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



 
                  SYSTEMIC RISK: ARE SOME INSTITUTIONS

                    TOO BIG TO FAIL AND IF SO, WHAT

                         SHOULD WE DO ABOUT IT?

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


                                HEARING

                               BEFORE THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                               __________

                             JULY 21, 2009

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 111-65

                 HOUSE COMMITTEE ON FINANCIAL SERVICES


                  U.S. GOVERNMENT PRINTING OFFICE
53-245                    WASHINGTON : 2009
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20402-0001



                 BARNEY FRANK, Massachusetts, Chairman

PAUL E. KANJORSKI, Pennsylvania      SPENCER BACHUS, Alabama
MAXINE WATERS, California            MICHAEL N. CASTLE, Delaware
CAROLYN B. MALONEY, New York         PETER T. KING, New York
LUIS V. GUTIERREZ, Illinois          EDWARD R. ROYCE, California
NYDIA M. VELAZQUEZ, New York         FRANK D. LUCAS, Oklahoma
MELVIN L. WATT, North Carolina       RON PAUL, Texas
GARY L. ACKERMAN, New York           DONALD A. MANZULLO, Illinois
BRAD SHERMAN, California             WALTER B. JONES, Jr., North 
GREGORY W. MEEKS, New York               Carolina
DENNIS MOORE, Kansas                 JUDY BIGGERT, Illinois
MICHAEL E. CAPUANO, Massachusetts    GARY G. MILLER, California
RUBEN HINOJOSA, Texas                SHELLEY MOORE CAPITO, West 
WM. LACY CLAY, Missouri                  Virginia
CAROLYN McCARTHY, New York           JEB HENSARLING, Texas
JOE BACA, California                 SCOTT GARRETT, New Jersey
STEPHEN F. LYNCH, Massachusetts      J. GRESHAM BARRETT, South Carolina
BRAD MILLER, North Carolina          JIM GERLACH, Pennsylvania
DAVID SCOTT, Georgia                 RANDY NEUGEBAUER, Texas
AL GREEN, Texas                      TOM PRICE, Georgia
EMANUEL CLEAVER, Missouri            PATRICK T. McHENRY, North Carolina
MELISSA L. BEAN, Illinois            JOHN CAMPBELL, California
GWEN MOORE, Wisconsin                ADAM PUTNAM, Florida
PAUL W. HODES, New Hampshire         MICHELE BACHMANN, Minnesota
KEITH ELLISON, Minnesota             KENNY MARCHANT, Texas
RON KLEIN, Florida                   THADDEUS G. McCOTTER, Michigan
CHARLES A. WILSON, Ohio              KEVIN McCARTHY, California
ED PERLMUTTER, Colorado              BILL POSEY, Florida
JOE DONNELLY, Indiana                LYNN JENKINS, Kansas
BILL FOSTER, Illinois                CHRISTOPHER LEE, New York
ANDRE CARSON, Indiana                ERIK PAULSEN, Minnesota
JACKIE SPEIER, California            LEONARD LANCE, New Jersey
TRAVIS CHILDERS, Mississippi
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
STEVE DRIEHAUS, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
DAN MAFFEI, New York

        Jeanne M. Roslanowick, Staff Director and Chief Counsel


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    July 21, 2009................................................     1
Appendix:
    July 21, 2009................................................    47

                               WITNESSES
                         Tuesday, July 21, 2009

Johnson, Simon, Professor, Massachusetts Institute of Technology.     9
Mahoney, Paul G., Dean, University of Virginia School of Law.....    14
Rivlin, Alice M., Senior Fellow, The Brookings Institution.......     5
Wallison, Peter J., Arthur F. Burns Fellow in Financial Policy 
  Studies, American Enterprise Institute.........................     7
Zandi, Mark, Chief Economist and Co-Founder, Moody's Economy.com.    12

                                APPENDIX

Prepared statements:
    McCarthy, Hon. Carolyn.......................................    48
    Johnson, Simon...............................................    49
    Mahoney, Paul G..............................................    61
    Rivlin, Alice M..............................................    68
    Wallison, Peter J............................................    79
    Zandi, Mark..................................................    86

              Additional Material Submitted for the Record

Frank, Hon. Barney:
    Written statement of the Property Casualty Insurers 
      Association of America (PCI)...............................   104


                  SYSTEMIC RISK: ARE SOME INSTITUTIONS

                    TOO BIG TO FAIL AND IF SO, WHAT

                         SHOULD WE DO ABOUT IT?

                              ----------                              


                         Tuesday, July 21, 2009

             U.S. House of Representatives,
                   Committee on Financial Services,
                                                   Washington, D.C.
    The committee met, pursuant to notice, at 2:03 p.m., in 
room 2128, Rayburn House Office Building, Hon. Barney Frank 
[chairman of the committee] presiding.
    Members present: Representatives Frank, Kanjorski, Maloney, 
Watt, Sherman, Moore of Kansas, Capuano, Clay, Green, Cleaver, 
Ellison, Perlmutter, Donnelly, Foster, Carson, Minnick, Kosmas, 
Himes, Peters; Bachus, Royce, Biggert, Capito, Hensarling, 
Garrett, Neugebauer, Bachmann, Marchant, McCarthy of 
California, Lee, Paulsen, and Lance.
    The Chairman. The hearing will come to order.
    Sometimes, we have hearings to find things out. That's not 
the unvarying reason why we have hearings, but sometimes we 
actually have hearings because we want to learn things. For me, 
this is one of those times.
    There is a great disparity I have encountered between the 
overwhelming consensus that we do not like the effects of ``too 
big to fail,'' and what to do about it.
    It is a concept, it seems to me, more easily denounced than 
dismantled. And we, I think, have broad agreement in this 
committee that it's not a good thing and it's not helpful for a 
number of reasons.
    And, you know, we are open to ways to deal with it. There 
are ways to deal with it indirectly and directly, but this is 
legitimately and we have a panel today unlike many of our 
panels.
    It does not consist of practitioners, people in the 
financial industry, consumer advocates. It's as near as we can 
see people with good analytical skills, and I mean this 
literally. I think there is a great eagerness on the part of my 
colleagues to figure out what's the most appropriate way to 
deal with ``too big to fail,'' and we are here to listen.
    The gentleman from Texas.
    Mr. Hensarling. Thank you, Mr. Chairman.
    I am curious, and I too want to listen to our witnesses 
very carefully. I'm not sure I have been convinced of the 
proposition of ``too big to fail,'' and if I have I haven't 
quite convinced myself that the cure is not worse than the 
illness. I'm not completely convinced we're not kicking the 
economic calamity can down the road for future generations to 
deal with.
    Now, back in the circumstances of last September and 
October, I believe there was fairly universal thought that 
Congress needed to act. Clearly, we disagreed on the plan on 
how best to do that. Even as a fiscal conservative, I was 
willing to put the full faith and credit of the United States 
on the line in what I perceived to be one of the first truly 
emergency situations I had seen since coming to Congress, 
although I hear the phrase every single day that I serve.
    But as I look closely at firms that may be designated 
supposedly as too big to fail, the two that come to mind are 
certainly Fannie Mae and Freddie Mac. Again, these were 
creations not of a competitive market, but creations in a 
government laboratory that never would have existed in a 
competitive market. And so I guess I'm convinced that 
government can create firms that some may view as too big to 
fail, that can create systemic risk, but I'm more convinced 
that there aren't more systemic events than there are systemic 
firms. And I'm not sure as this Nation has followed down the 
line of bailout mania that we necessarily have a whole lot to 
show for it.
    As we wake up today, we know since January that 2\1/2\ 
million more Americans have lost their jobs. We have, I 
believe, 9.5 percent unemployment. We're looking at the highest 
unemployment rate in a quarter of a century, and I feel that 
bailout begets bailout. Once we got away, for example, on TARP 
being about financial stability, bailing out Chrysler, bailing 
out GM, many of us said, we're going to throw good money after 
bad. They're going to end up in Chapter 11 anyway, and roughly 
$80 billion taxpayer dollars later, guess what? They did.
    You know, how is that fair to Ford who actually had to take 
on more debt to try to survive? And so, you know, to what 
extent is it even fair? To what extent is it even smart once 
you go down the road to start bailing out these firms? And so 
many of us fear, and I have introduced legislation, that TARP 
is now, regardless of its noble design back in September, 
October of last year, has morphed into a $700 billion revolving 
bailout slush fund that frankly is doing more harm to the 
economy than good. Now, I do want there to be an opportunity 
for large financial firms that fall into financial distress to 
be resolved and resolved quickly.
    That's why in the Republican financial markets reform bill 
there is a provision that would create in the Bankruptcy Code a 
new Bankruptcy chapter to do just this. But, you know, you have 
to ask yourself the question: Should it be the policy of the 
Federal Government to necessarily reward bad business models at 
the expense of good business models? And, by the way, 
apparently CIT was not necessarily on the Administration's list 
of ``too big to fail'' when apparently Uncle Sam wouldn't give 
them a bailout. Lo and behold! Look what happens. The market 
comes through.
    Isn't that interesting? You know, instead of CIT, maybe we 
should say see, I told you so. Maybe you ought to give private 
investment an opportunity to work. Again, bailout begets 
bailout. It keeps private investment on the sidelines. I'm 
convinced that it is hampering our economic growth. It's 
hampering our job creation, and I still look for the proof 
point that there are firms that are too big to fail, and that 
somehow by putting all this taxpayer liability exposure on the 
line, we're going to end up doing ourselves more good than 
harm.
    I'm not convinced of it, I don't think the American people 
are convinced of it, and so what do we have? We have a nation 
of bailout mania, trillions of dollars of debt. I think there's 
a better way. I yield back the balance of my time.
    The Chairman. The gentleman from California is recognized 
for 3 minutes.
    Mr. Sherman. Thank you, Mr. Chairman.
    Some say too big to fail, some say too interconnected to 
fail. Some of my constituents just think it's too well-
connected to fail. We need to design a system for the future 
that is bailout free. I was disappointed when the Secretary of 
the Treasury testifying about derivatives said in effect by not 
answering my question that we should continue to allow 
derivatives to be written today, that he reserves the right to 
seek to bail out tomorrow.
    We need to return to an economic system where bailout is 
not a possibility. We need to make sure that the resolution 
authority is extremely clear that it is not bailout authority. 
And we were still faced with this issue of what is too big to 
fail. Too big to fail means too big to exist. We cannot put the 
taxpayer in a position where entities are allowed to grow in 
their complexity or their size to the point where they can hold 
the American taxpayer hostage, and say, we're going to take 
risks. And if these risks turn out badly, you have to bail us 
out or the entire economy will suffer.
    The solution is obvious: Prevent risks from being taken 
that endanger the entire economy. Now, we will be told that 
taking all these risks is somehow wonderful for the overall 
Wall Street system. I don't think the American people want to 
hear it. They want no bailouts in the future; no possibility of 
bailouts in the future; and they want a system designed where 
everyone on Wall Street and everyone in Washington can say no 
bailouts ever.
    And if that means that our banks have to be smaller than 
their foreign competition, that is something I think the 
American people are ready to accept. So let us talk about 
breaking up those that are too big to fail before we talk about 
bailing them out, and hopefully we can, through better capital 
reserves and better regulation, eliminate both possibilities.
    Thank you.
    The Chairman. The gentleman from California for 2\1/2\ 
minutes, Mr. Royce.
    Mr. Royce. Thank you, Mr. Chairman.
    I would like to thank the witnesses for coming here today 
to testify, and a special thanks to Peter Wallison from AEI who 
for years warned about the systemic threat posed by the 
Government-Sponsored Enterprises Fannie Mae and Freddie Mac. I 
got to know Peter back in the old days when he was raising 
these concerns.
    Eventually, the Federal Reserve itself became convinced 
that Peter was absolutely right, and in about 2004, they began 
to warn on what he was warning that this represented a systemic 
threat to the financial system, not just here in the United 
States, but worldwide at one point, the Fed Chairman said.
    You know, for years there was this belief that should 
Fannie and Freddie run into trouble, the Federal Government 
would support them. After all, they had a line into the 
Treasury. They were Government-Sponsored Enterprises, and as 
Peter was warning, that perception allowed Fannie and Freddie 
to borrow at rates normally reserved for branches of the 
Federal Government, to take on excessive risk, and produce 
profits for shareholders and executives while they crowded out 
their competition. This was normally the result of when you 
have a government subsidy, this was the consequence.
    Well, the Federal Government had to step in to save Fannie 
and Freddie, and this could end up costing taxpayers $400 
billion before it's through, besides the effect that it had on 
the housing market, the collapse of the housing market. 
Additionally, the Federal Government is taking drastic steps 
using trillions of dollars to prop-up failed institutions 
because it was believed these institutions were too big to 
fail. One of the most unfortunate consequences of the massive 
move to provide public assistance is that moral hazard may 
become more deeply imbedded in our financial markets.
    We can and should take steps to eliminate the need and 
possibility of official bailouts in the future by avoiding 
labeling institutions as systematically important and providing 
an enhanced bankruptcy procedure to deal with non-bank 
financial institutions as an alternative to the course that we 
seem to be on. And this will provide clarity to the market. It 
will reduce the perceived government safety net, and lessen the 
moral hazard problem that has been created in recent months. In 
terms of the problems we're going to deal with looming in the 
future, I think we have to take lessons from the mistakes made. 
And this panel here today I think will give us an opportunity 
to discuss just such issues.
    Thank you, Mr. Chairman.
    The Chairman. The Federal requests, we have a couple. And I 
just want to comment in the meantime that some of the members 
have a different view of this hearing than I do.
    We have heard very eloquent arguments against bailouts. 
Yes, that's what this hearing is for, to see how we can avoid 
pressures to do them. This is not a case where it is an 
assumption that we're going to have these large institutions 
and then figure out what we do if we get into trouble. Yes, 
precisely our role is to try to avoid the situation that the 
Bush Administration faced as it felt with regard to Bear 
Stearns and with regard to Lehman Brothers and Merrill Lynch 
and AIG.
    All those happened under the Bush Administration, committed 
to free enterprise, but they felt that the consequences of the 
failures there would be disastrous. They had four different 
ways of dealing with them, none of them satisfactory to a lot 
of people, including themselves. So that is precisely the point 
of this hearing, so that one, you make it much less likely that 
there will be institutions in that situation, because of 
capital requirements and other things. And, two, that if you do 
get to that, there are ways of putting them down much less 
disruptively and much less expensively. So, as I said, this is 
not a reply of last year. It's enough to try and stop it.
    Mr. Garrett of New Jersey for 2\1/2\ minutes.
    Mr. Garrett. I thank the chairman. I thank all the members 
of the panel as well, and specifically Mr. Mahoney, because I'm 
just going to steal a little of your thunder because I think 
you made a good point in your remarks.
    Mr. Mahoney is the dean of University of Virginia law 
school, and in your remarks of which you'll go into more 
detail--but I just want to point this out--you say what 
approach that is used--I think which is a Republican approach--
believes that it was a mistake to bail out creditors of failed 
institutions when Bankruptcy proceedings were a tried and true 
alternative option. And this school of thought believes that 
policymakers should make it clear going forward that these 
mistakes will not be repeated and take steps to limit 
Treasuries and the Federal Reserve's ability to commit funds to 
failed institutions in the future.
    So, I would just say that I think this approach is 
basically in a nutshell what the Republican Financial Service 
Reform Plan is all about. The other approach is to concede that 
the government will not refuse to bail out certain large 
institutions and attempt to take steps to deal with their risky 
behavior, as the chairman just said.
    But, you know, if regulators fail to adequately limit their 
behavior, then a formal bailout framework would have to be set 
up in the meantime, and firms will be bailed out in a manner of 
course. So as I say, the Administration's plan basically 
follows this blueprint. The Administration's approach is 
premised on the anticipation that regulatory oversight would 
compensate for misaligned incentives. But we know time and time 
again, regulators have proved to be high on the curve and 
unable to keep up with the practices of companies that are 
tasked with regulating.
    So we don't need to make their job any harder by 
encouraging destructive behavior to misaligned incentives. I do 
believe that the Republican plan is preferable, because it is 
based on a more sound premise. It would reduce moral hazard, 
because companies and creditors and counterparties would be 
responsible for the costs associated with their failures, not 
the taxpayers. And when companies and creditors have their own 
money on the line rather than other people's money, sounder 
decisions are made benefiting the entire financial system. You 
saw what happened when Fannie and Freddie profits were 
privatized and risks were socialized.
    We don't want to repeat those mistakes time and again by 
following the Administration's proposal, which would create a 
whole privileged class of new Fannies and Freddie while 
institutionalizing an entire regime that would lead to expected 
and actual future bailouts. These would be bailouts that were 
paid for by the American taxpayer and smaller financial 
institutions, those that wouldn't even benefit from the 
government's ``too big to fail'' are premature in the first 
place.
    I thank you, and I thank Mr. Mahoney.
    The Chairman. We will now begin with Alice Rivlin.

