEMENT OF JOHN M. REICH, DIRECTOR, OFFICE OF THRIFT 
                          SUPERVISION

    Mr. Reich. Good morning, Chairman Dodd, Ranking Member 
Shelby, and Members of the Committee. I appreciate the 
opportunity to return today to give you an update on the 
financial condition and performance of the thrifts industry.
    As I reported to the Committee in March, thrift 
institutions are continuing to face significant challenges from 
the downturn in the housing sector and general economic 
weakness. But despite these challenges, the industry generally 
is continuing to hold up remarkably well. Capital is down 
slightly, but it remains solid. Managers of OTS-regulated 
institutions are showing that they take the challenges 
seriously by adding a record amount to their loan loss 
provisions in the first quarter of this year, $7.6 billion. And 
I have encouraged institutions' CEOs to be aggressive in adding 
to their loan loss reserves. Setting aside this money has 
decreased earnings, but the rise in troubled assets indicates 
that higher provisions are necessary.
    When I talk with the news media about the performance of 
the thrift industry, I am often asked how the current climate 
compares with the climate that existed in the 1980s and 1990s. 
One illustration I can provide is to point out the number of 
problem thrifts, which stood at 12 at the end of March, the end 
of the first quarter, and stands at 17 today, that figure 
compared to 1992, for example, when more than 200 thrifts were 
in troubled condition. During that time, industry capital was 
not in the solid condition that it is today. Although we 
anticipate the possibility of a few smaller institutions may 
fail in coming quarters, there is no comparison to the late 
1980s and the early 1990s, when hundreds of thrift institutions 
failed and were closed.
    My written testimony describes how OTS is emphasizing to 
thrift institution management the lessons learned from the 
current crisis as both examiners and institution executives 
assess their management of risk. Bank management is largely 
about managing risks, and risk management in the financial 
services industry was clearly inadequate in anticipating the 
approach of the current crisis and in accurately assessing its 
potential impact.
    Learning lessons from these inadequacies, doing a better 
job of identifying and measuring risks, and thereby preventing 
a recurrence are essential to the safety and soundness of our 
financial system. An attachment to my testimony is a March 
letter we sent to thrift CEOs describing specific areas where 
they should be focusing their attention in managing risks. We 
are continuing to emphasize these points during examinations 
and regular town meetings that we hold with thrift executives 
around the country.
    I might say that I have boosted the number of outreach 
events that I have had done since our March hearing with 
institutions around the country, and I have asked all members 
of my senior management in Washington, D.C., and in our 
regional offices around the country to go out on an examination 
this year to get a firsthand feel. Many of our senior 
management has not been out on examination for 5, 10, 15 years, 
and it is time that they reacquainted themselves with how 
things really are.
    Perhaps the most important lesson that we have learned from 
this crisis is that all of the players in the home mortgage 
market need to play by the same rules. There is a corrosive 
effect on the entire system when certain segments of the market 
can cut corners, unsound loan underwriting, and evade serious 
scrutiny.
    The OTS and the other Federal banking regulators have 
issued guidance and focused our supervisor attention on 
ensuring sound underwriting for nontraditional mortgage 
products and subprime loans. Many States have adopted this 
guidance, but others have not. So uniform nationwide 
protections do not exist for consumers making what is probably 
the largest investment of their lives.
    These regulatory gaps have a real impact on families across 
America, and in my opinion, we should make closing the gaps an 
urgent priority.
    For home mortgages, consistent regulation is essential for 
the brokers who originate home mortgages and for the mortgage 
companies, including mortgage banks. I believe the OTS is in a 
unique position to work with States to close the gaps in 
regulation, because our agency has nearly two decades of 
experience in supervising financial institutions engaged 
primarily in home mortgage lending and in other consumer-
related lines of business.
    For the originators, we need nationwide registration and 
licensing, financial obligation, demonstration of some 
financial capacity, such as a net worth requirement or a bond, 
and a change in compensation structure so that brokers have a 
stake in the long-term viability of every loan that they 
originate. The OTS would work with State regulators to 
establish such a system and monitor its effectiveness.
    For mortgage companies, we recommend following the model 
used by the FDIC and States in examining State-chartered banks, 
alternating examinations, or conducting joint examinations. The 
OTS would work with the Conference of State Bank Supervisors 
and other State regulatory groups to develop these 
partnerships, to ensure accountability, consistency, and 
transparency throughout the mortgage lending process.
    Thank you, Mr. Chairman, and I look forward to your 
questions.
    Chairman Dodd. Thank you very, very much as well.
    JoAnn Johnson from the National Credit Union 
Administration, we thank you.

  STATEMENT OF JOANN JOHNSON, CHAIRMAN, NATIONAL CREDIT UNION 
                         ADMINISTRATION

    Ms. Johnson. Thank you, Chairman Dodd, Senator Shelby, and 
Members of the Committee. Thank you for the opportunity to 
update the Committee regarding the state of the credit union 
industry in the context of your broader review of how financial 
institutions are performing during the recent turbulence.
    The overall financial state of the credit union industry 
remains strong and healthy, with financial trends indicating a 
safe and sound industry. We do note, however, isolated but not 
systemic problems. I will outline key data which supports this 
conclusion and also underscore NCUA's belief that the industry 
has implemented our regulatory guidance regarding the need for 
increased vigilance and more careful management of credit union 
balance sheets.
    Federally insured credit unions are well capitalized. Net 
worth stands at 11.1 percent, and over 99 percent are at least 
adequately capitalized. Total assets are at $792 billion, and 
aggregate net worth is $87.87 billion, the highest dollar 
amount in history. The Share Insurance Fund is strong, with a 
current 1.31 equity level. While we have increased our loss 
reserves, we expect the year-end equity level to be a 1.30 
percent with the ability to withstand any projected potential 
losses.
    Lending continues to be a main focus of credit union 
service to members. As of the end of 2007, loans represented 
just over 67 percent of credit union assets. Within that figure 
real estate loans comprise over 52 percent of total loans. 
Credit union mortgage lending is primarily of the traditional 
variety. Nearly 60 percent of credit union mortgage loans are 
fixed rate. Only 2.4 percent are interest-only or optional-
payment loans that have garnered much of the recent attention 
on Capitol Hill and made this hearing, unfortunately, 
necessary.
    Overall, loan delinquencies have decreased slightly since 
the last time we met to discuss this important issue from 0.93 
to 0.91 percent. And real estate delinquencies now stand at 0.7 
percent. Aggregate net charge-offs for all loans have increased 
from 0.5 percent to 0.67 percent, with real estate net charge-
offs currently at 0.19 percent.
    Those relatively low numbers indicate that credit unions 
have positioned themselves to withstand the current economic 
uncertainty and related mortgage problems. To make certain that 
continues, NCUA has played a proactive and aggressive role in 
issuing supervisory guidance regarding lending.
    Since 1995, NCUA has issued guidance on risk-based lending 
and specific mortgage lending guidance that has identified 
potential problem areas, particularly regarding subprime 
lending, credit risk management, due diligence, and stringent 
evaluation of third-party relationships. Home equity lines of 
credit and so-called exotic mortgage products, such as the 
interest-only and payment-optional, were also covered by this 
guidance.
    Last year, in concert with my fellow regulators, joint 
guidance regarding workout arrangements, subprime lending, and 
loss mitigation was issued. All of this was aimed at increasing 
credit union awareness of the potential pitfalls inherent in a 
rapidly changing and complex lending landscape. It also serves 
as a constant reminder to the industry of NCUA's vigilant 
posture when it comes to identifying and managing risk. While 
NCUA appreciates the desire of credit unions to serve their 
members as fully as possible, we recognize that there is no 
substitute for strong supervision that enhances safe and sound 
operations.
    Federally insured credit unions remain financially strong. 
They have implemented NCUA guidance related to real estate and 
other lending and as a result are positioned to weather the 
current economic turbulence. While data shows that the industry 
is not entirely insulated from the adverse impact of the 
mortgage situation, it also supports the conclusion that strong 
risk management and prudent standards, hopefully supervised by 
an engaged regulator, will ensure continued success.
    Thank you, and I look forward to your questions.
    Chairman Dodd. Thank you very, very much.
    Donald Kohn--Donald, thank you very much--Vice Chairman of 
the Federal Reserve.

STATEMENT OF DONALD L. KOHN, VICE CHAIRMAN, BOARD OF GOVERNORS, 
                     FEDERAL RESERVE SYSTEM

    Mr. Kohn. Thank you, Mr. Chairman, Ranking Member Shelby, 
and Members of the Committee. I appreciate this opportunity to 
appear today to discuss the condition of the U.S. banking 
system as a follow-up on our previous hearing in March.
    The U.S. banking system, while still in overall safe and 
sound condition, continues to face challenges. As the U.S. 
housing market has weakened and the economy has slowed over the 
past year, banking organizations have recognized significant 
losses. These losses stem from higher credit charges against 
residential mortgage-related loans held on their books and from 
sharp asset value write-downs of securitized mortgage-related 
positions and of leveraged loans. The largest bank holding 
companies performed better in the first quarter of 2008, but 
softening economic conditions have caused continued problems in 
mortgage loan portfolios, particularly home equity lines of 
credit, and in loans to real estate developers.
    Nonperforming assets of bank holding companies more than 
doubled over the past year, and loan loss provisions have also 
risen sharply, partly as institutions build their loan loss 
reserves in advance of expected further deterioration in loan 
quality. Bankers and their supervisors have increasing concerns 
about the potential for more losses from traditional lending 
activities, such as credit card loans, auto loans, home equity 
lines of credit, and loans to businesses.
    U.S. bank holding companies have raised more than $80 
billion in capital so far in 2008, and some have reduced 
dividend payouts. We support such efforts by institutions to 
improve their capital bases. Stronger capital positions will 
allow a banking institution to participate in and support the 
rebound in lending that will accompany the strengthening of the 
U.S. economy. Banking institutions must also continue to 
strengthen their liquidity positions, and we are highly 
supportive of those efforts as well.
    We see a similar overall outlook for State member banks and 
anticipate that the number of banks with less than satisfactory 
supervisory ratings will continue to increase from the 
relatively low levels that have existed in recent years.
    As recently documented in a series of public reports, the 
market events of the past year point to a number of risk 
management lessons for financial institutions. Bankers need to 
properly identify and measure and understand risks. They need 
to understand their liquidity risk on an enterprise-wide level 
and exercise strong management oversight to independent risk 
management functions. Overconfidence and complacency need to be 
continually battled, especially during an extended period of 
good times.
    On the supervisory side, we are improving our supervisory 
processes and supervisory guidance on liquidity risk 
management, compliance risk management, and other relevant 
areas. We are acting to ensure that banks improve their 
forward-looking risk identification processes, which should 
include a more comprehensive understanding of their main and 
emerging business lines and the full range of risks they 
generate. We are also counseling institutions to understand the 
limits of their more traditional risk identification processes, 
emphasizing the importance of stress testing and scenario 
analyses. Better risk management at banking organizations must 
also be accompanied by more robust liquidity and capital 
cushions.
    As you know, the Federal Reserve is a consolidated umbrella 
supervisor of large bank holding companies in the U.S. The 
process of consolidated supervision generally works well with 
strong, cooperative relationships between the Federal Reserve 
and other relevant bank supervisors and functional regulators. 
Recent events have highlighted the fundamental importance of 
enterprise-wise risk management, and we need to ensure that our 
system of consolidated supervision keeps pace.
    The Federal Reserve is enhancing its guidance on 
consolidated supervision to provide greater clarity for our 
examination staff as they deal with the challenges of 
supervising increasingly complex organizations. The 
enhancements will provide greater consistency in the Federal 
Reserve's consolidated supervision process, as well as improve 
our ability to look at risks across an entire organization 
regardless of the legal entities in which those risks reside.
    In this manner, the enhancements will assist us 
considerably in our broader financial stability rule. 
Naturally, under the upgraded guidance, we will continue to 
coordinate closely with other relevant supervisors and 
functional regulators.
    Going forward, we must continue to send strong supervisory 
messages to senior management at financial institutions, 
perhaps with more force and frequency than in the recent past, 
to ensure that institutions retain their focus on sound risk 
management in good times and bad. We continue to review our 
supervision practices to identify and act on potential areas 
for improvement in light of recent events. More generally, the 
Federal Reserve will continue to work with other banking 
agencies, foreign supervisors, and the Congress to help ensure 
that bank safety and soundness is maintained.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Mr. Kohn.
    Mr. Karsky.

