[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]



                       THE SCIENCE OF INSOLVENCY

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

                                HEARING

                               BEFORE THE

                   SUBCOMMITTEE ON INVESTIGATIONS AND
                               OVERSIGHT

                  COMMITTEE ON SCIENCE AND TECHNOLOGY
                        HOUSE OF REPRESENTATIVES

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                               __________

                              MAY 19, 2009

                               __________

                           Serial No. 111-27

                               __________

     Printed for the use of the Committee on Science and Technology


     Available via the World Wide Web: http://www.science.house.gov

                                 ______







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                  COMMITTEE ON SCIENCE AND TECHNOLOGY

                 HON. BART GORDON, Tennessee, Chairman
JERRY F. COSTELLO, Illinois          RALPH M. HALL, Texas
EDDIE BERNICE JOHNSON, Texas         F. JAMES SENSENBRENNER JR., 
LYNN C. WOOLSEY, California              Wisconsin
DAVID WU, Oregon                     LAMAR S. SMITH, Texas
BRIAN BAIRD, Washington              DANA ROHRABACHER, California
BRAD MILLER, North Carolina          ROSCOE G. BARTLETT, Maryland
DANIEL LIPINSKI, Illinois            VERNON J. EHLERS, Michigan
GABRIELLE GIFFORDS, Arizona          FRANK D. LUCAS, Oklahoma
DONNA F. EDWARDS, Maryland           JUDY BIGGERT, Illinois
MARCIA L. FUDGE, Ohio                W. TODD AKIN, Missouri
BEN R. LUJAN, New Mexico             RANDY NEUGEBAUER, Texas
PAUL D. TONKO, New York              BOB INGLIS, South Carolina
PARKER GRIFFITH, Alabama             MICHAEL T. MCCAUL, Texas
STEVEN R. ROTHMAN, New Jersey        MARIO DIAZ-BALART, Florida
JIM MATHESON, Utah                   BRIAN P. BILBRAY, California
LINCOLN DAVIS, Tennessee             ADRIAN SMITH, Nebraska
BEN CHANDLER, Kentucky               PAUL C. BROUN, Georgia
RUSS CARNAHAN, Missouri              PETE OLSON, Texas
BARON P. HILL, Indiana
HARRY E. MITCHELL, Arizona
CHARLES A. WILSON, Ohio
KATHLEEN DAHLKEMPER, Pennsylvania
ALAN GRAYSON, Florida
SUZANNE M. KOSMAS, Florida
GARY C. PETERS, Michigan
VACANCY
                                 ------                                

              Subcommittee on Investigations and Oversight

               HON. BRAD MILLER, North Carolina, Chairman
STEVEN R. ROTHMAN, New Jersey        PAUL C. BROUN, Georgia
LINCOLN DAVIS, Tennessee             BRIAN P. BILBRAY, California
CHARLES A. WILSON, Ohio              VACANCY
KATHY DAHLKEMPER, Pennsylvania         
ALAN GRAYSON, Florida                    
BART GORDON, Tennessee               RALPH M. HALL, Texas
                DAN PEARSON Subcommittee Staff Director
                  EDITH HOLLEMAN Subcommittee Counsel
            JAMES PAUL Democratic Professional Staff Member
       DOUGLAS S. PASTERNAK Democratic Professional Staff Member
           KEN JACOBSON Democratic Professional Staff Member
                    BART FORSYTH Republican Counsel
            TOM HAMMOND Republican Professional Staff Member
                      JANE WISE Research Assistant













                            C O N T E N T S

                              May 19, 2009

                                                                   Page
Witness List.....................................................     2

Hearing Charter..................................................     3

                           Opening Statements

Statement by Representative Brad Miller, Chairman, Subcommittee 
  on Investigations and Oversight, Committee on Science and 
  Technology, U.S. House of Representatives......................     5
    Written Statement............................................     6

Statement by Representative Paul C. Broun, Ranking Minority 
  Member, Subcommittee on Investigations and Oversight, Committee 
  on Science and Technology, U.S. House of Representatives.......     7
    Written Statement............................................    13

Prepared Statement by Representative Charles A. Wilson, Member, 
  Subcommittee on Investigations and Oversight, Committee on 
  Science and Technology, U.S. House of Representatives..........    14

                               Witnesses:

Dr. Jeffrey Sachs, Director, The Earth Institute, Columbia 
  University
    Oral Statement...............................................    15

Dr. Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, 
  MIT Sloan School of Management; Senior Fellow, Peterson 
  Institute for International Economics
    Oral Statement...............................................    16
    Written Statement............................................    18
    Biography....................................................    26

Dr. Dean Baker, Co-Director, Center for Economic and Policy 
  Research
    Oral Statement...............................................    27
    Written Statement............................................    29
    Biography....................................................    31

Mr. David C. John, Senior Research Fellow, The Heritage 
  Foundation
    Oral Statement...............................................    31
    Written Statement............................................    33
    Biography....................................................    35

Discussion
  Implications of a Stress Test..................................    36
  The State of Mortgages.........................................    37
  Determining the Right Size for Financial Firms.................    38
  The Validity of Stress Tests...................................    40
  Assessment Criteria for Banks..................................    41
  Indications of Further Economic Downturn.......................    42
  The Influence of a Financial Oligarchy.........................    42
  The Role of a Market-based System..............................    44
  Encouraging Lending............................................    45
  Potential Rules to Limit Systemic Risk.........................    46
  More on the Sizes of Financial Institutions....................    47
  More on the Market-based Approach..............................    48
  Financial Crises as Symptoms of Other Problems.................    49
  On Systemic Risk in the Financial Sector.......................    51
  Analogous Issues in Insurance Regulation.......................    52
  Large Loan Loss Reserves.......................................    53
  The Loan-to-Value Ratio........................................    54
  The Pursuit of Property........................................    56
  The Model of Credit Unions.....................................    58
  Future Difficulties............................................    59
  Mr. Broun's Closing Remarks....................................    61
  Further Areas of Inquiry.......................................    61
  Closing........................................................    63

 
                       THE SCIENCE OF INSOLVENCY

                              ----------                              


                         TUESDAY, MAY 19, 2009

                  House of Representatives,
      Subcommittee on Investigations and Oversight,
                       Committee on Science and Technology,
                                                    Washington, DC.

    The Subcommittee met, pursuant to call, at 10:07 a.m., in 
Room 2318 of the Rayburn House Office Building, Hon. Brad 
Miller [Chairman of the Subcommittee] presiding.


                            hearing charter

              SUBCOMMITTEE ON INVESTIGATIONS AND OVERSIGHT

                  COMMITTEE ON SCIENCE AND TECHNOLOGY

                     U.S. HOUSE OF REPRESENTATIVES

                       The Science of Insolvency

                         tuesday, may 19, 2009
                         10:00 a.m.-12:00 p.m.
                   2318 rayburn house office building

Purpose

    On Tuesday, May 19, 2009 the Subcommittee on Investigations and 
Oversight of the Committee on Science and Technology will hold a 
hearing to focus on what it means for a financial institution to be 
``solvent'' given the complexity of global financial markets. In order 
to do this, the Subcommittee will tap the insight of economists into 
how the tools of their discipline can be used in making determinations 
of current solvency and projections of future solvency on an objective, 
scientific basis.
    Economics aspires to be a science. The insights of economics have 
been used to inform almost every aspect of domestic policy. The 
National Science Foundation is the major funding resource for economic 
research in the Federal Government. What, then, do those whose 
perspectives are shaped by ``the dismal science'' have to say about the 
current financial morass?
    Balance sheets of financial institutions have become far more 
difficult to understand as the percentage of the assets listed therein 
consisting of direct loans (which have a relatively straightforward 
valuation) has diminished and that of derivative instruments has grown. 
Even with regards to assets based on more common financial instruments 
(mortgages, for example) what has the turmoil in the real estate market 
meant for accurately valuing and accounting for those holdings? This 
complexity for valuing balance sheets has been particularly difficult 
for the large institutions at the center of the financial system. These 
are the firms which have traded increasingly in the complex 
instruments--collateralized debt obligations (CDO), credit default 
swaps (CDS), and the like--whose connection to the underlying assets 
from which their value is derived can be far from transparent. 
Compounding the transparency problem is the fact that such instruments, 
rather than being standardized, are often born of specific deals and 
thus do not lend themselves to conventional trading, by which the value 
of major equities and commodities are established.
    Questions over the solvency of major financial institutions arose 
suddenly, on the heels of a boom period during which values seemed to 
spiral ever upward and, consequently, mechanisms of valuation went 
largely unchallenged. In retrospect, that growing value looks like the 
edge of an unsustainable bubble, driven largely by real estate. 
Valuation has become even more complex owing to an April decision by 
the Financial Accounting Standards Board (FASB) tying valuations of 
financial assets less tightly to current market prices and thereby 
increasing firms' flexibility in assigning value to them.\1\
---------------------------------------------------------------------------
    \1\ ``Under New Accounting Rule, Toxic Assets May Be Revalued,'' 
Washington Post, April 3, 2009, p. A15.
---------------------------------------------------------------------------
    Earlier this month the Federal Reserve announced the results of the 
``stress test'' performed on the 19 U.S.-owned banks whose assets 
exceeded $100 billion at the end of 2008. This test's design combined 
the Fed's choosing ``two alternative assumed paths for the U.S. 
economy,'' having supervisors make ``judgmental adjustments to the 
firms' loss and revenue estimates,'' and deciding on the assumptions of 
what the Fed Chairman, Ben Bernanke, called ``objective, model-based 
estimates for losses and revenues that could be applied on a consistent 
basis across firms.'' \2\
---------------------------------------------------------------------------
    \2\ Speech, Federal Reserve Chairman Ben S. Bernanke, Jekyll 
Island, GA, May 11, 2009, available at www.federalreserve.gov/
newsevents/speech/bernanke/20090511a.htm
---------------------------------------------------------------------------
    Such factors as FASB's decision and the Fed's methodology invite a 
discussion of the reliability and rigor of the modeling used in 
financial assessments, as well as what truly constitutes objective 
criteria. Can we find worthwhile data and reliable models to determine 
solvency at a time when markets are suddenly viewed as unreliable 
sources of information about value? Among the questions addressed in 
examining this issue will be:

          How can a financial instrument be assigned value in 
        the absence of a market for it? What models and other 
        techniques are available? Are new ones needed?

          Do objective standards for solvency exist? When it 
        comes to determining a firm's solvency, does a financial 
        institution constitute a special case as compared to, say, a 
        retail or industrial firm?

          Was the stress test sufficiently rigorous? Was it 
        fair? Did it look at appropriate factors and make valid 
        assumptions?

Witnesses

    The Subcommittee will take testimony from four prominent economists 
regarding these questions. We are looking for insights into how 
economists evaluate the current situation to give us a better sense of 
the state of the science, and the state of information that we rely on, 
to make legislative and policy choices.

Dr. Dean Baker, Co-Director, Center for Economic and Policy Research

Dr. Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, MIT 
Sloan School of Management

Dr. Jeffrey Sachs, Director, The Earth Institute at Columbia University

Mr. David John, Senior Research Fellow, Heritage Foundation
    Chairman Miller. Good morning. Before we begin, I think I 
should note that ProPublica, a distinguished organization, has 
announced the winners of the ProPublica prizes for 
investigative governance, and the prize for federal 
investigation, legislative branch, is to the Majority staff of 
the Subcommittee on Investigations and Oversight, House 
Committee on Science and Technology, for Toxic Trailers--Toxic 
Lethargy. Dr. Broun, it doesn't say a word about the Minority 
or, for that matter, about Members at all. But on behalf of all 
the Members of the Committee, I want to congratulate our 
Majority staff and say if there's any small way that the 
Members have been able to help you in your work, we are pleased 
to do it.
    Mr. Broun. Mr. Chairman, I reserve my right to object.
    Chairman Miller. Again, good morning and welcome to today's 
hearing, The Science of Insolvency.
    Several committees have jurisdiction of economic issues, 
but economics is also the subject of significant federally 
funded research within this committee's jurisdiction. And 
economics, after all, has never really shaken Thomas Carlyle's 
term ``the dismal science.''
    This subcommittee has championed scientific integrity as 
necessary to inform policy decisions. There is plenty of room 
for debate about policy implications, but scientific facts 
should be assessed by scientists without political 
interference.
    If we have ever needed sound, neutral evaluations of 
economic facts upon which to base policy, it is now.
    Dr. Simon Johnson, one of our witnesses today, in his 
written testimony, says that we have ``a desperately ill 
banking sector.''
    Congress and the Administration are working to treat the 
illness, but there has been remarkably little discussion of the 
precise nature of the illness. The diagnosis, the determination 
of what is wrong with our economy, appears to be a factual 
question, not a policy decision, but it is a factual question 
with enormous policy implications.
    The factual premise of our policy to this point appears to 
be that our banks are facing a rough patch, because many of 
their assets are illiquid, because there is no active market 
for those assets and persnickety accounting rules make those 
banks appear to be on shaky ground, but the assets are really 
fine and the banks are too. The determination, or discovery, of 
value appears to be the core competency of markets, and some 
who now argue that the markets are befuddled in valuing complex 
financial assets have for years genuflected when the word 
market was spoken.
    Others argue, I think including some of our witnesses 
today, that the markets are correctly valuing the assets, and 
the problem is that the assets are simply not worth much, and 
that many of our banks are insolvent.
    Edward Yingling, President of the American Bankers 
Association, told the New York Times that ``claims of technical 
insolvency'' at many of our banks was just ``speculation by 
people who have no specific knowledge of bank assets.''
    It is true that banks' assets and liabilities are not 
public knowledge, but many credible economists are not 
persuaded when regulators peek into the black box of banks' 
assets and liabilities and declare that there is nothing to 
worry about. And the regulators not so long ago told us that 
any problems in the financial sector arising from mortgage 
defaults would be easily contained.
    What should we make of the stress tests? When the stress 
tests were first announced, they were described as a rigorous 
examination of how our largest banks would perform in the event 
of a severe recession. The markets reacted with some 
consternation to that announcement. Then we heard about the 
stress tests which show that our 19 largest banks were all 
solvent. Then we heard that all the banks were solvent, but 
some needed more money to stay in business, which was my 
perhaps unsophisticated understanding of what it meant to be 
insolvent. Then we began hearing which banks might need 
additional capital and how much. Paul Krugman said that the 
leaks of the stress test results seem like trial balloons to 
see what would be believable. It almost sounded like one of the 
running jokes in the old television show, Get Smart. CitiGroup 
is solvent and needs no more capital. Would you believe that 
CitiGroup does not need any more capital? No, would you believe 
CitiGroup only needs $5 billion in capital? How about $10 
billion? The results of the stress test are now in, and they 
show that 10 of 19 biggest banks need to raise a total of $75 
billion in new capital by the fall. Dr. Johnson, though, 
sometime back told the New York Times that our banks needed a 
minimum of $500 billion in new capital and perhaps as much as 
$1 trillion in a severe recession. Dr. Johnson's estimate is 
generally consistent with those of various economic analyses, 
including international monetary funds, Goldman Sachs 
economists, Institutional Risk Analytics, among others, that 
have appeared in the press.
    So where do we really stand? What shape are our banks 
really in and what shape is our financial system in generally? 
And what are the policy implications of all of that?
    I now recognize the distinguished Ranking Republican 
Member, Dr. Broun of Georgia, for an opening statement.
    [The prepared statement of Chairman Miller follows:]
               Prepared Statement of Chairman Brad Miller
    Good morning, and welcome to today's hearing, The Science of 
Insolvency.
    Several committees have jurisdiction over economic issues, but 
economics is also the subject of significant federally funded research 
authorized by this committee. And economics, after all, has never quite 
shaken Thomas Carlyle's term ``the dismal science.''
    This subcommittee has championed scientific integrity as necessary 
to inform policy decisions. There is plenty of room for debate about 
policy implications, but scientific facts should be assessed by 
scientists without political interference.
    If we have ever needed sound, neutral evaluation of economic facts 
upon which to base policy, it is now. Dr. Simon Johnson, in his written 
testimony today, says that we have ``a desperately ill banking 
sector.''
    Congress and the Administration are working to treat the illness, 
but there has been remarkably little discussion of the precise nature 
of the illness. The diagnosis of the illness, the determination of what 
is wrong with our economy, appears to be a factual question, not a 
policy decision, but it is a factual question with enormous policy 
implications.
    The factual premise of our policy to this point appears to be that 
our banks are facing a rough patch, since many of their assets are 
illiquid because there is no active market for those assets and 
persnickety accounting rules make those banks appear to be on shaky 
ground, but the assets are really just fine and the banks are too. The 
determination, or discovery, of value appears to be the core competency 
of markets, and some who now argue that the markets are befuddled in 
valuing complex financial assets have for years genuflected when the 
word ``market'' was spoken.
    Others argue that the market is correctly valuing assets, and the 
problem is that the assets are simply not worth much, and that many of 
our banks are insolvent.
    Edward Yingling, President of the American Bankers Association, 
told the New York Times that ``claims of technical insolvency'' at many 
of our banks amounted to ``speculation by people who have no specific 
knowledge of bank assets.''
    It is true that banks' assets and liabilities are not public 
knowledge, but many credible economists are not persuaded when 
regulators peek into the black box of banks' assets and liabilities and 
declare that there is nothing to worry about. And the regulators not 
that long ago told us that any problems in the financial sector arising 
from mortgage defaults would be easily ``contained.''
    What should we make of the stress tests?

    Mr. Broun. Mr. Chairman, before I begin my opening 
statement, I want to wish you a happy birthday, and I wish you 
many happy returns. I hope it is a great birthday for you. I 
celebrated mine last week, so you and I are almost twins.
    Chairman Miller. That would have been an unpleasant 
delivery.
    Mr. Broun. Gives a whole new definition to interstate 
commerce or something, I think.
    Thank you, Mr. Chairman. Let me welcome the witnesses here 
today and thank them for appearing. Today's hearing on The 
Science of Insolvency may seem like foreign territory for our 
committee. Terms like derivatives, credit default swaps, 
collateralized debt obligations, and interest rate swap aren't 
used in this room as much as propellant mass fraction, albedo 
effects, and TeraFLOPS.
    That being said, there are similarities. Over the last 30 
years, Wall Street has increasingly leveraged mathematics, 
physics, and science to better inform their decisions. Even 
before the Black-Scholes Model and the Gaussian Copula 
function--boy, those are big words for a Southerner, I will 
tell you--were developed to determine value and analyze and 
mitigate risk, bankers and economists were looking for a silver 
bullet to help them beat the market.
    Despite the pursuit of a scientific panacea for financial 
decisions, models are simply tools employed by decision-makers 
and managers. They add another layer of insight but are not 
crystal balls. Leveraging a position too heavily or assuming 
future solvency based on modeling data alone is hazardous to 
say the least.
    This is a theme this committee has addressed several times 
in the past. Whether it is in regard to climate change 
modeling, regulating chemical exposures, determining spacecraft 
survivability, predicting future bank solvency, or attempting 
to value complex financial instruments, models are only as good 
as the data and assumptions that go into them. Ultimately, 
decisions have to be made based on a number of variables which 
certainly include models involving science, but as a witness at 
a previous hearing stated, ``Science describes, it does not 
prescribe.''
    This committee struggles with the complexities of modeling, 
risk assessment, and risk management regarding physical 
sciences. Attempting to adapt those concepts to finance is even 
more complex. As AEI Resident Fellow Alex Pollock recently 
wrote, ``The transcendent mathematical genius, Isaac Newton, 
having first made a lot and then lost even more of his own 
money in the collapse of the South Sea Bubble, wrote in 
disgust, `I can calculate the motions of the heavenly bodies, 
but not the madness of people.' You can apply math to finance, 
but that does not make it a science.''
    With that, Mr. Chairman, I would like to add a statement 
from Mr. Pollock to the hearing record by attaching it to my 
statement. I ask unanimous consent that that be done.
    [The information follows:]
    
    
    

    Chairman Miller. Without objection and so ordered.
    Mr. Broun. I look forward to the witnesses' testimony on 
the science underlying asset valuation and the methodologies 
behind the recent stress tests.
    Thank you, Mr. Chairman.
    [The prepared statement of Mr. Broun follows:]
                  Prepared Statement of Paul C. Broun
    Today's hearing on ``The Science of Insolvency'' may seem like 
foreign territory for our committee. Terms like Derivatives; Credit 
Default Swaps, Collateralized Debt Obligations, and Interest Rate Swap 
aren't used in this room as much as Propellant Mass Fraction, Albedo 
Effects, and TeraFLOPS.
    That being said, there are some similarities. Over the last 30 
years Wall Street has increasingly leveraged mathematics, physics, and 
science to better inform their decisions. Even before the Black-Scholes 
Model and the Gaussian Copula were developed to determine value and 
analyze and mitigate risk, bankers and economists were looking for a 
silver bullet to help them beat the market.
    Despite the pursuit of a scientific panacea for financial 
decisions, models are simply tools employed by decision-makers and 
managers. They add another layer of insight, but are not crystal balls. 
Leveraging a position too heavily or assuming future solvency based on 
modeling data alone is hazardous to say the least.
    This is a theme this committee has addressed several times in the 
past. Whether it is in regard to climate change modeling, regulating 
chemical exposures, determining spacecraft survivability, predicting 
future bank solvency, or attempting to value complex financial 
instruments, models are only as good as the data and assumptions that 
go into them. Ultimately, decisions have to be made based on a number 
of variables, which certainly include models involving science, but as 
a witness at a previous hearing stated ``science describes, it does not 
prescribe.''
    This committee struggles with the complexities of modeling, risk 
assessment, and risk management regarding physical sciences. Attempting 
to adapt those concepts to finance is even more complex. As AEI 
Resident Fellow Alex Pollock recently wrote

         ``The transcendent mathematical genius, Isaac Newton, having 
        first made a lot and then lost even more of his own money in 
        the collapse of the South Sea Bubble, wrote in disgust, `I can 
        calculate the motions of the heavenly bodies, but not the 
        madness of people.' You can apply math to finance, but that 
        does not make it a science.''