  STATEMENT OF ALICE M. RIVLIN, SENIOR FELLOW, THE BROOKINGS 
                          INSTITUTION

    Ms. Rivlin. Thank you, Mr. Chairman.
    I am really glad you're holding this hearing to focus on 
the question of systemic risk and how do we avoid getting into 
this situation again; and, as you pointed out, I don't think 
anybody wants more bailouts ever if we can avoid it. I think 
that requires focusing on prevention.
    How do we fix the financial system so that we don't have 
these perfect storms of a huge bubble that makes our system 
very prone to collapse? And then if this does happen, how do we 
make it less likely that we would have to resort to bailing out 
institutions?
    So I think the task before this committee is first to 
repair the regulatory gaps and change the perverse incentives 
and reduce the chances that we will get another pervasive 
bubble. But, however, hard we try to do this, we have to 
recognize that there's no permanent fix. And I think one 
concept of systemic risk, what I call a macro system stabilizer 
that we need is an institution charged with looking 
continuously at the regulatory system at the markets and at 
perverse incentives that have crept into our system.
    Because whatever rules we adopt will become obsolete as 
financial innovation progresses, and market participants find 
around the rules. This macro system stabilizer, I think, should 
be constantly searching for gaps, weak links, perverse 
incentives, and so forth and should make views public and work 
with other regulators and Congress to mitigate the problem. 
Now, the Obama Administration makes a case for such an 
institution, for a regulator with a broad mandate to collect 
information from all financial institutions and identify 
emerging risk. It proposes putting this responsibility in a 
financial services oversight counsel, chaired by the Treasury 
with its own expert staff.
    That seems to me likely to be a cumbersome mechanism, and I 
would actually give this kind of responsibility to the Federal 
Reserve. I think the Fed should have the clear responsibility 
for spotting emerging risks, and trying to head them off before 
it has to pump trillions into the system to avert disaster. The 
Fed should make a periodic report to the Congress on the 
stability of the financial system and the possible threats to 
it, similar to the report you heard from Mr. Bernanke this 
morning about the economy. It should consult regularly with the 
Treasury and other regulators, but it should have the lead 
responsibility for monitoring systemic risk.
    Spotting emerging risk would fit naturally with the Fed's 
efforts to monitor the state of the economy and the health of 
the financial sector in order to set and implement monetary 
policy. Having that explicit responsibility and more 
information on which to base it would enhance its effectiveness 
as a central bank. I would also suggest giving the Fed a new 
tool to control leverage across the financial system.
    While lower interest rates may have contributed to the 
bubble, monetary policy has multiple objectives, and the short-
term interest rate is a poor tool for controlling bubbles. The 
Fed needs a stronger tool, a control of leverage more 
generally. But the second task is one you have emphasized in 
your title, how to make the system less vulnerable to cascading 
failures, domino effects, due to the presence of large 
interconnected financial firms whose failure could bring down 
other firms and markets. This view of what happened could lead 
to policies to restrain the growth of large interconnected 
financial firms or even break them up.
    The Chairman. Could I get unanimous consent? I think it's a 
complicated subject. We don't have a lot of members here, so 
would there be any objection to going to 7 minutes for the 
witnesses?
    Hearing none, the witnesses get 7 minutes. It's not a lot 
of time, but at least it is a little more, so please continue.
    Ms. Rivlin. Okay. Thanks, Mr. Chairman.
    Some have argued for the creation of a single, consolidated 
regulator with responsibility for all systemically important 
financial institutions. The Obama Administration proposes 
making the Fed the consolidated regulator for Tier 1 financial 
institutions. I believe that would be a mistake. It would be a 
mistake to identify the specific institutions deemed ``too big 
to fail,'' and an even greater mistake to put this 
responsibility at the Federal Reserve.
    It's hard to identify systemically important firms in 
advance. The attempt to do so and cordon them off might 
encourage risky behavior to move outside the cordon. Moreover, 
identifying systemically important institutions and giving them 
their own consolidated regulator tends to institutionalize too 
big to fail and create a new set of GSE-like institutions.
    Higher capital requirements and stricter regulation for 
large, interconnected institutions make sense, but I would 
favor a continuum rather than a defined list with its own 
special regulator. There is no obvious place to put 
responsibility for regulating financial institutions, but it 
seems to me a mistake to give the Federal Reserve 
responsibility for consolidated prudential regulation of big 
interconnected companies as proposed by the Obama 
Administration. The skills needed by a central bank are 
different from those needed to run an effective regulatory 
institution.
    The Chairman. Could you finish up if you have a last 
sentence or two?
    Ms. Rivlin. Pardon?
    The Chairman. Do you have a last sentence or two?
    Ms. Rivlin. Okay. Let me just conclude, Mr. Chairman. In 
short, I think the Obama Administration has it backwards, that 
the general spotter of financial risk should be the Fed and 
that it would be a mistake to have a consolidated regulator of 
``too big to fail'' institutions. It's a worse mistake to put 
at the Fed.
    [The prepared statement of Ms. Rivlin can be found on page 
68 of the appendix.]
    The Chairman. Mr. Wallison?

   STATEMENT OF PETER J. WALLISON, ARTHUR F. BURNS FELLOW IN 
    FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE

    Mr. Wallison. Thank you very much, Mr. Chairman.
    Leaving aside Fannie Mae and Freddie Mac, which I think are 
a very special case, if there is such a thing as a firm that is 
too big to fail, it is only a large commercial bank. And we now 
have several of them that are enormous.
    When we say that a firm is too big to fail, we mean that 
its failure could have a major, adverse effect on the entire 
economy. This is not simply a mere disruption of the economy. 
It would have to be a systemic breakdown. We can't define that 
very well, but it would have to be something greater than 
simply the kind of disruption that would occur from the failure 
of a firm. In my view, only a large commercial bank can create 
this kind of systemic breakdown.
    When a large bank fails, its depositors are immediately 
deprived of the funds they expected to have to meet payrolls 
and to pay their bills. Smaller banks are depositors in the 
larger banks, so the failure of a large bank can send a cascade 
of losses through the economy. If there is such a thing as a 
systemic breakdown, this would be it. For the same reasons, it 
is difficult to see how a large non-bank financial institution, 
that is, a bank holding company, a securities firm, a finance 
company, or a hedge fund can cause systemic risk. And thus it 
is difficult to see why a non-bank can ever be, in terms we are 
talking about today, too big to fail.
    Non-banks do not take deposits. They borrow for the short-, 
medium-, and long-term, but if they fail, their creditors don't 
suffer any immediate cash losses that would make it difficult 
for them to pay their bills. No one deposits his payroll or the 
money he expects to use for doing business with a securities 
firm or a finance company. In addition, their creditors are 
likely to be diversified lenders, so all their eggs are not in 
the same basket.
    However, the freeze-up in lending that followed the 
collapse of Lehman Brothers has led some people to believe, and 
I think incorrectly, that Lehman caused that event. This is not 
accurate. They conclude that a non-bank financial firm can 
cause a systemic breakdown that it can thus be too big to fail. 
But Lehman's failure caused what is called a common shock, 
where a market freezes up because new information has come to 
light. The new information that came to light with Lehman's 
failure was that the government was not going to rescue every 
firm larger than Bear Stearns, which had been rescued 6 months 
before.
    In this new light, every market participant had to 
reevaluate the risks of lending to everyone else. No wonder 
lending ground to a halt. Common shocks don't always cause a 
financial crisis. This one did, because virtually all large 
banks were thought at that time to be weak and unstable. They 
held large amounts of mortgage backed securities, later called 
toxic assets, that were of dubious value.
    If the banks had not been weakened by these assets, they 
would have continued to lend to each other. There would not 
have been a freeze-up in lending and the investor panic that 
followed. So if we want to avoid another crisis like that, we 
should focus solely on ensuring that the banks--we're talking 
about commercial banks--are healthy. Other financial firms, no 
matter how large, are risk takers and should be allowed to 
fail.
    Accordingly, if we want to deal with the problem of too big 
to fail and systemic risk bank regulation should be 
significantly reformed. Capital requirements for large banks 
should be increased as those banks get larger, especially if 
their assets grow faster than asset values generally. Higher 
capital requirements for larger banks would cause them to 
reconsider whether growth for its own sense really makes sense. 
Bank regulators should develop metrics or indicators of risk 
taking that banks should be required to publish regularly. This 
will enhance market discipline, which is fundamentally the way 
we control risk taking in the financial field.
    Most important of all, Congress should create a systemic 
risk council on the foundation of the Presidents Working Group, 
which would include all the bank supervisors and other 
financial regulators. The council should have its own staff and 
should be charged with spotting the development of conditions 
in the banking industry, like the acquisition by virtually all 
banks of large amounts of toxic assets, that might make all 
major banks weak or unstable and leave them vulnerable to a 
common shock. If we keep our banks stable, we'll keep our 
financial system stable.
    Finally, as a member of the Financial Crisis Inquiry 
Commission, I urge this committee to await our report before 
adopting any legislation.
    Thank you.
    [The prepared statement of Mr. Wallison can be found on 
page 79 of the appendix.]

STATEMENT OF SIMON JOHNSON, PROFESSOR, MASSACHUSETTS INSTITUTE 
                         OF TECHNOLOGY

    Mr. Johnson. Thank you very much, Mr. Chairman.
    As you said at the beginning, the question, I think, is not 
controversial. The issue is to remove the possibility in the 
future that a large financial institution can come to the 
Executive Branch and say, ``Either you bail us out, or there 
will be an enormous collapse in the financial system of this 
country and potentially globally.''
    And I think there are two broad responses to that, two ways 
of addressing that problem that are on the table.
    The first is what I would call relatively technocratic 
adjustments, changing the rules around regulation or changing 
the rules around bankruptcy procedure.
    I think there are some sensible ideas there, that are 
relatively small ideas. I don't believe they will fundamentally 
solve this problem.
    The second approach is to reduce the size of these banks, 
and what we have learned, I think, over the past 9 months is a 
considerable amount about how small financial institutions can 
fail, and can fail without causing major systemic problems, 
both through an FDIC-type process, or through a market type 
process, as seen with the CIT Group.
    Let me emphasize or underline the difference between these 
two approaches, and why making them smaller is both attractive 
and feasible.
    I think that the key problem is this financial sector has 
become very persuasive. It has convinced itself, it has 
convinced its regulator, it has convinced many other people 
that it knows how to manage risks, that it understands what are 
large risks for itself.
    And of course this is what Mr. Greenspan now concedes was a 
mistake in his assessment of the situation during the boom. He 
thought that the large firms that had a great deal to lose if 
things went badly understood these risks and would control them 
and manage them. And they didn't.
    It's a massive failure of risk management and I see no 
indication either that the banks have improved this kind of 
risk management in the largest institutions, or that regulators 
are better able to spot this.
    And while I agree with the idea we should have a systemic 
risk spotter of some kind, analytically and politically, it 
seems to me we're a long way from ever achieving that.
    And if I may mention the lobbying of Fannie and Freddie on 
the one hand, and private banks on the other hand, it was just 
fantastic. These people are the best in the business, by all 
accounts, at speaking with many people, both with regard to 
legislation and of course detailed rules.
    Again, I see no reason to think that if you tweak the 
technocratic structures, you will remove this power and this 
ability that these large financial institutions have brought to 
bear.
    And it's not just in the last 5 to 10 years; it's 
historically in the United States and in many other countries, 
or perhaps most other countries the financial system has this 
kind of lobbying power, this kind of too-connected-to-fail 
issue raised by Mr. Sherman.
    Now I think, Mr. Chairman, if you put it in those terms and 
if you look hard at the technocratic adjustments, the most 
promising solution is to adjust the capital requirements of the 
firms, as Mr. Wallison said, in such as fashion as it becomes 
less attractive and less profitable to become a big financial 
firm.
    I also agree and would emphasize what Ms. Rivlin said, 
which is thinking about how to target leverage and control 
leverage, again through something akin to a modern version of 
margin requirements is very appealing in this situation.
    It's about size. CIT Group was $80 billion in assets. 
Treasury and other--looked long and hard not at that before 
deciding not to bail it out.
    I think from what we see right now, that was a smart 
decision. I think the market can take care of it.
    The line they're drawing seems to be around $100 billion in 
assets. Financial institutions above $500 billion in assets 
right now clearly benefit from some sort of implicit government 
guarantee, going forward.
    And that's a problem, that distorts incentives, exactly as 
many members of the committee emphasized it at the beginning.
    So I think stronger capital requirements. You could also do 
this with a larger insurance premium for bigger banks. What 
have they cost? What has the failure of risk management at 
these major banks cost the United States?
    Well, I would estimate that our privately held government 
debt will rise from around 40 percent of GDP, where it was 
initially to around 80 percent of GDP as the result of all the 
measures, direct and indirect, taken to save the financial 
system and to prevent this from turning into another Great 
Depression.
    That's a huge cost, and at the end of the day, you actually 
have more concentrated economic power, a more concentrated 
political access influence--call it what you want--in the 
financial system.
    So for 40 percent of GDP, we bought ourselves nothing in 
terms of reducing the level of system risk that we know now was 
very high, 2005-2007.
    I think it's capital requirements and you can combine that 
with higher insurance premium, reflecting the system costs. 
That's a lot of money. And include a tax on leverage.
    Now I want to, in my remaining 2 minutes, emphasize some 
issues of implementation I think are very important.
    The first is in terms of timing. I think the capital 
requirements can be phased in over time. I think the advantage 
of an economy that's bottoming out and starting to recover, you 
don't have to do this right away. The firms will likely--not 
for sure--will likely not engage in the same kind of restless 
risk-taking in the next 2 to 3 years.
    So there is some time to get ahead of this. But you really 
don't want to run through anything like the kind of boom that 
we have seen before. And of course this will reduce the 
profitability in this sector. No question about it.
    And the industry will point this out. They will be very 
cross with you, and they will tell you that this undermines 
productivity growth, and job creation in the United States.
    I see no evidence that is the case. I see no evidence that 
having an overleveraged financial system with excessive risk-
taking does anything at all for growth in the real non-
financial part of the economy.
    Now I would emphasize, though, two important pieces of this 
that we should also consider and that are more tricky.
    The first is foreign banks. So if we reduce the size of our 
banks, relative to the size of foreign banks, I think that does 
not create a competitive disadvantage for our industry. But it 
does raise the question of, ``How should you treat foreign 
banks operating in the United States?''
    For example, Deutsche Bank, or other big European banks, 
banks that are very big relative to the size of those economies 
in Europe, let alone the size of the banks that we may end up 
with.
    Those banks, to the extent they operate in the United 
States, should be treated in the same way as U.S. banks. The 
capital requirements have to be high based on where you 
operate. And if you want to operate in the U.S. financial 
markets, that will have to be a requirement.
    Otherwise, you get into a situation where the next bank 
that comes to the Treasury and says, you know, ``It's bailout 
or collapse,'' will be a foreign bank, and that will be even 
more of a disaster than what we have faced recently.
    The second transactional issue, and my final point is with 
regards to the resolutional authority, I think Congress is 
rightly considering very carefully the resolutional authority 
requested by the Treasury, and I think that broadly speaking, 
that's a good idea.
    But I would emphasize, it is not sufficient. It's not a 
global resolutional authority. If a major multi-national bank 
comes to you with a problem and you know, you would like to say 
to them, ``Go through bankruptcy,'' but then when you look at 
the details of that, you see it will be a complete mess, 
because of the cross-border dimensions of that business.
    The same thing is true for a bailout. If you bail them out 
under your resolutional authority, it's also going to be a 
disaster unless you have a global agreement at the level of the 
G-20.
    Thank you very much, Mr. Chairman.
    [The prepared statement of Mr. Johnson can be found on page 
49 of the appendix.]
    The Chairman. Mr. Zandi?