  STATEMENT OF TIMOTHY J. KARSKY, COMMISSIONER, NORTH DAKOTA 
DEPARTMENT OF FINANCIAL INSTITUTIONS, AND CHAIRMAN, CONFERENCE 
                   OF STATE BANK SUPERVISORS

    Mr. Karsky. Good morning, Chairman Dodd, Ranking Member----
    Chairman Dodd. Mr. Karsky, let me introduce you. He is the 
Commissioner of the North Dakota Department of Financial 
Institutions and Chairman of the Conference of State Bank 
Supervisors, and we thank you very much for joining us.
    Mr. Karsky. Thank you, Mr. Chairman. Good morning Chairman 
Dodd, Ranking Member Shelby, and Members of the Committee, my 
name, again, for the record is Tim Karsky, and I am the 
Commissioner for the North Dakota Department of Financial 
Institutions. I also serve as Chairman of the Conference of 
State Bank Supervisors, and we thank you for giving us the 
opportunity to discuss the state of the Nation's banking 
industry.
    As we reported to the Committee in March, our Nation's 
banks are operating in a challenging economy. Unfortunately, we 
are seeing and will continue to see some banks fail. Based on 
current conditions and trends, State banking regulators do not 
expect these failures to be widespread or beyond our capacity 
to manage.
    As the recent failures have demonstrated, the banking 
industry is strong enough to absorb failed institutions, 
providing stability to the local market. This was most recently 
illustrated by last Friday's bank failure in Minnesota, which 
was then acquired by a State-chartered bank in North Dakota. 
This largely market-based solution can be managed with limited 
losses to the Deposit Insurance Fund and without the Government 
having to provide direct support to provide market stability. 
We have the tools to handle this.
    If we are to look for ``lessons learned'' from the housing 
and capital markets crisis and the ongoing economic downturn, I 
believe that ``strength through diversity'' should be at the 
top of that list. ``Diversity'' does not just refer to 
variation within an institution's lending portfolio or lines of 
business. It is also diversity in the number and size of 
institutions. It is not an accident, but rather conscious 
policy decisions that have fostered the breadth of banks in the 
United States, which now stands at about 8,500.
    In my home State of North Dakota, community banking is a 
pillar of economic development. For this reason, I am concerned 
about the mission creep of the Farm Credit System and its 
direct competition with community banks. The preferential 
status of Farm Credit banks creates an unlevel playing field 
for community banks. This disparity could eventually result in 
safety and soundness issues for the banking system in my and 
other States.
    Since this Committee's hearing in early March, the Treasury 
Department released its blueprint for financial regulatory 
modernization and the failure of Bear Stearns prompted historic 
action from the Federal Reserve. We must acknowledge that 
failures and resolutions take on a variety of forms based upon 
the type of institution and its impact upon the financial 
system as a whole. Legislative and regulatory decisions that 
alter our financial regulatory structure or financial 
incentives should be carefully considered against how those 
decisions affect the competitive landscape for institutions of 
all sizes.
    We recognize that extraordinary events require 
extraordinary actions. To provide market stability, the Federal 
Reserve has provided a tremendous amount of liquidity through 
various lending facilities and access to the discount window by 
investment banks. As we evaluate our regulatory structure, we 
must examine the linkage between the capital markets and the 
traditional banking sector. Depository institutions are heavily 
regulated. Going forward, we believe that the capital markets, 
and investment banks in particular, require enhanced regulatory 
scrutiny.
    While State supervisors are leery of a complete overhaul of 
the banking system, we have long recognized the need for 
changes to residential mortgage regulation. As a result, CSBS 
has been working diligently to improve cooperation and 
coordination among State regulators and between State and 
Federal authorities. CSBS contends that an enhanced regulatory 
regime for the residential mortgage industry is necessary to 
ensure legitimate lending practices, provide adequate consumer 
protections, and to once again instill both consumer and 
investor confidence in the housing markets.
    We congratulate this Committee on the passage of the 
S.A.F.E. Mortgage Licensing Act of 2008. As recognized in the 
bill, the cornerstone of the State initiatives to improve 
mortgage supervision is the development of the CSBS-AARMR 
Nationwide Mortgage Licensing System. Since our last appearance 
before this Committee, the State Foreclosure Prevention Working 
Group, of which CSBS is a member, released its second data 
report, which is attached to my written testimony. This report 
contains important findings on loss mitigation efforts of 
mortgage servicers.
    I thank you for the opportunity to testify today and look 
forward to any questions you may have.
    Chairman Dodd. Thank you very, very much, Mr. Karsky. We 
appreciate your being with us this morning.
    Let me ask the clerk to put that clock on us here at 5 or 6 
minutes, if we can, and try to get around. We have had a good 
number turn out here this morning, and I want to give everyone 
a chance to engage in the discussion. So we will begin, and I 
will try and keep an eye on this clock myself.
    What I will suggest in advance, I suggest there will 
probably be a lot of questions, and we may not get to all of 
them. So I am going to leave that record open for several days 
so that if we don't get all of our questions asked, we will 
submit them to you quickly and ask for a quick response, if we 
can, as well.
    Sheila Bair, let me begin with you, if I can, and your 
testimony warns us of more bank failures to come this morning 
and says that these failures may not be confined to the smaller 
institutions. What specific factors do you believe lead these 
banks to be in that condition? And do you expect that this 
round of failures will pose different challenges to your agency 
or the agencies represented at the table than the failures did 
in the 1990s? And, last, are you concerned about the Deposit 
Insurance Fund reserve ratio?
    Ms. Bair. Thank you, Mr. Chairman. I think in terms of risk 
exposure, obviously those institutions that had monoline 
business models and were heavily involved in nontraditional 
subprime mortgage lending are of concern. Those institutions 
that have high CRE concentrations, particularly combined with 
rapid growth, are of concern.
    Within the CRE category, we are particularly focused on 
residential construction and development. That is where we are 
really seeing the delinquencies spike. And within that 
category, institutions with assets between $1 to $10 billion we 
think warrant a particular focus.
    Chairman Dodd. I am sorry. Would you repeat that?
    Ms. Bair. For mid-sized institutions with assets between $1 
and $10 billion with high CRE concentrations, we're seeing a 
significant increase in delinquencies especially for that 
category of assets.
    In terms of the resolution activity, so far, I am very 
proud of the way we have handled it. We perhaps were a little 
rusty. We went 2\1/2\ years without any bank failures. We had 
three last year, four this year. The number will go up. I think 
we have been working very hard to prepare, to staff up. There 
is a broad range of institutions that we need to keep a close 
eye on, but I do think we are taking all the steps that we can 
take.
    Again in terms of a very large institution failure, I don't 
see that happening. I would be very surprised if that happened. 
But we feel like we have to prepare for all contingencies.
    So we have been really going on two fronts--dealing with 
the more traditional resolution activity for the smaller 
institutions, where we know we have increases, and then trying 
to prepare through additional staffing and conducting 
simulation exercises for the larger, more complex institutions, 
as well as finalizing this rulemaking to get large institutions 
to update their deposit systems so we could very quickly make 
an insured deposit determination if the worst happens that we 
would have to close one.
    Chairman Dodd. And the ratios?
    Ms. Bair. The coverage ratio is a particular concern, and 
other regulators have mentioned that as well. The coverage 
ratio is a ratio of loan loss reserves to non-current loans. It 
has been slipping. It is down to 89 cents. We would like to 
keep it to about a dollar. That is a conservative range, but we 
would like to keep it there. So it has been slipping and, 
again, it appears that the institutions with large CRE 
concentrations, especially mid-sized institutions, is where we 
have seen a lot of slippage. So we are very, very focused, as 
are all the regulators, on getting those loan loss reserves up.
    I am sorry, the ratio on the Deposit Insurance Fund.
    Chairman Dodd. Yes.
    Ms. Bair. Yes. We are down to 1.19, mainly because of very 
robust deposit growth in the first quarter. But we also had an 
increase in our contingent loss reserve which has to be removed 
from the account balance that we use to determine the reserve 
ratio.
    So, as you know, Mr. Chairman, we are at 1.19 now. If it 
drops to 1.15, the Reform Act requires us to implement a 5-year 
restoration plan in a very quick time period. So, again, I 
think probably in mid-August we will have a better sense of how 
close we will be to that, but we will act very quickly.
    Chairman Dodd. But you are prepared to respond to that.
    Ms. Bair. Absolutely. Absolutely.
    Chairman Dodd. Do you anticipate that is going to happen?
    Ms. Bair. I am trying not to make predictions, Mr. 
Chairman, because there are a lot of uncertainties out there. 
So we are trying to prepare for all contingencies. It is 
certainly within the realm of possibility. I do not discount 
it, which is one of the reasons why I wanted to raise it at 
this hearing, so you would know and not be surprised.
    Chairman Dodd. Well, I appreciate that.
    Let me move quickly, if I can, to--one of the fundamental 
questions is whether we should be relying on models in setting 
bank capital, which is one of the components of Basel II, as 
you know.
    Don Kohn, my friend over here, argued that the Basel 
Committee will, and I quote him here, ``adjust the Basel II 
capital requirements in light of recent market events.''
    Ms. Bair, you have raised some concerns in your response by 
pointing out, and I quote your testimony, that the 
``unprecedented downgrades and massive losses incurred by banks 
on AAA-rated structured securities such as CDOs and asset-
backed securities are a prime example of why models cannot be 
relied upon to set capital requirements and are meant to 
protect and preserve the solvency of our Nation's financial 
institutions.''
    Mr. Kohn, let me ask you, how would you respond to Ms. 
Bair's concerns about whether or not we should be relying on 
these models, in light of her statements about the recent 
evidence that indicates that that is a dangerous precedent to 
be engaging in.
    Mr. Kohn. Well, I certainly agree with Chairman Bair that 
we should not rely exclusively on models to gauge the capital 
adequacy of risk-based capital. Models are one input. They 
didn't do very well in a number of respects, in a number of 
types of assets, and the most recent market turmoil. We are 
engaged with other supervisors in looking at the implications 
of that for the Basel capital requirements themselves. But I 
would also add there is a Pillar 2 to Basel, so that the 
banking regulators need to be confident that the numbers coming 
out of Pillar 1, based in part on model simulations, are 
adequate. And if we think they are not, we will insist that the 
banks hold more capital.
    So this is not--Basel II is not just relying on some 
mathematical formula. There is quite a bit of regulatory 
oversight of how those formulas are done and adjustments of the 
regulation and supplements to that.
    Chairman Dodd. Well, I know there is a lot of interest on 
that. Senator Reed has raised these issues before in previous 
hearings we have had, so we will be following it very closely.
    Let me move, if I can, to the issue of credit cycle and 
some of the write-offs, potential write-offs. As I mentioned in 
my opening statement, some people now believe that the worse is 
behind us in the current credit crisis, while others believe 
that there are still some large potential pitfalls in our path. 
And we do know that we have witnesses--we have witnessed an 
unprecedented amount of write-downs by banks, which have led 
them to raise additional capital. By one account, banks 
throughout the world have had to raise over $200 billion in 
additional capital to confront these write-downs and losses. So 
I have two questions for the panel, if you would quickly 
respond to them.
    First, is the cycle of mortgage-related write-downs nearing 
an end in your view? And, John Dugan, I will begin with you on 
this one.
    And, second, discuss the risks to financial institutions 
from additional credit exposures, including loans and 
securitizations from credit cards, commercial real estate, or 
other areas of lending that will need to be addressed in the 
coming period. Somebody mentioned auto loan issues, for 
instance, which are showing some stress, to put it mildly. I 
would like you to just quickly comment on this, if you could.
    Mr. Dugan. Well, if I may, on the first question about are 
we past the period of most significant write-downs, if you look 
at the things that caused the really huge losses--the CDOs that 
were on the biggest firms' balance sheets where they have taken 
very large write-downs already, in some cases 50 percent of the 
value of the asset, even though the asset continues to pay, it 
is a liquidity kind of write-down. We think that the pace of 
those write-downs has already slowed and was nearing a place 
where we do not think it is likely to go down too much farther, 
which is a good thing.
    If you ask about the particular loan level things like 
mortgages, home equity loans, et cetera, we expect that to 
continue to decline in almost all asset classes, as I have 
described. You mentioned auto. I would say home equity is a 
place that because it stands behind first mortgages, takes the 
first loss. We have seen very significant upturns in losses in 
that asset class, and unlike a lot of first mortgages which are 
sold off to third parties, those are pretty much all on the 
balance sheets of the institutions that originate them. We are 
still starting from a very low level of delinquency, so the 
fact that it has gone up is a concern, but not one that we 
would describe as a capital event, more an earnings event.
    But across all these asset classes, whether it is consumer 
or commercial, we are seeing an uptick--and more than an uptick 
in some places--of criticized and classified assets.
    The one thing I would like to emphasize, though--and you 
mentioned this--is institutions have been able to tap the 
capital markets and raise a tremendous amount of capital, and 
they did not do that in the 1980s. Not only did they not start 
with as much capital, but they were not able to access and 
replenish it. And that has been a difference, and a very 
significant, very healthy, difference this time around. And we 
expect to see more of that.
    Chairman Dodd. John Reich, do you have any comment?
    Mr. Reich. I think one of our biggest concerns today is 
housing prices and the growing inventory of housing that is for 
sale, to the point today where there is about an 11-month 
inventory of homes for sale today. The longer that continues to 
be the case, the more downward pressure that puts on housing 
prices today. And that will have an impact on our institutions, 
particularly on--HELOCs have been referred to today, home 
equity lines of credit that stand behind, generally, first 
mortgages. Thrift institutions have about $1.5 trillion in 
total assets. About 7.8 percent of their assets are in home 
equity lines of credit, about $118 billion.
    As I mentioned in my opening statement, we have been 
encouraging them to add to their reserves. A year ago, reserves 
for future loan losses stood at about a half of 1 percent. 
Today they are over 1\1/2\ of 1 percent. They have provisioned 
aggressively in the fourth quarter of last year and the first 
quarter of this year.