    With that, Mr. Chairman, I would like to add a statement from Mr. 
Pollock to the hearing record by attaching it to my statement. I look 
forward to the witnesses' testimony on the science underlying asset 
valuation and the methodologies behind the recent ``stress tests.''

    Chairman Miller. Thank you, Dr. Broun. I ask unanimous 
consent that all additional opening statements submitted by 
Members also be included in the record, and without objection 
it is so ordered.
    [The prepared statement of Mr. Wilson follows:]
         Prepared Statement of Representative Charles A. Wilson
    Thank you Chairman Miller for holding this important hearing.
    As a Member of both the Science and Technology and Financial 
Services Committee, I am eager to examine, dissect and hopefully fix 
the financial mess that we have gotten ourselves into.
    This hearing looks to examine our financial crisis in a different 
way, in a way that I am very interested in hearing. While I have sat 
through many hearings, this is the first of its kind.
    Panelists, thank you for joining us today. I look forward to 
hearing from you all. I intend to focus several things, including: 
reregulation, what do you all believe are the most important areas to 
focus on; the stress tests on banks . . . is a substantive exercise, 
are we looking at the right indicators; and, on the taxpayers going 
forward. Are they bearing too much of the cost of the bail-out, how can 
we make sure that they are protected?
    Again, thank you Chairman and thank you panelists. I look forward 
to our hearing today.

    Chairman Miller. It is my pleasure to introduce our 
distinguished panel of witnesses. Dr. Jeffrey Sachs is the 
Director of The Earth Institute at Columbia University. Dr. 
Simon Johnson is the Ronald A. Kurtz Professor of 
Entrepreneurship at MIT Sloan School of Management. Dr. Dean 
Baker is the Co-Director at the Center for Economic and Policy 
Research, and Mr. David John is the Senior Research Fellow at 
the Heritage Foundation.
    As our witnesses should know, you each have five minutes 
for your spoken testimony. Your written testimony will be 
included in the record for the hearing. When you have completed 
your spoken testimony, we will then begin with questions, and 
each Member will have five minutes to question the panel. We 
may do more than one round.
    It is the practice of the Subcommittee to receive testimony 
under oath. This is an investigative subcommittee. It seems 
unlikely there would be any perjury charges arising from this, 
we would have to prove that you knew what the truth was and 
that you departed from it and what the truth was, which seems 
an impossible task with this panel. Do any of you have any 
objection to swearing an oath? You also have a right to be 
represented by counsel. Do any of you have any counsel here? 
The witnesses all said that they did not object to swearing an 
oath and that none had counsel.
    Will you now please stand and raise your right hand? Please 
stand, yes. Do you swear to tell the truth and nothing but the 
truth? All of the witnesses did take the oath.
    We will now begin with Dr. Jeffrey Sachs. Dr. Sachs, please 
begin.

STATEMENT OF DR. JEFFREY SACHS, DIRECTOR, THE EARTH INSTITUTE, 
                      COLUMBIA UNIVERSITY

    Dr. Sachs. Thank you very much for this hearing and for the 
invitation to appear before this subcommittee, Mr. Chairman. I 
do not have written testimony submitted in format but I would 
like to submit testimony afterwards if that is all right with 
the Committee.
    Thank you for holding the hearing on The Science of 
Insolvency in the financial sector. A lot is known about this, 
though not a lot is known about the precise value of assets on 
the books of our banks right now. What is known about the 
science of insolvency of financial institutions is that banks 
require regulation because they are highly leveraged and they 
are maturity transformers, and what that means, of course, is 
that very modest movements in the valuation of assets held by 
banks and near-banks--I will include investment banks for this 
purpose--can lead to insolvency and can lead also to self-
fulfilling runs by short-term creditors, a very important 
concept in banking regulation.
    When bank assets become impaired, it may turn out that 
quite rational short-term creditors panic and withdraw their 
credits to these institutions. This can be depositors or 
purchasers of money market instruments such as commercial 
paper.
    We have known all of this for 75 years since the Great 
Depression. The Great Depression put in a system of regulation 
that included four components: lender of last resort facilities 
by the Fed, deposit insurance, banking regulation by a variety 
of institutions, and mechanisms for intervention in capital-
impaired institutions, mainly by the FDIC.
    At the essence of the current crisis is that the shadow 
banking system of the broker-dealer firms on Wall Street went 
outside of that regulatory regime. This is a crisis that 
started mainly not within our commercial banks but mainly in 
our investment banks. They did not have lender of last resort, 
they did not have tough regulation, they did not have capital 
adequacy standards, and they by and large did not have 
receivership mechanisms under FDIC.
    So we have a whole banking structure that didn't have a 
regulatory structure that was appropriate for the risks of 
leveraged maturity transformers. That is how we got to where we 
are right now, oddly speaking.
    When a crisis hits, there are two costs of the crisis. One 
is, short-term liquidity seizes up in the economy. That has 
happened world wide, especially after the Lehman default. And 
second is that the impairment of the bank capital means that 
the financial institutions restrict their lending. They de-
leverage. And so the economy as a whole gets less lending on a 
longer-term, medium-term basis.
    In terms of the sharp downturn, it is the restriction of 
liquidity which is the major cost. In terms of the speed and 
robustness of the long-term recovery, it is the impaired 
capital that is the main interest. We have been suffering 
through a liquidity crisis in recent months. We will now have 
for several years a more sluggish recovery because of less 
capital in the financial sector, but that will be a prolonged 
matter.
    When we turn to how this Administration, the preceding one, 
and the Fed have handled this crisis, Lehman was a big mistake, 
of course, in how it was handled because by letting Lehman 
simply file for bankruptcy, that invited the kind of creditor 
panic that ensued. What has happened since then has been a lack 
of a structured approach. There has been a lot of, I would say, 
clever, short-term response. The Fed has really done post-
Lehman a reasonable job of pushing an enormous amount of 
liquidity into the economy to prevent an outright collapse of 
liquidity, but on recapitalization, there has not been a 
strategy even to this moment.
    What the stress tests tell us I believe is not how the 
banks would perform under the worst circumstances, certainly 
not. They tell us that there is a fighting chance of muddling 
through right now if the economy modestly--performs moderately 
well going forward. That is fair enough. We learn something 
from this stress test. What we still don't have, however, is a 
mechanism to deal with the firms that are truly impaired or 
events in which the outcomes of the macro-economy are 
significantly worse than were in the stress test, which is also 
a very realistic possibility.
    My own view, and I will conclude here, I know I am over 
time, is that the FDIC receivership model is and should be the 
basic model that we hold to. Four standards that I would put 
forward that we do not have in place yet: that shareholders and 
bondholders should be the first to absorb losses, not the 
taxpayers; taxpayers should be getting value for money 
injected, and we are not seeing that yet; the recapitalization 
process should be transparent, it is not; and that it should be 
relatively speedy, and it is not. So the four criteria of a 
good workout are not yet in place.
    I will close by saying that I believe the specific 
mechanism of the PPIP so-called, the public-private-investment 
partnership, fails on all counts. It is unfair, non-
transparent, and likely to be very costly to the taxpayer. I 
believe that in view of the relatively good news and real news 
of the stress test, the PPIP should be set aside; and what we 
should be asking from the Administration are clear plans for 
how a real receivership would be operated if that turns out to 
be necessary in the event that the macro circumstances are 
worse than the stress tests allowed for.
    Thank you very much.
    Chairman Miller. Thank you, Dr. Sachs. Dr. Johnson for five 
minutes.

 STATEMENT OF DR. SIMON JOHNSON, RONALD A. KURTZ PROFESSOR OF 
   ENTREPRENEURSHIP, MIT SLOAN SCHOOL OF MANAGEMENT; SENIOR 
     FELLOW, PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS

    Dr. Johnson. Thank you very much. I think your 
introduction, Mr. Chairman, hit the nail on the head which is 
the science here, the science around insolvency, the science 
around how we think about insolvency and about how to handle 
insolvency of large banks has basically failed. The 
sophisticated models around the valuation of banks' balance 
sheets have obviously failed, otherwise we would not be in this 
crisis. I think we should just take that as a premise and ask, 
what are the implications on a practical side of an immediate 
policy and from a longer-term scientific side.
    I think there are three major implications of this deep, 
profound failure. The first is, we should go back to basics and 
think much more about the incentives of the people involved 
with the banking system. So I don't think we know the exact 
nature of insolvency and solvency in these financial 
institutions, but we have learned and we can see very clearly 
that the incentives for the people who run these banks have 
been bad, they have been distorted, and now they have become 
much worse. We can argue for a long time about the extent to 
which particular executives might or might not have believed in 
the past their institutions were too big to fail, meaning that 
if they were insolvent or faced a liquidity run of the kind 
that Professor Sachs outlined, that they would receive 
government support. Now, it is uncontroversial. Now, they know 
they are too big to fail, and they are receiving a massive 
amount of credit from the Federal Reserve which I have also 
supported from a short-term preserve-the-credit-system 
perspective, but we have to recognize the effectiveness on 
their incentives. There is a potential Fed-based bubble 
developing. The executives of these banks have learned that 
they can take massive amounts of risk, now it is with other 
people's money, and they will not face the consequences of 
these actions. So there is a big distortion behind all of the 
problems that got us into this. The confusion, the noise of the 
past six months has made it much easier to take or to tunnel 
wealth and property and cash out of these banks, and going 
forward the prospect is extremely bleak on that basis.
    The second point is in terms of you handle any kind of 
banking situation that enters into the kind of crisis as, 
again, Professor Sachs nicely outlined. The rule of--it is 
always the case in all countries you have this kind of 
confusion about who is solvent and who is not. The basic 
heuristic procedure, as used by the International Monetary Fund 
where I used to work as Chief Economist, and as endorsed and 
pushed by the U.S. Treasury, directly and through the IMF and 
all other country situations that I have been aware of is try 
and do a systematic tough stress test where the emphasis is on 
the tough and the emphasis is on looking at what would happen 
in a severe recession and recapitalizing on that basis. Now, it 
is true you may be able to muddle through without doing that, 
and what the government is doing is clearly a forbearance, 
muddling-through strategy, but your banking system will be 
short of capital, and there is no way that that either helps 
you get a robust recovery going or gives you the right kind of 
incentives. If anything, the evidence suggests, and the savings 
and loans from the 1980's in the United States is always held 
up as the best example of this, you get even more strange, 
distorted, perverted incentives on the part of bank executives 
where they take excessive risks, they gamble for resurrection, 
for example, or other kinds of perverse pathologies develop in 
terms of bank executive behavior.
    So the science is bad. It is broken. The incentives are 
getting worse for the banks. That we know. That is not a 
sophisticated, mathematical modeling observation. That is very 
basic economics and political incentives, and we haven't 
handled it in this country in the standard way these problems 
are handled elsewhere.
    The third point and the final point I would emphasize is 
about consumers. Now, you may or may not like the idea of 
consumer protection around financial products. It has not been 
a standard in this country, and other countries have addressed 
protection of consumers and the regulation of financial markets 
to only a very limited degree in this sense. Protecting 
consumers vis-a-vis financial products in the same way they are 
protected with regard to automobiles or baby cribs or potential 
lead paint on the toys that children buy. But we know the 
incentives are bad in the banking system. We have not made 
progress in fixing them. The stress test was not, for perhaps 
good reason, perhaps bad reason, applied in the standard way. I 
would be very worried about the way consumers are treated. For 
example, the increase in fees on consumers' credit cards right 
now or the ways in which consumers either have access or don't 
have access to refinancing possibilities, what are the terms 
and interest rates behind those. All of this is very murky. 
There is a great deal of confusion out there. It is very easy 
to take advantage of people, particularly when they are under 
duress because of recession, particularly when they are 
confused about what their real alternatives are. And I think 
that consumers need to have this kind of protection. I think it 
is long overdue, and particularly in recognition of the deeper 
failings of science in and around the banking system and the 
fact that mathematical models are honestly never going to 
really give you the kind of assurance that the banking system 
is going to be well-run. I think protecting the consumers is 
basic, it is fundamental, it is absolutely essential at this 
point.
    Thank you very much.
    [The prepared statement of Dr. Johnson follows:]
                 Prepared Statement of Simon Johnson\1\
---------------------------------------------------------------------------
    \1\ This testimony draws on joint work with James Kwak, 
particularly The Quiet Coup (The Atlantic, May 2009), and Peter Boone. 
Italic text indicates links to supplementary material; to see this, 
please access an electronic version of this document, e.g., at http://
BaselineScenario.com, where we also provide daily updates and detailed 
policy assessments.
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Main Points

 1)  The U.S. economic system has evolved relatively efficient ways of 
handling the insolvency of non-financial firms and small- or medium-
sized financial institutions. It does not yet have a similarly 
effective way to deal with the insolvency of large financial 
institutions. The dire implications of this gap in our system have 
become much clearer since fall 2008 and there is no immediate prospect 
that the underlying problems will be addressed by the regulatory reform 
proposals currently on the table. In fact, our underlying banking 
system problems are likely to become much worse.

 2)  The executives who run large banks are aware that the insolvency 
of any single big bank, in isolation, could potentially be handled by 
the government through the same type of FDIC-led receivership process 
used for regular banks. However, these executives also know that if 
more than one such bank were to fail (i.e., default on its 
obligations), this could cause massive economic and social disruption 
across the U.S. and global economy. The prospect of such disruption, 
they reason, would induce the government to provide various forms of 
bail-out. They also invest considerable time and energy into impressing 
this point onto government officials, in a wide range of interactions.

 3)  As an example of the ensuing bail-outs, in its latest iteration 
the current administration has (a) run stress tests in which the stress 
scenario was not severe, (b) determined that banks are solvent, but 
some should raise small amounts of capital, (c) at the same time 
continued to provide large amounts of government subsidy through FDIC-
guarantees on bank debt, large credit lines from the Federal Reserve, 
and cheap capital from the Troubled Assets Relief Program.

 4)  The government strategy today is forbearance, as in the early 
1980s, in which you wait for the economy to recover by itself and hope 
that this brings the banks back to financial health. This is risky 
because: it may not work (depending on the defaults seen in ``toxic'' 
assets); it may lead the banks to engage in undesirable short-term 
behavior (with either too much or too little credit, depending on how 
exactly their incentives are distorted); and it rewards banks for 
previous irresponsible actions (and therefore encourages more of the 
same in the future).

 5)  As a consequence of both this general failure to deal with big 
bank insolvency and the specific problems induced by current government 
policy, big bank executives have an incentive to reduce the probability 
that their bank fails for idiosyncratic reasons but they are much less 
concerned about their bank failing in a manner that is synchronized 
with other banks. These bank executives have a strong incentive to copy 
the actions and policies of other big banks.

 6)  By not changing incentives for powerful bank insiders, we are 
lining ourselves up for another big ``moral hazard trade''--think of 
this as a bail-out by the Federal Reserve of everyone, but especially 
banks. Current and future bank executives will take risk again--but 
next time it will be risk with the public's money. A housing bubble led 
to the current difficulties but the meta-bubble is a rise in financial 
services as a share of the economy, which has been underway since the 
1980s. In the latest manifestation of the ensuing shift in economic and 
political power towards the financial sector, an unsustainable ``Fed 
bubble'' is potentially underway. This may lead to outcomes that are 
considerably worse than what we have seen so far.

 7)  Everyone agrees that insolvent banks are a bad thing. Since 
September 2008, we have learned about the additional difficulties that 
follow when no one knows if banks are insolvent are not. There are many 
manifestations of this problem, including: illiquid markets for toxic 
assets; accounting tricks, like the FASB rule change and the preferred-
for-common stock conversion; and stress tests that turn out to be not 
very stressful, with outcomes that are apparently negotiable and mostly 
about public relations.

 8)  There is a striking contrast between how we deal with small/
medium-sized banks (using an FDIC intervention) and large banks--only 
the latter can obtain never ending bail-outs. The solution would be 
some kind of regulator able to take over any financial institution, but 
also better ways of measuring asset value, capitalization, etc. In line 
with that general approach, Thomas Hoenig has a strong proposal for our 
current situation, which is to use negotiated conservatorship, as was 
done with Continental Illinois. However, even his approach needs to be 
supplemented with quickly breaking up and selling off troubled banks; 
this is a daunting administrative task, but better than the 
alternatives.

 9)  The critical weakness in our system is that bank executives get to 
keep their jobs and their money. All key insiders should be fired when 
their banks become insolvent (as part of the government intervention 
and support process), irrespective of the reason for that insolvency. 
They should also be subject to large fines, equal to or in excess of 
the value of their total compensation while leading the bank that 
failed. As things currently stand, powerful insiders have learnt that 
they can gamble heavily and never lose personally or professionally.

10)  Our national debt will increase substantially as a result of 
direct bank bail-outs and, more importantly, the discretionary fiscal 
stimulus needed to keep the economy from declining--as well as the 
standard deficit due to cyclical slowdown (a feature of the ``automatic 
fiscal stabilizers''). This will constrain our future actions as a 
nation. For example, it may limit our options in terms of health care 
reform, with severe adverse social, economic, and budgetary 
implications.

11)  The costs to consumers from our broad and deep banking crisis come 
in many forms. For example, in a period of financial confusion, it is 
easier to raise fees on consumers--they will have a harder time 
switching to other credit companies and many of them need the credit in 
order to survive. Supporting consumption is a key part of our economic 
recovery, but we are letting credit card issuers hit consumers hard; 
this is evidence of prior uncompetitive behavior (i.e., limiting entry, 
in order to raise prices later).

    The remainder of this testimony provides further background 
regarding how this particular system (or lack of system) for handling 
financial insolvency developed. It also recaps some of the policy paths 
not taken in recent months, and suggests that our current trajectory 
with regard to banks is far from ideal. We need to find new ways to 
address the problems that arise when bank executives think their 
institutions are Too Big To Fail; this includes applying antitrust law 
in new ways.

Background

    The depth and suddenness of the U.S. economic and financial crisis 
today are strikingly and shockingly reminiscent of experiences we have 
seen recently only in emerging markets: Korea in 1997, Malaysia in 1998 
and even Russia and Argentina, repeatedly.
    The common factor in those emerging market crises was a moment when 
global investors suddenly became afraid that the country in question 
wouldn't be able to pay off its debts, and stopped lending money 
overnight. In each case, the fear became self-fulfilling, as banks 
unable to roll over their debt did, in fact, become unable to pay off 
all their creditors.
    This is precisely what drove Lehman Brothers into bankruptcy on 
September 15, and the result was that, overnight, all sources of 
funding to the U.S. financial sector dried up. From that point, the 
functioning of the banking sector has depended on the Federal Reserve 
to provide or guarantee the necessary funding. And, just like in 
emerging markets crises, the weakness in the banking system has quickly 
rippled out into the real economy, causing a severe economic 
contraction and hardship for millions of people.
    This part of my testimony examines how the United States became 
more like an emerging market, the politics of a financial sector with 
banks that are now ``too big to fail,'' and what this implies for 
policy--particularly, the pressing need to apply existing antitrust 
laws to big finance.

How could this happen?