   STATEMENT OF MARK ZANDI, CHIEF ECONOMIST AND CO-FOUNDER, 
                      MOODY'S ECONOMY.COM

    Mr. Zandi. Thank you, Mr. Chairman, and members of the 
committee for the opportunity to be here today.
    I am an employee of the Moody's Corporation, but my remarks 
today reflect only my own personal views. I will make five 
points in my remarks.
    Point number one: I think the Administration's proposed 
financial regulatory reforms are much needed and reasonably 
well designed. The panic that was washing over the financial 
system earlier this year has subsided, but the system remains 
in significant disrepair. Our credit remains severely impaired.
    By my own estimate, credit, household, and non-financial 
corporate debt outstanding fell in the second quarter. That 
would be the first time in the data that we have all the way 
back to World War II, and highlights the severity of the 
situation.
    I think regulatory reform is vital to reestablishing 
confidence in the financial system, and thus reviving it, and 
thus by extension reviving the economy.
    The Administration's regulatory reform fills in most of the 
holes in the current system, and while it would not have 
forestalled the current crisis, it certainly would have made it 
much less severe. And most importantly, I think it will reduce 
the risks and severity of future financial crises.
    Point number two: A key aspect of the reform is 
establishing the Federal Reserve as a systemic risk regulator. 
I think that's a good idea. I think they're well suited for the 
task. They're in the most central position in the financial 
system. They have a lot of financial and importantly 
intellectual resources, and they have what's very key--a 
history of political independence.
    They can also address the age-old problem of the 
procyclicality of regulation; that is, regulators allow very 
aggressive lending in the good times, allowing the good times 
to get even better, and tighten up in the bad times, when 
credit conditions are tough.
    I also think as a systemic risk regulator, the Fed will 
have an opportunity to address asset bubbles. I think that's 
very important for them to do. There's a good reason for them 
to be reluctant to do so, but better ones for them to weigh 
against bubbles.
    They, as a systemic risk regulator, will have the ability 
to influence the amount of leverage and risk-taking in the 
financial system, and those are key ingredients into the making 
of any bubble.
    Point number three: I think establishing a consumer 
financial protection agency is a very good idea. It's clear 
from the current crisis that households really had very little 
idea of what their financial obligations were when they took on 
many of these products, a number of very good studies done by 
the Federal Reserve showing a complete lack of understanding. 
And even I, looking through some of these products, option 
ARMs, couldn't get through the spreadsheet. These are very, 
very difficult products. And I think it's very important that 
consumers be protected from this.
    There is certainly going to be a lot of opposition to this. 
The financial services industry will claim that this will 
stifle innovation and lead to higher costs. And it's true this 
agency probably won't get it right all the time, but I think it 
is important that they do get involved and make sure that 
households get what they pay for.
    The Federal Reserve also seems to be a bit reluctant to 
give up some of its policy sway in this area. I'm a little bit 
confused by that. You know, I think they showed a lack of 
interest in this area in the boom and bubble. They have a lot 
of things on their plate. They'll have even more things on 
their plate if this reform goes through. As a systemic risk 
regulator, I think it makes a lot of sense to organize all of 
these responsibilities in one agency, so that they can focus on 
it and make sure that it works right.
    Point number four: The reform proposal does have some 
serious limitations, in my view. The first limitation is it 
doesn't rationalize the current alphabet soup of regulators at 
the Federal and State level. That's a mistake. The one thing it 
does do is combine the OCC with the OTS. That's a reasonable 
thing to do, but that's it.
    And so we now have the same Byzantine structure in place, 
and there will be regulatory arbitrage, and that ultimately 
will lead to future problems. I can understand the political 
problems in trying to combine these agencies, but I think that 
would be well worth the effort.
    The second limitation is the reform does not adequately 
identify the lines of authority among regulators and the 
mechanisms for resolving difference. The new Financial Services 
Oversight Council, you know, it doesn't seem to me like it's 
that much different than these interagency meetings that are in 
place now, where the regulators get together and decide, you 
know, how they're going to address certain topics.
    They can't agree, and it takes time for them to gain 
consensus. They couldn't gain consensus on stating simply that 
you can't make a mortgage loan to someone who can't pay you 
back. That didn't happen until well after the crisis was 
underway. So I'm not sure that solves the problem. I think the 
lines of authority need to be ironed out and articulated more 
clearly.
    The third limitation is the reform proposal puts the 
Federal Reserve's political independence at greater risk, given 
its larger role in the financial system. Ensuring its 
independence is vital to the appropriate conduct of monetary 
policy. That's absolutely key; I wouldn't give that up for 
anything.
    And the fourth limitation is the crisis has shown an 
uncomfortably large number of financial institutions are too 
big to fail. And that is they are failure risks undermining the 
system, giving policy makers little choice but to intervene.
    The desire to break up these institutions is 
understandable, but ultimately it is feudal. There is no going 
back to the era of Glass-Steagall. Breaking up the banking 
system's mammoth institutions would be too wrenching and would 
put U.S. institutions at a distinct competitive disadvantage, 
vis-a-vis their large global competitors.
    Large financial institutions are also needed to back-stop 
and finance the rest of the financial system. It is more 
efficient and practical for regulators to watch over these 
large institutions, and by extension, the rest of the system.
    With the Fed as the systemic risk regulator, more effective 
oversight of too-big-to-fail institutions is possible. These 
large institutions should also be required to hold more 
capital, satisfy stiffer liquidity requirements, have greater 
disclosure requirements, and to pay deposit and perhaps other 
insurance premiums, commensurate with the risk they take and 
the risks that they pose to the entire financial system.
    Finally, let me just say I think the proposed financial 
system regulatory reforms are as wide-ranging as anything that 
has been implemented since the 1930's Great Depression. The 
reforms are, in my view, generally well balanced, and if 
largely implemented, will result in a more steadfast, albeit 
slower-paced, financial system and it will have economic 
implications.
    And I think that's important to realize, but I think 
necessary to take.
    The Administration's reform proposal does not address a 
wide range of vital questions, but it is only appropriate that 
these questions be answered by legislators and regulators after 
careful deliberation. How these are answered will ultimately 
determine how well this reform effort will succeed.
    Thank you.
    [The prepared statement of Mr. Zandi can be found on page 
86 of the appendix.]
    The Chairman. Mr. Mahoney?