    We are seeing some positive signs. Net interest margin is 
showing some sign of improvement. There has actually been some 
improvement in the delinquency ratios for residential mortgages 
in the months of April and May of this year, during the second 
quarter of the year.
    But I am not really wanting to make any predictions either 
as far as what inning we are in or whether we are out of the 
woods. I think our institutions are--I think they have geared 
up. I think we are dealing with a situation as it stands today, 
and I have some degree of optimism. But I would hate to 
characterize that too clearly.
    Chairman Dodd. Ms. Johnson.
    Ms. Johnson. When you consider the charge-offs, the overall 
delinquency rate has ticked up, and the losses as well. But it 
is not an alarming figure. The credit unions are very well 
capitalized, and we feel it is a manageable situation.
    Chairman Dodd. OK. Don.
    Mr. Kohn. I agree with my colleagues, Mr. Chairman. I think 
as John Reich said, the housing market bottom is not here yet. 
Prices are continuing to fall in many localities. I was 
encouraged by Senator Martinez's comments that he was beginning 
to see a little bit of a bottom in Florida. I would like to see 
that in the data as well.
    So house prices are continuing to fall, but it is also the 
case that expected declines in house prices have been built 
into many of the prices of the securities that are driving the 
kinds of write-downs that John Dugan was talking about. So the 
market expects this to happen. They have built it in, and they 
have written down the price of the securities. So to that 
extent, I think both Johns are right.
    Still, as long as the housing market is on a downward path, 
as long as those prices continue to fall, I think there is a 
risk that the losses could continue to mount on a variety of 
loans.
    It is also the case that consumers, with a soft economy, a 
little bit of an increase in the unemployment rate we have seen 
so far--we have seen consumer spendable incomes pinched by 
rising energy prices, and we have seen upticks in problems in 
various consumer loan categories. And it would be surprising if 
that did not continue to rise for a while. Banks need to be 
prepared. I think by and large they are prepared. They are well 
capitalized. They have good capital cushions, and they have 
begun to build their reserves. But I also believe that they can 
use more, particularly against downside risk. So I would 
encourage them to continue the capital-raising path that they 
have been on to protect themselves against the potential that 
things turn out to be worse than people expect.
    Chairman Dodd. Mr. Karsky.
    Mr. Karsky. Thank you, Mr. Chairman. I would say that I 
think for State-chartered banks as a whole, we have come 
through a pretty good economic time where our banks have a 
history of high capital ratios and we have had some good 
periods of earnings. We have some concerns going forward. We 
will not make predictions, but I think our banks are in good 
shape to handle the future crises.
    Speaking for North Dakota, if I have a risk or a concern 
out there, it is just that we do not run into an agricultural 
crisis with overlending on land values and we continue to lend 
on cash-flow. We have learned some pretty valuable lessons from 
the 1980s and 1990s, and as long as we stick to what we have 
learned, I think we are going to be OK. But our land prices 
have gone up substantially, I think, in the Midwest due to 
those high commodity prices. If those commodity prices drop, 
land values are going to drop. If our banks overlend, we are 
going to have some problems.
    Chairman Dodd. Yes. Well, thank you. And I have some 
additional questions. I wanted to get to this discount window 
issue, but I will reserve that until I get around. I went over 
my time, as I promised I would not, with these questions, but 
there are so many panelists here.
    Let me turn to Senator Shelby.
    Senator Shelby. Governor Kohn, I want to pick up on some of 
the areas that Senator Dodd was into. As a lot of the subprime 
loans are reset, which they are being reset now, a lot of 
people in the financial markets are really concerned since this 
will have an impact not only on the price of housing but on the 
whole housing sector and financial sector. How do you see that? 
Is that already priced in? Or can it be priced in by the 
market? Because these are huge amounts of money we are talking 
about.
    Mr. Kohn. I think it is priced in to a certain extent. A 
couple of comments, Senator.
    One is I think because of our monetary policy actions, the 
threat from resets looks less dire than it did a year ago, 
because interest rates have come down, so they are not 
resetting to quite as high a rate as they were before. But they 
are still resetting, and many borrowers will----
    Senator Shelby. But there have got to be still concerns 
there for----
    Mr. Kohn. There are lots of concerns, and the concerns 
actually perhaps are more focused on this price issue, that the 
price of collateral, the price of the houses going down, and 
people are in the so-called negative equity position, and what 
will they do in those situations, and how can we help them stay 
in their homes, prevent foreclosures. I do think that there is 
still mounting stress in the mortgage markets, and foreclosures 
are increasing, and those foreclosures will, as I think 
Chairman Bair said, add to the pressure on prices. So----
    Senator Shelby. Is this more regionalized or is it across 
the board?
    Mr. Kohn. Well, it is true in a lot of places, but it is 
most evident in those areas that had very rapid run-up in 
prices, and so California, Arizona, Nevada, Florida, I think 
were the--but those places are really stretched. They had very 
rapid run-up in prices, and a lot of lending to the full value 
of the collateral, and sometimes beyond that, on the assumption 
that the value of the collateral would rise and bail people out 
of all their problems. And now the collateral is falling very 
markedly.
    The other stretch, geographical stretch of problems is in 
the upper Midwest where the industrial economy is in such bad 
shape.
    Senator Shelby. Ms. Bair, do you agree with his testimony? 
Is that some of your concerns as Chairman of the FDIC?
    Ms. Bair. I do, yes. We continue to be very, very focused 
on the housing market and this self-reinforcing cycle of 
foreclosures putting more pressure on home prices, resulting in 
more defaults and foreclosures.
    I noticed the Mortgage Bankers Association came out with 
their most recent data. I think it just confirms what Don 
indicated. Foreclosures again were up. California, Florida, 
Nevada, and Arizona accounted for 93 percent of the increase in 
foreclosures among subprime ARMs. So particularly with those 
states where there was a big boom, there is a big bust now. We 
are getting into this dynamic where it is not just 
affordability of the mortgage, it is a combination of 
affordability plus being underwater, and at what point do more 
and more borrowers just give up and walk.
    Senator Shelby. Are those the areas that Governor Kohn was 
talking about in the country, are those where you are most 
concerned about bank failures?
    Ms. Bair. Well, that is a very----
    Senator Shelby. Where there is big exposure to real estate?
    Ms. Bair. Some of our more recent closings were banks who 
have done lending in those areas. These banks were not based in 
those states, but they were doing lending in those states. They 
were doing out-of-area lending. So that is another risk factor 
that we are taking a close look at.
    Senator Shelby. What is the value roughly of the FDIC fund 
today?
    Ms. Bair. It is $52.8 billion.
    Senator Shelby. $52 billion----
    Ms. Bair. $52.8 billion.
    Senator Shelby. Billion. And that is a lot of money, but 
considering the risk, you don't know as Chairman if that will 
be adequate down the road, do you?
    Ms. Bair. Well, our target is 1.25, which is where it has 
been for many years. We are at 1.19, as I indicated, and it is 
declining primarily because of deposit growth, but also because 
of increased losses due to bank failures. We do have back-up 
liquidity lines with Treasury. We are guaranteed by the full 
faith and credit of the U.S. Government. So, I think it is very 
important for depositors to understand absolutely the resources 
are there to back all insured deposits.
    But I think we are fine. I think we are, even though there 
is an uptick in resolution activity, the number of failures is 
still low, certainly very low, compared to what was going on 
during the S&L days. So at this point, I think we are well 
prepared to handle it.
    Senator Shelby. Governor Kohn, I want to address another 
question to you, if I could. You are the Vice Chairman of the 
Federal Reserve. Current law, as I understand it, permits only 
entities that qualify as thrift, bank, or financial holding 
companies to exercise control over thrifts and banks. These 
laws were designed to protect the banking sector and have done 
so for about 75 years. At the same time, these restrictions 
limit many non-banking entities from providing capital to the 
banking system.
    In light of the legal reality and the ongoing volatility of 
the financial markets--you are the Vice Chairman of the Fed--do 
you have any questions or concerns about the pool of capital 
available to banks and thrifts in today's markets?
    Mr. Kohn. I think banks and thrifts have done a very good 
job in tapping a variety of capital in today's market, and they 
seem to have found ready sources of capital from a number of 
sources, including private equity, sovereign wealth funds, 
their own shareholders. I think so far there is ample capital 
out there if you are willing to pay for it, and they can do 
that.
    I think the restrictions that Congress has put in place, 
basically in Gramm-Leach-Bliley, trying to separate banking 
from commerce, is what is, I think, underlying your question 
about what kinds of companies----
    Senator Shelby. Absolutely.
    Mr. Kohn [continuing]. Should be allowed to buy banking 
companies. And I think if we broaden this out beyond financial 
holding companies, which we have now, I think that would be a 
very major step. I am not saying it should not necessarily be 
taken, but I think it would require a lot of discussion by the 
Congress as to whether they wanted to cross this boundary which 
they had drawn----
    Senator Shelby. It would be a big change from where we are 
today, would it?
    Mr. Kohn. It would be a huge change from where we are 
today, and I am not sure it is necessary in order to get 
capital.
    Senator Shelby. But you do anticipate some of our banks--I 
know we do--are going to have to seek additional capital to 
meet what you as regulators say they need--is that correct?--
considering the risk.
    Mr. Kohn. I think they do. I do not think it is a risk 
because I think they do, they will be raising capital, and they 
will find that capital----
    Senator Shelby. Well, the capital is to cover the risk, 
isn't it?
    Mr. Kohn. Yes, right. Right, they need the capital to cover 
particularly the downside risk in case things do not go very 
well.
    Senator Shelby. Governor Kohn--and I will address this to 
you and Chairman Bair--since the JPMorgan Chase takeover of 
Bear Stearns, there has been much discussion on the topic of a 
financial institution being too interconnected to fail, in 
addition to the older notion of too big to fail. The extension 
of the Federal Reserve discount window to securities firms, 
unprecedented, has now put Government funds at the disposal of 
these firms for the first time in our history, I believe.
    I have concerns, and other people do, about the processes 
in place should another large and interconnected firm face 
financial troubles, which some people think will happen. How do 
you believe a potential failure at a large and systemically 
important financial institution should be handled going 
forward? Same way you did with Bear Stearns? Which some people 
thought was stretching your legal authority and getting into 
some unknown territory.
    Mr. Kohn. As you know, in order to provide liquidity 
support for that transaction, we, the Federal Reserve Board, 
had to vote that circumstances were unusual and exigent, and we 
did that, I did that readily in the circumstances then 
prevailing. The situation in the second week of March in 
financial markets was very, very stressed and deteriorating 
very badly. There was a flight to liquidity and safety. That 
flight caught Bear Stearns--who was probably the least strong 
of the major investment banks. Our judgment was that had Bear 
Stearns been allowed to walk into bankruptcy court, that would 
have disrupted the financial system and had very serious 
effects on the economy. And we would be--I would--if something 
like this were coming again, I would have to make the same 
kinds of judgments. My judgments are balancing the costs and 
benefits of any action we take----
    Senator Shelby. Continue to bail them out, in other words, 
is that what you are saying?
    Mr. Kohn. I don't know what we would do. We would try to 
maintain the stability of----
    Senator Shelby. But you have set the precedent.
    Mr. Kohn. We would try to maintain the stability of the 
financial system.
    Senator Shelby. But you have set the precedent by Bear 
Stearns.
    Mr. Kohn. I agree.
    Senator Shelby. So some people believe that there are at 
least one or two more houses that if they don't fail, are going 
to come close to it. I hope not.
    Mr. Kohn. I don't want to comment on----
    Senator Shelby. I know that.
    Mr. Kohn [continuing]. The financial stability of these 
houses. I think that the investment banks in general have taken 
lessons from what happened in the first 2 weeks of March. They 
are building their liquidity. They are reducing their leverage. 
They are protecting themselves against downside risk. So I 
think we have a stronger set of investment banks than we had a 
month and a half ago.
    Senator Shelby. You really believe that now? You believe 
that we have a stronger set of investment banks, with all the 
stress and all the exposure, and most of them out looking for 
capital, than we did, say, a year ago? You think they are 
stronger?
    Mr. Kohn. I said ``than a month and a half ago.''
    Senator Shelby. A month and a half ago. All right.
    Mr. Kohn. I think they recognize the risks and they are 
taking steps to deal with the risks in a much more proactive 
way than was occurring before the middle of March.
    Senator Shelby. And a lot of that is because it is 
necessary to survive, is it not?
    Mr. Kohn. That is right. There are very--as we were talking 
about the banking system, the same is true of the investment 
banks. There are a lot of risks out there, much of it priced 
into the market, but not all of it. People are still very 
concerned about the liquidity and safety of where they have 
invested their money, and our major financial institutions need 
to make very sure that they understand the risks, they have got 
liquidity backstops to protect them against some very dire 
circumstances, and they have got adequate capital so that 
people will have no doubt about their viability.
    Senator Shelby. Have you ever seen this much stress in our 
financial system in your lifetime? You haven't, I know. I will 
answer that.
    [Laughter.]
    Senator Shelby. Chairman Bair, the FDIC's bridge bank 
model, should it be employed in areas like this? Do you want to 
comment on that?
    Ms. Bair. Well, I do think it is something Congress should 
consider, and I would hasten to say that we fully support what 
the Fed did with Bear Stearns. They had a very short timeframe, 
and they had no playbook for the situation. I think they were 
very creative in how they dealt with it.
    That said, I think that this does present an issue of lack 
of parity between how commercial banks--insured depository 
institutions that get in trouble--are treated if they are 
systemically significant, versus investment banks. The FDIC, as 
you know, must follow least-cost resolution, and plus make a 
systemic risk determination. Generally that means the bank has 
to be closed. It has to be put out for bid to multiple bidders. 
It means that equity shareholders and general creditors have to 
take full haircuts before we would experience losses in the 
DIF.
    So there are very elaborate procedures. I think they are 
good procedures. But I think Congress should consider whether 
perhaps a similar set of procedures should be established for a 
