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



 
                     THE END OF EXCESS (PART ONE):
                       REVERSING OUR ADDICTION TO
                           DEBT AND LEVERAGE

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                      OVERSIGHT AND INVESTIGATIONS

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                     ONE HUNDRED ELEVENTH CONGRESS

                             SECOND SESSION

                               ----------                              

                              MAY 6, 2010

                               ----------                              

       Printed for the use of the Committee on Financial Services

                           Serial No. 111-131

              THE END OF EXCESS (PART ONE): REVERSING OUR

                     ADDICTION TO DEBT AND LEVERAGE






                     THE END OF EXCESS (PART ONE):
                       REVERSING OUR ADDICTION TO
                           DEBT AND LEVERAGE

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                      OVERSIGHT AND INVESTIGATIONS

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                     ONE HUNDRED ELEVENTH CONGRESS

                             SECOND SESSION

                               __________

                              MAY 6, 2010

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 111-131




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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                 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 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
              Subcommittee on Oversight and Investigations

                     DENNIS MOORE, Kansas, Chairman

STEPHEN F. LYNCH, Massachusetts      JUDY BIGGERT, Illinois
RON KLEIN, Florida                   PATRICK T. McHENRY, North Carolina
JACKIE SPEIER, California            RON PAUL, Texas
GWEN MOORE, Wisconsin                MICHELE BACHMANN, Minnesota
JOHN ADLER, New Jersey               CHRISTOPHER LEE, New York
MARY JO KILROY, Ohio                 ERIK PAULSEN, Minnesota
STEVE DRIEHAUS, Ohio
ALAN GRAYSON, Florida


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    May 6, 2010..................................................     1
Appendix:
    May 6, 2010..................................................    41

                               WITNESSES
                         Thursday, May 6, 2010

Acharya, Viral V., Professor of Finance, Stern School of 
  Business, New York University..................................    28
Brown, Orice Williams, Director, Financial Markets and Community 
  Investment, U.S. Government Accountability Office (GAO)........    24
Geanakoplos, John, James Tobin Professor of Economics, Department 
  of Economics, Yale University..................................    26
Hoenig, Thomas M., President and Chief Executive Officer, Federal 
  Reserve Bank of Kansas City....................................     7
Walker, David A., John A. Largay Professor, McDonough School of 
  Business, Georgetown University................................    30
Walker, Hon. David M., President and Chief Executive Officer, 
  Peter G. Peterson Foundation, and former Comptroller General of 
  the United States..............................................     9

                                APPENDIX

Prepared statements:
    Moore, Hon. Dennis...........................................    42
    Acharya, Viral V.............................................    44
    Brown, Orice Williams........................................   214
    Geanakoplos, John............................................   232
    Hoenig, Thomas M.............................................   289
    Walker, David A..............................................   308
    Walker, Hon. David M.........................................   394

              Additional Material Submitted for the Record

Moore, Hon. Dennis:
    Federal Reserve Bank of New York Staff Report No. 328, 
      ``Liquidity and Leverage,'' by Tobias Adrian and Hyun Song 
      Shin, dated May 2008, Revised January 2009.................   420
    Congressional Research Service memorandum dated May 4, 2010..   459
    GAO report entitled, ``Financial Markets Regulation,'' dated 
      July 2009..................................................   472
    McKinsey Global Institute report entitled, ``Debt and 
      deleveraging: The global credit bubble and its economic 
      consequences,'' dated January 2010.........................   608
    Paper entitled, ``Growth in a Time of Debt,'' by Carmen M. 
      Reinhart and Kenneth S. Rogoff, dated January 7, 2010......   697
Biggert, Hon. Judy:
    Written responses to question submitted to Orice Williams 
      Brown......................................................   723
    Wall Street Journal article entitled, ``A Fannie Mae 
      Political Reckoning,'' dated May 6, 2010...................   730
    Bloomberg article entitled, ``Freddie Mac Stock Falls After 
      Seeking $10.6 Bln From U.S.,'' dated May 6, 2010...........   732
    Article from The New York Times entitled, ``Freddie Mac Seeks 
      Billions More After Big Loss,'' dated May 5, 2010..........   734
    Politico article entitled, ``Frank to White House: Fight the 
      GOP,'' dated May 5, 2010...................................   735
Walker, David A.:
    Forthcoming Journal of Economics and Business article 
      entitled, ``Long-Run Credit Growth in the US,'' dated March 
      2010.......................................................   738


                     THE END OF EXCESS (PART ONE):
                        REVERSING OUR ADDICTION
                          TO DEBT AND LEVERAGE

                              ----------                              


                         Thursday, May 6, 2010

             U.S. House of Representatives,
                          Subcommittee on Oversight
                                and Investigations,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to notice, at 10:05 a.m., in 
room 2128, Rayburn House Office Building, Hon. Dennis Moore 
[chairman of the subcommittee] presiding.
    Members present: Representatives Moore of Kansas, Lynch, 
Klein, Speier, Driehaus; Biggert and Lee.
    Also present: Representative Royce.
    Chairman Moore of Kansas. This hearing of the Subcommittee 
on Oversight and Investigations of the House Financial Services 
Committee will come to order.
    Our hearing this morning is entitled, ``The End of Excess 
(Part One): Reversing Our Addiction to Debt and Leverage,'' 
inspired by the April 6, 2009, Time cover story, right here, 
``The End of Excess: Why This Crisis is Good for America,'' 
written by Curt Anderson.
    This will be the first in a series of hearing where we will 
look at the key issues exposed by the financial crisis, and the 
next steps to continue improving financial stability in an 
economic recovery.
    We'll begin this hearing with members' opening statements, 
up to 10 minutes per side, and then we'll hear testimony from 
our witnesses.
    For each witness panel, members will have up to 5 minutes 
to question our witnesses.
    The Chair advises our witnesses to please keep your opening 
statements to 5 minutes to keep things moving so we can get to 
members' questions.
    Also, any unanswered question can always be followed up in 
writing for the record.
    Without objection, all members' opening statements will be 
made a part of the record.
    I now recognize myself for up to 5 minutes for an opening 
statement.
    The strength of our financial system and economy depends on 
the responsible use of credit and debt built on trust between 
the lender and borrower that payment will be made in the 
future.
    The word ``credit'' is derived from the Latin word 
``credo,'' which simply means ``I believe.'' While the 
financial industry complains about a lack of certainty as 
Congress debates financial regulatory reform, there's a more 
fundamental lack of trust that the American people now have in 
our financial system.
    To correct these two problems, this lack of certainty and 
understandable lack of trust, we must enact strong rules of the 
road this year, so the credibility of our financial system can 
be restored.
    A new law, unfortunately, can't heal our broken financial 
system. The financial industry must take their own steps to 
restore faith in their business. They must provide services 
their customers really want, and not use hidden fees or balance 
sheet tricks to cheat their way to the top again.
    We need to empower consumers and investors to make better 
financial decisions. Government must do its part in setting a 
good example, providing efficient financial oversight with 
limited resources, and getting on a path to balance the Federal 
budget so we're not passing a massive debt on to our children 
and grandchildren.
    In 1978, our combined outstanding debt across the economy, 
including financial firms, other businesses, households, and 
local, State, and Federal Government was $3.6 trillion, or 157 
percent of GDP. By the end of last year, that number ballooned 
to $50.3 trillion, or 353 percent of GDP. This is the highest 
level of combined debt of the United States on record.
    Since 1978, our economy is over 6 times larger than what it 
was, and we have grown, on average, $404 billion each year; but 
over the same timeframe, our combined debt has grown nearly 4 
times as fast, adding nearly $1.6 trillion each year on 
average.
    Even more troubling is the rapid growth of financial sector 
debt, as it grew over 41 times larger than what it was in 1978. 
As GAO noted in its leverage study that we'll hear about today, 
Wall Street investment banks had leverage ratios of over 30 to 
1, compared to the largest commercial banks, which averaged 
leverage of 13 to 1.
    In good times, this means their profits were supercharged, 
but when asset prices fall, excessive leverage accelerates a 
firm's failure, as we saw with Bear Stearns and Lehman 
Brothers.
    Are we addicted to debt and leverage? I'm afraid we might 
be, and unless we take bold new steps on both financial 
regulatory reform and budget reform soon, it will be very 
difficult to reverse this troubling trend.
    When I came to Congress in 1999--it was the last 2 years of 
the Clinton Administration--we had budget surpluses those 2 
years, and the first government surpluses in decades. When 
President Clinton left office, the national debt stood at $5.73 
trillion.
    Unfortunately, over the next 8 years, our national debt 
grew at a record pace, nearly doubling, and hitting $10.7 
trillion. Our economy was on the verge of going off the cliff, 
as we were still reeling from TARP and the financial panic in 
late 2008, and our economy was losing 750,000 jobs a month in 
early 2009.
    Experts and economists from the left and the right, 
including John McCain's economic advisor Mark Sandy, implored 
Congress to act with a large stimulus to stabilize the economy, 
so even though it wasn't popular, the government responded by 
enacting the Recovery Act, and TARP was used to implement the 
financial stability plan.
    What happened next? The economy stabilized, and slowly but 
surely, we are back on track with real economic growth.
    A Republican witness, Professor David Walker, agrees in his 
testimony, writing, ``Our economy would be rebounding much more 
slowly than it has, if we had not implemented the TARP 
program.''
    Congress has made strong budget reforms, passing the 
largest deficit-reducing legislation since 1993, in the new 
health care law. We have re-implemented statutory pay-go, and 
the President established a Fiscal Responsibility Commission 
with a report due at year's end.
    I look forward to hearing from our witnesses on these 
issues today, bringing their experience and expertise on these 
matters, so we can better understand how debt and leverage 
impacts every single American, and what are the steps we can 
take to get us back to a more stable path of economic growth.
    Chairman Moore of Kansas. I now recognize for 5 minutes the 
ranking member of our subcommittee, my colleague and friend 
from Illinois, Ranking Member Judy Biggert.
    Mrs. Biggert. Thank you, Chairman Moore, and thank you for 
convening this important hearing.
    Today's hearing is entitled, ``The End of Excess (Part 
One): Reversing Our Addiction to Debt and Leverage.'' However, 
I would like to add to that. I would add that Washington must 
reverse its addiction to Big Brother government, wasteful 
Washington spending, and permanent taxpayer-backed government 
bailouts.
    The denial in Washington must end. Washington must get on 
the side of the American taxpayer, American families, 
community-based financial institutions, and American small 
businesses--the job creators in our economy.
    Our Nation's debt is on an unsustainable track. The denial 
of some lawmakers that Washington take over with bailouts and 
spending that is out of control must end.
    The front page of today's Washington Post reads, ``Greece's 
debt-paying sparks violence.'' And as we have all seen in the 
paper, this European debt crisis will seem like a drop in the 
bucket when compared to our Nation's projected debt, which, by 
some estimates, will reach $15 trillion by the end of 2020, 
representing 67 percent of GDP.
    Levels of debt that are of this nature are not sustainable 
and represent a barrier to the future economic prosperity of 
our Nation.
    High taxes, inflation, and higher unemployment rates will 
be the byproducts of the current Administration's fiscal 
irresponsibility.
    Linked to this irresponsibility is the Administration's 
unlimited guarantee of the debt of Fannie Mae and Freddie Mac, 
with trillions in obligations that are guaranteed by our 
government, our taxpayers.
    Freddie Mac announced yesterday that it will need an 
additional $10.6 billion in government funding. That's $10.6 
billion more of taxpayers' money. The latest addition brings 
the GSE loss to taxpayers to $136 billion.
    And with that, Mr. Chairman, I would like to ask unanimous 
consent to insert in the record three newspaper articles: one 
from Bloomberg, saying, ``Freddie Mac seeks $10.6 billion from 
Treasury following first-quarter loss''; one from the New York 
Times, ``Freddie Mac seeks billions more after big loss''; and 
the third from Politico, ``Frank to White House: Fight the 
GOP.''
    Chairman Moore of Kansas. Without objection, they will be 
made a part of the record.
    Mrs. Biggert. Thank you.
    The Administration has yet to even appoint an inspector 
general to provide objective, independent oversight over the 
Federal bureaucrats who now control the GSEs, and I know you 
have had that bill to do that.
    It is inconceivable that officials managing these 
liabilities would be allowed to do so without proper 
transparency, independent oversight, and thorough reporting to 
Congress and the American people, and it's unacceptable that 
the Administration continues to kick the can down the road and 
still has no firm exit strategy to spare taxpayers from future 
losses associated with Fannie and Freddie. Republicans are 
ready to address this problem and get taxpayers out of this 
mess.
    Finally, the risk-takers on Wall Street need to know clear 
rules of the road. The rules must say that there will be no 
more bailouts and no more institutions ``too-big-to-fail.'' 
This message should be clear. If you run your company into the 
ground, you'll be shut down. Your creditors and counterparts 
won't get a bailout that's paid for by taxpayers, consumers, or 
community banks and small businesses that have had no role in 
your risky behavior.
    I look forward to the testimony of today's witnesses. I'm 
particularly interested in the findings of the GAO study from 
last July, that clearly pointed to the fact that because 
institutions thought that housing asset value, primarily 
housing prices, would continue to rise, institutional leverage 
increased.
    When these institutions began to experience significant 
losses due to decline in value of mortgage-related and other 
assets, financial institutions attempted to deleverage and 
reduce their risk by raising new equity, reducing dividend 
payouts, selling assets, and reducing lending.
    Raising capital, however, became increasingly difficult 
after the onset of the crisis, as would-be investors began to 
have doubts about the quality of these firms' assets, and 
financial institutions began to deleverage by selling assets.
    In the fourth quarter of 2008, broker-dealers reduced 
assets by nearly $785 billion, and banks reduced bank credit by 
nearly $84 billion.
    This series of events significantly contributed to our 
economic crisis. Today, our economy is essentially on thin ice 
and susceptible to even the most moderate economic shocks, 
according to GAO.
    For this reason, in the reform proposal, H.R. 3310, House 
Republicans proposed a market stability and capital adequacy 
board to monitor these interactions.
    Congress doesn't need to bestow more power on the same 
Washington bureaucrats who didn't do their job at policing the 
financial industry or protecting consumers in the first place. 
Regulators need to get their act together. We must enact smart 
financial reforms that require coordinated regulatory efforts 
and bailouts, and bring certainty to the marketplace so that 
investors invest, businesses expand, and more jobs are created 
to put Americans back to work.
    Finally, until our Federal house is in order, our children 
and grandchildren will be the ones who will bear the burdens 
associated with our Nation's addiction to excessive borrowing 
and spending.
    And with that, I yield back.
    Chairman Moore of Kansas. I thank the ranking member.
    I next recognize Mr. Lynch from Massachusetts for 2 
minutes, sir.
    Mr. Lynch. Thank you, Mr. Chairman, for holding this 
hearing, and I also want to thank our distinguished panelists 
for their willingness to come before this committee to help us 
with our work.
    Mr. Chairman, our Nation's growing addiction to debt is one 
that has been largely ignored until the collapse of the 
financial markets in the fall of 2007. According to the Federal 
Reserve, at the end of 2009, the combined outstanding debt in 
the U.S. economy was $50.3 trillion. That includes financial 
industry debt, non-financial business debt, household debt, and 
local, State, and Federal Government debt.
    Since the boom years began in the 1980's, our debt as a 
percentage of GDP has risen almost 200 percent, and while a lot 
of things have happened since the early 1980's, and some of 
that factor might be mitigated, I think the increase in debt 
has been instructive, as to where we have been and where we're 
going.
    As we know all too well, no other industry was as highly 
leveraged and addicted to debt as the financial system. We have 
learned that Lehman Brothers, and probably other banks, used 
techniques like the Repo 105 to conceal debt, masking just how 
highly leveraged they actually were from regulators and 
investors.
    Collateralized debt obligations and other over-the-counter 
derivatives were multiplying and disguising or transferring 
debt off the balance sheets of companies into opaque markets, 
such that regulators and market participants could only guess 
at the total amounts involved in these deals.
    The regulatory reform bill that the House passed last year, 
the Wall Street Reform and Consumer Protection Act, would 
establish a stability oversight council to give regulators 
better tools to monitor and regulate excessive leverage and 
risk-taking.
    I know my colleague, Mr. Miller, has introduced a bill that 
mirrors a number of amendments that the Senate is currently 
considering to their regulatory reform bill, limiting the size 
of mega-banks by setting a cap on any company's share of total 
deposits and setting minimum equity levels for bank holding 
companies and non-bank financial institutions.
    I think these are steps in the right direction, and I'm 
looking forward to hearing from our witnesses today on further 
proposals to help wean ourselves from this harmful addiction to 
debt.
    Thank you, Mr. Chairman. I yield back.
    Chairman Moore of Kansas. I thank the gentleman.
    The Chair next recognizes Ms. Speier from California for 3 
minutes.
    Ms. Speier. Thank you, Mr. Chairman, and thank you to the 
witnesses for participating in what is a very important 
hearing. This hearing on the impact of leverage and increasing 
debt burden is profound. I'm struck by the fact that the two 
sectors that dramatically increased their debt burden leading 
up to the current economic crisis were the financial sector and 
consumers, and we know that it was the financial institutions 
that fostered the growth in consumer debt through teaser-
interest-rate credit cards and loans, no-down auto loans, 2/28, 
and no-doc pick-a-pay payments, mortgages, and home equity 
loans, all so that they could be packaged into bonds and CDOs, 
and synthetic CDOs, that magically received AAA ratings and 
generated enormous fees and profits.
    I strongly believe that excessive leverage used by the 
large financial institutions was a major factor in the real 
estate bubble and subsequent financial collapse in 2008. In 
fact, according to Professor David Moss of Harvard Business 
School, outstanding debt in the financial sector--and this 
figure is truly mind-blowing--increased from $568 billion in 
1980 to more than $17 trillion in 2008.
    Leverage helped firms become ``too-big-to-fail.'' A firm 
with $1 billion in capital can have $40 billion in liabilities, 
which means that if it goes down, there are other banks and 
lenders who need $40 billion in repayments if their balance 
sheets are going to add up.
    The banks that survived the crisis best, like JPMorgan, had 
the lowest levels of leverage. The leverage ratio at Bear 
Stearns reached more than 40 to 1 before it failed. By 2007, 
the leverage ratios of many of the major Wall Street investment 
banks reached more than 30 to 1, including Lehman Brothers and 
Merrill Lynch.
    But these are only their on-balance-sheet levels. These 
firms also gamed their leverage numbers by using off-balance-
sheet vehicles and tricks, like Repo 105s, to make their 
balance sheets look better than they really were.
    The fact that most of this was short-term debt simply made 
matters worse, when the real estate bubble burst, and 
supposedly liquid mortgage-backed securities suddenly became 
unsellable, causing a downward spiral.
    I feel compelled to set the record straight. We are here 
today not because of overregulation, but because of systemic 
and systematic de-regulation, with the passage of the Gramm-
Leach-Bliley Act of 1999, the Commodities Future Modernization 
Act in 2000, which prohibits Congress from regulating 
derivatives, and the SEC's Consolidated Supervised Entities 
Program in 2004 that led to a relaxation of leverage ratios for 
investment banks, which then were 12 to 1. They just lifted it 
altogether.
    Regulators still had the power to take many actions in the 
months and years leading up to the current crisis, but they 
didn't believe there was a problem. Up until the bitter end, 
they asserted that there was no bubble and that the market 
would take care of itself. Well, it didn't.
    I'm gratified that the House Wall Street Reform and 
Consumer Protection Act includes my amendment that would limit 
debt to equity leverage at systemically risky firms to no more 
than 15 to 1. The regulators could still impose a lower limit.
    I'm delighted that Thomas Hoenig, president of the Federal 
Reserve Bank of Kansas City, is here. He has said publicly that 
he believes that there must be a leverage ceiling. In fact, he 
has said that 15 to 1 is too generous. I might add that Goldman 
Sachs is presently leveraged at 15 to 1 today, and breaking its 
own records for profits.
    It may be impossible to devise a truly foolproof regulatory 
regime to prevent the next crisis, but we should not again be 
totally reliant on the wisdom and good intentions of government 
regulators, or voluntary restraint by Wall Street firms.
    I thank the chairman. I yield back.
    Chairman Moore of Kansas. I thank the lady for her 
statement, and I'm pleased to introduce our first panel of 
witnesses.
    First, we'll hear from Mr. Thomas Hoenig, President and CEO 
of the Federal Reserve Bank of Kansas City. Welcome, Mr. 
President.
    And next, we'll hear from the Honorable David M. Walker, 
President and CEO of the Peter G. Peterson Foundation, and 
former Comptroller General of the United States. Welcome to 
you, sir.
    It's an honor to have such distinguished current and former 
public officials before our subcommittee today.
    Without objection, your written statements will be made a 
part of the record.
    Mr. Hoenig, sir, you're recognized for 5 minutes to provide 
a brief summary of your statement.