    The U.S. has always been subject to booms and busts. The dotcom 
craze of the late 1990s is a perfect example of our usual cycle; many 
investors got overexcited and fortunes were lost. But at the end of the 
day we have the Internet which, like it or not, profoundly changes the 
way we organize society and make money. The same thing happened in the 
19th century with waves of investment in canals, railroad, oil, and any 
number of manufacturing industries.
    This time around, something was different. Behind the usual ups and 
downs during the past 25 or so years, there was a long boom in 
financial services--something you can trace back to the deregulation of 
the Reagan years, but which got a big jolt from the Clinton 
Administration's refusal to regulate derivatives market effectively and 
the failure of bank regulation under Alan Greenspan and the George W. 
Bush Administration. Finance became big relative to the economy, 
largely because of these political decisions, and the great wealth that 
this sector created and concentrated in turn gave bankers enormous 
political weight.
    This political weight had not been seen in the U.S. since the age 
of J.P. Morgan (the man). In that period, the banking panic of 1907 
could only be stopped by coordination among private-sector bankers, 
because there was no government entity able to offer an effective 
counterweight. But the first age of banking oligarchs came to an end 
with the passage of significant banking regulation during and in 
response to the Great Depression. But the emergence of a financial 
oligarchy during a long boom is typical of emerging markets.
    There were, of course, some facilitating factors behind the crisis. 
Top investment bankers and government officials like to lay the blame 
on low U.S. interest rates after the dotcom bust, or even better--for 
them--the flow of savings out of China. Some on the right of the 
spectrum like to complain about Fannie Mae or Freddie Mac, or even 
about longer-standing efforts to promote broader home ownership. And, 
of course, it is axiomatic to everyone that the regulators responsible 
for ``safety and soundness'' were fast asleep at the wheel.
    But these various policies--lightweight regulation, cheap money, 
the unwritten Chinese-American economic alliance, the promotion of 
homeownership--had something in common, even though some are 
traditionally associated with Democrats and some with Republicans: they 
all benefited the financial sector. The underlying problem was that 
policy changes that might have limited the ability of the financial 
sector to make money--such as Brooksley Born's attempts at the 
Commodity Futures Trading Commission to regulate over-the-counter 
derivatives such as credit default swaps--were ignored or swept aside.
    Big banks enjoyed a level of prestige that allowed them to do what 
they liked, for example with regard to ``risk management'' systems that 
allowed them to book large profits (and pay large bonuses) while taking 
risks that would be borne in the future--and by the rest of society. 
Regulators, legislators, and academics almost all assumed the managers 
of these banks knew what they were doing. In retrospect, of course, 
they didn't.
    Stanley O'Neal, CEO of Merrill Lynch, pushed his firm heavily into 
the mortgage-backed securities market at its peak in 2005 and 2006; in 
October 2007, he was forced to say, ``The bottom line is we . . . I . . 
. got it wrong by being overexposed to sub-prime, and we suffered as a 
result of impaired liquidity . . . in that market. No one is more 
disappointed than I am in that result.'' (O'Neal earned a $14 million 
bonus in 2006; forced out in October 2007, he walked away with a 
severance package worth over $160 million, although it is presumably 
worth much less today.)
    At the same time, AIG Financial Products earned over $2 billion in 
pretax profits in 2005, largely by selling underpriced insurance on 
complex, poorly-understood securities. Often described as ``picking up 
nickels in front of a steamroller,'' this strategy is highly profitable 
in ordinary years, and disastrous in bad years. As of last fall, AIG 
had outstanding insurance on over $500 billion of securities. To date, 
the U.S. Government has committed close to $200 billion in investments 
and loans in an effort to rescue AIG from losses largely caused by this 
one division--and which its sophisticated risk models said would not 
occur.
    ``Securitization'' of sub-prime mortgages and other high risk loans 
created the illusion of diversification. While we should never 
underestimate the human capacity for self-delusion, what happened to 
all our oversight mechanisms? From top to bottom, executive, 
legislative and judicial, were effectively captured, not in the sense 
of being coerced or corrupted, but in the equally insidious sense of 
being utterly convinced by whatever the banks told them. Alan 
Greenspan's pronouncements in favor of unregulated financial markets 
have been echoed numerous times. But this is what the man who succeeded 
him said in 2006: ``The management of market risk and credit risk has 
become increasingly sophisticated . . . banking organizations of all 
sizes have made substantial strides over the past two decades in their 
ability to measure and manage risks.''
    And they were captured (or completely persuaded) by exactly the 
sort of elite that dominates an emerging market. When a country like 
Indonesia or Korea or Russia grows, some people become rich and more 
powerful. They engage in some activities that are sensible for the 
broader economy, but they also load up on risk. They are masters of 
their mini-universe and they reckon that there is a good chance their 
political connections will allow them to ``put'' back to the government 
any substantial problems that arise. In Thailand, Malaysia, and 
Indonesia prior to 1997, the business elite was closely interwoven with 
the government; and for many of the oligarchs, the calculation proved 
correct--in their time of need, public assistance was forthcoming.
    This is a standard way to think about middle income or low income 
countries. And there are plenty of Americans who are also comfortable 
with this as a way of describing how some West European countries 
operate. Unfortunately, this is also essentially how the U.S. operates 
today.

The U.S. System

    Of course, the U.S. is unique. And just as we have the most 
advanced economy, military, and technology in the world, we also have 
the most advanced oligarchy.
    In a primitive political system, power is transmitted through 
violence, or the threat of violence: military coups, private militias, 
etc. In a less primitive system more typical of emerging markets, power 
is transmitted via money: bribes, kickbacks, and offshore bank 
accounts. Although lobbying and campaign contributions certainly play a 
major role in the American political system, old-fashioned corruption--
envelopes stuffed with $100 bills--is probably a sideshow today, Jack 
Abramoff notwithstanding.
    Instead, the American financial industry gained political power by 
amassing a kind of cultural capital--a belief system. Once, perhaps, 
what was good for General Motors was good for the United States. In the 
last decade, the attitude took hold in the U.S. that what was good for 
Big Finance on Wall Street was good for the United States. The banking 
and securities industry has become one of the top contributors to 
political campaigns, but at the peak of its influence it did not have 
to buy favors the way, for example, the tobacco companies or military 
contractors might have to. Instead, it benefited from the fact that 
Washington insiders already believed that large financial institutions 
and free-flowing capital markets were critical to America's position in 
the world.
    One channel of influence was, of course, the flow of individuals 
between Wall Street and Washington. Robert Rubin, Co-Chairman of 
Goldman Sachs, served in Washington as Treasury Secretary under 
President Clinton, and later became Chairman of the Executive Committee 
of Citigroup. Henry Paulson, CEO of Goldman Sachs during the long boom, 
became Treasury Secretary under President George W. Bush. John Snow, an 
earlier Bush Treasury Secretary, left to become Chairman of Cerberus 
Capital Management, a large private equity firm that also counts Vice 
President Dan Quayle among its executives. President George H.W. Bush 
has been an advisor to the Carlyle Group, another major private equity 
firm. Alan Greenspan, after the Federal Reserve, became a consultant to 
PIMCO, perhaps the biggest player on international bond markets.
    These personal connections--which were multiplied many times over 
on lower levels of the last three presidential administrations--
obviously contributed to the alignment of interests between Wall Street 
and Washington.
    Wall Street itself is a very seductive place, imbued with an aura 
not only of wealth but of power. The people who man its towers truly 
believe that they control the levers that make the world go 'round, and 
a civil servant from Washington invited into their conference rooms, 
even if just for a meeting, could be forgiven for falling under its 
sway.
    The seduction extended even (or especially) to finance and 
economics professors, historically confined to the cramped hallways of 
universities and the pursuit of Nobel Prizes. As mathematical finance 
became more and more critical to practical finance, professors 
increasingly took positions as consultants or partners at financial 
institutions. The most famous example is probably Myron Scholes and 
Robert Merton, Nobel Laureates both, taking positions at Long-Term 
Capital Management, but there are many others. One effect of this 
migration was to lend the stamp of academic legitimacy (and 
intellectual intimidation) to the burgeoning world of high finance.
    Why did this happen, and why now? America is a country that has 
always been fascinated with rather than repelled by wealth, where 
people aspire to become rich, or at least associate themselves with the 
rich, rather than redistribute their wealth downward. And roughly from 
the 1980s, more and more of the rich have made their money in finance.
    There are various reasons for this evolution. Beginning in the 
1970s, several factors upset the relatively sleepy world of banking--
taking deposits, making commercial and residential loans, executing 
stock trades, and underwriting debt and equity offerings. The 
deregulation of stock brokerage commissions in 1975 increased 
competition and stimulated participation in stock markets. In Liar's 
Poker, Michael Lewis singles out Paul Volcker's monetary policy and 
increased volatility in interest rates: this, Lewis argues, made bond 
trading much more popular and lucrative and, it is true, the markets 
for bonds and bond-like securities have been where most of the action 
has been in recent decades. Good old-fashioned innovation certainly 
played its part: the invention of securitization in the 1970s (and the 
ability of Salomon Brothers to make outsized amounts of money in 
mortgage-backed securities in the 1980s), as well as the invention of 
interest-rate swaps and credit default swaps, vastly increased the 
volume of transactions that bankers could make money on. Demographics 
helped: an aging and increasingly wealthy population invested more and 
more money in securities, helped by the invention of the IRA and the 
401(k) plan, again boosting the supply of the raw material from which 
bankers make money. These developments together vastly increased the 
opportunities to make money in finance.
    Not surprisingly, financial institutions started making a lot more 
money, beginning in the mid-1980s. 1986 was the first year in the 
postwar period that the financial sector earned 19 percent of total 
domestic corporate profits. In the 1990s, that figure oscillated 
between 21 percent and 30 percent; this decade, it reached as high as 
41 percent. The impact on compensation in the financial sector was even 
more dramatic. From 1948 to 1982, average compensation in the financial 
sector varied between 99 percent and 108 percent of the average for all 
domestic private industries. From 1983, it shot upward in nearly a 
straight line, reaching 181 percent in 2007.
    The results were simple. Jobs in finance became more prestigious, 
people in finance became more prestigious, and the cult of finance 
seeped into the culture at large, through works like Liar's Poker, 
Barbarians at the Gate, Wall Street, and Bonfire of the Vanities. Even 
the convicted criminals, like Michael Milken and Ivan Boesky, became 
larger than life. In a country that celebrates the idea of making 
money, it was easy to infer that the interests of the financial sector 
were the same as the interests of the country as a whole--and that the 
winners in the financial sector knew better what was good for American 
than career civil servants in Washington.
    As a consequence, there was no shadowy conspiracy that needed to be 
pursued in secrecy. Instead, it became a matter of conventional 
wisdom--trumpeted on the editorial pages of the Wall Street Journal and 
in the popular press as well as on the Floor of Congress--that 
financial free markets were good for the country as a whole. As the 
buzz of the dot-com bubble wore off, finance and real estate became the 
new American obsession. Private equity firms became the destination of 
choice for business students and hedge funds became the sure-fire way 
to make not millions but tens of millions of dollars. In America, where 
wealth is less resented than celebrated, the masters of the financial 
universe became objects of admiration or even adulation.
    The deregulatory policies of the past decade flowed naturally from 
this confluence of campaign finance, personal connections, and 
ideology: insistence on free flows of capital across borders; repeal of 
the Depression-era regulations separating commercial and investment 
banking; a Congressional ban on the regulation of credit default swaps; 
major increases in the amount of leverage allowed to investment banks; 
a general abdication by the Securities and Exchange Commission of its 
enforcement responsibilities; an international agreement to allow banks 
to measure their own riskiness; a short-lived proposal to partially 
privatize social security; and, most banally but most importantly, a 
general failure to keep pace with the tremendous pace of innovation in 
financial markets.

American Oligarchs and the Financial Crisis

    The oligarchy and the government policies that aided it did not 
alone cause the financial crisis that exploded last year. There were 
many factors that contributed, including excessive borrowing by 
households and lax lending standards out on the fringes of the 
financial world. But major commercial and investment banks--and their 
fellow travelers--were the big beneficiaries of the twin housing and 
asset bubbles of this decade, their profits fed by an ever-increasing 
volume of transactions founded on a small base of actual physical 
assets. Each time a loan was sold, packaged, securitized, and resold, 
banks took their transaction fees, and the hedge funds buying those 
securities reaped ever-larger management fees as their assets under 
management grew.
    Because everyone was getting richer, and the health of the national 
economy depended so heavily on growth in real estate and finance, no 
one in Washington had the incentive to question what was going on. 
Instead, Fed Chairman Greenspan and President Bush insisted repeatedly 
that the economy was fundamentally sound and that the tremendous growth 
in complex securities and credit default swaps were symptoms of a 
healthy economy where risk was distributed safely.
    In summer 2007, the signs of strain started appearing--the boom had 
produced so much debt that even a small global economic stumble could 
cause major problems. And from then until the present, the financial 
sector and the Federal Government have been behaving exactly the way 
one would expect after having witnessed emerging market financial 
crises in the past.
    In a financial panic, the critical ingredients of the government 
response must be speed and overwhelming force. The root problem is 
uncertainty--in our case, uncertainty about whether the major banks 
have sufficient assets to cover their liabilities. Half measures 
combined with wishful thinking and a wait-and-see attitude are 
insufficient to overcome this uncertainty. And the longer the response 
takes, the longer that uncertainty can sap away at the flow of credit, 
consumer confidence, and the real economy in general--ultimately making 
the problem much harder to solve.
    Instead, however, the principal characteristics of the government's 
response to the financial crisis have been denial, lack of 
transparency, and unwillingness to upset the financial sector.
    First, there was the prominent place of policy by deal: when a 
major financial institution, got into trouble, the Treasury Department 
and the Federal Reserve would engineer a bail-out over the weekend and 
announce that everything was fine on Monday. In March 2008, there was 
the sale of Bear Stearns to JPMorgan Chase, which looked to many like a 
gift to JPMorgan. The deal was brokered by the Federal Reserve Bank of 
New York--which includes Jamie Dimon, CEO of JPMorgan, on its board of 
directors. In September, there were the takeover of Fannie Mae and 
Freddie Mac, the sale of Merrill Lynch to Bank of America, the decision 
to let Lehman fail, the destructive bail-out of AIG, the takeover and 
immediate sale of Washington Mutual to JPMorgan, and the bidding war 
between Citigroup and Wells Fargo over the failing Wachovia--all of 
which were brokered by the government. In October, there was the 
recapitalization of nine large banks on the same day behind closed 
doors in Washington. This was followed by additional bail-outs for 
Citigroup, AIG, Bank of America, and Citigroup (again).
    In each case, the Treasury Department and the Fed did not act 
according to any legislated or even announced principles, but simply 
worked out a deal and claimed that it was the best that could be done 
under the circumstances. This was late-night, back-room dealing, pure 
and simple.
    What is more telling, though, is the extreme care the government 
has taken not to upset the interests of the financial institutions 
themselves, or even to question the basic outlines of the system that 
got us here.
    In September 2008, Henry Paulson asked for $700 billion to buy 
toxic assets from banks, as well as unconditional authority and freedom 
from judicial review. Many economists and commentators suspected that 
the purpose was to overpay for those assets and thereby take the 
problem off the banks' hands--indeed, that is the only way that buying 
toxic assets would have helped anything. Perhaps because there was no 
way to make such a blatant subsidy politically acceptable, that plan 
was shelved.
    Instead, the money was used to recapitalize (buy shares in) banks--
on terms that were grossly favorable to the banks. For example, Warren 
Buffett put new capital into Goldman Sachs just weeks before the 
Treasury Department invested in nine major banks. Buffett got a higher 
interest rate on his investment and a much better deal on his options 
to buy Goldman shares in the future.
    As the crisis deepened and financial institutions needed more 
assistance, the government got more and more creative in figuring out 
ways to provide subsidies that were too complex for the general public 
to understand. The first AIG bail-out, which was on relatively good 
terms for the taxpayer, was renegotiated to make it even more friendly 
to AIG. The second Citigroup and Bank of America bail-outs included 
complex asset guarantees that essentially provided nontransparent 
insurance to those banks at well below-market rates. The third 
Citigroup bail-out, in late February 2009, converted preferred stock to 
common stock at a conversion price that was significantly higher than 
the market price--a subsidy that probably even most Wall Street Journal 
readers would miss on first reading. And the convertible preferred 
shares that will be provided under the new Financial Stability Plan 
give the conversion option to the bank in question, not the 
government--basically giving the bank a valuable option for free.
    One problem with this velvet-glove strategy is that it was simply 
inadequate to change the behavior of a financial sector used to doing 
business on its own terms. As an unnamed senior bank official said to 
the New York Times, ``It doesn't matter how much Hank Paulson gives us, 
no one is going to lend a nickel until the economy turns.''
    At the same time, the princes of the financial world assumed that 
their position as the economy's favored children was safe, despite the 
wreckage they had caused. John Thain, in the midst of the crisis, asked 
his board of directors for a $10 million bonus; he withdrew the request 
amidst a firestorm of protest after it was leaked to the Wall Street 
Journal. Merrill Lynch as a whole was no better, moving its bonus 
payments forward to December, reportedly (although this is now a matter 
of some controversy) to avoid the possibility they would be reduced by 
Bank of America, which would own Merrill beginning on January 1.
    This continued solicitousness for the financial sector might be 
surprising coming from the Obama Administration, which has otherwise 
not been hesitant to take action. The $800 billion fiscal stimulus plan 
was watered down by the need to bring three Republican senators on 
board and ended up smaller than many hoped for, yet still counts as a 
major achievement under our political system. And in other ways, the 
new administration has pursued a progressive agenda, for example in 
signing the Lilly Ledbetter law making it easier for women to sue for 
discrimination in pay and moving to significantly increase the 
transparency of government in general (but not vis-a-vis its dealings 
with the financial sector).
    What it shows, however, is that the power of the financial sector 
goes far beyond a single set of people, a single administration, or a 
single political party. It is based not on a few personal connections, 
but on an ideology according to which the interests of Big Finance and 
the interests of the American people are naturally aligned--an ideology 
that assumes the private sector is always best, simply because it is 
the private sector, and hence the government should never tell the 
private sector what to do, but should only ask nicely, and maybe 
provide some financial handouts to keep the private sector alive.
    To those who live outside the Treasury-Wall Street corridor, this 
ideology is increasingly not only at odds with reality, but actually 
dangerous to the economy.

The Way Out

    Looking just at the financial crisis (and leaving aside some 
problems of the larger economy), we face at least two major, 
interrelated problems. The first is a desperately ill banking sector 
that threatens to choke off any incipient recovery that the fiscal 
stimulus might be able to generate. The second is a network of 
connections and ideology that give the financial sector a veto over 
public policy, even as it loses popular support.
    That network, it seems, has only gotten stronger since the crisis 
began. And this is not surprising. With the financial system as fragile 
as it is, the potential damage that a major bank could cause--Lehman 
was small relative to Citigroup or Bank of America--is much greater 
than it would be during ordinary times. The banks have been exploiting 
this fear to wring favorable deals out of Washington. Bank of America 
obtained its second bail-out package (in January 2009) by first 
threatening not to go through with the acquisition of Merrill Lynch--a 
prospect that Treasury did not want to consider (although the details 
of exactly who forced whom to do what remain rather murky).
    In some ways, of course, the government has already taken control 
of the banking system. Since the market does not believe that bank 
assets are worth more than their liabilities--at least for several 
large banks that are a large proportion of the overall system--the 
government has already essentially guaranteed their liabilities. The 
government has already sunk hundreds of billions of dollars into banks. 
The government is the only plausible source of capital for the banks 
today. And the Federal Reserve has taken on a major role in providing 
credit to the real economy. We have state control of finance without 
much control over banks or anything else--we can try to limit executive 
compensation, but we don't get to replace boards of directors and we 
have no say in who really runs anything.
    One solution is to scale-up the standard FDIC process. A Federal 
Deposit Insurance Corporation (FDIC) ``intervention'' is essentially a 
government-managed bankruptcy procedure for banks. Organizing 
systematic tough assessments of capital adequacy, followed by such 
interventions, would simplify enormously the job of cleaning up the 
balance sheets of the banking system. The problem today is that 
Treasury negotiates each bail-out with the bank being saved, yet 
Treasury is paradoxically--but logically, given their anachronistic 
belief system--behaving as if the bank holds all the cards, contorting 
the terms of the deal to minimize government ownership while 
forswearing any real influence over the bank.
    Cleaning up bank balance sheets cannot be done through negotiation. 
Everything depends on the price the government pays for those assets, 
and the banks' incentive is to hold up the government for as high a 
price as possible. Instead, the government should thoroughly inspect 
the banks' balance sheets and determine which cannot survive a severe 
recession (the current ``stress tests'' are fine in principle but not 
tough enough in practice; a point which Saturday Night Live has 
noticed). These banks would then face a choice: write down your assets 
to their true value and raise private capital within thirty days, or be 
taken over by the government. The government would clean them up by 
writing down the banks' toxic assets--recognizing reality, that is--and 
transferring those to a separate government entity, which would attempt 
to salvage whatever value is possible for the taxpayer (as the 
Resolution Trust Corporation did after the Savings and Loan debacle of 
the 1980s).
    This would be expensive to the taxpayer; according to the latest 
IMF numbers, the bank clean-up itself would probably cost close to $1.5 
trillion (or 10 percent of our GDP) in the long-term. But only by 
taking decisive action that exposes the full extent of the financial 
rot and restores some set of banks to publicly verifiable health can 
the paralysis of the financial sector be cured. The indirect and hidden 
costs of postponing a proper bank clean up would be much larger--for 
example, as measured by the consequent increase in government debt.
    But the second challenge--the power of the oligarchy--is just as 
important as the first. And the advice from those with experience in 
severe banking crises would be just as simple: break the oligarchy.
    In the U.S., this means breaking up the oversized institutions that 
have a disproportionate influence on public policy. And it means 
splitting a single interest group into competing sub-groups with 
different interests. How do we do this?
    First, bank recapitalization--if implemented right--can use private 
equity interests against the powerful large bank insiders. The banks 
should be sold as going concerns and desperately need new powerful 
shareholders. There is a considerable amount of wealth ``on the 
sidelines'' at present, and this can be enticed into what would 
essentially be reprivatization deals. And there are plenty of people 
with experience turning around companies who can be brought in to shake 
up the banks.
    The taxpayer obviously needs to keep considerable upside in these 
deals, and there are ways to structure this appropriately without 
undermining the incentives of new controlling shareholders. But the key 
is to split the oligarchy and set the private equity part onto sorting 
out the large banks.
    The second step is somewhat harder. You need to force the new 
private equity owners of banks to break them up, so they are no longer 
too big to fail--and making it harder for the new oligarchs to 
blackmail the government down the road. The major banks we have today 
draw much of their power from being too big to fail, and they could 
become even more dangerous when run by competent private equity 
managers.
    Ideally, big banks should be sold in medium-sized pieces, divided 
regionally or by type of business, to avoid such a concentration of 
power. If this is practically infeasible--particularly as we want to 
sell the banks quickly--they could be sold whole, but with the 
requirement of being broken up within a short period of time. Banks 
that remain in private hands should also be subject to size 
limitations.
    This may seem like a crude and arbitrary step, but it is the most 
direct way to limit the power of individual institutions, especially in 
a sector that, the last year has taught us, is even more critical to 
the economy as a whole than anyone had imagined. Of course, some will 
complain about ``efficiency costs'' from breaking up banks, and they 
may have a point. But you need to weigh any such costs against the 
benefits of no longer having banks that are too big to fail. Anything 
that is ``too big to fail'' is now ``too big to exist.''
    To back this up, we quickly need to overhaul our anti-trust 
framework. Laws that were put in place over 100 years ago, to combat 
industrial monopolies, need to be reinterpreted (and modernized) to 
prevent the development of financial concentrations that are too big to 
fail. The issue in the financial sector today is not about having 
enough market share to influence prices, it is about one firm or a 
small set of interconnected firms being big enough so that their self-
destruction can bring down the economy. The Obama Administration's 
fiscal stimulus invokes FDR, but we need at least equal weight on Teddy 
Roosevelt-style trust-busting.
    Third, to delay or deter the emergence of a new oligarchy, we must 
go further: caps on executive compensation--for all banks that receive 
any form of government assistance, including from the Federal Reserve--
can play a role in restoring the political balance of power. While some 
of the current impetus behind these caps comes from old-fashioned 
populism, it is true that the main attraction of Wall Street--to the 
people who work there, to the members of the media who spread its 
glory, and to the politicians and bureaucrats who were only too happy 
to bask in that reflected glory--was the astounding amount of money 
that could be made. To some extent, limiting that amount of money would 
reduce the allure of the financial sector and make it more like any 
other industry.
    Further regulation of behavior is definitely needed; there will be 
costs, but think of the benefits to the system as a whole. In the long 
run, the only good solution may be better competition--finally breaking 
the non-competitive pricing structures of hedge funds, and bringing 
down the fees of the asset management and banking industry in general. 
To those who say this would drive financial activities to other 
countries, we can now safely say: fine.
    Of course, all of this is at best a temporary solution. The economy 
will recover some day, and Wall Street will be there to welcome the 
most financially ambitious graduates of the world's top universities. 
The best we can do is put in place structural constraints on the 
financial sector--anti-trust rules and stronger regulations--and hope 
that they are not repealed amidst the euphoria of a boom too soon in 
the future. In the meantime, we can invest in education, research, and 
development with the goal of developing new leading sectors of our 
economy, based on technological rather than financial innovation.
    In a democratic capitalist society, political power flows towards 
those with economic power. And as society becomes more sophisticated, 
the forms of that power also become more sophisticated. Until we come 
up with a form of political organization that is less susceptible to 
economic influences, oligarchs--like booms and busts--are something 
that we must account for and be prepared for. The crucial first step is 
recognizing that we have them.