  STATEMENT OF PAUL G. MAHONEY, DEAN, UNIVERSITY OF VIRGINIA 
                         SCHOOL OF LAW

    Mr. Mahoney. Thank you, Mr. Chairman, Ranking Member 
Bachus, and members of the committee. I appreciate the 
opportunity to present my views here today.
    I will discuss those portions of the Administration's 
regulatory reform proposals that deal with the largest 
financial institutions, the so-called Tier 1 financial holding 
companies.
    The Administration proposes a special resolution regime for 
financial holding companies outside the normal bankruptcy 
process, that would be triggered when the stability of the 
financial system is at risk.
    And when the Treasury triggers the special resolution 
regime, it will have the authority to lend the institution 
money, purchase its assets, guarantee its liabilities, or 
provide equity capital with funds to be recaptured in the 
future from healthy institutions.
    I think it is fair to use the term, ``bailout'' to describe 
that system.
    There are two general schools of thought on how best to 
avoid future financial crises leading to widespread bailouts. 
The first holds that it was an error in the recent crisis to 
help creditors of failed institutions avoid losses that they 
would have realized in a normal bankruptcy proceeding, and that 
the focus of policy going forward should be to make it clear 
that the mistake will not be repeated.
    The alternative is to concede that the government will 
ordinarily bail out large and systemically important financial 
institutions.
    Under this approach, Congress should focus on limiting the 
risks that those institutions can take, in order to minimize 
the likelihood that they will become financially distressed.
    Buy if those efforts fail, and a systemically important 
institution becomes financially distressed, a bailout will 
follow as a matter of course.
    The Administration's financial reform blueprint takes this 
approach.
    I think the first approach will produce a healthier 
financial services industry that will make fewer claims on 
taxpayer dollars going forward. It is based on a sounder 
premise--that the best way to reduce moral hazard is to ensure 
that economic agents bear the costs of their own mistakes.
    The Administration's plan is premised on the view that 
regulatory oversight will compensate for misaligned incentives.
    The central argument for trying to avoid bailouts through 
regulatory oversight rather than insisting that financial 
institutions bear the cost of their mistakes is that some 
institutions are too big to fail.
    Putting those institutions through bankruptcy could spread 
contagion, meaning that other banks or financial institutions 
may also fail as a consequence.
    Widespread bank failures in turn may reduce the 
availability of credit to the real economy, causing or 
exacerbating a recession.
    There is debate over that analysis. But in any event, it is 
not clear that the magnitude of the problem is sufficient to 
justify the scale of government intervention that we have seen 
in the past year.
    It is important to note that the loss of capital in the 
banking system in the recent crisis was not just the result of 
a temporary liquidity problem. It was the consequence of sharp 
declines in real estate and other asset values. A bailout can 
redistribute those losses to taxpayers, but it cannot avoid 
them.
    The bankruptcy process is itself a means of recapitalizing 
an insolvent institution. Bankruptcy does not imply or require 
that the firm's assets, employees, and know-how disappear. 
Instead, it rearranges the external claims on the firm's assets 
and cash flows. The holders of the firm's equity may be wiped 
out entirely while unsecured creditors may have to substitute 
part or all of their debt claims for equity claims, thereby 
reestablishing a sound capital structure.
    If the insolvent institution still has the skill and 
experience to facilitate credit formation, it will continue to 
do so under new ownership, management, and capital structure.
    Of course, the bankruptcy process is subject to 
inefficiencies and delays, and those should be addressed. A 
more streamlined process may be appropriate for financial 
institutions, because they do have short-term creditors.
    But this does not require an alternative regime of 
institutionalized bailouts. A bailout regime, unlike a 
bankruptcy regime, creates moral hazard problems that impose 
costs on the banking sector continuously and not just during 
crises.
    Because creditors of too-big-to-fail financial institutions 
anticipate that they will be able to shift some or all of their 
losses to taxpayers, they do not charge enough for the capital 
they provide. The financial institution in turn does not pay a 
sufficient price for taking risk.
    The result is a dangerous feedback loop. Large banks have 
access to cheap capital, which causes them to grow even larger 
and more systemically important, while taking excessive risks--
all of which increase the probability of a crisis.
    Thus, a bailout regime leads to more frequent crises, even 
as it attempts to insulate creditors from them.
    The Administration believes its proposal will alleviate 
moral hazard and decrease the concentration of risk in too-big-
to-fail institutions. The idea is that these Tier 1 financial 
holding companies will be subject to more stringent capital 
rules that will reduce the amount of risk they can take and 
create a disincentive to become a Tier 1 financial holding 
company in the first place.
    I think these disincentives are insufficient and 
implementation of the plan would increase and not decrease the 
concentration of risk. Once a firm has been designated a Tier 1 
FHC, other financial institutions will view it as having an 
implicit government guarantee.
    The theory behind the proposal is that this advantage will 
be offset by stricter capital requirements and other regulatory 
costs, which will on balance make the cost of capital higher 
for Tier 1 FHCs.
    That analysis strikes me as wildly optimistic. Having an 
implicit government guarantee, Tier 1 financial holding 
companies will be extremely attractive counterparties, because 
risk transferred to them will in effect be transferred to the 
Federal Government.
    Tier 1 financial holding companies will have a valuable 
asset in the form of the implicit guarantee that they will be 
able to sell in quantities limited only by the Fed's oversight. 
They will have powerful incentives to find mechanisms--new 
financial products, or creative off-balance sheet devices--to 
evade any limits on the risks they can purchase from the rest 
of the financial sector. And banks that are not already Tier 1 
financial holding companies will have strong incentives to grow 
to the point that they become Tier FHCs in order to guarantee 
access to bailout money.
    The fastest way to grow larger is to take bigger risks. An 
institution that can keep its gains while transferring losses 
to the government will engage in excessive risk-taking and 
excessive expansion, and the financial system as a whole will 
suffer more frequent crises.
    Thank you, and I look forward to your questions.
    [The prepared statement of Mr. Mahoney can be found on page 
61 of the appendix.]
    The Chairman. Thank you, Mr. Mahoney.
    Let me save some discussion about perhaps--a number of you 
have talked about this idea in the Administration of the list 
of Tier 1 companies. And I understand the Administration 
understood that to mean that this would be a terrible--this 
would be a kind of probation for them.
    It does seem very clear that most people think that the 
reaction of these companies to being on that list would be that 
of Brer Rabbit to the briar patch.
    And I'm going to suggest then they substitute a different 
model. I think with regard to identifying the companies that 
might be particularly a systemic risk, the Administration is 
going to have to adopt the approach of Potter Stewart to 
pornography. They will be able to know it when they see it, but 
they're not going to have a pre-existing list. I think that 
idea is pretty much gone.
    Now, Mr. Johnson, one interesting issue that you referred 
to that has been suggested to us is to vary the bank insurance 
fund according to the riskiness of the venture. Am I correct in 
that? Is that something that could be conceptualized, measured 
with some degree of appropriate specificity?
    Mr. Johnson. Yes, Mr. Chairman. That is an idea that 
technical people, experts on the banking system, are working 
on. And the people I know who have made the most progress have 
work that's not yet public, but I would be happy to--
    The Chairman. But if we had reached the level of reality 
that could be used as a basis for--
    Mr. Johnson. It will be a paper by one of my colleagues at 
Jackson Hole this summer, so--
    The Chairman. Okay. And you think that would have the 
effect of discouraging risk taking or penalizing those who took 
it?
    Mr. Johnson. Yes, sir.
    The Chairman. All right. That's a very important issue. By 
the way, it divides the banking community up. You see the 
smaller banks, the community banks who feel they have been 
victimized by the trash talking--the American Banking 
Association not so much.
    Mr. Wallison, on the Systemic Risk Council that you talk 
about?
    Mr. Wallison. Yes?
    The Chairman. That would be statutory, because the 
President's Working Group is just--
    Mr. Wallison. Yes--
    The Chairman. You know, five people get together and hang 
out--so you would make that statutory--
    Mr. Wallison. Pursuant to an Executive Order, right.
    The Chairman. All right. By Executive Order.
    And then, I'm interested as to its powers. I do note you 
talk about the countercyclical macro potential that it could 
limit growth. When you say limit growth and you say by imposing 
higher capital--I assume by the way, there did seem to be an 
agreement here that as somebody imposed higher capital limits 
on institutions that grow, we don't mean simply proportional, 
we mean disproportionate. That is, its--
    Mr. Wallison. Yes--
    The Chairman. You don't have a constant percentage, but 
that the bigger you are, the higher the percentage.
    Mr. Wallison. That's right.
    The Chairman. And would you go beyond that to put actual 
limits on it? I mean, we have, for instance, the 10 percent 
deposit limit. That doesn't seem to me to do a great deal, but 
would you give the Systemic Risk Council the ability to, in 
establishing and enforcing a level of bank growth, could they 
do an absolute limit, so you can't get any bigger? Or would it 
only be through the capital requirements in other ways?
    Mr. Wallison. First of all, Mr. Chairman, I want to be sure 
we're talking--the term, ``bank'' is used very loosely. I am 
talking here about a commercial bank.
    The Chairman. Yes.
    Mr. Wallison. Okay.
    The Chairman. The way you're using it--depository--
    Mr. Wallison. Okay. Yes. And in that case, I don't believe 
that there should be any limits placed on the size of the 
institutions. But as capital rises, I think the institutions 
will be required themselves to limit their growth--
    The Chairman. But you say here, ``The Systemic Risk Council 
could be authorized to establish an acceptable limit of bank 
growth and impose appropriate limits on growth that are not 
consistent with the limits.''
    By that, do you mean capital requirements? There's no 
actual limit?
    Mr. Wallison. No, there's no actual limit on the size of 
the institution. But as the capital increases the institution 
will decide to put some sort of cap--
    The Chairman. But--
    Mr. Wallison. I'm not for caps in general.
    The Chairman. All right. The language frankly could have 
supported that. So you're not quoted in opposition to 
something--you are talking about strict capital--
    What else would the Systemic Risk Council do--because you 
say here--and obviously I think this is an important possible 
area of some common ground--you say, ``The Systemic Risk 
Council would be authorized then to monitor the worldwide 
financial system, report to Congress and the public on the 
possible growth of systemic risk, or the factors that might 
produce a serious common shock.''
    Would they have any more power than just to report it to 
us? Do they just drop it in our laps? Or would you give them 
any power to do anything other than limiting the capital limits 
on banks?
    Mr. Wallison. Well, I outlined in my prepared testimony 
some things in addition that they might do.
    The Chairman. I didn't find any formal things. Help me with 
it, because I couldn't find any, other than there was a metrics 
of risk-taking.
    But the Systemic Risk Council identifies, as you say, the 
growth of systemic risk factors that might produce a serious 
common shock--would they be empowered to do anything about 
that?
    Mr. Wallison. The most important thing that the Systemic 
Risk Council would do, Mr. Chairman, is to identify areas that 
were not identified before the current crisis--
    The Chairman. And would they be empowered to act on that, 
once they had identified it?
    Mr. Wallison. I think the way it would work is that they 
would instruct the supervisors of the particular institutions. 
The members of the Council would be the Federal Reserve, of 
course, the OCC, the FDIC, and so forth. And when the Council 
saw that there was developing the kind of systemic risks that 
we have had up to now, which is all--
    The Chairman. Let's talk about what they would do. They 
give instructions to the regulators. Would they be binding on 
the regulators?
    Mr. Wallison. I would expect that the regulators would take 
those actions--
    The Chairman. Well, then we have to write laws. We can't do 
attitudes. I don't mean to be, you know, pressuring you too 
much. But I have to write a law here.
    Would the Systemic Risk Council have the power to order the 
regulators to act, once they have discovered something? Or 
would they not?
    Mr. Wallison. Well, I don't think it's possible to order 
regulators to do anything--
    The Chairman. By statue--
    Mr. Wallison. But if they have agreed to the Council's 
policies--
    The Chairman. I'm going to stop you here. You could 
statutorily say that the Systemic Risk Council had the 
statutory authority to require action. Of course you could. 
It's a question of whether you want to or not.
    Mr. Wallison. Well, the regulators are part of the Council, 
Mr. Chairman. I don't understand how--
    The Chairman. Does the Council have to vote by unanimous--
    Mr. Wallison. What the Council decides to do--
    The Chairman. Does the vote have to be unanimous on the 
Council? No.
    Mr. Wallison. I think that's the sort of thing a Council 
can decide on its own. I haven't run into those kinds of 
questions--
    The Chairman. Well, I'm going to say I'm disappointed, 
because you're leaving ambiguities here that are not--I'm 
sorry, Mr. Wallison, I'm going to finish--that are not 
appropriate to a statute.
    So can the fact that one member, one entity as a member of 
the Council doesn't mean that it might not be in disagreement. 
And I think you'll leave yourself hanging here when you say we 
have this Systemic Risk Council and they can report, monitor 
the growth of systemic risk or the factors that might produce 
common shock. And then you leave me hanging as to what they do 
about it.
    The gentleman from Texas?
    Mr. Hensarling. Thank you, Mr. Chairman.
    My first question for anybody on the panel who would care 
to take it is as you analyze the root causes of the economic 
turmoil we find ourselves in today, I am curious what aspects 
of the turmoil you can cite as resulting from a lack of 
regulatory authority as opposed to perhaps mistakes, 
malfeasance on the part of regulators.
    Clearly, we have a very large capital markets reform bill 
in front of us. Some have opined that we had a lack of 
regulatory authority. I am not sure with the exception of 
Fannie and Freddie, we have covered that history and battle 
before, but with that possible exception, I know for example we 
had testimony from the head of OTS that he had the resources, 
the financial expertise, the regulatory authority to regulate 
the credit default swaps of AIG, they just missed it.
    As we analyze the legislation before us, is it more 
regulatory authority that we need? Do we need to make sense of 
the regulatory regime we have before us, or do we just need to 
figure out a way to get regulators to act smarter and perhaps 
focus on systemic events that previously they have not focused 
on?
    Whomever might want to take that first. Mr. Johnson?
    Mr. Johnson. Mr. Hensarling, I think I completely agree 
with you on the safety and soundness point, which is that the 
regulators did have the ability, did have the statutory 
authority to reign in many of the excesses, including to 
prevent the abuses of consumers that we have seen, and they did 
not exercise those powers.
    That is part of the reason, I think, we should actually 
reinforce the protection of consumers through a new safety 
agency, focused just on consumers.
    I think with regard to banking safety and soundness, on 
derivatives, perhaps the regulators could have found the 
authority, but I think they were correctly interpreting the 
legislators' intent with regard to not regulating many 
derivatives' transactions, and I think that was a very 
conscious decision made at the end of the 1990's, which should 
be re-visited. I think putting that in the legislation makes 
sense.
    Mr. Zandi. Can I take a crack at it?
    Mr. Hensarling. Sure, Mr. Zandi.
    Mr. Zandi. I think that the reason why this financial 
crisis evolved into a financial panic last September--I think 
it was a manageable, albeit greater than garden variety crisis 
prior to September, it turned into a panic in September because 
policy makers, including the regulators, the Federal Reserve, 
the Administration, did not have a clear understanding of what 
their authority was and how they should use it.
    That begins with Fannie Mae and Freddie Mac in early 
September. That extends to Lehman Brothers. That extends to 
AIG. That extends to Citigroup.
    I think that goes to a key failing of the current 
regulatory structure.
    Mr. Hensarling. I have limited time. Let me move onto 
another line of questioning here. To me, a very fundamental 
question that we have to examine here is if we either 
implicitly or explicitly designate firms as being systemically 
significant, do we not have a self fulfilling prophecy?
    I am trying to figure out how does one avoid that. If you 
set up criteria for bank holding companies, there is so much 
public information there, if you attempt to keep these firms 
confidential, their names, sooner or later, the market is going 
to figure out which firms have the implicit guarantee and which 
do not.
    We know with Fannie and Freddie how implicit becomes 
explicit at the snap of a finger and hundreds of billions of 
dollars of taxpayer exposure/liability later.
    I just do not understand any mechanism that one steps up, 
and I appreciate the argument that regulators need to look at 
individual firms and that through capital and liquidity 
requirements, maybe there is much they can do to reduce the 
systemic risk, but once you set up a criteria, I do not know 
how you do not have a self-fulfilling prophecy and everybody is 