 STATEMENT OF THOMAS M. HOENIG, PRESIDENT AND CHIEF EXECUTIVE 
          OFFICER, FEDERAL RESERVE BANK OF KANSAS CITY

    Mr. Hoenig. Chairman Moore, Ranking Member Biggert, and 
members of the committee, I want to thank you for asking me to 
testify here today, to give me an opportunity to share some of 
my views on the issues around leverage.
    Certainly, among the factors that contributed to this 
financial crisis, there is no question that leverage was key, 
and the unwinding of this leverage contributed to the 
escalation of this crisis into the worst recession in 75 years, 
hurting Americans at all economic levels.
    I have spent more than 36 years at the Federal Reserve, 
deeply involved in bank supervision, and it has been apparent, 
to me at least, for some time that our Nation's financial 
institutions must have firm and easily understood leverage 
requirements.
    Leverage tends to rise when the economy is strong, as 
investors and lenders forget past mistakes and believe that 
prosperity will always continue. If we don't institute rules 
now, to contain leverage, another crisis, I can tell you, is 
inevitable.
    My written testimony addresses the systemic increase, or 
systematic increase in debt and leverage that has occurred in 
all major sectors of our economy over the past 2 decades. But 
my comments today will focus specifically on what occurred at 
the largest financial firms, which were the catalysts, in many 
ways, for this crisis.
    Leverage, of course, is the ability to use debt to build 
assets as a multiple of a firm's capital base. The leverage of 
banking organizations has risen steadily since the mid-1990's. 
It was not immediately obvious because of the many different 
ways capital and leverage can be measured.
    In my judgment, the most fundamental measure of a financial 
institution's capital is to exclude intangible assets and 
preferred shares and focus only on tangible common equity, that 
is, ownership capital actually available to absorb losses and 
meet obligations.
    Looking at tangible common equity, you see that leverage 
for the entire banking industry rose from $16 of assets for 
each $1 of capital in 1993, to $25 for each $1 of capital in 
2007.
    More striking, perhaps, this aggregate ratio was driven 
most significantly by the 10 largest banking companies. At 
these firms, assets rose from 18 times capital to 34, over the 
same period, and that does not include their off-balance-sheet 
activities.
    These numbers, in my opinion, reflect two essential points. 
First, that based on capital levels, the 10 largest banking 
organizations carried fundamentally riskier balance sheets at 
the start of this crisis than the industry as a whole. Second, 
their greater leverage reflects a significant funding cost 
advantage. Not only is debt cheaper than equity, but their debt 
was cheaper than the smaller organizations, because creditors 
were confident that these firms were too big to be allowed to 
fail.
    This was a gross distortion of the marketplace, providing 
these firms an advantage in making profits, enabling them to 
build size, and then, in the end, leaving others to suffer the 
pain of their collapse.
    This is not capitalism, but exploitation of an unearned 
advantage; and the list of victims is long, including families 
who lost homes, workers who lost jobs, and taxpayers who were 
left to pay the tab.
    This increase in leverage in the banking industry spread 
broadly to other sectors of the economy, creating a general 
excess of credit growth over the past 10 years, especially, as 
you said, among consumers.
    This economy-wide rise in leverage was based on the 
assumption that asset prices would continue to rise, especially 
those in housing this time. When prices fell and defaults and 
losses mounted, capital ratios that had been systematically 
reduced over time proved grossly inadequate.
    To illustrate, suppose the 10 largest banking organizations 
had been required to confine their leverage to an historically 
more reasonable level of $15 of tangible assets for every $1 of 
tangible common equity, rather than the 34 they had.
    Under this historic limit, they would have been forced to 
hold an additional $326 billion of equity, 125 percent more 
than they actually had, to absorb potential losses; or, they 
would have had to cut back on their growth by nearly $5 
trillion; or more likely, the combination of those two.
    The point is, the institutions got away from the 
fundamental principles of sound capital management, and those 
institutions with the highest leverage suffered the most. 
Financial panic and economic havoc quickly followed.
    The process of deleveraging is still under way. Rebuilding 
capital has begun. But during this rebuilding, loans are harder 
to get, which is impeding the economic recovery.
    With this very painful lesson fresh in our mind, now is the 
time to act. I strongly support establishing hard leverage 
rules that are simple, understandable, and enforceable, and 
that apply equally to all banking organizations that operate 
within the United States.
    As we saw in the years before the crisis, leverage tends to 
rise during the expansion, as past mistakes are forgotten, and 
pressure for growth and higher returns on equity mount. 
Straightforward leverage and underwriting rules require bankers 
to match increases in assets with increases in capital, and 
prevent disputes with bank examiners over interpretations of 
the rules. As a result, excess is constrained and a 
countercyclical force is created that moderates booms, and 
forms a cushion when the next recession might occur.
    I firmly believe that, had such rules been in place, we 
would have been spared a good part of the tremendous hardship 
the American people have gone through during the past 2 years.
    Thank you.
    [The prepared statement of Mr. Hoenig can be found on page 
289 of the appendix.]
    Chairman Moore of Kansas. Thank you, Mr. Hoenig.
    The Chair next recognizes the Honorable David M. Walker.
    Sir, you're recognized for 5 minutes.