                      Biography for Simon Johnson
    Simon Johnson is the Ronald A. Kurtz (1954) Professor of 
Entrepreneurship at MIT's Sloan School of Management. He is also a 
senior fellow at the Peterson Institute for International Economics in 
Washington, D.C.; a co-founder of http://BaselineScenario.com, a widely 
cited web site on the global economy; and a member of the Congressional 
Budget Office's Panel of Economic Advisers.
    Mr. Johnson appears regularly on NPR's Planet Money podcast in the 
Economist House Calls feature, is a weekly contributor to NYT.com's 
Economix, and has a video blog on The New Republic's web site. He is 
also co-moderator of the Washington Post's The Hearing, an on-line 
discussion centered around economics-related debates in Congress.
    Professor Johnson is an expert on financial and economic crises. As 
an academic, in policy roles, and with the private sector, over the 
past 20 years he has worked on severely stressed economic and financial 
situations around the world. His research and policy advice focus on 
how to limit the impact of negative shocks and manage the risks faced 
by countries.
    From March 2007 through the end of August 2008, Professor Johnson 
was the International Monetary Fund's Economic Counselor (Chief 
Economist) and Director of its Research Department.
    In 2000-2001 Professor Johnson was a member of the U.S. Securities 
and Exchange Commission's Advisory Committee on Market Information. His 
assessment of the need for continuing strong market regulation is 
published as part of the final report from that committee.
    He is co-founder and a current Co-Chairman of the National Bureau 
of Economic Research's (NBER) project on Africa. He is also faculty 
director of MIT Sloan's new Moscow initiative and a former member of 
the Global Advisory Board of Endeavor, which promotes entrepreneurship 
in Latin America and around the world.

    Chairman Miller. Thank you, Dr. Johnson. Dr. Baker for five 
minutes.

 STATEMENT OF DR. DEAN BAKER, CO-DIRECTOR, CENTER FOR ECONOMIC 
                      AND POLICY RESEARCH

    Dr. Baker. Thank you, Chairman Miller. I appreciate the 
opportunity to address the Committee on these issues.
    I want to make three main points in my comments this 
morning. First off, I think that the problem of troubled assets 
has been widely misconstrued. It is a problem first and 
foremost of mortgages, bad mortgages, not mortgage-backed 
securities or other complex derivative instruments. Secondly, 
that there really is no problem of the lack of market. There is 
a market there, and there is absolutely no reason to believe it 
is not properly pricing these assets, and thirdly, when it 
comes to the stress test that although there is some reason to 
question the quality of the stress test, whether they are harsh 
enough, that policy seems to be inconsistent with the 
conclusions that the Treasury has drawn from the stress test.
    Starting with the first point, one of the benefits we got 
from the stress test was just a clear delineation of what 
assets are at risk, and there we could see very clearly the 
analysis of the 19 banks showed that less than six percent of 
the troubled assets, or I should say the losses that were 
projected in the stress test, were attributed to mortgage-
backed securities. The mortgage-backed securities, I should say 
non-agency mortgage-backed securities, some to less than $200 
billion and many of those were not sub-prime and many of those 
are of older vintages, and therefore presumably not as troubled 
as, say, a sub-prime mortgage issued in recent years.
    So that is not the main story. The main story very clearly 
is mortgages, the losses projected from mortgages in this 
severe scenario were over $200 billion. That accounted for more 
than 30 percent of the total losses, far and away the largest 
single category. So it is clear that the trouble assets are 
mortgages, more than anything. It is not mortgage-backed 
securities.
    The second point is that we have a market for mortgages. 
This idea that somehow there is no market, I mean, all you have 
to do, FDIC has acquired tens of billions of dollars in 
mortgages, and they are auctioning them off on an ongoing 
basis. You could simply look that up on the web site, and you 
could find out the price of those mortgages. I eyeballed this. 
Other people have calculated it. It is around 30 cents on the 
dollar is a typical price that a non-performing mortgage 
commands.
    Now, the question is, is that an unreasonable price? And I 
just looked up--again a quick analysis, I looked up what had 
happened to the prices for the bottom tier of houses in the 
most bubble-inflated markets. This is taken from Case-Shiller 
data, very good series on house prices, and the reason for 
picking this--I wasn't just cherry-picking--the idea was that 
where would you find the most troubled mortgages? Well, you 
would expect to see them in sub-prime markets, in these bubble 
markets, places like Phoenix and Miami, Tampa, San Diego where 
prices had gone through the roof in the peak years of the 
housing boom that have now gone through the floor.
    So if we look at those prices--I included a short table in 
my testimony--you see that in many cases the prices have fallen 
by more than 50 percent, and in the worst case in Phoenix, the 
prices had fallen by 65.9 percent. Now that is data as of 
February of this year, and I point out that we since have about 
four months since that data, since those numbers were 
calculated. Prices in these markets are falling three to four 
percent a month.
    So if you say, okay, imagine that you have a mortgage on 
one of these houses where you are looking at a very high 
probability of foreclosure, how much will you get after the 
cost of foreclosure, which typically they estimate at 25 to 30 
percent of the face value of the mortgage, 30 cents on the 
dollar looks perhaps even high in many of these cases.
    So there is very little reason to think that we somehow 
have a market failure here. To my mind, 30 cents on the dollar 
indicates a perfectly reasonable price. I am not in the market 
for buying bad mortgages, but there is no obvious reason to 
question the market's judgment in this case.
    The last point--in terms of the stress test, again, I would 
agree with the prior statement from both Dr. Johnson and Dr. 
Sachs. I think it is questionable whether these were adequate. 
Just to give a couple quick points. The unemployment rate that 
is assumed as a year-round average for 2009 in the severe 
scenario is 8.9 percent. We of course hit that number in April, 
and I don't know anyone who doesn't expect it to go much 
higher. We are losing 600,000 jobs a month. They expect a 22 
percent rate of house price decline over the course of 2009. 
House prices are declining at a two percent monthly rate. That 
gives you 24 percent. So it is very hard to paint that as a 
worst-case scenario. But be that as it may, the 
Administration's interpretation of the stress test were that 
essentially the banks would for the most part, with the 
possible exception of GMAC, find that they would be able to 
raise the capital necessary from the private sector to maintain 
their capital requirements. If that is the case, it is hard to 
justify the level of government assistance we currently see, 
and it would be reasonable to ask when the special programs 
would be phased out. So specifically here I am thinking of the 
special lending through the FDIC where we have the FDIC 
ensuring government bonds or bank bonds issued by the 
government--I am sorry, issued by the banks. Secondly, the 
lending facilities that the Fed is creating, and thirdly and 
perhaps most egregiously, the AIG window which I don't think we 
have been given a very good explanation as to what the 
rationale was behind the payouts that AIG has made or might 
make in the future.
    Finally, again, agreeing very strongly with Dr. Sachs, the 
PPIP I think is a very large subsidy to the banks that perhaps 
there have been arguments for subsidizing them in the event 
that they really were on the edge of insolvency. But if we 
accept the results of the stress test, it is very hard to 
justify what could be a trillion-dollar program, and again, I 
agree very strongly with Dr. Sachs, that it is likely to be 
poorly run and lead to many opportunities for gaming and very 
large losses for taxpayers.
    Thank you.
    [The prepared statement of Dr. Baker follows:]
                    Prepared Statement of Dean Baker
    Thank you, Chairman Miller, for inviting me to testify before the 
Subcommittee and to share my views on the problem of insolvency facing 
the U.S. banking system. I wish to make three main points in my 
comments:

        1)  There is little logic to the claim that there is no market 
        for ``troubled assets,'' since in fact such assets are being 
        sold on a regular basis by the FDIC;

        2)  There is little reason to believe that the current market 
        prices for these assets are unreasonably low and that they will 
        be selling for substantially higher prices in the foreseeable 
        future; and

        3)  If the major banks are fundamentally sound, as suggested by 
        the recent stress tests conducted by the Fed and Treasury, then 
        there can be little justification for the various forms of 
        subsidies, such as the Fed's special lending facilities, which 
        allow banks to borrow at below-market interest rates.

    I will address these issues in turn.
    On the first point, it has been widely asserted that the central 
problem facing the banks is that they have large amounts of assets on 
their books that are not currently marketable due to the disruptions in 
national and international financial markets. I would argue that there 
is no obvious failure of the market. In fact, the ``troubled assets'' 
that the banks hold are being sold by the FDIC (among other 
institutions) on a regular basis, which must auction off mortgages and 
other assets from the banks that it has taken over in recent months.
    There has been considerable confusion about the nature of the 
troubled assets held by the banks. While banks do hold some amount of 
mortgage-backed securities, these securities are in fact a relatively 
small portion of their troubled assets. In its analysis of the bank 
stress tests, the Fed reported that the 19 bank holding companies it 
examined collectively held only about $200 billion in non-agency 
mortgage-backed securities. Furthermore, not all of these securities 
were of recent vintage or backed by non-prime mortgages, so the amount 
of these securities that could reasonably be placed in the troubled 
asset category would be even less than $200 billion.\1\ The Fed 
estimated the losses on these assets in the more adverse scenario at 
$35.2 billion, less than six percent of the total projected loss in 
this scenario. By contrast, the losses on mortgages were projected at 
$185.5 billion, more than 30 percent of total losses, by far the 
largest single category.\2\
---------------------------------------------------------------------------
    \1\ The structure of the banks' assets is discussed in Board of 
Governors of the Federal Reserve System, 2009. ``The Supervisory 
Capital Assessment Program: Overview of Results,'' pages 8-9, available 
at [http://www.federalreserve.gov/newsevents/bcreg20090507a1.pdf]
    \2\ Board of Governors of the Federal Reserve Board, 2009, Table 2.
---------------------------------------------------------------------------
    In short, the troubled assets on the banks' books are 
overwhelmingly mortgages, both first and second or other junior liens, 
not mortgage-backed securities. The FDIC has acquired large quantities 
of mortgages from its takeover of several dozen failed banks over the 
last year. It auctions these assets off on an ongoing basis. The 
results of these auctions are available on the FDIC web site.\3\ Non-
performing mortgages typically sell in these auctions at prices in the 
vicinity of 30 cents on the dollar.
---------------------------------------------------------------------------
    \3\ The FDIC web site reporting the results of its auctions can be 
found at http://www2.fdic.gov/closedsales/LoanSales.asp
---------------------------------------------------------------------------
    It is not clear on what basis these auctions can be said not to 
constitute a market. While the downturn and the constricted credit 
conditions affect the market, it is simply inaccurate to claim that 
there is no market for these assets. The major banks are undoubtedly 
not pleased at the prospect of having to sell off their loans at these 
prices, but this merely indicates that they are unhappy with the market 
outcome, just as a homeowner might be unwilling to sell her house at a 
loss. However, the unhappiness of the seller does not mean that there 
is no market.
    The second issue is whether there is some reason to believe that 
the prices that these loans currently command is unrealistically 
depressed and that they will command a substantially higher price in 
the near future. On its face, there is little evidence to support this 
view.
    Most of the loans that fall in this toxic category were presumably 
non-prime loans issued to buy homes near the peak of the housing bubble 
in the years 2004-2007. Most of these loans presumably went to buy 
lower-end homes in the most inflated bubble markets--places like Los 
Angeles, San Diego, Miami, and Phoenix.
    In these cities, house prices have fallen sharply from their bubble 
peaks. The table below gives the decline in nominal house prices from 
their bubble peaks for homes in the bottom third of the housing market, 
as reported in the Case-Shiller tiered price index. The data show that 
prices of homes in the bottom third of several of these markets have 
already declined by more than 50 percent from their bubble peaks. In 
Phoenix, the most extreme case of the cities included in the Case-
Shiller index, the price of houses in the bottom third of the market 
are already down more than 60 percent from their bubble peaks.



    Furthermore, house prices are continuing to decline rapidly. Prices 
for homes in the bottom tier are falling at a rate of three to four 
percent per month in the Case-Shiller index. The most recent data in 
the Case-Shiller indexes was for February. (The data is obtained at 
closing. Since there is typically more than a month between when a 
contract is signed and when closing takes place, the February data 
primarily reflect market conditions in January.) It is therefore likely 
that the price of houses for homes in the bottom third of these markets 
are already at least ten percent lower presently (May 2009), than 
indicated in the February data.
    In the peak years of the bubble, 2004-2007, it was common for home 
buyers to purchase homes with little or no money down. If a mortgage 
written against these homes is now non-performing, and the house has 
lost 60 percent of its value, then it is very plausible that the 
current market value of this mortgage is 30 cents on the dollar or 
less, based on the underlying value of the collateral. The costs 
associated with carrying through the foreclosure are likely to take up 
a large portion of the proceeds from the resale of the house.
    In fact, there have been several press accounts of instances where 
lenders have stopped carrying through foreclosures in some especially 
depressed markets.\4\ They have decided that the money from selling the 
home would not cover the cost of carrying through the foreclosure. In 
many former bubble markets or some very depressed non-bubble markets, 
such as Detroit or Cleveland, prices of 30 cents on the dollar may be 
high for non-performing loans.
---------------------------------------------------------------------------
    \4\ For example, see ``No Sale: Bank Wrecks New Homes,'' Wall 
Street Journal, May 5, 2009; A3.
---------------------------------------------------------------------------
    There is little reason to expect prices to bounce back from current 
levels. The run-up in house prices in the years 2004-2007 was quite 
obviously an asset bubble. There was no obvious change in the 
fundamentals of the housing market either nationally or in the most 
affected cities that could have justified this increase in house 
prices. Furthermore, the increase in house prices was not associated 
with any remotely corresponding increase in rents. If the fundamentals 
of the housing market had been responsible for the run-up in house 
prices, then there should have been some comparable increase in rents 
in this period. Instead, real house prices were mostly fairly stable. 
The plunge in house prices in the last two and a half years is now 
bringing them back in line with rents. There is no obvious reason that 
house prices should turn around and go back toward their bubble peaks.
    In short, the current market valuation of the banks' toxic assets 
seems like an appropriate valuation based on the available evidence. It 
is understandable that the banks are unwilling to take large write-
downs on these loans, especially if it will raise questions about their 
solvency, but there is no reason to believe that there is any real 
problem in the market for these assets. In short, in designing plans to 
relieve the banks of their toxic assets, the Treasury and the Fed are 
trying to fix a problem that does not exist.
    The final point that I want to address is the role of the Federal 
Government in the bank bail-out in the context of the recently released 
stress tests of the country's 19 largest banks. There are serious 
grounds for questioning the usefulness of the stress tests, most 
obviously the fact that the economic assumptions in the adverse 
scenario are now a relatively optimistic scenario given recent economic 
data.
    However, what is more striking is that policy does not appear to be 
consistent with Secretary Geithner's assessment of the stress tests. 
Mr. Geithner has indicated that the tests suggest that the banks are 
essentially healthy. While they showed that several banks would need to 
raise additional amounts of capital, with the exception of GMAC, it 
seems likely that the capital shortfall could be made up either through 
capital raised in private markets or by converting the preferred shares 
already held by the government into common stock.
    If it is in fact the case that the banks can weather this crisis 
without further assistance from the government, then it is reasonable 
to ask why the government is continuing to provide extraordinary 
assistance. Specifically, if the banks are able to stand on their own, 
is there really a need for the special lending facilities that have 
been created by the Fed and have more than $2 trillion outstanding in 
loans to the banks and other institutions? The FDIC is guaranteeing 
several hundred billion dollars of bonds issued by banks in the last 
eight months and has authorized the banks to issue tens of billions of 
dollars of additional debt with a government guarantee.
    The government continues to fund AIG to pay off counter-parties 
(mostly banks) who would have incurred large losses without the 
government's intervention. And the government stands prepared to 
subsidize the purchase of as much as $1 trillion in troubled assets 
from the banks' balance sheets through the Public Private Investment 
Partnership (PPIP) program.
    These programs all involve substantial subsidies from taxpayers to 
the banks. Arguably, such subsidies are necessary if the survival of 
systematically important institutions is at risk. However, if these 
institutions are essentially solvent, as Mr. Geithner suggests based on 
the stress test results, then it seems appropriate to put an end to 
these taxpayer subsidies, or in the case of PPIP, to cancel the program 
before it is put in place. There is an important public interest in 
maintaining a functioning financial system. There is no public interest 
in subsidizing banks. If the banks are able to stand on their own 
without further public assistance, then they should be given that 
opportunity.

                        Biography for Dean Baker
    Dean Baker is the author of Plunder and Blunder: The Rise and Fall 
of the Bubble Economy, The United States Since 1980, The Conservative 
Nanny State: How the Wealthy Use the Government to Stay Rich and Get 
Richer, Social Security: The Phony Crisis (with Mark Weisbrot), and The 
Benefits of Full Employment (with Jared Bernstein). He was the editor 
of Getting Prices Right: The Debate Over the Consumer Price Index, 
which was a winner of a Choice Book Award as one of the outstanding 
academic books of the year. He appears frequently on TV and radio 
programs, including CNN, CBS News, PBS NewsHour, and National Public 
Radio. His blog, ``Beat the Press,'' features commentary on economic 
reporting. He received his B.A. from Swarthmore College and his Ph.D. 
in economics from the University of Michigan.

    Chairman Miller. Thank you, Dr. Baker. Mr. John for five 
minutes.