waiting in line wanting to be the next systemically significant 
firm. I just do not see how you avoid it.
    Mr. Wallison?
    Mr. Wallison. It seems to me if we focus solely on the 
banking industry, we do not have that problem because all banks 
are regulated. Right now, the largest banks are regulated much 
more fully than the smaller institutions.
    One can assume that a large bank is too big to fail, but it 
does not have to be true. There is a certain amount of 
ambiguity when you come to a line between the very largest and 
the less large institutions.
    We have no idea what systemic risk is. That is one of the 
major faults in this legislation.
    What we ought to do is simply make sure that the banking 
industry is safe and sound and then we do not have to worry 
about any of the others.
    The main fault with what the Administration is doing is 
attempting to extend regulation which did not work for the 
banking industry across a broader range of our financial 
system. There is no need to do that. If we focus solely on 
banks, we can solve almost all of the problems that we 
encountered in 2007 and 2008.
    Mr. Hensarling. Thank you. It is up to the chairman. I see 
I am out of time, Ms. Rivlin.
    The Chairman. The gentleman from Pennsylvania.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Ms. Rivlin, in your testimony, I am not sure I understood 
whether or not you were indicating that the Federal Reserve 
should not be designated as the systemic risk regulator or that 
it was in fact well qualified to be the gatherer of information 
and data for the systemic risk regulator.
    Ms. Rivlin. I was trying to distinguish two concepts of 
systemic risk agencies. One is monitor and gatherer of 
information for which I think the Fed is very well qualified 
and should be doing it anyway and it is coordinate with its 
responsibilities on the economy. I would put that 
responsibility there.
    I do not think that it should be the systemic risk 
regulator in the sense of regulator of systemically important 
institutions, regulator supervisor of systemically important 
institutions, because (a) I do not think there should be such a 
designated responsibility for the reasons we have been talking 
about. I do not think you should have a list.
    Second, if you did do that, I sure would not put it at the 
Fed. I think it would dilute their monetary policy 
responsibilities and they would not be very good at it.
    Mr. Kanjorski. I agree with you, but I wanted to perhaps 
attack part of your premise there. I recall very clearly in 
2005, the Chairman of the Federal Reserve was testifying before 
this committee.
    I specifically asked him a question, whether or not there 
was a real estate bubble in his opinion, and he said he thought 
there was, and that the price of real estate was ever 
increasing, but it was perfectly manageable and it did not 
constitute a risk to the system.
    If he in fact were the gatherer of that information and the 
analyzer of that information, we would have missed the 
opportunity to have found systemic risk.
    What is your answer to Mr. Greenspan's lack of perceiving 
that difficulty?
    Ms. Rivlin. I think he was just wrong. He said that 
himself. He did not see this one. I think we have learned a lot 
about bubbles.
    One thing we have learned is that interest rates is not a 
perfect tool for controlling them, which is why I would give 
them more leverage control as well.
    Mr. Kanjorski. I understand that. Let me move to Mr. 
Wallison because you seem to be talking about that our only 
problem here in regard to systemic risk exists in financial 
institutions.
    Mr. Wallison. No. I think the only real problem exists with 
banks, commercial banks.
    Mr. Kanjorski. Just banks, nothing else?
    Mr. Wallison. Just banks.
    Mr. Kanjorski. Mr. Wallison, testimony before this 
committee not too many months ago was heard from General 
Motors, Ford and Chrysler. They appeared together, their CEOs, 
and I think the CFOs of those three corporations.
    Their testimony was quite clear that it was their opinion 
that the failure of any one of them, and particularly Chrysler, 
who only entertained 7 percent of the car market in the United 
States, would cause systemic risk if they were allowed to fail, 
and that was their opinion as to why the Congress should 
marshal the assets necessary to ``bail'' the three companies 
out if they needed it, but most particularly Chrysler and 
General Motors, who at the time did recognize the fact that 
they needed it.
    Their total argument was that they both feed off the same 
dealer base and supplier base. Just the loss of Chrysler 
Corporation's 7 percent penetration of the market and the use 
of the dealers and suppliers would bring down all of the 
suppliers and all of the dealers, and therefore bring down the 
entire industry.
    Just recently, on Friday, you probably have read the paper, 
the question that I would pose to you, I want your idea on the 
General Motors' problem, but then CIT, most of our regulators 
concluded that did not constitute systemic risk, I think that 
is the conclusion. Luckily, they did not need help from the 
Government ultimately.
    As I understand the problem, as it was explained to me on 
Friday, if it had been allowed to fail, that is the factory 
business that CIT was involved in, that it would have brought 
down 70 percent of the apparel suppliers in the country, to the 
extent that the department stores and specialty stores in the 
retail business in the United States would not have had the 
inventory to continue their practices.
    Hundreds of thousands if not several million jobs would be 
lost in the supplier trade manufacturing and in the retail 
businesses throughout the country.
    That came to my attention through a department store owner 
who called those facts to my attention.
    Would you not feel that perhaps is a systemic risk and it 
is not a financial institution--
    Mr. Wallison. In my testimony, Congressman, I looked very 
carefully at this question of the difference between a systemic 
risk and mere disruption.
    We really do not understand what systemic risk is or how it 
would be created or what kinds of institutions would create it. 
This is one of the fundamental problems with what the 
Administration is talking about.
    In the case of General Motors or Chrysler or Ford, for that 
matter, or CIT, yes, there would certainly be disruption if a 
large firm fell. I think the same thing is going to be true of 
financial institutions other than very large banks.
    That is why it is such a bad idea to provide to the 
government the authority to bail out or take control of any 
kind of institution, because the institutions will always come 
in and argue that their failure will cause some sort of huge 
loss in our economy, whereas in fact companies fail all the 
time. But they don't create a systemic event, just disruption. 
They get worked out in bankruptcy. Sometimes, they return to 
full activity. Other times, they are completely unwound.
    We have to make sure that we know the difference between a 
mere disruption, which they will claim, and a systemic risk. We 
do not know how to make that distinction.
    The Chairman. The gentleman from Alabama.
    Mr. Bachus. Thank you. I read something here for the first 
time. I agree with it. I have thought it. It is from Mr. 
Johnson, who actually was called by the Democratic Majority to 
testify.
    What he says are short-term measures taken by the U.S. 
Government since the Fall of 2008, particularly under the Obama 
Administration, have helped stabilize financial markets, 
primarily by providing unprecedented levels of direct and 
indirect support to the large banks.
    But these same measures have not removed the long run 
causes of systemic instability. In fact, as a result of 
supporting these leading institutions on generous terms, 
systemic risk has widely been exacerbated.
    In other words, the bailouts have actually increased the 
danger.
    Mr. Wallison, that is similar--you have said that in a 
different way, have you not? That we actually are creating a 
more dangerous environment?
    Mr. Wallison. Yes, of course. Every time we bail out one 
institution, we create the belief on the part of people in the 
markets that other institutions that have a similar size or 
maybe even smaller will also be bailed out, and as a result, 
great moral hazard is created, as Professor Mahoney made so 
clear in his testimony.
    Mr. Bachus. Mr. Kanjorski and I were at a meeting with one 
of the leading hedge fund managers. I will not name his name. 
The Financial Times said he was the smartest billionaire in the 
world. He said the same thing you said about Lehman in your 
testimony.
    The problem was the markets were shocked. They thought they 
were going to bail them out because they had bailed out Lehman, 
which is exactly what you said. I am not sure if you were 
aware. This gentleman is a very private individual. You all 
came to the same conclusion.
    Mr. Johnson goes on to say, and I believe this is 
absolutely true, some of our largest financial firms have 
actually become bigger relative to the system and stronger 
politically as a result of the crisis. The competition has been 
eliminated.
    Do you agree with that, Mr. Johnson?
    Mr. Johnson. Yes, sir.
    Mr. Bachus. Executives of the surviving large firms have 
every reason to believe they are too big to fail. They have no 
incentive to help bring system risk down to an acceptable 
level. That is exactly the problem we have today.
    Mr. Johnson goes on to say that when you have a situation 
like this, it is either bailout or collapse, but as it begins 
to affect other institutions, responsible official thinking 
shifts to bailout at any cost. We certainly have seen that over 
the past 6 months.
    Mr. Zandi says, and here is where I think we maybe can all 
come to a consensus, he said the Treasury and the Fed were 
seemingly confused as to whether they had the authority or 
ability to intervene to forestall a Lehman bankruptcy and 
ensure an orderly resolution of the broker-dealer's failure. 
The procedure was not in place.
    Mr. Mahoney today has said give them that procedure, as I 
understand it. Give them a procedure, but in bankruptcy.
    Is that right, Mr. Mahoney?
    Mr. Mahoney. That is right. I think the idea of adding 
another chapter to the Bankruptcy Code makes perfect sense. It 
is probably the case that the amount of agenda control that 
debtors have in the standard Chapter 11 bankruptcy proceeding 
could be disruptive in the case of a large financial 
institution where you are dealing with some short-term 
creditors who need to know what is the value of this obligation 
that I am holding sooner rather than later.
    I think you could create a quicker, more streamlined 
procedure. I would draw a sharp distinction between the 
procedure through which this happens and the substantive rules 
that will govern it.
    I think it is important that the substantive rules be the 
same as they would be for anyone else, which is to say the 
creditors take their losses in the order of their contractual 
priority so it is predictable. There is a set of rules that is 
known in advance, and everyone will understand where they are 
in the pecking order.
    Mr. Bachus. Mr. Zandi, you said the confusion is the big 
problem, but if we had the substantive rules that we used in 
dreadful WorldCom and Lehman, ultimately, you would clear up 
the confusion. You would have certainty, and the certainty 
would be that they would go into--you would have an expedited 
procedure, and you can call that expedited bankruptcy, but it 
really needs to be there, in my opinion.
    Mr. Zandi. I think the Bankruptcy Code probably would be 
inadequate for purposes of these kinds of failures.
    Mr. Bachus. If we made the procedure, if we changed the 
procedure--
    Mr. Zandi. I do not think the courts would be viable for 
the kind of decision-making that needs to be done as quickly as 
needs to be done.
    Mr. Bachus. We had a small bank in Washington fail and the 
FDIC put 400 people on it. Obviously, they would need help from 
the regulators. I would agree with that.
    Mr. Zandi. To me, too big to fail is more than the 
interconnectedness of the institutions, it also goes to the 
confidence we have in our system. You would get bank runs, and 
if you go into a bankruptcy proceeding, you may be able to 
solve the interconnectedness problems, but confidence would 
still be an issue.
    Mr. Bachus. Of course, you said about the regulators that 
we all know they had a complete lack of understanding.
    Mr. Zandi. And that needs to be changed, but I do not think 
the Bankruptcy Code is the way.
    Mr. Bachus. I do not know how you give understanding. That 
is worse than the bankruptcy courts to me. If you gave them the 
procedure, you gave them a right to do things, and you 
establish a procedure, maybe we can work together on some 
things, how we could amend that Code and use the basics.
    The Chairman. The gentlewoman from New York. May I ask the 
gentlewoman to yield me 1 minute? I did want to respond.
    Reading Mr. Johnson's point here that short-term measures, 
particularly under the Obama Administration, I am not sure 
entirely what he means. I do want to be very clear.
    Every single activity now characterized as a bailout that 
is going on in the United States was initiated by the Bush 
Administration, by Mr. Bernanke and Mr. Paulsen. That is AIG, 
Bear Stearns, Merrill Lynch, and Bank of America, which was 
kind of a bailout. That was General Motors, Chrysler. Every 
single one of them.
    The first proposal for a bailout that came to the Obama 
Administration was CIT, and they said no. Literally, every 
single bailout now going on was initiated in the Bush 
Administration for the Obama Administration to carry out.
    Yes, it is true, I agree, I think we all agree that where 
we are today is a result of the need for the bailouts and then 
the bailouts have made us more vulnerable. That is why our 
agenda is to try to do something about it. That is no great 
point.
    Sure, we need to do something, but again, there is not a 
bailout underway today that was not initiated by the Bush 
Administration.
    I thank the gentlewoman. The gentlewoman from New York.
    Mr. Bachus. Mr. Chairman--
    The Chairman. It is the gentlewoman from New York's time.
    Mr. Bachus. You took the extra time.
    The Chairman. I asked the gentlewoman to yield. This is the 
second time the gentleman has done that. I have asked other 
members to yield. It is disruptive. I have asked members to 
yield. I would ask the gentleman to pay attention.
    Mr. Bachus. I will be less disruptive in the future.
    [laughter]
    The Chairman. The gentlewoman from New York.
    Mrs. Maloney. Thank you, Mr. Chairman. I truly believe that 
our government was at its best following the 9/11 crisis, when 
we came together and created a bipartisan professional 
commission to study exactly what went wrong.
    They came forward with a professional report that sold more 
copies than Harry Potter. It pointed out 53 direct areas that 
they thought needed to be corrected.
    We then proceeded to react to their recommendations, and 
this Congress passed 47 of their recommendations.
    I do not believe that we were aware of what the true 
problems were until we got that report.
    I for one would like to see the report coming back from the 
bipartisan commission on what really caused this crisis, and 
their ideas of what we need to do to reform our system and to 
go through that process.
    We now have a blueprint that in many ways looks like the 
problems that we confronted. Many people say Fannie and Freddie 
with their implicit government guarantee caused many of the 
problems.
    What are we going to come back with? An implicit guarantee 
that tier one too-big-to-fail banks are going to be guaranteed. 
Therefore, everyone is going to want to do business with the 
guaranteed bank, and every bank is going to want to be a tier 
one in order to have that implicit guarantee that gives them an 
advantage in business, lower rates, more prestige.
    I am not so sure that is the direction we want to go in. 
Then the other idea is that we have a systemic risk regulator 
under the Federal Reserve. I would argue we have a systemic 
risk regulator now under the Federal Reserve. They have 
tremendous power to look anywhere they want.
    The prior Administration before Mr. Bernanke was criticized 
for never having taken a step on the subprime crisis, never 
coming forward with a directive, never pointing out what needed 
to be done. I am not so sure a systemic regulator, which is 
very much dependent on the ability and drive of the person in 
the position, is the exact answer to our problem.
    The only thing that we seem to totally agree on is that 
regulation failed, yet the regulation they are proposing is 
very similar to the regulation we already have right now.
    I would build on really a question the chairman brought up 
earlier, what happens when you disagree? When we have this 
council of regulators and they disagree, how do you come to the 
conclusion?
    Many people say Lehman brought down the stability of our 
financial sector in many ways. Where was the way to counter the 
decision of whomever made that decision? How would you agree 
with these councils?
    You have to have a specific way that you agree because you 
know they are going to disagree. I see it every day. There was 
tremendous disagreement recently over how to respond to other 
challenges in the private sector with various businesses that 
was played out in the press.
    My time has expired.
    The Chairman. Brief response? Mr. Johnson?
    Mr. Johnson. I agree completely with Mrs. Maloney. I think 
you have to assume that regulators will fail in the future as 
they have failed in the past, and you have to assume that 
extending any kind of implicit guarantee is going to create the 
same sort of distortions and problems as in the past.
    I think you need to design the system around those 
assumptions, and to my mind, making the largest institutions, 
financial institutions, smaller, is not a guarantee by any 
means against future problems, but it means when the problems 
occur, they should be more manageable. You should be more able 
to push them down to the bankruptcy courts.
    Still, sometimes it is going to be very hard to predict. 
Sometimes government may need to take actions. You need to make 
sure they have the appropriate authority to do that.
    The Chairman. The gentleman from New Jersey.
    Mr. Garrett. Thank you, Mr. Chairman. Before I begin, let 
me associate myself with the words of the gentlelady from New 
York on just about everything she said. That may be a first, 
but I do.
    Mr. Zandi, if I heard you correctly, and correct me if I am 
wrong, we need a systemic risk regulator and you advise it to 
be in the Federal Reserve?
    Mr. Zandi. Yes.
    Mr. Garrett. You need someone to address situations, future 
asset bubbles, for dealing with being countercyclical as 
opposed to being procyclical?
    Mr. Zandi. Right.
    Mr. Garrett. Also, someone who can address maybe on the 
regulatory side, capital requirements as well; is that correct?
    Mr. Zandi. Yes, they would have authority there as well.
    Mr. Garrett. You would put it in the Federal Reserve. The 
reason why I want to clarify that is if you look at the history 