troubled investment bank situation. We cannot deviate from 
least cost unless a supermajority of my board and the Federal 
Reserve decide that we should deviate from least cost. And, the 
Secretary of the Treasury has to approve it in consultation 
with the President. So it is a fairly elaborate procedure.
    Senator Shelby. If the Chairman will indulge me, I have got 
one other question.
    Hedge funds and private equity firms have become, as all of 
you know, increasingly large participants in many sectors of 
the world economy. As of now, it is my understanding that these 
entities are only allowed to hold non-controlling stakes in 
banks and thrifts.
    Governor Kohn, for the record, what constitutes control for 
each type of financial institution that you regulate? And I 
would also like to ask Chairman Reich this. And would you 
discuss the role you see private equity and hedge funds playing 
as large stakeholders in our financial markets as other 
traditional funding sources may either be strained or 
unavailable? And what are your thoughts about potential changes 
to investment limits on the harmonization of these rules?
    Governor Kohn? I know that is a big question.
    Mr. Kohn. Senator Shelby, I am not familiar with all of the 
specifics of all of our regulations, but let me give you a 
general answer here.
    So you are right, that if you want to control a bank or a 
bank holding company or a financial holding company, you must 
be a financial institution. And furthermore, under the laws 
that you have passed, you must be ready to support the bank, 
the depository institution.
    Senator Shelby. Right.
    Mr. Kohn. You must be a source of strength to that 
institution.
    So any organization that wants to conform to those rules 
that Congress has established is welcome to apply to become a 
financial holding company to own a bank. I think there is an 
upper limit of 24.9 percent in the law of the shares. But even 
below that, obviously you could have a lower stake in a bank--
--
    Senator Shelby. 24 percent could be working control.
    Mr. Kohn. Exactly. Exactly. And so we have put other 
metrics in place to ensure that Congress' intention about who 
controls a financial holding company is in place. So we have 
looked at whether the new equity owners, how many seats do they 
have on the board? What say do they have over the control? Do 
they have over the business strategy of the organization? What 
control do they have over hiring and firing the CEO? So we look 
at a number of metrics of control.
    I think these are things we are looking at all the time. 
There are elements of flexibility there and we have those under 
continuous consideration because, like you, we share the desire 
to have as much capital as possible in this----
    Senator Shelby. Chairman Reich, quickly.
    Chairman Dodd. Very quickly.
    Senator Shelby. The Chairman has been very indulgent.
    Chairman Dodd. I know, but I have other members here.
    Mr. Reich. We have two primary metrics that are involved 
here. One is 9.9 percent. If a private equity fund were to have 
9.9 or greater percent, they would have to rebut a presumption 
of control. And 24.9 percent, also the same as the Federal 
Reserve.
    We have had a number of conversations with private equity 
funds in the last several months. They have shown increasing 
interest in financial services. Most of them do not want to 
make an investment that would put them in the category of being 
a financial services holding company.
    Senator Shelby. Thank you.
    Chairman Dodd. Thank you very much.
    And let me just quickly say and move along to other 
members, I happen to be in support of what the Fed did with the 
Bear Stearns JPMorgan Chase issue. I have questions about why 
we did not do something earlier, maybe to avoid the issue. But 
I think, given the time and framework, it was the right thing 
to have done. And I think it is appropriate that there is an 
improvement, in my view, that things have improved since a 
month-and-a-half ago.
    And there are some additional questions I want to address 
on why it happened the way it did and what steps are being 
taken to make sure that those that are accessing that window 
are fulfilling some of these requirements. But we will get to 
that when I get back to my questioning.
    Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman.
    Governor Kohn, I mentioned in my opening statements, both 
Ambac and MBIA have been placed on a watch list by Moody's. Do 
you have a general notion of how much exposure that they are 
insuring against? Is this in the trillions of dollars?
    Mr. Kohn. I do not know the dollar amounts that they are 
insuring against.
    Senator Reed. But it is significant?
    Mr. Kohn. It is significant. That is correct. And many 
banks have bought insurance from these institutions. I think, 
in many cases, the banks have written down the value of the 
insurance that they have bought from them. So they have been 
anticipating this weakness.
    Senator Reed. Let me--specifically with the Fed, the 
collateral that you assumed in the Bear Stearns, to what extent 
are those products enhanced by insurance? And to what extend 
that you have to take similar steps? Do you have a notion about 
that?
    Mr. Kohn. I do not know to what extent the financial 
guarantors are involved. I do know that, for the most part, as 
was in the appendix to President Geithner's testimony, for the 
most part, these are mortgage, mortgage-related assets. They do 
have some hedges on them, which we are also taking. But I do 
not know the specifics of whether any of this is guaranteed by 
the financial guarantors.
    Senator Reed. It goes, I think, to the line of questioning 
that Senator Shelby was addressing, this interrelatedness which 
pops up in so many different ways, not so much--in this case, 
it is an insurance entity that insures some of these financial 
instruments that banks are holding as capital, that could 
become problematic.
    Mr. Kohn. I think that is an excellent point. So banks 
thought they had protection against a risk in the mortgage 
markets, in the housing markets. But the people they were 
buying the protection from themselves had a big exposure in 
those housing markets so their protection was worth less than 
they thought.
    Senator Reed. And this goes beyond just the mortgage part 
now because credit defaults swamps, collateralized obligations, 
credit cards, home loans, car loans, et cetera.
    Mr. Kohn. Right.
    Senator Reed. Let me ask Chairman Bair, in your capital 
discussions, which you say is adequate, are there instruments 
like this in that capital that you have been discussing with 
financial institutions about downgrading? Are you concerned 
about this issue that Governor Kohn illustrated?
    Ms. Bair. Yes, we are watching it very carefully. I think 
you need to separate their guarantee function on the structured 
financing versus their muni bond business. I think the muni 
bonds are safe with or without insurance. But there is bank 
exposure there, as well, particularly with the smaller banks.
    A lot of these instruments have been written down 
significantly already. It is difficult to gauge what the impact 
would be, whatever the future Ambac and MBIA ratings may be. 
The best we can do is closely monitor it, especially individual 
institutions that have significant exposure or are relying on 
the existence of insurance to not take a write-down. That is 
something that needs to be vigorously addressed on an 
institution-by-institution basis.
    Senator Reed. Mr. Dugan, please.
    Mr. Dugan. Yes, most of these exposures are by the large 
national banks that we regulate and they have to reserve 
against the likelihood or unlikelihood that the protection that 
they have bought would not be there when they needed it and 
make an adjustment accordingly. We monitor that quite closely.
    What Governor Kohn said about it is absolutely right, it 
turned out to be not as much protection as they thought they 
had. But in terms of national banks accounting for that in an 
appropriate way so that it shows up on their balance sheet, we 
absolutely monitor that.
    Senator Reed. Are you as satisfied of the structure that 
they are adequately monitoring for that and reserving for that 
risk?
    Mr. Dugan. Yes, but that is not the same as saying that the 
risk could not increase over time and might result in 
additional losses. I think they are accurately capturing what 
the risk is.
    Senator Reed. Mr. Reich, your comments?
    Mr. Reich. I believe that there is not serious exposure in 
the thrift industry here.
    Senator Reed. Thank you.
    Ms. Johnson, the same thing with respect to the credit 
union industry, not a serious exposure?
    Ms. Johnson. That would be accurate, there are not 
significant volumes.
    Senator Reed. Let me turn quickly, Chairman Bair, to 
another issue. And that is the issue of credit card 
delinquencies, which significantly are becoming, I think, very 
problematic. Not only delinquencies, but defaults and also 
bankruptcy filings in which the individual borrower is now 
essentially writing off the entire credit card debt, or at 
least the companies are until they can recover it through legal 
proceedings.
    Is this a significant issue that you are watching?
    Ms. Bair. Yes, credit card delinquencies are up. They are 
still relatively low but they are going up. As you indicated 
earlier, we are learning there is a clear interrelationship 
between mortgage distress and a consumer's ability to meet 
other types of consumer debt obligations, including credit 
cards.
    So we are watching it carefully. It is going up. It is 
still relatively low but it is an area of increased concern.
    And, because this is unsecured credit, the charge-offs come 
much more quickly than they would with other types of secured 
lending.
    Senator Reed. Mr. Dugan, please.
    Mr. Dugan. Yes, the national banks have about roughly about 
80 percent of the credit card market. And if you look at an 
average charge-off rate, it is about 5.5 percent over time.
    Frankly, it has been a little lower going into this and 
below that than we would have seen by this point. As Sheila 
just said, it has ticked up to that level. I think credit card 
providers have been more aggressive about managing credit lines 
and that kind of risk, and we are still at that average. It is 
not like what we are seeing in some of the other portfolios 
like home equity where the losses are way higher than 
historical averages. Here we come back up to historical 
averages, where the trend line is going up. Particularly in 
areas of the country where we have had bad housing market 
situations, we are seeing it even higher.
    Senator Reed. Thank you. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator Reed.
    Senator Allard.
    Senator Allard. Mr. Chairman, I just have one question for 
each member of the panel. I guess you could take 20 minutes to 
answer it, but I have got 5 minutes of time.
    My question is this: in regard to the recent events in the 
markets, from your perspective, would you comment on those 
areas you think where adequacy has done well and areas where 
you think there has been some shortfalls in our current system? 
And maybe comment a little bit about Secretary Paulson's fairly 
substantial reform for the Federal Reserve and banking 
regulatory systems?
    Ms. Bair. I think our strong supervisory function and 
strong capital standards have served us well going into this. I 
think where we did not do as well as we should have was with 
monitoring underwriting standards. We let it get out of 
control. It was being driven heavily by the non-bank sector, 
but banks were involved, too.
    So I think we need to get back--and we are getting back--to 
basics with banks and our supervisors, making sure people make 
responsibly underwritten loans.
    Senator Allard. Do you need legislation to deal with the 
underwriting?
    Ms. Bair. Well, I think there was a lot of regulatory 
arbitrage going on, and there are different ways to address it. 
But one of the aspects of the Paulson plan would be to create a 
prudential supervisor and a business conduct regulator for all 
financial institutions, so we do not have this more Balkanized 
system that we have now, yes.
    Mr. Dugan. I agree that the underwriting standards, in the 
subprime market in particular, declined obviously dramatically. 
But I think we did have a problem of uneven regulation. And I 
think the problems were way more pronounced outside of the 
insured depository institution framework. We need to have a 
system that evens out that regulation, so that basically the 
same rules apply to anybody who originates a mortgage loan. We 
do not really have that now. We have made progress toward that 
goal, but we do not have that. And that is a single area where 
I think we need to improve.
    Secondly, I agree that we had good capital coming into 
recent events. I think that is a positive sign. I think we, and 
everyone, relied too heavily on high credit ratings from the 
credit rating agencies. And I think that that created a false 
sense of security, both for institutions and for regulators. 
There is a lot of work being done now to examine that and 
reexamine not only what rules should apply to get those 
ratings, but also how much regulators should rely on them in 
the first instance. And I think this is very much worthy of 
review.
    Mr. Reich. I agree with Comptroller Dugan. It is a cliche 
to say that we have had an unlevel playing field with regard to 
supervision, but it is true. And it is gaps in supervision that 
really initiated the problems that escalated to a broader area 
in our portfolios.
    I think everyone agrees that housing and mortgage finance 
are major components of our economy that need continuing 
attention. And we need even level supervision among those 
areas. And I addressed in my opening statement that I thought 
that the Office of Thrift Supervision could be a part of the 
solution in leveling the playing field in that regard.
    Ms. Johnson. Thank you. Yes, I believe that the early 
vigilance and the early guidance that NCUA provided to the 
credit unions, particularly in these lending areas, have 
certainly paid off, in addition to the robust exams that we 
performed.
    We also have--credit unions are limited with more narrowly 
drawn investment opportunities and they have not been involved 
in most of this type--this part of the market.
    As far as the Treasury proposal, I believe that there is 
strong evidence that there is a need for an independent 
regulator for credit unions because of the nuances of the 
difference between the not-for-profit cooperatives and the 
banking sector. And I think the success that we have had during 
this time of turbulence stands to support that.
    Senator Allard. Yes.
    Mr. Kohn. I think the successes include the fact that we 
came into this with a very, very well capitalized banking 
system, so that the shock--which has been tremendous, as 
Senator Shelby was saying--has increased failures, it has 
caused a lot of stress. But in the commercial banking system 
and in the thrift system, I think the amount of fallout, while 
substantial, is certainly less than it would have been if we 
had entered this situation with much less robust capital.
    So I think the system learned a lot in the early 1990s and 
it has made it more robust in the mid-2000s.
    I think another thing that has worked reasonably well is--
--
    Chairman Dodd. Mr. Kohn, excuse me, if I can, just a 
moment.
    We have been--I wanted to complete this, if I could, but we 
have been notified that there is an objection been filed on the 
floor of the Senate to any committees meeting. I do not know 
what levity or discretion I have here to continue and finish 
the line of questioning, but I think under the rules of the 
Senate if an objection is filed, then you cannot continue to 
meet. I regret that deeply, this is a very important hearing.
    I apologize to our colleagues who have been here all 
morning waiting to ask questions. So we will leave the record 
open for the questions. But under the rules of the Senate, I 
think I am obligated to terminate the hearing. And I regret 
having to do that.
    Senator Allard. Those of you who did not answer my 
question, maybe you can get a written answer.
    Chairman Dodd. We will get a written statement for you. And 
any other questions we will have submitted and ask you to 
respond to our colleagues.
    But this Committee stands adjourned.
    [Whereupon, at 11:48 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]