  STATEMENT OF MR. DAVID C. JOHN, SENIOR RESEARCH FELLOW, THE 
                      HERITAGE FOUNDATION

    Mr. John. Thank you for having me. This is quite a panel to 
be on actually. Some of the great people in our field.
    I would like to make four points and four relatively quick 
points about the stress tests and the use of models in general 
and on the financial institution situation in general.
    First off, I would argue that the stress tests, regardless 
of whether they were a worst-case-scenario or not, actually 
achieved their purpose which was to distract people. If you 
look at the way the financial stocks were selling, the fear 
that was in the market at the time the stress tests were 
announced, we had CitiBank selling below $1 for about 20 
minutes or so. We had great concern that the financial 
situation as a whole was going to be a disaster and collapse. 
However, with the stress test, people were forced to focus on 
the future to wait for some data, regardless of how good it 
was, and the net result was that the hysteria seems to have 
subsided to a large extent, at least for now, and it did so 
without spending hundreds of billions of dollars to do so. So I 
would say that is a pretty cost-effective activity, at least 
for a short-run move.
    Second, are these valid numbers, and I think the answer is 
perhaps. I had an interesting situation the afternoon that 
Lehman collapsed in that I was in Scotland with a group of 
investment bankers after a conference with the British 
government looking at pension issues. And as the bankruptcy was 
announced, everyone's Blackberries went off except mine--I felt 
a little left out--because they had calls from financial 
institutions around the world saying, oh, my God, in this 
situation, do you have any idea what our assets are worth? And 
these were financial institutions both very well-capitalized 
and those who were not and a few that subsequently failed.
    We have made a great deal in finance and various of the 
other social sciences in the last several years of assuming 
that we can put everything together in a formula and that this 
will give us an accurate price or an accurate prediction, et 
cetera. Unfortunately, reality doesn't always understand the 
formula and sometimes does things slightly differently, the net 
result being that the old computer term of garbage in, garbage 
out actually does apply in most financial activities, and we 
have to recognize that the stress tests are educated guesses. 
Now, they are educated guesses that may not be worst-case 
scenarios as I thoroughly believe that they are not. But in 
this situation, they are reasonable-case scenarios. And as a 
result, they serve a purpose. The one thing we do know which we 
didn't know in January was that the top 19 financial 
institutions are not going to collapse into a heap of rubble 
some time in the next 15 or 20 minutes or so. It may well be 
that they do so some time as the recession deepens. But at 
least we have got enough information to keep people calm for 
the moment.
    Does this mean that the banking crisis is over? Absolutely 
not. As the recession continues and deepens, we will continue 
to see new problems with asset classes. One of the ones that 
was noted very heavily in the stress test was problems that are 
developing in the credit card portfolios. Today's Wall Street 
Journal looks at local banks and points out that it is mostly 
smaller banks that do commercial real estate construction loans 
which are now about to hit a very serious situation. Commercial 
real estate is about five percent of GDP as is residential real 
estate. So this could be fairly serious.
    But going forward, we have learned a few things and we have 
got some definite things to put into place. We discussed 
earlier the need for a resolution process. A resolution process 
is crucial, but it is also crucial to remember that not 
everything is too big to fail. The top 19 banks were chosen 
basically because they had over $100 billion. There was no real 
science there. It is a complete mistake to assume that all of 
these top 19 banks are too big to fail or should all remain in 
business, and as we have already seen in the takedown of 
Washington Mutual and the sale, or rather comedic sale, of 
Wachovia, larger banks can be dealt with. There are a few out 
there that are too big to fail.
    Last but not least, there is an interesting question of if 
we are going to deal with a systemic regulator, what that 
systemic regulator is supposed to do. I have seen lots of 
discussion about how to structure one but very little as to how 
it is actually going to work, and one of the problems that we 
run into is that in case after case after case, the problem 
originates in the unregulated section, and these are 
unregulated sections that may not have existed six months or 
six years before.
    So we are in a position right now where the good news is 
that we aren't in imminent disaster. The bad news is that we 
have a lot of work to do to make sure that this type of 
situation doesn't reoccur.
    Thank you.
    [The prepared statement of Mr. John follows:]
                  Prepared Statement of David C. John
    My name is David C. John. I am a Senior Research Fellow in 
Retirement Security and Financial Institutions at The Heritage 
Foundation. The views I express in this testimony are my own, and 
should not be construed as representing any official position of The 
Heritage Foundation.
    The stress test on the top 19 banks was a successful way to 
distract fearful investors from the obsession that several of those 
financial institutions were on the brink of failure. By promising an 
analysis of the most threatened banks, the Treasury and financial 
regulators induced investors to focus on the future, and as a result, 
the financial markets calmed down until the results were released. 
While less than perfect (as all modeling is), the results show that the 
largest 19 banks in the financial services industry is better 
capitalized than many consumers and experts feared just a few months 
ago.
    However, the most important question is what happens next. While 
risks remain, the banks' gradual return to health should signal the end 
of government's extraordinary intervention into financial services and 
especially efforts to micro-manage the day-to-day activities of these 
companies. As part of this transition, adequately capitalized banks 
should be not only allowed but encouraged to repay government 
investments in them.

Banks Healthier Than Expected

    With the exception of perhaps one or two smaller banks, even those 
10 banks that must increase their capital levels are not in dire shape 
and should be able to raise the needed capital fairly easily. The size 
of certain losses (especially on credit cards) will be substantial, but 
almost all of the major banks will be able to weather them, and those 
that cannot are small enough to be sold to healthier banks.
    While individual consumer's accounts were never at risk because 
they are fully insured by the FDIC up to $250,000 per account, they can 
feel reassured that the worst predictions of massive bank failures are 
increasingly unlikely to come true. In addition, customers of smaller 
banks or credit unions can rest assured that, with very few exceptions, 
those financial institutions appear to be strong and relatively 
unaffected by the recession. As the recession continues, certain of 
these smaller banks that made commercial real estate construction loans 
may run into difficulty as that sector continues to slow, but none of 
them are large enough to cause systemic risks, and all can be resolved 
in the usual way.

Stress Tests Are Not New or Unusual

    Major banks and bank regulators have been using stress tests--a 
computer simulation of what would happen to a bank's finances under 
certain economic conditions--for several years. The results released 
today are nothing more or less than a way of distracting a worried 
market until real information about the condition of major banks was 
available.
    However, it is important to keep in mind that while the stress 
tests show that most banks are healthy stress tests are a prediction, 
not a guarantee. Economic and financial modeling is an approximation of 
real life, and it is always possible that reality will not turn out as 
the model expects. As a result, it is possible that one or more of 
these 19 banks will have problems as the effects of the recession 
continue to be felt.

Failure Must Be Possible

    The press has loosely characterized all 19 banks that were stress 
tested as ``too big to fail,'' a term meaning that their failure would 
have large consequences on the rest of the financial system and on the 
economy as a whole. Treasury Secretary Timothy Geithner added to this 
impression by stating that none of the 19 will be allowed to fail. This 
is a serious mistake.
    While the failure of the largest of these banks would have serious 
consequences, the rest are not too big to fail and do not pose systemic 
risks. This includes the couple of stress-tested banks that may have 
trouble raising sufficient capital. Treasury decided to stress test any 
bank with more than $100 billion in assets. In the last year, Wachovia, 
which had substantially more assets than that, ran into trouble and was 
taken over with little problem.
    By indicating that none of these 19 banks will be allowed to fail, 
the Obama Administration has dangerously expanded the ``too big to 
fail'' problem. As the Administration itself has indicated previously, 
failure must be an option for financial firms if the market is to work. 
Certainly not all of these 19 financial institutions are ``too big'' to 
be allowed to fail.

Going Forward

    Now that there is public information about the how large banks are 
likely to fare in a serious recession, the information should be used 
to allow well-capitalized banks to be freed from government control and 
for taxpayers to be freed from investment in them.

          Allow Troubled Asset Relief Program (TARP) Repayment. 
        Stress tests are predictors. They do not guarantee that 
        problems with banks will not appear at a later date. But there 
        is no reason to keep banks that did well on these stress tests 
        under a program designed for a systemically failing financial 
        system. Firms must be allowed out of TARP without unnecessary 
        conditions. This will also allow these banks to end the 
        politically motivated interference into their day-to-day 
        activities.

          No Forced Subsidy. Firms that do need additional 
        capital should raise it from private sources. In no instance 
        should these firms be forced to take taxpayer money or cede 
        ownership rights to the Federal Government if it can raise 
        capital from the private sector or meet capital standards by 
        selling off assets. If any bank other than a select few cannot 
        raise the needed funds from private sources, it should be 
        merged into a healthy bank, taken over by new investors, or 
        allowed to fail.

Time for an Exit Strategy

    Six months ago, the financial services sector was in deep trouble. 
For the most part, that is no longer the case today. While there is 
still a possibility that certain banks--both large and small--could 
face problems, the sector is no longer in crisis. Now it is time for 
the Obama Administration, the Federal Reserve, and other regulators to 
end programs like TARP and, as credit markets continue to recover, 
gradually close the special financing mechanisms and other credit-
assistance programs that were seen as necessary during the time of 
crisis.
    These programs--and the micro-management of financial institutions 
that came with them--should not be a permanent part of the financial 
landscape. Now that there is clear public information about the 
conditions of the largest U.S. banks, it is time to return their 
control to the private sector.
                                ********
    The Heritage Foundation is a public policy, research, and 
educational organization operating under Section 501(C)(3). It is 
privately supported and receives no funds from any government at any 
level, nor does it perform any government or other contract work.
    The Heritage Foundation is the most broadly supported think tank in 
the United States. During 2008, it had nearly 400,000 individual, 
foundation, and corporate supporters representing every state in the 
U.S. Its 2008 income came from the following sources:

         Individuals        67%

         Foundations       27%

         Corporations       5%

    The top five corporate givers provided The Heritage Foundation with 
1.8 percent of its 2008 income. The Heritage Foundation's books are 
audited annually by the national accounting firm of McGladrey & Pullen. 
A list of major donors is available from The Heritage Foundation upon 
request.
    Members of The Heritage Foundation staff testify as individuals 
discussing their own independent research. The views expressed are 
their own and do not reflect an institutional position for The Heritage 
Foundation or its board of trustees.

                      Biography for David C. John
    David John is a Senior Research Fellow at The Heritage Foundation, 
a prominent Washington think tank. A 30-year veteran of Washington 
policy debates, John serves as Heritage's lead analyst on issues 
relating to pensions, financial institutions, asset building, and 
Social Security reform. He has also spoken on corporate governance, 
financial regulation, financial literacy, and asset building in lower 
income communities.
    In addition to his Heritage Foundation activities, John also serves 
as the Managing Director of the Retirement Security Project, a joint 
project of Georgetown University and the Brookings Institution that is 
funded by the Pew Charitable Trusts. RSP focuses on ways to improve 
retirement savings in the United States.
    David John is one of five experts who ``exert more influence'' on 
the Social Security debate than anyone else in Washington. In addition, 
he has a detailed knowledge of the U.S. financial regulatory system, 
and has worked with a number of financial companies and industrial 
groups on ways to improve compliance and reduce regulatory burden. He 
helped to develop a number of bills that would modernize portions of 
the regulatory system, and when he worked in the private sector, 
devised successful legislative strategies to get those changes 
implemented.
    He has also worked with Brookings Institution scholar J. Mark Iwry 
to come up with a ``third way'' to promote retirement self-reliance: 
the Automatic IRA. Their approach would encourage most workers not 
covered by an employer-sponsored retirement plan to build their own 
low-cost, diversified individual retirement accounts. It would work 
much like a direct paycheck deposit to a bank account--a feature now 
common in the American workplace. Unless workers choose to opt out, 
they would be automatically enrolled in the generic savings program, 
with a pre-set contribution rate and diversified investment portfolio. 
The contribution amount and portfolio selection could be adjusted by 
workers to meet their individual needs. This approach would let workers 
accumulate pre-tax retirement savings in every job they hold, even when 
their employers offer no such benefit of their own.
    This is just one of John's many professional achievements. Since 
coming to Heritage in 1998, he has written and lectured extensively on 
a number of financial and retirement topics. During this time, he has 
testified before a number of House and Senate committees on subjects 
ranging from Social Security and pension reform to improving the 
Nation's flood insurance program.
    John has testified before the House Ways and Means Committee on 
issues such as steps that should be taken to improve Social Security 
for women and minorities, how to increase the information that the 
public can receive about Social Security programs, and how the United 
Kingdom's pension system operates. He also testified before both the 
Senate Special Committee on Aging and the House Education and the 
Workforce Committee on proposals to strengthen the funding of defined 
benefit pension plans, before the House Budget Committee and the Senate 
Banking Committee on aspects of adding a savings element to Social 
Security, and before the Senate Finance Committee and the House 
Education and Labor Committee on improving the number of workers who 
can save for retirement.
    John has been published and quoted extensively in many major 
publications, including the Wall Street Journal, Financial Times, 
Washington Post, New York Times, Chicago Tribune, Los Angeles Times, 
Philadelphia Inquirer, Washington Times, Forbes, Business Week, and USA 
Today. He has also appeared on CBS News, NBC News, PBS' Nightly News 
Hour, CNBC, CNN, MSNBC, the Fox News Channel, BBC radio, and many other 
national and syndicated radio and television shows.
    John came to Heritage from the office of Rep. Mark Sanford (R-SC). 
He was the lead author of Sanford's plan to reform Social Security by 
setting up a system of personal retirement accounts. His Capitol Hill 
service also includes stints in the offices of Reps. Matt Rinaldo (R-
NJ), and Rep. Doug Barnard Jr. (D-GA). While working for Barnard, John 
helped write one of the first bills that would have eliminated 
restrictions on banks to sell securities and insurance. He also worked 
on this issue in Rep. Rinaldo's office and in the private sector.
    In the private sector, John was a Vice President at the Chase 
Manhattan Bank in New York, specializing in public policy development. 
In addition, he worked for three years as Director of Legislative 
Affairs at the National Association of Federal Credit Unions, and 
worked as a Senior Legislative Consultant for the Washington law firm 
of Manatt, Phelps & Phillips.
    John earned a Bachelor's degree in journalism, an MBA in finance, 
and a Master's degree in economics from the University of Georgia in 
Athens.

                               Discussion

    Chairman Miller. Thank you. I think that Dr. Broun has gone 
for votes in another committee that he serves on but will be 
back shortly.
    I now recognize myself for five minutes of questioning.

                     Implications of a Stress Test

    Mr. John, how you described the stress test is not really 
that dissimilar to how others have described it, including 
those who helped design it. Chairman Bernanke analogized it in 
a hearing in the Financial Services Committee to the bank 
holiday in the New Deal as perhaps not really being that 
rigorous a test but building confidence. And several of you 
have used the term ``run.'' In the 1930's, in the Great 
Depression, before there was deposit insurance, the run was by 
the depositors to get their money out before the bank went 
under. With deposit insurance which is now $250,000, surely 
everyone knows that whatever else becomes of the banks, it is 
not going to be the case that their deposits are not made 
whole, however much. I mean, whatever liabilities or whatever 
unsecured creditors or bondholders, for instance, might get, 
certainly depositors are going to get their money back.
    Whose confidence are we worried about in these stress 
tests? Are we worried about investors we are trying to attract 
to the banks? Are we worried about the public at large? Are we 
really worried about depositors? Anyone? Dr. Sachs, you seem to 
be----
    Dr. Sachs. I think, Mr. Chairman, we are mainly worried 
about short-term, money market, commercial paper, and other 
kinds of instruments that can seize up. We are not so much 
worried about--I would say we are almost not at all worried 
about depositors under FDIC. They showed no interest in budging 
at all through all of this, and rightly so. But what did seize 
up was interbank lending and many other--the commercial paper 
market and many other kinds of short-term credit lines. That is 
where the big damage of the real economy also occurred between 
last September and now. As I said, the longer-term recovery 
will depend on the overall health of the banking sector, 
longer-term lending, and many other things. But the sharp 
squeeze was the breakdown of short-term credit and the near 
collapse of the commercial paper market. I think that the 
Administration has gone way overboard in protecting everybody, 
including long-term bondholders to try to avert another post-
Lehman event. I think the post-Lehman event was a result of 
what we know happened in the money markets, but essentially 
what the administration has done is to throw an implicit, maybe 
even inching up to explicit, guarantee over all liabilities of 
the banking sector, including bondholders, long-term 
bondholders, who don't run because there is no run on long-term 
assets. They trade, but there is no run.
    And so in this sense, I believe that the taxpayers are 
being put at far too much risk for far too little real benefit 
of averting panic.
    Chairman Miller. Dr. Johnson.
    Dr. Johnson. I would just add to that that I think there 
were broader, confidence-building measures that were put in 
place by Congress at the behest of the Administration, 
including the fiscal stimulus enacted in February. And I think 
the stress tests bought some time for those effects to begin to 
come through the economy. In addition, the big support provided 
by the Fed in terms of lines of credit, and of course, the FDIC 
guarantees were put in place last fall.
    So I don't think the stress test per se convinced people, 
but people felt the real economy was bottoming out, and that 
fed through into a greater confidence that the banks are not 
going to get substantially worse and that helps the points that 
Professor Sachs is making. But I think it is not just the magic 
of not quite telling the truth with the stress test, it is a 
broader confidence-building measures that have actually been 
quite helpful.
    Dr. Baker. If I could just very quickly comment, I do worry 
a little bit about the magic of not quite telling the truth, 
and again, to Dr. John's comments, I do worry that we might 
have persuaded a lot of investors to perhaps throw their money 
away on bonds or stocks issued by the major banks in part as a 
result of the stress test, and to my mind, that is not good 
policy if that is in fact the case.

                         The State of Mortgages

    Chairman Miller. Okay. You don't have to elaborate. I do 
have one more question, although my time is expired. Dr. Baker, 
your description of the problem being in mortgages is very 
different from what we have heard. We have heard that the great 
majority of mortgages, particularly the problem mortgages, were 
sliced and diced is usually the term you hear, that they were 
put into pools and then divided into tranches, and then there 
were security bonds sold in the tranches and that it was high 
nigh impossible to put a mortgage back together.
    But your impression is or your analysis is that actually 
there are plenty of whole mortgages in portfolios out there?
    Dr. Baker. Exactly. I mean, the point the banks were trying 
to slice and dice and put them in the mortgage-backed 
securities with the idea of offloading them so they are not on 
their books, and these stress tests--I mean, one of the great 
things about the stress test was we can see who has what. For 
the most part, they were successful in that. So they still hold 
a lot of mortgages on their books, but to a large extent, they 
were successful in offloading the mortgage-backed securities. 
So at the moment, they are someone else's problem.
    Chairman Miller. Do we know who that someone else is?
    Dr. Baker. Pension funds. Well----
    Chairman Miller. Dr. Johnson.
    Dr. Johnson. Well, we know many of the most toxic versions, 
including the collateralized debt obligations are held in 
Europe. So there was a lot of selling of these overseas which 
is why it is a global financial problem. And the Europeans, of 
course, are way behind, even in terms of doing anything like a 
stress test on their banks, and that will come back to haunt 
us, too, most likely.
    Chairman Miller. That actually was one of the questions I 
had for later, but my time is expired. Ms. Dahlkemper.

             Determining the Right Size for Financial Firms

    Ms. Dahlkemper. Thank you, Mr. Chairman. We often talk 
about the fact that these firms are too big to fail, and we are 
willing to expend billions of dollars to save them. Dr. Johnson 
suggests it is too big to allow it to continue at this size. 
How do we right-size our financial firms? I am going to open 
this up to if any of you want to address this. Dr. Sachs.
    Dr. Sachs. I am not sure that it is literally the problem 
of too big to fail because it is not really the--even the 
collapse of one of these institutions that has the macro-
economic significance. What has macro-economic significance is 
when a failure turns into a more generalized market phenomenon 
of panic or unwillingness to lend or seizing up of liquidity. 
Lehman Brothers was not all that big in the size of the 
institution or its portfolio relative to any denominator of GNP 
or financial instruments. But it did lead to the largest panic 
in history in absolute size by far.
    So it is really how these crises are handled and resolved, 
rather than the size of the institution per se in my view. And 
I think there is a question about the resolution of bank 
holding companies as opposed to commercial banks per se, 
because while I am not an expert in this, the broad sense is 
that the FDIC's jurisdiction being only over the commercial 
banks and lacking jurisdiction in all of the ancillary pieces 
of a CitiGroup or Bank of America in the holding company makes 
an orderly resolution all that much more difficult.
    So I think there is a structural problem that involves the 
holding company, not its absolute size but the legal structure 
around resolution. And then I think that there is a big 
problem; in my view, the essence of the economics of this is 
how an institutional failure impacts short-term liquidity. That 
is not absolutely a function of the size of the failing 
institution, it is a function of how a panic unfolds and 
whether there are proper mechanisms for orderly resolution. 
Again, to my mind what we are doing right now with the 
Administration is implicitly saying all those bonds are also 
good. We are doing extraordinarily unpleasant things in PPIP 
and so forth, using taxpayer money at great risk to protect 
almost perhaps a trillion dollars of longer-term assets that I 
don't think give much help to the macro-economics of the 
situation at all.
    Ms. Dahlkemper. Dr. Johnson, did you want----
    Dr. Johnson. So I want to go a little bit further, and I 
think that the issue of size is important. I agree it is not a 
sufficient condition for avoiding these kinds of problems in 
the future, but I think it may be a necessary condition. It is 
absolutely true, as Professor Sachs says, that the notion of 
size is too big or too big to fail is much smaller than, say, 
standard measures of antitrust would pick up for you and say 
aha, here we have something we can go after with a standard 
antitrust action.
    But let me make the point like this. There are many banks 
in this country--most banks in this country can fail. Banks 
fail all the time. The FDIC takes them over; there is a well-
run, well-organized receivership process. In fact, we are 
world-class in closing down small banks, medium-sized banks. 
Big banks, we are hopeless it turns out, okay? At least we have 
not done very well recently. It is a very tough problem. Banks 
that are big relative to other banks in our system, and of 
course, our big banks are small relative to what they could 
become and relative to what they are in Europe. The biggest 
banks in the UK, for example, are 10 times relative the scale 
of their economy, 10 times what we have here.
    So it could get a lot worse, a lot more complicated. And I 
think the way to go about this, I mean, we have to look at all 
the possible tools. There is some discussion of finding ways to 
apply antitrust. This will be a new or not the standard 
application of antitrust, but it does go back to some of the 
initial principles around antitrust and the regulation of 
mergers, the legislation produced after World War II. There is 
also I think more regulation of behavior that can be done with 
regard to the amount of leverage you are allowed to take on. 
There is an issue of inter-connectedness, I think. So how do 
all the banks start acting in the same way, and if one of them 
fails, that creates a domino effect. That you have to get at 
through regulation of behavior, and I think while I am 
skeptical of the idea you can introduce a super-regulator and 
be done with these problems, I think regulators get captured, 
and super-regulators get super-captured.
    Having that as part of a much broader set of legislative 
reform I think probably does make sense as long as you come at 
it from all possible angles.
    Ms. Dahlkemper. Thank you. My time is expired.
    Chairman Miller. Dr. John, you can----
    Mr. John. I just wanted----
    Chairman Miller. Yes.
    Mr. John. Okay. Thank you. I appreciate it. Let me just add 
one quick thing because I happen to agree with most of what was 
said here. I think size is not necessarily the matter. Inter-
connectedness is a matter. We have to look at what happens to 
overseas subsidiaries because while we all know pretty much 
what the U.S. Bankruptcy Code allows and how things are dealt 
with, we don't necessarily find the same kind of treatment to 
overseas subsidiaries. That was why at the point that Lehman 
closed when the New York office was continuing to some extent, 
the London office was filled with pictures of people carrying 
out their possessions. That is going to be a serious problem. 
And I think we can't emphasize too much the need to deal with 
the holding company. Doug Elliot at Brookings did an 
examination of what would happen at CitiBank, and the only 
way--assuming at the time that CitiBank was about to die, the 
only way you could deal with CitiBank essentially was to buy it 
from the shareholders, have the taxpayers buy a failed 
institution at a premium so it could be resolved because the 
U.S. law at this point does very well deal with bank 
subsidiaries, but most of the interesting activities of 
financial institutions actually occurs at the holding company 
level.
    Ms. Dahlkemper. Thank you, Mr. Chairman.
    Chairman Miller. Thank you, Ms. Dahlkemper. Mr. Davis for 
five minutes.