of the Federal Reserve on each one of those points, you have to 
raise the question, why them? On the asset bubbles, someone 
else raised a question to Ms. Rivlin with regard to the housing 
bubble that we had, I am going back even further than that with 
the tech bubble.
    Alan Greenspan later on said maybe I missed that one and he 
sort of re-wrote history, some would say, as far as his review, 
whether he knew about that or not, but if you look at the 
minutes of the Federal Reserve, not just him but the entire 
Federal Reserve, they all missed that. There was no discussion 
whatsoever with regard to an asset bubble during the entire 
time. They were looking at it purely as an increase in 
productivity.
    On the countercylical aspect of it, the Federal Reserve was 
out front for a long time on Basel II; were they not? Which 
would go in the wrong direction with regard to that.
    As far as on the capital requirements, did not the Federal 
Reserve have the ability with regard to institutions under 
them, Citi and Bank of America, and did they do anything? The 
answer is no, regarding raising capital requirements.
    Here is an entity that you are nodding your head to, with a 
``dismal'' track record in each one of those, but you, sir, 
would suggest they are the ones we are going to give the 
authority to.
    Mr. Zandi. Right. If I were king for the day, I would 
design it differently. I would think that a model where the 
regulatory function was in a separate entity, that was a 
systemic risk regulator that was separate from the Federal 
Reserve would make the most sense.
    I think in the context of where we are starting from and 
just the practicality of the situation, I think the most 
logical place for that to reside is the Federal Reserve.
    Mr. Garrett. Of all the bad choices that are out there, 
they are the best one?
    Mr. Zandi. Exactly; right. I do think there was a general 
philosophy, maybe even to this day, that the Federal Reserve 
should not weigh against asset bubbles, that is not in their 
job description, so to speak. I think that is inappropriate.
    I think that it should be something they should do and the 
tool that they need to implement that--
    Mr. Garrett. It is not in their rules that they should be 
weighing in with regard to asset bubbles?
    Mr. Zandi. No. There is a reluctance to weigh against asset 
bubbles, yes, at the Federal Reserve.
    Mr. Garrett. Before you can even weigh into them, you first 
of all have to see them.
    Mr. Zandi. That is probably why they have a reluctance to 
do that.
    Mr. Garrett. And they did not see them.
    Mr. Zandi. My view is bubbles are created largely by 
leverage, that if they have a very clear ability to control or 
manage leverage throughout the entire financial system, which 
they would have as the systemic risk regulator, then they would 
have the tool they need to be able to manage that aspect of 
monetary policy.
    Ms. Rivlin. May I?
    Mr. Garrett. Sure. You are where I was going next.
    Ms. Rivlin. I think there is a difference between the 
bubble in the 1990's in the stock market and the housing market 
bubble.
    I was at the Fed in the 1990's. We did not miss the stock 
market bubble. We knew it was there. We talked about it. Mr. 
Greenspan made the speech. We did not do enough about it, in my 
opinion. We could have raised margin requirements. It would 
have been largely symbolic, but we should have done it.
    We did not have the right tool. Raising the short-term 
interest rate in the middle of the bubble, we also had the 
Asian financial crisis and a lot of other things going on, so 
you do not have the right tool if you are relying entirely on 
the short-term interest rate.
    Mr. Garrett. Mr. Wallison, I thought you were going to say 
a quick no to the chairman's question in regard to the policy, 
this council being able to tell the regulators what to do. I 
thought you were saying no, they cannot do that.
    Do you have another comment to make?
    Mr. Wallison. Yes. I have a comment on the question of 
bubbles. I think we have to distinguish this bubble from every 
other bubble. We will always have them. We are human beings. We 
tend to believe that when things are going in one direction, 
they will continue to go in one direction. That is both up and 
down.
    This bubble was completely different. In this bubble, we 
had 25 million subprime and non-traditional loans that are 
failing at rates that we have never seen before. The question 
we have to answer is, why did that happen? That is one of the 
major reasons that this particular bubble turned into a 
worldwide financial crisis.
    Mr. Garrett. Thank you.
    The Chairman. The gentleman from North Carolina.
    Mr. Watt. Thank you, Mr. Chairman. Ms. Rivlin, I confess I 
am having a little trouble understanding what you would do. You 
talk about a ``macro system stabilizer'' and then you talk 
about a ``systemically important'' or somebody who is over--I 
thought that what you were proposing was akin to what the Obama 
Administration has proposed, that the Fed be put in charge of 
the kinds of things that you indicate a ``macro system 
stabilizer'' would do, but you seem to have some concerns about 
that. Can you clarify what it is you are proposing?
    Ms. Rivlin. Yes. I am proposing the exact opposite of what 
the Obama Administration is proposing. We both recognize that 
there are two kinds of tasks here. One is spotting problems in 
the system that might lead to excessive boom or a crash.
    Mr. Watt. Okay, and they propose, the Administration 
proposed to give that to the Fed?
    Ms. Rivlin. They propose to give that to a council. I would 
give it to the Fed because I think it is very similar to the 
kind of responsibility that the Fed has already to spot 
problems in the economy.
    Mr. Watt. And if one of those spot problems was that one of 
these institutions' interconnectedness is an issue, would you 
not give the Fed the authority to deal with that?
    Ms. Rivlin. I would not.
    Mr. Watt. Who would you give the authority to deal with 
that?
    Ms. Rivlin. I think we need a new regulatory institution to 
be the consolidated regulated of financial institutions. I 
would not separate out the too-big-to-fail ones and give them a 
special regulator.
    Mr. Watt. But that should not be the Fed, is what you are 
saying?
    Ms. Rivlin. And I certainly would not have the Fed do that. 
I do not think they do--
    Mr. Watt. So you would create a new agency for that 
purpose?
    Ms. Rivlin. Ideally, I would. And I think that that--
    Mr. Watt. We are getting quite a bit of push back from the 
proposal to create a new agency for consumer protection. Would 
you create a new agency for consumer protection too?
    Ms. Rivlin. I would let, but let me explain what I meant on 
the first time. I would consolidate regulation of institutions, 
financial institutions, into a single regulator, ideally. I 
would not separate out the too-big-to-fail ones from the other 
ones.
    Mr. Watt. So this new agency would be--would have the 
responsibilities of all of the existing regulators plus some 
others?
    Ms. Rivlin. Yes, so you would un-make a bunch of agencies. 
I did not stress that in my testimony because what I wanted to 
stress was not doing the too-big-to-fail institutions 
separately and not putting that at the Fed.
    Mr. Watt. Would this big new agency have responsibility for 
the institutions that might be too big to fail?
    Ms. Rivlin. Among others.
    Mr. Watt. So you would put that under their jurisdiction?
    Ms. Rivlin. Well, but I would not have a separate list.
    Mr. Watt. Oh, yes, okay. You did not tell me what your 
opinion was on the consumer protection agency. You did I guess, 
but you did not tell me why?
    Ms. Rivlin. I think a new consumer protection agency would 
be a good idea because the existing agencies have not performed 
this function well. And you can either make sure that they 
perform it well, the Fed did not, for example. Or you can put 
it in a new agency. At the moment, I think I would opt for a 
new agency.
    Mr. Watt. All right, I thank you, Mr. Chairman. I yield 
back. I just wanted to get clarification.
    The Chairman. Will the gentleman give me 30 seconds? Ms. 
Rivlin, how much time when you were at the Fed did you spend on 
consumer issues?
    Ms. Rivlin. It depends on what you mean by that. We spent 
quite a lot of time on--there were consumer councils who 
advised on whether TILA and so forth were being--
    The Chairman. Credit cards, home mortgages, unfair and 
deceptive practices?
    Ms. Rivlin. Yes, not very much. I do not think the Fed did 
that well.
    The Chairman. Yes, thank you. No, I did not mean you 
personally. The gentleman from Texas?
    Mr. Marchant. Thank you, Mr. Chairman. Mr. Wallison, I saw 
you on a TV program this morning, and you made a comment that I 
would like you to follow-up a little bit about. You said that 
AIG actually was not too big to fail. Am I misinterpreting 
that?
    Mr. Wallison. No, that is right.
    Mr. Marchant. And that there was actually no default there, 
no actual default on the part of AIG?
    Mr. Wallison. I think we were talking at that time about 
credit default swaps.
    Mr. Marchant. Yes.
    Mr. Wallison. And a credit default swap is, in shorthand, 
like an insurance policy. You are insuring someone against a 
loss. My point was simply that when AIG failed, it did not 
cause any losses to any of the people who were its 
counterparties. It is just exactly like you have an insurance 
policy on your home, and your insurer fails. You would go out 
and get another insurer, but unless you had already had a fire, 
you had not suffered a loss.
    And that is exactly the case with credit default swaps. 
There is in my view a lot of misinformation around about credit 
default swaps, suggesting that they are very dangerous. I do 
not believe they are dangerous. And I do not believe in the 
case of AIG there was any need to bail out AIG. AIG had one 
major counterparty, and a lot of others, but the biggest one 
was Goldman Sachs, $12.9 billion in credit default swaps, with 
which AIG was protecting Goldman Sachs. When it was learned 
that Goldman Sachs was in fact the major counterparty, the 
press went to them and said, ``What would have happened if the 
government had allowed AIG to fail?'' And Goldman Sachs said, 
``Nothing, we were fully protected. We had collateral from AIG. 
And, in addition, we had bought other protection against a 
possible failure by AIG. So it would not have been a problem 
for us.'' And that I think is how we have to look at the AIG 
question. It was large. It was engaged. It was interconnected, 
as all financial institutions are always interconnected, but 
the possibility of loss from AIG was very small.
    Mr. Marchant. Mr. Zandi, would you comment on the fact that 
this last bubble was created in large part by financial 
instruments that did not exist maybe 20 years ago, and 
especially the derivative part of the mortgage part of it, and 
how it sustained a bubble in the housing market, which really 
sustained the mortgage market, which continued to sustain the 
housing market?
    Mr. Zandi. Well, I think one of the root causes of the 
bubble in the housing market was that the process of 
securitization was fundamentally broken, that no one in the 
chain of the process had a clear understanding of all the risks 
in its entirety. The lenders made the loan. They sold it to the 
investment banks. The investment bank's package got the rating. 
The rating agencies then put their stamp on it. And then it was 
sold to Goldman investors. And no one was really looking at the 
entire system, making sure that the structure was properly 
working, that the loans that were ultimately being made were 
good loans. So the process of securitization fell apart. It 
just was not functioning well because in my view there was not 
a systemic risk regulator looking at it holistically and 
saying, does this make sense, and will it work if it is 
stressed under a bad economy, under a bad housing market?
    Mr. Marchant. And it was a product that really was 
unfamiliar to anyone who was looking at it, even its regulator, 
even a lot of the regulators?
    Mr. Zandi. I do not think anyone truly understood the 
entire process altogether. I think the process of 
securitization I should say has economic value and it makes 
sense under certain circumstances, but that got abused and the 
economic value got lost in the profit-making that was going on 
during the period.
    Let me just say I do not agree with AIG. I think it is very 
clear that if AIG failed, it would have been a very substantive 
risk to the entire financial system and the economy. And this 
goes to an important point. We talk about too-big-to-fail in 
the context of relationships, in the case of AIG, credit 
default swaps, but it also goes to confidence. That you have to 
remember back to that day in mid-September when AIG was about 
ready to go under, confidence was completely eviscerated, and 
if that institution failed, a lot of other institutions in the 
entire system and the economy would come to a grinding halt. So 
I do not agree with that assessment.
    Mr. Marchant. Thank you, Mr. Chairman.
    The Chairman. We are going to break now. And let me say 
this, votes will probably take 35 to 40 minutes, and then we 
are taking our picture. I plan to come back. I am going to skip 
the picture. And if other members want to come back, we will 
start again. I do not want to impose--if you can stay, we would 
appreciate it. Obviously, you have a right to leave. But if 
anybody can stay, I plan to be back in about a half-hour and 
any other members who are here, and we will do some more 
questioning for another 45 minutes or so after that if that is 
acceptable. Again, I will understand if you have obligations 
and do not want to sit around while we have our picture taken. 
We are in recess.
    [recess]
    The Chairman. I am going to recognize myself for another 
round, and I will recognize other members. But this has been 
very useful. One important question, and I must tell you this 
is partly a hearing, as I said, to learn things, but it is 
partly to refute things. There is out in the country a 
frustration about the fact there were bailouts and anger about 
too-big-to-fail. I think there are some people who think it is 
easier to do than others. Of course, one obvious answer that 
you get from some people is, if something is too big, what do 
you do? You make it smaller. And one of the things I want to be 
clear about, and Mr. Wallison, although he is not with us, 
already made this clear, several of you said there were ways to 
restrain growth by a higher capital charge that is 
disproportionate by insurance levies. So we understand that. 
And I think there was a general consensus that things that 
would restrain growth could be very helpful. Does anyone on the 
panel favor either an absolute limit on growth or even beyond 
that, reducing the size of existing institutions? And I ask you 
that because that is a very important view that is there. And 
when people say, ``Gee, you do not want it too-big-to-fail, 
make it smaller, keep it small,'' let me go down the line, what 
is your response to people who say, ``Hey, if it is too big, 
make it smaller or keep it small?'' Ms. Rivlin?
    Ms. Rivlin. I do not think there is a feasible, defensible 
way to break up institutions, so my answer to that would be no, 
but discourage growth.
    The Chairman. Right, but you would not put a cap, a legal 
cap on it going forward?
    Ms. Rivlin. No.
    The Chairman. I know, Mr. Wallison, that we have already 
discussed that. Mr. Johnson?
    Mr. Johnson. I would favor a cap certainly in the interim 
until you feel that these restraining measures have bite. As 
you pointed out, Mr. Chairman, at the beginning, we would have 
a cap I guess on the books.
    The Chairman. At 10 percent.
    Mr. Johnson. Yes, exactly. And the rationale behind that 
presumably is it is not antitrust because we have a different 
mechanism looking at that, it is sort of a back-up, it is a 
fail safe.
    The Chairman. You are right because I do not know of an 
antitrust regime in which 10 percent gets you into the anti-
competitive situation.
    Mr. Johnson. Not usually.
    The Chairman. Except the way some of us feel about people 
who run against us but other than that. What would the cap be, 
what could you cap as an interim?
    Mr. Johnson. Well, I think--we do not have perfect 
information on this, but I think that the Treasury itself 
identified 19 institutions that they thought were systemically 
important and therefore subject to stress tests. That is on the 
one hand. On the other hand, we see the experience of CIT 
Group, which is just one data point but it is extremely 
informative because in terms of the arguments they were making 
about being interconnected, their importance to the real 
economy, there were all kinds of arguments about how they are 
widely cited synthetic CDOs, I think that all turns out to be 
baloney. They are not that systemically important. You can let 
them fail through bankruptcy or renegotiating with their 
creditors. So that says the threshold is somewhere between $100 
billion total assets and $500 billion total assets, subject to 
a leverage caveat, Ms. Rivlin, right? You have to--
    The Chairman. But that is assets? What is the cap? We know 
we have one on deposits and that is a percentage one. What 
would be--the metric be, would it be assets?
    Mr. Johnson. Yes, well, it is assets, it is either total 
dollar assets or it is assets as a percentage of GDP. So I am 
saying 1 percent of GDP total assets would be the CIT 
threshold.
    The Chairman. Wachovia failed, Countrywide failed. They 
were pretty big. It did not cause the skies to drop because we 
had a regime. Mr. Zandi, what is your sense of this?
    Mr. Zandi. I think it would be very difficult and 
counterproductive to try to break up private institutions. I do 
not think that makes a lot of sense. I think it makes a lot of 
sense to raise the cost of being large and larger, and I do not 
think there needs to be any cap at all. As you get larger, you 
pay more because you are relying on the system in a more 
significant way.
    The Chairman. And I assume the rationale for that is that 
if you raise capital, reduce leverage, particularly in a kind 
of disproportionate way, you are making failure both less 
likely and less costly if it happens?
    Mr. Zandi. Exactly, also I think you might want to also in 
addition to capital ratios or leverage ratios, the deposit 
insurance fee or another insurance premium so that you are 
self-insured.
    The Chairman. Mr. Mahoney?
    Mr. Mahoney. I would not agree with a cap. I think there 
are ample small- and medium-sized banks that could compete 
effectively with the large banks if they are on a level playing 
field. And the problem is they are not currently on a level 
playing field because there is one group that has this implicit 
guarantee and there is another that does not. You would do away 
with that.
    The Chairman. I appreciate that. Let me tell you as an 
economic historian, as to the level playing field, no entity in 
the economic history of America has ever been on the high end 
of the level playing field. I know economists have concepts 
about constantly downward sloping things, we have a constantly 