STATEMENT OF THE HONORABLE DAVID M. WALKER, PRESIDENT AND CHIEF 
  EXECUTIVE OFFICER, PETER G. PETERSON FOUNDATION, AND FORMER 
            COMPTROLLER GENERAL OF THE UNITED STATES

    Mr. David M. Walker. Chairman Moore, Ranking Member 
Biggert, and members of the subcommittee, thank you for the 
opportunity to testify today.
    It's very important to state at the outset of this hearing 
that not all debt and leverage is bad, however, excess debt and 
leverage is. In addition, individuals, businesses, and 
countries must not become accustomed to taking on debt in order 
to finance their ongoing operating costs and current wants at 
the expense of future needs and future generations.
    Now, let me turn to the state of the U.S. Government's 
finances, which is what I was asked to focus my testimony on 
today.
    It is clear that the United States is a great nation, 
possibly the greatest in the history of all mankind. At the 
same time, our country is resting on its past successes and its 
sole superpower status, which is temporary, while at the same 
point in time, ignoring a range of leading indicators that 
clearly demonstrate that we are on an imprudent and 
unsustainable path in many respects.
    This includes matters such as public finance, savings 
rates, educational performance, health care costs and outcomes, 
and the state of our Nation's critical infrastructure.
    The truth is, our country's future standing and the 
standard of living for future generations of Americans is 
threatened by these key sustainability challenges, and given 
the subject of this hearing and series of hearings, I'll focus 
my remarks on America's structural deficits, growing debt 
burdens, increased reliance on foreign lenders, and low savings 
rates.
    During the first approximately 200 years of our republic's 
existence, the Federal Government did not experience 
significant and recurring deficits, unless the country was at 
war, meaning a declared war, was experiencing a depression or 
recession, or faced some other major national emergency.
    However, within the past several decades, both America and 
too many Americans became addicted to spending, deficits, and 
debt. This cultural challenge is real, and it has reached 
epidemic proportions in Washington, D.C.
    As an example, total Federal debt levels have more than 
doubled in less than 10 years, and they could double again, 
within the next 10 years, on our present path.
    Clearly, trillion-dollar deficits are a matter of growing 
public concern. However, it's important to understand that 
today's deficits do not represent the real threat to our ship 
of state. The real threat is the large, known, and growing 
structural deficits that will exist when the economy has 
recovered, when unemployment is down, when the wars are over, 
and when the crises have long passed. These literally threaten 
the future standing of the United States and the future 
standing of living of Americans; and as we can see, that absent 
dramatic and fundamental spending and tax reforms, our Federal 
debt levels are expected to skyrocket in the future. Believe 
me, the markets will not allow us to get nearly very far down 
this road.
    Federal spending levels have grown by almost 300 percent 
net of inflation over the past 40 years, and the Federal budget 
is now dominated by mandatory spending programs that grow on 
auto-pilot. These mandatory spending programs serve to 
constrain our ability to invest in our children, in critical 
infrastructure, and other areas that help to create a better 
future.
    As I have traveled the country and appeared to the media 
promoting the need for fiscal responsibility, many have asked, 
``Are we Greece?'' Their question is based on the current 
challenges being experienced by that country, and the answer 
that I typically give is, the United States is not in the same 
situation as Greece today. However, our key public debt ratios 
will be as bad as Greece's in less than 10 years. And given our 
present path, we must learn the lessons of Greece and past 
history, if we want to avoid a similar crisis of confidence.
    Today's paper notes, ``Riots in the streets of Greece.'' 
This could happen in the United States in less than 10 years, 
on our present path.
    Today's paper notes the dominance of concern in Britain 
about public debt. And as you will see, most Americans don't 
realize, including most Members of Congress in all likelihood, 
that our key total public debt ratios exceed Great Britain. 
They exceed Spain. They exceed Ireland. They're not as bad as 
Greece, but they'll be there within less than 10 years.
    The truth is the debt to GDP numbers that the Federal 
Government pushes on the public, tend to understate the 
Nation's true leverage.
    For example, current debt held by the public is about 58 
percent of GDP and rising. However, if you add debt that's owed 
to Social Security and Medicare and other so-called trust 
funds, the debt to GDP ratio would be about 89 percent. And if 
you consider the debt that's held by Fannie Mae and Freddie 
Mac, which many believe should be consolidated with the U.S. 
Government's financial statements, we're well over 100 percent, 
and rising rapidly.
    What about savings rates? Savings rates have declined 
dramatically, and the net national savings rate has plunged to 
the lowest level since the Great Depression.
    We must recognize reality and understand that the four 
factors that caused the mortgage-related subprime crisis exist 
for the Federal Government's own finances: first, specifically, 
a disconnect between those who benefit from prevailing 
practices and those who will pay the price and bear the burden 
when the bubble bursts; second, not enough transparency as to 
the nature, extent, and magnitude of the real risk; third, too 
much debt, not enough focus on cash flow, and overreliance on 
credit ratings; and finally, a failure of existing governance, 
risk management, oversight, and regulatory functions to act 
until a crisis is at the doorstep.
    In my view, in summary, while America is a great nation, we 
are at a critical crossroads. The decisions that are made, or 
that fail to be made by elected officials over the next 3 to 5 
years, especially in the fiscal area, will largely determine 
whether our future is better than our past, or whether our best 
years are behind us.
    We must move beyond delay and denial, we must start making 
tough choices, and we must do so before we pass a tipping 
point, which is what happened in Greece.
    If you look what happens when you pass a tipping point and 
you lose the confidence of your foreign lenders, interest rates 
can escalate dramatically, which can set off a chain of events 
that not only would have adverse economic consequences in the 
United States, but dramatic adverse consequences around the 
world.
    The United States will not default, but we may well have to 
pay much higher interest rates in the future because of not as 
much concern about default, but concern about what is the 
dollar worth that lenders will receive.
    Thank you very much, and I'll be happy to answer your 
questions.
    [The prepared statement of Mr. David M. Walker can be found 
on page 394 of the appendix.]
    Chairman Moore of Kansas. Thank you, sir, for your 
testimony.
    Mr. Hoenig, thank you for testifying today, and for your 
36-plus years of service with the Fed. You and your staff at 
the Kansas City Fed have been leaders in our community, and an 
invaluable resource as our country has slowly managed our way 
through the financial crisis.
    As both you and Mr. Walker have pointed out, leverage is a 
double-edged sword and can be responsibly used for productive 
economic outcomes. But it seems, in the last decade especially, 
discipline was sacrificed for excessive risk-taking at times.
    Would you elaborate on your point that, ``the greater 
leverage reflects a significant funding cost advantage,'' for 
larger firms? I agree with your views that this represents a 
gross distortion of marketplace, and is an exploitation of an 
unearned advantage.
    Can you help us better understand this point, sir?
    Mr. Hoenig. I hope so. The way I would start, is if you 
look at my final comments, with how much additional capital it 
would take to have what I think is a reasonable leverage ratio 
in terms of tangible capital, you would have to raise over $300 
billion equity.
    Equity is more expensive, and therefore, by not having to 
raise that, to be allowed to have a higher leverage ratio, your 
cost of funding was, in effect, less, because smaller 
institutions, who are not ``too-big-to-fail,'' of course, don't 
have that advantage.
    So you really have biased the outcome towards the largest 
institutions. They don't have to raise as much capital; 
therefore, their costs are less; plus, they're thought to be 
``too-big-to-fail.'' Therefore, their credit costs, as well, 
are less than you would have in a regional bank that everyone 
knows could be closed if it were to fail.
    So that's a huge advantage, and it perpetuates the ever-
increasing size and consolidation of the financial industry, 
because, think about it. If you're on that borderline as being 
thought ``too-big-to-fail,'' you have to go and get a merger 
partner and get above that threshold and bring your costs down. 
So it has a very perverse incentive system, that I think harms 
us.
    Chairman Moore of Kansas. Thank you, sir. At the end of 
your testimony, Mr. Hoenig, you note that critics will oppose 
more conservative capital ratios on the grounds it will 
restrict growth. You admit it will, but the point that everyone 
seems to miss is that runaway, excessive growth and dependence 
on leverage and debt is unsustainable and dangerous, and puts 
all Americans at risk.
    We need to return to a more sustainable and responsive--do 
we need to return to a more sustainable and responsible use of 
leverage and debt; is that correct?
    Mr. Hoenig. Absolutely correct, sir. I'm convinced--I have 
been told many times that, if you put these leverage 
constraints, you make it a rule of, say, 15 to 1, that during 
the growth period, you will constrain growth.
    And my answer is, yes. That's the nature of sound fiscal 
management, that your capital requirements limit you. So if you 
want to go out and grow your balance sheet, you have to raise 
new capital to do so, which keeps it sounder, but also keeps 
the growth from running away.
    So, under those conditions, under having firm rules, the 
capital ratios become countercyclical. When you allow them to 
move, they become less restrictive during the growth period and 
more restrictive during the recession. You get a procyclical 
outcome. The boom is bigger, and the recession is much worse. 
And that's what we want to avoid. I think this would do it.
    Chairman Moore of Kansas. Thank you, sir.
    Mr. Walker, thanks for your years of public service, and 
what you have done to raise awareness about our long-term 
budget challenges.
    First, I think you make a great point in your testimony 
that all debt and leverage is not bad, and with its responsible 
use, it can lead to productive economic activity. But like our 
addiction to foreign oil, and the dangers it poses to our 
national security, you note that, ``our low savings rate and 
large spending appetite, America has become unduly reliant on 
foreign investors to finance our Federal deficits and debt.''
    Would you explain, sir, how our dependence on excessive 
debt may be a threat to our national interests in a little more 
detail, if you would, sir, please?
    Mr. David M. Walker. Yes, I will.
    First, the fastest-growing expense in the Federal budget 
today is not health care costs, although they do threaten our 
future. It's interests costs. Within 12 years, without a risk 
premium for interest rates, the single largest line item in the 
Federal Government's budget will be interest on the Federal 
debt, and we get nothing for that.
    If we have to start paying a risk premium, say 200 basis 
points, or 2 percent, by 2040, the only thing the Federal 
Government could pay, based on historical revenue levels, is 
interest on the Federal debt. We get nothing for it.
    So the fact is, we have to recognize that, by having 
excessive leverage, we are crowding out our ability to invest 
in our future. In addition to that, we are increasing the risk 
of passing a tipping point, whereas foreign investors may 
decide that they want to charge us higher interest rates in 
order to offset any potential risk, not as much of default, but 
of a significant reduction in the value of our currency and, 
therefore, their effective yield.
    We are a great country, and we benefit from the fact that 
we have about 62 percent of the world's global reserve 
currency. That gives us more rope. It gives us more time. But 
ultimately, we are not exempt from the fundamentals laws of 
prudent finance; and yet we act like we are.
    We're talking about our future national security, our 
future international standing, and our future standard of 
living.
    I think we have to recognize reality. There are two kinds 
of taxes: current taxes; and deferred taxes. And to the extent 
that you run large deficits, those represent deferred taxes 
that will have to be paid with interest.
    So this is not just an economic and national security 
issue; it's a moral issue.
    Chairman Moore of Kansas. Very good point. Thank you for 
your answer to my question, sir.
    The Chair next recognizes Ranking Member Biggert for 5 
minutes.
    Mrs. Biggert. Thank you, Mr. Chairman.
    Mr. Hoenig, the bill that is before us, the regulatory 
reform bill that Democrats have proposed, isn't it, if they 
have the ``too-big-to-fail'' that's a problem, isn't it likely 
that the leverage problems will become even worse in the 
future?
    Mr. Hoenig. If we fail to address the ``too-big-to-fail'' 
issue, then the leverage issue and the consequence from that 
will only get worse through the next cycle.
    In other words, all the banks are deleveraging right now, 
because of the pressure. But once the economy turns around and 
we begin to expand again, the leverage, the drive for leverage 
will increase as return on equity demands, return to investors 
becomes of paramount focus by that CEO, and the deleveraging 
will start again, and we will repeat the cycle, in my opinion.
    That's why we need to have in the legislation, firm 
leverage rules that the rule of law then dictates that, 
inhibits that from happening, and it will, in fact, inhibit the 
growth of some of these largest institutions by taking their 
advantage away.
    Mrs. Biggert. What, then, do we do when these--if they have 
funding advantages, and the creditors, since they seem to have 
a different status, the creditors will be more likely, when 
they monitor, not to be as vigilant when they look at the 
institution's leverage, so that it would go up.
    Is that a potential problem, too?
    Mr. Hoenig. As long as we do not address ``too-big-to-
fail,'' that is not a potential, but an immediate, real 
problem.
    The creditors have to be under--that's why I prefer a rule 
of law that takes away discretion from the bureaucrat or from 
the policy person, so that in the crisis, you don't have that 
option to bail out, so that you have to take certain steps, 
controlled, to prevent a financial meltdown as such, but we can 
do that, and then the creditor knows that they will be in line, 
and they will get--
    Mrs. Biggert. So it would be like an enhanced bankruptcy?
    Mr. Hoenig. That's correct. An enhanced bankruptcy for a 
failure process that assures everyone that the largest 
institution will be dismantled if it fails.
    Mrs. Biggert. Okay. How has recent Fed policy encouraged 
the use of debt financing?
    Mr. Hoenig. In the sense of the last of this past cycle, 
I'm on the record as saying that when you keep interest rates 
exceptionally low for an extended period, you are encouraging 
credit, because of course, it's cheaper to borrow than to raise 
equity, it's more convenient, and therefore, you encourage 
credit. So you add to the incentives by keeping interest rates 
lower than they would otherwise be under normal market supply 
and demand conditions. So that's one of the issues we have to 
confront.
    Mrs. Biggert. Thank you.
    Mr. Walker, then, you point out some alarming numbers, and 
alarming other things, too. And thank you for your testimony. I 
hope you don't scare everybody to death.
    Regarding the Federal debt, when you account for the debt 
owed to Social Security, Medicare, and the total GSE 
liabilities, what should be done regarding the GSE debt?
    In other words, you talk about mandatory spending, and we 
have to reduce that? Really, discretionary spending is not near 
the amount of the mandatory. But how does the GSE liability fit 
in there, and what should be done with their debt, and can we 
continue to really continue to fund Fannie and Freddie as we're 
doing now?
    Mr. David M. Walker. First, in my personal view, the debt 
that's owed to the Social Security and Medicare trust funds 
should be deemed to be a liability.
    On one hand, we hold it out as an asset of the trust funds. 
We tell the beneficiaries of those programs that you can count 
on it, it's guaranteed by the full faith and credit of the 
United States Government, both as to principal and interest. We 
won't default on it. But yet, right now, it's not considered a 
liability.
    And so, therefore, if it was, and by the way, it is part of 
the total debt subject to the debt ceiling limit, our current 
debt to GDP ratio would be 89 percent, and rising rapidly.
    The issue of Fannie Mae and Freddie Mac is a little 
different. We do account for transactions, such as the $100 
billion plus that we have already provided to them. The 
Treasury has now effectively guaranteed trillions of dollars of 
Fannie Mae and Freddie Mac debt. That's a contingent liability. 
But now, the Federal Government essentially controls Fannie Mae 
and Freddie Mac, and one of the questions that's going to have 
to be answered for this year's financial statements is, should 
they be consolidated into the financial statements of the 
United States Government.
    Current accounting allows for that not to happen if it's 
temporary. It's not so clear to me how temporary this situation 
is, and so it's something that's very serious and we need to 
focus on it.
    Bottom line, we're in worse shape than we tell people, and 
we need to recognize reality, that we're not exempt from the 
fundamentals of prudent finance. We also need to do what it 
takes to avoid what's happening in Europe right now.
    Mrs. Biggert. Thank you. My time is up. I yield back.
    Chairman Moore of Kansas. Thank you.
    The Chair next recognizes, Mr. Lynch, from Massachusetts. 
Sir, you have 5 minutes.
    Mr. Lynch. Thank you, Mr. Chairman.
    I want to thank you both for your willingness to come 
before the committee here today, and I also thank you for the 
frankness of your testimony; and I share a lot of the same 
sentiments about where we're heading.
    One of the particular areas I think that--let's go to the 
``too-big-to-fail'' discussion. We talked about the 10 banks 
that really exceeded, by everyone's estimate, the existing 
capital structure regulation, and they accomplished that. We 
had regulations in place about how much leverage there could be 
for these banks.
    What they did is, they used derivatives, they used these 
special purpose vehicles, used them by several names, but 
basically, in many cases, they contained these collateralized 
debt obligations, or collateralized loan obligations, and they 
moved that debt off their balance sheet.
    And that way, they were able to stay within the regulatory 
framework, at least nominally, until it hit the fan, and these 
folks had to take all that stuff back on their balance sheets 
because there were no buyers, and those investments basically 
deteriorated.
    That practice allowed these banks to become ``too-big-to-
fail,'' in my opinion.
    I'm just wondering what you think about the Senate version 
of financial services reform, and also the House version, where 
we put some limits on these derivatives, we have established 
exchanges, which provides for transparency, we have provided 
for clearinghouses, and I'm a little bit nervous, because it 
still allows these clearinghouses to be owned by these 10 
banks. As a matter of fact, 5 of the banks own 97 percent of 
all the clearinghouses, and that troubles me greatly.
    But there's also a dark market that is maintained, for 
unilateral trading of these complex derivatives that go on 
between individuals. And so, I'm nervous about the perpetuation 
of this practice of moving stuff off the balance sheet, and 
that has allowed this leverage to go on.
    I would just like to hear from each of you whether or not 
you think my fears are unfounded, or perhaps you might suggest 
a way of getting at that.
    Thank you.
    Mr. Hoenig. I think your fears are well-founded. I think 
the amount of off-balance-sheet activities with certain kinds 
of derivatives and synthetic derivatives have contributed to 
this crisis. I think that would be hard to refute, actually.
    I do believe that the legislation should provide, number 
one, for better disclosure and for requiring these institutions 
to keep a portion of that on their balance sheet, whether it's 
5 percent or 10 percent, so that you can monitor, and they have 
some skin in the game, if you will, to monitor that off-
balance-sheet activity. That's number one.
    Number two, on your exchanges, I'm very strongly supportive 
of a clearinghouse, but even exchanges, where you bring it to 
the light of day. A market discovery price is more available, 
people can, not behind the scenes this dark market manipulate 
to, say, push something so they can gain in a short position, 
and so forth.
    I know there's a lot of discussion right now in the Senate 
on those particular industry players, but I think that can be 
dealt with, and the main objective should be to get 
transactions in the open, that is, a clearly regulated exchange 
or clearinghouse--it has rules that it abides by--would be the 
best outcome for the American people, and for the financial 
industry, actually.
    Mr. David M. Walker. I think, clearly, with regard to the 
private sector, there's no question that there need to be 
tougher capital requirements, that also give appropriate 
consideration to derivatives.
    In addition, there needs to be more transparency, no 
question, and better oversight than historically has been the 
case.
    But let me remind you that you're correct, Congressman 
Lynch, that these special purpose entities and the use of 
derivatives didn't serve to mitigate risk but to enhance risk, 
which was part of the problem.
    The Federal Government has special purpose entities, too. 
They're called trust funds. And one could argue that GSEs might 
be deemed to be special purpose entities, too.
    So we need to practice what we preach. We need to do what 