                      The Validity of Stress Tests

    Mr. Davis. I want to thank the Chairman and Ranking Member 
for holding the hearing today to discuss the solvency of U.S. 
financial institutions given the complexity of the global 
financial marketplace.
    As we are currently on the heels for receiving the results 
of the Federal Reserve's stress test of the 19 largest U.S.-
owned banks, I think now is a good time as any to bring up 
solvency of our financial institutions, how solvency is 
determined and what it says about the state of the financial 
sector. As we heard earlier this month, according to Secretary 
Geithner's assessment of the test, these 19 banks were 
basically healthy, financially sound institutions, and so I 
have to ask, how many more taxpayer dollars will go toward 
subsidizing these healthy banks?
    This may surprise you, but from the very beginning I 
opposed Wall Street's big bank bail-out the Congress and the 
Administration proposed because I am fundamentally against 
rewarding those who contributed so heavily to our economic 
crisis, those who put their own greed ahead of the financial 
and economic health of our entire nation.
    I want to thank you all for being here. I got a couple of 
questions you could probably answer very briefly, and you have 
some already among your testimony. Do you think the stress test 
provided an accurate picture of the financial health of the top 
19 banks? Either of you.
    Dr. Baker. I would say that I think it was an overly 
optimistic picture. As I say, I think the adverse scenario is 
an optimistic scenario at this point. Just to give you one 
example of the loss ratios they assumed in the adverse 
scenarios that we would have 18 to 20 percent losses in credit 
cards over the two-year period. We are already at a 15 percent 
loss ratio in the first quarter, and the unemployment rate is 
rising considerably. And if you just think about that dynamic 
through time, as people are unemployed for a longer period of 
time, they go through their resources, exhaust their 
unemployment benefits, it is inconceivable that the loss ratio 
on credit cards is not going to rise considerably from current 
levels and almost certainly far above the levels assumed in the 
stress test.
    Mr. Davis. Anyone else?
    Dr. Johnson. I agree with Dr. Baker. The stress test is 
supposed to show you the stress scenario, not right now, 
situations that say what could happen. Do you need more capital 
if the recession turns out to be prolonged, severe, and it 
didn't do that. Dr. Baker illustrated why.
    Dr. Sachs. I think there is general professional 
concurrence that this was not a worst-case scenario, it was a 
moderate-case scenario, even a mildly optimistic case scenario. 
Things could get worse, and that is why it is important for the 
government to prepare for that eventuality without putting the 
taxpayer unduly on the line. It may not happen that the worst 
occurs, but it could happen. It is not ruled out by the stress 
test.
    Mr. John. The only thing I would add is that the one other 
value to the stress test was because we had data on individual 
banks, it starts to allow us to divide out which banks are able 
to survive and which banks are likely to run into severe 
trouble if the situation gets much worse.

                     Assessment Criteria for Banks

    Mr. Davis. I have always had difficulty of looking at 
investment bankers who knowingly invested in high-risk 
investments to reap higher profits, higher returns. And then we 
have asked the taxpayers to bail some of those folks out. That 
has just been a problem I haven't been able to arrive at.
    I guess, could you give me some criteria that you think 
ought to be used for an accurate assessment of these banks? Any 
of you. What criteria would you have used?
    Dr. Baker. Well, I think the basic modeling of the stress 
test is okay. They just needed a worse scenario. I mean, for 
example, I was mentioning unemployment rates assumed 8.9 
percent this year, 10.3 percent average for next year. If I 
were to say what sort of the worst-case scenario I could 
imagine, it would probably be about 9.3, 9.4 for 2009 and 
probably 11, 11.5 for 2010. And you might also want to carry 
this out and go beyond 2010 because the economy is very 
unlikely to see much of a recovery, even through 2011. So you 
might want to ask what does a three-year story look like.
    So that would be sort of the outlines. They had the basic 
model set up. You just had to carry it a little further.
    Dr. Johnson. I think if you want to take a macro-economic 
benchmark, you could use the downside scenario that the IMF 
has, for example. This is available to all member governments. 
I understand the idea of getting input from the IMF, from my 
personal experience, is not exactly welcomed by the U.S. 
Treasury. Nevertheless, it is a very sensible, global macro-
economic picture. It takes care of interactions across 
countries. I think from everything I know about it, because I 
am not on the inside right now, it would come out exactly or 
pretty much where Dr. Baker just said.
    Dr. Sachs. And I think that in addition to fine tuning the 
stress test, what we still lack is a public policy around what 
to do in the worst outcomes. That clearly does not exist right 
now. There is a tremendous amount of improvisation, but there 
is not a public policy.
    Mr. John. And I just very much agree with that last 
comment.
    Mr. Davis. Thanks. I yield back my time. There's none left.
    Chairman Miller. Thank you. Mr. Wilson is next.
    Mr. Wilson. Thank you, Chairman Miller. Good morning, 
gentlemen. Thank you for coming in this morning. Forgive me. I 
had to go in and out. Sometimes we have two different meetings 
going on at one time, and so if I am redundant and ask a 
question that has already been asked, please work with me on 
that.

                Indications of Further Economic Downturn

    I start with Dr. Sachs. You say that the chances of an 
economic situation worse than the bad case in the stress test 
at a one and three, where would we look for an early indication 
that things are turning worse?
    Dr. Sachs. It is clear that the demand side of our economy 
is going to drive either the speed of the recovery or a second 
dip into accelerated decline. And so month to month we are 
looking at household spending, consumer confidence, at housing 
starts, and the news is still quite mixed. And with the 
certainly a possibility of either a very flat, prolonged period 
which would mean rising joblessness without growth or even the 
possibility of a continued downturn. I think the ground is not 
solid beneath our feet just at the moment, and the macro-
economic scenarios have a pretty wide dispersion of possible 
outcomes.
    Mr. Wilson. Dr. Johnson, comment?
    Dr. Johnson. Yes, Mr. Wilson. You might look at the front 
page of the Wall Street Journal today. They have a very nice--
scary, sorry, scary analysis of the effect of commercial 
property losses on small- or medium-sized banks in the U.S. As 
you know, those banks have a large exposure to commercial real 
estate. This is what went wrong in previous recessions, and I 
think while we are rightly focused on the too-big-to-fail 
financial institutions, further hits to other parts of our 
financial sector should not be ruled out, and those are going 
to come back and hit households the way Dr. Sachs was 
outlining.
    Mr. Wilson. Thank you. Dr. Baker.
    Dr. Baker. I was going to say, it is easy to see lots of 
sources of bad news, this being one, further falloff in 
construction which the numbers on housing construction today 
showed an even further decline. I am beginning to look like an 
optimist because it turns out worse than I had expected. But 
you know, areas like wage growth continue to trail off. One of 
the things that I have been relatively encouraged about was 
that wage growth had maintained its momentum into the beginning 
of this year, it seems to have collapsed. That leads to the 
prospect of sort of a deflationary spiral which would be very 
bad news. So it is easy to see lots of sources of bad news. It 
is hard for me at this point to see much good news on the 
horizon.
    Mr. Wilson. Thank you. Dr. John.
    Mr. John. I am actually just going to agree with that. 
Every time I pick up the newspapers, I have to take a deep 
breath.

                 The Influence of a Financial Oligarchy

    Mr. Wilson. It is frightening for all of us. Next question. 
Dr. Johnson says that our country's ability to develop 
appropriate policies to deal with the crisis is limited by the 
influence of financial oligarchy, and I haven't seen that word 
since freshman economics maybe, and dominates our view of the 
world. Do you agree? Let me do that again. Dr. Johnson----
    Dr. Johnson. Yes, that is my--that is an accurate statement 
of my view. I think particularly there is a culture, a set of 
beliefs that are developed in Washington vis-a-vis the 
importance of Wall Street, the importance of big banks that is 
really in the way right now.
    Mr. Wilson. That being said, what should we do about it?
    Dr. Johnson. Well, I think you have to--this is one reason 
you have to take on these big banks. You have to challenge 
them, and you have to where appropriate and where possible down 
the road find ways to intervene them, find ways to take them 
over. And if you really decide that the outcome of all the 
regulation hearings you are going to have over the next six 
months, they are ultimately still too big to take over and 
close down, then you have to find ways to make them much 
smaller. Their economic power makes them politically powerful, 
and that then feeds back into deregulation and more ways to 
make money and more ways to take on risks that isn't 
appropriately controlled by them or anybody else.
    Mr. Wilson. So if I am understanding you correctly, it 
becomes a vicious circle then?
    Dr. Johnson. That is what we have seen over the past 25, 30 
years, yes.
    Mr. Wilson. Thank you. Dr. Baker, do you see that any 
differently?
    Dr. Baker. No, I see it very much the same way, and just to 
raise a concrete point, what I think was at issue was given the 
depth of the current crisis--and I am sure Dr. John will 
disagree on this one--but I think one of the immediate outcomes 
here of course is the millions of people facing the loss of 
their home and the fact that Congress to this point hasn't 
passed some form of relief, for example, temporarily changing 
the bankruptcy law. Again, that raises an issue for me as to 
whether Congress is responding to the power of the banks.
    Mr. John. And I would just say, I do disagree on the 
bankruptcy law situation. I have written against that, but I 
think one of the problems that we are facing here is that all 
of the supposed responses are coming from conventional wisdom, 
and conventional wisdom was how we got into this situation, and 
it is going to be a matter of looking a little bit larger, 
looking at some fairly different alternatives. I have great 
concerns as I mentioned with the idea of a systemic regulator. 
I don't know how it is going to operate. I don't think it can 
operate. I think we are setting ourselves up for a fall in that 
situation. I think that is true actually of most of the other 
solutions that have been made at this point.
    Mr. Wilson. Thank you, Dr. John, and gentlemen, thank you. 
I yield back the balance of my time.
    Dr. Sachs. Congressman, may I add a comment to your----
    Mr. Wilson. Certainly.
    Dr. Sachs. Thank you. I think we have one glaring problem 
which is that almost all of the decision-makers in this issue 
are tightly tied to Wall Street. And so there is almost no 
political scrutiny in terms of the actual policy preparation 
outside of the immediately concerned sector, and the revolving 
door phenomenon is so powerful here, that one is led to have 
very grave concerns. There was an article in the Wall Street 
Journal today about the role of BlackRock in every single 
function of advising, pricing, buying, and that is just an 
example of what is underway right now. Many of us feel that 
hundreds of billions of dollars of taxpayer money are being put 
at risk without proper balance and scrutiny.
    But a second point that I would add is that we have a 
Credit Control Act in this country that I believe is not being 
applied properly in these circumstances because every time the 
Fed or the FDIC or other institutions make loans, put 
guarantees on, do other things, that is supposed to be scored, 
and when the FDIC says that its participation in PPIP doesn't 
really raise any risks, that in my view, in paraphrasing, does 
not rise to scientific scrutiny. In other words, when taxpayer 
money is put at risk in these bail-outs, we have a legal 
framework I believe, if I understand it correctly, that 
absolutely needs to be invoked to say what are the risks? What 
are the probabilities? How much money could be lost? What 
happens when we guarantee $306 billion of CitiBank? What 
happens when we put a leverage to allow private buyers to 
perhaps overpay for toxic assets? Under our law, that has to be 
quantified in terms of taxpayer risk. I don't see that being 
done right now.
    Mr. Wilson. Thank you, Doctor. I apologize, Mr. Chairman, 
for going over time.
    Chairman Miller. That is all right. It was Dr. Sachs as 
much as you. I don't think I have ever heard taking our largest 
banks into receivership and selling them off in bits and pieces 
as the conventional wisdom before.
    Dr. Broun, for five minutes. Welcome back. I trust that you 
did not prevail in any of your recorded votes in the other 
committee?
    Mr. Broun. Actually, I was at Homeland Security, and we had 
a unanimous vote about a resolution of inquiry. So it was 
something that I needed to be at, and I apologize for having to 
leave. And I apologize to the panel for having to leave.
    But to begin with, I want to say, Dr. Sachs, I am extremely 
disappointed in your not providing written testimony because 
you make it extremely difficult for us as a Congress to do our 
job. I had the right to object to seating you. I did not do 
that, but your failure to give us written testimony prior to 
your testimony here makes it extremely difficult for all of us. 
And I hope this will never happen again if you ever come back 
to Congress, not only this committee, but any others because it 
is very disconcerting for me and very disappointing to me for 
that.

                   The Role of a Market-based System

    Mr. John, in your testimony you mentioned that failure must 
be an option for financial firms if the market is to work. Is 
there any way to avoid a massive failure in a market-based 
system, and are there some regulations or reforms that would 
cause the market to operate with fewer peaks and valleys?
    Mr. John. Well, not really. I mean, when it comes down to 
it, every system of regulation is going to attempt to keep 
things calm and quiet, but the fact is that the market 
innovates. If it doesn't innovate in New York, it is going to 
innovate in London or Hong Kong or somewhere along that line or 
it may innovate in Greenwich, Connecticut, as in the term of a 
long-term capital markets or something along that line. The 
only way that the financial markets can be completely 
stabilized is if you basically try to turn them into a form of 
utility offering only a set type of product to a select group 
of constituents and customers, et cetera, knowing full well 
that something else is going to burst outside and offer 
something that is even better. Consumers are not well-served 
with that area. If you look at interest on checking accounts, 
that didn't occur in banking, it occurred in the credit union 
industry some time around 1979, 1980 or so. So no, I don't 
think that there is. The fact is that because of the speed of 
innovation in the marketplace--regulators are always going to 
be fighting the last war in attempting to create the Maginot 
Line, and that is fine. And what worries me about this is not 
that we shouldn't try but that there is going to be a level of 
expected success which is then going to be disappointed. We 
have seen this time after time after time.
    Mr. Broun. Well, I thank you, Dr. John. The point I am 
trying to make here is that a normal marketplace does have 
peaks and valleys----
    Mr. John. Constantly.
    Mr. Broun.--and I think that the peak that we had in the 
housing market which brought down the economy was created by 
government regulation, overregulation in my opinion, 
particularly with the Community Reinvestment Act from Carter 
and then reauthorized under Clinton, and then with Freddie and 
Fannie doing what they were doing, and then ACORN acting as 
thugs to threaten banks is what created this problem, and I 
believe the marketplace is the best way to solve this problem 
and everything else, not through government regulation or 
government intervention. So I appreciate that answer.

                          Encouraging Lending

    In talking with my community bankers, they are really 
locked down by FDIC and by the government regulations that they 
have today, and they are unable to loan money for the simple 
reason that the regulators are preventing them from doing so. I 
would like to hear from any of the four of you or all four, 
what can we do to start the cash flow in our local banks so 
that we can start developing a stronger economy because what we 
are doing right now today is not working. Open to any one of 
the four. Dr. Johnson.
    Dr. Johnson. I think that the most important thing for any 
part of the banking system is to make sure that the banks have 
sufficient capital and at the level--I think you were out of 
the room when we were discussing the latest data printed in the 
Wall Street Journal today with regard to the losses and the 
potential losses at smaller- and medium-size banks. I think 
there is an issue of stress testing those banks. Any bank that 
is undercapitalized is going to be reluctant to lend. At the 
same time we have to recognize there is a big problem on the 
demand side for loans so that many borrowers don't want to go 
to the banks anymore. So I think there is a demand and a supply 
side that need to be addressed here. And I would completely 
agree that we are struggling on both dimensions.
    Mr. Broun. Well, my time is up. Maybe we can get written 
statements from all of you. And Mr. Chairman, I appreciate your 
forbearance, and I just want to make a statement that mark-to-
market accounting has not worked, particularly in this downturn 
of our economy, and we have got to find some other method of 
finding out what the capital lapse is and what the regulators 
are doing now today to the banks. They are undercapitalized a 
lot because of regulatory burdens upon the banks where their 
true capital is not being considered, and with that, I will 
yield back. Thank you, Mr. Chairman.
    Chairman Miller. Thank you, Dr. Broun. Mr. Grayson for five 
minutes.

                 Potential Rules to Limit Systemic Risk

    Mr. Grayson. Thank you, Mr. Chairman. Let us assume, 
gentlemen, that you wanted to create hard, fast, clear rules 
against institutions that pose systemic risk and would require 
a government bail-out. Let us assume that you were the ones 
deciding what those rules should be or what they would be, and 
let us assume that you did not want to leave it up to the 
wisdom or lack thereof of a particular person put in the 
position of judging systemic risk. What rules would you 
establish? Let us start with Dr. Baker.
    Dr. Baker. I don't know if I can give you an exact set of 
rules. I mean, size would certainly be a factor, but again, 
deferring to the comments made by both Dr. Johnson and Dr. 
Sachs earlier, those would not be the only--that would not be 
the only factor. But I really don't know that you could get 
around the judgment of the particular regulators. I mean, I 
think basically at the end of the day you would have to say can 
the FDIC deal with this institution, and we have had the issue 
raised about resolution authority, and I think it would be 
desirable for the regulators to have resolution authority in 
the event of a major bank with a large bank holding company 
with large operations apart from the bank. I think that would 
certainly be desirable. I don't think that is absolutely 
essential, by the way. I think it has been striking how the 
government has been very effective in steering the course, say, 
with Chrysler and General Motors, even though it obviously has 
no resolution authority of the sort that it would with a bank. 
So I think it would be desirable to see Congress pass 
legislation like that, but I don't think that should be used as 
an excuse for not having dealt with CitiGroup or some of the 
other banks that may actually be insolvent.
    Mr. Grayson. Dr. Johnson, what rules would you establish?
    Dr. Johnson. I would pick up on a point that was just 
beginning to emerge in the exchange between Dr. John and Dr. 
Broun a moment ago which is, I think you need banks to operate 
much more like utilities as they did in the 1950's and '60s. 
And I think you need a risk-taking part of the financial 
system, but it shouldn't be the banking system. As I looked at 
these great paintings that you have along the wall here, it 
reminded me of the era of innovation and breakthrough 
technologies we had after World War II driven largely by 
private-sector, a lot of private-sector innovation as well as 
sensible use of public money in a system where at a time when 
the banking system was very tightly regulated in terms of the 
banks that made payments, the banks that took deposits, and 
there was a separation of the payments part of the economy, the 
part that, you know, if that collapses, we have got a very big 
problem and the very simple credit-making part of the economy, 
including the very positive role of a lot of smaller banks that 
were also part of this regulatory structure with the risk-
taking venture capital, new venture creation part of the 
economy. I am a professor of entrepreneurship at MIT. No one 
could be more pro-entrepreneur than I am, and I think that is 
completely consistent with keeping the rest of the banking 
system much more tightly contained. Go back to the 1950's and 
'60s in terms of bank regulation.
    Mr. Grayson. Dr. Sachs, what substantive rules would you 
establish to simply prevent institutions from reaching the 
point where they pose systemic risk?
    Dr. Sachs. I believe that at the core, even though we have 
a commercial banking crisis, that this was a shadow banking 
crisis. It was the essence of this. And as I mentioned in my 
opening remarks, the four elements of proper banking regulation 
that have protected us from a massive commercial banking run 
and crisis for decades are deposit insurance, strong regulation 
over capital adequacy, lender of last resort facilities, and a 
mechanism for resolution. We lacked all of that with Wall 
Street. All of that. That led to a bubble in the housing sector 
and in other sectors that brought the whole economy into this 
upturn and then massive downturn, and we still apparently lack 
clear legal structures for resolution of bank holding 
companies.
    So I believe that we have the makings, though not being 
properly used right now, for this strict commercial banking 
sector. We do not have a regulatory system around the near 
banking sector, which is a big failure. We do not have a clear 
resolution mechanism for the bank holding company structures, 
like CitiGroup or Bank of America and we need it for that.
    I do not believe personally that if we need to intervene in 
Bank of America or CitiGroup, if that turns out to be the 
outcome that that is going to be a calamity per se. I think we 
have structures that can do that with respect to the commercial 
bank components of those even big institutions. I don't regard 
that as beyond what we have. I think we are throwing a lot of 
arbitrary things into this situation right now in a way out of 
reaction to a panic that was set off by mistakes in the shadow 
banking sector last fall with the failure of Lehman.