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RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM SHEILA C. 
                              BAIR

    There was an article in the June 4, 2008, Financial Times 
that said banks could be forced to bring up to 5 trillion of 
assets currently held off their books onto their balance 
sheets. This raises many questions, but I will start with 
three.
Q.1. First, in the current markets can the banks raise the 
capital they need to hold against these assets?

A.1. The June 4, 2008 Financial Times article addresses 
lingering concerns with off-balance sheet exposures. Firms have 
used loopholes in off-balance sheet accounting for years in 
order to enhance their financial statements without shedding 
risk. Capital and accounting rules need to reflect the economic 
reality of the transactions that our large financial 
institutions engage in on a daily basis.
    Financial institutions have shown a remarkable ability to 
raise capital even in this stressed market, which I view as a 
positive reflection on the long-term prospects for the U.S. 
banking system. Bloomberg reports that the ten U.S. bank 
holding companies with the largest write-downs and credit 
losses since second quarter 2007 raised $114.5 billion in 
capital during this same time period. This amount more than 
offsets the $100.2 billion in write-downs and losses that these 
institutions reported. To shore up their capital bases, 
institutions have reduced and in some cases eliminated cash 
dividends and have raised common stock and preferred shares 
from a wide range of sources.
    While their ability to continue to access the capital 
markets for funding is not assured, institutions have taken the 
right steps to adequately plan for their capital needs. 
However, several market participants have indicated that 
continued losses are expected as we work through the credit 
market turmoil, which could place additional pressure on bank 
capital levels.
    We are continuing to evaluate the potential impact of any 
FASB action on off-balance sheet accounting on regulatory 
capital and on the securitization business in general, and will 
be in a better position to consider changes once the FASB 
proposals are issued for public comment.

Q.2. Second, since you are their regulators, do you know and 
have you known all along what those assets are?

A.2. U.S. regulators have three important tools at our disposal 
for identifying and evaluating the risk present in bank 
operations: on-site examination, off-site surveillance, and 
public disclosures. While these tools provide us with a 
significant amount of information necessary to assess the 
safety and soundness of our banks, the financial innovations 
that have transpired over the past several years have made it 
more difficult to fully understand the risks present in off-
balance sheet structures such as securitized investment 
vehicles (SIVs) and collateralized debt obligations (CDOs). 
These vehicles were used to transfer a wide variety of 
exposures to investors without a sufficient degree of 
transparency and disclosures. However, the opacity in these 
structures served to exacerbate problems since investors and, 
in some instances, regulators were not able to quickly identify 
the assets placed in these vehicles.
    The work underway in the Basel Committee to improve the 
disclosures governing off-balance sheet vehicles should address 
many of these concerns. In addition, I have been a strong 
advocate of requiring banks that invest and manage 
securitization exposures to fully understand the risk 
characteristics present in the securitization vehicles and the 
underlying collateral supporting these structures before they 
can take any capital relief from external ratings. These are 
bare minimum due diligence standards that serve as the 
foundation of prudent investment management.

Q.3. And third, why were they allowed to move trillions of 
dollars of what turned out to be the riskiest assets off their 
books to avoid capital charges?

A.3. The accounting and capital rules have provided banks with 
the ability and incentive to remove assets from their balance 
sheet. I believe that the accounting standards and the capital 
rules need to be reassessed in order to ensure that they 
provide the right incentives for managing risks at our largest 
financial institutions. Securitization in general has provided 
several benefits to the financial markets--it has enhanced 
credit availability and has provided market participants with 
another asset class in which to invest. At the same time, the 
off-balance sheet rules were abused in some cases. I am pleased 
to see that the Financial Accounting Standards Board is 
reviewing their off-balance sheet accounting standards with an 
eye towards eliminating any loopholes. The Basel Committee and 
U.S. regulators need to consider these issues as well in 
conjunction with any revisions to our capital rules.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOLE
                      FROM SHEILA C. BAIR

Q.1. In March, the Attorney General of New York, OFHEO, and the 
GSE's entered into an agreement creating new appraiser 
requirements that are inconsistent with existing practices. 
Last month, I introduced an amendment to the Federal Housing 
Finance Regulatory Reform Act of 2008 that would require the 
Director of OFHEO to issue a regulation establishing appraisal 
standards for mortgages purchased or guaranteed by Fannie and 
Freddie. It would establish a common set of appraisal standards 
governing mortgage lenders that are federally supervised and 
regulated. In your opinion, would this amendment strengthen the 
appraisal standards of federally regulated mortgages?

A.1. The New York Attorney General, Fannie Mae, Freddie Mac, 
and the Office of Federal Housing Enterprise Oversight (OFHEO) 
have proposed a Home Valuation Code of Conduct that would 
overlay the long-standing set of federal banking agency 
appraisal regulations and Uniform Standards of Professional 
Appraisal Practice (USPAP) guidelines. The FDIC provided a 
comment to OFHEO on the proposal on June 20, 2008, which is 
attached. Our comment letter strongly supports the concept of 
appraiser independence and USPAP standards, but articulates our 
belief that the use of in-house or affiliated appraisers may be 
appropriate if managed prudently.
    The Dole amendment would direct OFHEO to devise appraisal 
rules for mortgages purchased or guaranteed by government-
sponsored enterprises in a way that is consistent with 
appraisal regulations issued by the federal banking agencies. 
This would have the advantage of establishing a common set of 
appraisal standards for insured depository institutions and 
other mortgage lenders nationwide. As indicated in our comment 
letter, the FDIC supports an interagency rulemaking process to 
establish comprehensive appraisal and appraiser standards.


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 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM JOHN C. 
                             DUGAN

Q.1. There was an article in the June 4, 2008, Financial Times 
that said banks could be forced to bring up to 5 trillion 
dollars of assets currently held off their books onto their 
balance sheets. This raises many questions, but I will start 
with three. First, in the current markets can the banks raise 
the capital they need to hold against these assets?