we need to do with regard to institutions and instruments that 
represent systemic risk, but we also need to put our own 
financial house in order, and make sure that we're leading by 
example, and practicing what we preach.
    Mr. Lynch. Thank you. I yield back.
    Chairman Moore of Kansas. Thank you, sir.
    The Chair next recognizes Mr. Driehaus for 5 minutes.
    Mr. Driehaus. Thank you very much, Mr. Chairman. Thank you 
for holding this hearing.
    And I appreciate the testimony of the two witnesses. I 
think it's an issue that, while we talk about it from time to 
time on the surface, very rarely do people dig down and try to 
get toward solutions when it comes to our indebtedness.
    I was very interested, Mr. Walker, specifically, in some of 
the solutions that you had focused on in your testimony, one of 
those being the issue of tax expenditures, which I think the 
vast majority of Americans pay very little attention to. This 
idea that we, as the Federal Government, forego over $1 
trillion in tax revenue is very serious.
    I describe it as a revenue stream that looks like Swiss 
cheese, because of all of the carveouts that exist, not just--
and it happens in the States as well as in the Federal 
Government.
    But what ends up happening is the rates that are then 
applied don't really bring in the revenue that it's suggested 
that they otherwise might. Instead, you have a situation where 
government is picking winners and losers in the economy, which 
only leads to a declining revenue stream.
    The challenge, though, is that anytime you try to close one 
of those loopholes, anytime you try to close one of those 
intentional carveouts, you're accused of raising taxes.
    As you look at The President's Commission to Address the 
Deficit and the Debt, how do we treat the Tax Code, especially 
tax expenditures, so that they're no longer being viewed as 
political football, but that we have a long-term, sustainable 
tax policy that businesses in the United States can actually 
count on, while actually lowering the rates, in my opinion, 
because I think you can close a lot of loopholes, and 
dramatically lower the rates.
    But I would be very interested in your comments.
    Mr. David M. Walker. First, there are two kinds of 
spending. There's front-door spending, which is about $3.8 
trillion for this year. And there's back-door spending, which 
is the revenue that we lose because of tax preferences, 
deductions, exemptions, exclusions, credits, etc., over $1 
trillion a year.
    They're not in the budget. They're not in the financial 
statements. They're not part of appropriations. And they're not 
systematically reviewed for reauthorization. That has to 
change.
    We have to take a hard look at them to understand whether 
or not their future focused, results oriented, to try to 
understand who is benefitting from them. And, in many cases, 
quite frankly, they fuel problems.
    For example, the largest tax preference is the exclusion 
from individual income and payroll taxes of employer provided 
and paid health care. That fuels health care cost increases. It 
creates great inequities between the haves and the have-nots.
    So I think it's important that be on the table. It has to 
be part of comprehensive tax reform.
    And, quite frankly, I think ultimately the Federal 
Government is going to have to employ a special process, 
possibly with outside experts, to go through a disciplined, 
independent review of major spending programs, both front-door 
and back-door, and to make recommendations on what the Congress 
should consider doing to put us on a more prudent and 
sustainable path.
    There's no question that we need comprehensive tax reform, 
and that if we broaden the base, we can keep rates low and, in 
fact, potentially even lower, especially on the corporate side, 
for competitiveness reasons.
    At the same point in time, I can also tell you that, 
because of a very simple principle, math, taxes are going up. 
There's no way that we can solve our structural fiscal 
imbalance solely on the spending side--although my personal 
view is we have to do more on the spending side of 
reprioritization and constraint than on the revenue side--but 
we're going to have to have more revenues.
    And the longer we wait to come to the realization that we 
have to make tough choices on both sides, the bigger the change 
is going to have to be, the less transition time, and the more 
risk of passing a tipping point.
    Mr. Driehaus. Would you support a systemic process within 
the Congress, a litmus test, if you will, so that any Member, 
coming before the Ways and Means Committee or any other 
committee, with a tax expenditure, would have to meet a set of 
criteria in order for the tax expenditure to even be 
considered?
    Mr. David M. Walker. Absolutely. I think we need a set of 
criteria for direct spending and indirect spending.
    Believe it or not, this country has been in existence since 
1789, and it has never had a strategic plan.
    Believe it or not, this country doesn't have a set of 
outcome-based indicators--economic, safety, security, social, 
environmental--to assess what's working and what's not, and how 
do we compare to others.
    Believe it or not, we have never gone through a systematic 
review of major tax preferences or spending programs to find 
out whether they're future-focused, delivering results, 
affordable, and sustainable.
    It's about time.
    Mr. Driehaus. Mr. Hoenig, I don't know if you have any 
comments on tax--
    Mr. Hoenig. I would answer one thing, though, that plays on 
this, that I think is important.
    If we don't address the issues, front-door, back-door, the 
issues you're bringing up, I'm absolutely confident that there 
will be mounting pressure on the Federal Reserve system to help 
finance this through monetization of debt, and the outcome for 
that for this country is inflation at some point in the future. 
And of course, that is a tax.
    Mr. Driehaus. Yes.
    Mr. Hoenig. And it's the most regressive tax we can put on 
the American people.
    So it's important, I agree so much with Mr. Walker, that we 
address this starting now in some systematic fashion, or we 
will pay dearly a generation, or a lot sooner than that, ahead 
of us.
    Mr. Driehaus. Thank you, Mr. Chairman.
    Chairman Moore of Kansas. We have a little bit of time 
left. If it's okay with the witnesses, if you're okay with 
this, we're going to each ask one more question, if that's all 
right, if people have the questions.
    Mr. Hoenig, when considering a leverage ratio cap of 15 to 
1, would you include off-balance-sheet assets in that number, 
and how do those get considered in monitoring leverage?
    Mr. Hoenig. What I would tend to do is require a portion of 
the off-balance-sheet to be counted on the balance sheet.
    If you originate it and push it out, you keep a portion of 
it, and then your leverage against that.
    Because I think the fact that you constrain the leverage to 
that very hard number, and keep a fair amount of the off-
balance-sheet then in your calculation, you will constrain the 
use of off-balance-sheet activities. Otherwise, it becomes very 
complex.
    One of the issues in our past crisis around capital is, 
frankly, the Basel capital standards, which were so complex 
that they were gamed almost immediately by the institution that 
wanted to leverage out.
    So the simpler, the more direct, the better.
    Mr. David M. Walker. If I may, Mr. Chairman--
    Chairman Moore of Kansas. Mr. Walker, yes, sir.
    Mr. David M. Walker. --on that.
    First, to me there's a difference between how do you treat 
them for capital requirements and for regulatory purposes, and 
what do you do with them from an accounting standpoint.
    I don't think that Congress should set accounting 
standards. We could be in real trouble if that happens. But I 
do think that you have to give consideration, as has been 
mentioned, about what do you do for purposes of capital 
requirements and regulatory heft.
    Chairman Moore of Kansas. Thank you, sir.
    The Chair next recognizes the ranking member, Ms. Biggert, 
if you have a question.
    Mrs. Biggert. Thank you, Mr. Chairman.
    This testimony has been really, really good. Thank you.
    Could you just, each of you, say what would be the first 
three things that you would do right now, that we can do 
immediately, to stop the bleeding, to stop the debt increase?
    We'll start with you, Mr. Walker.
    Mr. David M. Walker. First, tell the American people the 
truth, which is what we're trying to do, about where we are, 
where we're headed, how do we compare to other nations, the 
benefits of acting sooner rather than later, the dramatic kind 
of changes we're going to have to make, and the potential 
adverse consequences to our country and their families if we 
don't.
    That means engaging the American people outside the Beltway 
in ways that haven't been done, representative groups. And 
frankly, we're going to fund, along with the MacArthur 
Foundation and the Kellogg Foundation, an effort to do so in 19 
cities around the country on June 26th of this year, but that's 
just a beginning.
    We also are publishing this Citizens' Guide and 
distributing it, and each of you have a copy.
    Secondly, I think next year, we should reform Social 
Security to make it solvent, sustainable, secure, and more 
savings-oriented. It's a lay-up. You can miss a lay-up. But 
it's a high-percentage shot.
    I think there's pretty much a parameter of what needs to be 
done there. Social Security is not our biggest problem, but it 
would be a credibility enhancer and a confidence builder.
    Secondly, next year, I think we should enact statutory 
budget controls--spending constraints, etc.--that will take 
effect once we hit certain triggers relating to economic growth 
and unemployment.
    And then, beyond that, I think that we need to set the 
table for what will be very tough choices for health care cost 
reduction, which the last bill really didn't do much on, and 
for comprehensive tax reform that will improve the economic 
growth, enhance our competitive posture, and generate more 
revenues.
    Those things, I think, are going to have to be done 
together, because they're going to involve very tough choices 
and you're going to have to do tradeoffs and probably deal with 
it as a package.
    Mrs. Biggert. Thank you.
    Mr. Hoenig?
    Mr. Hoenig. I would add--I think those are great 
suggestions--I think there needs to be brought forward to the 
American people a realization that we have to engage in a 
shared sacrifice, if you will, that we're all going to have to 
take a hit, because I find that we all want to do this, but not 
for our particular area, our particular project. And there has 
to be this education, communication that would take that 
forward.
    I think that has to also be incorporated into the 
congressional process. In other words, we are going to take 
this forward as a Congress, not as a party, and so we can deal 
with this.
    And then I do agree, we need to put budget constraints on 
ourselves that force us then to then face up to these shared 
sacrifices and these cuts and these taxes that are ours to 
face.
    Mrs. Biggert. Thank you.
    Chairman Moore of Kansas. Shared sacrifice. What a radical 
notion. That's really something I agree with.
    You're recognized, Mr. Lynch, for up to 5 minutes.
    Mr. Lynch. Thank you. Thank you, Mr. Chairman.
    Mr. Walker, you're passing comment regarding the recently 
passed health care bill, and I cannot ignore that.
    I'm one person who voted against that for precisely the 
reason that you raised, that the idea at the beginning of the 
health care debate was that, since we were paying 3 times as 
much as any other nation on health care, that we would squeeze 
down the costs and use the savings to pay for some health care 
for the people who weren't covered.
    And I know I disagree with a lot of my colleagues on this, 
but, it's sort of like throwing an anchor to a drowning man, 
from a budgetary standpoint, committing $1 trillion when we 
have all these problems on our plate.
    Mr. Hoenig, I read your comment on that, and I think both 
of you have said that we have to realize that the rules of 
finance apply to us, and that goes for the Fed, that goes for 
Treasury, and that goes for the people in Congress, and to the 
President, that the rules of finance apply to us.
    And sometimes around here, we act like there's no 
connection at all to what we do and what we pass and someone 
who's going to have to pay the bill somewhere down the road.
    I read recently, in my clips here, I can't track it down, 
but Moody's--and this was regarding the discussion with Greece 
and Spain and Portugal and Ireland, and Moody's--someone at 
Moody's made a statement that the United States ought to be 
careful, because based on the amount of debt that we're 
acquiring here, and the track that we're on, that we could lose 
our AAA bond rating, and that would be devastating, to increase 
greatly the cost of our borrowing, and the loss in confidence 
in the United States.
    And I was wondering if you could comment on that, and what 
the repercussions might be if the financial markets, given how 
we're running our business here, called the United States of 
America, if there were loss of confidence and we were to lose 
that AAA bond rating.
    Mr. Hoenig. I think your concern is very legitimate. And 
I--whether it's a financial institution or a company or the 
U.S. Government, I have a saying that, based on my experience, 
once there is a shred of doubt, it's too late.
    Mr. Lynch. Right.
    And so, we're now in a position where we see this wave 
coming at us, and we can do something about it. But once it 
gets to our shores, if you will, and this doubt enters, then we 
will see it reflected in our interest rates, in our value of 
our currency, and in our future wealth.
    So we need to do it now. Doubt is going to be the outcome, 
and that will be a very expensive proposition for us all.
    Mr. David M. Walker. About a year ago, the major rating 
agencies downgraded the outlook for Great Britain to maintain 
its AAA credit rating. It didn't downgrade their rating. It 
downgraded the outlook.
    Our ratios on total public debt are worse than Great 
Britain. If we fully accounted for the trust fund obligations 
and other activities, even with regard to the Federal level, 
they're worse.
    And so I think the fact of the matter is, we benefit from 
having 62 percent of the world's global reserve currency, and 
secondly, home team bias. Most rating agencies are based here.
    And in my view, there's absolutely no question, on the path 
that we're on, one would have to seriously question how long we 
will retain a AAA credit rating under our current path. We 
shouldn't get to that point.
    And that's why, last month, we surveyed about 100 top 
former leaders, from Congress, the Executive Branch, and the 
Federal Reserve. Chairs and ranking members of Finance, Ways 
and Means, the Budget Committees, Treasury Secretaries, Fed 
Reserve Board members, Treasury Secretaries, OMB directors, CBO 
directors.
    There was 100 percent agreement, with a 60 percent response 
rate roughly, that we're on an unsustainable path. Super-
majority agreement that we must take concrete actions within 1 
to 2 years to avoid the risk of passing a tipping point. 
Numbers like that are clear and compelling.
    So we have to move past denial. We have to move past delay. 
We need a plan, and we have to start acting.
    Mr. Lynch. Thank you both.
    I yield back.
    Chairman Moore of Kansas. Thank you, sir.
    Mrs. Biggert. Mr. Chairman, could I ask unanimous consent 
to allow Mr. Royce from California to--he's a member of the 
general committee, but--
    Chairman Moore of Kansas. Certainly. Without objection, it 
is so ordered.
    Mr. Royce, you're recognized for 5 minutes.
    Mr. Royce. I appreciate it, Mr. Chairman.
    I had a question for Mr. Hoenig.
    In a recent book co-authored by two economists, Rogarth and 
Reinhart, they note the painful consequences of the rising 
government debt load that often follows financial implosion, or 
a financial crisis. And despite vocal warnings from economists, 
the United States is following the pattern that they set out, 
rather blindly.
    We were overleveraged prior to the financial crisis, but 
the Federal Reserve and the U.S. Government have lent or spent 
or guaranteed about $8.2 trillion to prop up the economy in the 
last 2 years.
    And a quarter--you also throw into the mix here that 
Chairman Bernanke has said our budget deficits and the budget 
proposal put forward by the Administration, going forward, is 
unsustainable. So we don't see things getting better with these 
trillion dollar deficits that we are budgeting for now.
    The IMF and the OECD are projecting that the stock of 
public debt in advanced economies is going to double and reach 
an average level of 100 percent of GDP in the coming years.
    So I would ask you, we have been through a financial crisis 
where much of the private sector debt was simply transferred to 
the Federal Government. In essence, that's the bottom line. And 
that's contributed, then, to these unsustainable Federal 
deficits.
    So where does this road lead; and do you foresee a 
financial crisis that now morphs instead into a sovereign debt 
crisis here in the United States?
    Mr. Hoenig. I think that the steps that were taken in the 
crisis to staunch it, to end it, were taken aggressively. I 
think now we have to be prepared to reverse that, and we need 
to do it carefully and systematically, but we need to reverse 
it.
    These debt levels that we have been talking about here this 
morning, whether it's the financial institutions, the Federal 
Government, and even the Federal Reserve's balance sheet, need 
to be addressed and reduced. And I think that's paramount.
    Or, as Rogarth and Reinhart have shown, we will compromise 
our future and, as we have been talking here this morning, it 
will as well, and I think, as I said earlier, there will be 
increasing pressure.
    If this isn't addressed sooner and systematically, and 
people don't have confidence that we're going to address it, 
then we will see pressure for the Federal Reserve to monetize 
more of this debt, inflationary pressures will rise, and there 
will be a strong impact on the dollar, long-term, and on our 
Nation's wealth.
    So it's--
    Mr. Royce. That is the concern of a number of economists, 
that the path of least resistance here might be runaway fiscal 
deficits which will then be monetized by the Federal Reserve.
    I think you recently gave a speech highlighting the 
possibility that Congress could soon be knocking on the Fed's 
door to monetize the debt.
    Mr. Hoenig. Right.
    Mr. Royce. Are you concerned with the precedent that has 
been set by the Fed in this regard, because last year, the Fed 
bought $1.8 trillion of Treasury securities and agency debt?
    And the other issue that I just asked about, which comes 
out of that same book by Rogarth and Reinhart, is that the 
buildup of excessive debt, they say, inevitably leads to 
stagnant economic growth going forward, which you alluded to. 
Clearly, there is the need for deleveraging that lies ahead for 
our economy, both in government and privately held debt, and 
instead, we seem to be piling on, especially if you look at the 
increases in all of the agency spending, the appropriations, 
the separate appropriations bills, which go up by double 
digits.
    Do you foresee a stagnant economy, as long as this level of 
debt remains? What's your forecast here?
    Mr. Hoenig. First of all, yes, I am concerned by the 
precedent set, and I think we need to, that's why I say we need 
to reverse that quickly to bring our balance sheet back down. 
We need to do it systematically and carefully, but we need to 
do it.
    If we don't, and we get ourselves into an environment of 
growing debt, unsustainable, as Mr. Walker had pointed out, and 
we then put pressure to monetize it, which would cause us to 
have inflation, we will endanger our economy and stagnation is 
a possibility. It's unavoidable, if we don't take action now.
    Mr. Royce. Thank you, Mr. Hoenig.
    Mr. David M. Walker. Congressman, if I can respond quickly?
    Mr. Royce. Absolutely.
    Mr. David M. Walker. First, on my testimony, I talked about 
the four parallels between the factors that caused the 
mortgage-related subprime crisis and the Federal Government's 
own finances. We need to learn lessons from that.
    Secondly, with regard to the book you're referring to, I 
think it refers to the fact that once you have debt equal to 
about 90 percent of the economy, then it has an adverse effect 
on economic growth; and once you get to 100, it's very 
troubling.
    If you count the Social Security and Medicare debt, we're 
at 89 percent, and growing rapidly. That doesn't count the GSEs 
and things of that nature.
    And then lastly, you can't monetize your way out of this 
problem, and let me tell you why: because, while monetizing 
your way out, which creates an inflation risk, might help deal 
with the current debt, and lessen the burden of the current 
debt, the real threat to the future of this country is the $45 
trillion in off-balance-sheet obligations, $38 trillion for 
Medicare alone, that grows faster than inflation and faster 
than the economy.
    You have to make tough choices. You need to do it within 2 
years, at least to start, or else we could be facing something 
that we don't want to see in this country.
    Mr. Royce. Thank you.
    Chairman Moore of Kansas. I thank the gentleman.
    And I would, at this time, like to thank our panel members 
here, Mr. Hoenig and Mr. Walker, for your testimony, and for 
answering our questions. It has been a very, very good 
exchange, and I very much appreciate that.
    I'm advised that votes will be called in the very near 
future, probably in the next 5 to 10 minutes, and I would like 
to excuse the first panel, and again thank you for your 
testimony and your service, and ask the second panel members to 
be seated so we can maybe just get at least preliminarily 
started here, and then move on.
    Thank you again.
    I'm pleased to introduce our second panel of witnesses, and 
please work with me and forgive me if I mispronounce any names 
here.
    First, we will hear from Ms. Orice Williams Brown, 
Director, Financial Markets and Community Investment at GAO.
    Next, will be Professor John Geanakoplos, James Tobin 
Professor of Economics at Yale University.
    Then, we'll hear from Professor Viral Acharya--excuse me. 
Will you pronounce it, sir? Okay--Professor of Finance, Stern 
School of Business at New York University.
    And finally, we'll hear from another David Walker, a 
different David Walker, Professor David A. Walker, who is the 
John Largay Professor at the McDonough School of Business at 
Georgetown University.
    Without objection, your written statements will be made a 
part of the record.
    Ms. Williams Brown, you're recognized, ma'am, for 5 
minutes.