              More on the Sizes of Financial Institutions

    Mr. Grayson. Dr. Baker, how do you know when an institution 
is too big to fail?
    Dr. Baker. Well, again, that would inevitably be a judgment 
call, but I mean basically, the question here is----
    Mr. Grayson. Is that inevitable? Is it really inevitable? 
That it's a judgment call.
    Dr. Baker. Well, let me put it this way. The judgment call 
we had the opportunity to see back in the fall when Treasury 
Secretary Paulson and Federal Reserve Board Chairman Bernanke 
and Timothy Geithner at the New York Fed made the decision that 
Lehman brothers was not too big to fail and ended up being, I 
think, wrong, at least in the sense that they needed to have 
some sort of orderly process, orderly resolution which clearly 
was not put in place. Could you have known in advance? Perhaps, 
but clearly they made a very big mistake. So I am a little--I 
certainly have been very critical of all three of those 
gentlemen, but you know, I do respect their intelligence, and I 
think they had much more data than I did and they still made a 
very big mistake.
    So I don't think you could have a simple formula that will 
always tell you that, you know, this bank is too big to fail or 
this bank is not.
    Dr. Johnson. You should war game it. One of the things that 
regulators don't do enough, and the International Monetary Fund 
does a little bit but also not enough, is play out scenarios 
where you have a massive shocks of the kind that, you know, are 
not in your briefing memos but this is really what happens in 
the actual world. You should see what happened if you go 
through exactly how you are going to deal with particular banks 
failing, and if you feel you can't intervene under certain 
circumstances in a particular bank, because it is too scary, 
that bank is too big to fail.
    Mr. Grayson. Thank you, Mr. Chairman. This has been an 
excellent hearing from my perspective, and I really am glad we 
conducted it.
    Chairman Miller. Thank you, Mr. Grayson. Mr. Bilbray for 
five minutes.

                   More on the Market-based Approach

    Mr. Bilbray. Mr. Chairman, I appreciate it. Mr. John, one 
of the big concerns I had was when we watched this, it seemed 
like instead of following the Swiss model we might have been 
following the Japanese model, which I think history says strung 
out the difficulties for over a decade. In your testimony, you 
mentioned failure must be an option in financial firms. Is 
there any way to avoid massive failure that some people were 
projecting in a market-based system and are there some of the 
reforms that are possible to keep the valleys from being too 
deep and the peaks from being too high?
    Chairman Miller. I think you meant Swedish model.
    Mr. Bilbray. Swedish. I am sorry.
    Mr. John. Swedish, yes. I don't know that there is a way to 
avoid them necessarily. I mean, if I were going to answer the 
previous gentleman's questions about how do you set up 
something along that line, the simple fact is the 1950's are 
over and they are not going to come back. We could 
hypothetically set up a series of check cashing agencies and 
consumer lending agencies. I think we have them, and I think 
they are called credit unions at this point. But that is not 
realistic for finance at this point in time, and it is 
certainly not realistic for high finance.
    Two, four, three banking was the joke many years ago where 
you took in money at two percent, you loaned it out at four 
percent, and at 3:00 you were on the golf course. But that is 
not reality anymore, and it is not going to be. Anything that 
is going to be done in the future has got to be flexible 
because while we have some very brilliant and highly dedicated 
regulators out there, we also have some exceptionally high-paid 
lawyers, accountants, and financial talent finding ways of 
getting around these various and sundry rules. I would say they 
would have to be very, very flexible, and I think we have to 
expect that there is going to be a failure, meaning that 
whatever regulations are put out there are probably not going 
to work in the long run and need to be re-examined regularly.
    Mr. Bilbray. Go ahead.
    Dr. Johnson. If we follow the logic of what Dr. John is 
saying, it says this, that we can't change the system, we are 
stuck with what we have got, there is going to be systemic 
failure down the road, we are going to have to throw in 
taxpayer money. According to the CBO, we are going to go from 
around 40 percent debt to GDP to at least 60 percent. I think 
realistically we are going to go closer to 80 percent of GDP. 
And that says that is a 40 percentage point increase in debt 
GDP from one, you know, pretty substantial financial crisis. If 
we have another one, if we have one every 10 years, we will 
bankrupt the country. There is an issue of solvency of the 
Nation here, and while the changes may be difficult, I 
completely accept that. I recognize fully the political power 
of Wall Street, for example, and the technical issues involved. 
How many financial crises can we afford to have in the next 20 
years?

             Financial Crises as Symptoms of Other Problems

    Mr. Bilbray. Dr. Johnson, my concern is one thing that is 
not talked about enough is that the housing crisis was not a 
crisis, it was a symptom of a deeper problem, that we keep 
chasing symptoms, Mr. Chairman, rather than going around and 
saying, wait, where are we going? And Dr. Baker, I will give 
you a chance to address this, too, but one of the things that 
Government Oversight, that Greenspan brought up was that the 
dirty little secret of trying to operate a healthy economy 
where energy is costing more than labor was not sustainable. 
And the fact is that one thing we didn't see, this bubble in 
the housing market wasn't just loans given out but why were 
loans given out is because so many of our dollars were going 
overseas in the form of petrol dollars being exported, and when 
you were in those countries that were receiving so much petrol 
dollars from all over the world, where is the one place you put 
a lot of assets that you knew were secure, at least you assumed 
was secure, was going back and buying paper in American real 
estate. And as Greenspan pointed out, there was a bubble--they 
knew the bubble was there but didn't know how inflated it was. 
And the fact is that so much of this was a by-product of the 
fact that we still went 30, 40 years with not addressing the 
energy issue, and in fact, created an artificial bubble in the 
market that ended up now being targeted as the problem rather 
than a symptom of a problem. Gentlemen, I will open that up.
    Dr. Baker. I think we could argue over what was symptom, 
what was cause, but in any case, I was able to come up with a 
fairly precise measure of the bubble. I would put it around $8 
trillion just looking at the long-term trend in house prices. 
And it was guaranteed that when that burst, that would lead to 
a very, very severe downturn, and basically I think it was an 
inexcusable failure on the part of the Fed to have failed to 
attack that bubble. So I mean, I think to my mind, we are 
looking at a lot of issues here. How can you have perfect 
regulation? And we certainly want to improve the quality of our 
regulation. We had a colossal failure from an institution that 
had the authority, had the ability to crack down on the bubble, 
and basically it was incredibly negligent.
    Mr. Bilbray. Dr. Johnson.
    Dr. Johnson. So Mr. Bilbray, the point that Dr. Greenspan 
of course is making is with regard to global imbalances, with 
regard to the capital that was available from the savings of 
countries, not only in the Middle East but also in China and 
Japan and the effect that that had on real interest rates 
around the world.
    Now, I am completely in favor of us consuming less energy, 
becoming more energy efficient for many reasons, and that would 
have the positive effects that you are indicating which is you 
would buy--you would have a smaller current account surplus, 
other things being equal in some countries. All parties would 
have smaller current account surpluses, and that would 
contribute.
    But the bigger issue I think is what was the role of this 
global so-called savings glut, okay, and what did the Federal 
Reserve do about it? Now, Chairman Bernanke, before he was 
Chairman of the Fed, was warned about this. Nothing was done. I 
think Dr. John's point about regulators failing systematically 
is absolutely right, and we have to build this into our 
understanding of how the world operates, how regulators really 
operate. The bigger picture around regulation, of course, is 
the deregulation and the Fed stepping back and Alan Greenspan 
himself saying very publicly, and now largely recanting, the 
view that we could let the market sort this out and that 
pricking bubbles is not what central banks should do. They 
should clean up afterwards. Well, cleaning up afterwards turns 
out to be incredibly expensive. This time it was about energy. 
This time it was about that version of the current account 
imbalance, perhaps a little bit, but the broader picture is 
about deregulation and it is about allowing the financial 
system to go up and go down. It turns out when you go down, it 
is a lot of public debt you are going to incur in the clean-up. 
We just can't afford to do that repeatedly.
    Mr. Bilbray. Thank you, Mr. Chairman.
    Chairman Miller. Thank you, Mr. Bilbray. Just one point 
quickly. The Community Reinvestment Act only applies to banks 
and thrifts with federally insured deposits, and only 20 to 25 
percent of subprime lending in the 2004 to 2006 period, which 
is the problem period, were by institutions subject to the CRA. 
According to the Federal Reserve Board, six percent of the 
loans were actually subject to the CRA because they were a CRA 
lender in a CRA assessment area, the neighborhoods in which CRA 
encouraged lending; and the Federal Reserve Board concluded 
that the CRA had nothing to do with the foreclosure crisis.
    Are any of you aware of any scholarship, any authority that 
contradicts that? Okay.
    Second, I have listened closely for six years to all the 
testimony on the Financial Services Committee about mortgage 
lending from the time that I have been in Congress, which is a 
little more than six years now, and I do not recall any witness 
ever complaining that they were making loans they really didn't 
want to make, that they thought were foolish loans because the 
CRA was making them do that. Do any of you remember any 
complaints like that during that period? Okay.

                On Systemic Risk in the Financial Sector

    Dr. Johnson, you said that you thought banks should go back 
to being utilities which is pretty much what they were in the 
'50s and the '60s. Paul Krugman, who, in addition to being a 
notorious liberal, is a Nobel laureate in economics, so maybe 
we should take him seriously, has said much the same thing. You 
said we should make banks boring again. Your Atlantic article 
points out that just a couple years ago, in addition to a 
compensation system that was almost twice what most people 
make, when in the past it was about what most people made, that 
the financial sector made more than 40 percent of corporate 
profits. Obviously what we have now is a pretty sick financial 
system, a pretty sick banking industry, but that is not a real 
healthy one, either. One that bounces from that to this and 
back is certainly an unhealthy one. Was part of the problem 
that banks were making too much money, and second, you know, 
the money appears to be gone. It appears to be paid out in 
profits or as bonuses or dividends or something, but it is not 
now available to help the banks get through the trouble that 
they are in now; and as all of you pointed out, taxpayer money 
is subsidizing banks to keep them alive.
    IMF estimates that about 17 percent of loan exposures at 
American banks are consumer lending; another 52 percent 
mortgage lending; commercial mortgages are only six percent, 
corporate, 15; other, I don't know what that is, is 11, it is 
other; and securities is four percent, consumer residential 
mortgage, 42 percent; commercial mortgage six percent; 
corporate 32 percent; other 16 percent. I mean, it certainly 
sounds like the industry was making a lot of their money from 
consumers. Is that correct? Is that consistent with what all of 
you know or believe?
    Dr. Johnson in your opening testimony, you talked about the 
value that there might be in having better consumer protection 
for financial products. Do any of the rest of you see that as 
part of the way we should approach systemic risk to make sure 
that the sector is not trying to bring in too much money off 
consumers? Dr. Baker.
    Dr. Baker. I mean, one of the points I think we would all 
agree, but I will let everyone speak for themselves, is that 
part of the story of innovation is--I think innovation creates 
an environment in which you are more likely to see systematic 
risk, and in the event that you limit innovation, you know, on 
the one hand you can have a downside that there can 
occasionally be a financial product that will have benefit for 
consumers that you will delay the introduction, but you will 
also limit the extent to which you can expect to see systemic 
risk. You won't have someone, a bank or a financial 
institution, coming out with some new product that will get a 
huge amount of business and then later end up exploding in our 
face as what happened with subprime mortgages.
    Chairman Miller. Dr. John--Mr. John. No, Dr. John. I am 
sorry.
    Mr. John. Actually, I am a Mr. John, but Dr. John is my 
father. I think one has to be very careful, however, that if 
you look at the regulatory system, and particularly the state-
based regulatory system for insurance, you often see that under 
the guise of safety and soundness, et cetera, that good 
products are actually sidelined and not allowed, and this in 
turn allows market share to be kept at its current level, 
rather than facing competition that might change that market 
share. So this is something that one has to be very careful 
about.
    Chairman Miller. Dr. Sachs, I want to come back to that.
    Dr. Sachs. Mr. Chairman, I think it is also important to 
address these crises more from the balance sheets and behavior 
of the institutions, rather than the consumer per se actually 
because there are many ways that financial bubbles arise, and 
they are not all consumer driven. We had a developing country 
debt crisis in the 1980's when the banks heavily invested in a 
very different kind of security. The regulation needs to 
enforce capital adequacy, a balanced portfolio. We should add 
in this discussion that the Federal Reserve made tremendous 
mistakes not only in regulation but in monetary policy per se, 
in stoking this bubble. So many things went into this, but I 
don't believe that ultimately we are going to get a handle on 
stopping financial crises by addressing the end product of 
lending per se, rather than the behavior of the financial 
intermediaries themselves, what their balance sheets look like, 
the kinds of risk that they are allowed to take, the capital 
standards, the nature of the oversight, the guarantees that 
implicitly or explicitly are given by government.
    And we should remember, I believe, one more critical point 
which is what makes these crises dangerous are the links 
between the bank failure and the liquidity of the economy. That 
is the tight link, not the mere loss of an institution that 
goes bankrupt. That happens quite frequently in a market 
economy. It is the seizing up of liquidity. So that is why we 
need regulation to prevent a bank failure from spilling into a 
kind of Lehman panic, which is the essence of the sharp decline 
that we are experiencing.

                Analogous Issues in Insurance Regulation

    Chairman Miller. I would like to pursue this question with 
Dr. Broun's indulgence.
    Dr. John, the insurance regulation model at the state level 
is to require--well, it is roughly equally divided between 
requiring prior approval and just filing followed by beginning 
to use, beginning to sell insurance products. But the filing 
requirements and the approval requires filing of policy forms 
so that a regulator or in a public filing, anybody, can see 
exactly what is being insured against so that there is not 
quite the asymmetry of information that there are in insurance 
policies that really accept from insurance the risk that a 
consumer might think that they were getting covered. And 
second, show the actuarial numbers to support the pricing, to 
support the premium for two reasons. One is to make sure that 
consumers are not being gouged but also to make sure the 
insurance companies are not charging too little and putting 
their solvency at risk. It certainly appears that insurance 
companies who are subject to that kind of regulation have come 
through this much better than the mortgage market. But you 
think that we would be better off not--and some of them were 
arguing to be turned loose the way the mortgage market was just 
a couple of years ago. Do you still think that is a good idea?
    Mr. John. I don't think necessarily that is a good idea, 
but the fact is that these 50 states regulate insurance in many 
different ways. Some of them do it precisely as you said and in 
a very responsible manner, but we have seen situations where 
various products which would have been beneficial to consumers 
were blocked or delayed significantly in certain states, mainly 
so companies that didn't offer that type of product could 
either develop it or so that they could continue to keep their 
market share. This is one of my deep worries about the idea of 
a financial product safety commission, which is that regulation 
in theory works fine in some cases but it is subject to 
political influence. It is subject to normal human 
interactions, and it is very possible to delay products, to 
delay innovations, charge that they are too risky, et cetera, 
and the net result being that something that would actually be 
very beneficial to consumers never sees the light of day.
    Chairman Miller. Okay. Anyone else have comment? Dr. 
Johnson.
    Dr. Johnson. Yes, I think that this idea of pursuing the 
insurance type model makes a lot of sense to me. You know, 
there is cost to any regulation, and I think Dr. John is right 
that you have capture and you can ossify your market structure, 
that is true. But we are trying to balance the cost of 
deregulating, and your contrast between what happened with 
insurance where, for whatever reason, there was some holding 
back of the industry that wanted to tear ahead with what 
happened in and around the mortgage market where essentially it 
was a free-for-all. That contrast is really quite striking, and 
I think we should draw from it the kind of lessons that you are 
indicating.
    Dr. Baker. I would just like to say that I agree with that. 
To my mind, again, there obviously are trade-offs here, and I 
think that the risks of under-regulating swamp the potential 
loss from delaying the onset of the introduction of a new 
product. So that is really what we are asking about here.
    Chairman Miller. Is that what we are under now is the 
swamping, the inundation from the swamping?
    Dr. Baker. In my mind, yes. Absolutely.
    Chairman Miller. Doctor, my time has long expired, but I 
will be similarly indulgent within reason of the other Members. 
Dr. Broun.

                        Large Loan Loss Reserves

    Mr. Broun. Thank you, Mr. Chairman, and maybe you and I can 
discuss over dinner how the Community Reinvestment Act and 
ACORN played a part in all this housing problem. There is 
certainly a lot of risk that can be spread around to many, many 
factors, and that is not just the only risk, but the bankers 
that I talked to were not happy to make the loans that they 
made but were very happy to have Freddie and Fannie be able to 
bail them out and sell off those high-risk loans that some of 
them or a lot of them turned out to be what is now called toxic 
assets and certainly the Fed had a big part to play in all 
that, too.
    It is often said that hindsight is 20/20. However, given 
the current state of the financial markets, do you think it was 
a mistake for the SEC to oppose the idea of building large loan 
loss reserves? Would it make sense to create a system of loan 
loss reserves similar to the system that Spain has created with 
their housing market problems that they had over there? To the 
whole panel. Dr. Johnson.
    Dr. Johnson. I think that the broader--yes, I think there 
was too much--back to sort of the original purpose of the 
hearing which is the science and to what extent, what is the 
sensible science around evaluating the risks of lending. People 
bought into these models far too much, and I think that was a 
mistake. I am not singling out the SEC. I think it was very 
broad across the regulatory agencies, across pretty much all 
branches of government bought into the idea that somehow we had 
made a lot of progress in terms of thinking about risk, 
quantifying risk, and that the people who earned enormous 
amounts of money on Wall Street, really had cracked this very 
tough, age-old human problem. The bottom line is they hadn't. 
We still don't understand risk or we still are subject to being 
tripped up by our own misperceptions of what risk was in the 
past, and I am afraid, you know, the SEC is no exception to the 
broad set of people--academics are definitely included in this 
as well, by the way--who fundamentally misunderstood and 
mischaracterized risk and drew the wrong implications from 
faulty science.
    Mr. Broun. Do you think the Spanish model is a good model 
for us to look at?
    Dr. Johnson. Frankly, I followed the Spanish situation 
closely when I was with the IMF. I haven't looked at it in the 
last two months. What I saw then, and I had a very close 
colleague, a senior person at the IMF who was the former 
governor of the Central Bank of Spain, Mr. Jamie Caruana. He 
warned repeatedly everyone involved in the Spanish housing 
market about over-exuberance and about mismanagement of risks 
by regulators and by banks, and he turned out to have been 
absolutely correct on that. The Spanish housing market is a 
disaster. I would have to go back and look at exactly 
individual pieces of the policy to see if I could glean 
something useful from it, but the broad picture of what has 
been done in Spain, how the peaks and the valleys have been 
managed is a terrible tale. It is going to end up much worse 
for their citizens than even for our citizens.
    Mr. Broun. Mr. John.
    Mr. John. I actually have nothing to add in this case.