A.1. The accounting changes referenced in the article relate to 
work of the Financial Accounting Standards Board (FASB) to 
revise two accounting pronouncements. One is FAS 140, 
Accounting for Transfers and Servicing of Financial Assets and 
Extinguishments of Liabilities, which is the primary accounting 
standard for securitization transactions. The other is FIN 
46(R), Consolidation of Variable Interest Entities, which is 
the primary accounting guidance for the consolidation of 
special purpose entities. FIN 46(R) often affects whether banks 
have to consolidate asset-backed commercial paper conduit 
programs including structured investment vehicles. While 
proceeding separately, the International Accounting Standards 
Board (IASB) is also undertaking work to enhance the accounting 
and disclosure standards for off-balance sheet entities.
    While the article you cited claims that $5 trillion could 
be brought onto bank balance sheets as a result of FASB's 
actions, the precise amount is difficult to gauge. A major 
reason for the uncertainty is that the proposed accounting 
changes have yet to be fully articulated and subjected to 
public comment. We understand that the FASB intends to issue 
the proposed FAS 140 and FIN 46(R) amendments contemporaneously 
in the coming weeks, for formal public comment prior to a final 
standard being released and becoming effective. While we do not 
know for certain which current off-balance sheet entities would 
be consolidated under revised accounting standards, many people 
following the FASB project believe that certain structured 
finance entities (e.g., ABCP conduits) and revolving 
securitization trusts (e.g., credit card receivables) will be 
required to be consolidated by the sponsoring entities. It is 
less certain whether securitized residential mortgages and 
money market funds would be affected significantly by the 
proposal.
    In relation to your first question, while investors have 
shown strong willingness to provide capital to U.S. banks, a 
change in generally accepted accounting principles (GAAP) that 
would add a large amount of assets onto bank balance sheets and 
a related increase in the need for regulatory capital would 
place additional strain on the banking system. As I noted in my 
written testimony, the OCC believes policy makers and 
accounting standard setters need to carefully evaluate how 
these proposed accounting changes may affect markets and 
institutions and ensure that appropriate transition periods are 
provided if significant changes are adopted. Specifically, we 
believe any effective date and transition period should provide 
time for financial institutions to review their existing 
transactions and respond to the final FAS 140 and FIN 46(R) 
amendments. This would allow U.S. banks an opportunity to raise 
capital, shed assets, or make other adjustments to their 
balance sheets to prepare for the influx of off-balance sheet 
exposures. Moreover, enhanced coordination between FASB and 
IASB could minimize international competitive issues resulting 
from differing accounting standards governing these activities.
    We are considering the extent to which these accounting 
changes should flow through to regulatory capital requirements, 
which would also affect whether banks need to raise more 
capital. As is discussed in more detail below, our regulatory 
capital rules already require capital against many off-balance 
sheet exposures. Once the details of the proposed accounting 
changes are available, we will evaluate how our capital 
requirements might need to be altered.

Q.2. Second, since you are their regulators, do you know and 
have you known all along what those assets are?

A.2. As touched on above, off-balance sheet exposures that 
might be affected by the accounting changes include a wide 
array of assets, including residential mortgage loans, auto 
loans, and credit card receivables that have been sold through 
securitization transactions. The accounting changes might also 
affect asset-backed commercial paper programs used by banks to 
provide financing to bank customers for assets such as trade 
receivables. As part of our supervisory process, we are 
actively engaged in evaluating our banks' activities and risk 
exposures, including an in-depth understanding of bank 
exposures not shown on the balance sheet.

Q.3. And third, why were they allowed to move trillions of 
dollars of what turned out to be the riskiest assets off their 
books to avoid capital charges?

A.3. It is important to note that the assets that might be 
brought onto bank balance sheets if accounting changes are 
enacted can often be of relatively high credit quality. The 
fact that assets are off-balance sheet does not imply that 
those assets are riskier than assets kept on the balance sheet. 
For example, credit card receivables and prime mortgage loans 
that have been securitized and sold to third-party investors 
generally do not appear on bank balance sheets but could be 
brought on as a result of accounting changes. Although the loss 
rates on these types of exposures are increasing due to the 
effects of the housing and economic downturn, we do not expect 
the losses to approach those experienced in the collateralized 
debt obligation (CDO) market. Similarly, we anticipate that 
loss rates for home equity loans, which typically are not 
securitized, will be substantially higher than loss rates for 
securitized prime mortgages.
    The ability to move assets off the balance sheet is 
dictated by GAAP, which are governed in the United States by 
FASB. While the regulatory capital rules build off of the 
accounting framework, bank regulatory capital requirements take 
into account exposures beyond just the assets appearing on the 
balance sheet. In particular, the agencies' risk-based capital 
rules include charges for off-balance sheet risks. These risk-
based capital requirements attempt to look at the economic 
risks of a given transaction, as opposed to being driven solely 
by the accounting decision of whether the assets can be removed 
from the balance sheet. For example, unfunded portions of 
liquidity facilities, as well as credit guarantees that banks 
provide to asset-backed commercial paper programs, are 
generally off-balance sheet, but they are captured under the 
risk-based capital rules.
    With that said, the banking agencies readily acknowledge 
that our existing regulatory capital rules warrant review and 
enhancement. Recent events have revealed some shortcomings in 
our capital rules, and we are considering changes to these 
rules to better reflect risks. One of the motivations of 
developing the recently finalized Basel II-based capital rules 
was to further enhance risk sensitivity of the regulatory 
capital framework. We believe that, once implemented, the Basel 
II-based rules will better reflect risks--both on and off the 
balance sheet.
    Furthermore, we have not stopped considering how to improve 
the rules with the adoption of Basel II. Recent events have led 
the Basel Committee on Banking Supervision to examine making 
refinements to various aspects of the securitization framework 
of the international Basel II Accord. Changes to the Accord 
could affect the minimum regulatory capital required for off-
balance sheet exposures, such as bank exposures to asset-backed 
commercial paper conduits. Changes could also affect on-balance 
sheet exposures, such as certain CDOs and other structured 
finance transactions that have contributed significantly to 
large losses at banks in recent months. We will consider the 
changes to the Accord developed by the Basel Committee for 
adoption by U.S. banks through our notice and comment process.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOLE
                       FROM JOHN C. DUGAN

Q.1. In March, the Attorney General of New York, OFHEO, and the 
GSE's entered into an agreement creating new appraiser 
requirements that are inconsistent with existing practices. 
Last month, I introduced an amendment to the Federal Housing 
Finance Regulatory Reform Act of 2008 that would require the 
Director of OFHEO to issue a regulation establishing appraisal 
standards for mortgages purchased or guaranteed by Fannie and 
Freddie. It would establish a common set of appraisal standards 
governing mortgage lenders that are federally supervised and 
regulated. In your opinion, would this amendment strengthen the 
appraisal standards of federally regulated mortgages?

A.1. As we understood Senator Dole's amendment, it would 
require the Director of OFHEO to issue a final regulation 
establishing appraisal standards for mortgages purchased or 
guaranteed by Fannie Mae and Freddie Mac. In doing so, the 
Director would be required to ensure that the regulation is 
consistent and does not conflict with the regulations and 
guidelines issued by the Federal banking agencies and the NCUA. 
Finally, the regulation would supersede the terms of ``any 
agreement relating to appraisal standards'' (including the 
agreement with the New York Attorney General (NYAG) referred to 
in this question) to the extent of any inconsistency between 
the regulation and any such agreement. The Director would have 
the authority to determine whether or not such an inconsistency 
exists. (``Consistent'' provisions of any such agreement would 
not take effect until one year after issuance of the Director's 
final regulation.)
    In the opinion of the OCC, Senator Dole's amendment would 
further the crucial objective of ensuring that appraisal 
standards applicable to the GSEs do not run counter to the 
standards that already have been established by the Federal 
banking agencies and the NCUA to implement the framework for 
appraisal regulation that Congress provided in the Financial 
Institutions Reform, Recovery and Enforcement Act (FIRREA). The 
FIRREA appraisal provisions provided the foundation upon which 
an extensive regulatory scheme for appraisal standards and 
oversight for appraisers and depository institutions has been 
built. The imposition of new and inconsistent standards on 
mortgages purchased by the GSEs is unnecessary and could add 
additional, unwarranted impediments to the availability of 
mortgage credit and an unnecessary new and potentially 
disruptive factor in the mortgage marketplace. In two recent 
letters to the Director of OFHEO, the OCC has described its 
serious concerns in these respects.\1\ If enacted, the Dole 
amendment would prevent these problems. The OCC supports that 
result.
---------------------------------------------------------------------------
    \1\ See Letter from John C. Dugan to James B. Lockhart III (May 27, 
2008) (OCC Letter); Letter from Randall S. Kroszner, John C. Dugan, 
John M. Reich, and JoAnn M. Johnson to James B. Lockhart III (June 19, 
2008) (Interagency Letter).
---------------------------------------------------------------------------
    Two modifications to the Dole amendment would further 
promote consistency in the appraisal standards that apply to 
federally supervised lenders and to the GSEs. (1) The Director 
of OFHEO should be required to consult with the Federal banking 
agencies and the NCUA in two instances to ensure such 
consistency: first, consultation should occur prior to the 
Director's promulgation of the regulation required by the 
amendment; second, consultation should occur when the Director 
determines whether there is inconsistency between the 
regulation and any agreement relating to appraisal standards. 
(2) The provision at the end of the amendment that makes 
``consistent'' agreement provisions effective one year after 
the Director issues the regulation can be eliminated. To the 
extent the OFHEO regulation is ``consistent'' with an 
agreement, it would be unnecessary for the agreement to 
continue in effect at all.
                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM JOHN M. 
                             REICH

Q.1. There was an article in the June 4, 2008, Financial Times 
(attached) that said banks could be forced to bring up to 5 
trillion dollars of assets currently held off their books onto 
their balance sheets. This raises many questions, but I will 
start with three. First, in the current markets can the banks 
raise the capital they need to hold against these assets? 
Second, since you are their regulators, do you know and have 
you known all along what those assets are? And third, why were 
they allowed to move trillions of dollars of what turned out to 
be the riskiest assets off their books to avoid capital 
charges?

A.1. The Financial Times article was referring to structured 
investment vehicles (SIVs). SIVs were primarily an off-balance 
sheet financing tool or arrangement used by large money center 
banks.
    Typically a large bank utilizing a SIV would also provide a 
line of credit to the investor/lender that was used to help 
guarantee the credit rating of the underlying collateral. Only 
the largest banks have both the wherewithal and credit rating 
necessary to provide these guarantees that would be acceptable 
to investors/lenders.
    Thrifts did not utilize this type of financing.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOLE
                       FROM JOHN M. REICH

Q.1. In March, the Attorney General of New York, OFHEO, and the 
GSE's entered into an agreement creating new appraiser 
requirements that are inconsistent with existing practices. 
Last month, I introduced an amendment to the Federal Housing 
Finance Regulatory Reform Act of 2008 that would require the 
Director of OFHEO to issue a regulation establishing appraisal 
standards for mortgages purchased or guaranteed by Fannie and 
Freddie. It would establish a common set of appraisal standards 
governing mortgage lenders that are federally supervised and 
regulated. In your opinion, would this amendment strengthen the 
appraisal standards of federally regulated mortgages?