STATEMENT OF ORICE WILLIAMS BROWN, DIRECTOR, FINANCIAL MARKETS 
AND COMMUNITY INVESTMENT, U.S. GOVERNMENT ACCOUNTABILITY OFFICE 
                             (GAO)

    Ms. Williams Brown. Thank you.
    Chairman Moore, Ranking Member Biggert, and members of the 
subcommittee, I appreciate the opportunity to testify before 
you this morning on the role of leverage in the recent 
financial crisis.
    As you know, the Emergency Economic Stabilization Act of 
2008 mandated that GAO study the role of leverage in the 
crisis. My statement today is based on that report.
    While the report covers a wide range of issues, I would 
like to highlight a few key points concerning how leverage is 
defined, its cyclical nature, how it's constrained, and 
regulatory limitations.
    The buildup of leverage during the market expansion, and 
the rush to reduce leverage or deleverage when market 
conditions deteriorated, was common with this and past 
financial crises.
    Leverage traditionally has referred to the use of debt 
instead of equity to fund an asset, and has been measured by 
the ratio of total assets to equity on the balance sheet. But 
the recent crisis revealed that leverage can also be used to 
increase an exposure to a financial asset without using debt, 
such as by using derivatives.
    Given the variety of strategies to achieve leverage, no 
single measure can capture all aspects of leverage.
    Our findings concerning the role of leveraging and 
deleveraging in the recent crisis reveal that leverage steadily 
increased within the financial sector before the crisis began 
in mid-2007, and banks, securities firms, and others sought to 
deleverage and reduce their risk during the crisis.
    While this work, which builds upon the work of others, 
suggests that efforts taken to deleverage by selling assets and 
restricting new lending could have contributed to the crisis, 
others noted that the crisis was the result of prices reverting 
to their fundamental values after a period of overvaluation.
    These varying perspectives illustrate the complexity of the 
crisis, and, given the range of assets involved, are not 
necessarily contradictory.
    Moreover, some argue that leverage created vulnerabilities 
in the market that increased the severity of the crisis.
    In addition, subsequent disorderly deleveraging by 
financial institutions may have compounded the crisis.
    For example, some studies suggest the efforts taken by 
financial institutions to deleverage by selling financial 
assets could cause prices to spiral downward during times of 
market stress, and exacerbate a financial crisis.
    Second, the studies suggest that the deleveraging by 
restricting new lending could slow economic growth. However, 
other theories also provide possible explanations for the sharp 
price declines observed in certain assets.
    The issues raise questions about how leverage is 
constrained, which varies by type of institution.
    For example, for federally regulated institutions, 
regulators can limit leverage through minimum-risk-based 
capital, leverage ratios, and liquidity requirements. However, 
for other institutions such as hedge funds, market discipline 
supplemented by regulatory oversight of institutions that 
transact with them, conserve to constrain their use of 
leverage.
    The crisis revealed limitations in the regulatory 
approaches used to restrict leverage.
    For example, regulatory capital measures did not always 
fully capture certain risks, which resulted in some 
institutions not holding capital commensurate with their risk 
and facing capital shortfalls when the crisis began. Moreover, 
regulators faced challenges in countering cyclical leverage 
trends.
    The crisis also revealed that, with multiple regulators 
responsible for individual markets or institutions, none has 
clear responsibility to assess the potential effect of the 
buildup of system-wide leverage or the collective effect of 
institutions' deleveraging activities.
    Finally, a lesson of the crisis is that an approach to 
supervision that focuses narrowly on individual institutions 
can miss broader problems that are accumulating in the 
financial system. In that regard, regulators need to focus on 
system-wide risks to and weaknesses in the financial system, 
not just individual institutions.
    In closing, I would like to note that, since the onset of 
the crisis, regulators have continued to re-evaluate capital 
standards, namely, Basel II, and the countercyclical nature of 
leverage and capital.
    However, efforts to monitor leverage must include a 
mechanism to evaluate the amount of leverage in the system, in 
order to better identify and mitigate potential systemic risk.
    Mr. Chairman, Ranking Member Biggert, this concludes my 
oral statement, and I would be happy to answer any questions at 
the appropriate time.
    [The prepared statement of Ms. Williams Brown can be found 
on page 214 of the appendix.]
    Chairman Moore of Kansas. Thank you for your testimony.
    The Chair next recognizes Professor Geanakoplos.
    You're recognized, sir, for 5 minutes.