downward sloping playing field. I have been doing this for 
many, many years, and I have heard the playing field invoked 
several times and never has anyone ever been at the top of it. 
It is an extraordinary playing field in which everybody is at 
the bottom. It is the reverse of Lake Wobegon. Everybody is way 
below average.
    But I appreciate that. And I guess what I am saying is to 
the extent that it is a too-big-to-fail issue, it is not anti-
competitive, and so that is why antitrust--people raise about 
antitrust. The problem is not anti-competitive; it is the 
negative impact of failure.
    Let me just ask Mr. Johnson, it is important to sort this 
out, would it be the prudential regulator of each institution? 
I know Mr. Wallison only talks about banks. Others I think did 
not think it would be limited to banks. Who would say when the 
time had come to put the cap on? Would it be the council or the 
individual regulator? Mr. Johnson, you are the only one who 
wanted a cap so I ask you?
    Mr. Johnson. I am not a big council fan myself and not 
really endorsing that, but I think it has to rest with whomever 
has the authority to do the bailouts. Who makes the bailout 
versus collapse decision? It is Treasury under our system. I 
think it remains Treasury because they write the checks.
    The Chairman. I think that is a good point. And I know your 
prior history at the IMF. I understand your aversion to the 
conciliatory form of governance. I am sure it was a trial from 
time to time.
    Mr. Royce?
    Mr. Royce. Thank you, Mr. Chairman. I would ask a question 
of Mr. Mahoney and Mr. Zandi for their opinion on this. For 
many years I was concerned about the perceived government-
backing of Fannie Mae and Freddie Mac and about the ability of 
these firms to borrow at interest rates that were a lot lower. 
They were near governmental rates. And most private companies 
of course because of perceived investment risk associated with 
Fannie and Freddie being so much lower, most of their 
competitors were at a disadvantage. At the same time, they were 
allowed to involve themselves in arbitrage. I think the 
leverage was 100 to one.
    I think that one of the main problems that we had was 
legitimizing the idea that subprime loans were safe. And I 
think the fact that the Government-Sponsored Enterprises went 
out and purchased for their portfolios a half trillion of 
these, directed by the government to do so, by the way; and one 
of the comments made by one of the GSE officials was that we 
sought to indicate to the market the safety of mortgage-backed 
securities that were subprime.
    And I do think that that entire process, and the way in 
which they became a duopoly, forced their competitors out, 
became too big to fail, there is a probably a lesson we should 
learn out of that. And I think it would be very dangerous for 
Congress to move to set up a regulatory structure that 
separates these institutions that are deemed systemically 
significant from the other institutions, whether you do that de 
facto or de juri, whether you name them or you do not name 
them. The result I suspect is likely to be the same. There will 
be the perception that these particular institutions are going 
to be covered. So how will the market perceive these companies, 
and are you concerned that counterparties will then perceive 
their investment risk in these institutions would be a lot 
lower and therefore it starts the process of being able to 
overleverage. It starts the process certainly of having a lower 
cost of capital, which will force your competitors out of the 
market. What will this mean for institutions competing against 
these now government-backed companies that in essence become 
too big to fail and Government-Sponsored Enterprises in a way. 
That would be the result I fear out of it?
    Mr. Mahoney. Well, I agree with that point entirely. I 
think that the counterparties of that entity are going to--all 
other things being equal, want to deal with a so-called tier 
one entity because they will see that it has the implicit 
guarantee. Whether you call that a competitive advantage or 
simply point out the fact that those entities are likely to 
increase in size, I think they will increase in size because 
they will be the most attractive entities to do business with. 
So if your objective is to limit size, I think this is exactly 
the wrong way to go.
    I also think that it is probably not a solution to just say 
we will not identify the entities that are too big to fail. 
Part of the problem that arose, particularly after Lehman 
Brothers, was the fear that we could not really predict what 
the government would do next and what it was going to do was 
going to be quite ad hoc, and this in some sense enshrines an 
ad hoc and unpredictable process.
    Mr. Royce. Let me ask Mr. Zandi for his observations on 
those two questions?
    Mr. Zandi. Yes, I sympathize with the concern. I think that 
at the very least we cannot identify any institution as so-
called tier one institutions, too big to fail, because it would 
lead to some of the concerns that you have enumerated and it 
would lead to the same kind of problems we have had with Fannie 
Mae and Freddie Mac.
    I do think though, unlike Mr. Mahoney, I think if we do not 
identify those institutions, and we treat all institutions the 
same, we say these are the rules, as you grow in size in terms 
of your asset base and your deposit base, as the composition of 
your asset base shifts to more riskier assets, than you have to 
put up more capital, you have to pay higher deposit insurance, 
you have perhaps another insurance premium to pay in case you 
do fail, I think that would work reasonably well.
    And it is important to remember that Fannie Mae and Freddie 
Mac were born out of the government and did have a guarantee. 
They had a line to the Treasury, and none of these institutions 
that we are discussing today have that similar kind of heritage 
or that similar kind of backing.
    Mr. Royce. I will ask one quick last question and that is 
on subordinated debt, we have talked before, Mr. Zandi, about 
how we might have avoided this in the past, but what do you 
think of Mr. Wallison's concept of structuring that 
subordinated debt, if I could ask you? I do not know if you had 
a chance to see his paper on that?
    Mr. Zandi. Yes, I read his paper. I do not know it well 
enough to really comment. I do not have an opinion. I thought 
it was an interesting idea, but I have not thought it through 
well enough to really comment.
    Mr. Royce. Okay, thanks. Yes?
    Mr. Johnson. Sir, if I could on the subordinated debt and 
the more general idea that the market can pick up the risk, I 
would point out that the evidence says the market pricing of 
risk, for example look at the CDS for Citigroup prior to the 
crisis, was going the wrong way. They thought Citigroup was 
becoming less and less risky. As we know, looking back, it was 
actually becoming more and more risky. So I am afraid, as one 
thing to look at, it is okay, but as a panacea or something to 
put a lot of weight on, I would do that with hesitation.
    Mr. Royce. But basically the way it would work is that the 
largest banks would be required to issue the subordinated debt, 
and it could not be bailed out. And so if the interest rate on 
these instruments were to rise above the rate on Treasury, 
substantially above the rate on Treasury securities, it 
certainly would be one signal to regulators that the market 
perceives excessive risk taking by that bank, and it would 
then--you could set up a structure so at least there would be 
an objective way to monitor this, and at the same time you 
would have the advantage of the subordinated debt out there.
    Mr. Zandi. But why wouldn't you pick up that information in 
the CDS mark or credit spreads on bonds or even in the equity 
premium? I am not sure why there is any additional--I do not 
know.
    Mr. Royce. But it has the additional benefit at least of 
having a subordinated debt there that by definition cannot be 
bailed out. So it is one more indicator but it is an indicator 
combined with something that is going to reduce the incentive.
    The Chairman. The gentleman from California?
    Mr. Sherman. Thank you, Mr. Chairman. Mr. Mahoney, thank 
you for focusing on the portion of the White Paper dealing with 
resolution authority. It is being sold as if it is just a 
tweaking of the Bankruptcy Code, but as you illustrate it is 
permanent TARP and not limited to $700 billion. It is unlimited 
TARP. Wall Street will love the money. Treasury will love the 
power. It has absolutely no chance in that form of passing the 
House of Representatives on a fair up or down vote. So the 
question really is whether my party will fall in love of the 
idea to the point where we try to force Members to vote on it 
in the dead of night or as part of some major appropriations 
bill because I think the only thing less popular than TARP in 
an emergency is unlimited permanent TARP.
    The economists here have asked us to design a system that 
implies the possibility of bailouts, at least as a possibility. 
And I would hope that whether that is great economics or not, 
you would recognize the political situation and help us design 
whatever the best economic regulatory system is that absolutely 
shuts the door permanently and absolutely on bailouts. I do not 
think there are many Members of the House who do not want to 
shut that door.
    The idea of hiding which companies are tier one seems 
absurd. First, we are in favor of transparency. Second, 
everybody will know anyway. And, third, I think if we are going 
to require additional capital of certain companies, that will 
identify who is tier one. If we do not require additional 
capital of tier one companies, then we are going to give them 
the possibility of being bailed out and being a systemic risk 
without even requiring additional capital.
    Professor Johnson, you put forward an interesting idea of 
trying to limit size but pointed out how do we apply this to 
foreign-based banks? One idea would be to say that no financial 
institution could have actual or contingent liabilities to 
Americans in excess of $100 billion or $200 billion or whatever 
the figure is. So that Deutsche Bank or Bank of America could 
pose the same level of risk to the United States economy. If 
the German government wants Deutsche Bank to have liabilities 
to Germans of a couple of trillion, that is up to them, but if 
a bailout is necessary, it will be because of the effect its 
collapse could have on the German economy and presumably that 
money would come from Berlin. Could you comment on the idea of 
setting an absolute limit on the size that a financial 
institution could be in the American economy measured by its 
actual or contingent liabilities to Americans?
    Mr. Johnson. Certainly, and obviously this raises 
complications in terms of international agreements. It is not 
something you would necessarily do unilaterally, but I think 
that is why you need the G-20 to be brought with you.
    Mr. Sherman. The G-20 will never do this. We have a right 
to say that you cannot borrow more than a certain amount from 
Americans as a single financial institution.
    Mr. Johnson. No, I agree completely.
    Mr. Sherman. And if we were to do it and they were to 
disagree, what are they going to do to us? Go on.
    Mr. Johnson. I completely agree with you. I was just 
talking about process. Look, I think you do this in terms of 
anybody who is deposit taking. So if you look at what went 
wrong with Icelandic banks in the UK, for example, at the 
retail level, they participated in the deposit insurance scheme 
of the UK and that took care of people with deposits below the 
UK limit. The issue was the other liabilities to UK citizens. 
And they obviously got into a very nasty fight with the British 
government about what assets all of those Icelandic banks would 
be used to settle up those debts. And I think what you are 
pointing to is exactly what implicitly came out of this, which 
is the British government felt that they could claim a lot of 
these Icelandic assets in the UK, that was supposedly in the 
UK. They even threatened to use anti-terrorist legislation to 
do that. That is where this thing is heading unless and until 
the United States impose these kinds of limits.
    Mr. Sherman. Would we, if we are going to limit too big to 
fail means too big to exist, can we do that just for depository 
institutions and/or their holding companies? Or if we are going 
to protect the American people from both systemic risk and the 
risk of having being called upon to make a bailout, do we need 
to apply it to entities other than banks?
    Mr. Johnson. I think you have to apply it to entities other 
than banks. I realize that I am quite far from the consensus 
view on this, but I think that it is really very important. 
When we are talking about all financial institutions, I think 
we have not talked enough about insurance companies today 
actually. The conversation has tended to gravitate towards 
commercial banks. I would not assume that the next financial 
crisis is going to be just like this financial crisis. They 
tend to mutate. They tend to involve other kinds of risk-taking 
institutions where we do not fully understand to measure the 
risk. So I think your point is very important, it has to be 
broad and it has to be across a lot of financial institutions.
    Mr. Sherman. Ms. Rivlin, I wonder--you seem to have a 
comment?
    Ms. Rivlin. No, I agree with that, and I was glad to get a 
chance to counteract the absent Mr. Wallison who thinks we only 
need to worry about banks. I think the lesson of this crisis is 
we need to worry about the whole financial sector and a lot of 
the trouble came from outside the banking system.
    The Chairman. I am going to recognize myself, and I will 
give myself one more round, having to come back to this for 
about 2 minutes, and that is I want to deal with this notion 
that we are somehow--it seems to me people have gotten attached 
to a whipping boy and unwilling to be torn away from it, the 
whipping boy with the name tier one companies. We have said we 
are not going to name tier one companies, and some people are 
reluctant to move on. And they say, ``Oh, well, you will have 
secret tier one companies.'' No, there will not be any tier 
ones in the legislation we are dealing with. And you say, 
``Well, but if you are raising capital,'' well, the requirement 
that people raise capital will not only apply to the largest. 
There will be a general thing. So, again, I think people have 
decided this is a nice thing to attack. I want to make it very 
clear, there is no tier one.
    There was a great Marx Brothers movie in which Chico is 
negotiating a contract with Groucho and Chico keeps objecting 
to this cause and that cause, and they keep tearing up the 
causes. And, finally, Chico says, ``What's this?'' And Groucho 
says, ``Well, you cannot object to that. That is the sanity 
clause.'' And Chico rips that up and says, ``Hey, you cannot 
kid me. There ain't no sanity clause.'' Well, there ain't no 
tier one either. It is just not there, so people have to let 
that whipping boy and strawman go.
    Mr. Sherman. If the chairman will yield? Whether tier one 
are identified or not identified, as long as companies are 
eligible for bailouts, the ones most eligible will be the 
biggest.
    The Chairman. No question about it, but that is your 
argument, what you are saying is anything big. So I understand 
the gentleman's position is a law, which of course would not be 
persuasive, by the way, you are arguing against yourself, 
because all you could pass would be a statute that said there 
could never be a bailout. And what can you do to a statute?
    Mr. Sherman. You could repeal it.
    The Chairman. I will yield again to the gentleman. In fact, 
the TARP was a statute. So if there had been a law on the books 
that said you can never have a bailout, it would have been 
amended by the TARP. There was no way under the Constitution. 
So if you posit that at some point people are going to say, 
``Oh, I have to have a bailout. You cannot stop me, I am 
jonesin' to do a bailout,'' then there is no way around that. I 
do believe there are structural things you can do but let's not 
have the strawman of the tier one or the company. If you say, 
``As long as they are a big company, then people will think 
there could be a bailout,'' even if there is a statute that 
says no bailout, it is not binding against the present statute.
    I yield to the gentleman.
    Mr. Sherman. I would think that there is a huge difference 
between adopting the President's proposal, which is permanent 
power for bailouts, and saying, ``Yes, there could be a bailout 
if you can pass it on the Floor at some other time.''
    The Chairman. I will take my time back to say that I do not 
know where the gentleman thinks he is. We are not confined to 
picking Plan A or Plan B. We are going to write the bill, and 
it is not necessarily what the President does. We are going to 
deviate from what the President does in a number of cases, as 
witness to the fact that they have these tier one companies. 
And I understand it is a lot easier to beat up the tier one 
companies, but that fight is over. There are not going to be 
any inside, outside. And the fact that capital requirements are 
increased will not be a tip off because all manner of 
institutions will be told, small banks will be told by the 
FDIC, others will be told, to increase capital.
    So if you are convinced, I think probably the only way you 
could break the habit is there would be a couple of people who 
fail. So I would differ with the gentleman in this sense, I 
think the likelihood of this society holding to an absolute 100 
percent hard and fast never a bailout is less likely than a 
resolving regime that would say you have to fire the CEO, that 
you have to fire the board of directors, that you have to 
impose other penalties. You have to make it really unpleasant. 
And that rule out in the course of that, as sometimes happens 
in a bankruptcy, some payment. Those are the two choices but it 
is not the strawman that people wanted.
    The gentleman from Colorado?
    Mr. Perlmutter. Thank you, Mr. Chairman. And I think I 
agree with the chairman on increasing capitalization for all 
institutions, and especially in good times increase the 
capital, in bad times, give them a little bit of a break. But I 
guess sort of as a philosophical economic question to the 
panel, whether we are better off or worse off having over the 
years slowly eroded and chipped away at Glass-Steagall and unit 
banking so that we have separated the investment side, the 
stock traders from the bankers and the insurance company, and 
we have made banks stand--every bank stand on its own capital? 
So that would be my first question to the panel. Are we better 
off by having a more efficient system or were we better off by 
having every bank stood on its own merits, and we kept the 
investment side separate from the banking side?
    Ms. Rivlin. In other words, should we never have passed 
Gramm-Leach-Bliley?
    Mr. Perlmutter. And Garn-St. Germain and start of national 
banking and branch banking. We cannot ``unring'' this bell but 
just as a general principle, do we want a really efficient 
system, which is where we headed, and then it all collapsed 
very quickly, or do we want to put some brakes in the system 