A.1. The Office of Thrift Supervision (OTS) welcomes 
congressional efforts to promote quality appraisals and 
appraiser independence for secondary mortgage market 
transactions. OTS is very interested in this amendment because 
of the potential effect of any new appraisal requirements on 
federal housing and mortgage markets and the institutions we 
regulate. OTS supervises an industry whose primary activity is 
mortgage lending.
    We support requiring, among other provisions, that the 
Office of Federal Housing Enterprise Oversight (OFHEO) issue a 
regulation establishing appraisal standards for mortgage 
transactions that are guaranteed or purchased by the Federal 
Home Loan Mortgage Corporation or Federal National Mortgage 
Association (collectively, the GSEs). This provision would 
ensure that appraisal requirements adopted by the GSEs are 
established through a process that follows procedural and other 
laws applicable to a federal agency rulemaking.
    This open and public process would provide federally 
regulated institutions and other interested parties the 
opportunity to provide meaningful input and to question the 
assumptions upon which proposed requirements are based. In 
contrast, the requirements imposed by the Home Valuation Code 
of Conduct and the Home Valuation Protection Program and 
Cooperation Agreements (the Code and Agreements), as executed 
by OFHEO, the Attorney General of the State of New York (NYAG), 
and the GSEs, are not the result of a federal agency 
rulemaking. In our view, the Code and Agreements are the 
products of a flawed process that would implement sweeping 
changes in the industry without adequate notice and public 
comment.
    More importantly, we are very concerned that certain 
requirements imposed by the Code and Agreements would 
unnecessarily undermine the safe and sound extension of credit, 
reduce the availability of mortgage credit to many consumers, 
and ultimately lead to less reliability and accuracy in 
appraisals as explained in our attached correspondence.\1\ Such 
requirements would conflict with the existing regulatory 
framework for appraisal standards and appraiser oversight that 
implements the Financial Institutions Reform Recovery and 
Enforcement Act of 1989 and other legislation. To address these 
concerns, the amendment ensures that OFHEO's appraisal 
regulation would supersede any agreement entered into by OFHEO 
or the GSEs to the extent that any such agreement is 
inconsistent with the regulation.
---------------------------------------------------------------------------
    \1\ OTS issued the attached comment letters concerning the legal 
and policy issues presented by the Code and Agreements. See letter 
dated April 30, 2008, from T. Ward, Deputy Director for OTS, and the 
joint letter dated June 19, 2008 from Randall Krozner, Governor, Board 
of Governors of the Federal Reserve System, John M. Reich, Director for 
OTS, John C. Dugan, Comptroller of the Currency, and JoAnn M. Johnson, 
Chairman for the National Credit Union Administration.
---------------------------------------------------------------------------
    Finally, the amendment directs OFHEO to issue an appraisal 
regulation that (i) would be consistent with appraisal 
regulations and guidelines issued by OTS and other federal 
banking agencies, including regulations related to the 
independence and accuracy of appraisals and (ii) would not 
conflict with any other banking regulations. While we support 
this provision, it is important that OFHEO's appraisal 
regulation not create unnecessary regulatory burden for 
federally regulated institutions or otherwise adversely affect 
mortgage credit availability. Our concern is that a new set of 
appraisal requirements could be ``consistent'' and yet impose 
additional standards already addressed by our current 
regulations. If this were to occur, we would address the 
specific requirement with OFHEO well in advance of a final 
regulation.

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 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CORKER FROM JOHN M. 
                             REICH

Q.1. In an earlier hearing in front of this committee, an OTS 
plan was outlined which would have created negative equity 
certificates for 2nd lienholders in refinancing troubled or 
underwater mortgages. This was of particular interest to me 
because I believed that the incentive for 2nd lienholders to 
work out their obligations with servicers and borrowers was not 
there if they would be required to forfeit the entire lien at a 
loss. However, I am told, that this would actually have cost 
the U.S. government and the taxpayers a great deal more than 
the plan we recently passed out of committee because the uptake 
would have been higher. I am also told that we will have a 
better picture of what our housing situation looks like in 
September when we are able to see how much of the inventory was 
``cleared'' during the typically busy spring and summer months. 
In the state foreclosure working group report that was just 
released on seriously delinquent loans, it indicates that 2nd 
liens are a growing problem and a tremendous obstacle in 
getting servicers to do what needs to be done in refinancing. 
Do you think that the Banking Committee's passed legislation 
strikes the right balance between market based solutions and 
government intervention in this unprecedented housing 
situation?

A.1. The OTS proposal includes the idea of creating a 
certificate in which the borrower, servicer and perhaps the 
second lien holder may be entitled to some percentage 
ownership. This proposal is based on our belief that the 
servicer needs an incentive to aggressively seek modifications 
of troubled loans. The cost of a loan modification can run as 
high as $500 per loan and takes considerable time to negotiate. 
The negative equity certificate gives the servicer some 
potential upside in a loan modification, should there be any 
proceeds available from the eventual sale of the home. By 
offering a percentage ownership of the certificate to the 
homeowner, it is our hope that this will give the owner an 
incentive to maintain the home and seek to get the highest 
price for the home in a sale. Finally, if desired, the second 
lien holder may be offered a share of the certificate to 
provide an incentive for the holder to agree to the loan 
modification. We too, understand that second lien holders may 
stand in the way of a modification and may require an incentive 
to consent to a modification.
    The Committee's legislation addresses many issues that 
plague our housing market and we believe many participants will 
take the necessary measures to do their part to correct the 
problem. However, voluntary efforts to address troubled loans 
may delay the necessary and immediate action required to help 
these homeowners stay in their homes. We continue to believe 
that an incentive for those most intimately involved to execute 
the modification will expedite the process and help move the 
U.S. housing market back to health.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOLE
                       FROM JOANN JOHNSON

Q.1. In March, the Attorney General of New York, OFHEO, and the 
GSE's entered into an agreement creating new appraiser 
requirements that are inconsistent with existing practices. 
Last month, I introduced an amendment to the Federal Housing 
Finance Regulatory Reform Act of 2008 that would require the 
Director of OFHEO to issue a regulation establishing appraisal 
standards for mortgages purchased or guaranteed by Fannie and 
Freddie. It would establish a common set of appraisal standards 
governing mortgage lenders that are federally supervised and 
regulated. In your opinion, would this amendment strengthen the 
appraisal standards of federally regulated mortgages?

A.1. Senator Dole's proposed amendment to the Federal Housing 
Finance Regulatory Reform Act of 2008 would strengthen the 
standards used for federally regulated mortgages in that it 
would supersede the agreement the government sponsored 
enterprises (GSEs) entered into with the Office of Federal 
Housing Enterprise Oversight (OFHEO) and the New York State 
Attorney General. As a result, Senator Dole's amendment would 
avert the unintended consequences stemming from the agreement.
    As currently drafted, by virtue of the agreement, lenders 
desiring to sell mortgages to the GSEs after December 31, 2008 
must comply with appraisal standards that are not entirely 
consistent with existing federal regulations. If the agreement 
between the New York State Attorney General, OFHEO, and the 
GSEs goes into effect, lenders face an unfortunate choice of 
either incurring excessive costs to comply with the agreement 
or losing a significant source of liquidity by discontinuing 
their relationships with the GSEs.
    While the goals of the agreement may be laudable, it unduly 
emphasizes structural issues, as opposed to internal controls, 
without the support of essential and important empirical data. 
Moreover, the provisions of the agreement, which affect all 
lenders selling to the GSEs, were not put into place through an 
appropriate rulemaking process.
    In contrast, the existing federal regulatory structure for 
appraisals was developed over time and encompasses public 
comments that considered the views of all stakeholders. 
Existing guidance also provides appropriate deference to agency 
supervision of individual lenders and sound risk management 
practices.
    Senator Dole's proposed amendment would improve standards 
by restoring the credibility of the existing federal regulatory 
structure and superseding any prior agreements OFHEO and the 
GSEs have entered into that contradict existing federal 
standards and regulations. Moreover, Senator Dole's proposed 
amendment would require OFHEO to consult with appropriate FFIEC 
regulators to ensure any future regulations affecting the GSEs 
are consistent with federal regulations and guidelines.
                                ------                                


RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM DONALD L. 
                              KOHN

    There was an article in the June 4, 2008, Financial Times 
that said banks could be forced to bring up to 5 trillion 
dollars of assets currently held off their books onto their 
balance sheets. This raises many questions, but I will start 
with three.
Q.1.a. First, in the current markets can the banks raise the 
capital they need to hold against these assets?

A.1.a. The Financial Accounting Standards Board (FASB) has not 
yet made public the proposed changes to accounting standards 
that would require consolidation of certain off-balance sheet 
securitization exposures; however, it is expected that the 
initial proposal would be subject to a period of public 
comment. It is difficult to estimate with any degree of 
certainty which structures would be consolidated and the 
associated impact on bank balance sheets and capital 
requirements. The basis for the $5 trillion estimate in the 
Financial Times article was not disclosed, so we are unable to 
verify that number. In addition, it is unknown whether the 
accounting change will include a grandfathering or transition 
provision, which would make the potential impact of 
consolidation more gradual.
    The effect of the accounting change, whatever its final 
details, will depend on each individual bank's activities. The 
vast majority of banking organizations do not engage in 
material securitization activities; however, there could 
potentially be a material impact for those institutions, 
primarily the largest U.S. banking organizations, with 
significant securitization activities. With respect to those 
banks affected by the proposed accounting change, some may 
already have sufficient capital cushions to support the newly 
consolidated assets. Others may need to raise capital. During 
the current market turmoil, banks have been able to raise 
capital when needed. It is likely some banks will need to raise 
more capital to cover losses and position themselves to lend in 
the future. In that regard, a requirement to raise substantial 
amounts of new capital to accommodate the addition of 
securitized assets will put pressure on the cost of capital for 
all banks. I would urge FASB to allow banks a considerable 
period of time to prepare before any new consolidation 
requirement became effective.

Q.1.b. Second, since you are their regulators, do you know and 
have you known all along what those assets are?

A.1.b. We have a good understanding of bank asset 
securitization processes and firms' explicit exposures arising 
from securitizations based on both supervisory activities and 
information collected through regulatory reports. The Federal 
Reserve, the Office of the Comptroller of the Currency, and the 
Federal Deposit Insurance Corporation collect information on 
the outstanding principal balance of assets sold and 
securitized by a bank with servicing retained or with seller-
provided credit enhancements, as well as on the bank's maximum 
amount of retained credit exposure to the securitizations. They 
also collect information on unused commitments to provide 
liquidity to securitization structures. The agencies began 
collecting detailed data on securitization activities in 2001.

Q.1.c. And third, why were they allowed to move trillions of 
dollars of what turned out to be the riskiest assets off their 
books to avoid capital charges?

A.1.c. Accounting rules, set by the FASB, prescribe which 
assets must be consolidated on a banking organization's balance 
sheet. The U.S. banking agencies' risk-based capital 
requirements do not focus solely on consolidated assets, but 
also consider banks' exposures to off-balance sheet 
securitization transactions. We have in place capital 
requirements on securitization exposures. Together with other 
supervisors, we are taking a hard look at the requirements for 
these exposures under Basel II to ensure they are appropriate.
    Securitization provides banks with several important 
benefits. The securitization process offers banks alternative 
sources of funding and liquidity, and provides an opportunity 
to reallocate some of the risk of securitized assets (for a 
price) to investors. The funding costs associated with asset 
securitization maybe lower than the cost of direct borrowing. 
Moreover, the reduced risk and leverage created by 
securitization allows banks to redeploy capital efficiently to 
support other banking activities. Although regulatory capital 
considerations influence some securitization activity, they are 
not necessarily the driving force; asset securitization 
provides a critical source of funding for certain banks and, 
consequently, increases the availability of credit for 
borrowers.
    The U.S. federal banking agencies have worked for many 
years to reduce opportunities for regulatory capital arbitrage 
associated with securitization activities. Importantly, in 
2001, the agencies published a final rule directly addressing 
the regulatory capital treatment of securitization exposures. 
In many cases, a sponsoring bank is required to hold dollar-
for-dollar capital against the risk it retains in association 
with a securitization. Capital is also required for other 
securitization exposures, such as investments in asset-backed 
securities and liquidity facilities provided to asset-backed 
commercial paper conduits. The new Basel II-based risk-based 
capital rules, which the agencies currently are in the process 
of implementing, provide an even more risk-sensitive approach 
to banks' securitization exposures. In addition, banks are 
required to conduct an internal assessment of the capital 
needed to support securitization activities.