    STATEMENT OF JOHN GEANAKOPLOS, JAMES TOBIN PROFESSOR OF 
      ECONOMICS, DEPARTMENT OF ECONOMICS, YALE UNIVERSITY

    Mr. Geanakoplos. Thank you for inviting me to talk today 
about managing leverage, managing the leverage cycle.
    For a long time, we have recognized the need to manage 
interest rates. That's what the Federal Reserve does. But we 
don't have a regulator to manage leverage. And I have written 
about this for 10 or 15 years.
    I wasn't the first one to think of this idea. Shakespeare, 
400 years ago, in The Merchant of Venice, explained, in a 
negotiation over a loan, you had to figure out not only the 
interest rate but also the collateral. And if we ask, which did 
Shakespeare think was the more important, nobody can remember 
the rate of interest that Shylock charged, but everybody 
remembers the collateral, the pound of flesh.
    The play ends, by the way, with the regulatory authority of 
the court deciding not to change the interest, not to change 
the principal, but to change the collateral. It should have 
been a pound of flesh, but not a drop of blood. And that's what 
I'm advocating today, that we manage leverage, and not manage--
pay so much attention to interest rates.
    I'm talking about securities leverage. When you have a 
house at 20 percent downpayment, that means a 5 to 1 leverage, 
the cash divided into the amount of assets. That's what I'm 
talking about.
    The reason I wrote about this is, there's a puzzle in 
economics: how could it be that one supply-equals-demand 
equation determines two things, the interest rate and the 
leverage, or the amount of collateral? In my theory, it does. I 
resolved that problem.
    So leverage is important for three reasons, two of which 
people know: The more leveraged you are, the riskier your 
situation. If the asset changes by 1 percent, your profits go 
up by 5 percent, if you leverage 5 to 1. Also, there's no 
recourse aspect of collateral. You can walk away from your 
house, and if the house goes to zero, you lose the $20 you put 
down.
    But there's a third aspect of leverage that didn't get so 
much attention, which is the main thing I have called attention 
to, which is that, with a lot of leverage, a very few people 
can own all the assets, and the implication of that is, the 
more leverage in the economy, the higher the asset prices; the 
less leverage, the lower the assets prices.
    The reason for that is, if you think of people, the buyers, 
on a continuum for the most enthusiastic at the top to the 
least enthusiastic, wherever the price is, the people above who 
are going to think that it's a good deal, and they'll be 
buyers; the people who are less optimistic will think that it's 
a bad price, and they'll be sellers.
    If you allow leverage in the system, the marginal guy, the 
guy on the threshold of buying or selling, his opinion is 
determining the price. If leverage goes up, you need fewer 
people at the top to buy all the assets. The marginal guy, on 
the threshold, is higher, and so the price now reflects his 
opinion, which is a higher opinion, because he's a more 
optimistic person. That's why prices go up when there's more 
leverage.
    The reason for this heterogeneity between people more if 
some people are more risk-tolerant, some people like to live in 
the houses more, many reasons, some people are more optimistic.
    So the leverage cycle is that there's too much equilibrium 
leverage in normal times, and therefore, too high asset prices, 
and then suddenly there's too little leverage in a crisis, and 
therefore, too low asset prices. And this bouncing up and down 
of asset prices is very harmful to the economy.
    The crisis always begins the same way. There's bad news, 
but it's not just bad, it's scary. For example, they tell you 
your plane is 10 minutes late. Well, 10 minutes isn't so bad. 
It's that you start to worry maybe it's going to be an hour or 
two late.
    A bank announces it's going to lose $5 billion. That's not 
the end of the world. But if it's going to lose $5 billion, 
maybe it will lose $10 billion. And that's what you're worried 
about.
    Or delinquencies in the home--homeowner delinquencies go 
from 1 percent to 5 percent. The real problem is people now 
think they might go to 30 percent.
    So the next stage is, the lenders get nervous, and they cut 
lending, and they increase margins, and leverage starts to 
collapse, and then the optimistic buyers, when the prices are 
going down, they lose all their money.
    So a price might go down from 95 to 69, not because anybody 
thinks their own information justified--the bad news isn't 
enough for anyone to think it should go down that far.
    But the optimists who bought at the beginning, the top 13 
percent, say, when the price starts to go down, they get wiped 
out.
    Then the next group, who's going to buy after the crash, 
the next group are not only not as optimistic, but they can't 
borrow the money to buy it. So it takes a lot more of them to 
buy it.
    And so the marginal buyer goes way down, way below where he 
was before, and the price is lower, not because of the bad news 
alone, but because of these, the bankruptcy of the optimists 
and also because leverage is so far down.
    So that's my theory. And this has recurred over and over 
again, in 1994, 1998, 2007.
    So just to show you some data, there's a famous graph. That 
green curve, which is Schiller's home price data, it went from 
2000 at 100, 90 percent up, to 190, and then dropped to 130. 
And he called it irrational exuberance.
    But if you look at the downpayments, the purple, it went 
from, measured from the top, 14 percent down to 2.7 percent 
down, and then to 20 percent down. It reached the peak at 
exactly the same time.
    If you look at toxic mortgage security prices, they 
collapsed, went from 100 to 60, and now they're going back up 
to 80.
    If you look at the blue line, that measures downpayment 
again, in reverse direction, you see that leverage suddenly 
collapsed, and leverage went back up, and that's why prices are 
going back up.
    So, the leverage cycle was worse this time than all the 
previous times--I'm just going to go 20 more seconds--worse 
this time than all the previous times because the leverage 
wasn't just a few financial institutions, but millions upon 
millions of homeowners, and so we had a double leverage cycle, 
millions of people plus our financial institutions, and also we 
introduced CDS, which is another way to leverage.
    So, what should we do about the leverage cycle? The most 
important thing to do is monitor leverage, securities leverage.
    Go to all the big financial institutions and ask, ``What is 
the downpayment you're requiring for housing, for securities 
that people are buying,'' and publish that data every month, 
and also measure people's leverage. Put CDFs on exchange and 
regulate leverage in normal times. Don't let banks make 2 
percent downpayment loans on houses and banks lending on 
mortgage securities.
    The last thing is, people keep--this is my last slide--
people talk about monitoring leverage with the 15 percent rule 
that has been advocated by the previous panelists. In my 
opinion, that's a mistake. We should be looking at leverage at 
the securities level, not at the investor leverage. What's the 
downpayment on securities?
    Leverage can move from one institution to another. If you 
require 15 percent for some institutions, it will move to some 
other place. People can lie about their leverage. You can't lie 
about what the downpayment is, because there are two people you 
can check what the downpayment was.
    Thirdly, and most importantly maybe, leverage at the 
investor level goes in the wrong direction. When there's a 
crisis, and it's hard to get a loan, and the downpayments go 
way up, the bank, the investor leverage looks like it's going 
up, because their equity is disappearing, so debt to equity is 
going up, just when the leverage is actually collapsing in the 
system. And also, there's less pressure on a regulator to 
monitor security leverage.
    So I went over. Thank you.
    [The prepared statement of Professor Geanakoplos can be 
found on page 232 of the appendix.]
    Chairman Moore of Kansas. Thank you, sir, for your 
testimony.
    The Chair will next recognize Mr. Acharya--is that correct, 
sir--for up to 5 minutes.
    And I would advise the people in the room here that votes 
have been called. We have about 10 to 12 minutes, I think, for 
votes. So if we can get both of these last remaining witnesses 
for 5 minutes each, we would appreciate that.
    Sir, you're recognized.

  STATEMENT OF VIRAL V. ACHARYA, PROFESSOR OF FINANCE, STERN 
            SCHOOL OF BUSINESS, NEW YORK UNIVERSITY

    Mr. Acharya. Thank you, Mr. Chairman, and members of the 
subcommittee.
    Along with my colleagues at the Stern School of Business, 
New York University, I have co-edited two books on the 
financial crisis and co-authored research papers that help 
understand how the financial sector escalated its leverage 
before the crisis, and what can be done about it in future. 
Much of what I say today is based on this research.
    We seem to witness, on a somewhat regular basis, episodes 
in which financial intermediaries are all overextending credit, 
and are themselves funded with excess leverage. When the 
economic cycle turns downward, they fail in a wholesale manner 
requiring massive government interventions.
    While leverage has its bright side in expanding finance for 
households and the real economy, its dark side is precisely 
this boom-and-bust cycle. Unfortunately, this dark side has 
become enduring.
    With each cycle comes in place, more government 
intervention and guarantees of financial sectors debt, some 
explicit, such as deposit insurance, and others implicit, such 
as ``too-big-to-fail,'' or ``too-systemic-to-fail.''
    The result is that financial firms find it cheap to borrow 
and post their returns without sufficient regard for risks.
    One of the most salient such episodes was the period since 
2004, during which the financial sector in the United States, 
and in many parts of the Western world, grew its balance sheet 
at an unprecedented speed, and did so mainly through leverage.
    There were three primary failures, in my view, that led to 
this escalation of leverage: one, access to government 
guarantees that were not paid for, especially for the 
commercial banks and Government-Sponsored Enterprises; two, 
ineffective enforcement that allowed bank regulation to be 
arbitraged--that is, circumvented by a sophisticated financial 
sector; and three, in case of investment banks and the 
insurance sector, simply poor design of regulation.
    The end effect of these failures was that large and complex 
financial institutions, 10 of which owned over 50 percent of 
the financial sector's assets, operated at historically high 
leverage, in some cases exceeding 25 to 1, or, in other words, 
$24 of leverage on a $25 balance sheet.
    Much of this leverage was undertaken in the shadow banking 
world, the less-regulated, or unregulated part of the financial 
sector.
    This part of the financial sector consists of off-balance-
sheet entities that are connected to, but do not appear on bank 
balance sheets, borrowing and lending between financial firms, 
including through repos, or repurchase agreements, and the 
over-the-counter derivatives.
    Much of this leverage was also short-term in nature, to be 
rolled over each night or week, and yet it funded long-term and 
illiquid assets, such as subprime loans.
    This exposed the financial system to great risk from a 
secular economic downturn, and because the leverage was highly 
opaque, when financial firms failed, uncertainty about how 
losses would transmit to others paralyzed the system. In the 
end, the government and the Federal Reserve ended up bearing 
much of the losses.
    What can be done to deal better with this boom-and-bust 
cycle of leverage in the financial sector?
    In the interest of time, I'll focus only on those 
regulatory options that directly deal with leverage in good 
times.
    First, current capital regulation does not take into 
account the leverage structure of a financial firm's balance 
sheet. This major shortcoming should be addressed, for 
instance, by imposing a tax on leverage, or better, by 
introducing upper limits on leverage, such as 15 to 1, as has 
been employed successfully in other countries such as Canada; 
or better still, by embedding leverage information in 
supervisory tests to assess whether banks can withstand extreme 
losses in economic downturns.
    Second, the regulation of the shadow banking world needs to 
be brought in line with the on-balance-sheet regulation of 
financial firms. Any attempt to regulate leverage that ignores 
the shadow banking world would only lead to further growth of 
off-balance-sheet forms of leverage.
    In addition, greater transparency of the shadow banking 
world needs to be legislated so that regulators and market 
participants have timely and accurate information to understand 
and, if needed, restrict and discipline the leverage of 
financial firms.
    And last, but not least, the government should plan for a 
graceful exit from the large number of guarantees provided to 
the financial sector, not just as part of the rescue package in 
2008, but from well before. In particular, reform of the 
financial sector should also include reform of the Government-
Sponsored Enterprises.
    I'll be happy to provide more detailed proposals on these 
during the question-and-answer period. Thank you, Mr. Chairman.
    [The prepared statement of Professor Acharya can be found 
on page 44 of the appendix.]
    Chairman Moore of Kansas. Thank you, sir. Mr. Walker, you 
are recognized for 5 minutes. And votes again have been called, 
but I think we have time for your testimony.
    We're going to hear your testimony, then we're going to 
take a break for votes, and we'll be back for questions.