                        The Loan-to-Value Ratio

    Mr. Broun. Okay. Anybody else. Moving on, much of the 
financial crisis has been blamed not only on the bubble in the 
housing market but also on pressuring the banks to give loans 
with the loan-to-value ratio close to 100 percent and sometimes 
many loans were given that were above the value, which 
statistically show a high rate of default when you have those 
kinds of loans. If banks were to return to the convention loan-
to-value ratio of 80 percent, do you believe it would help 
avert future financial crises? Mr. John.
    Mr. John. Well, I think it would but I think we have to 
look at the subsidiary costs of that also. I mean, we have 
direct proof that foreclosure and problems with paying go up 
directly with--or inversely I guess--with the size of the down 
payment. So if you have a 20 percent down payment, you have got 
a lot of your own money at risk and it is going to be much less 
incentive to walk away. The flip side of it however is that if 
we want homeownership to be spread across a very broad section 
of the economy, and speaking as a conservative I can say that 
homeownership has a direct correlation with reductions in teen 
pregnancy, with reductions in crime, and a variety of other 
situations there, that you want to be very careful that in the 
process of creating safety and soundness in the banking 
industry you don't price a significant portion of the 
population out of the housing market.
    Mr. Broun. Dr. Baker.
    Dr. Baker. I just would agree largely with what Mr. John 
said. Obviously, you will price more people out of the housing 
market in terms of buying homes, but I think that has actually 
been a problem of our housing policy that has been very one-
sided, that for a lot of people in many circumstances it 
doesn't make sense for them to be homeowners, and I would like 
to see us have a policy that doesn't treat someone as a second-
class citizen simply because they are renters. So I think a 
policy that was focused on ensuring that people had good 
housing as either renters or owners, we have consistently had 
roughly one-third of our households as renters. There has been 
a little bit up or down as you go year by year, but that has 
been the basic story as far back as you want to go, and I think 
we are always going to have to envision a situation where much 
of the population is renters and that idea that involves 
second-class citizenship is a bad one.
    Mr. Broun. Amen. I couldn't agree with you more. I don't 
think we have a God-given Constitutional right to own a home. 
Dr. Johnson.
    Dr. Johnson. I think this loan-to-value question is a good 
one. It raises an interesting issue, again back to the purpose 
of this hearing which is, where did the models go wrong? What 
was the analytical counterpart perhaps to the political economy 
and the regulatory failures and so on and so forth? And I think 
at least one plausible explanation--I don't have proof and I 
know I am still under oath--so let me just say it is an 
impression at this point, is that there was an expectation the 
price would keep going up, and the lenders were not wrong in 
their calculation of the default rate, but they were completely 
wrong in their calculation of the losses they would incur 
because they thought the house prices would keep going up. And 
they knew that, you know, when you foreclose on a property you 
lose a substantial amount of value, but they didn't mind 
because they thought house prices would keep going up. Now, I 
raise this because of course, 80 percent loan-to-value would be 
helpful relative to 100 percent of the situation, but how much 
craziness would happen and how much you could sort of expect a 
recurrence of some version of this would depend on what kind of 
price bubble you get into. And I don't think the next issue is 
going to be housing. We don't usually rerun exactly the same 
bubble, but for sure, we rerun bubbles every couple of years at 
the level of the global economy. And I think we convince 
ourselves, this time it is different, this time there has been 
a fundamental shift in prices. We are going from a low level to 
a high level, and you could lose out big time with 80 percent 
loan-to-value ratio depending on how much you miss your 
thinking on this price transformation.
    Mr. Broun. Dr. Sachs.
    Dr. Sachs. I think there is plenty of evidence that even 
during the lending boom there was a great deal of awareness 
that the terms of these loans were simply not prudent and that 
loans were being made that were unlikely to be paid off, and 
the regulatory forbearance on that was irresponsible in my 
view. So had the lending standards been better enforced and had 
the dangers of these loans which were recognized at the time by 
professionals in the real estate market then observed, we would 
have avoided at least some of this. We should not be making 
loans on the basis of ever-continuing increases of prices. 
Prices don't ever continue to increase in real terms. That is 
what you get in bubbles, not what you get in an economy over 
the long-term, and regulators should know that. And regulators 
were warned that repeatedly by many participants in this 
process.
    Mr. Broun. Dr. Sachs, many Members of Congress were warned 
about the impending bubble, too, and Congress refused to do 
anything about it in spite of repeated warnings from many 
sources that proved to be right unfortunately.
    Mr. Chairman, I yield back.
    Chairman Miller. In my clock, you had another minute, so 
you yielded that back. Dr. Johnson, it is true, you are under 
oath, but again, a perjury prosecution would require a showing 
of what the truth was and that you knew what the truth was and 
consciously departed from it. So I think all of you can relax 
about that.
    Mr. Bilbray.

                        The Pursuit of Property

    Mr. Bilbray. Yes, a comforting concept there. You know, I 
think we are really underestimating a lot of the discussion 
here. I guess when we were talking about second-class citizens 
to own property or not property, but let us remember right from 
the get-go, you know, the whole concept, life, liberty and the 
pursuit of happiness was really originally life, liberty and 
the pursuit of property. Most people--historians understand. 
The pursuit of happiness was synonymous with the pursuit of 
property, and I guess, Dr. Baker, the problem, I guess the fine 
point here is not the guarantee of property, it is just the 
pursuit of it. So I think that we have got to recognize, this 
runs really deep in our national psyche, the concept of moving 
from being a serf or a renter to being a property owner right 
down to the fact of leaving the security of the Eastern 
Seaboard to venture out into the wilderness so that you could 
own a piece of, you know, turf, something that motivated people 
out of England, France, and other parts of the world. So, you 
know, I just think that that psyche is really something that we 
underestimate as being part of the American experience. Would 
you agree with that, Dr. Baker?
    Dr. Baker. Well, certainly I don't want to take away 
opportunities for people to own homes, but I think what we have 
to do is try and--as designing policy, design policy that makes 
sense. And what that means is for a lot of people, it simply 
doesn't make sense to own a home in certain circumstances. If 
you are in an unstable family or employment situation, you 
expect to be moving in a year, two years, or three years, you 
are almost certainly going to lose money buying a home, you 
know, even apart from issues of bubble price.
    Mr. Bilbray. But would you agree that our problem was that 
we moved from guaranteeing the right of pursuit to trying to 
guarantee the right of possession?
    Dr. Baker. That is perhaps a way to put it, yes. I think we 
put too much emphasis on ownership, home ownership.
    Mr. Bilbray. I want to clarify that because I think that 
when we got into it, both sides were very guilty of the concept 
of needing to expand, you know, the middle class through the 
housing strategy, and it almost ended up being where you had 
the left and the right with different agendas, moving in the 
same direction without really keeping our eyes open about that. 
I see the right looking at this as a great way to create more 
capitalists, more people with property so they defend the 
property aspect, and the left may be looking at this as a way 
of being able to actually re-engineer a welfare program to 
allow access to a population that traditionally had not been 
allowed to. Dr. Johnson.
    Dr. Johnson. I agree that what you are discussing is part 
of the ideology behind some of the housing froth. I don't think 
it is the deeper issue, I don't think it explains how we got 
into the deregulation. But I remember I read something right on 
this point this morning by Chairman Miller, actually, so I 
quote him with some hesitation because I might actually know 
the truth and get it wrong here.
    Chairman Miller. I think you should treat that as 
authoritative.
    Dr. Johnson. Which as I recall, Chairman Miller dug up some 
numbers on how much of the subprime mortgages came from 
refinancing of existing homes, and the people who had entered 
into unstable families, who had family problems, who had hit a 
rough patch, and it was a very large proportion of subprime 
mortgages, originally from people who already owned homes. It 
wasn't in other words expanding the pool of ownership in the 
way you are describing, it was, you know, I think you could 
say, people who had been taken advantage of by unscrupulous 
lenders.
    Mr. Bilbray. Or people doubling down.
    Dr. Johnson. Maybe, and that there is this very good book, 
of course, new book by Ed Andrews, a New York Times 
correspondent, Busted, where he goes through his own very 
personal circumstances that induced to make him an absolutely 
terrible financial decision, and he is a business correspondent 
for the New York Times. I think that this--I don't want to put 
words into Chairman Miller's mouth but I think this is a much 
deeper issue of the sort of regulation of behavior. Why do we 
make these mistakes? Why do very sophisticated people make 
these mistakes? And I think a lot of it is about our personal 
circumstances and being taken advantage of when times are 
tough.
    Mr. Bilbray. Well, I think there is also the issue that 
those of us in Washington really encouraged this to a large 
degree. Our taxation codes give a great incentive. There is a 
whole lot of across-the-board kind of inspiration here. But let 
us go back and try to find, you know, where--and this may fall 
right into a category a Republican normally doesn't want to 
talk about.

                       The Model of Credit Unions

    Let us talk about the institutions that seemed to have 
functioned, the credit unions. Is it because they weren't 
allowed to go out into certain fields, they were limited in 
that? Let us talk about where the credit unions were during 
this process. Why don't they seem to be at the point of this 
crisis, though they are getting a residual problem? It is more 
residual, not specific to their industry. Let us look at the 
success there.
    Dr. Baker. I would say that the answer is that they were 
boring. You know, they know their customers, they weren't 
trying to expand 20, 30 percent a year. They weren't trying to 
get into very complex mortgages that, you know, they may not 
have fully understood themselves. Basically they were following 
old practices, and those turned out to be good practices from 
the context of this housing bubble.
    Mr. Bilbray. Boring? I can imagine my wife using that as 
the example of why our marriage has lasted 26 years. Go ahead.
    Dr. Johnson. I bank with a credit union and with a small 
bank. One is in Massachusetts where I used to live and one is 
in Washington, D.C. These are exactly boring, safe 
institutions. You go in there, you know exactly what they are 
talking about. They don't offer the most sophisticated 
products. There are people who are offering cheaper mortgages. 
I have had two mortgages, one in Massachusetts, one here. And 
they are plain vanilla mortgages, and they know exactly what 
they are going to do, which ones they are going to sell, to 
whom they will sell them, and which ones they hold. And in 
fact, in both cases, I took mortgages that these people hold on 
their own books because it just seems much more 
straightforward. It is very, very boring. They, you know, make 
some money but no extremely high money and they pay some of it 
back to their members. I think that is exactly what we are 
talking about in terms of going back to a previous type of 
basic banking.
    Mr. Bilbray. Thank you.
    Mr. John. I am going to agree very quickly, and I have the 
same relationship in that I have a relationship with a small 
bank and I have a relationship with a credit union. My small 
bank is very similarly operated to the credit union except for 
the fact that it has made a fair amount of construction loans 
in our area, and that is going to be interesting to see how 
those construction loans play out as time goes forward. The 
credit unions did very well, but the one place, the one blip 
that they got involved with was corporate credit unions which 
some of us actually had dealt with 15 years ago, and they had 
precisely the same problem then, which was the one area where 
they tried to get into the more exotic instruments. A corporate 
credit union is a credit union for credit unions, and there was 
a similar situated bank, Silverton, which went bust a few weeks 
ago also, and when they got outside of their comfort range, 
that was when they got into trouble.
    Mr. Bilbray. In fact right now, where they are running into 
trouble is not their loans but the loans that their clients had 
gotten from somebody else, and that is coming back to hurt 
them. You have a comment on the credit unions before my----
    Dr. Sachs. I was going to say that I think it is important 
to keep the focus on the Federal Reserve Board, the SEC, and 
the behavior of a few large Wall Street Firms because this is 
where this particular episode arose, and this is a failure 
mainly of regulation at the heart of the system. And I would 
put the core of responsibility at the Federal Reserve Board.
    Mr. Bilbray. Mr. Chairman, I appreciate the time, and let 
me just say, I was around when we were looking at all of this 
at Energy and Commerce, and let me tell you something. I heard 
bankers have to again and again and again say that because of 
their federal charter, because of their federal oversight, they 
should be exempted from all kinds of other things that other 
people and they should basically be able to move it, and it's 
almost like an elite attitude that they, somehow the rules 
shouldn't apply to them. And all during the late '90s I just 
remember the bankers saying, you are right, but we are a 
federally chartered bank so thus we should be exempt from this, 
this, and this. Thank you, Mr. Chairman.

                          Future Difficulties

    Chairman Miller. Thank you, Mr. Bilbray. We are probably 
getting close to the end, but I do have a couple more 
questions.
    Dr. Sachs said that we had a realistic shot of muddling 
through this, which I assume means that we will do essentially 
what we did in the early '80s through some kind of back-door 
subsidies that will not provoke quite the rage of very low 
interest rates from the Federal Reserve, then loaned at a much 
higher rate. The banks might actually kind of earn their way 
back to solvency, but I guess one question is what are the 
downsides of doing it that way? But second, you have all 
mentioned that there are other shoes that might still drop.
    Dr. Johnson, you mentioned the European banks were much 
less far along than we were which is kind of hard to imagine in 
recognizing loss. One thing I have heard is that there is a 
distinct possibility of sovereign debt default in Eastern 
Europe which could bring down the entire European banking 
system, and that might in turn bring down ours after all else.
    What other shoes are there to drop and if no other shoes 
drop and we do muddle through, what are the downsides of having 
muddled through?
    Dr. Baker. Well, certainly some of the other shoes other 
than what you just mentioned but also, if the downturn is 
worse, if the drop in house prices is worse, say, than was 
assumed in the stress test, we are going to be looking at much 
bigger bank losses, and that by itself could be another shoe. 
But one other point, this gets back to the Europe issue, and I 
have not seen this pursued. Maybe someone has pursued it, but I 
just haven't seen it. With AIG, much of the payments that were 
made through AIG were to European banks, and I assume that was 
for a reason. Again, the government had no legal obligation to 
make those payments. So I do wonder to what extent, you know, 
we have an issue of those banks concealing at this point or not 
owning up to very bad losses connected with the U.S. market and 
then what the implications would be, both politically and 
economically, if at some point they have to realize those 
losses.
    Chairman Miller. And I have heard that explained as the 
reason AIG made the payments to European banks was their 
connections to American banks. Anyone else? Dr. Johnson.
    Dr. Johnson. I think the European situation is very 
difficult. I am not expecting, at this point, sovereign 
defaults. They have large loans from the IMF supported by the 
United States, of course, and they are rolling over a lot of 
their external creditors; but their external creditors are 
mostly Western European banks. Their equivalent of subprime is 
crazy loans to real estate in Eastern Europe which has got a 
whole other levels of weirdness and stupidity to it. They 
didn't heed any warnings that they were given, so you know, we 
are all in very good company there. I think you have a very big 
slowdown in Europe. You got to big global recession coming. You 
know, there will be some isolated defaults, but not the 
precipitate collapse that we might have seen or might have been 
worried about three or four months ago. Still, that is bad, and 
that is a big drag on the U.S. economy, and that feeds into the 
kinds of problems that Dr. Baker is talking about.
    In terms of the downsides, think about this one. If the 
banks are authorized, approved, and encouraged and on their way 
back to solvency, then what are the regulators going to be 
saying when they raise credit card fees or find ways to squeeze 
extra value out of people who, you know, whose credit has 
become impaired, who can't easily switch to another lender? 
This situation is ripe for predatory practices of all kinds, 
taking advantage of consumers because we were telling the 
banks, go out and earn you way back. And we know that there are 
lots of loopholes around the regulatory protection for 
consumers. I understand this might feel like closing a barn 
door after, you know, a particular kind of horse has left. But 
I do think that consumers are in the line of fire right now 
with regard to bank practices, and I do worry going forward 
about the ways in which consumers are going to get sideswiped 
by all kinds of potential financial, you know, bubble-building 
technology that we are going to cook up in the future and 
convince ourselves this time it is different. It is never 
different. It is always the same, and it is always the 
consumers and the taxpayers, the regular, ordinary citizens who 
get hammered in the end.
    Chairman Miller. I saw an estimate that banks expect to 
collect $40 billion in overdraft fees this year which is more 
than four times what they have collected in the past.
    Dr. Johnson. And this they will get away with under 
existing consumer protection, the existing antitrust 
regulation. But think of it like this. There is a stickiness to 
your relationship with the bank. At the time of crisis, it is 
harder to switch, okay? So you are locked in much more. Well, 
locking in is exactly what has gotten information technology 
companies into trouble. All right? And I think the Department 
of Justice is beginning to think a little bit along these 
lines. They should be encouraged to think a lot more about the 
kinds of exercise of monopoly power and pricing power you get 
in a period of total confusion when people's credit scores have 
been hurt through circumstances beyond their control.
    Chairman Miller. Dr. Sachs, did you----
    Dr. Sachs. Broadly speaking is the macro-economic situation 
which is going to determine whether the muddling through works 
or whether we get another serious dip, further dip, in the 
economy; and then all these scenarios will be brushed aside. 
The muddling through scenario has the advantage that it will 
not necessarily involve another large amount of taxpayer 
dollars. That is the advantage of it. The downside is that it 
could mean a somewhat slower recovery because of bank capital 
only being gradually rebuilt.
    The other aspect of the muddling through, though, is that 
the Administration continues to pursue measures like this 
public-private partnership to rebuy toxic assets which in my 
view are likely to be very costly, even under the favorable 
scenario that they are presenting as a result of the stress 
tests. So I am not too happy about the continuing risks that 
taxpayers face in all of this, and that is why I believe the 
bottom line is the continuing lack of a resolution strategy and 
a continuing lack of clarity about what the policies really are 
because at this stage at least, I would say, muddling through 
is reasonable if it protects the taxpayers. If it further 
endangers taxpayers, I think it needs to be examined and if it 
turns out to be inadequate, we need a backup that doesn't put 
us on the line first as taxpayers, but rather puts the 
bondholders and the shareholders in line first in a way which 
doesn't create another panic. That is what I would like the 
Administration to come forward with.

                      Mr. Broun's Closing Remarks

    Chairman Miller. My time is expired. Dr. Broun.
    Mr. Broun. Mr. Chairman, just for the sake of time, I am 
not going to go through another set of questioning of our 
panel. I want to thank you all for coming. If we could, I would 
like to give you all some written questions for you to respond 
to, and I appreciate the response to those things. But I just 
want to make one final comment, and it is kind of a follow-up 
on something that Dr. Johnson said. I believe very firmly if we 
don't stop spending money as a government, all of this is not 
going to make any difference because we are borrowing and we 
are actually stealing from our grandchildren's future. And we 
are going down a road that I think is going to be disastrous. 
We are going down the same road that FDR went down during the 
Great Depression. Keynesian economics I don't think has ever 
worked, and it is not going to work with even greater and 
greater federal spending, and we need to get out of this 
financial crisis. And I believe very firmly in the marketplace. 
I think that is the way to do it, and I think over regulating 
the system is going to do nothing but guarantee mediocrity and 
is going to further delay the return. So with that, Mr. 
Chairman, I will yield back.

                        Further Areas of Inquiry

    Chairman Miller. Thank you, Dr. Broun. I think we have 
ended our question. This sort of question is not another round 
of questions, but for purposes of our committee thinking about 
what our role may be, the jurisdiction of the Science Committee 
and therefore the Oversight Subcommittee of the Science and 
Technology Committee is research, scientific research or 
research. And the NSF, National Science Foundation, is within 
our committee's jurisdiction. A great deal of economics 
research is done by NSF. They have on their web page the Nobel 
laureates in economics who have done research pursuant to 
grants from the NSF they note with some pride. Measurement is 
part of our committee's jurisdiction. We obviously do not have 
the jurisdiction to pass legislation on this topic, but we can 
kind of add to the debate and the knowledge about the 
scholarship on economics.
    Do any of you think, either now or can suggest later, other 
areas of inquiry for this subcommittee on this topic? Dr. 
Johnson.
    Dr. Johnson. I think you indicated at the beginning, and 
actually this is in Dr. Broun's testimony as well, that you 
have to pay close attention to how science is applied in 
presumably public projects but also more broadly. So I think 
you could look, if I understand correctly, at exactly who 
developed these models, how were these models applied, and on 
what basis? What was the miscalculation if you like in terms of 
thinking about risk? And that would be extremely informative 
for you and for us because really understanding the thinking, 
what were they thinking? What on earth were they thinking is a 
very good question. These are extremely smart people who built 
these models. They worked very closely with the phenomenon. Was 
it a conceptual failure? Was it purely a failure of incentives, 
was it a failure of oversight? Was it a failure of governance 
within the structures? That sounds to me like exactly what you 
would look at when there was a problem with the space shuttle 
for example which, again from the paintings, I think you have 
some jurisdiction over. That strikes me as being an excellent 
topic to pursue, that is the application of science to these 
problems of fundamental social value.
    Chairman Miller. Dr. Sachs.
    Dr. Sachs. One other area that might be interesting is that 
there is considerable amount of research and writing about 
resolution issues. What do you do with the bad bank? And I 
believe that the link of the science to the policy-making is a 
very important issue, because a lot of that sits outside, 
complains about policies, but doesn't get incorporated into the 
policy-making. So thinking about what is the research on 
resolution issues and how can it be better applied in our 
current circumstances might be very valuable.
    Chairman Miller. You don't all have to have an answer to 
this question. But if you have one--Dr. Baker.
    Dr. Baker. Yes, just quickly, just carrying on what Dr. 
Johnson said. I think certainly we do want to get to the bottom 
of the extent to which, you know, the mistakes were sort of 
ones of bad science or bad incentives, and certainly, as the 
Administration considers rules on incentive structures and 
financial institutions, that would be very, very helpful. And 
the question will be, do we need to fundamentally alter those 
incentive structures to prevent this sort of thing from 
occurring again?
    Mr. John. Last but not least, I think it would be very 
useful to look at the actual role of the United States in the 
global financial markets. One of the things that I have 
wondered throughout is to what extent we actually had control 
over our own destiny and to what extent we were floating on a 
boat that was in a global stream. It would be intriguing to 
see, especially in conjunction with the resolution authority, 
how the resolution authority works in the United States is one 
thing, but how it works with a very complex global financial 
institution is something else very different.
    Chairman Miller. Well, I said that wasn't really a round of 
questioning, but Dr. Broun, do you have any other questions? 
Okay.

                                Closing

    Well, thank you very much. This has been very distinguished 
panel and a very helpful discussion. I want to thank all of you 
for testifying today. Under the rules of the Committee, the 
record will remain open for two weeks for additional statements 
from the Members as well as any follow-up questions. Dr. Sachs, 
you said you wished to prepare some written testimony that you 
would submit for the record. And with that, the witnesses are 
excused and the hearing is now adjourned.
    [Whereupon, at 12:10 p.m., the Subcommittee was adjourned.]

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