Q.2. On June 4, 2008, Moody's placed two of the largest bond 
insurers (MBIA and Ambac) on watch for downgrade, and S&P 
lowered their rating the following day. Is any collateral 
pledged at the various facilities or in the Fed's assets from 
the Bear Stearns deal insured by those insurers? What impact 
does the downgrade, and the potential for further downgrades, 
have on the value of collateral the Fed has been taking at the 
various facilities and on the Fed's assets from the Bear 
Stearns deal? What will the Fed do about any pledged securities 
that are downgraded? Is the Fed continuing to rely on ratings 
from the rating agencies in assessing the risk and value of 
pledged collateral, and if so, why given the unreliability of 
those ratings? Beyond using ratings from ratings agencies, what 
is the Fed doing to verify the quality of the collateral it is 
getting?

A.2. The Federal Reserve accepts a wide range of collateral 
under its standing liquidity facilities for depository 
institutions and primary dealers. It is important to note that, 
for all of the Federal Reserve's existing liquidity facilities, 
the Federal Reserve has recourse to the borrowing institution 
beyond the specific collateral pledged. Although the collateral 
requirements for the various liquidity programs vary somewhat, 
credit ratings are used in some cases as a screen to eliminate 
assets of poor quality. Assets that pass this screen are then 
assigned market values based on market pricing sources, and 
haircuts are then applied to these market values to determine 
the final collateral value of the pledged collateral. For those 
assets without available market prices, substantially larger 
haircuts are applied to the outstanding principal balance to 
determine the final collateral value. Market prices are updated 
regularly and haircuts are set to provide a significant measure 
of protection against market, credit and liquidity risk. In 
addition, the credit ratings of the assets pledged as 
collateral are monitored on an ongoing basis. Finally, the 
Federal Reserve independently reviews assets pledged as 
collateral to ensure that acceptability criteria are met and 
that all necessary legal documentation is in place.
    A downgrade of the bond insurers could result in a 
corresponding downgrade of an asset that is pledged as 
collateral at the Federal Reserve. If the downgrade of Federal 
Reserve collateral meant that it no longer met basic 
eligibility criteria, the collateral would be returned to the 
borrower and the institution would be required to provide 
alternative collateral of sufficient quality. Of course, even 
if the collateral pledged at the Federal Reserve is not 
downgraded, the troubles at bond insurers could affect the 
market value of the Federal Reserve's collateral. In this case, 
changes in market valuation would be captured through our 
regular pricing updates, and the final value of the collateral 
pledged would decline. The Federal Reserve closely monitors the 
value of collateral pledged to ensure that it exceeds the value 
of credit extended at all times.
    Regarding the special financing arrangement in the case of 
Bear Stearns, the Federal Reserve and JP Morgan Chase extended 
credit to finance a pool of about $30 billion in assets. As 
described in the Federal Reserve's public announcements, the 
Federal Reserve extended about $29 billion of senior financing 
under this arrangement, and JPMorgan extended about $1 billion 
of financing through a first loss position. The asset portfolio 
is professionally managed by an independent portfolio 
management firm and will be marked to market values on a 
quarterly basis; those values will reflect the effects, if any, 
of the downgrades of the guarantors. Details regarding the 
value of these assets and the outstanding balance on the credit 
extension are published weekly on the Federal Reserve's H.4.1. 
statistical release. The Federal Reserve determined to enter 
into this special financing arrangement because a disorderly 
failure of Bear Stearns would have posed a serious threat to 
overall financial stability and would most likely have had 
significant adverse implications for the U.S. economy.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOLE
                      FROM DONALD L. KOHN

Q.1. In March, the Attorney General of New York, OFHEO, and the 
GSE's entered into an agreement creating new appraiser 
requirements that are inconsistent with existing practices. 
Last month, I introduced an amendment to the Federal Housing 
Finance Regulatory Reform Act of 2008 that would require the 
Director of OFHEO to issue a regulation establishing appraisal 
standards for mortgages purchased or guaranteed by Fannie and 
Freddie. It would establish a common set of appraisal standards 
governing mortgage lenders that are federally supervised and 
regulated. In your opinion, would this amendment strengthen the 
appraisal standards of federally regulated mortgages?

A.1. The Federal Reserve is supportive of promoting sound 
appraisal practices in residential mortgage lending that ensure 
lenders use independent, quality appraisals and that protect 
appraisers from inappropriate influence by the loan production 
staff, borrowers, or other third parties. In fact, these 
important principles are embodied in the existing appraisal 
regulations and guidance of the Board and other federal 
financial regulatory agencies, which have been in place since 
the early 1990s.
    Your proposed amendment would acknowledge that federally 
regulated institutions and their affiliates are already subject 
to an appraisal regulatory framework and would address 
potential confusion on the part of those entities as to the 
appraisal standards for which they will be held accountable.

Q.2. Vice Chairman Kohn, would you review this technical issue 
with the other Members at the Federal Reserve Board? Could the 
Board please get back to us in writing with a detailed letter 
articulating all the inconsistencies and conflicts of this 
agreement with current banking law, and the corresponding risks 
associated therein? I would ask that this letter not only 
articulate the inconsistencies and conflicts with current 
banking law, but also the potential risks to safety and 
soundness, as well as the expected impact on consumers as it 
relates to the costs and availability of mortgage credit.

A.2. The Federal Reserve has reviewed the agreement and the 
accompanying Home Valuation Code of Conduct and provided 
written comment to the Office of Federal Housing Enterprise 
Oversight.\1\ Our letter to OFHEO should provide sufficient 
information to respond to your request for explanation on the 
inconsistencies and conflicts of the agreement with current 
banking laws and regulations. Further, the letter outlines our 
most significant concerns with the agreement and code, and 
explains how the agencies' existing appraisal regulatory 
framework promotes appraiser independence and reliable 
valuations of real estate collateral in mortgage lending by 
federally regulated institutions.
---------------------------------------------------------------------------
    \1\ See the attached letter dated June 19, 2008, from Randall S. 
Kroszner, Governor, Board of Governors of the Federal Reserve; John C. 
Dugan, Comptroller of the Currency; John M. Reich, Director, Office of 
Thrift Supervision; and JoAnn M. Johnson, Chairman, National Credit 
Union Administration, to James B. Lockhart, Director, OFHEO.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] 


RESPONSE TO WRITTEN QUESTIONS OF SENATOR CORKER FROM DONALD L. 
                              KOHN

Q.1.a. What is the banking system's exposure to the monoline 
insurers?

A.1.a. Banks have two basic types of exposures to monoline 
financial guarantors:
    Direct exposures stemming from lending transactions as well 
as from purchasing credit derivatives protection from 
guarantors as hedges against a variety of structured credit 
products, which generates counterparty credit exposures.
    Indirect exposures, which are exposures to assets that are 
``wrapped'' (i.e., guaranteed) by the guarantors, may reside on 
banks' balance sheets or in off-balance-sheet vehicles that are 
sponsored by banks or to which banks have extended some form of 
support.

Direct Exposures

    Exposures from lending facilities to monoline guarantors 
are generally not a significant share of banks' capital or of 
total credit exposures at banking organizations.
    More importantly, financial guarantors have reported 
selling over $500 billion in notional value of credit 
derivatives-based protection to financial institutions, with 
roughly $125 billion of that protection sold on so-called CDOs 
of ABS that contain subprime mortgage-related collateral in the 
asset pool. Some of that protection was purchased by large 
domestic bank holding companies. The current counterparty 
credit exposures generated by these hedges are a function of 
the market value of the positions being hedged, and are not the 
same as the notional values.
    Given the deterioration in the positions hedged by banks 
using these credit derivatives, particularly with respect to 
the CDOs of ABS, banks' direct counterparty credit exposures to 
financial guarantors from these hedges have grown significantly 
over the past year. Nonetheless, for domestic bank holding 
companies, these exposures are equivalent to only a moderate 
share of the firms' capital and are a relatively small share of 
total credit exposures across the firms.
    As has been noted in the press and in some firms' publicly 
reported statements of financial condition, many financial 
institutions, both foreign and domestic, have begun to take 
markdowns and/or reserves--generally in the form of a ``credit 
valuation adjustment''--against the value of these exposures, 
with over $20 billion of write-downs reported through end-March 
2008. If deterioration in credit markets continues, banks' 
exposures will grow further and, given the associated 
deterioration seen in the financial guarantor sector, they will 
likely take further write-downs and/or reserves against their 
counterparty credit exposures to the financial guarantors.

Indirect Exposures

    A substantial majority of wrapped cash assets are municipal 
bonds, which are generally solid credit risks even without the 
guarantees provided by the monolines. There are also a variety 
of other types of credit assets that are guaranteed, including 
asset-backed and mortgage-backed securities. Most of these 
wrapped assets have seen market price declines over the past 
year as the value of the guarantees have been discounted, and 
banks have seen some losses from marking to market these assets 
over that time period. Given the ongoing marking down of the 
value of these assets over time, significant future losses on 
these assets resulting from the deterioration of the guarantors 
appears unlikely, as market participants are generally now 
looking directly at the underlying assets and have already 
discounted the value of the guarantees.

Q.1.b. Likewise, what is the banking system's exposure to the 
mortgage insurance companies?

A.1.b. The banking system's exposure to the mortgage insurance 
companies comprises two categories: direct loans to mortgage 
insurers and exposure to mortgage insurers as providers of 
insurance on mortgages underwritten by the banks. As to the 
first category, as of May 2008, syndicated loans to mortgage 
insurers extended by federally regulated institutions totaled 
$3.9 billion. As to the second category, we estimate that 
banks' exposure to mortgage insurers as of March 2008 was 
approximately $37 billion.

Q.1.c. In light of the exposure of counterparty risk related to 
the monolines and mortgage insurers, how do you quantify the 
safety and soundness of these counterparties and what do the 
regulators need to do to understand and monitor the risk going 
forward?

A.1.c. Monoline financial guarantors and mortgage insurers are 
regulated by state insurance regulators.
    The Federal Reserve has been very closely monitoring 
developments in the financial guarantor sector and has engaged 
in a number of discussions with supervised firms regarding 
their exposures to guarantors and the implications of continued 
deterioration in the condition of the guarantors. We will 
continue to closely monitor the monolines' financial condition 
as well as the size and performance of the various exposures 
that exist at supervised banking organizations.
    As to mortgage insurers, we monitor the health of this 
segment continuously, by studying the industry, gathering 
publicly available data, and meeting with state insurance 
regulators. In addition, we are in contact with the banks that 
are the largest beneficiaries of mortgage insurance and are 
obtaining detailed information on their exposure to this 
industry. Supervised banks' exposures to the mortgage insurers 
are relatively small relative to their exposures to other 
industries and relative to their capital (and balance sheet 
size), and are generally well distributed across those banks 
that have exposure to mortgage insurers.
    I appreciate the Federal Reserve's efforts to address 
unfair and deceptive practices in the credit card industry. I 
am pleased that the Federal Reserve has solicited public 
comments on the proposal from consumers, credit card issuers 
and other interested parties to fully understand the impact 
these new rules will have on the marketplace.

Q.2. In that regard, has the Fed considered the impact these 
rules will have on consumers who pay their bills on time? Could 
timely-paying consumers see an increase in the cost of credit 
as a result of this rule due to the fact that the Fed would 
restrict, in a fairly significant way, the ability for banks to 
adjust prices for those consumers who demonstrate a higher 
risk?

A.2. In proposing restrictions on credit card issuers' ability 
to increase rates on existing balances, the Board carefully 
considered the potential costs and benefits for all consumers. 
The proposal seeks to balance issuers' need to price for risk 
with consumers' need to have greater transparency so they can 
better predict how their decisions and actions will affect 
their costs. The proposed rules would not affect card issuers' 
ability to price for risk when setting rates at account 
opening. Although ``hair trigger'' re-pricings for existing 
balances would be prohibited (for example, when a payment 
arrives one day late), issuers could re-price existing balances 
for a serious delinquency when the account is 30 days past due. 
In addition, after providing 45 days' advance notice, issuers 
could increase the rate on new transactions. As new business 
models emerge, consumers might see some costs decline while 
other costs might potentially increase, but the intent is to 
increase transparency and fairness in how credit card accounts 
operate, which should enhance competition and benefit consumers 
as a whole.