    STATEMENT OF DAVID A. WALKER, JOHN A. LARGAY PROFESSOR, 
      McDONOUGH SCHOOL OF BUSINESS, GEORGETOWN UNIVERSITY

    Mr. David A. Walker. Thank you.
    Chairman Moore, Ranking Member Biggert, and subcommittee 
members, thank you for this opportunity to testify in front of 
the House Financial Services Oversight and Investigations 
Subcommittee.
    I'm David A. Walker, the John A. Largay Professor in the 
McDonough School of Business at Georgetown University.
    Large firms that are managing their risk effectively are 
not necessarily too big, and our economy needs their services. 
Some mismanaged firms needed greater regulation. Some 
aggravated the financial crisis, and many of those have already 
failed. Breaking up a large firm that shows unreasonable risk 
would be much preferred to future bailouts.
    There are three recommendations I would like to offer to 
the committee: one, merge the Office of Thrift Supervision into 
the Office of the Comptroller of the Currency, as soon as 
possible; two, do not subject small insured depository 
institutions to unnecessary additional capital restrictions--
Basel I and Basel II are more than sufficient; and three, 
assign consumer financial protection responsibility to the 
FDIC, without creating a new agency and an additional 
bureaucracy.
    For the record, I submitted copies of two papers: a peer-
reviewed study on long-run credit growth in the United States, 
co-authored with Dr. Thomas Durkin, former senior economist 
with the Federal Reserve, and my Georgetown colleague, 
Professor Keith Ord; and a second policy paper on impacts of 
TARP on commercial banks, with Max Gaby.
    The issue Durkin, Ord, and I analyzed is how levels of 
consumer credit have changed over the past 60 years. 
Surprisingly, we show that the aggregate real consumer credit, 
adjusted for price increases, and excluding mortgage credit, 
has increased at about the same annual rate as real U.S. 
disposable income.
    Conclusions with regard to mortgage credit are very 
different, and with subprime lending, every segment of the 
industry had abuses.
    Perhaps the greatest problem in the housing crisis was poor 
supervision by the Office of Thrift Supervision. The failures 
of IndyMac and Washington Mutual were holding company thrifts 
supervised by the OTS. I believe that if all holding companies 
were supervised by the Fed, the results would be somewhat 
different. This would be just one more example where the 
independence of the Federal Reserve is essential.
    I'm a strong proponent of merging the OTS into the Office 
of the Comptroller of the Currency, and I wish the Congress 
could pass such a separate bill to accomplish this very 
quickly.
    Mark Flannery has proposed requiring large banks to hold 
debt instruments he calls contingent capital certificates. They 
would automatically convert from debt to equity if the market 
value of a large bank's equity fell below an established 
threshold. This eliminates regulatory delays and negotiations 
when a large bank might be in jeopardy.
    Leverage of insured depository institutions can be examined 
by a simple ratio that I have talked about in my testimony, 
where you take liabilities minus deposits as a ratio to Tier 1 
capital. My research shows that risky large banks and large 
savings and loans could be identified by this ratio.
    I recommend that you not create a new government agency for 
consumer financial protection. Please consider placing the 
responsibility within the FDIC.
    As an independent agency, with separate budget authority, 
many necessary consumer protection systems already in place, 
and an existing Consumer Affairs Department, the FDIC is 
ideally suited, in my opinion, to implement the consumer 
financial protection that the Congress deems necessary.
    The aggregate fiscal debt in the United States has 
increased dramatically since World War II under both Republican 
and Democrat--
    Chairman Moore of Kansas. Mr. Walker, may I interrupt you? 
And I apologize for doing this. We have 2 minutes and 15 
seconds left before the conclusion of votes, so I think we're 
going to have to stand in recess right now, and I would ask you 
if you would finish your--
    Mr. David A. Walker. Sir, I could finish in 30 seconds.
    Chairman Moore of Kansas. Very good. Thank you.
    Mr. David A. Walker. The IMF establishes a 5 percent 
country target maximum of fiscal deficit ratio to GDP. The 
Honorable David Walker has already talked about this in great 
detail, and I wouldn't attempt to repeat what he says. I just 
want to also urge the subcommittee not to burden the United 
States with any further taxes that are regressive, like the VAT 
tax.
    That concludes my testimony, and sir, I'm sure you 
appreciate that for academics to do anything in 5 minutes is 
monumental.
    [The prepared statement of Professor David A. Walker can be 
found on page 308 of the appendix.]
    Chairman Moore of Kansas. Same thing for Congress. And 
we're going to stand in recess right now. I thank the 
witnesses. We'll be back probably in about 20 or 25 minutes. If 
you can remain here for questions, I would appreciate it very 
much.
    Thank you.
    [recess]
    Chairman Moore of Kansas. The committee will be back in 
session.
    I'm going to recognize myself for 5 minutes.
    Ms. Williams Brown, thank you for presenting this very 
helpful report by GAO on leverage. I'm interested in GAO's 
observations with respect to leverage and international 
efforts, such as Basel II, to better supervise financial firms.
    As Congress finishes up writing financial regulatory 
reform, what steps should we take to coordinate our efforts 
with other countries to do two things: first, to better monitor 
and even understand leverage and risk-taking; and second, to 
better constrain excessive leverage?
    Ms. Williams Brown. I think any efforts that we take in the 
United States, we have to make sure they have a strong 
international component. I think the crisis made it very clear 
that the focus, the national focus also had a huge global 
effort.
    So in terms of Basel II, I think the United States has to 
continue to be very involved in that process, in making sure 
that we do a true lookback at Basel II to determine if we need 
to go back and have a fundamental reassessment of the current 
approach to determining regulatory capital.
    There have been efforts in the past several months to deal 
with certain issues, such as the procyclical nature of capital, 
and making sure that institutions are building up capital 
levels during the good times, so they aren't forced to do that 
in the midst of a crisis.
    But there are a number of other efforts that we need to 
continue to focus on from a global perspective, and Basel II is 
one place definitely to take a look.
    Chairman Moore of Kansas. Thank you.
    Professor Acharya, I had one thing that was troubling for 
our committee and Americans to learn at our recent hearing on 
the failure of Lehman Brothers, was how they used Repo 105 and 
other means to hide their excessive leverage.
    How concerned are you about debt masking, especially since 
the SEC depends on quarter-end reporting requirements? Is there 
a better way to monitor debt and leverage?
    Mr. Acharya. I think this ought to be one of the most 
significant concerns, especially if we are talking about 
regulating leverage, not just the use of Repo 105 by Lehman 
Brothers. Especially from 2004 until the middle of 2007, there 
was over $1 trillion of assets parked in what were apparently 
not balance sheet entities, which had direct connections back 
to bank balance sheets, but that were never consolidated, 
either for accounting purposes or for purposes of calculating 
regulatory capital.
    So one of the big messages, I think, from this crisis is 
that it's not just important to put in place a law with the 
right intention. I think the enforcement of the law, good 
enforcement of the law is equally important. And we really have 
to legislate the shadow banking world, because one of the 
reasons why the shadow banking world has developed is precisely 
to get around some of the important leverage and capital 
regulations.
    So I would say two things. Any leverage regulation that 
does not address the shadow banking world will simply push more 
leverage into the shadow banking world. And two, the right way 
to proceed is to legislate transparency so that regulators, on 
a high-frequency basis, can actually observe the leverage of 
these institutions, and provide timely aggregated reports to 
themselves, as well as to market participants.
    Chairman Moore of Kansas. Thank you, sir.
    Professor Walker, you say in your testimony, ``I believe 
that the TARP commitment was essential,'' and later say, ``Our 
economy would be rebounding much more slowly than it has if we 
had not implemented the TARP program.''
    Of course, a lot of Americans were very upset about TARP, 
and most of us who voted for it didn't feel good about it when 
we did it, but we felt we had to. And all the experts who 
looked at this said we didn't have an option.
    Will you elaborate, sir, on how, if TARP was not enacted 
into law, the situation might have been worse, not just for 
Wall Street, but for Americans and our constituents back home, 
if you agree with that?
    Mr. David A. Walker. Yes, I do, Congressman.
    And I think that, without TARP, we could easily have had 
unemployment double the current rates. There have been a few 
policy pieces written on that, maybe not as analytical as we 
would all like, but I think there was a real risk.
    The other thing was that--and this was sort of my 
perspective at the time--it was clear that Congress was 
standing up and tackling this vigorously, and I think that 
inspired some confidence. I think it may have inspired some 
confidence in international markets. Yes, we had this crisis, 
but we weren't going to ignore it, and the Congress was taking 
the lead.
    Chairman Moore of Kansas. Thank you, sir.
    My time has expired.
    Ms. Biggert, you're recognized for 5 minutes.
    Mrs. Biggert. Thank you, Mr. Chairman.
    In the Wall Street Journal today, there is a Fannie Mae 
political reckoning article, and I just want to read something 
from there.
    It says: ``The Financial Crisis Inquiry Commission spent 
yesterday focusing on financial leverage, using Bear Stearns as 
an example, but Fannie and Freddie were twice as leveraged as 
Bear and much larger as a share of the mortgage market. Fannie 
and Freddie owned, or guaranteed, $5 trillion in mortgages and 
mortgage-backed securities when they collapsed in September 
2008. Reforming the financial system without fixing Fannie and 
Freddie is like declaring a war on terror and ignoring Al 
Qaeda.''
    And then in the former panel, I asked the other Mr. Walker 
about how you would--that there were some alarming numbers 
regarding the Federal debt, especially when you account for the 
debt owed to Social Security, Medicare, and the total GSE 
liabilities.
    What should be done regarding GSE debt? Can the Federal 
Government afford to continue writing a blank check to Fannie 
and Freddie?
    Who would like to answer that?
    Mr. Geanakoplos?
    Mr. Geanakoplos. ``Geanakoplos.''
    Mrs. Biggert. ``Geanakoplos.''
    Mr. Geanakoplos. It means ``Johnson,'' in Greek.
    Mrs. Biggert. Oh, good. You must be Swedish, then. Just 
kidding.
    Mr. Geanakoplos. Yes. We should never have allowed Fannie 
and Freddie to get so big and so leveraged. The only reason 
they were able to get so big is, the government implicitly 
guaranteed their debt, so they would borrow tremendous amounts 
of money, and investors wouldn't think twice about it, when 
giving them money, because they figured that the money was good 
because the government was backing it.
    And many people called for regulation of Fannie and 
Freddie, and called for them to be--for their debt levels to be 
held lower, and called for them to be smaller, and we ignored 
those calls. And then, in fact, they did fail, and we are now 
put in the position of having to honor what was only an 
implicit guarantee.
    So we could, at one point, have--at that point, we could 
have defaulted on the debt. And a lot of it is held by China, a 
lot of it is held by American investors. We made a choice not 
to default, and now we hold the debt.
    And as you said, if you put Fannie and Freddie's portfolios 
together with all the loans they insured and so on, it comes--
plus if you put together the other government purchases, like 
through FHA, you're talking about $6- $8 trillion worth of 
mortgages that our government--debt offset by mortgages that 
our government owes.
    And the fact is, we're going to--there are going to be a 
lot of defaults. We might lose almost $1 trillion. There are 
estimates at $400 billion. It might come to almost a trillion.
    I don't know what we can do about it now. We have committed 
ourselves to back it. Unless we default on it, we're going to 
lose that money. We just have to prevent ourselves from ever 
getting in that position again.
    Mrs. Biggert. Would you agree, then, that the government 
has to get out of the business of financing or providing 
guarantees across the entire economy?
    Mr. Geanakoplos. The government can never be on the hook 
for such a tremendous amount of money.
    Right now, almost all the mortgage lending is being done by 
the government. There are hardly any other loans being done by 
the private sector.
    The government has to find a plan of not--the FHA plan is 
to loan at 3 percent down now. That's again, that out-competes 
any private lender. So instead of encouraging private lending, 
they're discouraging private lending.
    So I think that we need a different kind of initiative that 
will foster more private lending instead of government lending.
    Mrs. Biggert. Thank you.
    Then, Mr. Walker, you--given the data that you provided on 
government debt, which is alarming, would you agree that the 
government has to get out of the business of financing or 
providing guarantees across the entire economy?
    Mr. David A. Walker. I don't think we can have the U.S. 
Government get out of that activity, but I think what we really 
need to do is to make sure that the public understands, and the 
markets understand, the various aspects of the debt.
    I am guessing, if we did a survey, and let's say we took a 
survey just of people who have business education degrees, 
undergraduate and Master's, just that limited group, and we 
asked them about the role of Fannie and Freddie in terms of the 
U.S. Government, that most would say they are government 
agencies.
    We have a tremendous job to do in terms of financial 
literacy in the United States, and it's not just people who 
have had no training, in terms of understanding risk and 
leverage and things that this committee is dealing with in 
these hearings.
    Mrs. Biggert. So you would call for greater transparency?
    Mr. David A. Walker. Absolutely.
    Mrs. Biggert. We really have, what, two choices. One is 
that we would put them on a budget, as a government agency, and 
be under the controls of salaries and everything else; or, we 
would just turn them into a private, just a private company, 
and they would fend for themselves.
    Mr. David A. Walker. Either one of those would be a big 
improvement from the current environment, and the--I would put 
it on budget as soon as possible, and then think about 
gradually privatizing.
    I have done a little bit of work in some of Central 
European countries in terms of privatization, and actually have 
a paper linking privatization and fiscal deficits. And it turns 