that do not exist right now?
    Ms. Rivlin. I think we want as efficient a system as we can 
get consistent with reasonable stability. And I realize that is 
kind of gobbledygook, but it is a trade off. And if we were to 
go back to no-branch banking and so forth, I do not think that 
is either feasible or sensible. But we may have gone too far in 
allowing growth, and maybe not even for efficiency reasons. And 
so we need to re-visit this question and see where we want the 
trade off to be.
    Mr. Perlmutter. Mr. Johnson?
    Mr. Johnson. Do we really have an efficient system at this 
point? Mr. Bernanke gave a speech recently where he talked 
about financial innovation and the value of it, he did not name 
a single innovation since the 1970's in the financial system, 
okay. We did not get that much efficiency, I think we need to 
apply the brakes. I do not think you can go back to where we 
were before. You cannot ``unring'' the bell as you said, but I 
think applying the brakes is absolutely critical.
    Mr. Perlmutter. And how would you do that?
    Mr. Johnson. The main thing, the main proposal I put 
forward, as we have been discussing, is to reduce the size of 
the largest financial institutions so that when you find 
yourself in a collapse or bailout situation, you can say, ``No, 
that is okay, you go to bankruptcy. You sort it out with your 
creditors.'' You are more like CIT Group last week than 
Citibank over the past 6 or 9 months.
    Mr. Perlmutter. Or could you demand sort of as a compromise 
to that that you do not break up the bank or reduce their size 
and make them spin something off but you say, as to the 
Northeast, you have to show capital for Massachusetts, 
Connecticut, Maine, New York, whatever, so that you have a 
version of unit banking, that your bank has to stand on capital 
based on a section of the country? There are a lot of ways to 
deal with this. The chairman and I have been in a disagreement. 
I think that really you have to look at both the size of the 
institutions as well as their product mix, not just markets--
not just capitalization, but I am trying to find something that 
maybe I can get him to bite on.
    The Chairman. If the gentleman will yield?
    Mr. Perlmutter. Yes, I certainly would yield to the 
chairman.
    The Chairman. My disagreement is I cannot get the gentleman 
to tell me what he proposes?
    Mr. Perlmutter. Well, I am asking the experts.
    The Chairman. Well, the gentleman referred to a 
disagreement. The only disagreement is I cannot understand what 
you are talking about. I have asked you to tell me what it is 
you want to do.
    Mr. Perlmutter. I know what I want to do. I want to reduce 
the size of some of the biggest institutions.
    The Chairman. With regard to Glass-Steagall, are you 
proposing we repeal Gramm-Leach-Bliley? I keep asking the 
gentleman because he made it public, what would the gentleman 
do to restore it?
    Mr. Perlmutter. Mr. Johnson, please help me here?
    Mr. Johnson. If I could make a suggestion, I would not go 
on the--perhaps the chairman would consider a graduated capital 
requirement so that it is not the zero one, tier one or not, 
but a capital requirement that increases quite sharply, because 
we know the system risk, an amount of extra GDP that is taken 
on when these big guys fail is enormous, so this is a very 
sharply increasing curve.
    The Chairman. When I said a disproportionate increase in 
capital, that is what I meant.
    Mr. Johnson. The question is in the numbers then. I think 
the question is, how fast does it increase? How big is the 
disincentive to size?
    Mr. Zandi. I do not think you want to go back to any kind 
of regional kind of criteria. If you remember back 
historically, we had vicious regional economic cycles in large 
part because of unit banking, because the bank was stuck to its 
region and exacerbated the downturn in those regions. And so we 
had very severe regional economic cycles in large part because 
of the unit banking system that we had, so I think that would 
be very counterproductive, very counterproductive.
    Mr. Mahoney. I completely agree with that point. I would 
also just note that in the crisis, what you saw is that 
institutions that had a lot of exposure to subprime did very 
badly. Some of those were stand-alone investment banks like 
Lehman. Some of them were more or less stand-alone commercial 
banks like Countrywide. Some were combined investment and 
commercial banks like Citigroup. So I do not think that that is 
a strong piece of evidence that we need to reestablish Glass-
Steagall.
    Mr. Perlmutter. Thank you, and I yield back.
    The Chairman. I am going to just take time, since the 
gentleman raised it, I frankly did not recognize my views as he 
characterized them. I still do not understand what the 
proposal--yes, in terms of capital requirements, I very much 
agree but the gentleman has not given me any idea with which I 
could disagree.
    Mr. Perlmutter. The gentleman is working on it, and that is 
why he was asking the panel for some assistance. And if I 
cannot come up with an answer that satisfies you, then I cannot 
come up with an answer.
    The Chairman. But characterizing it as disagreement is sort 
of puzzling.
    Mr. Sherman. If the gentleman will yield? I did put forward 
an idea, not based on whether you are mixing investment banking 
with insurance and the Glass-Steagall idea, but just a dollar 
limit. You cannot have debts to Americans in excess of $100 
billion.
    The Chairman. Well, I agree, but that is not the specific 
point. The gentleman from Colorado was specifically referencing 
Glass-Steagall. Part of this hearing is to get out on the table 
vague ideas. Is it too big to fail? One of the arguments--
    Mr. Perlmutter. Would the gentleman yield?
    The Chairman. --would be bring back Glass-Steagall? If that 
is what people want, discuss it. Your proposal--
    Mr. Perlmutter. Mine is certainly like a Glass-Steagall. I 
do not believe that, and I think that the investment banking 
community is all about risk, and I think they should be allowed 
to do whatever derivatives they want to do, subject to 
disclosing to their investors in an open fashion. And they are 
over in this part of the investment or in the financial 
community. And the banking system, which I believe is like a 
public utility, which is why we pumped in $700 billion because 
we had to keep the lights on, and we intervened in substantial 
ways through the Fed, that is in my opinion what we had to do 
last fall, which was a radicalizing moment for me. So I just 
believe that they really look at the world differently.
    The Chairman. I understand that but does the gentleman--
first of all, that does not account for AIG. AIG was not a 
bank. AIG was doing derivatives and the Federal Reserve 
intervened without us. People should remember that the Federal 
Reserve with the approval of Treasury came to us and announced 
that they were intervening. It was not part of the TARP 
initially, they just did that on their own. Mr. Wallison said 
it was not necessary but it was not because they were banks.
    But my other point to the gentleman is you say that, what 
is it--we have been talking about this for months, and I still 
do not know what is it you are proposing?
    Mr. Perlmutter. I am proposing, one, to limit the amount of 
deposits a single institution can take, which right now is 10 
percent.
    The Chairman. That is not what we are talking about.
    Mr. Perlmutter. I am talking about size and product mix. So 
I am also saying that insurance companies cannot be part--
insurance companies, stock trading companies and banks should 
be separate, as they were Glass-Steagall. I believe that the 
Roosevelt Administration did the right thing when its first act 
was Glass-Steagall to separate those--
    The Chairman. Are you proposing that we be imposing Glass-
Steagall? That is the first I have heard of your proposing that 
as a solution.
    Mr. Perlmutter. That is the best way I can articulate what 
it is that I believe. So with that, I yield back.
    The Chairman. The gentleman from Indiana?
    Mr. Donnelly. Thank you, Mr. Chairman. We have been talking 
about too big to fail, and there is another area and that is 
too big of an effect on the entire market. And, Mr. Zandi, I 
want to ask you, and I read your statement where it talked 
about emerging market investors did little or no research of 
their own and that the credit--this could not have occurred 
without someone providing the credit. But did not the triple A 
ratings given by Moody, is not that how the credit flowed was 
if you give me triple A, the credit will come from that? And so 
we had a large investor who talked to us and said if the credit 
rating agencies had not done that, this never would have 
started in the first place?
    Mr. Zandi. Well, let me just reiterate, I am an employee of 
the Moody's organization but these are my own personal views.
    Mr. Donnelly. No, I understand.
    Mr. Zandi. And I think there is plenty of blame to go 
around in that chain of securitization, from the lender to the 
investment bank, to the rating agency, to the investor, all of 
them were culpable, all of them made mistakes, all of them were 
wrong. And if you read through the entire statement, I go 
through that chain.
    Mr. Donnelly. Right, and I did. And I guess what I am 
asking is we have been talking about solutions to this.
    Mr. Zandi. Yes.
    Mr. Donnelly. And so with the credit rating agencies, the 
question is what keeps a Moody's from being in the same 
position with their triple A ratings again?
    Mr. Zandi. Right.
    Mr. Donnelly. And that is what we have been looking at. And 
we have talked about cutting the cord or the apparent conflict 
of interest of the person who is asking you to rate these 
securities being the same one who pays the fees. And there have 
been a couple of things offered, and I guess I wanted to get 
your opinion, is it something that, like they do in the legal 
world when you go to file a case, that the judge is pulled out 
of a hat so you cannot pick your judge. And so is this in 
effect a number of these organizations are put in a hat and 
that you cannot say, ``I want Moody's because they will give me 
a triple A?''
    Mr. Zandi. Right. And I think that in my own personal view 
is worth an experiment. I do not know if that works better or 
not, but I think it probably is an idea that is worth some 
experimentation.
    There are a number of things though that I think should be 
done. I think the reliance on ratings in regulatory 
requirements is inappropriate. Right now, if you are a money 
market fund, it can say I can only invest in securities with a 
rating of above a certain amount, I think that is 
inappropriate. Regulators are outsourcing their function to the 
rating agencies, and they should not do that.
    I think the SEC, as the regulator of the rating agencies, 
should be more active in monitoring and evaluating what the 
rating agencies are doing, much like banking regulators do with 
credit risk officers of major commercial banks. They look at 
the model. They say does this make sense and should it be doing 
this?
    I think it should be required that the data that the rating 
agencies use in the ratings should be vetted in some way. One 
of the biggest problems, in my view, was that the rating 
agencies would say, ``You give me the data, I do not re-
underwrite the loan, I take it as given and then I rate.'' And 
they say that to everybody, the investment bank and the 
investor, ``That is not what we do, and that is the way it has 
been since we started our business 100 years ago,'' but that 
makes no sense to me. There should be a third party firm that 
vets the data, samples the data, and makes sure it is okay.
    So, I think all these things could be--should be 
implemented and tried. But let me say one thing, and this is no 
win for me, right, because you are not going to believe me 
anyway?
    Mr. Donnelly. No, no, that is not true. I read your book 
and everything.
    Mr. Zandi. Okay. But bottom line, I do not believe that 
this conflict of interest, and there is one, is fundamentally 
why they screwed up, why they made a mistake in the ratings. I 
do not believe that is it. I think it is these other issues 
that we have discussed. And I do not think, I would experiment 
with the approach you just articulated, but fundamentally you 
are going to have conflicts no matter what you do and no matter 
how you design it and it is a matter of managing the conflicts 
as best you can.
    Mr. Donnelly. One of the other things the investor, this 
fellow, talked about was, and he talked to all of us, was maybe 
what we ought to do is just throw a couple of cents on every 
tray and have in effect a quasi-public rating system so that we 
do not have to speculate on the opinion of Moody's or that they 
be part of in effect almost become like a public utility, that 
it is too important getting this right to our economy, to the 
global economy. We had the Fed chairman in today who said if we 
had let this get out of hand, the whole global economy would 
have collapsed. And so much of it was tied in to these 
incorrect ratings given by Moody's and others.
    Mr. Zandi. Well, let me just say two things. One, I think a 
fee, a transaction fee, is a good way to raise revenue, the 
only problem is you have to do it globally.
    Mr. Donnelly. Right.
    Mr. Zandi. You cannot just do it here because it is--
    Mr. Donnelly. Then you are not non-competitive.
    Mr. Zandi. --just not going to work.
    Mr. Donnelly. Right.
    Mr. Zandi. And talk about G-20--
    Mr. Donnelly. But what we are trying to do is we are 
throwing out ideas of how we can fix this.
    Mr. Zandi. Yes.
    Mr. Donnelly. Anything from any of you.
    Mr. Zandi. In a financial transaction, it might be a good 
way to raise revenue to self-finance too-big-to-fail, right? It 
is a way to generate revenue, you put in the fund so that might 
be a way to do it, but you cannot do it unless it is a global 
process.
    The Chairman. Mr. Johnson wanted to say something, I think.
    Mr. Johnson. I think there is an assumption here, which is 
that we will get it right next time. The analytics will be 
better, the politics will be better.
    Mr. Donnelly. And that is why I said, why can we assume 
that next time we will do it any better?
    Mr. Johnson. I am not opposed to these ideas, let's try 
them, but fundamentally we will get it wrong again. We have 
every reason to think we just have not changed the nature of 
human society and human judgment and the politics of the entire 
process and the power of the most powerful people in the 
system, so a quasi-public rating system will get it wrong also. 
And you should plan, we should design something that can 
withstand the failure of that. It may be a good idea to tweak 
it, I am not opposed to that. But I think we should design 
something that--and the only way I think to do that is to make 
sure that when things fail, they are not so big relative to the 
economy.
    The Chairman. Let me at this point because I want to close 
it out, but one point Mr. Zandi makes, we are making progress 
in reaching consensus, such as with the tier one companies. I 
think that it is overwhelmingly likely that we will repeal all 
statutory mandates to rely on rating agencies, and that we will 
instruct the regulatory agencies to examine theirs. So that is 
one way to deal with. That one I can guarantee you will be in 
the final bill, that all those--there are two forms. In some 
cases, people are not allowed to do certain things unless they 
get a certain rating. In other cases, people cannot invest in 
other entities unless they have certain rating. We are combing 
the statutes now. There is agreement, that is something that 
was independently come up with in the Republican plan and our 
plan. That will happen.
    Mr. Sherman. Mr. Chairman?
    The Chairman. Sure.
    Mr. Sherman. I thought we were going to do another round. I 
wonder if I could have 1 minute then?
    The Chairman. Sure.
    Mr. Sherman. I would just say that we are trying to 
minimize the belief on Wall Street that particular companies 
have somehow a Federal guarantee. The best way to do that is to 
have no bailout authority vested in Treasury unless and until 
some future statute is passed. TARP will expire, and then Wall 
Street would have to recognize that it would be very difficult 
under any circumstances to pass TARP again. The way to maximize 
the belief on Wall Street that those companies that they 
identify as systemically important are going to get a Federal 
bailout, and therefore are entitled to lower-cost capital is to 
vest in Treasury the right to bail out companies. And the fact 
that the management of that company might lose its job is of 
little interest to the counterparties. What we are trying to do 
is make sure that the cost of capital does not reflect the 
belief that there may be a bailout of the institution. And 
whether management comes or goes, it does not really matter to 
the rating institution.
    The Chairman. Will the gentleman yield?
    Mr. Sherman. I yield.
    The Chairman. Would the gentleman identify to me, because 
we obviously have not done it yet, but what in the--is it in 
the resolving authority, where do you find this bail-out 
authority?
    Mr. Sherman. The bail-out authority, I think, was well-
summarized by Mr. Mahoney.
    The Chairman. No, but I am asking you where you found it in 
the Administration's position because I think you have 
overstated it significantly? Where in the Administration's 
position are they asking for money to be able to give out?
    Mr. Sherman. I do not have--they do not ask for an 
appropriation. I do not have a copy of the proposal. I do have 
Mr. Mahoney's testimony, and my statements are fully consistent 
with the second page of his testimony.
    The Chairman. Mr. Mahoney, do you have the reference? What 
is it that you think constitutes bail-out authority?
    Mr. Mahoney. Well, I think it is the--there is a statement 
that in the special resolution procedure, there are all these 
authorities given to spend money. Now, the White Paper does not 
say where the money comes from. I believe there was--
    The Chairman. The question would not be where it came from, 
but where it went to. Is the authorization to bail out 
creditors?
    Mr. Mahoney. The authorization is to re-capitalize, to 
purchase assets from, to make loans to, and that would go 
directly from Treasury into the--
    The Chairman. My understanding of it was regarding the 
bankruptcy situation, where you were not paying off old debts 
but trying to get things going forward, but we will look at 
that.
    Mr. Mahoney. If that is all that is being talked about, 
then that is great, but I certainly did not read it that way.
    The Chairman. It is in the White Paper?
    Mr. Mahoney. That is right.
    The Chairman. That is not our impression but, again, that 
will be our decision. The hearing is adjourned.
    I apologize, the Property and Casualty Insurance 
Association asked that we submit a statement. Any member who 
wishes to submit any information, including any of the 
witnesses, without objection, the hearing record will be open 
for 30 days.
    [Whereupon, at 5 p.m., the hearing was adjourned.]


                            A P P E N D I X



                             July 21, 2009


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