out that, for the most part, rising privatization needs to 
accompany larger Federal deficits.
    So I'm not sure that would be translatable to 
industrialized countries, but it is something to be alerted to.
    Mrs. Biggert. Thank you. My time has expired.
    Chairman Moore of Kansas. Mr. Lee, you're recognized for 5 
minutes, sir, if you have questions.
    Mr. Lee. Thank you very much.
    I apologize for my lateness, but I'm glad to have a chance 
to hear from some of you.
    And it's ironic we're talking about deleveraging of the 
banking institutions, but one of my bigger concerns is the 
deleveraging of the U.S. Government. Among the lessons that we 
learned from the financial crisis was certainly the dangers of 
financial concentrations.
    Many institutions relied on particular investors to roll 
over the loans, and when those investors would not oblige, over 
the concerns of the leverage of the institutions, as we all 
know, failures began to result. These institutions were not 
able to finance through other investors, and began defaulting 
on their own obligations.
    When I see the Administration implementing a policy of 
borrow-and-spend, I believe there are very scary parallels to 
this situation.
    My background prior to coming here last year was running a 
manufacturing business, and I know a little bit about 
leveraging and being able to read a balance sheet. And if you 
look at our balance sheet, it's a frightening set of 
circumstances.
    Under the President's current budget, we are on plan to 
borrow 42 cents for every dollar we spend in this country. It 
is--if this was done in the private sector, I hate to tell you, 
the company would be out of business.
    In just 2 years from now, our national debt will be bigger 
than the size of our entire U.S. economy. We're talking about 
close to a $15 trillion deficit. Our debt to GDP ratio would be 
at over 100 percent. And what people forget is, Greece is at 
125 percent. We're not far behind.
    Getting to my point here, the Chinese hold a huge amount of 
our government debt, I believe in total, in aggregate, of 
roughly 7 percent. My concern is, when they decide to stop 
financing our spending, what ultimately could happen is the 
same thing that we're seeing in some of our financial 
institutions. The United States is going to have to search out 
for other investors.
    Ultimately, what we will see are higher interest rates, and 
we're looking at--when you're looking at a deficit this high, 
the interest payment alone will typically exceed what we're 
paying out, for example, in Social Security, or what we're 
doing with our national--with our defense.
    We have a policy here that the Administration is really, in 
my opinion, shying away from, and we have to get our fiscal 
house in order.
    Maybe I can start with Mr. Walker. Your concerns--do you 
agree that this is a real possibility with how leveraged the 
U.S. Government is?
    Mr. David A. Walker. Everything I know about--the numbers 
that you have posed are very accurate.
    I was surprised to hear you say the 7 percent. I thought 
the number was larger than that, but it may depend on 
calculations, for China.
    I am very concerned about the rise in interest rates, and I 
cite in my testimony, in the submitted testimony, work of the 
budget director previously writing about fiscal deficits 
causing rising interest rates. So I agree with you.
    But I don't think we had a choice. I think--
    Mr. Lee. If you were an auditor on safety and soundness, 
and you were auditing our books, would you shut us down?
    Mr. David A. Walker. No, I wouldn't shut us down. I would 
say, as the Comptroller General, former Comptroller General 
David Walker, has written extensively, that we need to make 
some dramatic changes.
    One of the things I have heard him say in other 
presentations was that we need to index the age at which people 
collect Social Security. When we started Social Security 
originally, we said people can collect at age 65, and the 
expectation was that you would live 7 years, maybe 9 years.
    Now, the expectation is, you begin collecting Social 
Security, at age 65, and you could well be collecting it for 25 
years.
    So I think, if I were the auditor--and I don't have that 
training in accounting--I would say, ``Look, we need to go back 
and make a lot of changes in how we're committing.''
    Mr. Lee. Does anybody else want to comment?
    Mr. Acharya. Yes. I just wanted to note something that 
President Hoenig actually mentioned earlier in the day, which 
is that the real danger we face is that the pattern of capital 
flows, in this case, money coming from China, is such that it 
remains very stable for long periods of time, and, boom, one 
day it will just start reversing itself.
    So--
    Mr. Lee. If that were to occur, what impact would you 
expect if that happened?
    Mr. Acharya. My sense is that it's kind of too late to do 
much at that point. I think--
    Mr. Lee. If China stopped buying our debt, what would you 
think the short-term impact would be?
    Mr. Acharya. I think the short-term impact would be a 
substantial rise in the borrowing costs, compared to what we 
have.
    There's a sense in which the flood of Chinese money coming 
in is a mixed blessing, which is that it's sort of masking, 
actually, the ``true'' cost of our borrowing.
    Mr. Lee. It's much like the housing market. When we had the 
bubble, nobody wanted to end the parade, and now we have China 
coming in buying our debt, and again, it's giving us an excuse 
not to make some hard decisions in this country.
    Mr. Acharya. Absolutely.
    Mr. Lee. With that, I appreciate your comments, and I'll 
yield back.
    Chairman Moore of Kansas. Thank you, sir.
    We're going to do a second round of questions, if that's 
all right.
    Professor Geanakoplos, you make some suggestions that, 
instead of monitoring leverage on a firm-by-firm basis, 
especially if those firms have an incentive to use off-balance-
sheet instruments to hide their true leverage and risk-taking, 
that we should monitor leverage on a transaction-by-transaction 
basis, looking at how much downpayment was used to purchase a 
security.
    Would you please, sir, explain how this might help us 
better constrain excessive leverage?
    Mr. Geanakoplos. Thank you for the question. You have put 
it exactly the way I intended it.
    Everybody who borrows money, practically, has to put up 
collateral, so if you monitor things transaction-by-
transaction, you get all the transactions. So you'll find out 
not just about a few banks, how leveraged they are. You'll find 
out something about the entire system. That's number one.
    Number two, the transaction's, I call it security leverage, 
the downpayment, is an accurate indicator of where the economy 
is going.
    If you do investor leverage, you often get the opposite 
number. So take a problem where the--like we had recently. The 
market is going down, nobody is able to borrow, precisely 
because they have to put up too much collateral.
    So the actual leverage is going down in the system, but if 
you look at one of our big banks, their leverage is going up, 
most of those institutions, because they're Lehman or Bear 
Stearns, just before they go out of business, they're running 
out of equity, and it looks like their leverage is 
skyrocketing.
    If you measure investor leverage, you're often going to get 
precisely the wrong number, so just at the moment when there's 
a crisis, and if anything you should be loosening leverage, 
their leverage looks like it's getting tighter, and the 
regulator might be led to do the exact wrong thing.
    Third, as you said, you can hide your leverage, if you're 
an institution. You put things off-balance-sheet, you can do 
all kinds of tricks. But if you're talking about an actual 
transaction, the lender is going to want protection, so there's 
going to be real collateral there, and you'll know how much it 
is. You also have two people telling you what the leverage is.
    So for all those reasons--oh, and then lastly, if you try 
to set a 15 percent rule, I think this could be quite 
dangerous. If you set a 15 percent rule for a select few 
institutions, the leverage will move. You'll have a huge 
incentive to move the leverage somewhere else, and you'll never 
be able to catch up to it. But if you're looking at it, 
security-by-security, it has to be there. It's something 
measurable.
    So I think everyone would agree that transparency is 
tremendously important. The numbers that should be published 
every month are averages of the security leverage numbers, so 
the average downpayment on a house, the average downpayment on 
a mortgage security if you buy it.
    And those numbers, if they appeared in newspapers, and 
generally speaking, people would have a much more accurate 
picture of what was going on in the economy, and the regulator 
would have pressure from the public, actually, to do the right 
thing, because everybody would know where we are.
    But if you just measure a few institutions, that leverage 
is going up and down in the wrong direction part of the time, 
depending on their profitability, and not on what the borrowing 
conditions really are.
    Chairman Moore of Kansas. Thank you.
    Does anybody else have a comment on this? Ms. Williams 
Brown?
    Ms. Williams Brown. I would like to comment on this.
    The Systemic Risk Council concept continues to be very much 
individual institution focused, but if the council is really to 
function effectively, it needs to be able to look for risk 
throughout the system, and this offers an interesting way to 
begin to try to peel that onion of looking at and identifying 
risk that may be building up in the system, that poses a 
systemic risk. So I think it's an interesting idea.
    Chairman Moore of Kansas. Mr. Acharya?
    Mr. Acharya. I would just like to add one institution that 
is being discussed, which could serve a very big role here--the 
Office of Financial Research. I think its goal should be 
exactly what John has described, which is to record the 
financial transactions which are taking place, be it issuing a 
new debt out there, doing a derivatives transaction.
    And the most important thing is that some of this 
information is being recorded right now, but no one is actually 
recording how much up-front payment or collateral is actually 
being put up when the transaction is being done.
    Even in our derivative contract records, we don't have this 
information right now, so we are relying on markets' ability to 
discipline each other, but that's leaving a lot to the market.
    Mr. Geanakoplos. Could I add one more thought on that?
    Chairman Moore of Kansas. Yes, sir.
    Mr. Geanakoplos. I would just re-emphasize that point.
    So one of the ways of leveraging the system is using 
derivatives, but this--and people say it's very hard, how to 
keep track of leverage, when there are all these derivatives 
and things.
    But actually, this transaction-by-transaction approach 
works there, too, because if you write a CDS insurance contract 
saying you'll pay if the bond defaults, you have to put up 
collateral for that, too. So we know how much collateral is 
being put up for that, as well. So you'll cover the derivatives 
case, as well as leverage moving around, and many--it's a 
principled way of getting at the problem.
    Chairman Moore of Kansas. Thank you.
    My time has expired.
    Ms. Biggert, do you have questions?
    Mrs. Biggert. Thank you, Mr. Chairman.
    Ms. Williams Brown, thank you for talking about the risk, 
as such. I hope that you would take a look at H.R. 3310, the 
Republican bill, which really addresses that issue.
    In your study of leverage, did the GAO review the current 
status of the balance sheets of the GSEs, Fannie and Freddie?
    Ms. Williams Brown. We did not include them.
    Mrs. Biggert. Can you do that?
    Ms. Williams Brown. Yes.
    Mrs. Biggert. Yes. Since Fannie and Freddie were leveraged 
twice as much as Bear Stearns, does the GAO plan to examine why 
the GSEs were leveraged to such extremes?
    Ms. Williams Brown. We currently don't have plans, and we 
haven't been asked to do that, but if we were asked to do that, 
we would.
    Mrs. Biggert. Okay. Is that because it's--there's no 
reason, it's just you haven't been asked?
    Ms. Williams Brown. Correct.
    Mrs. Biggert. Okay. Would this fall within the mandate to 
examine leverage in ESA?
    Ms. Williams Brown. It's something that we could have 
expanded the scope to do, but on this particular mandate, we 
were given a fairly short window to do the work, so we did not 
specifically include Freddie and Fannie in our study at the 
time.
    Mrs. Biggert. Could I ask you to do that?
    Ms. Williams Brown. Yes.
    Mrs. Biggert. Or, I ask you to do that.
    Ms. Williams Brown. Okay.
    Mrs. Biggert. Professor Walker, you mentioned that larger 
institutions are riskier than smaller institutions based on a 
non-deposit liability to Tier 1 capital ratio.
    Is that higher risk, level of risk due to the ``too-big-to-
fail'' status, or is there another issue there?
    Mr. David A. Walker. I didn't do calculations that I guess 
would direct me immediately to ``too-big-to-fail,'' and I think 
that, when we go through and look at individual institutions, 
of the large ones, we see some that, where this would surely be 
a problem, and others not. So I think we would have to take it 
one at a time.
    The ratio that I used struck me as a way of getting at the 
pieces of the leverage and liabilities of institutions that 
were not deposits, and I'm not assuming all those deposits are 
insured, but they are different from the other aspects of the 
liabilities, and I wanted to get a handle on that.
    I should also mention, and there's a table in my testimony 
showing this, that I broke large and small at $1 billion in 
assets, and with more time, I would take that apart and do 
considerably finer lines, to try to narrow down sort of where 
the break point would be.
    I'm guessing that it would be $10 billion or maybe even $25 
billion, where you would see the higher risk.
    Mrs. Biggert. With that, I yield back.
    Chairman Moore of Kansas. Thank you, Ms. Biggert, and thank 
you to our witnesses.
    I want to thank all of the witnesses for your testimony 
today. Today's hearing was helpful to further explore these 
important issues of debt and leverage, giving us a better sense 
of how we need to use them for responsible purposes, and not 
get carried away, putting our financial system and economy at 
risk.
    At future hearings in this series this summer, we'll be 
exploring the importance of risk management, better 
understanding short-term markets like the repo market, 
financial literacy, and other key issues.
    I ask unanimous consent that the following items be entered 
into the record: the McKenzie Global Institute's Report on Debt 
and Deleveraging; GAO and CIS reports on leverage; a paper on 
growth and debt by Professors Reinhart and Rogarth; and a paper 
on liquidity and leverage by Adrian and Chen.
    The Chair notes that some members may have additional 
questions for our witnesses, which they may wish to submit in 
writing. Without objection, the hearing record will remain open 
for 30 days for members to submit written questions to our 
witnesses and to place their responses in the record.
    This hearing is adjourned, and again, I thank our witnesses 
for appearing and testifying today.
    [Whereupon, at 12:47 p.m., the hearing was adjourned.]


                            A P P E N D I X



                              May 6, 2010


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